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A Record Revenue For Canadian Pacific Railway: More Buybacks And Dividend Hikes Are Underway – Canadian Pacific Railway Limited (NYSE:CP)

A Record Revenue For Canadian Pacific Railway: More Buybacks And Dividend Hikes Are Underway - Canadian Pacific Railway Limited (NYSE:CP)

Introduction

Railway operators are an fascinating breed. They often take pleasure in a pleasant moat (as rivals gained’t actually assemble new railways subsequent to an present one, and the investments are predominantly specializing in updating, renewing and increasing the rolling inventory.

ChartCP knowledge by YCharts

The efficiency of railway corporations does depend upon how the North American financial system is doing, and the state of affairs for Canadian Pacific Railway (NYSE:CP) isn’t totally different. The corporate has now launched the monetary outcomes of the third quarter, and the numbers affirm CP is having fun with a considerable tick-up in its income and income. It stories its monetary leads to Canadian greenback, and that may also be the default foreign money used on this article. To calculate the USD equal of the outcomes, it’s essential to divide the reported CAD outcomes by 1.31 (which is the present USD/CAD change fee).

A robust monetary efficiency

Within the first 9 months of the yr, Canadian Pacific Railway reported a pleasant 10% income improve, fueled by an exceptionally robust third quarter (whereby each phase confirmed a considerable income improve, permitting CP to report a 20% income improve in Q3). The state of affairs is a little more combined within the first 9 months of the yr, however the complete income from freight of just about C$5.2 billion is a wonderful efficiency.

(Supply: Canadian Pacific Press Launch)

The corporate was additionally capable of hike its Revenue per Ton Mile (the fee to ship one tonne of a product over a distance of 1 mile), which clearly had a constructive impression on the income combine as nicely.

(Supply: Canadian Pacific Monetary Statements)

The income improve is good, however sadly, the prices escalated as nicely, primarily on the again of a 12% improve in wage – however the primary contributor to the upper bills is the gasoline value. The typical value per gallon of locomotive gasoline elevated from US$2.07 to US$2.72. This 31% improve, mixed with a 6% larger gasoline use, resulted in Canadian Pacific having to fork over a further C$191 million in gasoline-associated prices (+40%).

That’s the primary cause why the working revenue within the first 9 months of the yr elevated by simply 6.5%. It does emphasize the significance of the corporate’s wonderful efficiency within the third quarter, as that’s when CP transformed the working revenue lower it reported in H1 to a YTD improve, because the working revenue in Q3 elevated by C$168 million. The web revenue of C$1.four billion was a bit decrease than the C$1.42 billion reported within the first 9 months of final yr, however because of the decrease share rely (see later), the EPS elevated by 1% to C$9.81. That’s an incredible outcome, however have in mind this features a pension-associated restoration of C$287 million. Canadian Pacific Railway has a pension surplus relatively than a deficit, and as of the top of September, it had a internet pension surplus of just about C$1 billion.

(Supply: Canadian Pacific Monetary Statements)

Canadian Pacific reported an working money move of C$1.78 billion, however this included a working capital change in addition to a deferred tax. After isolating these two elements, the adjusted working money stream was roughly C$1.7 billion, which suggests CP generated a constructive free money move of roughly C$600 million within the first 9 months of the yr, of which roughly C$235 was generated in Q3 regardless of the excessive capex invoice of C$430 million.

(Supply: Canadian Pacific Firm Presentation)

It wouldn’t be truthful to make use of a C$600 million free money circulate end result as a foundation to worth Canadian Pacific. The capex degree is clearly larger than the depreciation price (C$1.08 billion, versus C$516 million), indicating the railway operator continues to spend money on additional progress. Based on the corporate’s presentation on the Capital Markets day, roughly 50% is sustaining capex, with a further 10% of the guided C$1.6 billion to be spent on IT and community enchancment. This implies the complete-yr sustaining capex will probably be C$950 million-1 billion within the subsequent few years, and that’s a greater start line for our assumptions.

