Canadian Pacific's Intermodal Activity Stabilizing; 2024 Growth Outlook Favorable

Senior Equity Analyst

Matthew Young

Following the appointment of railroading legend Hunter Harrison as CEO in 2012, Canadian Pacific embarked on a successful profitability turnaround. Initially upon taking the helm, Harrison closed numerous intermodal terminals and hump yards to rightsize the network. He also sold nonessential rail lines, turned over leadership, and rightsized the workforce and overall asset base. 

Harrison and his successor—operations expert Keith Creel (who worked alongside Harrison for 20 years)—have taken CP from ranking as one of the worst Class I margin performers to among the best. We like that CEO Creel has further infused CP's culture with precision scheduled railroading principles, which stand behind the rail's progress. In 2018, CP's profitability caught up with PSR pioneer and historical margin leader Canadian National and surpassed CN in 2019 with a 60% operating ratio, or OR.

CP's freight mix is rich in bulk commodities such as grain, fertilizer, potash and metallurgical coal. Coal has historically made up a larger proportion of CP's portfolio than it does for peer CN due to CP's agreement with Teck Resources to haul cost-advantaged export coal. Intermodal is also a key business for CP, making up around 40% of carloads and more than 20% of revenue (primarily in Canada). Although CP's intermodal growth lagged that of CN at times over the past decade, PSR-related service enhancements have driven incremental new business opportunities and its growth profile improved materially. As with the other Class I rails, we expect CP's strong competitive footing to support average core pricing at or above cost inflation over the long run, rising around 3%. Intermodal pricing will likely come in slightly lower due to exposure to truck competition.

Following a multiyear regulatory review and STB approval in March 2023, CP Merged with Kansas City Southern in April 2023. The deal essentially creates a new single-line railway connecting Canada, the US, and Mexico, and we expect the firm to secure meaninful revenue synergies in the years ahead.

Business Strategy & Outlook

In our view, each of the North American Class I railroads we cover, including Canadian Pacific Kansas City, enjoys a wide economic moat driven by cost advantages and efficient scale. Core pricing and margin resilience in past freight recessions and in the face of substantial coal volume losses over the past decade-plus are a testament to the rails’ robust competitive positioning. With near certainty, we expect the rails to continue to leverage their two core moat sources into economic profit for the next 10 years and more likely than not 20 years from now. 

Cost advantage is a key driver of CP's wide economic moat. While barges, ocean liners, aircraft, and trucks also haul freight, railroads are by far the low-cost option where no waterway connects the origin and destination, especially for freight with low value-per-unit weight (bulk commodities). Along those lines, railroads enjoy roughly quadruple the fuel efficiency of trucking (per ton-mile of freight), and through greater railcar capacity and train length, rails make more effective use of locomotive assets and manpower despite the need for train yard personnel. Rails can also carry significantly more freight at once. Even for freight that can be shipped by truck, we estimate railroads enjoy a 10%-30% discount on a similar lane (on average). Even for intermodal container freight, which is largely made up of consumer-related products, rail has historically been cheaper than its key competitor truckload shipping on average over the cycle thanks to the rails’ aforementioned fuel efficiency and more economical use of labor. 

Furthermore, route density plays a role in rails’ cost advantage relative to a would-be new railroad entrant in a given corridor. We don’t expect any new mainlines to be built in the future, but the incumbent Class I providers would enjoy vastly lower unit and marginal costs than an upstart given immense network/lane density—the existing seven North American Class I railroads have thousands of customers across myriad end markets and geographies that drive significant freight volumes across their networks.

In addition to cost advantage, CP and its peers benefit from efficient scale. Would-be rational competitors have little incentive to enter because massive up-front infrastructure costs and the potential for creating excess capacity amid limited demand would preclude economic profit and destroy value. The network of track and assets that the North American Class I railroads have in place is essentially impossible to replicate. CP's network spans Canada from east to west, and following the April 2023 KCS merger, it operates seamless single-linehaul services from Canada and the upper Midwest down through Texas, the Gulf of Mexico, and into Mexico. Railroads occasionally build new spurs and restore abandoned lines, but we don't expect any new mainlines to be built, given massive entry barriers.

Efficient scale followed industry consolidation escalated by the 1980 Staggers Act, which permitted extensive rail line sales, abandonment, and combination while allowing for private contracts and rate setting based on market demand. In 1980, more than 40 Class I rails operated across North America, and today there are only seven; by definition, a Class I rail generates at least $475 million of revenue. Consequently, on all but the busiest lanes, a single railroad often serves an end-of-the-line shipper, only two railroads operate in most regions, and the rails have been able to reinvest while becoming quite profitable. In fact, we suspect that absent government intervention, the rational number of competitors on the continent would be two, via additional consolidation. This is because in most regions customers already have only two capable providers that service the market effectively and efficiently.

Wide

Economic Moat

Canadian Pacific Kansas City Limited

Canadian Pacific Railway Ltd. operates as a holding company, which engages in the provision of rail services. It offers a suite of freight transportation services, logistics solutions and supply chain expertise. The company was founded in 1881 and is headquartered in Calgary, Canada.

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Canadian Pacific Kansas City Ltd. engages in the provision of rail freight transportation services. It offers rail services linking Canada, the United States and Mexico. The company was founded on June 22, 2001, and is headquartered in Calgary, Canada.

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