Canadian Pacific Kansas City Is on the Right Track

Put majestic forests, hockey, southern BBQ and this year’s Super Bowl LVII champ in a blender, and you get Canadian Pacific Kansas City Ltd. NYSE: CP. The mouthful of a company is the combination of Calgary-based Canadian Pacific railway and K.C.-based rail operator Kansas City Southern. It is the caboose in a long line of railroad industry mergers and takeovers.

Much has changed since American railroads ferried soldiers across the country during World War II. For one, the automobile soon took over as the main source of public transportation, sending rail ridership downhill. This set off a wave of consolidation that has persisted to the present day.

Dozens of railroad mergers and acquisitions have been completed since the 1940s, in part to keep the industry relevant in a tech-driven world of airplanes and electric vehicles. And while railroads aren’t the nation’s biggest revenue producer as they were in the early 20th century, they still play a vital role in modern supply chains. 

Food, construction materials, energy, chemicals and (ironically) automobiles are hauled around the country 24/7. Approximately a half million carloads and intermodal units buzz through rail networks each week. Billions of dollars are being invested to make freight railroads a safe and cost-effective transportation solution for the future of American industry. 

The Federal Highway Administration estimates that from 2020 to 2050, U.S. freight volumes will increase 50%. Yes, some 100 years after WWII, railroads will still be important.

Despite all the M&A activity, there are more than 600 U.S. and Canadian railroad companies. Among the biggest is Canadian Pacific Kansas City (CPKC). After federal regulators approved the $31 billion deal in March 2023, it became the first railroad to operate across North America, linking the U.S., Canada and Mexico.

On April 26th, a week after the merger was finalized, CPKC reported quarterly results for the first time as a transcontinental railway. Let’s just say, it is full steam ahead.

How Did Canadian Pacific Kansas City Perform in Q1?

First-quarter revenue rose 23% year-over-year to $1.7 billion, aided by an 11% jump in freight volume. Adjusted earnings per share (EPS) jumped 26% to $0.67. The fact that profit growth outpaced revenue growth is a major positive because it shows that CPKC was able to grow sales beyond its higher costs. Management’s three-year financial targets include a 1% decline in annual operating expenses, a goal it missed last year but is off to a good start in 2023.

Another key performance indicator in the railroad industry is revenue ton-miles (RTM). Last quarter, CPKC posted a 7% increase in RTM, which marked a slight slowdown from 8% growth in the fourth quarter of 2022 — but is still solid. The uptick was led by higher coal revenue as well as strong performances from automotive, forest products and potash.

The market reacted favorably to CPKC’s latest results, and its shares have continued to trend higher. Thanks to an 11% year-to-date advance, the stock is closing back in on its March 2022 record high. With all the buzz around the merger and its potential synergies, CPKC is outperforming Canadian National Railway — and is miles ahead of Norfolk Southern in 2023. 

Is Canadian Pacific Kansas City a Good Stock?

With a combined 20,000 miles of railroad tracks, CPKC is an interesting way to invest in the North American economy. While its transport volumes generally ebb and flow with broader economic activity, it does have a unique defensive flair. Since grain shipments are the largest revenue contributor, constant demand for food commodities can help it outperform during macro weakness. The stock has a 1.0 beta, which means it moves roughly in line with the S&P 500.

Where CPKC differs from the S&P 500, however, is valuation. Based on expected EPS over the next 12 months, the P/E ratio is 24x. This represents a premium to the S&P’s 18x forward P/E. 

The stock pays a 0.7% dividend that is well below the S&P yield. Yet, with a payout ratio of only 15%, there is plenty of room for dividend growth on this train.

So to like CPKC here, investors must believe that the valuation is attractive relative to the growth ahead — and forgo the higher dividends available from Norfolk Southern, Union Pacific and other peers. 

In a class of its own as North America’s only transcontinental railroad, CPKC probably has above-industry growth prospects that stem from its ability to serve customers with both U.S. and Canadian operations. Combined with a below-industry debt load, strong fundamentals could keep this stock chugging to new all-time highs.