Where Are We Now
Updated on: 11/6/2021
CP Rail will always remain one of North America’s most important businesses. It ships the goods the economy needs to merely function using its low-cost railroad network. Without it, global trade with and within North America would undeniably suffer. We think CP Rail is a great holding for the long run, especially after recent weakness in its share price.
The company has a chance at acquiring Kansas City Southern. Although subject to regulatory approval, this acquisition would grant CP Rail with North America’s first three-coast rail network.
Although grain production has been weak in 2021, grain is a large growth opportunity for CP Rail. Plus, supply chains returning to North America means CP Rail will get more business on its critical 13,000-mile network.
CP Rail is a powerful contender of CN Rail, its closest competitor, boasting a dense east-west network in North America and industry-leading operating margins.
CP Rail obtains its competitive edge from its fortress position as a massive railroad incumbent, short routing options, innovation and technology, and bulletproof balance sheet.
The proposed acquisition of Kansas City Southern ("KCS") would expand CP Rail's market reach and provide new competitive transportation options. If approved, the merger will create the first US-Mexico-Canada rail network.
CP Rail's profitability improvement has been nothing but impressive over the years. With the improved network efficiency and disciplined operating mindset, CP Rail has a best-in-class position to grow whether the KCS acquisition is approved or not.
On October 3, 2001, CP Rail spun out its five subsidiaries into separate companies. As a result, CP Rail is fully independent and publicly traded on both the Toronto Stock Exchange and the New York Stock Exchange. Today, CP Rail offers transportation services and supply chain expertise with access to eight major ports and key markets across North America.
In Canada, CP Rail operates in a duopoly alongside Canadian National Railway. CP Rail also operates in a highly competitive and consolidated North American market among six other major railways:
Canadian National Railway
Union Pacific Corporation
Norfolk Southern Corporation
Kansas City Southern
CP Rail Revenue by Segment (Q3 2021)
Source: CP Rail Investor Relations
CP Rail’s revenue sources come from two main segments. Freight revenues make up the majority of the total revenues, with non-freight revenues contributing to the remainder.
CP Rail’s freight segment breaks down further into nine product categories:
Fertilizers and sulphur
Energy, chemicals and plastics
Metals, minerals and consumer products
Freight Revenue by Product (Q3 2021)
Source: CP Rail Investor Relations
CP Rail has enjoyed solid growth throughout the last decade.
Revenues have grown at a low single-digit compounded annual growth rate ("CAGR") throughout the last decade, which includes the slow economic period around 2016 and the COVID-19 pandemic in 2020. Despite the capital-intensive and competitive nature of the industry, CP Rail has maintained exceptionally high industry-leading operating margins in recent past, showcasing the brute strength of its business.
CP Rail Revenue ($M) (Q3 2021)
CP Rail Operating Profit ($M) (Q3 2021)
The Geographical Fortress
CP Rail owns a railroad network in North America that connects the Canadian east and west coasts, as well as several Midwest US states.
With access to eight major ports and key markets across North America, CP Rail is able to carry a wider variety of goods compared to its competitors. Additionally, vast geographical coverage also means CP Rail's customer base and business mix is quite diversified.
The geographical fortress shows through in CP Rail's financials. Revenue ton miles (i.e., "RTM" or revenue earned for carrying one ton of freight over one mile) and freight revenue per RTM have been rising steadily. Demand for shipping goods on CP Rail's railroad network is rising, causing rates for each ton mile to consistently increase over time.
CP Rail Revenue Ton Miles (Millions) (Q3 2021)
Source: CP Rail Investor Relations
CP Rail Freight Revenue per RTM (Cents) (Q3 2021)
Source: CP Rail Investor Relations
Unless the industry were to de-consolidate, high barriers to entry will likely always exist. It is simply unfeasible for any new entrant or eager entrepreneur to obtain, spend, and expect a reasonable return on billions of dollars of capital spend each year.
