Canadian Pacific Railway: A New Dividend Aristocrat

A Canadian Dividend Aristocrat is a good search starting point if you are looking for a high-quality company in which to invest. One such company is the Canadian Pacific Railway, a new Dividend Aristocrat!

Canadian Versus US Dividend Aristocrats

The term Dividend Aristocrat is defined differently in Canada and the United States. Let’s look at the differences.

The US Dividend Aristocrat criteria are:

• member of the S&P 500
• dividend increases for at least 25 consecutive years
• the float-adjusted market capitalization must be at least $3B
• the average daily trading volume of at least $5 million

The Canadian Dividend Aristocrat criteria are far less stringent.

• The company’s security is common stock or income trust listed on the Toronto Stock Exchange and a constituent of the S&P Canada BMI.
• The security has increased ordinary cash dividends every year for 5 years. It can, however, maintain the same dividend for a maximum of 2 consecutive years within that 5-year period.
• The float-adjusted market capitalization of the security must be at least $0.3B.
• The company is to have increased its dividend in the 1st year of the prior 5 years of review. This rule does not apply to current index constituents.

In my recent Canadian National Railway An Overvalued Dividend Champion article I concluded that shares are richly valued and I will not acquire additional shares at this time other than through the automatic reinvestment of dividends.

In this article, I look at Canadian Pacific Railway Limited (CP) which is the smaller of Canada’s two Class 1 railroads.

Railroad Industry

The U.S. Department of Transportation Federal Railroad Administration provides a comprehensive Freight Rail Overview. Similar information for Canada can be found on the Government of Canada’s Rail Transportation webpage and also on the Railway Association of Canada (RAC) website.

Class 1 rail carriers in the U.S. have annual revenue of at least $346.8 million in 2006. In Canada, a Class 1 rail carrier has earned gross revenues above $0.25B for each of the previous two years.

In North America the 7 Class 1 rail carriers are:

• BNSF Railway (owned by Berkshire Hathaway) – trackage in Canada and the US
• Union Pacific Railroad – trackage in the US
• Canadian National Railway – trackage in Canada and the US
• CSX Transportation – trackage in Canada and the US
• Norfolk Southern Railway – trackage in Canada and the US
• Canadian Pacific Railway – trackage in Canada and the US
• Kansas City Southern – trackage in the US and Mexico

Canadian Pacific Railway Overview

I cannot do justice by trying to explain Canadian Pacific Railway in this post. I, therefore, encourage you to learn about CP’s markets, history, culture, and strategy through its website.

The magnitude of this company’s scale and scope can be found in the most recent Annual Report and Investor Fact Book located in the Overview section of the company’s website.

The following image provides a quick snapshot of Canadian Pacific Railway’s 13,000-mile rail network.

Financial Review

Q4 and FY2020 Results

Canadian Pacific Railway’s latest quarterly results were released on January 27, 2021.

FY2020 results are impacted by COVID-19. Volumes, however, steadily improved over the second half of 2020 and revenue ton-mile grew in Q4.

Source: Q4 2020 Earnings Review

Operating Ratio

In my recent Canadian National Railway An Overvalued Dividend Champion article I state the operating ratio is a key metric to analyze railroads. This ratio is a company’s operating expenses expressed as a percentage of revenue; it is the opposite of operating margin which divides operating income by revenues. We must, however, not overlook other key metrics such as revenue growth, strong profit margins, efficient capital deployment, etc.

Canadian Pacific Railway has a reputation for consistently having one of the best operating ratios amongst Class 1 railroads. In FY2019 and FY2020, the company reported an operating ratio of ~59.9% and ~57.1%, respectively. In contrast, Canadian National Railway reported an operating ratio of 62.5% and 65.4% in FY2019 and FY2020 and 61.7% and 61.9% after adjustments. Canadian Pacific Railway’s operating ratio is exceptional considering a good operating ratio is typically in the low to mid 60% range.

Other Key Efficiency Metrics

The following are FY2019 and FY2020 efficiency metrics.

