Canadian Pacific Kansas City (TSX:CP) stock price is about 17% higher year over year. More gains could be coming for the large-cap stock. First, the railway company has combined with Kansas City Southern, expanding its geographic footprint into Mexico. Second, the company has illustrated a track record of growth. Third, the stock’s valuation is still reasonable at current levels, which should lead to total returns that more or less align with its earnings growth going forward.
CP Rail is a good gauge of the economic health
The class-one railroad business is a good gauge of the economic health, as it hauls a wide range of products, including shipments of grain, coal, potash, fertilizers, sulphur, forest products, energy, chemicals, plastics, metals, minerals, automotive, and intermodal containers.
Its first-quarter results that it reported in late April were solid. It reported revenue growth of 23% year over year to $2,266 million, while operating expenses climbed 10%. Its operating ratio (i.e., operating expense relative to revenue) improved 7.5% to 63.4%. As a result, its operating income jumped 55% to $829 million and diluted earnings per share (EPS) rose 37%. It also experienced good growth of 34% for its adjusted EPS to $0.90.
Connecting Canada, the U.S., and Mexico
CP Rail has combined with Kansas City Southern to create the first and (by far) only single-line transnational railway connecting Canada, the United States, and Mexico. This should help it win business from certain clients.
Fuel, which made up close to 23% of its operating expense for the quarter, saw the largest jump of 19% versus the other expenses. As energy prices have weakened, this expense should come down as well, which could result in higher earnings growth.
Track record of growth
CP stock has price momentum and tends to trend upward. Even before merging with Kansas City, the rail company has had a track record of delivering solid long-term returns through economic cycles. Its five-year return on asset and return on equity of about 9.3% and 27.6%, respectively, are impressive.
Since 2013, the growth stock has returned approximately 18% per year, essentially turning an initial $10,000 investment into about $56,281. Since 2008, CP stock has returned about 15.9% per year, transforming an initial $10,000 investment into roughly $97,045.
The company is expected to surface value from the combined company and juice out synergies and benefits, allowing it to generate growing free cash flow, which can drive a higher stock price.
Valuation
Importantly, Canadian Pacific Kansas City is not an expensive stock given its double-digit earnings-growth potential and the current valuation it trades at. At $104 and change per share, CP stock trades at about 26 times its blended earnings compared to its estimated EPS growth rate of about 13.3% per year over the next three to five years.
Surely, the stock could be cheaper, but wonderful businesses hardly go on sale. The analyst consensus 12-month price target agree that the stock is not expensive. The consensus target suggests CP stock is discounted by almost 12%.
Returns potential
Assuming the stock’s valuation stayed the same and it experienced earnings-per-share growth of 13% annually, over the next five years, investors can expect total returns of about 13% per year. With valuation expansion, combined with earnings growth and its dividend, CP stock can deliver annualized returns of about 16% in the period.
