The North American freight rail industry operates as three duopolies, with two rail networks operating across the East, West and Central US into Canada. These rail networks have very high entry barriers, given the prohibitive cost and regulatory challenges associated with trying to lay a new rail network. More than half (55%) of rail industry revenue has no substitutes, while 45% of freight revenue could be substituted by trucking. Given this strong industry position, rail has been able to price above its cost inflation over the long-term.
Three important factors make it an attractive time to invest in the rail operators. Firstly, the rail companies have implemented Precision Scheduled Railroading (PSR), a method of operating the railroad more efficiently, which should allow them to improve their service levels and lower their costs. Secondly, rails are four times more fuel efficient than trucking, and with higher fuel prices, their relative price discount to trucking increases further. Finally, longer-term, the increasing need for supply chains to decarbonise, favours rail freight over trucking given its greater fuel efficiency. A 2% shift in volume from trucking to rail freight would increase the rail market size by 14%, given that the truck market is so much larger.
Canadian Pacific is one of the two North American freight railroads that transport traffic between Canada and the Midwest in the US. It is run by Keith Creel, arguably the best manager in the North American rail industry and a protegee of E. Hunter Harrison, who developed PSR. In addition, Canadian Pacific is in the midst of a merger with Kansas City Southern, which will make it the only rail with access to six North American ports and transit between Canada the US and Mexico.
Canadian Pacific trades at a price-earnings multiple of 22 times, but we expect this to rapidly derate to 17 times 2024 earnings as synergies are captured and as Canadian grain volumes rebound from a low harvest last year.