CPR director Donald Smith drives the Last Spike in the national railway - 7 Nov 1885 Library and Archives Canada.

5 June 2012

The End of a Dream

Toronto Ontario - In 1881, the Canadian Pacific Railway was incorporated to build a transcontinental railway to hold the new country of Canada together. It was an integral part of Sir John A. Macdonald's "national dream."
 
By the beginning of the 20th century, it was by far the largest corporation in Canada, not only bigger than the older Grand Trunk Railway but also bigger than the Bank of Montreal, which had provided much of the financial and human resources to create the company.
 
Early in the 20th century, the CPR not only owned and operated more dining and parlour cars than any other railway in the world, it also owned steamships, hotels, a telegraph system, and mines, not to mention an extensive colonization and development operation. Most of the stock was held in either the United Kingdom or the United States.
 
Like all major Canadian corporations, CP was hard hit by the recession of the early 1980s and in 1986 CP lost money for the first time in decades, something it had even managed to avoid in the Great Depression. The times were a-changing and conglomerates were going out of fashion. The company began to get out of unprofitable businesses. In 1996, after more than a century in Montreal, CP moved west to Calgary, not even giving Toronto a look.
 
In 2001 the board of directors decided to break the company into its component parts so that each company, whether it be rail, or steam ship, or hotels, could concentrate on their core competency. This should have been good news for the railway company, but that is not the way it worked out.
 
Today investors don't compare the two major Canadian railways, they compare the six major class 1 railways in North America, of which CP is not only the smallest, half the size of the former government-owned CNR, but more importantly has the worst operating ratio of any of the six. Furthermore, its stock performance has been by far the worst of the six in recent years.
 
This poor performance led to an assault by Pershing Square, the U.S. hedge fund led by Bill Ackman. The attack saw the stock nearly double from the mid $40s in late March to nearly $80 as the annual general meeting approached. Prior to that meeting in Calgary in mid-May both the company and Pershing fought an epic paper battle. Pershing titled its attack CP Rising and demanded the resignation of Fred Green, the CP CEO, and the resignation of the board of directors led by John Cleghorn, former CEO of the Royal Bank of Canada.
 
Rarely, if ever, has an establishment Canadian corporation, such as CP, been challenged so publicly and viciously by a U.S. hedge fund. The response in Canada was interesting, with the large pension funds such as Ontario Teachers siding with the U.S. corporate raider.
 
Hours before the annual meeting, Green submitted his resignation. Chairman Cleghorn also announced that he and four other directors would not stand for re-election.
 
Ackman and the disgruntled shareholders had won, or had they? CP stock lost nearly 10 percent of its value in May and may well lose more in the next few months. So what does the future hold?
 
As a consequence of the decision of six experienced CP directors to step down and be replaced by Pershing nominees, the board of directors is arguably weaker than it was. It is assumed, but not confirmed, that Hunter Harrison, the former CEO of CN, will be appointed as the new CEO of CP. Harrison is an outstanding railway CEO, but he is not as young as he was when he did such a terrific job with CN and there may be health issues.
 
Many employees were disgruntled before the change in leadership. CP rail workers subsequently went on strike and the government of Canada unwisely legislated them back to work, which will not be good for employee morale.
 
And just how will CP bring its operating ratio down to the 70s that the old management committed to, never mind the 60s which Pershing is committed to? One obvious overlooked fact is the state of the CNR when Harrison became CEO. CN was privatized in 1994 and former civil servant Paul Tellier became CEO. In 1998, Tellier, with the wisdom of the historic French vision of the commercial empire of the St. Lawrence, oversaw the acquisition of the Illinois Central, which ran from Chicago to New Orleans.
 
CN was able to increase its economies of scale, gain benefits from the North American Free Trade Agreement, and as a consequence get its operating ratio down. This is easier to do with a rail line that is twice the length of CP and has a run from Chicago, which is less than 600 feet above sea level, downhill to the Gulf of Mexico. Meanwhile CP, short on economies of scale, still has to run through the Rogers Pass 4,400 feet above sea level, contributing factors to its high operating ratio.
 
So what will happen if Hunter Harrison cannot get the operating ratio dramatically down and the stock price up? A reasonable expectation would be that Pershing will opt to sell to a U.S. railway such as Union Pacific, the largest of the Big Six.
 
While CP is as large as Potash Corp., it will not have the premier of Alberta, at least the current one, fighting to retain ownership in Canada in the way that Premier Brad Wall of Saskatchewan fought for Potash Corp. And CN will presumably not be able to buy it in order to prevent a monopoly situation within Canada. And thus will end Sir John A.'s national dream.
 
Joe Martin.