Canadian Pacific Railway Limited (NYSE:CP) Q3 2023 Earnings Call Transcript

Canadian Pacific Railway Limited (NYSE:CP) Q3 2023 Earnings Call Transcript October 25, 2023

Canadian Pacific Railway Limited beats earnings expectations. Reported EPS is $0.92, expectations were $0.7.

Operator: Good afternoon. My name is Travis and I will be your conference operator today. At this time, I would like to welcome everyone to CPKC’s Third Quarter 2023 Conference Call. The slides accompanying today’s call are available at investor.cpkcr.com. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]. I would now like to introduce Chris de Bruyn, Vice President, Capital Markets, to begin the conference. Please go ahead, sir.

Chris de Bruyn: Thank you, Travis. Good afternoon, everyone, and thank you for joining us today. Before we begin, I want to remind you this presentation contains forward-looking information. Actual results may differ materially. The risks, uncertainties, and other factors that could influence actual results are described on slide 2 in the press release and in the MD&A filed with Canadian and US regulators. This presentation also contain non-GAAP measures outlined on slide 3. Please note, in addition to our regulated quarterly financials, there are supplemental Q3 combined revenue and operating performance data available at investor.cpkcr.com which some of today’s discussion will focus on. With me here today is Keith Creel, President and Chief Executive Officer; Nadeem Velani, our Executive Vice President and Chief Financial Officer; John Brooks, our Executive Vice President and Chief Marketing Officer; and Mark Redd, our Executive Vice President and Chief Operating Officer.

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The formal remarks will be followed by Q&A. In the interest of time, we would appreciate if you limit your questions to one. It is now my pleasure to introduce our President and CEO, Mr. Keith Creel.

Keith Creel: Thanks, Chris. Let me start by thanking the CPKC family of 20,000 railroaders across our three great nations. We’ve been hard at work providing service for our customers. The effort and the passion they’ve demonstrated each day as we integrate and execute is truly commendable. So let’s take a look at the results of the quarter. The second quarter produced revenues of CAD 3.3 billion on volumes that were down 3% versus last year with an operating ratio of 61.7, core EPS of CAD 0.92. So no doubt a challenging quarter as we dealt with a softer demand environment and supply chain impacts from the strike at the Port of Vancouver. I’m going to let John talk more about that in a few minutes. As you’re seeing in the press release, given the more challenging environment, further stress by the labor strike, we’re adjusting our 2023 guidance accordingly.

Certainly not the outcome we had planned, but it’s the prudent thing to do at this point. That said, it’s not the challenges that define us, but rather how we respond. And I’m very proud of how this team, our collective CPKC families are responding to the challenges. I’ll say a few things about the Mexico Task Force. That’s an excellent case in point to how we respond in the task force. You recall back in our second quarter call, we talked about an enhanced focus on operations in Mexico. Shortly after that, we deployed a task force to Mexico that was led by John Orr. John who many of you are familiar with, has a lot of experience in Mexico from his previous role as EVP, Ops of KCS and KCSM. And I can tell you, this effort was monumental. It brought together railroaders from every part of the organization, nearly 100 employees across information services, network services, marketing, engineering, mechanical, and many others came together to support John on the task force objectives.

And we’re seeing the results from that effort. You’ve seen noticeable progress across all the operating metrics, train speed improvements, terminal dwell reduction, car miles per car day improving, locomotive productivity improving and, ultimately, the most important part, the service experience for the customer. And this transformation is ongoing, and the investment in people, process infrastructure, and technology in our Mexican operations, as well as our US and Canadian operations is a continual journey. On the safety front, we’ve continued to rise to the challenge from a safety perspective. Mark will speak to some of this in more detail in a moment. But I can tell, on a combined basis, we’ve seen year-to-date improvement in FRA personal injuries of 12%, FRA train accident frequency of 37%, which is a tremendous result that I want to commend the entire team on as we continue to lead the industry in the space.

