Canadian Pacific Kansas City Limited (CP) Earnings Call Transcript & Summary

Good morning. Welcome to our next session. I'm Ken Hoexter, BofA's Airfreight and Surface Transportation Analyst and Marine Shipping Analyst. With us, next up, we have Canadian Pacific, Nadeem Velani, the CFO. This is -- actually, Nadeem, this is your first time presenting at the conference over the years. I know you've been here many times in your prior roles. Though he was named CFO at CP back in 2016, this is the 16th time Canadian Pacific has participated in the 21 years we've hosted the event. So we thank you for your continued commitment. With us in the audience -- I don't see , but Chris de Bruyn, somewhere from Investor Relations. So Nadeem, we'll send you to Chris with all the tough questions. So with that, Nadeem, welcome. I think you have a few slides to get started.

No.

No? Good. Okay. So then let's just talk about what's going on. Maybe I'll just turn it over to you for an update, here we're on midway through the second quarter, and how things are progressing?

Good. Well, thanks, Ken. Thanks for having me, and yes, it's a pleasure to participate. Great to be back in-person. So I'd say, we -- a tough start to the year, a challenging first quarter, whatever could go wrong seemed to go wrong. We had down 14% in volumes, tough winter, whether impact of Omicron on crew shortages, et cetera, high derailment costs, high stock-based comp. Anyways, it was a challenging first quarter. That being said, we highlighted that we expect that to be an anomaly and that we'd see a sequential improvement in the OR on the order of at least 1,000 basis points, and that we'd see in the second half that, that could see double-digit RTM growth and still line of sight to positive earnings for the year. And pleased to say that since then, we've had a very strong April. May is also on track. Arguably, volumes are a little bit better than expected. So the headline number is down, but we're still battling through a very poor grain crop in Canada. Volumes are down about 65% on Canadian grain, our largest business unit. But if you strip that out, our volumes, overall, are up mid-single digits. So we'll see continued kind of weakness in grain, and it will probably fall off a cliff here as soon as we fully run out of Canadian grain and they go through the [ deseeding ] processes as we speak over the next week or 2 here. That being said, we're optimistic for a more normal crop. The moisture levels are looking favorable. So we're optimistic that we'll see a very strong rebound in Canadian grain, starting with the crop in August 1. So with that, I think we have a very positive outlook as far as our volumes, the operating leverage that comes with that. The network is running very well. Trains speeds are up, dwell is down. We're getting some more density on the network, which is key to operating leverage. And as we get the volumes of Canadian grain recovering, and where we see some of our own self-help initiatives when we look at some -- on the intermodal side, on the ECP side, it's a pretty strong outlook for the rest of the year. And then, of course, we head into 2023 with subject to STB approval, the opportunity to consolidate CPKC. We're optimistic in the first quarter of next year. And then we start layering on some of the potential of what we can do with that network, in terms of the revenue synergies, the $1 billion synergies that we've outlined. And we're -- by the day, we're getting more optimistic on the ability to the size of that pie growing. So I'm very optimistic on the next several years of what we have in front of us. It's a good time to be at CP.

So if I think about your volumes, you mentioned carloads are down 4%. RTM is down 5% somewhere, give or take, and both in line with our targets. Revenue per RTM was up nearly double digits in the first quarter. Any indication in terms of what we're seeing on the maybe pressure on the spot market in trucking? Is there any impact on pricing as you look on the rail side?

We're not seeing that in the near term at all. In fact, we look at our overall pricing, about 40% of our book is being repriced this year. Long-term contracts are being renewed kind of in that 6% level. So in my 25 years in this industry, it's never been as strong as I see it today. We're seeing in some areas in the spot market on the intermodal side, high single digits. End of April, we got the decision by CTA on Canadian grain that's regulated. The increase on the VRCPI, as they call it, is up 12.7%. Obviously, that does include a bit of fuel. That being said, when a regulated environment is increasing at that level, it sets quite the tone in terms of the pricing environment. So we're -- near term, we don't see the softness, I'm, kind of, watching for it, not -- we don't have our head in the sand that the economy is just going to continue to grow. And obviously, there's a lag in what the Fed does and what Bank of Canada does on the macro side, but so far so good.

Wonderful. Let me just take it down to near term before we go longer term, right? So your first quarter adjusted OR came in just around 70% from mid-50s last year, with [ degradation ] from the strike from fuel. You noted that CP can operate sub-60% for the rest of the year. Is there anything that you see that derails that, whether it's fuel, whether it's other costs that have crept up?

