Canadian Pacific Railway (CP) is certainly topical. The subject of activist investor Bill Ackman's 2012 reorganization and now run by Ackman-backed legendary railroader Hunter Harrison, the stock has gone nowhere but up since Harrison was put in office.
Source: Yahoo Finance
Harrison has promised (and delivered) rapid improvements in the railway's "operating ratio" - a measure of its costs as a percentage of revenue and a metric frequently used to compare railways. Historically, the benchmark for operating ratio in Canada, was set by CN Rail, CP's major competitor, which itself was formerly run by Harrison. Harrison has set a target of getting the operating ratio into the mid 60% range by 2016. The time frame is important because it coincides with Harrison's 72nd birthday and longer-term investors will have to look to his successor for leadership thereafter.
There is no question that CP has improved its operating performance rapidly since Harrison took over, a feat that has yet to be marred by more than a couple of derailments that spilled oil into the countryside here and there, no doubt related to the decision to run longer trains and run them faster - an important contributor to reducing the operating ratio. Governments and investors alike have given CP a pass for these oil spills, which have not attracted the violent outbursts of vocal environmental groups the way a similar spill from a pipeline might. Time will tell whether CP is taking more risks than it should but that is not the issue for today.
Today's issue is simply valuation. A key question for investors is what is a railroad worth?
We are not short of railroads in North America, so it was a relatively simple matter to set out how the market perceives them in terms of earnings multiples and find that a price-to-earnings ratio of between 14 and 18 is about right.
Canadian Pacific Railway Comparables
The comparables set out in the table represent large-cap North American railroads that fairly can be described as alternatives to investment in CP.
To make the point that CP appears overvalued I have put together a table that takes CP's 2012 results and adjusts them to reflect a CEO's dream result after a major cost cutting and efficiency drive. To be specific I have assumed:
- A 20% cut in compensation and benefits achieved through either reduced headcount or lower wage rates;
- 15% volume growth without additional personnel
- No increases in fuel or material costs in relation to sales
- Volume growth achieved without additional purchased services
- 10% lower interest expense (can rates get much lower?)
- No change in income tax rates
These results are unlikely to ever be achieved, not by Harrison or by anyone else, so I have labeled them as "BLUE SKY DREAM." The fact is that railroads are a competitive business and higher volumes require more rail cars and more people to run them. Customers are unlikely to pay any particular railroad a higher rate for its transport of goods because of its "brand" or its CEO's public persona. Instead, freight customers are going to trade off the costs of trucking and rail or, in the case of oil, pipelines, and make their decision based on costs.
CP has enjoyed a short-term boost in volume arising from limited pipeline capacity for oil from Canadian producers to U.S. destinations, a problem that will last no more than a couple of years as Keystone, Northern Gateway and other pipeline options to transport oil come to fruition. So let's turn our minds back to the assumptions. Can Harrison achieve results such as those listed?
If Harrison can achieve those kinds of results he should be canonized. Assume he can. The results are set out in the table below.
CANADIAN PACIFIC RAILWAY IMPLIED VALUATION
Blue Sky Dream
15% growth with no additional investment
Compensation and benefits
Same rate of use
Same rate of use
No new equipment rented
No new equipment purchased
No additional services needed
No further costs
No further costs
Other income and charges
Income before taxes
Value at 12 x earnings
Value at 15 x earnings
Value at 18 x earnings
Market capitalization today
The result is remarkable, in my view. The fact is that the market is paying today more than 18 times hoped-for 2016 earnings, almost triple the current level, as if there was no risk that earnings would not materialize nor any likelihood that the competing railroads would improve whatsoever.
Do I buy it? Not on your life. I am short CP.