Canadian Pacific Railways (CP) operates a transcontinental railway in Canada and the United States over a network of approximately 14,800 miles. It has direct links into eight different ports in U.S. and Canada including Montreal, Vancouver, New York and Philadelphia. Canadian Pacific transports bulk traffic such as grain, coal, and sulphur; merchandise such as forest products, energy and automotive. It has a major presence in intermodal shipping to transport high-value retail goods from across the globe to North American markets.
Canadian Pacific is well poised to take advantage of several global macro trends. Its intermodal transport business is going to benefit with continued global expansion. If high oil and gas prices persist, the upside is even higher as manufacturers and retailers choose rail over truckers for cost-effective shipping. It is a major player in soft commodities such as grain and fertilizers and is likely to benefit from increased global food and agricultural trade.
Canadian Pacific is well integrated into the supply chain of key energy resource areas such as the Bakken formation, Marcellus shale, Alberta oil sands, major ethanol production facilities in the U.S. Midwest and wind energy tower manufacturers in Canada. Energy is its fastest-growing business and Canadian Pacific nearly doubled its crude oil shipments in Q4 2011.
It is a major transporter of metallurgical coal generated by Teck Resources (TCK) and recently signed 10-year agreement to integrate deeply into Teck's supply chain to handle growth in coal shipment volume. Coal is almost 50% of Teck's revenue and is likely to experience a period of significant growth. The main driver is lack of replacement to Kyoto Protocol during last December's UN conference in South Africa on climate change. The Kyoto Protocol will now remain in place until 2020 with no long-term global agreement on limiting greenhouse gases. This is a bullish scenario for coal producers and Canadian Pacific is going to be an important beneficiary.
It is no surprise that Bill Ackman of Pershing Square Capital has set his sights on Canadian Pacific by acquiring nearly 14% of the shares. Bill Ackman wants to install five new board members and a new CEO, Hunter Harrison, former CEO of Canadian National. The shareholders are scheduled to vote in May. But shares of Canadian Pacific already had a nice run and are up over 45% since the announcement by Pershing Square Capital.
While the current management is opposed to change, it is likely to lose the proxy battle. On operating metrics, Canadian Pacific fares much worse than the railways, in general and Canadian National (CNI), in particular. Canadian Pacific's return on equity is 12%, much less than the rail and road industry's average of 20% and about half of the Canadian National return on equity of 22%. Its operating ratio (operation expense divided by net sales) at 78% is also much lower than Canadian National's ratio of 65%.
Bill Ackman's argument is straightforward and compelling. Hunter Harrison, former CEO of Canadian National, is ideally suited to bring Canadian Pacific's operational efficiency closer to that of Canadian National. He has done this before and there is little doubt if he can pull it off again. If one assumes that Canadian Pacific's revenue grows at its historic 6% annual growth rate and if the proposed operating ratio is met, its earnings five years out will be around $10 per share. At its historical five-year P/E of 14, its shares will be trading at $140 - almost twice its current price. The savings due to improved operations could be returned to shareholders through increased dividends - its current yield is 1.6% - or share buybacks. This would be another plus if they can pull it off.