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Canadian Pacific Kansas City (CP)

On April 14th, 2023, Canadian Pacific drove a historic golden spike to join with Kansas City Southern, creating the first and likely only ever single line end to end rail network connecting the United States, Mexico and Canada. In just three and a half years, Canadian Pacific has transformed from a subscale east-west Canadian railroad into a transnational network set to facilitate and benefit from secular growth in industrial production, nearshoring, and shifting regional and global trade patterns. In Canadian Pacific Kansas City, we see a long term compounder with seven paths to shareholder value creation.

First, revenue growth from the merger will exceed management guidance for near term revenue synergies. The Canadian Pacific-Kansas City Southern merger combined the sixth and seventh largest North American railroads. Given its size, track record of service and safety, and the pro competitive nature of the merger, Canadian Pacific was unique among North American railroads in its ability to win approval for the merger from the Surface Transportation Board. Despite this advantage, a high bar for railroad mergers stemming from historical precedent of anticompetitive action and disrupted traffic created an environment where the prudent course of action was for Canadian Pacific to be overly conservative in its guidance for revenue synergies. An extensive two year regulatory review process then created a backdrop for significant outperformance on these already conservative revenue synergies. During this period, management has been busy meeting with customers and signing non-disclosure agreements for new services that layer volume growth on the fixed costs of the Canadian Pacific Kansas City rail network. The historical fact pattern of Canadian Pacific’s 2019 acquisition of Central Main & Quebec Railway provides an illustrative example of how we expect the path of revenue synergy outperformance to unfold. The Central Maine & Quebec Railway acquisition gave Canadian Pacific the increased scale necessary to create a service that reached coast to coast across Canada. With the benefit of a full east-west rail network, Canadian Pacific was able to create service offerings that enabled outperformance on revenue synergy guidance of over 250%. In regards to the Canadian Pacific-Kansas City Southern merger, a single line connecting three countries with direct access to eleven ports creates significantly greater opportunities for scalable revenue growth. The importance of the single line lies in its value to Precision Scheduled Railroading. Precision Scheduled Railroading refers to the operating strategy in which a railroad focuses on moving cars on a set schedule, as opposed to the historical method of building trains for maximum capacity and efficiency. In operating trains on a set schedule, the railroad is able to cycle equipment faster, thereby improving shipping times and thus enabling customers to turn inventory faster. This improvement in customer value proposition then provides leverage to drive volume growth and flex pricing power. However, true Precision Scheduled Railroading is not fully achievable without a single line network. Without a single line network, car handoffs at rail interchanges necessitates operational and administrative coordination between companies where a lack of ultimate accountability to the end customer often results in bottlenecks that add cost and delays that slow down the service offering. As North America’s only end to end single line rail network, Canadian Pacific Kansas City is now uniquely able to offer customers ultimate accountability for direct service to eleven ports, the grain belt in Canada, the grain and protein belt in the Midwest, and a vast industrial footprint across the United States, Mexico and Canada. While we believe there will be many new service offerings in time (the inaugural investor day is on 6/28/23), the Mexico Midwest Express is one recent illustrative example of Canadian Pacific Kansas City creating a service to drive volume growth on the network. The Mexico Midwest Express is the first daily single line rail service between the Midwest and Mexico. This is a market which is served by hundreds of trucks a day that are subjected to congestion at the US-Mexico border when regulators stop, unload and inspect cargos. To support the Mexico Midwest Express, Canadian Pacific Kansas City is building inland terminals to create a regulatory ecosystem that then enables instant border crossing and offers customers unmatched service reliability. The Mexico Midwest Express is but one initial example of what can be created when a customer service focus is layered on this rail network. In time, Canadian Pacific Kansas City will have many more such service offerings to meaningfully grow volumes and revenues.

Second, guidance on cost synergies is overly conservative. The guidance on cost synergies neglects the advantages in productivity that accrue from running more efficient trains that create increased capacity on the network. Additionally, the unification of the single line rail network creates a dynamic where legacy Kansas City Southern is no longer predominantly an interchange railroad. As such, a mix shift to origination driven volume minimizes interchange rail handoffs and dwell time while maximizing operational flexibility to drive further cost savings. In addition to increased efficiency and mix shift cost savings, we see meaningful opportunities for asset sales to reduce operating costs.

Third, Canadian Pacific Kansas City’s return on invested capital is poised to inflect upwards. Over the last two years, Canadian Pacific’s return on invested capital has gone from a historical range in the high teens to the high single digits. The decline in return on invested capital is due to a timing mismatch between recent investments that Canadian Pacific made to enable volume growth and the flow through of high incremental margins. As Canadian Pacific and Kansas City Southern are integrated, we see benefits of increased route density scaling revenues on Canadian Pacific Kansas City’s fixed cost structure, providing meaningful operating leverage and incremental margins to drive a surge in return on invested capital and shareholder value.