Capital expenditures for maintenance and growth are in the billions for CP Rail. The industry is also heavily regulated, especially in the US by the Surface Transportation Board ("STB"), meaning large upfront expenses must be incurred by new entrants to obtain regulatory approval to build a rail network.
Adding to the list of issues in entering the market is the utter lack of opportunities to consolidate operationally and the stringent regulatory environment in place that discourages mergers and acquisitions ("M&A") in an already-consolidated industry. New entrants likely have negligible opportunities to partner with, or purchase Class I railroads in North America.
Where its rails currently exist, there is next to no chance a new entrant can uproot the massive industry incumbent, CP Rail, plain and simple.
Lowest Cost Wins
Even though aircrafts, trucks, and ocean liner transportation businesses compete with railroads, railroads are the lowest-cost option in areas where no efficient waterway connections exist. This is especially true with bulk commodities, CP Rail's largest business segment.
CP Rail's dense and vast 13,000-mile network makes it almost impossible for new entrants to compete based on its low marginal costs and ability to allocate capital towards growth opportunities and technology. Lowest cost wins.
Time is Money
In contrast to its closest competitor, CN Rail, CP Rail boasts a network with plenty of short routing options for customers to choose from in key lane areas. For example, CP Rail connects Vancouver to the US Midwest, Chicago and Detroit, and the East and West Canadian coasts with shorter transportation services than CN Rail.
In addition to these short routing options, CP Rail also has a plethora of connections with other Class I railroads in Canada and the US. It does not end there — CP Rail partners with smaller short-line partners to expand its reach, provide exceptionally efficient services to customers, and make sure customers are getting the most bang for their buck.
In our consumer-centric part of the world, time is money. As a result, we believe CP Rail's short routes in key lanes is an underrated competitive advantage from which pricing power can be drawn.
The Innovative Railroad
CP Rail recognizes that the leading transportation services of tomorrow must invest in technology and streamline operations today.
The company's high margins are supported by its efforts to nail down incredible performance. CP Rail operates under a precision railroading using such methods like Precision Scheduled Railroading ("PSR"), a strategy using point-to-point stops across its network of track and terminals to pick up and drop off train carts.
CP Rail also created the Railway Performance Monitoring ("RPM") and Trip Plan systems. The former allows it to increase the volume of deep internal performance data and the latter helps CP Rail keep track of shipments from pick-up to drop-off.
PSR, RPM, and Trip Plan are some of the efforts that collectively contribute to CP Rail's exceptional operating performance. Over the past few years, train speed, terminal dwell, train weight, and train length are all trending in directions that imply better services and more value to customers.
Other notable technologies leveraged by CP Rail include:
Predictive Analytics — big data analytics to anticipate issues and prevent service interruptions and damage.
Intermodal Demand Management — smoothing demand across the week based on customer delivery requirements to prevent bottlenecks.
Mobile Workforce — use of mobile devices to automate inventory management and provide crews with safety documents at a whim.
CP FastPass — self-serve kiosks and mobile apps that reduce time spent by drivers at terminals dropping off or picking up loads.
Robotic Process Automation — automation of repetitive, high-volume tasks to save time and money.
Track Asset Management — inspection application providing broad view of overall track conditions and health.
These efforts, in conjunction with consistent reinvestment to improve processes and technologies, mean that CP Rail is able to inspect tracks and railcars quickly, improve safety, save on input costs (e.g. fuel), and provide a better service to customers at the end of the day. These efficiencies are exemplified in CP Rail's financials — the company has the best margins of all the Class I railroads.
We expect operating metrics to continue to improve throughout the intermediate time horizon as these efforts translate into efficient spending and growing revenues.
Room on the Balance Sheet
Despite the capital-intensive nature of the industry, CP Rail is (surprisingly) in a very strong financial position. Competition is fierce and capital expenditures for growth are on the forefront of the railroads' priorities, but CP Rail still has a low amount of net debt (total debt including leases less cash) as a multiple of EBITDA.
CP Rail's leverage ratio has been declining due to disciplined cost management, margin expansion, top-line growth, and prudent capital allocation.
