3 Things to Look for in Canadian Pacific's Earnings

With its stock priced to perfection,Canadian Pacific's fourth-quarter results need to impress

Jan 28, 2014 at 7:00PM

Canadian Pacific (NYSE:CP) releases its fourth-quarter results on Wednesday, and investors should pay close attention. They will soon know whether Canadian Pacific can continue delivering for investors, or if a train wreck is just around the corner?

U.S. equity investors were rewarded nicely in 2013 with the S&P 500 index up 30%. However, investors in North America's leading railroads did even better. CSX (NYSE:CSX) rose 43%, Norfolk Southern (NYSE:NSC) climbed 47% and Canadian Pacific delivered shareholders a 43% return on their investment.

Today, Canadian Pacific's stock is priced for earnings perfection. It's trailing-12-month, price-to-earnings ratio is over 30, but on a forward earnings basis, the same figure is around 17.Clearly the market is expecting strong earnings growth over the next year, and into 2015.

Investors had a lot to cheer about last quarter. During the third-quarter revenue rose 6%, operating expenses fell 6%, and EPS grew 45%. The results were impressive, but the market expects even more this quarter. Which signals will indicate that CEO Hunter Harrison and the rest of Canadian Pacific's management team are on the rack track? When the company releases its fourth-quarter results, here is what to look for.

Lower operating ratio
At the end of 2012, Canadian Pacific's operating ratio -- how much of its revenue goes toward funding its operations -- was 77%. At that time, the company announced its aim to reduce that figure to 65% by 2015. That's an incredible, some say impossible, objective. It took Harrison 12 years to accomplish a similar task when his was CEO at Canadian National, reducing its operating ratio from 77.3% in 1997 to 66.7% in 2009.

But Harrison and his team at Canadian Pacific delivered the goods in the third quarter. They achieved an operating ratio of 65.9%, an astounding 8.2 percentage point improvement over the same period in 2012. When Canadian Pacific releases its fourth-quarter results, investors should be looking for continued improvement in its operating ratio, and hopefully be reassured that progress made to date is sustainable for the long term.

Improved productivity
Deliver more with less -- that about sums up Canadian Pacific's strategy for increasing shareholder value. Locomotive productivity, measured by gross ton miles per active horsepower, improved 22% last quarter. At the same time, total workforce fell by 18%. Impressive, but delivering more with less can't come at the expense of safety, particularly for a railroad. So far this year, train accidents per million train miles, as measured by the Federal Railroad Administration, increased 14% at Canadian Pacific. This is a concern, and investors should be listening closely to what management has to say, and whether this trend continued into the fourth quarter.

Meeting revenue and earnings expectations
As a forward-looking instrument, stock markets are all about expectations. Canadian Pacific forecasts 2013 revenue growth to be in the high single digits and earnings-per-share growth in excess of 40%. Both objectives look well within reach, but the average earnings estimate among analysts calls for $1.96 per share in the fourth quarter and $6.51 for 2013. That equates to a 51% growth in EPS for 2013. For the stock to support its current valuation, Canadian Pacific needs to surpass its own forecast, and deliver against market expectations. If it doesn't, the share price will suffer.

It's been a great ride for Canadian Pacific shareholders. When its latest quarterly results are released on Wednesday, investors should have a good idea whether to stay aboard, or get off at the next station.   

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Justin Lacey has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway. The Motley Fool owns shares of CSX. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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