CANADIAN PACIFIC RAILWAY LTD CP
December 17, 2013 - 11:10am EST by
sandman898
2013 2014
Price: 158.00 EPS $6.49 $8.40
Shares Out. (in M): 177 P/E 24.4x 18.9x
Market Cap (in $M): 26,500 P/FCF 36.7x 13.5x
Net Debt (in $M): 4,300 EBIT 1,764 2,185
TEV ($): 30,800 TEV/EBIT 17.5x 14.1x

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  • Activists involved
  • Railroad
  • High Barriers to Entry, Moat
  • Management incentive
  • Great management
  • Capital Allocation
 

Description

CP is a high quality railroad led by a very accomplished, experienced, and aligned CEO who is finalizing his legacy as the industry's best operator. Over the next two years the company will report results that exceed published estimates, achieve close to industry-leading margins, divest substantial non-core assets, initiate a recurring buyback program, and potentially be put up for sale. Applying Canadian National (CNR)’s current 17.0x multiple to 2016E EPS of $12.35 results in a year-end 2015 target price of $210/share.

We kind of reach this point maybe a year and a half, two or three years in, pretty nice results and people say, well that story is over. What is next? This story is not over. It's a long way from over...I think if you look out at where we're going to be in 2016, 2017, given that we do what we are say we're going to do, it's pretty exciting to me as a shareholder. I will be hopefully retired by then, but I've have got a lot of my, whatever little wealth I have is tied up in this company, a lot of it. And it wasn't what I was given. It was what I picked out of my own cash out of my pocket and laid on the tab le and laid it down, and I'm betting my own resources as well as others. – CEO Hunter Harrison (12/06/13)

   

2016 Projected Operating Ratio

   

68%

67%

66%

65%

64%

63%

62%

61%

60%

59%

58%

 

1%

$8.02

$8.34

$8.65

$8.97

$9.29

$9.60

$9.92

$10.23

$10.55

$10.87

$11.18

 

2%

$8.33

$8.65

$8.98

$9.30

$9.63

$9.95

$10.28

$10.60

$10.93

$11.26

$11.58

 

3%

$8.63

$8.97

$9.31

$9.64

$9.98

$10.31

$10.65

$10.98

$11.32

$11.65

$11.99

3-Year

4%

$8.95

$9.30

$9.64

$9.99

$10.33

$10.68

$11.02

$11.37

$11.71

$12.06

$12.40

Revenue

5%

$9.27

$9.63

$9.98

$10.34

$10.69

$11.05

$11.40

$11.76

$12.11

$12.47

$12.82

CAGR

6%

$9.60

$9.97

$10.33

$10.70

$11.06

$11.43

$11.79

$12.16

$12.52

$12.89

$13.25

14-16

7%

$9.93

$10.31

$10.69

$11.06

$11.44

$11.81

$12.19

$12.57

$12.94

$13.32

$13.69

 

8%

$10.27

$10.66

$11.05

$11.43

$11.82

$12.21

$12.59

$12.98

$13.37

$13.75

$14.14

 

9%

$10.62

$11.02

$11.42

$11.81

$12.21

$12.61

$13.01

$13.40

$13.80

$14.20

$14.59

 

10%

$10.97

$11.38

$11.79

$12.20

$12.61

$13.02

$13.42

$13.83

$14.24

$14.65

$15.06


CP BEFORE HUNTER

Under its former CEO Fred Green, CP’s financial performance was unjustifiably poor. From 2006 through 2011, margins declined (4%), EBIT fell (1%), and the stock declined (18%). Another VIC member posted a write-up in March 2011, which gives a pretty good sense of the business and its position at that time. In 2012, Pershing Square bought 14% of the company and after a seven month proxy battle, was able to successfully gain control. Hunter was courted out of retirement by Pershing to lead the company, signing a four-year contract to help restructure the business. Hunter’s goal was to get to a 65% OR (=35% EBIT) by 2015, a target considered highly unrealistic at the time by several analysts. (all quotes below are from Hunter unless otherwise noted)

I want to look back in three, four, or five years and say we, the team, were able to accomplish a lot for the shipper, the employee, and maybe more importantly, the shareholder in terms of return. Then I can go out to pasture again.

One main reason why CP struggled for so long under its prior leadership is because the railroad’s heavily-unionized culture was very resistant to change. Given the high labor component for most railroads, any real cost cutting initiative necessitates reducing labor. By the time Hunter joined, CP’s unions interpreted anything related to “increasing efficiency” as corporate speak for “firing members.”

Culturally, this was a very – not unlike my former employer— a very permissive environment. For years and years, we've known, for example, that on the West Coast in Vancouver, people took these "early quits," and it's not only in the rail industry, get paid for eight [hours]. Well, we're not going to do that on my watch, number one. So people understood they're going to have to start giving a fair day's work for a fair day's pay… You would say to the local chief, tell me what you did today here. Well, we put in three couplers and ten pair of wheels and we've got kind of standards for those things that we had developed and fine-tuned and we added all those up and we say, okay, you gave us 68 man hours a day, how many man hours do you pay? 150 man hours. Where is the difference? I don't really know. Well, we know now. And so that's – when you get that kind of waste, that kind of low hanging fruits, some of these things are little more easier to do than you would think otherwise. Now, some people say, look, why don't the other people do that? It's not easy. It's change. It's hard. It's difficult. You get pushed back. You get resistance. And really, the organization did not possess at that time the type of leadership that it needs to be able to create and sustain that type of change.

Rather than dodge the issue, Hunter hit the unions directly.

We sat down together here when I started this journey with you. You work with me; I'll work with you. My role is not to make people happy. I hope I can make them happy. I hope I can make shareholders happy and the employees happy and customers happy. It's tough to do at the same time. So there we signed five agreements. We still have the CAW and the Running Trades hanging out which are two big ones. The CAW has lost a significant amount of people as a result of the downsize and the Running Trades also. Now, I think the running trades have come to their – well, they called yesterday and said we'd like to sit down and talk. Up until that time, they had no interest in talking to me. Now, they urgently want to sit down and talk, that's encouraging. CAW is a little bit upset. They're going to be pushing back, but we will work through that. But we are going to – you're going to see some things in the paper. There was a thing in the paper yesterday I think in Canada about our culture of fear. They're going to start that again. Look, our culture, as I see it, is about accountability and consequences. You've got a job to do. If they do it well, they're going to be rewarded. That's part of the consequences. If they don't follow the rules and instructions and do what they're supposed to do, they aren't going to like the consequences. And if that's the culture of fear, they better get ready to deal with fear.

Whether because it was his third time around or because of his prior success restructuring the only other Canadian railroad, with only a moderate amount of quarrelling, Hunter was able to very quickly and efficiently get the unions to align with his strategy. Total headcount has since been reduced from 19,500 to 15,000 with future headcount reductions clearly telegraphed (~13,400 by 2016), pensions have been capped, and labor agreements are in place with all six unions through early 2015.

PRECISION RAILROADING

In traditional railroading, operators held each train until it was completely full before allowing it to depart for its destination. The strategy maximized single locomotive efficiency, but delayed customer shipments, demanded significant resources, and resulted in poor asset utilization. A good analogy would be if airplanes were delayed indefinitely until every single seat was filled. When Hunter restructured Illinois Central, he completely reexamined the way a railroad was operated. In the process, he invented a new approach to operations which he called precision railroading. This approach worked at both Illinois Central and then again at CNR. Over the decade that followed, CNR has continued to enhance the initial concept with new technology in order to maximize locomotive utilization, loadings, maintenance scheduling, train length, and fuel optimization. CNR views this modernized approach to precision railroading as a powerful strategic advantage. In fact, CNR actually sued Hunter and threatened his $40MM pension in order to prevent him from transferring this knowledge to CP.

