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The Little Engine That May Not
05/08/2012 11:30 am EST
This Canadian railroad stock had great promise, but it’s now running into new management with big ideas, and it’s time to get out before it goes off the rails, writes Tom Slee of The Canada Report.
Eleven years ago, when Canadian Pacific split into five separate companies, the railway looked like a sure-fire takeover target. As a small player in an industry of giants, it obviously needed a parent.
But the meaningful bids never came. The other four offshoots were soon swallowed up, but the railway was left to soldier on. Nobody was interested. Saddled with brutal terrain and obsolete facilities, Canadian Pacific Railway (CP) was and is fundamentally unattractive.
But now Pershing Square Capital Management, a New York-based shareholder activist, has arrived on the scene with a plan to breathe new life into the company. Having acquired a 14.2% stake, Pershing thinks that drastic management changes can make CP much more profitable.
The current directors are resistant, leading to a climactic showdown at the upcoming annual general meeting (AGM) in Calgary on May 17. The stock has surged 20% since October because Wall Street is convinced that Pershing is going to be successful. I am not so sure.
Here is the plan. Pershing wants to appoint six new board members and install Hunter Harrison, who successfully ran CN Rail (CNI) as CEO. Harrison will then apply his “precision management” and transform CP into a dramatic turnaround story.
He aims to reduce the company’s key operating ratio (the percentage of revenues needed to run the system) to 65% from its present dismal 81.3%, an ambitious target when you consider that the industry’s average operating ratio is about 71%.
Everybody agrees that there is room for sizable margin improvement at CP, but so far Harrison has provided no details on how he will achieve this, other than by cutting management. That’s a start, but corporate overhead is not the problem.
The company’s real trouble is much deeper, originating in the 1990s, when Canadian Pacific starved its railway of capital by focusing on more exciting ventures. In those days, railroads were a sunset industry; road haulage was to be the wave of the future.
As a result, CP’s tracks and support structure were neglected. In fact, the company is still struggling to build adequate sidings and repair facilities.
Harrison faces some additional challenges: The company has been borrowing heavily in order to reduce its pension deficit of over $700 million.
A great deal of CP’s important Vancouver business flows through the avalanche-prone Rogers Pass, a treacherous stretch where five meters (16.4 feet) of snow in a year is not unusual. The terrain poses challenges like steep gradients, iced rails, and bottlenecks. You have to wonder how “precision management” is going to fix that.
There are a few other things to consider. Contrary to all the hype that led to CEOs being paid astronomical salaries, modern corporations are never a one-man-band. Successful companies require a team effort. Even if Harrison does take charge, he will have to put his own people in place, and that will take time.
In fact, he is already contacting old CN colleagues. But that could work against him: Canadian Pacific Railway is far different from CN Rail.
CN’s impressive performance was accomplished to a large extent through acquisitions, the redirecting of its major traffic to north/south from east/west, and the government forgiveness of most of its debt. CP does not have these advantages, to say nothing of the unfriendly terrain. The company veterans refer to CN engineers as “lowlanders."
Let’s be clear: Pershing is not making a takeover bid or injecting capital. Its business model is to shake up underperforming companies, take advantage of any surge in the stock, and move on. Pershing CEO Bill Ackman has already done his job. He’s netted $300 million from this deal.
I think that CP is now overvalued. At the current price of $75.92, the shares are trading at more than 17 times this year’s forecast earnings of $4.45. Just look at CN Rail, a far better company: it’s similarly priced at $78.72, but has a 14 multiple.
It’s possible, of course, that CP will move up sharply if Pershing is successful on May 17, but that is mere speculation. A more likely scenario is that the present board will successfully defend its current CEO, causing the stock to drop, especially if Pershing starts unloading its stake. Even if Ackman wins the battle and Hunter Harrison takes over, we are going to see disappointing earnings for the foreseeable future.
Action now: Sell. I originally recommended Canadian Pacific Railway in March 2011 at $64.96. We have received dividends of $1.19 since then. If you bought on the original recommendation, you have a total return of 18.7% including dividends.
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