Canadian Pacific Kansas City Limited

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

Canadian Pacific Kansas City Limited (CPKC), a Class I freight railroad, operates a vast network spanning Canada, the United States, and Mexico, providing crucial transportation services for various commodities.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

CPKC’s operations are broadly divided into the following segments:

  • Bulk: Transports commodities like grain, coal, potash, and fertilizers across its network. This is a significant portion of their revenue, representing nearly 40% of freight revenues and offering solid, stable contracts.
  • Merchandise: Moves finished goods and other diverse products. This segment provides more consistent year-to-year revenue than some of the other segments and focuses on a wider customer base. This segment accounts for roughly 38% of freight revenue.

  • Intermodal: Focuses on the movement of containers, both domestic and international. Intermodal is growing quickly, as companies seek to utilize the benefits of intermodal transportation, offering fast and predictable service. This segment is a smaller portion of revenue and accounts for roughly 23% of freight revenues.

  • Automotive The transportation of various types of finished vehicles, machinery, equipment parts and materials for the automotive and manufacturing industries accounts for only a very small part of the revenue.

The company is also involved in other activities such as real estate, finance, and other rail operations, which have some influence in the company, but aren’t the main focus of the business.

CPKC’s recent acquisitions, particularly Kansas City Southern (KCS) in 2023, were a major growth driver, and has expanded the company into a tri-national operation. However, the integration also presents significant challenges.

Industry Trends & Competitive Landscape:

The railroad industry has seen a trend of consolidation over the past decades, with a few major players emerging. The industry is quite capital-intensive, requiring significant investments in infrastructure. Despite this, it faces stiff competition from trucking, especially for shorter-distance routes.

  • Fuel Costs: One key challenge is the volatility of fuel costs, which makes margins unpredictable and harder to control. The war in Ukraine, for example, caused spikes in fuel prices, and that impacted overall revenues and operating costs.
  • Labor Costs and Relations: Labor issues are quite significant in the railway industry, and the company’s labor relations, compensation structure and hiring and retaining workers is something to keep on eye on.
  • Regulatory Landscape: Railway operations are also subjected to heavy regulations in all 3 countries where they operate. Changes in regulations have had major impacts on the whole industry and can put extra burden on any company.
  • Pricing Power: Railroad companies typically have some pricing power, as the lack of adequate substitutes means that customers are often willing to pay higher prices for reliable and predictable service. However, there are times they are unable to raise prices due to contractual agreements, and also because there might be overcapacity in the industry.
  • Competitive Advantage The rail industry has high barriers of entry with their large and complex infrastructure. This means that there’s usually limited competitors within the specific area and it’s usually difficult for new entrants to compete.

Financial Analysis

CPKC’s financials are complex and affected by many factors and have high operating leverage. Here’s a summary of key aspects:

  • Revenue Growth:
  • CPKC’s revenue growth has been pretty good over the last year due to the acquisition of KCS and increase in fuel surcharges.
  • Revenues in 2022 were 8.8 billion which is an increase of 20% over 2021.
  • For the nine months ended September 30, 2023 the revenues are 8.67 billion which is about 11% more than the same period of the last year.

  • The 2022 revenues includes the revenues of KCS from April 14th, 2022 while the 2023 data contains the revenues of KCS for a full 9 months, which is a contributing factor to the increase.

  • Profitability:
    • The cost of fuel makes a large part of operating expenses, therefore fluctuations in that sector can have material implications.
    • The company has had impressive margins that have been increasing in recent quarters. For the nine months ended September 30, 2023, the operating income was 2.6 billion, a 14% increase from the same period of the previous year.
    • Operating ratio (ratio of operating expenses to revenues) stood at 70% in the 9 months ended September 30 2023, compared to 70.3% in the same period of the previous year. The main goal of all railway companies is usually to reduce their operating ratio.

  • Return on invested capital is about 6.7%, but this figure can change based on the calculation, if intangibles are included etc.

