2023-07-14 18:15:39 ET
Summary
- Canadian Pacific Kansas City Limited, formed by the merger of Canadian Pacific and Kansas City Southern, is set to benefit from economic reshoring and post-merger synergies in all North American nations.
- The company aligns with Mexico's vision for economic growth, capitalizing on near-shoring opportunities and increased exports to the U.S.
- Canadian Pacific Kansas City Limited expects significant growth, double-digit earnings per share increase, and strong shareholder returns while maintaining a solid balance sheet. I consider the company to be undervalued with high growth potential.
Introduction
In 2014, Paul Richards, who was head of FX at UBS Group AG ( UBS ), went on CNBC to explain why he was so bullish on stocks and the dollar. He made the case that he was so bullish it hurts .
CNBC
Back then, some people made fun of it, as it was a hilarious way to explain one's view on the market - his call also turned out to be correct.
Having said that, I always wanted to use this in an article title.
This article is the perfect opportunity, as I am extremely bullish on Canadian Pacific Kansas City Limited ( CP ) , one of my largest investments.
The railroad, which is the result of the merger between Canadian Pacific and Kansas City Southern earlier this year, is poised for greatness. While investors have priced in a lot of growth, we're dealing with one of the most fascinating companies in North American logistics.
I believe that CPKC can benefit from economic reshoring like no other company. It is also in a great spot to generate tremendous post-merger synergies by offering new routes, getting trucks off the roads, starting new partnerships, and connecting Canada, the U.S., and Mexico, in a highly efficient way.
In this article, we'll discuss all of this, using the recent investor conference as a basis.
But before I continue, I wanted to quickly note that the Kansas City Southern name is also visible in the screenshot above - I found that quite an interesting coincidence.
Anyway, let's get to it!
So Much Long-Term Potential
While I like every railroad in my portfolio and every long-term investment, CPKC has a special place in my heart because it goes so well with various of my long-term views.
The most obvious benefit is that CPKC is now the first - and only - railroad to connect all North American nations. While railroads like Union Pacific ( UNP ) also do business in all nations, it's mainly done through partnerships. CPKC has access to all nations with its own trains.
On a side note, CPKC revealed its new livery on June 23. Trains.com reported on this news. While it doesn't impact my thesis, I wanted to mention it, as a lot of train enthusiasts were waiting for news regarding the new train livery.
Going back to the merger benefits, during the June investor conference, CEO Keith Creel highlighted the importance of Mexico in CPKC's investment thesis, particularly due to near-shoring and changing global dynamics.
The reliability and talent of the Mexican labor force, along with the ability to de-risk supply chains, have contributed to the growth potential in the region.
I also have the data to support these comments. For the first time in 20 years, Mexico is exporting more goods to the U.S. than China (on an unsmoothed basis). This is a perfect confirmation of the reshoring thesis I have discussed on Seeking Alpha since 2020.
Furthermore, the alignment of CPKC's interests with President Obrador's vision for job growth and economic prosperity creates a unique opportunity for success.
After all, Mexico isn't just letting restoring happen. It wants to capitalize on it by boosting its economy on a sustainable and long-term basis.
Using Morgan Stanley ( MS ) data, CPKC believes that $155 billion of additional exports to the U.S. (from Mexico) are a high likelihood over the next five years, further supporting the virtuous cycle.
For example, as near-shoring grows, there is a corresponding increase in capital expenditure to expand manufacturing capacity in Mexico.
This strengthens the local supplier base and encourages further companies to pivot to Mexico. The cycle continues as Mexican exports increase, drawing in more CapEx and reinforcing the enduring near-shoring opportunity.
To improve its services in the region, CPKC announced the acquisition of the Meridian & Bigbee Railroad ("MBNR"), which includes 50 miles of track from Meridian, Mississippi, to Myrtlewood, Alabama, as well as a lease arrangement for the next 117 miles to Montgomery, Alabama, which is currently owned by CSX Corp. ( CSX ).
Trains.com
The goal is to optimize the capacity and create a second alternative to the existing best-in-class service east of Meridian. The strategic move allows CPKC to connect with CSX customers and provide more options for supply chains, particularly in the growing Southeastern region of the United States.
This is a win for customers in the region, for CPKC, and for CSX.
All of this is part of a business transformation that started well-before CP announced its plans to buy Kansas City Southern.
John Brooks, the CMO of CPKC, made the case that the company is a marketing and sales-driven company that underwent a shift to become operationally driven in order to pivot to growth.
Despite being the smallest railroad among its Class I peers, CPKC successfully achieved significant growth through unique solutions, competing against larger networks. While the graph above is far from scientific (no visible y-axis), there is a lot of other data to back up that CP has been the best railroad.
Over the past five years, CP has been the best performer, beating the market and all of its peers on a total return basis.
Also, during the investor conference, Mr. Brooks identified four critical elements that contributed to CPKC's success:
- sales and marketing culture,
- high-performance sales team,
- constructive tension,
- and monetizing land assets.
He mentioned that these elements will continue to be key in CPKC's future growth strategy.
To be more precise, the company identified opportunities amounting to $5 billion.