Financial Guidance

FY2021 guidance calls for:

• Double-digit adjusted diluted EPS growth relative to FY2020’s adjusted diluted EPS of $17.67
• High single-digit volume growth in Revenue Ton Miles (RTM);
• CAPEX of $1.55B versus $1.647B in FY2019 and $1.671B in FY2020

Key assumptions used to derive this guidance are a 24.6% effective tax rate and a $40 million increase relative to FY2020 in other components of net periodic benefit recovery. Other components of net periodic benefit recovery were $0.342B in FY2020. This is a decrease of $39 million, or ~10%, from $0.381B in 2019. This decrease is primarily due to an increase in the recognized net actuarial loss resulting from a reduction in the discount rate.

Risk Assessment

Although Canadian Pacific Railway’s balance sheet remains strong with leverage of 2.5 times adjusted net debt to adjusted EBITDA, I look at the ratings assigned by the major credit rating agencies to gauge if my risk as an equity investor is reasonable.

Moody’s has rated the unsecured long-term debt Baa1 since November 2014 and S&P Global has assigned a BBB+ rating since November 2014. Both ratings are the top tier of the lower-medium grade investment-grade category. These ratings indicate the company has an ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

The current ratings are investment grade and are satisfactory for my risk profile.

Dividends

A $0.95/share dividend is payable on April 26 to holders of record at the close of business on March 26 and the July dividend will likely also be $0.95. Canadian Pacific Railway’s dividend history shows the April dividend will be the third quarterly dividend at this level.

Dividend Yield

Although Canadian Pacific Railway is a new Dividend Aristocrat, some dividend yield-hungry investors may be reluctant to take a position because of the sub 1% dividend yield. I, however, make an investment decision by looking at the potential overall return and do not let the dividend yield totally influence my decision-making process.

CP’s share price is currently $459.10 and stock screeners currently reflect a $3.80/year dividend and a ~0.83% dividend yield. We can expect two more $0.95/share quarterly dividends and two $1.0825/share quarterly dividends over the next 4 quarters. This totals $4.065/share in dividends over the next 4 quarters for a ~0.89% dividend yield.

Dividend Payout Ratio

In the Q4 earnings call, the company’s EVP and CFO indicated the company has been increasing its dividend with the view of getting the dividend payout ratio closer to 25% – 30% of diluted EPS. Canadian Pacific Railway has increased its dividend the fastest amongst its peer group for the last 5 years. Since EPS growth in the last 4 years is ~16%, it becomes a challenge to approach this payout ratio.

The Board is mindful that its shareholder base has changed and there is an increasing view they want a bit more dividend. The plan, therefore, is to have a balanced approach from a dividend and share buyback perspective. To get to the 25% – 30% payout ratio the dividend is likely to increase at a faster pace than historically.

We know that in FY2020 the company generated $17.67 of adjusted diluted EPS and FY2021 guidance calls for double-digit adjusted diluted EPS growth. A 10% – 15% growth range gives us an FY2021 adjusted diluted EPS range of $19.44 – $20.32. If the dividend payout ratio is to reach the 25% low end of the target range the new dividend should be ~$4.86 – $5.08.

I expect the increase in the dividend payout ratio will be phased in over two years; a sudden jump from $3.80/year to $4.86/year in 1 year is a stretch.

If the gap between the current payout ratio and the low end of the desired payout ratio occurs over 2 years, we could expect a $0.53/year, $0.1325/quarter, starting with the October 2021 dividend. The new quarterly dividend would, therefore, be ~$1.0825..95/share quarterly dividends and two $1.0825/share quarterly dividends over the next 4 quarters. This totals $4.065/share in dividends over the next 4 quarters for a ~0.89% dividend yield.

Share Split

On January 27, CP announced its Board of Directors will seek shareholder and regulatory approval for the implementation of a 5:1 share split of CP’s issued and outstanding common shares. The share split is subject to the approval of shareholders at the April 21 Annual and Special Meeting of Shareholders. Management deems this to be an appropriate step to enhance liquidity in the stock to provide better access to ownership for a wide range of investors.

Share Repurchases

In 2020, $2B was returned to shareholders through share buybacks and dividends despite a pause in share buybacks early in Q2 given the uncertainty in credit markets. These buybacks resumed in June based on improved confidence in the outlook and the strength of the company’s balance sheet. Ultimately, CP completed 90% of its latest share buyback program at an average price of $369/share.