Harrison was intimately involved in every detail of CN’s business. Not every detail was confidential, of course, but a great many were – and still are. Under Harrison’s leadership, CN grew into a far more efficient and valuable railroad than its principal competitor, CP. Harrison is not the only executive who could run CP, but he is the only executive who possesses the unique body of CN confidential information, access to which by CP would be devastating. – CNR 01/2012

In contrast to traditional railroading’s focus on optimizing an individual train, precision railroading instead focuses on transporting each individual shipment as efficiently as possible from point A to point B. To do so, trains run on scheduled intervals regardless of their capacity. This enables the railroad to reduce substantial headcount from its operations while increasing railroad velocity and operational efficiency. The initial transition can be painful as unprofitable routes must be culled, but once completed, the process results in a material increase in both service quality and network predictability which in turn yields excess assets, pricing power, and the potential to pick up some volume that customers had formerly shipped with other modes of transportation. While CP has come a long way in a year, it is important to note that the company essentially started from the absolute bottom.

CP couldn't spell it [precision rail]. Seriously, this was not a big item on the agenda. The best way I can describe it in the short-term here, without going through a ten-hour lecture, railroads typically, during my career as I have grown up, have run on volumes. Now, thankfully, in the recent years, we've gotten awakened a little bit, but we were driven by volumes, of being able to put a lot of goods behind a couple of drivers, and that's well and good, except when you do that, you don't know when you're going to run the trains, so the trains don't have schedules. The volume makes the schedule. So the customer doesn't know when he's getting his goods, you can't plan your assets, that didn't make a lot of sense to me. So when I got into position, what we effectively did is say, we're going to give away a little bit on the volume side, on the capacity management side, and we didn't lose a whole lot, used some of our market intelligence, and we're going to run trains and cars and all the processes that lead up there in a very disciplined manner. And so, if we say we're going to go from Toronto every morning at 0800 to Chicago, we're going, whether we have 50 cars or 150 cars. Now, that does several things for us. It, first of all – we know when the train is going to be there, and more importantly, the customers know when his goods are going to be there. We were able to better manage our assets, and that's been one of the real overlooked themes, is that our asset turns and the velocity of our assets have improved dramatically, so it provided better service with lower cost, with better asset utilization, able to improve the quality of life of our people and it just fit real well. And we took this to the market kind of untried initially at Illinois Central, and it worked. You can kind of say, well, is that the low cost model? No, it's a service model, but it's done all of the above. It's improved service, it's lowered cost, and it's improved asset turns all at the same time. So in kind of a capsuled version, that's precision schedule railroading.

MARGIN IMPROVEMENT

 

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

CNR

31.2%

33.2%

34.2%

26.5%

31.4%

43.2%

44.9%

46.4%

45.0%

42.7%

43.4%

46.5%

46.3%

46.5%

46.5%

47.2%

47.8%

49.2%

CP

15.9%

31.5%

31.8%

32.9%

30.1%

30.6%

32.9%

34.8%

34.8%

30.1%

29.3%

32.2%

28.1%

31.7%

39.3%

43.7%

45.4%

46.7%

Spread

15.3%

1.7%

2.4%

(6.3%)

1.3%

12.6%

12.0%

11.7%

10.2%

12.6%

14.1%

14.1%

18.2%

14.7%

7.4%

3.5%

2.4%

2.5%




 

 

 

 

The results of Hunter’s efforts so far have mostly impacted CP’s margins. Last year’s EBITDA margin of 32% should increase 7% to 39% this year and is expected to continue this trajectory as expenses are reduced until hitting 47% in 2016 (to help reconcile these EBITDA margins with OR, D&A is currently 9% of sales and should fall to 8% by 2016). This implies OR of 70% this year going to 62% by 2016. Hunter formerly talked about beating CNR in the long-run, though CNR just reported a surprisingly strong margin with an OR under 60% last quarter. While the margin story is in the final innings, there remains some room for further margin upside.

I think the market would be pleased if they're [CNR] at 59% [OR] and we got to 60%, everybody would love it, I think. So if somebody's going to – in 18 months, somebody says, hey, you missed it. Well so I missed it. But I still think we're going to go down, we're going to go down further. If we're at 65 now, with all the things we got in the blender that sure is not the end, okay. And there ain't a lot of space in between and so we're going to stay after them. Just it's not a driving force here. So clearly, Tom, we ought to have the opportunity, particularly second and third quarter, to move in the range of lower than 65, and you got to get to the low 60s or shame on us. And can we go below that? We'll see. And that's probably going to be dependent upon how well we convert on the revenue side.

REVENUE GROWTH

In order for CP to continue surpassing investor expectations, revenue growth will have to continue going forward. Volumes have been fairly flat over the last year while pricing has been strong. The company has lost some low-profitability intermodal contracts and has foreshadowed the possibility of more to come, which explains some of the analyst reservations regarding volume growth. Hunter has guided to 5-7% revenue CAGR with the potential to reach industry-leading margins by 2016 but as CP progresses into 2015 and 2016, the company will need to both sustain its strong price increases while taking on incremental volume.

Clearly, this is a service improvement cost take-out story. Our costs were way out of line. Our service was not what it should be; and as a result, the quality of our revenue wasn’t. So we had discounted a lot of rate as a result of not having a very good service offering. Now, all of that is changing, as we speak. Our services improved significantly. It's going to improve a lot more. We're going to see the quality of revenue come up. We've got some accounts – probably, 20 or 25 accounts right now that just don't meet the hurdle rate internally that they're going to – bad news, but they're going to have to belly up and pay for the service…We're starting to see a really better product out there, but the market's not going to change overnight based on the fact that you go out and blow your horn about your service. They've got to see it. And so there's going to be some lag, a year or so, and it'll dribble out over time until people convert and make the change. So I think you'll see the revenue growth start in 2014, but it's not – but probably 2015 we'll really see a big jump on the service side if we're right in what we're seeing…this is not something that happens overnight. Number one, the market doesn't like change to begin with, as people are resistant to change. But if they start to see value in it, as we've seen with the domestic, I think we will see, on the domestic intermodal and this merchandise book, excluding crude, in every one of those areas, forest products, metals, minerals, you name it, I think we're going to see some growth. And that's without any boost in the economy.

Ultimately, this is a bet that customers will see value in faster and more reliable deliveries. If they do, CP will be able to pick up a substantial amount of price with a healthy volume lift as well. A large portion of the company’s contracts are multi-year in duration, so even after the value proposition has been proven to customers, the impact on revenue will not be immediate. While it is too early to confidently determine the magnitude of this impact, there is considerable potential for CP to exceed the high end of revenue guidance.

Our longer-range guidance has been 5% to 7% CAGR over the next four years, and I think that's probably going to turn out to be a very conservative number, because I happen to think that this issue of service is going to play a big part in our growth. And when people see the service, they actually see it. It's not what we're just talking about. They can understand what it does to their fleets as far as asset turns and their inventories…if we get a little bit of boost with the economy, could we exceed the 7% CAGR? Yeah.

ASSET MONETIZATION

One of the key benefits of precision railroading is that it moves more with less and therefore creates a surplus of assets that reduces future capital expenditures as the company is able to reallocate railcars and locomotives within its own network. Since converting its operations, CP has reduced railcars by 11,000 and created a surplus of locomotives which can now be leased out to other railroads, reducing equipment expenses going forward. As a result, FCF conversion for CP should exceed that of other railroads for the next few years. CP is also in the process of selling a portion of DM&E, a Class II railroad purchased by the prior management team which could create a modest $1-2 per share of upside. Perhaps more importantly, CP has a significant amount of land that was formerly being used as hump yards which are now no longer needed.

We did not need the hump yards. The best analogy I can give you for the humps is that if Henry Ford was going to build 10 or 15 Model Ts a day, he would have never had an assembly line. When he got to 400 to 500, it started to make sense. Now, these humps were all late 50s, early 60s vintage. So you can imagine the condition, hard to buy parts for the retarders and software for some of the computer controlled retarders, for an example, and we started to look at, quickly, our mix of business. And the highest volume hump we had, which was the only surviving hump, was St. Paul. And the next on the ledger was Calgary and Toronto, when they were both humping 700 or 800 cars and some of those were twice. And so people that understand hump yards, understand processing, our book of business had gone from a place in the late 50s where 80% of the traffic need to be sorted, where today we're more of a bulk franchise and only 20%, 25% of it needs to be sorted. So those were obvious. Now, those hump yards that it took out obviously, it took out the internal mechanisms to operate those humps, and all the support, it eliminated car delay, and we just started going through very simple IE [industrial engineering] type studies.