Final yr, the C$9 million adjusted working money stream (OpCF) represented 65% of the complete-yr adjusted OpCF. If I have been to use an analogous ratio, I might anticipate CP to generate a full-yr adjusted working money movement of C$2.6 billion. After deducting the deliberate C$1 billion in sustaining capex (the mid-level of the equation), I anticipate Canadian Pacific to generate an adjusted sustaining free money move of C$1.6 billion. This represents C$11.2/share based mostly on the present share rely of 142.6 million shares.

Returning money to the shareholders in dividends and share buybacks

Canadian Pacific’s operations are throwing off a whole lot of money, and the corporate has some rules on the way it plans to spend the money.

(Supply: CMD presentation)

Roughly 25-30% of the EPS shall be paid as a dividend, and Canadian Pacific expects to steadily improve the payout ratio. Contemplating the corporate was paying an annualized dividend of simply C$2.25/share, this might have represented a payout ratio of simply 17% on a C$9.81 EPS within the first 9 months of the yr. The dividend hike in Q2 wasn’t a shock, and Canadian Pacific elevated the quarterly dividend to C$zero.65, placing it on monitor to pay C$2.60 per yr in dividends. Though that’s nonetheless on the decrease finish of the steerage, it undoubtedly is an enchancment. Based mostly on the complete-yr expectations to generate an EPS of C$13.5 (roughly 20% greater than final yr), a C$2.60 dividend would nonetheless characterize a payout ratio of simply 19-20%, so it’s protected to say we will anticipate extra dividend will increase.

Utilizing a share rely of 140 million shares over FY 2019, the dividend will value the corporate simply C$400 million, which suggests it has entry to fairly a little bit of extra money movement. One other pillar of the corporate’s shareholder rewards program is the buyback program. Canadian Pacific intends to repurchase three% of its inventory per yr, and has just lately acquired approval for a share repurchase program of roughly four% of its share rely.

Repurchasing four.25 million shares (which represents the typical of three%; if Canadian Pacific certainly repurchases four% of its inventory this yr, it should purchase 5.5 million shares) at a mean worth of C$255 per share would value the corporate C$1.1 billion. The buyback program, mixed with the dividend, means Canadian Pacific is spending its complete sustaining free money move on rewarding its shareholders, and that’s a technique that does make sense given the shortage of enlargement alternatives (you possibly can’t construct new railways only for the sake of increasing the community if the demand isn’t there).

(Supply: CMD presentation)

The corporate can afford to spend its whole money movement on share buybacks, as though its internet debt is fairly excessive (C$eight.13 billion), the annual curiosity bills are slightly below C$450 million. The curiosity bills ought to be trending down, as Canadian Pacific has been refinancing debt at a decrease value; it retired US$275 million of 6.5% notes and C$375 million of 6.25% notes, whereas issuing a brand new US$500 million 10-year bond with a coupon of simply four%. It will save the corporate roughly C$14 million per yr in curiosity bills.

Funding thesis

Canadian Pacific Railway isn’t low cost, however railway shares not often are (until the North American financial system is collapsing prefer it did in 2008), because of the moat related to transporting merchandise utilizing two iron bars. In a really perfect world, I’d wish to see Canadian Pacific spending much less on its share repurchase program and use additional cash to scale back its internet debt, as each C$100 million of retired debt would scale back the curiosity bills by C$5 million per yr, and this might finally increase the EPS and FCF/share as properly.

A buyback program seems optically higher, and so long as the web debt ratio stays inside the 2.5-three vary, I’m high-quality with that. I’m not a purchaser on the present costs, however I’m intently watching the developments.

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Disclosure: I/we’ve no positions in any shares talked about, and no plans to provoke any positions inside the subsequent 72 hours.

I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (aside from from In search of Alpha). I’ve no enterprise relationship with any firm whose inventory is talked about on this article.

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