Bill Ackman - Date/Photographer unknown.

31 March 2012

Bill Ackman's Railroad Venture May Derail Canadian Pacific

Plano Texas USA - Eleven years ago when Canadian Pacific Ltd. 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 percent 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 17 May 2012. The stock has surged 20 percent 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 as CEO. Mr. Hunter 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 percent from its present dismal 81.3 percent, an ambitious target when you consider that the industry's average operating ratio is about 71 percent.
 
Everybody agrees that there is room for sizeable margin improvement at CP but so far Mr. Hunter 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 Ltd. 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.
 
Mr. Hunter 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 metres 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 Mr. 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 under performing companies, take advantage of any surge in the stock, and move on. Pershing CEO Bill Ackman has already done his job. He's netted US$300 million from this deal.
 
I think that CP is now overvalued. At the current price of $75.71 the shares are trading at more than 17 times this year's forecasted earnings of $4.45. Just look at CN Rail, a far better company:  it's similarly priced at $79.27 but has a 14 multiple. It's possible, of course, that CP will move up sharply if Pershing is successful on 17 May 2012 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 Mr. Ackman wins the battle and Harrison Hunter takes over, we are going to see disappointing earnings for the foreseeable future.
 
Tom Slee - Analyst.