Safety’s a never ending journey. And it continues, and will always be our number one priority. Few comments on the integration. On the integration front, integrating these two companies, obviously, is a challenge in and of itself, particularly so in today’s world with an industry with a history of merger related service challenges. We certainly not been perfect. There are opportunities to improve that, that we’re reminding everyday 24/7. But the teams from the legacy CP and legacy KCS have embraced the challenge, they’ve united, working together to produce a unique outcome that will benefit our customers, our communities, and each other. A couple points on the M&BR. While we continue to make progress integrating these two railroads, we also continue to progress the M&BR transaction that we announced in June.

Pleased to announce that we filed our application for the deal with the STB on October 6. So in closing, we’re a little over six months into this combination into our forever story. There’s no doubt there’s a few near term challenges from a softer demand environment. Regardless, the differentiated growth opportunities we’ve laid out and guided to remain unchanged. We’re successfully integrating this network. We’ve maintained our commitments to our customers, to the regulators and we’re seeing momentum in our operating performance. So with that said, I’m going to hand it over to Mark to speak to the operations before John brings some colors on the markets and Nadeem elaborates on the numbers.

Mark Redd: Certainly. Thank you, Keith. And good afternoon. I’d like to start by thanking the CPKC operating professionals for their tireless work and dedication to safety and operational excellence. The first six months of the merger has been both exciting and challenging. This team is up to the task and they’re delivering on their mandate to integrate the CP and the KCS network seamlessly, while maintaining safety as CP’s top priority. So if we’re looking at safety for the quarter, I’m pleased to report that we continue to build on industry leading record. Our Q3 FRA reportable injuries improved by 35% to a 0.97. Our train accident as reported improving 9% to 1.3. As I’ve discussed on last quarter, stakeholder engagement is a core pillar of our safety performance.

We regularly engage our employees, our union leadership, our regulators to collaborate safety best efforts, ensuring alignment. Since day one, we have failed two safety walkabouts where CPKC leadership and partners directly engage with the field employees across the property. Our safety walkabouts are key to a strong consistent safety culture. Now, turning to the operating performance, I will speak on the metrics from a comparison to CPKC if the combination occurred in 2022. Locomotive productivity improved 4% versus Q3 last year. Our average train speed and length declined 2% and 1% respectively. And the average train weight was down 2%. As we focus and remain on our aligning operating practices across our network, we feel very good about the progress that we have made in the first six months.

We’re optimizing our train concepts, improve locomotive productivity and fuel efficiency. To that, fuel efficiency approved sequentially Q2 and Q3, and I expect that to continue in the area for opportunity as we look forward. So if we’re looking at where we sit today, network wide dwell has improved 13% since the beginning of the third quarter. We have further to go, but the metrics across the board, locomotive productivity, car miles per car day and dwell are all moving in the right direction. We feel confident that these gains are sustainable. If we look at our capital projects for the year, our construction of the second span of the Laredo bridge is 35% complete. We remain on target, operationally should be in by the end of 2024. If we look at 275 [ph] on our merger capital commitment we’ve made, we have put in service to the five sidings.

We look for the next three sidings to be within – service within three months. In closing, when we look at the early stages of the journey as a combined company, I’m very confident in the actions and in the – taking the development, the network and alignment operations, this story will continue to have – have continuous improvement and my team will be laser focused on delivering strong results. With that, I’ll turn it over to John.

John Brooks: All right. Thank you, Mark. And good afternoon, everyone. So as Keith said, we’re over – just over a half a year in as CPKC and I want to say that I’m excited as ever about the unique opportunities that this franchise has to offer our customers. While it’s certainly been a more challenging quarter than I expected, nothing that we’ve seen diminishes any of the exciting growth opportunities that we’ve guided to over the long term. My team has been hard at work at creating new markets, capturing new business and I’m extremely proud of what we’ve accomplished to date despite this challenging economic backdrop. CPKC’s unique footprint and our self-help initiatives are differentiators in this marketplace, and were extremely well positioned as the volume environment rebounds.