On the Q3 call, Hunter shocked a number of sell-side analyst by quantifying the surplus assets at over $10 per share.

We're trying to get the right model to optimize those assets. And there are several alternatives that we're considering exploring. But it's not going to all come in, obviously, in 2014 and it might be 2015 before you start to see the full value, depending on which way we go. But it's nice to know that we've got something that's convertible, that's got value, that's in that $2 billion range, that's kind of gravy to this whole plan.

These asset sales should begin hitting the balance sheet starting next year and have been largely excluded from sell-side models. Since FCF plus asset sales over the next two years will now result in CP being in a net cash position, it seems reasonable to assume that the company will allocate nearly all of the proceeds into stock repurchases.

It’s basically all what I would describe as surplus assets. A lot of it's been a result of the close in the hump yards and movement and consolidation of yards and terminals, and it's opened up. For example in Chicago, we put all our intermodal business into Bensenville and closed the other facility and it's just a lot of that. And then, the company had not focused a lot on what we owned. In fact, I don't think there had been a very extensive look at all of those properties for probably 25 years. So we found properties in Northern Ontario that I didn't even know we owned. So, as we took all of these structures, all the land that's been made available, which makes up a high percentage of it, that's at this point our best estimate of what the "appraised" value might be today. Now I'm not a big – I don't think appraised value gives you a lot. But I think then we got to figure out how the best way is. And I can tell you this. I don't think we will do it in some traditional way of just selling off properties at a discount rate like a typical railroad. We're going to look and optimize this to the best of our ability to reward to the shareholder…we're not going to sit on a lot of cash that will get us closer to some buyback program. This is, of course, a board decision, not my individual decision. I would anticipate that if we continue to have the kind of performance we talked about, that we would probably be taking a strong hard look at the buyback within the next 12 months.

EXIT STRATEGY

Since the ‘90s, Mr. Harrison has shown significant creativity and risk-taking around asset sales and purchases. He is the only CEO currently running a Class I rail who has both sold his company and acquired other railroads of size. Despite broad agreement among peer CEOs that further industry consolidation is unlikely, Mr. Harrison maintains that more M&A is not just inevitable, it’s good for the economy, industry and customers. We don’t know what sort of strategic actions Mr. Harrison might envision, but we’re willing to continue to recommend the shares considering that we do not believe an option on a bold strategic action is priced into shares. – Morgan Stanley (12/13/13)

When Hunter took the job at CP, he forfeited $1.5MM in annual benefit from CNR to take an annual salary of only $2.0MM. Instead of annual compensation, nearly all of his economic upside comes from 0.65MM options striking at $73 per share that are now worth over $50MM if exercised today. It’s important to note that these options do not vest until one year after he retires. While Hunter has been clear on his intention to retire after the restructuring is completed in 2016, I view it as highly unlikely that he leaves both his economic future and what will ultimately be his legacy to chance. Interestingly, prior to even knowing about his future opportunity at CP, Hunter had laid out a vision for a final railroad merger at the Wolfe Conference in May of 2011.

I will tell you this that not many people agree with me here, there's going to be another merger. If I had to put a timeframe on it I'd say in the next five to eight years you're going to see a merger. It's going to be a bold move and whoever makes it is going to get way ahead of the game and be rewarded for it, once again in my view. Now, having said that, a merger will have to be done with a different operating model than we've had before to gain Washington's approval, requiring some degree of access…and so for this carrier, or these carriers to become merged, they would have to allow competition to run on their network if they're not providing the right service for a competitive price. Now if a combined carrier, and the shipper has the protection of being able to bring in a carrier B, is going to let carrier B come in on their railroad and provide better service at a lower cost and take business away from them, shame on them. Now there will be a lot of rhetoric about it, but it's going to have to be done. One of the big advantages of it is it creates capacity. It creates capacity without significant capital investment and additional infrastructure. Now some of us have forgotten the criticism this industry went through in 2005, '06, and '07 when things were really rolling about lack of capacity and about service issues and about bottlenecks in Chicago and pinch points on various carriers. If and when, and it will, this economy moves back to those levels, given that we don't have some of those mergers for example, there's going to have to be additional infrastructure added or different operating models to be able to handle the traffic. Now there's been some things done as we speak. I think one of CN's smartest moves was the acquisition of the EJ&E to move around the perimeter of Chicago. But there are other pinch points. If you look at the opportunity that a merger would bring, the capacity it would, I don't want to call it artificially add, it's hard to add additional infrastructure in this country. There's not going to be any more railroads built. We'll be lucky if we keep what we've got. So somehow we need to figure out a way to take the existing capacity and get more out of it.

Given that he is one of the few individuals to have sold a railroad and integrated a merger, this prediction should carry some weight. We attended the Wolfe Conference again in May of this year, and when dismissing rumors that CP would buy KSU Hunter again made a quick comment about the potential sale of CP.

All my comp – well, the so called – the ones that people are raising issues about is on the back end. It's in the way of options on the back end. After four years, they vest a quarter, a year – and I cannot – and I've got a holding period of a year after I leave the organization….I still think that there will be consolidations in the industry. I think it's the right thing to do. I think competitive issues and the STB issues can be addressed and can be taken care of. We are certainly – we'll become along the short line, regional front, more aggressive than we have been in the past because when your cost is at 80 OR as opposed to 64, 65 OR, you are in a different position. There's lot of those short lines that I'd like to control that I don't. So, now, we're not – it's not probably in our interest right now to focus on anything else. We've got to keep our eye on the ball, get this thing, hit it in the right direction, get everyone comfortable that this is the story that we're going to produce and we're going to produce value. And I think if we do that, we'll do fine. It'd be hard for us to put together the wherewithal to be able to make an acquisition of a Class I. That's just probably not on the cards for some time. Having said that, that's something I look forward, but I don't think that's around the corner. I don't necessarily agree with the report that came out of Canada last week, I guess, that one of us thought about KSU. I don't know that – that story is worn out. That story I've been hearing for 15 years. And we lost the concession and I thought it was over. I do think there will be consolidations one day. It's probably going to be post-Harrison. And I do think that the strength that I think this company will develop, I think, will put us in a good position for shareholders and others. As this plays out, it will be good for CP shareholders because I think that the way this might be structured, and the timing of it, it's going to be pretty important. And so, if it's – if they take the index card that I leave and read them and don't get off the playbook too much, they can make a big hit.

There are only a handful of Class I railroads and realistically only BNI or UNP could make a play for CP, but if they did, it would make tremendous sense for both of them as the deal would be immediately financially and strategically accretive. Buffett purchased BNI stand-alone at 18x forward earnings in 2010 while KSU currently trades at 26x due to its acquisition potential. A buyout of CP would likely warrant a multiple somewhere in between these two numbers. We believe Hunter is very likely to outline a plausible exit strategy for CP prior to 2016.

RISKS

Hunter is 69. Reliance on a key individual naturally bears some risk, especially given Hunter is approaching 70 years of age. On the other hand, Hunter’s age has served as an incentive for him to overhaul the management team with individuals who embrace his vision. Hunter was able to poach COO Keith Creel in February. Creel served under Hunter at Illinois Central and CNR, where he was the COO until his departure. Creel carried a hefty price tag, because in exchange for his hiring, CP had to agree not to hire a defined set of 60 other individuals from CNR until 2016. Creel is likely going to work as hard as possible for the next few years given that the CEO position on Hunter’s retirement is now his to lose.

I am extremely pleased, extremely pleased, that at the top of the pyramid of the house, I think things have come together very well. I think the first big addition that filled and sealed a lot of holes was the addition of Keith Creel as the President and Chief Operating Officer, I guess, eight, ten months ago now. Keith I've mentored and coached, and led Keith since 1994.... He is a hard-working, bright young man. Probably the brightest, in my view, operating mind in North America. Clearly, people were concerned about succession, about, God forbid, of all things, my age. I don't have any problem with it, but a lot of other people did. But now we know where we are there...This week we just announced we brought on a new Executive Vice President and Chief Financial Officer, a gentleman named Bart Demosky from Suncor who was one of the most – we did an intensive search, I can tell you, throughout North America. And Bart has been – has a reputation as one of the top CFOs in Canada, and we are extremely pleased to be able to bring him on board and to solidify that team.