We believe these efforts are bearing fruit, giving the company financial optionality to take on large projects and investments without being overburdened by intolerable levels of debt. We think investors should be excited in this regard.
Deal of the Century
Earlier this year, CP Rail's proposed acquisition of KCS for US$29.0 billion fell apart after CN Rail approached KCS with a ground-breaking US$33.6 billion rival offer. However, it later became uncertain whether CN Rail's offer would pass regulatory approval after the STB rejected CN Rail's plan to use a voting trust on August 31, 2021.
Consequently, KCS accepted CP Rail's raised bid of US$31 billion made in August due to greater deal certainty after the STB had already approved CP Rail's request for a voting trust in early 2021. On September 15, 2021, CP Rail and KCS entered into a merger agreement.
This merger, if ultimately approved by regulators, will create the first US-Mexico-Canada rail network that would expand the consolidated company's market reach and provides new competitive transportation options to customers. According to CP Rail's statement, CP-KCS will also seek to improve on-time performance under their respective PSR programs and create annualized (expected) synergies of approximately $1 billion over the next three years.
Overall, we think the CP-KCS deal will create huge potential from a strategic perspective and the combination will bring in meaningful opportunity by CP Rail:
becoming the first tri-coastal rail network in North America and the first to connect Canada, the US, and Mexico with one continuous railroad;
complementing its current network by making business easier for customers to ship goods across the continent using one major Class I railroad;
capturing synergies and creating a more efficient network; and
directly obtaining new business and further diversification through new growth opportunities, such as the Mexican automotive business (automotive represents a very small portion of CP Rail's revenues).
CP is currently in the process of compiling and submitting its merger application to the STB for the acquisition of KCS. The STB will review this application and consider the public interest, pricing, customers, and the future of the network and its consolidation. Because Class I railroads are so large and possess lots of pricing power stemming from their massive networks, we expect regulators to scrutinize and question CP Rail's pitch to a great degree.
Nonetheless, we are hopeful the deal will close in late 2022 due to the following non-exhaustive list of reasons:
the two railroads are highly complementary and have no overlapping sections of rail;
if combined, CP-KCS would still be the smallest Class I railroad;
realizing synergies and gaining efficiencies should theoretically put a cap on prices over a longer time period; and
having direct access throughout North America on one connected railroad should be an extremely powerful proposition that would mainly benefit customers.
We cannot emphasize enough that we are not experts on the STB and regulation surrounding transportation consolidation. While we think there are compelling reasons for the deal to close, this deal could also go the other way. We caution investors to consider our stance with a grain of salt and maintain an open mind to a wide range of potential outcomes.
Should this deal close, we believe it is reasonable to assume this would be the last major M&A deal in the industry for some time. It's possible CP Rail just secured the deal of the century.
Space to Grow
Literally and figuratively, CP Rail has the space to grow internally even if CP-KCS is rejected in the end by the STB.
Management points to three foundational areas that could be expanded or built upon to absorb higher freight demand:
Excess train capacity and ability to increase train length
Network and terminal capacity
CP Rail owns about 2,100 acres of vacant land and a number of adjacent underutilized buildings across its network. With minimal investments, these properties can be spruced up to meet a variety of new and emerging needs, such as:
growing existing intermodal capacity in Vancouver, Canada's largest trade gateway;
co-locating customers for efficient access to rail; and
general capacity buildout and repurposing.
The closure of CP-KCS would undoubtedly be a huge long-term win for the company as reshoring, near-shoring, and de-globalization pick up steam. However, having internal capacity growth opportunities is even more important.
If offshore manufacturing operations return to North America (or close to it) in large quantities, it would be a shame if a railroad is already running at maximum capacity. Not only would the company miss out on net new contracts, it would also lose share to competitors. CP Rail is in the fortunate position to have a once-in-a-lifetime acquisition opportunity (KCS) as well as vast capacity buildout opportunities to ensure it gets its fair share of the reshoring and near-shoring demand.