Now as I look to the third quarter results, on a reported basis versus CP standalone in 2022, total revenues were up 44% while volumes were up 31%. On a combined basis, total revenue was down 4% while volumes declined 3% versus pro forma CPKC a year ago. FX was a 3% tailwind while fuel was a 6% headwind on the quarter. The pricing environment remains strong with inflation plus renewables across our book of business. Now taking a closer look at our third quarter revenue performance, I’ll speak to the FX adjusted results on a comparison versus CPKC had the combination occurred in 2022. Starting with bulk. Grain revenues are up 7% on 9% RTM growth. Canadian grain volumes were up 13% year-over-year driven by the improved harvest, lapping the drought affected prior year.

US grain volumes were up 6% as this year’s harvest has been solid in our service territory, and we are benefiting from our expanded destination market reach. We continue to see new and unique grain flows emerge on the CPKC system. Customers are taking advantage of the opportunity to connect grain origination and destination in ways never available to them in the past. Now looking forward, projections for the current Canadian grain crop harvest has come down since our Q2 call. Our customers are now estimating the crop size to be in the 60 million to 65 million metric ton range. Currently, in Canada, we are seeing customer demand to start this crop year at levels below our resource planning, giving us available capacity to offset some of this headwind with shipments of US grain.

As a reminder, the CPKC combination has further diversified our grain franchise, and the US grain markets now make up more than half of our grain revenues. On the potash front, revenues were down 22% on a 28% volume decline. Our potash volumes were impacted in the quarter by the strike at the Port of Vancouver and continued outage of Canpotex Portland terminal. To say this has been a challenging supply chain year for our export potash volumes with Canpotex is a true understatement. Now looking ahead, although we do not expect the Portland terminal to come back online before the end of the year, we do have a strong demand outlook for Q4, and we’re working hard to maximize our volumes through all available terminals to build some momentum with Canpotex as we close out the year.

And to finish out on our bulk business, coal revenue was flat on 7% volume growth. With favorable compares in Q4 following last year’s outage of Teck’s Elkview mine and higher met coal prices as we sit here today, I see a very strong growth in coal as we finish out the rest of this year. Now moving on to merchandise. The energy, chemicals, plastics portfolio saw a 3% decline in revenue on a 5% decline in volumes. Lower volumes were driven by a decrease in crude business as a result of a facility maintenance and less demand in LPG. However, this was partially offset by growth in our refined fuels, including new business with Shell that began in August and continues to ramp up. And plastics growth out of Canada into the US and all the way down into Mexico.

Now as we move into the fourth quarter, I expect positive RTM growth in energy, chemicals, plastics, driven by continued strength in refined fuels as Shell continues to ramp up and we onboard new share wins. Forest products revenues declined 6% on a 4% decline in volumes. While we are seeing the impact of a softer economy and slower housing markets, we are very encouraged about the quick development of long haul forest product shipments from Canada down to our southern markets. The combination of our seamless route to market and the development of our transload network will position us well to capture synergies in this market as it rebounds. The metals, minerals and consumers products portfolio was up 2% on a 1% decline in volumes. Performance in this space was mixed as consumer products and frac sand were down as metals continued to have a strong performance.

We are particularly encouraged by continued growth from the Mexico field space. Production is ramping up to support strong demand for the auto industry and for infrastructure construction projects and CPKC’s footprint in Mexico is uniquely positioned to service this growing market. Automotive revenues continued to be strong, up 21% on 11% volume growth, a record quarter. Demand for finished vehicles remain strong as the auto industry continues to be challenged with high finished vehicle ground counts exceeding available supply chain capacity to move these vehicles to market. We are working with many of the OEMs to create unique solutions to improve rail efficiencies that will increase capacity and help clear this inventory. I’ll note that, as of now, we do not expect the auto strike to materially impact our business as we are focused on servicing the strong demand from our production facilities in Canada and in Mexico.