Pershing Overhang. In June, Pershing Square announced its intention to sell 7MM shares over a year, and this created some overhang on the stock including an analyst downgrade, though the same analyst upgraded the stock after Q3 results. Afterward, Pershing Square announced a public offering to sell the firm’s remaining 6MM shares of the announced sale, which effectively removed the overhang. Pershing Square remains the largest shareholder with two board seats and 9.8% of outstanding shares.

We’ve made a lot of money in Canadian Pacific. We’ve sold some of our stock simply because it went from being an 11-12% position to being a 28% position because of appreciation. We’ve only sold stock because of portfolio management. – Bill Ackman, Oxford University Business School, 10/29/13

Commodity Prices. CP moves coal, grain, and potash though in most cases this is volume-based, and CP’s customers are low-cost providers. Perhaps more important than any of these commodities, is the price of oil. Fuel makes up the company’s largest cost component after labor, accounting for 16% of revenue. CP stopped hedging for fuel earlier this year as coverage from its fuel cost recovery program has improved and was deemed adequate. There is, however, a lag effect with escalating fuel prices causing an earnings headwind and declining fuel prices causing an earnings tailwind for about a 90-day period as it is priced through contracts. It is important to note, however, that the long-term benefit of higher fuel prices is that it makes the cost of highway transportation more expensive than rail transportation which the rails have traditionally arbitraged by raising prices.

Macro. Freight volume growth is generally dependent on a healthy economy, especially as industrial and consumer products account for a quarter of the company’s freight revenues. There is exposure to volatile grain production (20% of revenues), coal exports (10%) and auto trends in Canada (7% of revenues). CP’s guidance does not assume a material improvement in the macro environment, but alternatively, also does not assume that it gets materially worse.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Q4 Earnings
  • New long-term operating targets
  • Return of capital strategy
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    Description

    CP is a high quality railroad led by a very accomplished, experienced, and aligned CEO who is finalizing his legacy as the industry's best operator. Over the next two years the company will report results that exceed published estimates, achieve close to industry-leading margins, divest substantial non-core assets, initiate a recurring buyback program, and potentially be put up for sale. Applying Canadian National (CNR)’s current 17.0x multiple to 2016E EPS of $12.35 results in a year-end 2015 target price of $210/share.

    We kind of reach this point maybe a year and a half, two or three years in, pretty nice results and people say, well that story is over. What is next? This story is not over. It's a long way from over...I think if you look out at where we're going to be in 2016, 2017, given that we do what we are say we're going to do, it's pretty exciting to me as a shareholder. I will be hopefully retired by then, but I've have got a lot of my, whatever little wealth I have is tied up in this company, a lot of it. And it wasn't what I was given. It was what I picked out of my own cash out of my pocket and laid on the tab le and laid it down, and I'm betting my own resources as well as others. – CEO Hunter Harrison (12/06/13)

       

    2016 Projected Operating Ratio

       

    68%

    67%

    66%

    65%

    64%

    63%

    62%

    61%

    60%

    59%

    58%

     

    1%

    $8.02

    $8.34

    $8.65

    $8.97

    $9.29

    $9.60

    $9.92

    $10.23

    $10.55

    $10.87

    $11.18

     

    2%

    $8.33

    $8.65

    $8.98

    $9.30

    $9.63

    $9.95

    $10.28

    $10.60

    $10.93

    $11.26

    $11.58

     

    3%

    $8.63

    $8.97

    $9.31

    $9.64

    $9.98

    $10.31

    $10.65

    $10.98

    $11.32

    $11.65

    $11.99

    3-Year

    4%

    $8.95

    $9.30

    $9.64

    $9.99

    $10.33

    $10.68

    $11.02

    $11.37

    $11.71

    $12.06

    $12.40

    Revenue

    5%

    $9.27

    $9.63

    $9.98

    $10.34

    $10.69

    $11.05

    $11.40

    $11.76

    $12.11

    $12.47

    $12.82

    CAGR

    6%

    $9.60

    $9.97

    $10.33

    $10.70

    $11.06

    $11.43

    $11.79

    $12.16

    $12.52

    $12.89

    $13.25

    14-16

    7%

    $9.93

    $10.31

    $10.69

    $11.06

    $11.44

    $11.81

    $12.19

    $12.57

    $12.94

    $13.32

    $13.69

     

    8%

    $10.27

    $10.66

    $11.05

    $11.43

    $11.82

    $12.21

    $12.59

    $12.98

    $13.37

    $13.75

    $14.14

     

    9%

    $10.62

    $11.02

    $11.42

    $11.81

    $12.21

    $12.61

    $13.01

    $13.40

    $13.80

    $14.20

    $14.59

     

    10%

    $10.97

    $11.38

    $11.79

    $12.20

    $12.61

    $13.02

    $13.42

    $13.83

    $14.24

    $14.65

    $15.06


    CP BEFORE HUNTER

    Under its former CEO Fred Green, CP’s financial performance was unjustifiably poor. From 2006 through 2011, margins declined (4%), EBIT fell (1%), and the stock declined (18%). Another VIC member posted a write-up in March 2011, which gives a pretty good sense of the business and its position at that time. In 2012, Pershing Square bought 14% of the company and after a seven month proxy battle, was able to successfully gain control. Hunter was courted out of retirement by Pershing to lead the company, signing a four-year contract to help restructure the business. Hunter’s goal was to get to a 65% OR (=35% EBIT) by 2015, a target considered highly unrealistic at the time by several analysts. (all quotes below are from Hunter unless otherwise noted)

    I want to look back in three, four, or five years and say we, the team, were able to accomplish a lot for the shipper, the employee, and maybe more importantly, the shareholder in terms of return. Then I can go out to pasture again.

    One main reason why CP struggled for so long under its prior leadership is because the railroad’s heavily-unionized culture was very resistant to change. Given the high labor component for most railroads, any real cost cutting initiative necessitates reducing labor. By the time Hunter joined, CP’s unions interpreted anything related to “increasing efficiency” as corporate speak for “firing members.”

    Culturally, this was a very – not unlike my former employer— a very permissive environment. For years and years, we've known, for example, that on the West Coast in Vancouver, people took these "early quits," and it's not only in the rail industry, get paid for eight [hours]. Well, we're not going to do that on my watch, number one. So people understood they're going to have to start giving a fair day's work for a fair day's pay… You would say to the local chief, tell me what you did today here. Well, we put in three couplers and ten pair of wheels and we've got kind of standards for those things that we had developed and fine-tuned and we added all those up and we say, okay, you gave us 68 man hours a day, how many man hours do you pay? 150 man hours. Where is the difference? I don't really know. Well, we know now. And so that's – when you get that kind of waste, that kind of low hanging fruits, some of these things are little more easier to do than you would think otherwise. Now, some people say, look, why don't the other people do that? It's not easy. It's change. It's hard. It's difficult. You get pushed back. You get resistance. And really, the organization did not possess at that time the type of leadership that it needs to be able to create and sustain that type of change.

    Rather than dodge the issue, Hunter hit the unions directly.

    We sat down together here when I started this journey with you. You work with me; I'll work with you. My role is not to make people happy. I hope I can make them happy. I hope I can make shareholders happy and the employees happy and customers happy. It's tough to do at the same time. So there we signed five agreements. We still have the CAW and the Running Trades hanging out which are two big ones. The CAW has lost a significant amount of people as a result of the downsize and the Running Trades also. Now, I think the running trades have come to their – well, they called yesterday and said we'd like to sit down and talk. Up until that time, they had no interest in talking to me. Now, they urgently want to sit down and talk, that's encouraging. CAW is a little bit upset. They're going to be pushing back, but we will work through that. But we are going to – you're going to see some things in the paper. There was a thing in the paper yesterday I think in Canada about our culture of fear. They're going to start that again. Look, our culture, as I see it, is about accountability and consequences. You've got a job to do. If they do it well, they're going to be rewarded. That's part of the consequences. If they don't follow the rules and instructions and do what they're supposed to do, they aren't going to like the consequences. And if that's the culture of fear, they better get ready to deal with fear.

