Canadian Pacific – Ackman wanting to shake up CP, why?

As reported today in the National Post, Bill Ackman will engage in a proxy battle to replace the Board of Directors and CEO of Canadian Pacific (CP).  The National Post reported:

In the letter,  [to shareholders] Mr. Cleghorn emphasized the board’s confidence in CP’s strategy to reduce its operating ratio – an important gauge of profitability measuring operating costs as a percentage of revenue – to the low 70s within the next three years from 82.4% at the end of the third quarter.  The lower the better.

What does Model Price say?  Under “Key Concepts” and “Theoretical Earnings” (TE) we introduce the concept of what the level of earnings a company needs to maintain state or constant over time.  Let’s compare theoretical earnings per share of CP not only with CNR but also with US rails CSX, NSC, UNP.  We will also compare TE with 2012 estimated earnings estimates.

Company Name 2012 Estimated Earnings/share Theoretical Earnings (TE)/share (current) 2012 Earnings Estimates / TE
CNR $5.38 $1.21 4.45 x
UNP $7.82 $1.82 4.30 x
NSC $5.98 $1.83 3.27 x
CSX $1.93 $0.57 3.39 x
CP $4.27 $1.85 2.31 x

What does the above table say?  It’s OK that a company has a given level of earnings but the market, in our judgment, pays more for the same level of earnings given a more efficient balance sheet.  CNR makes more money with a smaller TE therefore the market is given CNR a much higher valuation than CP.  Also, CNR has a higher valuation than the US rails listed above.  This makes sense in our world.  To the outside this would be covered in Return on Equity (ROE) analysis.

It’s good that Mr. Cleghorn is confident on CP’s strategy to reduce its operating ratio, however looking at the underperformance of CP relative to its peers which includes 2012 earnings estimates, current management has a long way to go.

It may not be fair, but if CP had the same valuation as CNR, (this may not be totally unreasonable since Bill Ackman wants to bring in Hunter Harrison, former CEO of CNR) Canadian Pacific would be trading around $90 to $95/share, a 35% increase in share value given the balance sheet values as of today.  This will be a big Canadian financial story this year and looks like Mr. Cleghorn will be working hard, very hard.

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