My original plan for today had been to warn you that as much as the sacking of Canadian Pacific’s leadership by the company’s own shareholders is a huge, watershed moment in the annals of Canadian business, it means little for CP’s investors.
I was in agreement with my colleague David Berman, who noted Friday that CP’s shares had already gained 24 per cent over the course of the assault by activist investor William Ackman.
Even worse, CP, the basket case of the North American rail industry, happens to be easily the most expensive stock among its peers. CP’s forward price-to-earnings ratio, according to Standard & Poor’s CapitalIQ, is 16.3; CN’s is 14.7, and the three major U.S. railroads (as they are called there) trade from 11 to 13 times earnings.
Indeed, the market has already priced in a modest turnaround at CP. However, the numbers suggest it isn’t expecting all of Mr. Ackman’s bold predictions to come true.
That implies, rather intriguingly, that investors can still profit even if the railway’s new leader fails. As a result, I have had to reconsider my skeptical stance.
The whole reason CP got itself into its recent contretemps was that it had a serious, long-term profitability issue that even the aggressive Mr. Ackman suggests will take several years to fix.
The focus of Mr. Ackman’s scorn is CP’s operating ratio, a measure of the company’s costs per dollar of revenue. In the case of this ratio, lower numbers are better and CP had been clocking in above 80, the industry’s worst figure. Its rival CN typically registers operating ratios in the high 60s.
Mr. Ackman has said he plans on CP having an operating ratio of 65 per cent within four years, a goal a number of analysts say, unsurprisingly, is “aggressive.”
What happens, however, if CP gets halfway to that number?
Walter Spracklin of RBC Dominion Securities, who expects CP’s new management to “gradually back off” its original goal after it thoroughly evaluates CP, projects a 71 per cent operating ratio for 2015.
If CP posts 7.1 per cent annual revenue growth, Mr. Spracklin estimates it would produce $7.13 in earnings per share that year. A price-to-earnings multiple of 14 then yields a $100 stock. (Mr. Spracklin’s 12-month target price of $82 is derived by discounting that price back to 2012 dollars).
Barclays Equity Research analyst Brandon Oglenski, one of the most bullish analysts, sees CP dropping its ratio to 76.5 in 2012, then improving it to 71 by 2014. That leads him to project earnings of $7.30 per share, a 15 multiple, and a $109 share price — a nearly 50 per cent gain from today’s levels.
To be clear, there’s a fair amount of optimism here, even if these projections fall short of Mr. Ackman’s assertions. Fadi Chamoun of BMO Nesbitt Burns, who has a “market perform” and $81 target price, believes that CP can get the operating-ratio figure in the range of 68 to 72 in five years, but “the road is still long and fraught with risks.”
Morningstar Equity Research analyst Keith Schoonmaker, who says CP has a “fair value” of $70 in U.S. dollars, echoes deposed CEO Fred Green’s comments when he says: “A CEO can’t change weather, mountain grade, exposure to Teck coal (10 per cent of sales), or pension funding status (except via strong cash flow).”
And the potential share-price gains seem more modest when a less-robust multiple is applied. The current average forward P/E among the major North American rail companies, CP excepted, is 12.5, not Mr. Spracklin’s 14 or Mr. Oglenski’s 15.
Applying that 12.5 multiple to Mr. Oglenski’s $7.30 of EPS in 2014, when much of CP’s efficiency-driven earnings improvement may already have occurred, yields a $90 price. Use an earnings figure of $6.40, closer to analysts’ consensus, and you get $80 — not much of a two-year gain over today’s levels.
Those scenarios, however, require the P/E multiple to contract. That seems incongruous for a stock that would be growing earnings so rapidly. It seems more likely that if CP does just half of what Mr. Ackman says, it can maintain a P/E close to CN’s. If so, investors who bet on CP could gain even beyond today’s pricey levels.