    Whether because it was his third time around or because of his prior success restructuring the only other Canadian railroad, with only a moderate amount of quarrelling, Hunter was able to very quickly and efficiently get the unions to align with his strategy. Total headcount has since been reduced from 19,500 to 15,000 with future headcount reductions clearly telegraphed (~13,400 by 2016), pensions have been capped, and labor agreements are in place with all six unions through early 2015.

    PRECISION RAILROADING

    In traditional railroading, operators held each train until it was completely full before allowing it to depart for its destination. The strategy maximized single locomotive efficiency, but delayed customer shipments, demanded significant resources, and resulted in poor asset utilization. A good analogy would be if airplanes were delayed indefinitely until every single seat was filled. When Hunter restructured Illinois Central, he completely reexamined the way a railroad was operated. In the process, he invented a new approach to operations which he called precision railroading. This approach worked at both Illinois Central and then again at CNR. Over the decade that followed, CNR has continued to enhance the initial concept with new technology in order to maximize locomotive utilization, loadings, maintenance scheduling, train length, and fuel optimization. CNR views this modernized approach to precision railroading as a powerful strategic advantage. In fact, CNR actually sued Hunter and threatened his $40MM pension in order to prevent him from transferring this knowledge to CP.

    Harrison was intimately involved in every detail of CN’s business. Not every detail was confidential, of course, but a great many were – and still are. Under Harrison’s leadership, CN grew into a far more efficient and valuable railroad than its principal competitor, CP. Harrison is not the only executive who could run CP, but he is the only executive who possesses the unique body of CN confidential information, access to which by CP would be devastating. – CNR 01/2012

    In contrast to traditional railroading’s focus on optimizing an individual train, precision railroading instead focuses on transporting each individual shipment as efficiently as possible from point A to point B. To do so, trains run on scheduled intervals regardless of their capacity. This enables the railroad to reduce substantial headcount from its operations while increasing railroad velocity and operational efficiency. The initial transition can be painful as unprofitable routes must be culled, but once completed, the process results in a material increase in both service quality and network predictability which in turn yields excess assets, pricing power, and the potential to pick up some volume that customers had formerly shipped with other modes of transportation. While CP has come a long way in a year, it is important to note that the company essentially started from the absolute bottom.

    CP couldn't spell it [precision rail]. Seriously, this was not a big item on the agenda. The best way I can describe it in the short-term here, without going through a ten-hour lecture, railroads typically, during my career as I have grown up, have run on volumes. Now, thankfully, in the recent years, we've gotten awakened a little bit, but we were driven by volumes, of being able to put a lot of goods behind a couple of drivers, and that's well and good, except when you do that, you don't know when you're going to run the trains, so the trains don't have schedules. The volume makes the schedule. So the customer doesn't know when he's getting his goods, you can't plan your assets, that didn't make a lot of sense to me. So when I got into position, what we effectively did is say, we're going to give away a little bit on the volume side, on the capacity management side, and we didn't lose a whole lot, used some of our market intelligence, and we're going to run trains and cars and all the processes that lead up there in a very disciplined manner. And so, if we say we're going to go from Toronto every morning at 0800 to Chicago, we're going, whether we have 50 cars or 150 cars. Now, that does several things for us. It, first of all – we know when the train is going to be there, and more importantly, the customers know when his goods are going to be there. We were able to better manage our assets, and that's been one of the real overlooked themes, is that our asset turns and the velocity of our assets have improved dramatically, so it provided better service with lower cost, with better asset utilization, able to improve the quality of life of our people and it just fit real well. And we took this to the market kind of untried initially at Illinois Central, and it worked. You can kind of say, well, is that the low cost model? No, it's a service model, but it's done all of the above. It's improved service, it's lowered cost, and it's improved asset turns all at the same time. So in kind of a capsuled version, that's precision schedule railroading.

    MARGIN IMPROVEMENT

     

    1999

    2000

    2001

    2002

    2003

    2004

    2005

    2006

    2007

    2008

    2009

    2010

    2011

    2012

    2013

    2014

    2015

    2016

    CNR

    31.2%

    33.2%

    34.2%

    26.5%

    31.4%

    43.2%

    44.9%

    46.4%

    45.0%

    42.7%

    43.4%

    46.5%

    46.3%

    46.5%

    46.5%

    47.2%

    47.8%

    49.2%

    CP

    15.9%

    31.5%

    31.8%

    32.9%

    30.1%

    30.6%

    32.9%

    34.8%

    34.8%

    30.1%

    29.3%

    32.2%

    28.1%

    31.7%

    39.3%

    43.7%

    45.4%

    46.7%

    Spread

    15.3%

    1.7%

    2.4%

    (6.3%)

    1.3%

    12.6%

    12.0%

    11.7%

    10.2%

    12.6%

    14.1%

    14.1%

    18.2%

    14.7%

    7.4%

    3.5%

    2.4%

    2.5%




     

     

     

     

    The results of Hunter’s efforts so far have mostly impacted CP’s margins. Last year’s EBITDA margin of 32% should increase 7% to 39% this year and is expected to continue this trajectory as expenses are reduced until hitting 47% in 2016 (to help reconcile these EBITDA margins with OR, D&A is currently 9% of sales and should fall to 8% by 2016). This implies OR of 70% this year going to 62% by 2016. Hunter formerly talked about beating CNR in the long-run, though CNR just reported a surprisingly strong margin with an OR under 60% last quarter. While the margin story is in the final innings, there remains some room for further margin upside.

    I think the market would be pleased if they're [CNR] at 59% [OR] and we got to 60%, everybody would love it, I think. So if somebody's going to – in 18 months, somebody says, hey, you missed it. Well so I missed it. But I still think we're going to go down, we're going to go down further. If we're at 65 now, with all the things we got in the blender that sure is not the end, okay. And there ain't a lot of space in between and so we're going to stay after them. Just it's not a driving force here. So clearly, Tom, we ought to have the opportunity, particularly second and third quarter, to move in the range of lower than 65, and you got to get to the low 60s or shame on us. And can we go below that? We'll see. And that's probably going to be dependent upon how well we convert on the revenue side.

    REVENUE GROWTH

    In order for CP to continue surpassing investor expectations, revenue growth will have to continue going forward. Volumes have been fairly flat over the last year while pricing has been strong. The company has lost some low-profitability intermodal contracts and has foreshadowed the possibility of more to come, which explains some of the analyst reservations regarding volume growth. Hunter has guided to 5-7% revenue CAGR with the potential to reach industry-leading margins by 2016 but as CP progresses into 2015 and 2016, the company will need to both sustain its strong price increases while taking on incremental volume.

    Clearly, this is a service improvement cost take-out story. Our costs were way out of line. Our service was not what it should be; and as a result, the quality of our revenue wasn’t. So we had discounted a lot of rate as a result of not having a very good service offering. Now, all of that is changing, as we speak. Our services improved significantly. It's going to improve a lot more. We're going to see the quality of revenue come up. We've got some accounts – probably, 20 or 25 accounts right now that just don't meet the hurdle rate internally that they're going to – bad news, but they're going to have to belly up and pay for the service…We're starting to see a really better product out there, but the market's not going to change overnight based on the fact that you go out and blow your horn about your service. They've got to see it. And so there's going to be some lag, a year or so, and it'll dribble out over time until people convert and make the change. So I think you'll see the revenue growth start in 2014, but it's not – but probably 2015 we'll really see a big jump on the service side if we're right in what we're seeing…this is not something that happens overnight. Number one, the market doesn't like change to begin with, as people are resistant to change. But if they start to see value in it, as we've seen with the domestic, I think we will see, on the domestic intermodal and this merchandise book, excluding crude, in every one of those areas, forest products, metals, minerals, you name it, I think we're going to see some growth. And that's without any boost in the economy.

    Ultimately, this is a bet that customers will see value in faster and more reliable deliveries. If they do, CP will be able to pick up a substantial amount of price with a healthy volume lift as well. A large portion of the company’s contracts are multi-year in duration, so even after the value proposition has been proven to customers, the impact on revenue will not be immediate. While it is too early to confidently determine the magnitude of this impact, there is considerable potential for CP to exceed the high end of revenue guidance.

