CP Rail (CP) delivered a really solid quarter with Hunter Harrison showing just how quickly he and his team were able to bring down the closely watched operating ratio to an industry-leading 65.9%. Quarterly net income of $82 million was better than expected, held down by charges related to the disposition of surplus rail assets. With those "adjusted" out of the way, net income was a more impressive $338 million or $1.91 per share - up 49% from 2012.
For the year as a whole, adjusted net income was $1.1 billion or $6.42 a share and even the unadjusted net income was a pretty solid $875 million versus $494 million in 2012.
You would think I was a CP bull, but I am not. This is a railroad. Hunter Harrison has lead a team which has done some major cost cutting and now has the company operating with a very high level of efficiency. CP's guidance for full year 2014 was for continued improvement and a 30% increase in net income over the 2013 figure. CP didn't do the arithmetic for us but that implies net income of $8.35 a share, on a 6 to 7% increase in forecast revenues.
To really understand CP it is useful to compare it to other railroads. The Table below sets out CP's 2013 results against full year 2012 for its competitors and calculates the ratio to sales of each cost element.
Source: CP Release and Company 10-K's
Next, I am going to credit CP with the industry's best cost performance on each of the line items, that is, I will forecast CP with 14% cost of fuel to sales; 19% compensation and benefits to sales; 8% depreciation to sales; and, 16% purchased services, materials and equipment rentals to sales.
This requires CP to reduce compensation costs by $171 million; fuel costs by $85 million; depreciation expense by $40 million; and, costs of purchased services, materials and equipment rentals by $314 million. If it could accomplish those reductions and meet the higher level of its revenue guidance of 7%, it would earn $1.9 billion on $6.5 billion in sales.
That would be an extraordinary achievement. Even if Hunter Harrison and his team could pull it off, the value of CP at 15 times earnings would be $28 billion. But today the market values CP at more like $30 billion.
The fact is that this train has run about as far as it can go on cost cutting. Harrison enjoyed a tailwind from oil by rail shipments that grew dramatically since his appointment. He ran longer trains with fewer people and ran them faster. That brought costs down and risk of derailment up.
Harrison does not even target $1.9 billion for 2014 earnings. His target is a 30% increase over 2013 adjusted earnings or about $8.25 a share.
What is the right multiple to value a railroad? Let's look at the data on Yahoo.com Finance for leading competitors. The market values direct competitor Canadian National at 14.7 times forward earnings;
the market values Norfolk Southern Corporation at 12.3 times; and,
the market values CSX at 12.2 times.
CP is not best in class in North American railroads and even if it was, it is not worth $30 billion. At best, if Harrison can meet his goals the stock is worth 12 to 15 times $8.25 a share which is somewhere between $100 and $125 a share. Even if CP was the low cost operator on every line item, the company's earnings would be on the order of $10 a share and the stock might have a value of $120 to $150.
CP reports in Canadian currency, as are the above data. In U.S. Funds with the exchange rate now about $0.90, CP has an outside shot at $7.25 to $7.50 a share in earnings in 2014 and should trade between $85 and $115 U.S a share. That is a lot lower than it trades today.
I am short the stock.