The Truth Behind Canadian Pacific's First-Quarter Results

Canada's second-largest railway, Canadian Pacific (NYSE: CP  ) reported first-quarter results earlier this week. And by many measures, it was a record performance.

For the first quarter, total revenues increased just 1% to $1.5 billion, yet operating income increased by 17% to $423 million. And net income of $254 million, or $1.44 per diluted share, was an improvement of 16% from the same period a year earlier.

Here are three important takeaways from Canadian Pacific's latest earnings release, and what it means for investors.

Volumes down, revenues up
It's been a brutal winter, and no-doubt part of the reason for the decline in Canadian Pacific's freight volumes -- 6% fewer carloads and a 5% decline in revenue ton miles, or RTM. The most dramatic declines were in forest products and automotive, down 22% and 14% respectively. Despite moving less, Canadian Pacific's freight revenue increased by 1%.

Revenue per carload, and revenue per RTM improved by 8% and 6% respectively. How? It can be explained by a weaker Canadian dollar, better pricing on contract renewals, and a positive mix toward higher yielding traffic, primarily industrial products.

The transport of industrial and consumer products were, by far, the most important factors to Canadian Pacific achieving the 1% growth in freight revenue – increasing by 11%, or $40 million, over the year earlier period. Continued growth in the transportation of oil-by-rail, and fracking sand, used in the process to extract crude oil and natural gas from shale rock, is key to continued growth in freight revenues in upcoming quarters.  

Weather-defying operating ratio
Maybe the most impressive figure achieved by Canadian Pacific during the quarter, at least upon first glance, was its operating ratio of 72%, a 380 basis point improvement from the first quarter of 2013.

However, a closer look at the components of the decrease in operating expenses that contributed to the lower operating ratio is revealing. For the quarter, operating expenses fell by 4%, driven primarily by lower stock based compensation and a swing of $34 million, from expense to income, in the company's pension plan. 

What happened to my dividend increase?
Canadian Pacific had a great 2013 -- record revenue, an all-time low operating ratio and improved productivity across the board. It ended the year with free cash of $530 million, and provided unofficial guidance of free cash flow generation of between $1.0 billion-$1.5 billion for 2014. Though Canadian Pacific can afford to raise its dividend, it has chosen another path in the name of creating shareholder value.

Earlier this month, Canadian Pacific unveiled a share buyback plan to repurchase up to 5.3 million shares, or about 3% of the total outstanding, over the next year. Based on the stock's current share price, the value of the program could reach nearly $820 million.

Based on data compiled by Bloomberg, U.S. investors own nearly 73% of Canadian Pacific's stock, compared to just 47% for Canadian National (NYSE: CNI  ) . And U.S. based hedge fund Pershing Square Capital, managed by activist investor Bill Ackman, controls nearly 10% of Canadian Pacific stock.

American investors in Canadian companies tend to prefer share buyback programs due to the heavy taxation of dividends from companies north of the border. On a possible dividend increase, Hunter Harrison, Canadian Pacific's CEO, commented that, "U.S. holders are not crazy about dividends because of the tax treatment. U.S. investors would rather have a buyback than a dividend."

Unfortunately, the case for share buyback programs enhancing shareholder value is a difficult one to make. Corporate boards often initiate share buyback programs at inopportune times. With Canadian Pacific's stock hovering around its 52-week high, now is not the best time to begin buying in the interest of shareholder value.

Foolish bottom line
Despite the slower than expected start to 2014, Hunter Harrison, Canadian Pacific's chief executive officer, reaffirmed his confidence in meetings expectation for revenue growth of between 6% and 7%, a full year operating ratio of 65% or better, and earnings-per-share growth of greater than 30%. At current valuations, including a price to earnings ratio exceeding 30, Canadian Pacific stock is priced for perfection.

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