  • Capital Structure:
    • The company has high long term debt to equity ratio, and long term debt comprises the majority of their capital structure.
    • The equity value of the company is about 30B. In terms of liabilities, most of the obligations are long-term debt. Total debt is 21B.
  • Cash Flow:
    • Operating cash flows have been increasing over the last few years, this reflects the increased revenue and cost optimization strategies that management has employed.
    • The company has spent significant money on acquiring KCS and for maintaining their existing infrastructure.
  • Acquisitions As discussed earlier, the acquisition of KCS has had a major impact on the company and has created a new challenge of merging the operations of the two companies. This integration can be complex and can also be very challenging from a regulatory point of view.

Moat Assessment: 3 / 5

CPKC has a narrow moat, derived primarily from:

  • Asset Specificity: Rail infrastructure, with long-term useful life, is costly and complex to replicate and creates a barrier to entry. It takes an incredible amount of capital to create a railway line to compete with existing ones, therefore the company is protected from new entrants.
  • Scale: The extensive rail network provides a cost advantage due to route density, which is difficult for new entrants to duplicate. Due to their vast network and numerous customers, they are able to spread out their fixed costs which is very hard for new competitors to replicate.
  • Switching Costs: Shippers that rely on rail transport may face switching costs due to the cost of reconfiguring their supply chains. However, this is a weaker moat compared to the ones present in software companies.

However, the moat is not as wide as other industries due to:

  • Intermodal Competition The existence of trucking creates intense competition.
  • Price Regulations Governments in all 3 countries have varying regulations about the pricing of the services.

Moat Threats and Business Resilience:

While the company has a narrow moat, it faces legitimate risks that could undermine it:

  • Technological Disruption: While it is unlikely for the existing method of operation to be disrupted by a brand new technology, there could still be some advancements in AI and software that will make supply chains much more streamlined or better utilized.
  • Regulation Changes: Regulatory changes have a significant impact, that the company’s revenues and margins can be affected. This can take many forms such as environmental regulations, tariff regulations and safety regulations. Also changes in regulations in other countries (specially Mexico) may hinder their ability to utilize cross-border transportation.
  • Environmental Liabilities: A growing concern about the environmental impact of their business might cause further regulations and the requirement to spend more on remediation. There’s also a risk of natural disasters that can disrupt operations.
  • Economic Downturn The transportation business, as a whole, is closely related with the economic cycle, and can be severely affected if the economy goes into recession or if some financial crisis occurs.
  • Fuel and Labor Costs If fuel costs soar, it can hurt the bottom line of the company. Similarly, increased labor costs without a corresponding increase in revenues can reduce the returns of the company.
  • Competition Even though the barriers to entry are high, it is not impossible for another company to enter the market. Furthermore, trucking provides a cheaper alternative on certain shorter routes and they are always competing with the railway industry.

Understandability: 3 / 5

The business is moderately complex. Here’s why:

  • Pros: It has relatively simple operations that mostly consist of transporting raw materials and other materials through railway.
  • Cons: However, the specific metrics, such as financial ratios, cost calculations, and operating techniques are somewhat hard to grasp. Furthermore, since the company operates in 3 different countries and has varying reporting and legal requirements, that also increases the complexity.

Balance Sheet Health: 4 / 5

CPKC’s balance sheet is generally healthy, but there is also room for improvement.

  • Pros:
    • The company’s liquidity profile is acceptable, which is demonstrated by the fact that they have sufficient cash and equivalents at hand, although most of their capital is tied up in the debt that they have taken to finance acquisitions.
    • The company has a stable business model, and generally high cashflows to meet their debt obligations, which is important in the railway industry due to high capital costs.
  • Cons:
    • The company has a high debt-to-equity ratio, with most of their financing coming through long-term debt. This introduces risk when the interest rates are rising and may limit future prospects due to this debt.

Based on this, CPKC has a narrow moat because of specific advantages provided by its business operations, but these are not impenetrable. The company is moderately complicated to understand and they have relatively good balance sheet health with some major issues in debt management.