CP Rail: DM&E Deal Presents Rare Opportunity

When investors are given a choice between company share buybacks and an acquisition, they prefer the buybacks. That, at least, is one conclusion that can be drawn from Wednesday's bid by Canadian Pacific Railway Ltd. (CP) for privately held Dakota, Minnesota & Eastern Railroad Corp.

Canadian Pacific shares dropped as much as 4.5% on the news of the US$1.5-billion deal, which will add about 2,500 miles of track to CP's 14,000-mile network. They closed at C$70.93, down C$2.54. The shares have been on a roller-coaster ride this year -- rising on strong fundamentals for the commodity and economy-sensitive North American railway sector, then spiking on a takeover attempt by Brookfield Asset Management Inc. (BAM), then diving after that offer went sour in July.

The shares are up 15% in 2007, but down 20% from their peak. Are they cheap or heading into a rough stretch?

The deal with DM&E, which could involve another US$1-billion in contingency payments tied to expansion projects in the Powder River Basin coal-mining area, effectively puts Canadian Pacific's share buyback program on hold, a move that investors do not take lightly.

Share buybacks have been a popular way for cash-rich North American companies to boost their earnings-per-share without growing their profits by much. Fewer shares outstanding mean that earnings are not divided as widely. Of course, there can be better things to do with excess cash than buying back shares -- but, clearly, investors are concerned that this particular deal might not be a good alternative.

Their concerns stem in part from the belief that Canadian Pacific could be buying DM&E for too much money just as the economic cycle is about to turn. The impact of unwinding credit markets could hit the global economy, and the U.S. economy in particular. Wednesday, the Bank of Canada left interest rates unchanged, reflecting these concerns.

A slower economy would likely translate into lower commodity prices and a downturn in global trade -- the lifeblood of railways, and Canadian Pacific is no exception. As well, some analysts are not convinced the deal will result in any meaningful cost savings, or synergies, for Canadian Pacific anytime soon.

But keep in mind that railways operate within an unusual environment in North America, thanks to strict regulations that limit mergers because of a concern about diminished competitiveness in the sector. Just 70 years ago there were well over 100 major railways in North America. Now, there are just a handful.

Obviously, this environment makes it difficult for railways to grow at a time when they are in high demand as a fuel-efficient way to haul finished goods and commodities across the continent. It also makes the DM&E deal a rare opportunity.

Canadian Pacific's takeover news arrives soon after some not-so-keen analysts had been warming to the stock because of its lower valuation. Today, the shares trade at a reasonable 17 times trailing earnings, versus about 21 times earnings just two months ago.

Any further selling could put the stock into bargain territory. Yes, this investment comes with the risk that the North American economy is marching toward a precipice. But if you can stomach that risk, Canadian Pacific's merger plans look more foresighted than share buybacks.