Canadian Pacific Earnings: Intermodal Weakness and Margin Pressure Persist, but Outlook Positive

Wide-moat Canadian Pacific Kansas City’s CP third-quarter pro forma revenue (combining CP and Kansas City Southern results) fell 4% year over year, mostly due to persistent intermodal weakness, easing accessorial income, and lower fuel surcharges. Revenue missed our forecast on greater than anticipated intermodal and potash volume declines, which saw incremental pressure from the Canadian West Coast port strikes. We note that core carload pricing remains positive.

Total pro forma yield rose 1% year over year, while consolidated pro forma volume fell 5%. Intermodal activity declined 9% because of minimal retailer restocking, excess capacity in the competing truckload sector, and port disruption. Carload volumes (excluding intermodal) fell roughly 2%, primarily driven by lower potash (customer facility issue and port strike), soft crude and LPG activity, lower frac sand, and sluggish forest products shipments. For carloads, these factors were only partly offset by new business wins over the past year, higher grain (solid U.S. volumes), and continued healthy automotive restocking activity. Note that management doesn’t expect an outsize impact from recent United Auto Workers strikes.

CP’s pro forma adjusted operating ratio (expenses/revenue excluding merger costs and deal amortization) deteriorated 320 basis points to 61.7% on lost leverage from lower intermodal revenue, significant wage and benefit inflation, and fuel surcharge lag. Management did not provide specific OR guidance, but (as we heard it on the call) it thinks the OR can improve sequentially in the fourth quarter.

We don’t expect to drastically alter our $71 USD denominated fair value estimate as a result of third-quarter results. The shares have pulled back over the past month and now trade in fairly valued territory (previously overvalued) relative to our long-term free cash flow growth forecasts.