Canadian Pacific: Great Business, But Wait For A Lower Price

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About: Canadian Pacific Railway Limited (CP)
by: Patrick Doyle
Summary

Although I prefer the other Canadian railroad, I've been very pleasantly surprised by the company's ability to execute.

That said, the shares are priced very optimistically at the moment in my view, and for that reason, I would recommend that most people avoid the name until at present.

For those of us who are manically impatient, I recommend an options trade that provides what I think is a win-win trade.

Shares of Canadian Pacific Railway Ltd. (CP) are up ~20% over the past twelve months, and I thought I'd check in on the company to see if now is a good time to buy or not. It's not. In spite of the fact that this company managed a great first quarter (along with most other Class 1 railroads), the shares are excessively priced in my view. For that reason, I think the patient among us would be better off waiting for a better entry price. For the impatient among us (I include myself in this camp), there is, of course, an options trade that we can do. I'll offer the specifics of that trade later in the article.

Background

Canadian Pacific Railway owns approximately 12,500 miles (20,000 km) of track and spans from the city of Edmonton into the mid-West in the United States. The following is a map of the company's current network.

Source: Wikipedia

One of the things I find interesting in railroads is the size and scope of the network. If a network has access to interesting resources or touches multiple coasts etc., I think the business deserves a premium. For example, as I stated in my article on Canadian National (NYSE:CNI), I like that railroad because it touches three coasts in North America and largely bypasses the congested city of Chicago. Unfortunately, when I review the Canadian Pacific network, I remain uninspired. The most interesting thing that's happened to this network over the past decade turned out to be a non-starter. Specifically, in an (ultimately unsuccessful) attempt to compete against Union Pacific (NYSE:UNP) and BNSF in the Powder River Basin, the company acquired the Dakota, Minnesota, and Eastern railroads in 2009. Three years later, Canadian Pacific abandoned their plans to compete in the Powder River when they announced that they'd be selling the entirety of the former DM&E track West of Tracy, Minnesota to Genesee & Wyoming (NYSE:GWR).

That said, the company has improved (just like every other Class 1 railroad) a great deal over the past several years, with train lengths up 21% since 2012 and train speeds up 26% in that time.

Source: Canadian Pacific investor factbook, 2018

Financial Snapshot

This improvement in operations is reflected to some degree in financial performance, as both revenues and net income are up nicely over the past several years. Specifically, revenue has grown at a CAGR of about 2% over the past five years, and net income is up 5.7%. In addition, as a result of management buying back about $7.6 billion of shares over the past five years, earnings per share are up even more at a CAGR of about 10%. This trend has continued in the first quarter of this year relative to last, with revenue up ~6% relative to Q1 2018, and net income up just under 25%. Given the preponderance of cold weather track here, it's no surprise that operating ratio spiked during the first quarter of 2019. It's not much higher than the same period in 2018.

Source: Company filings

The Stock

One of the things that I find interesting about investing is that it's about more than seeking outgrowing cash flows. It's at least as important to not overpay for those cash flows. For that reason, I must spend some time talking about the stock itself as a thing distinct from the business itself. I'd say that the Canadian Pacific stock is a poor proxy for the health of the business in my view. According to the chart below, the company is at a multi-year high in terms of the price earnings ratio. It's not as expensive on a price to free cash basis at the moment, but as one commenter pointed out in an earlier article, cash flow may be a less relevant metric when looking at a capital intensive business such as this one. All this suggests to me that the stock is too rich and that investors would be wise to avoid at these levels.

Source: Gurufocus

An Option Trade

Just because I wouldn't buy at these levels doesn't mean I wouldn't buy at any levels. It's obvious that this is an earnings generating machine, with an enormous economic moat. This puts me on the horns of an uncomfortable (for me) dilemma. Do I simply wait and buy the shares when they drop or do I place a trade today that locks in a price that I would be willing to pay. I think the latter is a more effective strategy for me at this point because many is the time I've refused to pay market price for a great company, only to watch the manic crowd drive price higher. At the moment, the December Canadian Pacific puts with a strike of $200 is bid at $3.70. So if an investor sells these puts, one of two things will happen. If the shares continue to rise, they will simply pocket the premium received and move on (not a hardship). If the shares do fall in price from here, the investor will be obligated to buy the shares at a price ~15% below the current level. In my view, this is a "heads, I win, tails I win a bit more" trade.

Conclusion

While I prefer its Canadian competitor, I must admit that Canadian Pacific has demonstrated a tremendous capacity to grow earnings at a faster rate than revenue. In addition, management seems quite shareholder-friendly in their approach, having returned billions to shareholders over the past five years. That said, we don't buy the business, we buy the shares, and the shares are at multi-year highs on a PE basis. Thus, I would recommend that conservative, patient investors wait for a more attractive entry price. For those of us who find patience anathema, there is what I think is a great options trade.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will be selling the puts mentioned in the article over the next few days.