To The Moon

$CANADIAN PAC KANS CITY LTD(CP)$

Today, we're analyzing Canadian Pacific Kansas City Railroad stock, ticker symbol CP. This is the U.S. version of the ticker, and I believe it’s the same on the Toronto Exchange. There may be some differences in the numbers, so that’s worth noting upfront.

As always, this is not individual investing advice—just how I personally analyze stocks. I originally thought I had wrapped up my railroad stock series, but someone requested this one yesterday. So, to officially conclude this playlist on railroad stocks, I’m going to cover the Canadian Pacific–Kansas City Southern merger.

Long-Term Earnings Trends

Looking at long-term earnings patterns, we generally see solid growth. If we move to the present day, the basic earnings growth rate stands at about 11% over this period. This figure excludes drawdowns—it’s simply measured from one point to another.

Now, let’s examine historical earnings cyclicality. The dark green shaded area in the chart represents earnings trends, while the fast graph below shows annual drawdowns. The stock peaked at $0.88 per share and bottomed at $0.53 per share two years later, during a recession. This means earnings declined over two years, showing moderate cyclicality—though not deeply cyclical, it's approaching that level. My rough threshold for deep cyclicality is around a 50% decline, and in this case, earnings dropped about 40%. Afterward, there was a recovery year followed by another rough year, before earnings started growing again.

Overall, this is a quality business that can navigate recessions, though it does experience moderate cyclicality.

Analyst Expectations and Earnings Growth

Analysts are quite optimistic about future earnings growth, though I’m not sure why. I’ll take their projections for this coming year into account when estimating near-term earnings per share, but for the overall growth calculation, I’ll focus on the period from around 2015–2016 through the end of 2024.

Looking at the fast graph, we don’t see any major drawdowns, just a small one, and the reported earnings growth rate is 18%. However, this includes the impact of the Kansas City Southern merger. Canadian Pacific technically acquired Kansas City Southern, though it was structured as more of a merger.

One key point: before the merger, earnings per share showed a noticeable jump. This is because Canadian Pacific issued new shares as part of the deal, increasing the overall share count. However, in the years leading up to the merger, the company had reduced its share count by nearly 20% over a seven-year period.

This buyback strategy inflated the earnings per share growth reflected in the fast graph and the reported growth numbers. When companies buy back shares, they reduce the number of outstanding shares, making per-share earnings appear to grow faster than actual earnings. So, while the reported growth looks impressive, it’s partly due to financial engineering rather than true business expansion.

Post-merger, the company has not been repurchasing shares. If we examine earnings growth since 2022—over the last three years—it has been flat. In fact, earnings per share in 2023 were actually one cent lower than in 2021. This illustrates the impact of buybacks: when a company stops repurchasing shares, its earnings growth often slows or stalls.

The company likely has debt from the merger that it’s paying down, so this isn’t a one-to-one comparison. However, it clearly demonstrates how much of the past earnings growth was driven by buybacks rather than organic expansion.

Adjusted Earnings Growth Rate

Before adjusting for share buybacks, the reported earnings growth rate was 8%. After making adjustments, that figure drops to about 5%.

A 5% growth rate isn’t particularly strong. Considering inflation has averaged around 3% annually over this period, the company’s real earnings growth is only about 2% per year. While that’s not extraordinary, it’s still a growing business—many companies struggle to grow at all or even fail during downturns.

This also highlights why the merger likely made strategic sense for Canadian Pacific. By combining with Kansas City Southern, they’re aiming for long-term growth and efficiency, which could help justify the deal despite the short-term stagnation in earnings per share.

Since there isn’t much organic growth in the railroad industry, having fewer competitors increases pricing power—and that’s essential. While I don’t know the exact merger details, consolidating makes sense in theory, so I don’t have any major criticisms of it.

Payback Time Calculation

The goal of this calculation is to determine how long it would take to recover our investment through the company's earnings. If we paid $100 for the business, how many years would it take to accumulate $100 in earnings?

Analysts predict 17% earnings growth, though I’m skeptical. Still, I’ll use their estimate along with my own adjusted long-term growth rate of 4.94%. This assumption is already fairly optimistic. I’ll assume strong growth this year, followed by a steady 5% annual increase.

To calculate the earnings yield: If you bought Canadian Pacific for $100, you’d generate $3.63 in annual earnings, assuming no growth. Factoring in 4.94% growth, we can project earnings year by year.

Starting at $3.63, growth brings it to $3.81 in year one, then $4.00 in year two, and so on. Using this method, it would take roughly 18 years to break even on the investment.

Debt Adjustment

I also adjusted for debt by increasing the stock price by 22%. The company’s long-term debt-to-capital ratio is 28%, but the difference between market cap and total enterprise value is about 22%, so I used that figure. This adjustment assumes you’re covering the debt to effectively own the business debt-free. With this factor included, the stock is valued at $95 per share instead of $78.

Valuation vs. Peers

With this 18-year payback period, Canadian Pacific is expensive. The S&P 500 average is about 15 years, which is already on the high side, and I generally look for a 10-year or lower payback before considering a buy. Anything over 15 years leans toward a sell unless there’s a compelling reason to expect rapid earnings growth.

For comparison:

• Union Pacific & CSX: 17-year payback (similar valuation)

• Norfolk Southern: 15-year payback (closer to S&P 500 average)

On a relative basis, Canadian Pacific is in line with its peers, but whether it’s worth the price depends on whether the market’s growth projections hold up.

If earnings growth reached 133%, the payback period would shrink to 12 years—but that’s a pretty extreme scenario. Realistically, the market is expecting 17%, 15%, and 13% growth over the next three years, which seems overly optimistic to me.

Market Assumptions & Recession Risk

One key thing to note: the market isn’t pricing in a recession at all. If we factor in a 40% earnings decline over two years (similar to the Great Recession), the payback period stretches out further, reducing long-term earnings growth expectations.

The company would need to sustain 15% average earnings growth over the next three years. That seems highly unlikely for a decade-long period unless there’s a massive inflationary environment. Railroads aren’t high-growth businesses anymore, so I tend to be conservative with my assumptions. The best-case scenario is likely GDP-level growth, and that’s what most investors should expect.

That completes my analysis of railroad stocks!

Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.

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