    Our longer-range guidance has been 5% to 7% CAGR over the next four years, and I think that's probably going to turn out to be a very conservative number, because I happen to think that this issue of service is going to play a big part in our growth. And when people see the service, they actually see it. It's not what we're just talking about. They can understand what it does to their fleets as far as asset turns and their inventories…if we get a little bit of boost with the economy, could we exceed the 7% CAGR? Yeah.

    ASSET MONETIZATION

    One of the key benefits of precision railroading is that it moves more with less and therefore creates a surplus of assets that reduces future capital expenditures as the company is able to reallocate railcars and locomotives within its own network. Since converting its operations, CP has reduced railcars by 11,000 and created a surplus of locomotives which can now be leased out to other railroads, reducing equipment expenses going forward. As a result, FCF conversion for CP should exceed that of other railroads for the next few years. CP is also in the process of selling a portion of DM&E, a Class II railroad purchased by the prior management team which could create a modest $1-2 per share of upside. Perhaps more importantly, CP has a significant amount of land that was formerly being used as hump yards which are now no longer needed.

    We did not need the hump yards. The best analogy I can give you for the humps is that if Henry Ford was going to build 10 or 15 Model Ts a day, he would have never had an assembly line. When he got to 400 to 500, it started to make sense. Now, these humps were all late 50s, early 60s vintage. So you can imagine the condition, hard to buy parts for the retarders and software for some of the computer controlled retarders, for an example, and we started to look at, quickly, our mix of business. And the highest volume hump we had, which was the only surviving hump, was St. Paul. And the next on the ledger was Calgary and Toronto, when they were both humping 700 or 800 cars and some of those were twice. And so people that understand hump yards, understand processing, our book of business had gone from a place in the late 50s where 80% of the traffic need to be sorted, where today we're more of a bulk franchise and only 20%, 25% of it needs to be sorted. So those were obvious. Now, those hump yards that it took out obviously, it took out the internal mechanisms to operate those humps, and all the support, it eliminated car delay, and we just started going through very simple IE [industrial engineering] type studies.

    On the Q3 call, Hunter shocked a number of sell-side analyst by quantifying the surplus assets at over $10 per share.

    We're trying to get the right model to optimize those assets. And there are several alternatives that we're considering exploring. But it's not going to all come in, obviously, in 2014 and it might be 2015 before you start to see the full value, depending on which way we go. But it's nice to know that we've got something that's convertible, that's got value, that's in that $2 billion range, that's kind of gravy to this whole plan.

    These asset sales should begin hitting the balance sheet starting next year and have been largely excluded from sell-side models. Since FCF plus asset sales over the next two years will now result in CP being in a net cash position, it seems reasonable to assume that the company will allocate nearly all of the proceeds into stock repurchases.

    It’s basically all what I would describe as surplus assets. A lot of it's been a result of the close in the hump yards and movement and consolidation of yards and terminals, and it's opened up. For example in Chicago, we put all our intermodal business into Bensenville and closed the other facility and it's just a lot of that. And then, the company had not focused a lot on what we owned. In fact, I don't think there had been a very extensive look at all of those properties for probably 25 years. So we found properties in Northern Ontario that I didn't even know we owned. So, as we took all of these structures, all the land that's been made available, which makes up a high percentage of it, that's at this point our best estimate of what the "appraised" value might be today. Now I'm not a big – I don't think appraised value gives you a lot. But I think then we got to figure out how the best way is. And I can tell you this. I don't think we will do it in some traditional way of just selling off properties at a discount rate like a typical railroad. We're going to look and optimize this to the best of our ability to reward to the shareholder…we're not going to sit on a lot of cash that will get us closer to some buyback program. This is, of course, a board decision, not my individual decision. I would anticipate that if we continue to have the kind of performance we talked about, that we would probably be taking a strong hard look at the buyback within the next 12 months.

    EXIT STRATEGY

    Since the ‘90s, Mr. Harrison has shown significant creativity and risk-taking around asset sales and purchases. He is the only CEO currently running a Class I rail who has both sold his company and acquired other railroads of size. Despite broad agreement among peer CEOs that further industry consolidation is unlikely, Mr. Harrison maintains that more M&A is not just inevitable, it’s good for the economy, industry and customers. We don’t know what sort of strategic actions Mr. Harrison might envision, but we’re willing to continue to recommend the shares considering that we do not believe an option on a bold strategic action is priced into shares. – Morgan Stanley (12/13/13)

    When Hunter took the job at CP, he forfeited $1.5MM in annual benefit from CNR to take an annual salary of only $2.0MM. Instead of annual compensation, nearly all of his economic upside comes from 0.65MM options striking at $73 per share that are now worth over $50MM if exercised today. It’s important to note that these options do not vest until one year after he retires. While Hunter has been clear on his intention to retire after the restructuring is completed in 2016, I view it as highly unlikely that he leaves both his economic future and what will ultimately be his legacy to chance. Interestingly, prior to even knowing about his future opportunity at CP, Hunter had laid out a vision for a final railroad merger at the Wolfe Conference in May of 2011.

    I will tell you this that not many people agree with me here, there's going to be another merger. If I had to put a timeframe on it I'd say in the next five to eight years you're going to see a merger. It's going to be a bold move and whoever makes it is going to get way ahead of the game and be rewarded for it, once again in my view. Now, having said that, a merger will have to be done with a different operating model than we've had before to gain Washington's approval, requiring some degree of access…and so for this carrier, or these carriers to become merged, they would have to allow competition to run on their network if they're not providing the right service for a competitive price. Now if a combined carrier, and the shipper has the protection of being able to bring in a carrier B, is going to let carrier B come in on their railroad and provide better service at a lower cost and take business away from them, shame on them. Now there will be a lot of rhetoric about it, but it's going to have to be done. One of the big advantages of it is it creates capacity. It creates capacity without significant capital investment and additional infrastructure. Now some of us have forgotten the criticism this industry went through in 2005, '06, and '07 when things were really rolling about lack of capacity and about service issues and about bottlenecks in Chicago and pinch points on various carriers. If and when, and it will, this economy moves back to those levels, given that we don't have some of those mergers for example, there's going to have to be additional infrastructure added or different operating models to be able to handle the traffic. Now there's been some things done as we speak. I think one of CN's smartest moves was the acquisition of the EJ&E to move around the perimeter of Chicago. But there are other pinch points. If you look at the opportunity that a merger would bring, the capacity it would, I don't want to call it artificially add, it's hard to add additional infrastructure in this country. There's not going to be any more railroads built. We'll be lucky if we keep what we've got. So somehow we need to figure out a way to take the existing capacity and get more out of it.

    Given that he is one of the few individuals to have sold a railroad and integrated a merger, this prediction should carry some weight. We attended the Wolfe Conference again in May of this year, and when dismissing rumors that CP would buy KSU Hunter again made a quick comment about the potential sale of CP.

    All my comp – well, the so called – the ones that people are raising issues about is on the back end. It's in the way of options on the back end. After four years, they vest a quarter, a year – and I cannot – and I've got a holding period of a year after I leave the organization….I still think that there will be consolidations in the industry. I think it's the right thing to do. I think competitive issues and the STB issues can be addressed and can be taken care of. We are certainly – we'll become along the short line, regional front, more aggressive than we have been in the past because when your cost is at 80 OR as opposed to 64, 65 OR, you are in a different position. There's lot of those short lines that I'd like to control that I don't. So, now, we're not – it's not probably in our interest right now to focus on anything else. We've got to keep our eye on the ball, get this thing, hit it in the right direction, get everyone comfortable that this is the story that we're going to produce and we're going to produce value. And I think if we do that, we'll do fine. It'd be hard for us to put together the wherewithal to be able to make an acquisition of a Class I. That's just probably not on the cards for some time. Having said that, that's something I look forward, but I don't think that's around the corner. I don't necessarily agree with the report that came out of Canada last week, I guess, that one of us thought about KSU. I don't know that – that story is worn out. That story I've been hearing for 15 years. And we lost the concession and I thought it was over. I do think there will be consolidations one day. It's probably going to be post-Harrison. And I do think that the strength that I think this company will develop, I think, will put us in a good position for shareholders and others. As this plays out, it will be good for CP shareholders because I think that the way this might be structured, and the timing of it, it's going to be pretty important. And so, if it's – if they take the index card that I leave and read them and don't get off the playbook too much, they can make a big hit.

