Once upon a time Canadian Pacific trains included a caboose - 1976 Phil Mason.

2 November 2011

What Does Bill Ackman Know About CP?
Less Than You Think

Toronto Ontario - Pershing Square's Bill Ackman didn't make a name for himself by investing in companies that are impeccably managed. Mr. Ackman takes big positions in companies whose stocks are laggards and whose management is viewed in some way as deficient. He then proposes relatively simple ideas and reaps the rewards.
 
So it must be a little embarrassing to be Fred Green, who runs Canadian Pacific Railway. CP's stock surged after Mr. Ackman disclosed a big position last Friday, along with his intention to help create value.
 
Not only did investors cheer, even the analysts did, albeit in their own subtle ways. Some of them raised their price targets. Others spoke glowingly of Mr. Ackman, highlighting his past successes while ignoring his failures.
 
Is this enthusiasm warranted? What no one is saying is that Mr. Ackman, a bright and successful investor surrounded by bright people, is venturing very far from home with this foray. We'll never be privy to all of Pershing's investments, but the ones we do know about, and the ones the publicity-seeking Mr. Ackman is famous for, are pretty similar.
 
Here's a list of some of his high-profile investments:  McDonald's, Wendy's, Target, J.C. Penney, Kraft, Barnes & Noble, Borders, and Sears Canada.
 
As for his strategy with these investments, they tend to involve the balance sheet, capital structure issues such as share buy backs and bigger dividends, and spinoffs.
 
Notice anything about this list? It's retail and consumer-specific. It is certainly not industrial. Mr. Ackman has a clear preference for these types of businesses, presumably because he's comfortable and experienced in these worlds. He also likes real estate (his family is in New York real estate).
 
So the first question is:  What does he know about rail? We all know it's an attractive business to long-term value investors, because Warren Buffett and Bill Gates have both made big investments in railways. But Mr. Ackman is not quite the long-term investor these two billionaires are. He tends to move in and quickly unlock value, often selling his stakes, at least partially, in relatively short order (another of his favourite techniques is to invest heavily in options of the companies he invests in, this is a great way for his fund to get a leveraged return.)
 
But let's assume that Mr. Ackman spent the last year with private tutors boning up on railways and gaining insights that no one else has. Unlikely, but let's just pretend.
 
What can he do at CP? It's no secret that the company is a statistical laggard. Its operating ratio is worse, a lot worse, than CN. And CP has become a predictable disappointment. There was a time when CN investors lamented that company's relative under performance. CN made an acquisition, brought in a new CEO, and now the shoe is on the other foot. Mr. Green, who is no Steve Jobs, gets the blame. The slightest hint that there's a fire burning under his feet puts investors in a good mood.
 
This is what they see:  CP's operating ratio is roughly 15 percentage points worse than CN's. Each point adds between 10 and 15 cents of earnings per share. Each share trades for 14 times earnings. The simple math tells you that the stock goes up as much as 50 percent if the difference in performance is eliminated.
 
No one expects that, of course. While some improvement is possible, CP will never be CN. It has a different business and especially a different rail system, which is more susceptible to bad weather and has steeper grades.
 
CP has embarked on a campaign to make its trains move faster, more efficiently, and more reliably. So improvement is not only possible but likely on its way, and it's the easiest way to add value.
 
Can Mr. Ackman help this happen? He wouldn't know where to add a siding and he's not likely to find a flatter pass through the Rockies. Can he bring in a new CEO? He can try, but he'd likely have to wait until CP's efforts have either borne fruit or failed.
 
As for the balance sheet, there's not much opportunity for fiddling. There are no obvious divestitures, no receivables to sell. There is a big pension hole though, which makes it harder to manoeuvre.
 
To be sure, the market has sent CP's board and CEO a message:  Get your act together.
 
But to expect the usual magic from Mr. Ackman looks ambitious. Investors should be patient and hope he doesn't get in the way, at least for now.
 
Fabrice Taylor.