No, not at all. I mean the utmost confidence -- I wouldn't have said it if we didn't feel that way. Utmost confidence will be sub-60% in Q2 and still have a view that mid-50s in the back half of the year is achievable when you think about what I highlighted in terms of where volumes are, where the network is. Sure, fuel has gone up, but that also creates opportunities on the intermodal side. And some of these things that we've seen upside on when we talk about the VRCPI, the better grain performance or better grain pricing outlook. So no, absolutely optimistic in the fact that we've had a very strong April, a very strong start to May as well or halfway through May.

And the regulated grain pricing kicks in...

Kicks in August 1 with the new crop.

Okay. So let me jump over to PSR for a second. You were part of the original team deploying with Hunter and the recent STB debate on the impact of PSR and the reduction of industry employees and kind of almost blaming it for congestion and lack of fluidity in the rail network. What do you think the misperception is about PSR in terms of -- or where is the industry missing, how to use it to flip to growth?

All right. That's a question. So I'd say, better -- and I don't speak for the U.S. rails, let me speak from our perspective, which -- at CP and previously, at the other Canadian railroad. PSR, it's not an overnight thing. You can get some quick wins overnight. But to me, it's something that has to be kind of integrated into the culture of the organization, which takes years. We know we've spent a lot of time. Hunter used to do Hunter Camps and spend the majority of his time with people. Keith has continued that and what we do in terms of leadership development, the training, the education of PSR, how we structure internally within the organization, how we collaborate. A lot of that has -- to me, you get the added benefits of PSR and how it gets really integrated in the culture, into how we operate day in, day out, how we allocate resources, how we adjust when volumes are down, how we adjust when volumes are up. It also takes a great deal of, to me, the right type of capital investment. You look back and you've been around for a long time, how -- we spent a lot of capital and a lot of discussion around how do you get the benefits of PSR with the longer trains, with some of the blocking, what you do in terms of terminals and investments, the extended sidings. It's years of capital investments that you can save on locomotives, you can save on railcars. If you're running PSR the right way, your asset utilization is going to improve significantly. But I'd argue that some of that capital needs to be put into the base infrastructure to get the most out of running PSR, running those longer trains and getting the density on the network, working with customers to get the loading and unloading to get that supports asset utilization. So to me, it's not something that you can just necessarily do overnight. I think there's been a lot of success in the U.S. network. I think there's maybe a bit of lack of experience, to be honest with you. I think some of the rails have great experience, and it doesn't just occur overnight. I'd say that when you pivot to growth, leveraging that low cost and better service, it drives opportunity to grow from rails, grow from truck. We haven't seen that yet, but I'm optimistic that they'll recover well. I think it'll go higher and get some of the training that's required to get capacity up to what they need to grow. And I'm optimistic about the industry.

Wonderful. And I think to prove this point, right, despite the work stoppage, whether your operating metrics improved, right? I mean you saw train speeds up 1%, train lengths up 1%, right? So are there -- were there specific measures you took in terms of getting there? Or is this just continued [ hiring ]?

Yes. I mean, we had a choice, right, in January when we had to cut train lengths with the weather, when we didn't have -- when we were down almost 10% of crews because of Omicron and COVID and so forth. Can you look at it short term and say, "Okay, we're going to cut costs as much as we can to overcome that significant drop in volumes"? The short-term view would be, yes. The long-term view would be continue hiring, continue to stick to the plan because as you recover and you get out of the short-term kind of headwinds, you'll be able to generate the benefits of the volume growth. So through this, we didn't take that kind of short-term view of just slashing and burning. That's not PSR anyways. It's setting yourselves up so that when the network is in a position to recover, you've got the resources and the ability to leverage that growth. And that's what we did. So we've been hiring. We've been training with this view of everything I talked about, in terms of some of the growth and market share that we have in front of us in this more normal grain crop. It's going to be a significant volume increase, starting in August, September, for us. So we need to hire. We need to train. And so despite kind of volumes being down, we had to kind of have that longer-term view and increase our labor force and to set ourselves up for kind of the longer-term success.

Now that you can definitely see the companies that are moving faster, you're seeing the need for those employees. So where do you expect to climb, right? So is there a percentage you've given on employees in terms of where we should...

Yes, we'll continue to -- we're adding as we speak. So the training process 6 months or so. So we're across the network. We're adding employees back because you always have attrition, right? I think that's something that maybe the naysayers are forgetting that there's 7% to 10% attrition in our industry. And then you take a look at what's happened with the Great Resignation here with COVID and so forth, that's accelerated that as well. So you need to hire, you need to train just to get the base level and then for growth. So we're -- we expect to be flat headcount for the year. So we'll continue to ramp up through the Q2, Q3 and get to that kind of flat level.