Fourth, Canadian Pacific Kansas City has a long runway to reinvest in high return on invested capital opportunities to grow the business while strengthening the durability of its competitive advantages. In three and a half years, Canadian Pacific has transformed from a short haul Canadian railroad with limited market reach into a single line railroad connecting North America. Previously, due to the subscale nature of Canadian Pacific’s network and the interchange nature of Kansas City Southern’s business, Canadian Pacific’s more than one thousand acres of surplus land and Kansas City Southern’s more than six thousand acres of surplus land had limited value. With the recent merger, the reach and density that the scale of the network provides has caused the option value of this land to increase meaningfully. This option value lies in Canadian Pacific Kansas City’s ability to develop surplus land and co-locate customers to create customer centric service offerings that enable volume growth and pricing power. Opportunities range from those in the near term such as inland terminals and a capacity doubling bridge that collectively enable instant border crossing for the Mexico Midwest Express to longer term opportunities such as the buildout of a significant exclusive footprint at the Port of Lazaro Cardenas. Additionally, capacity expansion and customer co-location opportunities exist across nearly every key part of the rail network. The addition of the increased reach and scale of the network acts as a catalyst for the development of the expansive land footprint, thereby creating an impetus for increased volume and pricing power for Canadian Pacific Kansas City.

Fifth, the operating ratio (cost per dollar of revenue) can improve meaningfully. We are less than three months into the historic Canadian Pacific-Kansas City Southern merger. We see the extensive reach of the network driving volume growth at high incremental margins that enable investments to create faster asset turns, improved customer service and lower costs. Solely from combining the networks, we see the operating ratio improving by a low double digit percent. When we factor in the fact that eighty percent of legacy Kansas City Southern volume interchanged with an interline carrier, and the fact that legacy Canadian Pacific drove seventy-five percent incremental margin on new volumes, we see volume density on the fixed costs of the rail network driving incremental margins much higher. Canadian Pacific CEO Keith Creel’s mentor, railroading legend Hunter Harrison, drove operating ratios to levels most thought impossible. We believe that the same can happen at Canadian Pacific Kansas City. In the near term we see a path to an operating ratio below fifty percent, and we are optimistic for longer term improvement even without factoring in any flexing of the pricing power that this network enables.

Sixth, we see several long term secular tailwinds that support scalable volume, revenue, and earnings growth. After growing nearly uninterrupted for the half century post World War II, manufacturing capacity in the United States has not grown since China joined the World Trade Organization in 2001. Today, a combination of geopolitical tensions, demand for resiliency in supply chains stemming from the aftermath of pandemic induced shortages, the replacement of the North American Free Trade Agreement (NAFTA) with the United States-Mexico-Canada Agreement (USMCA), and trillions of dollars of fiscal stimulus (CHIPS and Science Act, Inflation Reduction Act, and Infrastructure Investment and Jobs Act) have set the stage for a return to industrial production growth. The United States is currently experiencing a factory building boom, with a multi year pipeline of planned factory construction that has yet to break ground. On top of the demand backdrop from industrial production growth in the United States, a secular shift to nearshoring of supply chains disproportionately benefits Mexico given its young, cost competitive labor force, proximity to end markets, and existing free trade agreements with a large number of trading partners. With a vast rail network connecting the industrial heartland of Mexico, growing industrial markets in the United States, and direct access to eleven ports across North America that connect to regional and global trade routes, we see Canadian Pacific Kansas City as uniquely positioned to provide high value picks and shovels services to industrial production in North America.

Seventh, independent from the first six aspects of our investment thesis, we see meaningful returns from simple capital allocation inherent in Canadian Pacific Kansas City’s equity bond and public market LBO attributes. We see Canadian Pacific Kansas City reaching its leverage target by 2024, after which we see excess free cash flow being used to increase the dividend and reinstate share buybacks. Even absent any revenue or earnings growth, we see a return of capital in the high single digits annually and a sum total of nearly the entire market cap over the next decade. Should any of the first six aspects of our thesis come to fruition, we see meaningful additional upside.

When we make investments in businesses that serve industrial end markets, we look for a flywheel in which business quality and operational excellence drives free cash flow that supports reinvestment in high return on invested capital initiatives to grow the business while growing the durability of the competitive advantages around the business. In Canadian Pacific Kansas City, we see a structural oligopoly with a culture of operational excellence and a long runway of high return on invested capital initiatives to grow revenues, earnings, and durable competitive advantages. Additionally, we see a variety of self help initiatives and secular tailwinds that support a long runway for value creation. Canadian Pacific was founded in 1881 to fulfill the founding promise of Canada to physically connect the disparate provinces by rail. Canadian Pacific Kansas City was created on April 14, 2023 to launch a new era of North American trade and industrial production growth. Can’t you hear the whistle blowing?


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