The following segment was excerpted from this fund letter.
CP is a high-quality, inflation-protected business led by a best-in-class management team that operates in an oligopolistic industry with significant barriers to entry. With an improving volume and pricing outlook combined with the upcoming transformational acquisition of Kansas City Southern (“KCS”), we believe that CP’s prospects are bright.
CP reported revenue growth of 7% in the second quarter as pricing and mix, fuel surcharge pass-throughs and foreign exchange more than offset a small decline in volumes. CP is leveraging the strong pricing environment to renew contracts at an average price increase of over 6%. Pricing directly benefits earnings as rails pass on increases in fuel and other expenses to customers through contractual fuel surcharges and CPI escalators. In addition to earnings growth, high inflation should help rail transportation take share from trucking and lead to incremental volume growth over time.
Customers are choosing cheaper transportation solutions as prices rise, and CP’s mission-critical rail service is often the cheapest or only viable method for transporting heavy freight over long distances. High fuel prices and wage gains also disproportionally increase the cost of trucking, which is up to three times less fuel efficient and much more labor intensive than rail transportation.
The demand outlook for CP continues to improve, especially given the current geopolitical environment. Russia’s invasion of Ukraine and the resulting supply disruptions have boosted demand for Canadian exports such as grain and potash. Deglobalization has also increased the likelihood of major North American onshoring and energy production, which will accelerate CP’s volume growth in the future.
Total volumes declined by 2% in the second quarter due to the smaller than average Canadian grain harvest, while volumes excluding grain increased by 5%. The grain headwind will flip to a tailwind in the fall as CP anticipates a normal grain crop, which supports management’s double-digit volume and revenue growth outlook for the second half of 2022.
CP’s pending acquisition of KCS remains on track as the Surface Transportation Board’s likely approval approaches. Based on the Board’s updated procedural schedule, if all goes as expected, CP will gain operational control of KCS by the first quarter of 2023 at the latest. In the meantime, CP and KCS are preparing for synergies by holding productive discussions with potential customers, running proof of concept trains, and making capacity investments.
By creating the only direct route from Canada to Mexico, the procompetitive merger offers shippers the unrivaled speed and service that is sorely needed to help ease supply chain congestion. We are confident in management’s ability to achieve its revenue and cost synergy targets and create value for all stakeholders.
While CP’s year-to-date results reflect its strong business performance and favorable outlook, we believe CP’s current valuation represents a meaningful discount to intrinsic value in light of the company’s high-quality business model and long-term growth potential.
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