So you mentioned the CPKC merger in terms of the $1 billion and opportunistic on -- even beyond that. Maybe just walk through what happened with the data submission? Did that delay anything on the back end? Is it still January, February? Is that still the timeframe? And maybe, what are the opportunities on that $1 billion? Can you maybe revisit those and talk to us and walk us through how you get there?

Sure. Yes. So the STB asked us to recall some of the data. There's an adjusted procedure schedule that they gave notice on, end of April. They gave us till the end of May, or May 27 specifically, to file that. We filed at May 13, so a couple of weeks ahead of schedule. Now the -- any interested parties have 20 days to respond, and then we would then respond to that. So we're looking at a similar timeline as kind of what we highlighted in January, in that we do think we'll have a decision sometime first part of the 2023. By statute, they do need to provide a decision on February 23 -- by February 23, 2023. So I think we're on track. We're back on -- the schedule is now active again. So I don't think there's a significant delay, in our view.

So nothing changed with that February 23 deadline. That's still...

That's correct.

And then your thoughts on the $1 billion?

Yes. So I mean, I think the $1 billion that we highlighted, originally, it was closer to $800 million when we announced the transaction back in March of 2021. Then, as we went through the year and went through the process, as we dug in, you learn more. You engage with customers, you look at the opportunities and you work -- you engage with your employees and so forth. And we bumped that up to $1 billion, majority of that through growth. Since then, that we've continued that process and obviously, when macro events change, that can drive other opportunities as well. You look at what's occurred, the horrific issues overseas, the geopolitical events that are occurring. I mean that's -- on the positive side, it's creating some opportunities. I mean if you look at what -- potash demand is exceptionally strong. Perfect example when we look at our synergies and the size of the pie potentially expanding potash export by Canpotex, [ we're ] the majority of that contract. Their biggest customer is now Brazil, outpacing China. They're looking for outlets. They're looking for other opportunities to export, diversify their transportation. K+S who are the sole supplier of their potash transportation within Canada. So recently, we had part of the team -- by team, I say John and Keith, looking at the network and looking at opportunities, and they were down in Port Arthur, Texas, where we do exports or where we do move some of the DRU crude out of Hardisty down to Kansas City, interchange with KCS and move it to Port Arthur. Well, that terminal has untapped capacity that they used to do soda ash. Why can't a terminal such as that be an opportunity to export potash? So we had further Canpotex team, further K+S team, our team, looking at that facility and saying, "Could this be a 2 million, 3 million ton kind of export facility?" So there's opportunities like that, that come along that -- you can't model back in March when they announced the deal. You couldn't model it back in September when we reannounced the deal. So as you kind of mind the opportunities, other things come up. As the macro environment changes, other things come up. So to me, that's one example. I've got a half dozen of those that we probably don't have too much time to go through them. But to me, the size of the pie is growing. Our confidence in the ability to deliver the synergies is growing. So we're excited. We just -- we've got to be patient. We're in trust right now. We'll honor that. So -- but I can assure you that as soon as STB willing, we get the approval, we'll be hitting the ground running and deliver those -- that $1 billion.

Wonderful, and huge opportunity there. So when you think about intermodal, right, so we're coming up on the July 1 negotiation deadline for West Coast ports. They seem confident that they're going to keep operating, not an issue. Are you seeing some share shift already ahead of that to Vancouver? Are you seeing increased congestion? I know you like to talk about the East Coast opportunity, we're certainly seeing that, but let's stick on the West. What -- how is that trending so far?

Yes. I mean you got to remember Vancouver relative to L.A. Long Beach, Prince Rupert relative to L.A. It's such a small piece, but small moves are meaningful to us in Canada. So we continue to see strength. I wouldn't say -- I can't point to something right now, Ken, to say that because of this strike, we're seeing a shift. That'd be a bit bold for me to say. I can't give credence to that. But I think if you look over the last decade of what the share shift in Canadian ports as Canadian -- the reliance and the reliability of Canadian rail, the labor stability, the cost advantage, currency certainly helps, I think it's a great opportunity, and I think we'll continue to see some share shift. And yes, we are excited to talk about the East, and so I'll happy to speak there as well if you'd like.

Yes. I mean, feel free. I mean, talk about your -- I mean it's something Keith loves to talk about the development of East Coast untapped capacity within the network. So...