The diluted weighted average number of shares outstanding has declined from ~150.5 million in 2016 to ~136 million in 2020. The decline has been ~3 – ~4 million shares a year during this time frame. On this basis, I anticipate the FY2021 share count will be ~133 million.

On the January 27, Q4 Earnings Call, management responded to an inquiry from an analyst about having a healthy discussion about share buybacks versus dividend increases. The Board is trying a balanced approach from a dividend and share buyback perspective.

At the time of the January 27 analyst call, management’s opinion was that shares were undervalued at ~$423; other rail companies may not execute as well as Canadian Pacific Railway but they get better premiums.

CP continually looks for opportunities to buy back its stock at reasonable valuations. Since 2014, ~$10B of stock has been acquired at half of CP’s ~$423 stock price on the day of the earnings call.

Valuation

The following reflects CP’s 2016 – 2020 PE, adjusted PE, P/FCF using each year’s low and high share price. We can see there is quite a variance in CP’s valuation metrics when we use the low and high share price for each year.

Valuation Based on Earnings and Adjusted Earnings

The current PE based on a $459.10 share price and FY2020’s $17.97 EPS gives us a ~25.55 PE. This level is higher than the PE in the timeframe analyzed when we use the year’s high stock price and much higher when we use each year’s low stock price.

FY2021 adjusted diluted EPS guidance from 21 brokers is a mean of $20.46 and a low/high range of $19.54 – $21.40. Based on the current $459.10 share price and the mean estimate, the forward adjusted diluted PE is ~22.4.

In FY2020, CP generated $17.67 of adjusted diluted EPS and FY2021 guidance calls for double-digit adjusted diluted EPS growth. A 10% – 15% growth range gives us an FY2021 adjusted diluted EPS range of $19.44 – $20.32. Based on the current $459.10 share price, the forward adjusted diluted PE range is ~22.6 – ~23.6. This level is higher than in previous years when we use CP’s high stock price except for FY2020.

Valuation Based on Free Cash Flow

FY2021 FCF guidance has not been provided. If, however, CP were to generate ~$1.2B of FCF in FY2021, which is similar to that generated in FY2020, and we use a diluted weighted average number of shares outstanding of ~133, we get FCF/share of ~$9; this level is greater than in priors years except in FY2019. The current $459.10 share price dividend by ~$9 gives us a Price/FCF per share of ~51. This level is definitely high in comparison to recent historical levels.

Based on the valuation metrics calculated above, Canadian Pacific Railway is a new Dividend Aristocrat but it is an overvalued Dividend Aristocrat.

Conclusion

There is no disputing Canadian Pacific Railway can be a great long-term investment. The challenge investors currently face is that this Dividend Aristocrat appears overvalued and acquiring shares at the current lofty valuation will very likely lead to a poor investment return. We appear to be witnessing a period of irrational exuberance where many investors disregard valuation and invest for ‘fear of missing out’ (FOMO).

I have been investing in individual equities for 3 decades and have learned that ‘stuff’ happens. When it does happen, overvalued shares often experience a sudden and sharp share price pullback.

I envision Canadian Pacific Railway’s share price will not retrace to the $278.50 I paid when I acquired 200 shares in March 2020. A share price of $380 or less based on FY2021 guidance, however, seems more appropriate than the current $459.10. A $380 share price and an adjusted diluted EPS of $20.32, which represents 15% growth from FY2020’s level, give us an adjusted diluted PE of ~18.7. This is more consistent with the 2016 – 2020 adjusted diluted PE mid-point.

Furthermore, we see that Canadian Pacific Railway’s valuation based on FCF/share is close to the high we have witnessed during the entire 2016 – 2020 timeframe.

Buying shares a year ago was a ‘no brainer’. Based on my analysis, however, I will wait for this new Dividend Aristocrat to be better valued.

Author bio: This is a guest post provided by Financial Freedom is a Journey which is an independent financial information provider focused on analyzing stocks with a value investing approach. Its main goal is to help investors make better investment decisions.

Disclaimer: The author does not know your individual circumstances and is not providing individualized advice or recommendations. You should make investment decisions after conducting your own research and due diligence. No compensation is received for this article.

Disclosure: The author owns shares in Canadian Pacific Railway in the FFJ Portfolio and in accounts for which details are not disclosed.

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