And finally, on the intermodal side, revenue was down 19% on a 10% volume decline. Domestic intermodal volumes continue to be pressured by soft market demand, higher inventories and competitive over-the-road rates. However, we remain extremely encouraged by the uptake of our new 180/181 cross border service. The opportunity in the cross border intermodal space is significant, our services consistent and truck-like and we’re in the earliest stages of developing this premium rail market. Moving over to the international intermodal area, volumes were challenged in the quarter by the Vancouver port strike and softer demand. Although we are excited as ever about this space and we look to continue to expand our services out of the port of St John and to grow Lázaro Cárdenas, we expect near term headwinds as ocean carriers continue to blank failings and rightsize their capacity in reaction to the softer demand.

In closing, so certainly while we are not as immune to the headwinds impacting the economy and certainly the entire rail and transportation sectors, we remain uniquely positioned to deliver long term differentiated growth. This powerful combined franchise is creating new opportunities for our customers to grow. And our synergy gains and the opportunities ahead of us continue to exceed our expectations. So with that, I’ll now pass it over to Nadeem.

Nadeem Velani: Thanks, John. And good afternoon. I would like to first thank the entire CPKC team for its hard work, focus and resilience. This team of railroaders is making history and I’m very pleased with their perseverance and dedication in the face of a more challenging operating and macroenvironment. Well, looking at the quarter, CPKC’s reported operating ratio was 64.9%. And the core adjusted combined operating ratio came in at 61.7%. Earnings per share was CAD 0.84 and core adjusted combined earnings per share was CAD 0.92. Results this quarter were impacted by the change in fuel price on both revenue and operating expenses. The impact of fuel price was a CAD 95 million headwind to combined operating income. This includes the CAD 72 million unfavorable lag effect on combined fuel revenue.

The CAD 95 million impact to combined operating income translated to a 70 basis point and CAD 0.08 headwind to core adjusted combined operating ratio and EPS respectively. Based on where fuel prices sit today, we expect the fuel price headwind from Q3 to be a slight tailwind in Q4. Now taking a closer look at our income statement, reported operating expenses provided on slide 14 and combined operating expense on slide 15. Similar to what we shared last quarter, our combined operating expense illustrates the estimated effects of the acquisition for the third quarter as if the acquisition closed on January 1, 2022. Reported comp and benefits expense was CAD 598 million, down 4% on an FX adjusted basis when compared to combined comp and benefits expense a year ago.

Driving the FX adjusted decline was lower current service costs and the DB pension plan resulting from higher discount rates and lower stock-based compensation. That decline was partially offset by wage inflation. Headcount was down slightly sequentially in Q3. We expect headcount to be down sequentially again in 4Q, which will continue to give us improved operating leverage as volumes accelerate into the end of the year. Fuel expense was down CAD 86 million or 21% on an FX adjusted basis when compared to combined fuel in Q3 2022. The decline was primarily driven by a CAD 93 million or 16% decline in combined fuel price along with lower GTMs versus prior year. As I mentioned a moment ago, that reduction in fuel expense due to price is more than offset by CAD 188 million headwind from a decline in combined fuel surcharge revenue.

Combined materials expense was down 4% on an FX adjusted basis. The decline was largely driven by reduced locomotive maintenance materials spend. Equipment rents were up CAD 24 million on a combined basis or 34% on an FX adjusted basis. The equipment rents increased due to higher car, higher payments resulting from automotive volume growth, lower use of CPKC intermodal equipment by other roads and increased use of pooled equipment. Combined depreciation expense was up CAD 32 million or an FX adjusted 6%, resulting from a higher asset base. Combined purchase services and other was CAD 506 million or roughly flat year-over-year on an FX adjusted basis. Our business interruption insurance recovery in the quarter related to 2021 flooding and wildfires in British Columbia offset increased casualty expense and cost inflation.