    There are only a handful of Class I railroads and realistically only BNI or UNP could make a play for CP, but if they did, it would make tremendous sense for both of them as the deal would be immediately financially and strategically accretive. Buffett purchased BNI stand-alone at 18x forward earnings in 2010 while KSU currently trades at 26x due to its acquisition potential. A buyout of CP would likely warrant a multiple somewhere in between these two numbers. We believe Hunter is very likely to outline a plausible exit strategy for CP prior to 2016.

    RISKS

    Hunter is 69. Reliance on a key individual naturally bears some risk, especially given Hunter is approaching 70 years of age. On the other hand, Hunter’s age has served as an incentive for him to overhaul the management team with individuals who embrace his vision. Hunter was able to poach COO Keith Creel in February. Creel served under Hunter at Illinois Central and CNR, where he was the COO until his departure. Creel carried a hefty price tag, because in exchange for his hiring, CP had to agree not to hire a defined set of 60 other individuals from CNR until 2016. Creel is likely going to work as hard as possible for the next few years given that the CEO position on Hunter’s retirement is now his to lose.

    I am extremely pleased, extremely pleased, that at the top of the pyramid of the house, I think things have come together very well. I think the first big addition that filled and sealed a lot of holes was the addition of Keith Creel as the President and Chief Operating Officer, I guess, eight, ten months ago now. Keith I've mentored and coached, and led Keith since 1994.... He is a hard-working, bright young man. Probably the brightest, in my view, operating mind in North America. Clearly, people were concerned about succession, about, God forbid, of all things, my age. I don't have any problem with it, but a lot of other people did. But now we know where we are there...This week we just announced we brought on a new Executive Vice President and Chief Financial Officer, a gentleman named Bart Demosky from Suncor who was one of the most – we did an intensive search, I can tell you, throughout North America. And Bart has been – has a reputation as one of the top CFOs in Canada, and we are extremely pleased to be able to bring him on board and to solidify that team.

    Pershing Overhang. In June, Pershing Square announced its intention to sell 7MM shares over a year, and this created some overhang on the stock including an analyst downgrade, though the same analyst upgraded the stock after Q3 results. Afterward, Pershing Square announced a public offering to sell the firm’s remaining 6MM shares of the announced sale, which effectively removed the overhang. Pershing Square remains the largest shareholder with two board seats and 9.8% of outstanding shares.

    We’ve made a lot of money in Canadian Pacific. We’ve sold some of our stock simply because it went from being an 11-12% position to being a 28% position because of appreciation. We’ve only sold stock because of portfolio management. – Bill Ackman, Oxford University Business School, 10/29/13

    Commodity Prices. CP moves coal, grain, and potash though in most cases this is volume-based, and CP’s customers are low-cost providers. Perhaps more important than any of these commodities, is the price of oil. Fuel makes up the company’s largest cost component after labor, accounting for 16% of revenue. CP stopped hedging for fuel earlier this year as coverage from its fuel cost recovery program has improved and was deemed adequate. There is, however, a lag effect with escalating fuel prices causing an earnings headwind and declining fuel prices causing an earnings tailwind for about a 90-day period as it is priced through contracts. It is important to note, however, that the long-term benefit of higher fuel prices is that it makes the cost of highway transportation more expensive than rail transportation which the rails have traditionally arbitraged by raising prices.

    Macro. Freight volume growth is generally dependent on a healthy economy, especially as industrial and consumer products account for a quarter of the company’s freight revenues. There is exposure to volatile grain production (20% of revenues), coal exports (10%) and auto trends in Canada (7% of revenues). CP’s guidance does not assume a material improvement in the macro environment, but alternatively, also does not assume that it gets materially worse.

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    • Q4 Earnings
    • New long-term operating targets
    • Return of capital strategy

    Messages


    SubjectRE: Hunter
    Entry01/03/2014 12:33 PM
    Memberthistle933
    Biffins, When shall we expect your rebuttal? I'm interested to read it.

    SubjectRE: RE: Hunter
    Entry04/25/2014 12:19 PM
    MemberBiffins

    Stock is trading sideways at the moment. I am still doing more work on it. I am less convinced that it's a short so didn't bother writing it up. But the following article shows all the reasons why you love it, and also all the reasons why you should be concerned. The bull scenario is that he just keeps driving OR down through all his changes. The pushback from me is that events like this winter's grain fiasco become more common with a much leaner workforce and possibly even causes the regulator to move in to force these guys to increase service levels. CP could also lose more work to CN. At the moment I don't want to fight the financial engineering either. They are going to buyback a ton of stock. 

    I know this is a feeble update. But with rails generally benefitting from so many things, like US housing, crude-by-rail, intermodal, etc etc, that I wouldn't call CP a good short. All I'd say is that I'd much rather own UNP or CN than CP. 

     

    Article published in The Globe and Mail overnight

     

    Driving through the rusty underbelly of southeast Calgary, past the scrapyards, used car lots and grain mills, you come upon a windswept field of train tracks and semi-abandoned buildings—a century-old industrial site gone to seed. Along the edge of the property, rising from the dirty snow of a long, hard winter, sits a low-slung white-and-grey building with “Canadian Pacific” emblazoned across it in bright red. 

    If it looks like a factory, that’s what it was—a railcar shop. But now it’s been stripped to its steel skeleton, and retrofitted with a second storey of executive offices, fields of cubicles, a NASA-style operations centre and hallways full of oil paintings of severe men with names like William Van Horne and Donald Smith.

    In this remote brownfield of tracks and ties, a new head office of the company that built post-Confederation Canada has taken shape. Standing guard, near the entrance to the rail yard, is a bronze statue of 19th-century tycoon Lord Mount Stephen, but the building itself is a monument to the new lord of the line—a modern-day rail wizard named Hunter Harrison. As CP’s hedge-fund-anointed saviour, he has moved more than 1,000 people—some very reluctantly—to the Ogden Yard, where he is asking them to build a new CP amid the wreckage of a company that had lost its way.

    The early results are impressive. It’s been only two years since the bitter proxy fight led by U.S. hedge-fund mogul Bill Ackman that overhauled the CP board and swept aside former CEO Fred Green. But Harrison has already engineered a remarkable turnaround, and he insists there is more to come. The veteran railman, who will be 70 in November, has undertaken a whirlwind agenda of efficiency moves, job cuts and a top-to-bottom culture shock that is still sending tremors through the company. It has made investors delirious, but left critics questioning whether this single-minded focus on operating profits is jeopardizing the railway’s long-term health.

    The new head office is testimony to the Harrison effect. When he arrived in mid-2012 to save benighted CP, he came upon this downsized rail yard and was appalled by the spectacle of underused facilities, especially when juxtaposed with pricey leased offices on Calgary’s downtown 9th Avenue. There is a refrain you hear in CP: Hunter hates downtown offices, he hates wasted assets, and he likes employees to see and touch what they do. Which is, at the core, running a railway.

    In the new Canadian Pacific Railway, what Hunter likes, Hunter gets—whether a new $40-million head-office complex or over $40 million in extra compensation to offset lost pension from another of his reclamation projects, Canadian National Railway.

    The Harrison team takes care to respect CP’s 133-year history but not its recent record as the worst-performing of the continent’s major railways. “People told me all the history, that Western Canada wouldn’t be here but for the CP. But the CP is not the CP is not the CP,” asserts Harrison in his Tennessee drawl. “There was a great period for CP and there were some horrible ones.”

    He has left one of those horrible eras in the dust, having roared out of retirement vowing to trim CP’s operating ratio, the much-watched index of profitability that measures operating costs as a percentage of revenue. His initial goal was to hit 65% by 2015, rivalling CN’s stellar results, and down from CP’s woeful 80% levels before he took over. He is way ahead of that schedule. In the fourth quarter of 2013, the “OR” plunged to 65.9%, a company record. For the full year of 2013, the operating ratio was 69.9%.

