2023-12-01 10:11:21 ET
Summary
- Canadian Pacific Kansas City Limited is an attractive compounder in the industrial sector.
- Class-1 railroads have wide moats, making it difficult for competitors to disrupt them.
- CP has the potential to compound its free cash flow at a 20% annual rate over the next 5 years.
I just bought shares of what might be the most attractive compounder in the industrial sector: Canadian Pacific Kansas City Limited ( CP ).
Not long ago I published an article highlighting my bullish outlook on one of CP's peers, Canadian National Railway ( CNI ).
Since then, I've built up a sizable position in CNI and I hope to continue to buy those shares so long as they trade below my fair value estimate in the $115 area.
In that piece, I noted that I like the railroad industry so much because of the extremely wide moats that class-1 railroads have.
At this point in time, it would be nearly impossible for a competitor to enter into this industry at scale.
Class-1 railroads are defined by annual sales; they must generate at least $250 million in revenue to quality.
After 100+ years of consolidation, there are only 7 class-1 railroads left:
-
Amtrak
-
BNSF Railway (owned by Berkshire Hathaway) ( BRK.A )/( BRK.B )
-
Canadian National Railway
-
Canadian Pacific Kansas City ( CP )
-
CSX Corp. ( CSX )
-
Norfolk Southern Corp. ( NSC )
-
Union Pacific Corp. ( UNP )
These companies represent an oligarchy for the most efficient way to move massive goods/people overland.
Railroads are much more fuel-efficient than trucks, for instance.
Union Pacific highlights this on their investor relations website, stating , "In fact, trains can haul one ton of goods an average of more than 480 miles on just a single gallon of fuel, making them 3-4 times more fuel efficient than trucks."
And looking at industry trends, I don't think this advantage is going to change anytime soon.
Like the trucking industry, railroads are looking into electronic and hydrogen fuel cell technology to bolster their fuel efficiency.
And ongoing advances in precision scheduled railroading ((PSR)) is leading to lower idle times, longer/larger trains, and faster train speeds, widening the gap with other, overland alternatives.
Honestly, I think it's impossible to predict what a very futuristic society will look like.
But, even if in 50-100 years we're living in a world that resembles settings in science fiction IP like Star Wars or The Jetsons, I still think railroads will be playing a major role in the transport industry.
Those long-term tailwinds, alongside the best-in-breed railroads' strong competitive positioning, and my belief that secular trends such as the reindustrialization of America (driven by onshoring and near-shoring of manufacturing and supply chain management in response to the pandemic and other growing geopolitical issues that are hurting globalism) has increased my desire to own North American railroads.
In a recent shareholder presentation, CP highlighted a slew of industrial development projects announced along its routes.
CP 2023 Investor Day
And with all 3 North American trade partners expressing desire to enhance their manufacturing output, I suspect that this trend will continue for years (decades, really) to come.
Well, of these 7 class-1 players, only 1 of them owns a track that spans the entire continent (Canada, Mexico, and the US). You guessed it: The company is Canadian Pacific Kansas City Limited.
This company's assets connect to major seaports on both coasts, as well as in the Gulf of Mexico, and serve as a mission-critical economic vein from Veracruz up to Vancouver.
CP 2023 Investor Day
So, I think CP makes a really nice counterpart to my CNI stake, rounding out the railroad exposure in my portfolio nicely.
Canadian Pacific Kansas City Limited: Primed For Double Digit Growth.
CNI remains my largest position in the railroad industry because of its attractive dividend yield, dividend growth history, and attractive valuation.
CNI shares are trading for roughly 19.5x my 2024 EPS expectations, and unlike both Union Pacific (which is my favorite domestic railroad with a much larger market cap and an A-rated balance sheet) and Canadian Pacific Kansas City, CNI has maintained its positive dividend growth trajectory.
Dividend growth is my top priority when investing my hard-earned dollars, so it shouldn't come as a surprise that my CNI stake is more than twice the size of my newly established CP position.
However, CP has something that CNI and UNP do not have: The realistic possibility of compounding its free cash flow at a ~20% annual rate over the next 5 years or so.
During their annual investor day presentation, CP guided towards "double-digit core adjusted EPS growth" from 2024-2028.
They also touched upon 90% FCF conversation, as well as double-digit ROIC results, both of which I love to see.
CP 2023 Investor Day
Not only does CP expect its top and bottom lines to post strong growth over the next 5 years…management is focused on keeping costs down.
Capex should hover right around 2023 levels throughout the next 5 years…and when earnings are rising, but capex is staying the same, free cash flow soars.
CP 2023 Investor Day
As I told subscribers…anytime that I see a wonderful company posting guidance calling for a 15-20% FCF CAGR, I become very interested in owning shares.
That's especially the case when I think strong dividend growth in on the way.
CP has frozen its dividend since 2021 due to the lengthy M&A process associated with their Kansas City Southern merger.
Shareholders of both companies approved this $31 billion merger back in 2021; however, it wasn't officially approved by regulators until March of 2023.
This approval process created a lot of uncertainty for management, so I don't blame them for being conservative with the dividend.