Yes. So we acquired the CMQ just 2 years ago, and we -- it was a $40 million railroad, which we were hoping to grow to $100 million railroad. We're on pace now for over $200 million of revenues through that network. We -- a big focus was on Saint John -- the Port of Saint John, an untapped port that had huge potential but just wasn't realized. And this week, we're -- next week actually, we're going to start moving a second call for Hapag-Lloyd. They've got ships in the water as we speak. That's 1% of the total revenue type of opportunity, just this additional call. And you can argue that you're utilizing capacity that is very underutilized right. It's an opportunity to grow margins. When you look at why Hapag-Lloyd in this environment chooses its rail partners, I mean service matters. Their ability to turn their assets, get them back on the water for them to get another revenue move is so critical. And so it's a classic example of utilizing untapped capacity, working with partners of Port Saint John, with the NBSR, the short line that we work with, and then our chief -- our main customer being Hapag-Lloyd selling service and driving opportunities on untapped rail. So it's very exciting. That move in itself is growth from Northern Europe. It's an opportunity to not necessarily take market share but just to benefit from unprecedented growth. So it's exciting.

So within -- I'm going to go with some of the commodities real quick. So within ECMP, what is the status of crude contracts, liquid data damages? Are we cycled through that? Or is there still some...

It's slowing down. So that was the -- you'll see kind of the year-over-year kind of headwind was at its peak in Q1. So overall, as we go through the year, you're going to see kind of cents per RTM in crude, about [ $5.25, $5.50 ]. It's -- crude, overall, is relatively slow. There's still pipeline capacity. We'll see what occurs with production at $115 crude. The Canadian producers are doing well. They've been able to reduce their costs significantly over the last 6 years, 7 years. But I'm not sure whether they're going to just start ramping up production. They've got a lot of dividends to pay back and buybacks to do. So we'll see.

Grain, are you still seeing incremental benefits from the new cars and the train capacity? Or is that now [indiscernible]?

We're still adding to the fleet. So we're not done. We'll be done early part of next year. But you're going to see the benefits of the new hopper cars kind of this year with this new crop. So obviously, we've been ramping up the -- unfortunately, we ramped up at the peak when we got the drought. So we haven't seen the benefits yet. But at the same time, we've been investing. Our customers have been investing on the 8,500-foot model that allows us to both originate and land our longer trains. So they're going to benefit from these hopper cars. So part of the reason why I'm so optimistic about the operating leverage we'll get on the upside is all of that. We haven't seen that data.

Okay. Perfect. Auto timing, is there a SAAR target you kind of have built in your thoughts on the rebounding?

Yes, we don't -- I don't have a SAAR target, and the reason being is, our auto French is a bit unique. It's not as, call it, economically sensitive. It's -- we have a lot of our own self-help initiatives. Right now, auto is up double digits for us. Part of that are market share shifts we've seen at the end of 2021. We've seen some of our customers with the Toyotas of the world that have strong sales that are getting -- allocating some of the chips that they have to the production of their vehicles. So we have some additional kind of upside on autos when we look at other potential contracts. And then, of course, when we get into the synergy potential, we think that can be a big area of growth for us. So yes, not a base economic kind of SAAR number that I'll point to.

And then coal, have you -- [indiscernible] of the Teck business to see a number that was April.

I think we have -- Yes, I think we have one more month. You'll see the end of it this quarter. And then -- it was April of last year, so you'll see it through this quarter, and then we'll lap it.

And then sustainability of demand, just consistent met coal exports.

Yes. I mean Teck is an industry leader in terms of their cost structure, their ability to get it to market. So I think that it's -- I think the demand for steel and met coal is going to continue over the foreseeable future. I don't think that there's a viable replacement for it in the near term. I think there's -- global demand is still exceptionally strong, and we're aligned with Teck being a key producer.

So let me get your thoughts on rails and inflationary environment. Historically, I mean, obviously, you talked about pricing, which is looking at this the regulated grain pricing, what's going on in the rest of your base is just really robust. And that's kind of a follow-on effect of when truck pricing also skyrocketed. Now, we're starting to see that loosen. And we've got some rails in the U.S. having some service issues. But the rails have been protected on pricing for a while. So what's your thoughts on an inflationary environment? How do the rails perform in their ability to continue to get those pricing [ gains ]?

Well, I think we're in also a bit of a new environment if you think about some of the benefits of rail and from a sustainability point of view that the environmental benefit. So I think that's -- it's unique kind of going forward. We haven't really seen the benefit of that, historically. I think, generally, when you think about how rails can do, obviously, our margins are very strong. The ability to price above inflation. You've still got the alternative being truck being -- still having challenges from a hiring, hours of service. I don't think we've seen the ability to really drive market share gains in any sort of meaningful way the last decade. To me, in an inflationary environment, you're going to see opportunities for customers to choose lower and cheaper transportation solutions. You look at some of the major retailers that have released results the last few days, they're -- part of their challenges with their earnings has been transportation costs. Well, I can assure you that they're moving majority of their freight by truck, and for them to find opportunities within rail, within intermodal, that can be much cheaper than the truck alternative is, to me, a solution. So in this inflationary environment, I think that there's a big opportunity for the rails.