We are encouraged by the ample internal growth and capacity buildout opportunities identified by management, alluding to the team's ability to think out far into the future. As a railroad that consistently achieves a return on invested capital ("ROIC") around the 15% mark, we also believe CP Rail's investments to expand capacity and grow will pay off and result in value creation for the company and shareholders.
Although CP Rail's leverage ratio will expand drastically if the CP-KCS closes, the company's balance sheet is exceptional and allows for room to reinvest and grow. Over the long run, we think CP Rail is a fantastic anchor holding in a diversified portfolio.
Perfecting the Product Mix
CP Rail has a well-diversified product mix from which it makes large chunks of money from bulk, merchandise, and intermodal transportation services. We would like to specifically point out the growing grain and fertilizer market to which CP Rail has a higher gearing as a proportion of its revenues than CN Rail.
Besides the pain Canadian grain producers are facing due to harsh drought-like conditions sweeping through Western and Central Canada, grain production is rising with increasing demand from Asia.
Since the early 2000s, grain production has been steadily growing in Canada and is not expected to stop anytime soon.
CP Rail's physical presence and dense networks in and around the Canadian and US large crop-growing zones renders the company as one of the best transportation services for grain producers.
However, CP Rail is not settling for "good enough" — it is actively investing in the future of grain transportation.
In pursuit of building greater grain elevator and train capacity to meet growing demand, CP Rail is working with customers to upgrade existing grain supply chains to support high-capacity 8,500-foot trains, called High Efficiency Product ("HEP") trains. Today, less than half of the grain elevators CP Rail serves handle the new HEP trains, a large opportunity for expansion and ability to open up Canadian grain business to the world.
In contrast to the low-capacity 7,000-foot trains, HEP trains can increase grain volume per train by over 40%. By the end of 2022, CP Rail expects to have 7,400 high-capacity hoppers in service, a substantial overachievement of the four-year target of 5,900 hopper acquisition goal set out in 2018.
CP Rail is a crucial member of the North American supply chain as a transportation service that connects the continent with the rest of the world, and vice versa. Investments like these result in pricing power tomorrow — greater efficiency, reduced shipping times, and increased capacity help drive the premium value proposition that is inherent in CP Rail's current and future rail network.
While we believe the CP-KCS merger will bring various opportunities to the table, it also carries potential pitfalls. Given the fact that CP Rail offered a premium to purchase KCS and subsequently raised its bid as the feud with CN Rail picked up, it exposes CP Rail to the risk of "overpaying" — not realizing the full synergetic potential it had originally set out to obtain and ultimately destroying shareholder value.
The timing of these synergies are also uncertain and may not materialize. Nonetheless, we are optimistic on the prospects of the combined company should the STB ultimately grant full acquisition approval.
Most of CP Rail’s revenues are generated from freight, which include commodities from industries that fluctuate with the market. When the economy does poorly, or any of these sectors struggle, CP Rail’s financials could face strong headwinds in the near term.
CP Rail's heavy exposure to grain can also result in near-term performance weakness compared to peers. Western Canada is facing poor growing conditions. Low crop yields may mean that CP Rail will have substantially less product to ship, hurting the top and bottom line to a potentially large extent.
Since CP Rail carries freight for chemical and energy, it exposes CP to legal liability if any of the hazardous material leaks or spills and harms the immediate environment.
In addition, Joe Biden’s recent executive order issued to the STB to examine rail competition may set a new precedent in the market that puts consolidation further out of favour and hurts profitability for the railroads, including CP Rail.
CP Rail has been a major player of the railroad and transportation industry since 1881. It is Canada's first transcontinental railway and among the ten largest companies in Canada by market capitalization. Moreover, CP Rail is one of two Canadian railroads and one of seven North American railroads that were rated Class I.
Originally founded to connect Canada, CP Rail today carries the mission to connect North America and the world. The company is arguably the best in the industry, thanks to its moat, innovation and technology, and vast network of customer-favourite railroads. These competitive advantages allow CP Rail to continuously thrive in the current market and take advantage of opportunities ahead.