This acquisition also added a lot of debt to CP's balance sheet (see CP's long-term debt trend below).
Macrotrends
(Blue columns represent billions of long-term debt)
CP's debt-to-equity ratio wasn't damaged by the KSU deal because of the assets it picked up in the process; however, its over-leveraged ratios, such as net debt to EBITDA were initially worrisome to me.
In a low interest rate world, leveraging debt can have a really positive impact on a company's financials and earnings results. But, with interest rates rising rapidly during 2022/2023, I've been hesitant to add to highly indebted companies. If/when they decide they need to refinance this debt, interest rate expenses could be harmful to dividend safety. But, in CP's case, I believe that compounding cash flows will more than offset this potential headache.
CP 2023 Investor Day
I like management's plan to lower its leverage ratio with conservative capex as the synergies from the KSU deal kick in.
I also appreciate their commitment to their investment grade credit rating and moving forward, I think CP has the potential to receive credit upgrades which would bump their credit scores up into the A-rated category alongside peers CNI and UNP (right now, CP's S&P credit rating is BBB+, which is the same as CSX's and NSC's).
Valuation
I don't consider CP to be best-in-breed (that title goes to CNI); however, I think the financial data speaks for itself with regard to CP's overall quality.
This is a blue chip stock with incredibly strong growth prospects now that the KSU deal is complete and after CP's -12% performance during the trailing twelve months, I think the shares are attractively valued.
Right now, CP shares trade with a 25.7x blended P/E ratio attached. That might seem high to some (especially since CSX and NSC trade in the 17x area). But, no other class-1 railroad has similar growth prospects and I think that the double-digit bottom-line growth guidance that management provided in its long-term outlook means that these shares deserve a premium.
FAST Graphs
Yes, CP is trading above its long-term average P/E of ~19.4x, but stocks trade on expectations of forward cash flows.
If double-digit EPS growth occurs over the next 5 years it won't take long for the stock's fundamentals to justify today's multiple.
If CP grows its EPS at a 12% annual rate moving forward, it'll double its EPS in 6 years' time.
If that EPS growth rate is closer to 14%, it'll take only 5 years.
I expect to see full-year 2023 EPS to come in around $2.80.
Therefore, looking at CP's 2028 guidance, I don't think it's absurd to assume nearly $6.00 in earnings 5 years down the road.
Right now, CP's dividend payout ratio is approximately 20%.
That's in line with the company's long-term average (over the last 20 years, the average of CP's year-end payout ratio is 22.4%).
Place a 22% payout ratio on $5.60 (2x 2023's $2.80/share expectation) in earnings and you're looking at a $1.23 annual dividend.
That's roughly twice the size of today's $0.56 annual payment.
Yes, these numbers are USD figures and there will always be forex risk when owning a foreign stock; however, I don't fear USD/CAD volatility.
CP has outperformed historically with these forex concerns in play and moving forward, I don't think that's going to change.
With all of this in mind, today's $71/share price doesn't seem pricey.
Actually, there's an argument to be made that shares are cheap.
I don't want to look too far down the road when evaluating CP because I know that a lot of unexpected events can happen between now and 2028.
But, I think the company's 2024/2025 growth outlook is likely to occur with synergies from the KSU deal coming into play and with that growth in mind, I think a 22x multiple is fair.
22x the consensus earnings estimate of $3.23/share next year is $71.06.
I think CP is likely to beat those expectations (this company has beaten Wall Street's EPS estimate during 13 out of the last 20 quarters).
With that in mind, I think $71.50 is where fair value lies and taking a page out of Warren Buffett's book, I was happy to pay what I believed to be a fair price for a wonderful company.
Assuming CP meets EPS growth expectations, even in the event of multiple contraction from 25x to 22x between now and 2025, the company will still generate a total return CAGR of nearly 10%.
And, if I'm being overly conservative here and CP continues to trade for 25x, then the bottom-line growth that analysts expect would lead to a total return CAGR north of 17%.
Conclusion
When CP's bullish growth guidance is combined with negative sentiment in the market, leading to relative underperformance…well, I couldn't help but pick up shares of a beaten-down blue chip.
CP 2023 Investor Day
The past doesn't perfectly predict the future…but these results are fantastic.
Historically, the railroads have generated alpha for investors and I've been confidently buying the dip in companies like CNI and CP because I believe that this trend will continue over the long term.
I know there's a risk that the synergies of the CP/KSU deal won't play out as well as management hopes.
There's always going to be execution risk when it comes to big M&A deals like this. It's unavoidable.
But, if those 2028 EPS and FCF targets are anywhere close to accurate then it's akin to buying CP at ~10x earnings 5-years down the road.
That's a bargain if I've ever heard of one and I look forward to sitting back and watching this company benefit from the secular shifts that I'm seeing at a macroeconomic level (onshoring/near-shoring trends).
The way I see it, CP's rapid growth and fair valuation have the potential to result in strong, market-beating returns over the long term.
For further details see:
Canadian Pacific: Why I Just Bought Shares Of This Blue Chip Railroad