I'm going to -- want to switch it to CapEx, but let me just see if there's any question in audience. No? All right. So CapEx, you're talking about [indiscernible] about $1.5 billion, which is about 18% of revenues. Would be -- I guess, what we're seeing in the PSR railroads have moved it down to kind of 14% when you want to position the growth that kind of starts creeping up again. What are your thoughts in terms of -- your thoughts on -- as you prepare for growth? Obviously, we saw your peer in Canada kind of get hit by growth multiple years and then kind of behind the curve on CapEx. Is it the recognition of that to stay ahead of kind of where you see the pinch points and keep investing? Is that a right level? Or is there some catch-up that you're looking at? What's your thoughts on that?

Sure. Yes. So I mean we plan our capital kind of multiyear. We -- percent of revenue, we haven't been a big fan of that as a metric. But that being said, when we look at what opportunities we have in front of us, of course, the base investment back into basic capital, which is about $800 million a year, above and beyond that, we look at where the growth opportunities are. We look at what we need to do from a systems point of view, et cetera. I mean, so $1.5 billion is a fair number for us. We've had accelerated investment into the hopper car program that I mentioned, about $150 million a year. So that's going to roll off early part of next year. But then we've got some other opportunities to grow when we think about what we're going to be spending on capital for the CPKC network. I think when -- all told, when we look at our capital investment, [ $1.5 billion, $1.6 billion ] is a fair number.

Okay. CFO, thoughts on timing of debt pay-down. You've now got, what, about $20 billion in debt, 5x leverage post the acquisition. What's your thoughts on timing to get back to your target?

Yes. So we're sub-4 as we speak. I think we'll be -- end this year around 3.5x. I think we'll -- end of 2023 is our target to get back to that 2.5x, 2.6x. I think outside of a massive change in the currency, if its the Canadian dollar depreciate significantly, could that move a little bit? Perhaps. But I think we're on pace for that 2.5x, 2.6x by -- in the next 18 months.

Okay. And 2.5, 2.6, that's where you -- your target? Or that's just...

Yes, that's what we've always targeted as our -- as kind of our sweet spot. And that's what we've committed to when we did the financing for the acquisition. We've been very clear with the rating agencies that we want to get back to that level. We won't look at any sort of buybacks. We won't look at any sort of dividend increase until we get to -- at least to that level. And we have a lot of pretty exciting investment opportunities in front of us on the CapEx side. So we've historically had a 16%, 16.5% return on invested capital. So we've had a lot of meaningful opportunities to get returns through our capital process and generate value for our shareholders. As we reduce our debt and we get that draw-down to that 2.5x level, we'll reassess our capital allocation at that time.

In the past, is there -- as you mentioned fuel getting up to $115, is there a point where you start to see degradation in economic activity, based on fuel?

It's a great question. I mean, being a Calgarian living in Alberta, we're a bit maybe biased that there's huge benefits, obviously, locally. But no, you do question and you do look at it from a macro point of view, like I mentioned, Target announcing today and Walmart, you see the impact on the consumer. At some point, it is going to -- our fuel surcharges, the truck fuel surcharges, et cetera, it's going to impact the consumer, and it will slow down the economy, whether that's $115, $190. To me, I've always felt like a sweet spot is in around that $80 to $90. It's kind of balanced, in terms of the benefits to the economy and what we move as a company versus the impact on inflation in the consumer. So $115 is getting a bit high. Yes, we just heard from J.B. Hunt, too. They said, on the lower end, they're also seeing it on their furniture-moving business.

All right. So I guess just -- we've got just a couple of seconds here. So if I try and sum up, right, so pricing, very robust, regulated, even better. Boost in August, mid-50s OR, certainly in the second half. Hitting sub-60 in the second quarter despite the impact of fuel. Operations continue to perform very well. Excited about the acquisition, the $1 billion opportunity. And I presume you even see some upside to that as you move forward and look at some of the opportunities. Is there anything you kind of want to wrap up with or anything I'm missing there?

No. I think you summed it up well, Ken. We're excited for finishing this year strong and more excited about what's in front of us starting in 2023.

Wonderful. Sounds great. Thank you.

Thanks, Ken.

Appreciate it.