Canadian Pacific Railway Limited (CP), the second-largest Canadian railroad’s financials, suffered a major setback due to a severe winter in the first quarter of the year.
Despite improving market demand, the company’s service capacity failed to deliver strong results due to weather conditions. As a result, we maintain a cautious stance on the company though we are hopeful of better financial conditions in the ongoing second quarter and beyond on economic improvements ahead.
We believe Canadian Pacific remains focused on delivering strong volume growth and operating efficiency through continued global economic revival including increased Asian trade and healthy energy markets.
Despite a major setback in operating metrics in the recently concluded quarter (primarily hit by weather conditions), the company strives to produce an operating ratio in the low 70s over the long term. Further, we expect an above-inflation pricing strategy and higher fuel surcharge to accelerate revenue growth in 2011 and beyond.
In 2011, Canadian Pacific plans to invest approximately C$950 million to C$1,050 million in capital programs, which include track maintenance and expansion programs, volume growth and productivity initiatives, network enhancement upgrade, information technology systems, Positive Train Control (PTC) implementation as well as purchase of 16 new locomotives in August.
We believe the investment will lead to increased profitability and improve the company’s route structure and network.
The company’s biggest customer for coal transport, Teck Resources projected metallurgical coal sales volume of 23.5 million to 24.5 million metric tons in 2011, suggesting an increase in the range of approximately 1% to 6% from the 2010 level.
Considering the upbeat projection, we expect Canadian Pacific’s short haul coal shipment to Kamloops, British Columbia to also increase. Additionally, strong Asian demand for metallurgical coal exports and the floods in Australia will drive growth at metallurgical coal markets in Canada and the U.S.
Other product lines of Canadian Pacific are also expected to register growth. We believe increased production of North American light vehicles will boost automotive production to up to 13.3 million units in 2011 while Forest Products will grow on higher pulp and lumber shipments.
With respect to the Intermodal segment, we expect continued strong domestic intermodal shipment attributable to truckload conversions to rail Intermodal. Further, fuel price inflation remains favorable for the company’s Bakken and Alberta oil sands transport business.
Canadian Pacific is strengthening its balance sheet by improving near-term liquidity with debt offering and pension prepayment. The company lowered its debt position by $100 million in the first quarter and rewarded its shareholders by increasing dividend payments approximately 11%. We believe the increased dividend stems from the company’s confidence of delivering strong earnings as economic growth accelerates.
However, Canadian Pacific remains exposed to strong competition in freight transportation market in Canada and the U.S., primarily from railroad companies like Canadian National Railway (CNI), which operates almost through the same network.
Canadian Pacific is subject to acts like PTC, which triggers additional capital expenditures on the company. Canadian Pacific has already invested approximately $14 million in PTC and estimates it to increase to $250 million in 2011 due to its implementation in U.S. railway operations.
Further, fuel constitutes a large portion of the company’s operating costs. Volatility in diesel fuel prices can have a significant impact on the cost structure and reduce net income.
Given persisting flood conditions in the Canadian and North American region, weather disruptions remain potential headwinds in the near term. Further, the company’s automotives business might also suffer due to reduced North American assembly operations by Toyota and Honda following the tsunami and earthquakes in Japan.
Consequently, we are maintaining our long-term Neutral recommendation supported by the Zacks #3 Rank (Hold).