Looking to 4Q, I still expect PS&O to come in around CAD 530 million to close the year. Moving below the line, other components of net periodic benefit recovery decreased CAD 17 million, reflecting higher discount rates compared to 2022 and other expense was up CAD 6 million in the third quarter on a reported basis. Net interest expense was CAD 207 million or CAD 202 million on an adjusted basis. The decline was driven by a reduced debt balance. On a combined basis, income tax expense was CAD 258 million. We now expect the CPKC core adjusted combined effective tax rate to be approximately 25% for the year, a reduction of 50 basis points from the outlook provided in Q2. Turning the slide 17. We’re generating strong cash flow with cash provided by operating activities of CAD 1,027 million in Q3.

Our first call on capital remains the business and growth, and in the quarter we reinvested over CAD 700 million, in line with our expectation to invest approximately CAD 2.7 billion in combined capital in 2023. We generated CAD 454 million in adjusted combined free cash flow on the quarter in just under CAD 1.4 billion year-to-date. Our combined leverage is 3.6 times on our path back to our target leverage of 2.5 times. In review of the quarter, despite challenges, John’s teams continue to bring on synergies and our operations are gaining momentum, especially in Mexico. We remain well positioned to deliver on our long term guidance, and I’m extremely confident of this team’s ability to execute. I’m excited about what this franchise can deliver.

And I look forward to sharing our success with you going forward. With that, Keith, let me turn things over to you.

Keith Creel: Okay. Thank you, gentlemen. Let’s go and open it up to questions.

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Q&A Session

Operator: [Operator Instructions]. Our first question comes from Chris Wetherbee, Citi.

Chris Wetherbee: I guess you just mentioned that you’ve been able to capture some of the synergies from the deal. So maybe, if you can help us sort of understand what you think from a synergy perspective you’ll be able to realize here in 2023. And then, I guess what it’ll take to maybe reaccelerate earnings growth back towards some of the longer term targets that you have? Is it simply just getting into a better macroenvironment? Or are there some incremental cost actions or others that you can take sort of early in 2024 to kind of reaccelerate the earnings growth profile?

John Brooks: Well, maybe I’ll start, Chris, on the synergy piece. This is John. So, as I said, I’m really pleased. Despite the challenges we’re facing certainly in the macro and all the geopolitical things going on that we’re all facing, the team has been laser focused on the synergies and certainly delivering on a lot of things we laid out at Investor day. I think we said at Investor Day, we saw an immediate run rate of CAD 240 million sort of annualized. I can tell you, I know we pushed that to CAD 350 million that we talked about at some conferences, and I’m comfortable in telling you that we’re beyond that now. I’m not going to pick quite a number for you at this time. But I’m quite comfortable, we’re going to end up north of a number like that. So I’m quite pleased. And I’ll tell you, there’s a number of contracts and opportunities that are ready to go, but we’ll start up in 2024, but that’ll continue to add to that story.

Mark Redd: Chris, I’ll just add a little color on the cost side. We’re ahead of our target on the cost side as well. If we talk about accelerating, what I expect to see in 2024, is we debottleneck and continue to improve upon even numbers that Mexico is experiencing back to November of last year. That momentum will continue. We’ve got the investments that we made this year in the physical infrastructure that’s tied to the merger application. I think we’ve got five siding that are here online now, two more come on within about a month. And then we’ve got one more to close the year out. So we’ll get the benefit of that in 2024. So what I expect is the railroad to continue to incrementally improve from a fluidity standpoint, the locomotive productivity standpoint, and ultimately, you put those two together, you’re going to turn your assets faster, will have better car productivity, car miles per car day, and you’ll see operating expense tied to the synergies including these two networks accelerate a bit from the run rate that we’ve been after the last six months.

And again, I’ll finish where I started. We’re exceeding our expectations. Now there’s some puts and takes to that, but as far as where we thought we would be or where we should be, to realize the synergies that we committed to you on the cost side, we’re in a good spot, getting better every day.

