Don't Underestimate This Railroad Company

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Canadian Pacific Railways (NYSE: CP) is trading near its 52-week high. Many people believe that the stock has reached its peak and therefore they hold a bearish outlook on the stock. Therefore, a suitable question at this point in time will be: Has the stock peaked or is it moving onto the next step of valuations?

An Overview of CPR

The last time I discussed the railroads, I wrote a thorough bullish thesis on Kansas City Southern (NYSE: KSU). However, the story of this Calgary-based railroad is a lot different from the growth story of KCS. The company not only expects growth in the top-line but also has a solid restructuring plan underway that will expand the bottom-line.

Quantifying Bottom-Line Expansion

The major changes in yard operations and an aggressive pursuit of a reduction in train starts (enabled by longer / heavier trains) support the large 23% reduction in headcount (which includes both employees and contractors) that CPR is targeting. Despite a potential pension headwind on the order of $100 million in 2013, it appears that cost reductions are likely to be a powerful driver of margin expansion in 2013 and 2014. The EPS forecasts by the sell-side reflect nearly 400 bps of margin expansion in both 2013 and 2014.

Sources of Top-Line Growth

Clearly, a proper execution of the cost program is the most critical element of the CPR upside story. Nevertheless, I believe that CP is favorably positioned to realize a strong revenue tailwind from growth in its crude oil by rail business over the next several years. The volume growth in CPR's bulk franchise (coal, grain, potash) is a source of potential upside. Moreover, the intermodal volume is also expected to show a stronger growth at some point during CPR's four year planning horizon.

CPR has been a strong stock but I believe that it remains very early in the story with room for substantial upside in the medium term. Therefore, the reward to risk story remains compelling for this company.

Peers

Four railroads have already announced their earnings for the last quarter: KCS, Canadian National, CSX Corp (NYSE: CSX) and Norfolk Southern (NYSE: NSC). A quick look on earnings releases tell us that  favorable growth in energy related demand and continued expansion of intermodal service seem to be the important drivers of earnings expansion. Despite a slight rebound in natural gas prices, coal remains a headwind. The following chart shows the different revenue streams for different railroads:

<img src="/media/images/user_15211/capture4_2_large.PNG" />

Clearly, CSX and Norfolk face the highest exposure to coal. The intermodal as a percentage of total revenues ratio is almost the same across the industry. CP does not disclose the amount of revenue its makes from different commodities. However, the following table gives us a hint about where the volumes are going for CP:

<img src="/media/images/user_15211/capture1_13_large.PNG" />

 

Valuation

The price target of $120 is based on applying a 16x P/E multiple to the 2014 EPS estimate of $7.50/share. CPR stock is likely to sustain valuation above the historical average rail valuation range of 11x-15x as long as there is a considerable visibility to a path of strong margin expansion and EPS growth. CPR is currently trading at a forward multiple of 19.1x.

Risks to Rating and Price Target

Hiccups to the execution of CPR’s cost reduction program are a source of potential downside risk to my bullish stance on this stock. More aggressive price competition in the intermodal segment is also a source of potential risk. Whereas my bullish stance relies much more heavily on the cost reduction plan rather than the revenue growth story, a meaningful reduction in the volume in these segments would be a source of risk for my bullish outlook on this stock.


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