26 April 2007
CPR's Buyback Ploy
"You can't say yes and you can't say no," said Fred
Green, the head of Canadian Pacific Railway Ltd., redefining the concept of beating around the bush.
He was speaking during this week's quarterly conference call about whether or not CPR might be the object of a leveraged buyout, like
BCE, the United Way, and anything else with a bank account and revenue.
What made investors wonder was the fact that the railway announced a massive buyback on the heels of decent first-quarter
earnings. Observers suggested that the buyback was meant to deter private equity or LBO marauders.
Sure, buybacks are usually good for shareholders, but takeovers at fat premiums are better.
If a takeover is less likely, why was CPR's stock up on the news? Because the likelihood of a private equity foray was probably slim
to begin with.
Here's how the numbers work: CPR is proposing to buy back and cancel 15.5 million shares over the next year. To put that in
context, CPR has bought back only 675,000 shares so far this year.
At current prices, the proposed buyback would cost about a billion bucks. The company expects free cash flow this year of
$300-million. The difference, it stands to reason, has to be borrowed.
The company won't have trouble raising that kind of coin in the debt markets, although it might be a tad more expensive: On
hearing the buyback news, DBRS bond raters cut the outlook on CPR to negative from stable. Mr. Green shrugged off the change, noting
that DBRS had only recently upgraded its trend on CPR to stable. "This just gets us back to where we were a little while
ago," he said.
While it's true that borrowing a few hundred million would add stress to the balance sheet, equity analysts who follow the company
aren't terribly worried about it. CPR, like any rail operator, is basically a monopoly in the areas it serves. It charges what it
wants - within reasonable limits - and because of a healthy market in commodities, few complain. This is the kind of business investors
like, including two of the richest men in the world, Warren Buffett, who owns a big slug of Burlington Northern Santa Fe and two other
undisclosed railways, and Bill Gates, who owns almost $2-billion worth of Canadian National Railway. Debt can be
dangerous, but it's less dangerous when you have a degree of real pricing power.
Debt helps make the buyback accretive to earnings and cash flow per share. Besides fewer shares, debt is tax deductible. Combine that
with lower dividend payments as shares are retired and the cost of financing the buyback is offset. That's on top of what should be
decent organic earnings growth.
As for that pre-emptive strike, this move is not really a negative because an LBO seems like wishful thinking. CPR looks
like a cash cow, churning out more than a billion a year in cash flow. All you have to do is go out and milk it, right?
No. That cash flow figure is basically earnings plus depreciation. The money shareholders can take out of the company without hurting
its operations is a lot lower because every year, CPR has to replace and add to its rolling stock and other equipment. Subtract the
cost of replacement from the cash flow number and you get the so-called free cash flow, the amount that, in theory, you
could pay in dividends.
Because we live in an inflationary world, especially where commodities are concerned, the cost of replacing worn out rail ties, and
rolling stock is a lot higher than what CPR originally paid for the stuff it's replacing.
You can gauge this difference by comparing capital expenditures to depreciation: Over the past six years, capex is almost twice
as high. This is partly because the company is adding new equipment as it grows, but a lot of it illustrates the fact that railway
earnings tend to overstate the value of the company (which is not to say they aren't very valuable concerns).
Private equity players tend to prefer companies who, among other things, have more free cash flow than earnings. That doesn't seem
like the case here.
That's not to say an LBO is out of the question. It's to say that for existing investors, there's more value in having management act
as though it might happen, than in banking on it.
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