We are initiating coverage on Canada’s second-largest railway Canadian Pacific Railway Limited (CP) with a Neutral rating. Currently, the stock has the Zacks Rank of #3 (Hold).
We believe Canadian Pacific is benefiting from strong volume growth and continued operating gains. Despite the choppy economic recovery, management is confident of delivering strong results with low operating ratio (defined as operating expenses as a percentage of revenue) over the upcoming years. The company remains on track to produce an operating ratio in low 70s over the next three-to-five years. This low operating ratio can be achieved through structural cost reductions, longer runs and heavier trains equipped with distributed power, greater asset utilization as well as consolidating divisions, yards and shops.
Canadian Pacific’s third quarter earnings per share surpassed the Zacks Consensus Estimate by 2 cents and was well above the year-ago earnings. Strong results were driven by double-digit revenue growth and an improved operating ratio. Revenue climbed 15% year over year and operating ratio improved 270 bps to 73.7%.
The company is strengthening its balance sheet by improving near-term liquidity with debt offering and pension prepayment. In the recently concluded quarter, total debt-to-total capitalization ratio was 46.6%, down from 46.4% in the year-ago quarter, and is within management’s guidance of 50%. The company generates strong returns to shareholders in the form of dividend. In May 2010, Canadian Pacific raised its dividend by 9% to twenty seven Canadian cents from twenty-four and three quarter Canadian cents. We believe this dividend increase shows management’s increased confidence in delivering an earnings growth.
Further, Canadian Pacific, which competes with Canadian National Railway (CNI), is focusing on structural cost savings by consolidating eleven service areas into six regions. This will facilitate Canadian Pacific in running longer heavier trains, providing on-time performances. This consolidation is expected to fuel the company’s profit and margins in 2011. In addition, we believe the company’s recently signed 10-year contract with Teck Resources Limited (TCK) will lead to a rise in coal volumes in 2011 and solidify its presence in export trade. Also, strong Asian demand for metallurgical exports as well as solid rebound in potash shipments will drive revenue going forward.
On the flip side, 2011 outlook was tempered by weak forest products and automotive volumes, lack of visibility in fertilizer demand as well as a possible slowdown in intermodal growth. We remain on the sidelines due to competitive threats, unionized workforce (78% of total workforce), volatility in fuel prices and currency fluctuation that may limit the upside potential of the stock.
Canadian Pacific Railway Limited, together with its subsidiaries, operates a transcontinental railway in Canada and the U.S. The company owns approximately 10,700 miles of track. An additional 4,700 miles of track are owned jointly, leased or operated under trackage rights.Canadin Pacific serves the principal business centers of Canada, from Montreal to Vancouver, as well as the U.S. Northeast and Midwest regions. The company derives revenues from Freight transport and Other services.