After five months on the job, Hunter Harrison is finally speaking and the markets are listening. The Canadian business press today is filled with Mr. Harrison’s plan to turn around Canadian Pacific after a much publicized proxy battle earlier this year.
What caught my eye were two paragraphs in the Financial Post on Wednesday, December 5, 2012.
Throughout the campaign, Pershing Square and Mr. Harrison maintained they would be able to hit a 65% operation ratio – an important gauge of the company’s profitability that measures operating costs as a percentage of revenue – by 2015. The lower the figure, the better, and CP’s operating ratio was stuck at a stubbornly high 81% in 2011.
Analysts have speculated that an improvement of that magnitude could drive CP’s share price up to between $140 and $160 from about $90.
Well let me give you the answer first, and the analysis later in this blog. Comments from some of my readers say my blogs are too long, so I will endeavour, where possible, to give my answers first, when appropriate, and for those who like the backup analysis, you can continue to read onward.
If Canadian Pacific were trading at the same valuation as industry leader Canadian National, Hunter Harrison’s former company, CP would be trading for $104 per share. CP closed at $96.37 a share, on December 5, 2012 therefore leaving investors a possible 8% upside at current prices – comparing apples to apples. I’m hard pressed to see the $140 to $160 shares these unquoted analysts see.
The market, being the market, has already judged much of Mr. Harrison’s restructuring a success and giving shareholders a valuation commensurate with his possible success, even though he has just announced his reorganization plan. Plainly this is why Mr. Ackman encouraged Mr. Harrison out of retirement. The market believes in Harrison and has already priced in his future work!
Yes, people like Mr. Harrison are a rare commodity in that the market has given his new company a valuation as if he has already accomplished his turnaround of the company – that’s credibility. From the end of November 2011 to today, CP has added an additional $6.3 billion of market value for shareholders through a proxy battle and the appointment of Mr. Harrison as CEO of the company masterminded by Mr. Ackman.
As you will see in my analysis CP has a long way to go before catching up to CNR in terms of estimated earnings versus theoretical earnings – my metric of success instead of the quoted “operating ratio” noted above – however the market is pricing in only an 8% discount to CNR!
If for any reason if Mr. Harrison doesn’t deliver on his announced plan, the market will react violently to the downside. At which point the same unquoted analysts will probably say this hypothetical market correction is way overdone and doesn’t make any sense.
I will start with our model price charts both for Canadian Pacific and Canadian National as at the close on December 5, 2012.
Canadian Pacific with weekly price bars, EBV Lines (colored lines) and model price (dashed line)
Canadian National with weekly price bars, EBV Lines (colored lines) and model price (dashed line)
In my first blog on CP, on January 10, 2012 I introduced my readers to a table listing all the publicly traded railroads, with their 2012 earnings estimates and theoretical earnings (TE) calculations. I then take the projected earnings estimates and divide by each company’s TE to produce a ratio. The higher the ratio, it usually follows, the higher the valuation of the company in question.
Here is the table from my blog on January 10, 2012.
||2012 Estimated Earnings/share
||Theoretical Earnings (TE)/share (current)
||2012 Earnings Estimates / TE
||2013 Estimated Earnings/share
||Theoretical Earnings (TE)/share (current)
||2013 Earnings Estimates / TE
I have updated this table, with 2013 earnings estimates and theoretical earnings (using current September balance sheets), with the resulting ratio.As you see Canadian National (CNR) goes from strength to strength further improving their ratio from 4.45x to 5.06x. Analysts are expecting higher earnings for CP in 2013, improving CP’s ratio from 2.31x to 2.99x. Forecasting a 30% improvement, however still behind CNR’s outstanding ratio.Just as an aside, notice Norfolk Southern’s ratio fell from 3.27x to 2.68x, overtaking CP as the lowest ratio in the group. It is no surprise the Norfolk’s stock has been hitting new 52-week lows recently.
Investors have hopped on the bandwagon with Mr. Harrison and Canadian Pacific with dreams of substantially higher stock prices if Mr. Harrison accomplishes his well-publicized reorganization plan. Unfortunately the market is way ahead of investors pricing in Mr. Harrison’s future success leaving nothing but disappointment if there is a hiccup along the way.