Revenues climb as CP “plays through the pain” of service issues

Canadian Pacific President and CEO Keith Creel.

Second quarter revenues were higher at Canadian Pacific Railway on improved carload results, though earnings slipped compared to the prior-year quarter.

Revenue increased by 7% to $1.75 billion from $1.64 billion, while earnings were off 7%, to $3.04 from $3.27. Adjusted diluted earnings was $3.16, up 14% from $2.77 a year ago.

The Calgary-based carrier’s operating ratio for the quarter was 64.2%, up from the restated operating ratio of 62.8% in 2017. Volumes as measured by revenue ton-miles increased 4% and carloads increased 2%.

“Overall, it was a good quarter that sets the franchise up well for the remainder of 2018 and beyond,” said Keith Creel, CP President and Chief Executive. “Our quarterly performance was impacted by service interruptions related to labor negotiations and strike notices. However, we were able to reach tentative long-term agreements with both the Teamsters Canada Rail Conference and the International Brotherhood of Electrical Workers, which will serve the CP family, customers, shareholders and the North American economy well for years to come.

“With labor stability in place, strong underlying network performance and a robust demand environment, the path is clear and the opportunities are many. We will continue to take a disciplined and strategic approach to growing the franchise, but with our 12,800 strong CP family and our precision railroading model, there has never been a better time to be a CP railroader.”

In a note to investors, Cowen and Co. Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl wrote that CP is “playing through the pain” of service issues: “With tempered expectations ahead of the print, CP reported a modest beat vs. consensus on both top and bottom lines. Revenue of C$1.75B was above our and consensus C$1.73B estimate. Operating income of C$627M was above both our C$616M and consensus C$620M expectations. The company’s OR of 64.2% was slightly better than our 64.4% forecast and in line with consensus expectation of 64.2%.

“Although CP beat us on revenue, operating income, and operating ratio, their adjusted EPS of C$3.16 was below our C$3.23 forecast (but above consensus C$3.12). The shortfall relative to our expectations came in below the line in the form of lower-than-anticipated other income. When comparing the quarter to the prior year, revenue and EPS were both better while operating income and operating ratio were worse.

“The two service disruptions this quarter caused a 250bps impact on revenue; without this service stoppage, OR would’ve been flat. Fuel was up 3% in the quarter, which caused another 180bps deterioration in OR. While fuel can be a proverbial wild card for railroads, the service issues caused by the labor strike in 2Q should be behind CP now that a tentative four-year labor agreement was reached. Additionally, the company continues to make various service improvements in both track and operations.

“One of the areas of productivity improvements that management highlighted was improved train length. We believe CP should continue to benefit from longer trains in 2H18. As a result, we remain confident CP is positioned well for the remainder of the year.

“Core pricing came in at the high end of the company’s historical 3-4% range in the quarter. However management noted that renewals in the quarter were tracking above the 4% mark. Such a strong pricing environment was predicted in our recent proprietary 2Q Railroad Shipper Survey. These renewals will be needed in the back half as regulated grain pricing is set to come in at 2.8%.

“About 6% of CP’s book of business is exposed to tariffs, with lumber and forest product, steel, and soybeans to China each accounting for [about] 1% and finished vehicles being moved from Canada to the U.S. accounting for the other 3%. Management did not seem concerned about the potential for tariffs to hurt their business. They believe that while autos are exposed, other products are likely to still move, since the U.S. doesn’t produce its own potash and NAFTA doesn’t include forest products. Management called out the possibility for flow changes in the movement of steel, and how lumber has been subject to a 20% tariff for quite some time but has still been a strong commodity for CP. “Additionally the exchange rate (the Canadian dollar is trading at a decent discount to the U.S. dollar) should help Canadian products absorb some of the impacts of potential tariffs. Unlike some of their Class I peers, much of CP’s Asia exposure is outside of China, with mining company Teck’s exposure to China only around 15% and potash exporter Canpotex’s sales to China last year less than 20%. Furthermore, Canadian grain could actually benefit from U.S. grain export restrictions with Asia.

“We are slightly increasing our 3Q EPS estimate and modestly lowering our 4Q EPS estimate. That, along with the reported 2Q result, has the net effect of pushing our 2018 EPS to C$13.31 from C$13.36. Given the strong pricing environment and the fact that CP appears to have labor peace we are raising our 2019 EPS to C$14.80 from C$14.70. On a USD basis, our 2018 EPS estimate goes to $10.38 from $10.42, and our 2019 estimate goes to $11.84 from $11.71. We are adjusting our multiple down a half a turn to 19x to be a little more conservative which is how we arrive at our new price target of $225.