Canadian Pacific Railway (US) (CP-$70.46-Peer Perform). What a Difference a Year Makes

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Canadian Pacific Railway (US) (CP-$70.46-Peer Perform)

What a Difference a Year Makes

• UPSIDE REPORT. Yesterday evening, CP reported 3Q continuing EPS of C$1.23, above both Cons. of $1.18 and our $1.17. Rev., EBIT and EPS grew by 3%, 8% and 14%, mostly decelerated from 7%, 9% and 12% growth during 2Q. Results were a bit worse on an operating basis as CP benefited by $0.02 from a lower tax rate and from a 1-time labor settlement gain which was not yet quantified.

• REPORTED YIELDS TURN NEGATIVE. Total yields declined 3.7% y-o-y, well below our +0.3% estimate and down from +2.2% last qtr. Yields were negative at CP for the 1st time since 1Q:04, although we suspect most of this is related to mix and the weaker US dollar. Total vols increased 6.2% and margins improved 110bp y-o-y including the impact from the 1-time labor benefit.

• CP GUIDES TO LOW END OF EPS RANGE. CP now expects C07 EPS at the low end of its unchanged C$4.30-$4.45 range. Despite -2.2% vols in C06, CP grew EPS by 20% last year and beat its original EPS guidance by C$0.10. However, this year with vols tracking up 3% YTD, CP is reducing guidance to the low-end of its initial range and forecasting only 9% EPS growth. Despite stronger vols, CP is suffering with slower yield growth and fewer productivity gains. What a difference a year makes.

• LOWERING OUR EPS ESTIMATES. We are lowering our 4Q:07 estimate by 7% to C$1.21, vs. prior Consensus of C$1.28. Our C07 estimate of C$4.33 is now in-line with CP’s lowered expectations. We are also lowering our C08 estimate by 4% to C$4.90, and we are now below prior Consensus of C$4.94. We expect the weak U.S. dollar to continue to be a drag on reported rev. and EPS.

• INVESTOR WORKSHOP TODAY. CP will host its earnings conf. call later this morning, followed by its analyst day presentations in the afternoon. Earlier this morning, CP guided to C08 EPS of C$4.70-$4.85, which at the midpoint is 3% below prior Consensus and 2%-3% below our downwardly revised estimate from last night. We will revisit our model following today’s meetings.

INVESTMENT CONCLUSION: CP is currently trading at 14.8x and 7.3x our downwardly revised U.S. dollar EPS and EV/EBITDAR estimates. This compares with its 1, 3, and 5-year averages of 15.3x, 14.3x and 13.5x and 8.6x, 7.7x and 7.3x. This is also roughly in-line with our Large Cap Rail Index excluding CP, which is currently trading at 15.0x and 7.3x.

We continue to be impressed with CP’s ability to grow volumes this year when the other rails have not been able to do so. We also remain impressed with management’s continued evolution to a culture of cost improvement. That said, EPS growth has slowed this year despite increased volume growth and into reduced productivity measures (speed, dwell, etc.). We expect continued pressure on CP’s earnings over the intermediate term from 1) the relatively weak U.S. dollar, 2) contractual down y-o-y Elk Valley coal pricing during C08 and early C09, and 3) the likely ramp-up of its build-in to the Powder River Basin at some point towards the end of C08 or C09. At current high end historical valuations and facing these EPS headwinds, we remain on the sidelines with a Peer Perform rating.