In previous articles, I have expressed my bullish outlook on the rail industry. In this one, I argued, frankly, that "railroad stocks are heading skyward". Satiating my interest in railroads with my background in proxy fights, it is interesting to watch the battle going on at Canadian Pacific (CP). Hedge fund manager Bill Ackman has his eyes set on replacing the board of Canadian Pacific and getting his nominee, Hunter Harrison, elected as CEO. Ackman laments that the incumbent CEO, Fred Green, has underperformed rail peers for the last six years and believes that Harrison is the right replacement given the nominee's success at Canadian National (CNI).
The main element activist hedge fund managers, like Ackman, look for when making investment decisions is a deep-value discount. Ackman humorously calls this metric "Return on Invested Brain Damage", which makes sense when you consider that benefits from waging a proxy fight (ie. the discount to intrinsic value) must outweigh the costs (ie. filing proxy materials, implicit economic time, negative investor distraction, etc.) In this article, I will run you through the DCF model on Canadian Pacific and then triangulate the result with a review of the fundamentals against CSX, Norfolk Southern (NSC), and Union Pacific (UNP). I find that Canadian Pacific is less undervalued than these rail peers.
First, let's begin with an assumption about the top-line. Canadian Pacific had $5.1B in revenue in FY2011, which represents a 1.4% gain off of the preceding year. I model a 7.5% per annum growth rate over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 41% of revenue versus 39% for SG&A and 16% for capex. Taxes are estimated at 14% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I estimate this figure hovering around -2.7% over the explicitly projected time period.
Free cash flow comes out to around $335M by 2014. The stock is currently worth $13.4B, which means that it trades at nearly 40x my 2014 free cash flow estimate.
All of this falls within the context of operational improvement:
This morning, Canadian Pacific reported a strong start to 2012, with EPS of $0.82 and an operating ratio of 80.1%. This represents an operating ratio improvement of 1,050 basis points over last year and an improvement of 220 basis points over Q1 of 2010. We're executing on our plans and delivering record operating metrics.
Importantly, the records we're setting are not just for the first quarter. We're setting all-time operating records for any quarter, evidence that these are sustained improvements, not just easy comparisons. The programs we have underway are resulting in new, unparalleled level of performance. We have clear accountabilities to ensure the consistent execution of the integrated operating plan, we're realizing real market growth, we're delivering on our pricing targets and we're providing a superior service to our customers.
From a multiples perspective, Canadian Pacific is also more expensive than its peers. It trades at a respective 23.2x and 14.9x past and forward earnings versus 12.8x and 10.8x for CSX, 13.4x and 11.3x for Norfolk Southern, and 15.8x and 12.3x for Union Pacific. It appears that Ackman is really betting on either the effect that a CEO change will have on Canadian Pacific's operating performance or at least the positive effect that the market will assume.
Consensus estimates for CSX's EPS forecast that it will grow by 9% to $1.82 in 2012 and then by 13.7% and 14% more in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $2.04, the stock would hit $28.56 for 27.6% upside. CSX is led by top management and even offers a reasonable dividend yield of 2.2%.
Consensus estimates for Union Pacific's EPS forecast that it will grow by 20.8% to $8.12 in 2012 and then by 14.4% and 13.6% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $9.27, the stock would hit $129.78 for 14% upside. This stock is also led by top management that offers a 2.2% dividend yield. According to data sourced from NASDAQ, the stock is rated around a "strong buy" by Wall Street analysts.
Consensus estimates for Norfolk Southern's EPS forecast that it will grow by 8.3% to $5.84 in 2012 and then by 12.2% and 12.4% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $6.49, the stock would rise by 23.8%. The company offers a high dividend yield among peers at 2.8% and is also relatively safe with only 9% more volatility than the broader market. I am further optimistic about management's knowledge of the industry and believe it is a safe investment despite macro uncertainty. In sum, given the upside CSX, Union Pacific, and Norfolk Southern, I believe that Ackman should consider at least backing these peers as a way of hedging his bet on Canadian Pacific.
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