Nadeem Velani: Chris, I’ll just add, running a fluid network which we’re seeing clearly today is going to help us on the operating the cost side ex synergies. We had talked about finishing the year with a lower labor headcount number, and that’s certainly going to be the case. I think we’ll have incrementally sequentially about 1,000 person reduction in headcount. And that’s just attributed to timing of some of the works projects and also just your normal seasonality. So you’re going to see us see the benefits of operating leverage. We do expect to see growth in this quarter from a volume standpoint. So, that operating leverage is going to naturally provide us some – the ability to take our costs down, improve our margins, and I fully expect – I’m sure we’re going to get this question, so might as well hit it now. I fully expect this sub 60 OR in this quarter.

Operator: Our next question comes from Scott Group, Wolfe Research.

Scott Group: Nadeem, you got me on the OR question already, so I won’t ask it again. How are you thinking about RTM growth in the quarter? And then I know it’s early, but when I think back to the analyst day, you talked about high-single digit revenue growth, mid-teens kind of earnings growth. Do you have visibility to getting to those kinds of growth rates in 2024 or is it just too early to tell at this point?

John Brooks: Now, let me take the RTM piece. So we’re slightly positive now for the quarter, Scott. We continue to expect to ramp up in November, December, and I fully expect the quarter, probably mid-single, 4% to 5% RTM growth versus last year.

Nadeem Velani: Scott, when we gave our guidance, I guess three or four months ago now, we talked about the five year plan. Nothing’s changed on that front when you look at it from a long term perspective. We didn’t expect it to just be without some level of cycle in during that timeframe. And so, we’re seeing that macro challenge now. I think we’ll see a bit of a softer grain crop in Canada next year. We’ve diversified our franchise, as John has pointed out. We’re not as reliant on Canadian grain, but it’s going to affect us probably in Q2 of 2024. That being said, I fully expect when we give guidance in January, consistent with what we’ve described in June, that we’re going to have double digit EPS growth in our sights. We always said that, over that four or five year period guidance, we’re going to ramp up the synergies.

And in the outer years, we’re going to be at the stronger levels, not only because of the ramp up and synergies, but also the benefit of some – the ability to buy back shares and lower the share count and what that provides from EPS accretion. So from our perspective, as we stand here today, I certainly expect double digit EPS growth.

Operator: Our next question comes from Brandon Oglenski, Barclays.

Brandon Oglenski: John, I think on the last earnings call here, we were talking about incremental business wins that have you guys pretty relatively bullish on the volume outlook in your network for the fourth quarter. Is that still coming through the way you thought back then? And can you talk to some of those specific opportunities that we should be looking for coming down the line in the near term?

John Brooks: Certainly, we talked about the win in the ECP area, which we’ve definitely seen that volume ramp up. And that, frankly, has caused the ECP area to inflect positive. I’ll tell you that that’s an area where I continue to see ramp up. There’s two or three recent contract renewals in that area that I feel really good about the share growth that CPKC and the team has delivered in that area. So I think you’ll continue to see upside in that space. I had said, we’re just getting started on that 180 and 181 train pair north/south. There’s a number of pieces of business that you should expect to see start up on that train pair – Chicago, Kansas City down to and into Mexico and out Laredo. We’re projecting yearly, I’m going to say, 10% growth in our reefer business this year, in a year where much of intermodal is down.

That’s been an area of growth and it’s going to be an area of growth you’re going to see to continue to come on to that north/south train pair. And then maybe last, I’ll leave you with this, as you look across all the North American ports, I’m quite pleased with where Lázaro Cárdenas sits today. We’re seeing import export growth of about 26% at that terminal. And as you think about LA Long Beach, minus 20; Rupert, minus 30; East Coast ports, minus certainly double digits, Lázaro has seen growth. And I’m not suggesting – we’ve got a long ways to go and a lot of work to do in a challenged international area. But we are making some headway. We’re doing a lot of ease of business thing. We’re working with [indiscernible]. I don’t know if you saw, but them recently announced a new port of call into Lázaro that’s going to start up November 9, so not only domestic Mexico, but for also shipments into the US.

So, that’s another area that I just think you’re going to see us continue to position ourselves well. And when things rebound, we’re going to be in a really good spot there.

Operator: Our next question comes from Fadi Chamoun, BMO.