These opportunities are categorized into:
- rail-to-rail,
- truck-to-rail,
- industrial development and near-shoring,
- and other self-help areas.
In the rail-to-rail segment, the company sees the potential for share shift and direct route conversion, where CPKC aims to attract customers who have been locked into using other rail providers.
The truck-to-rail conversion also presents a significant opportunity, with an estimated $1.8 million addressable truck market. This also includes environmental tailwinds, as rails are much more efficient than trucks. So, in order to make supply chains more sustainable, companies can prioritize rail transportation.
As written earlier this year :
The merger application for Canada Pacific ("CP") and Kansas City Southern ("KCS") rail, green-lit by the Surface Transportation Board ((STB)) just last week, promises to take 64,000 long-haul truck shipments off the road each year, and the Biden administration will most likely hold them to that.
The charts below show that CPKC has a lot of overlap with busy trucking routes.
CCJ Digital
The company also sees industrial development and near-shoring opportunities, which includes attracting investment and the potential for infrastructure development.
So far, this is also turning into reality, as spending on manufacturing construction has exploded in the United States.
Wall Street Journal
Lastly, the other self-help category involves creating new markets, extending reach through transloads, leveraging short-line partnerships, and improving business discipline.
Adding to that, even China is benefitting from Mexico, as China is moving some production to Mexico as it wants to be protected against (future) tariffs on Chinese goods.
Lastly, I am also a huge fan of the tailwinds that applied to CP before the merger with KSU was even a thing. This includes its massive footprint in agriculture (grains and fertilizers), coal, and port/intermodal expansions in Canada.
Future Growth & Shareholder Returns
Thanks to the aforementioned tailwinds, CPKC anticipates significant value creation and free cash flow generation over the next five years, aiming for about 90% free cash conversion.
Return on invested capital ("ROIC") is expected to return to double-digit levels, while earnings per share are projected to DOUBLE during the 2024-2028 period.
Bear in mind that the company expects to boost growth while capital spending is expected to remain relatively flat over the next five years at around C$2.6 billion to C$2.8 billion, which is great news for free cash flow growth.
In 2025, expectations are that free cash flow could exceed C$4.2 billion, which would be more than 20% above the expected 2024 result.
Furthermore, the projected synergies extend beyond the initial $1 billion expected over the first three years, with a larger scope and longer runway.
As both Canadian Pacific and Kansas City Southern operate under a Precision Scheduled Railroading model, further cost synergies are anticipated.
Also, CPKC aims to optimize its workforce and improve train speed, dwell time, locomotive productivity, fuel efficiency, and procurement practices to drive operating leverage and cost savings.
So, what does this mean for shareholders?
During the aforementioned investor conference, CPKC explained that it had reduced leverage and expects to reach a 2.5x leverage ratio in 2024.
Adding to that, the pension plan is in a solid position, with no significant cash usage.
With the potential for approximately 90% free cash conversion, CPKC expects to revisit its shareholder return strategy in the future, with a historical preference for share buybacks.
Shareholder returns will be balanced by maintaining a BBB+ rating and protecting the balance sheet.
In 2024, I also expect a significant dividend hike, as CP currently yields less than 1% with a high likelihood of subdued leverage at the end of 2024.
Valuation
I do not believe that CP is overvalued.
While CP has the highest forward EV/EBITDA multiple, it also has the most growth opportunities.
For example, between now and 2025, the company is expected to boost annual EBITDA from C$6.6 billion to C$8.8 billion. That's 33% growth without incorporating potential cyclical growth tailwinds.
After that, growth is expected to remain high, as the company aims for high-single-digit annual revenue growth. Again, others cannot compete with that.
Using 2025E numbers, the company is trading at 13x EBITDA. While I am using numbers that are more than two years into the future, I believe it's fully warranted because CP is the only company in its industry with significant secular tailwinds.
Making valuation assumptions based on short-term expectations would be plain wrong.
Paying 13x 2025E EBITDA isn't deep value, but it's far from overvalued.
I would make the case that it's a good deal, which is why I expanded my position by more than 10% last week.
Takeaway
Being so bullish on Canadian Pacific Kansas City that it hurts, I see tremendous potential for this railroad company. The merger between Canadian Pacific and Kansas City Southern positioned CPKC as the first and only railroad to connect all North American nations, capitalizing on economic reshoring and synergies.
With Mexico's growing exports to the US, CPKC is in a prime position to benefit from near-shoring and capitalize on President Obrador's vision for job growth and economic prosperity.
The company's strategic acquisitions, marketing-driven approach, and identified growth opportunities further support its success.
With expectations of significant value creation, free cash flow generation, and double-digit EPS growth, CPKC aims to deliver strong shareholder returns while maintaining a solid balance sheet.
As a believer in CP's growth prospects, I've expanded my position, and at 13x 2025E EBITDA, CP represents a compelling investment opportunity.
If economic growth indicators bottom, I believe that Canadian Pacific Kansas City Limited shares could experience a violent breakout above $85.
FINVIZ
For further details see:
Canadian Pacific Kansas City Limited: I'm So Bullish, It Hurts