    Propelled by such numbers—and Harrison’s mystique as a railway operator—the stock has been a runaway train, allowing Ackman to sell a third of his holdings last fall for three times the buying price.

    Rarely has a widely held company been so tightly in the grip of a single compelling personality, backed by grateful investors and a board of directors totally in his thrall—and surrounded by management acolytes, many of whom have followed him back and forth across the continent, from south to north and east to west, fixing railroads and spreading a gospel of transformation.

    Brian Stevens, national rail director for the union Unifor—which represents parts of the workforce at both railways—says Harrison has already done far more at CP than he did in making over CN. “From a labour relations perspective, in terms of changing the culture, he has gone further, harder, more aggressive in issuing disciplines and terminating employees.” According to Stevens, “The board has given him the power—he did not have that power at CN.”

    But Harrison has also found himself on the defensive in a rail industry marred by controversy. Rail companies have made big gains in hauling crude oil as an alternative to pipelines, but the industry has suffered a rash of oil-car accidents, including the Lac-Mégantic explosion that left 47 people dead. Then, this past winter, grain shipments, so vital to Western Canada, were hopelessly snarled, leading to proposed regulatory changes allowing more choice for shippers—and, perforce, the threat of added competition from U.S. railways—as well as Ottawa giving itself the power to levy fines if the railways do not move certain thresholds of volumes.

    Through it all, CP has maintained it is still the safest railway in North America, with the lowest frequency of train accidents. And Harrison is irate over Ottawa’s new shipping proposals, which he says amount to a politically motivated act that unfairly targets railways that were caught in a perfect storm of record grain crops and a punishing winter.

    It is clear Harrison does not shy away from a fight, whether taking on governments or dealing with recalcitrant employees. “When you go to a new location, in a railroad or whatever, you’ve got to find the meanest son of a bitch and whip his ass—you get a lot of attention,” he says. If you’re in a rail yard, he says, where a big bully has always got his way, “you take care of the big bully and a lot of things come together.”

    Of course, Harrison comes from a long tradition of tough, polarizing rail chiefs. “They don’t make cute and cuddly railway presidents. Hunter is a hard man,” says Bill Brehl, a 34-year CP employee and president of the Teamsters division that represents the workers who build and maintain the CP tracks.

    But Harrison is also a sophisticated leader, who comes with a well-thumbed playbook of efficiency and change management, earned by turning around a venerable but dying Illinois Central and helping revive a newly privatized Canadian National. Over 11 years, he was CN’s chief operating officer and then chief executive officer, all the time spreading his gospel of precision railroading—the novel concept that trains should run often, quickly and on time, in order to serve customers.

    Backed by human resources policies that inspire and intimidate, Harrison took CN from the bottom rung to top spot among the continent’s seven Class 1 railways. But CP is CN on speed. He was given just four years to turn around this entrenched loser, and embed a new culture, before handing the shop over to his hand-picked successor, Keith Creel, 45, another hard-nosed rail fanatic from south of the Mason-Dixon line.

    And the job at CP is twice as big as at CN. When he arrived at CN in 1998, then-CEO Paul Tellier had privatized the bloated Crown corporation, and taken out dozens of senior officers and thousands of employees. He had established the model of a continental transportation giant by buying Illinois Central and got Hunter Harrison as part of the bargain. At CP, Harrison has to cut and build at once, all within a compressed time period, and he has moved with a speed that both impresses and distresses critics.

    He started right at the top, moving out most of the core of Green’s senior team in his first 90 days, and airlifting in managers who shared his impatience with bureaucracy and process—what Harrison calls the “mud” in an organization. “CP is the first place where I had to change a lot of senior people,” he says. “It was a horrible culture and they were heavy in fat.” He adds that “I didn’t get Fred [Green]—someone else got Fred—and I had to make changes for the others under him. They just saw the world differently.”

    He pulled in old loyalists, such as Mark Wallace, who performs the same chief-of-staff duties as he did at CN, and Creel, the former CN chief operating officer and a Harrison protégé all the way back to Illinois Central. Creel came at a price: CP had to agree to keep its hands off 64 of the other top management people at CN. But Harrison has worked around this, picking up people beyond the untouchable 64 or reeling in converts from other companies.

    CP is thus sprinkled with CN alums—from Jason Ross, who had gone to a steel company after his CN stint and now runs CP’s operations centre, to Tommy Browning, an Alabaman plucked out of CN in Chicago and now entrusted with pushing merchandise and energy sales, a rising business but with sliver-thin margins that Harrison is determined to widen. Conveniently, Peter Edwards, one of Harrison’s key human resources people at CN, was already at CP, and has resumed his role as chief proselytizer of the leader’s people principles.

    It creates a fascinating dynamic. The two transcontinental railways compete on only about 25% of their networks, but the rivalry is intense, as can only happen when two groups share so much history and so many people have crossed the tracks. Inside CP, there is a lot of talk of “the other guys” or “the eastern railway,” with its Montreal base. And Harrison was not entirely happy about how he was put out to pasture when CN didn’t renew his CEO contract in 2009

    At CP, Harrison has again applied his brand of precision railroading, aiming at a leaner company with longer trains and fewer train starts, faster velocity, and better service at lower cost—all of which, he says, are proceeding as planned. He has also taken his scalpel to the place, cutting a net 4,800 jobs (from a roster of 19,500 when he took over), shedding 400 older locomotives and 11,000 cars, dropping some terminals, and initiating a whack of disciplinary actions against a workforce that, he argues, had got slack about safety and working rules. The company says only 200 people have been “separated,” with most of the job losses coming by attrition, and 1,000 new people have actually been hired. But union officials say many employees—management and rank-and-file alike—have quit, tired and frustrated with the arbitrariness of decision-making and the barrage of disciplines. The result has been a loss of critical know-how that cannot easily be replaced.

    Harrison’s team negotiated five-year agreements in 2012 with four of its bargaining units, but relations are strained in other places. Doug Finnson, a Teamsters vice-president who represents so-called running trades such as conductors and engineers, says the number of arbitrated discipline and dismissal cases has skyrocketed in his area of the company. He paints a picture of an American style of labour relations that values confrontation over conversation, and a workforce facing a bewildering turnover of managers, with ever-shifting interpretation of the rules.

    For its part, the railway agrees discipline actions are up, as managers strive to enforce rules that were being ignored in some areas. “We have some radical concepts, where we want you to come to work the whole eight hours,” says Peter Edwards, the HR vice-president. “Some operations people were leaving after four hours—both union and management. We asked them to stay the whole day.” While the running trades experience the highest discipline rates, across the system the number of such actions is “not even double,” Edwards insists.

    Whatever the numbers, the spate of actions has revived the image of a “culture of fear and discipline,” a description coined six years ago in a federal review of rail safety while CN was under Harrison’s leadership. But he doesn’t shrink from that “fear” word. If people are afraid, that’s fine—they are finally feeling pressure on the job after years of indifferent execution of the rules. Behind it all is a message: When employees behave in a certain way, bad or good, there are going to be consequences.

    If a culture of fear exists, Harrison says, it is a matter of “here’s your job to do, do it, and if you don’t, you are not going to get to stay. That looks to me a pretty simple contract.” He adds that “you can call it fear or accountability, responsibility, whatever, but it is just basic. The hard part is that someone created a culture of permissiveness, which means somebody else has to come in and make a change.”

    Harrison believes that to accept change, people have to find a WIFM—a what’s-in-it-for-me payback. It can be the prospect of job security, higher compensation, or just a good feeling about working at CP. Keith Creel insists the speed of change stems from unleashing the pent-up frustration at being considered second-class. “I had anticipated a hard grind from the very beginning similar to what we experienced at CN, but the same level of resistance was not there.”

    Every change story relies on a strong narrative, and it helps that Hunter Harrison has one of the best. This son of a Memphis cop grew up with a passing acquaintance with Elvis Presley, started out as a 19-year-old car maintenance worker for the St. Louis-San Francisco Railway and became the consummate operator and turnaround ace. “I know this business. I happen to be, with a little humility, pretty good at it,” he says.

    His years in the trenches fashioned a leadership style that is highly personal, with no hesitance to micromanage. While the old CP had a reputation for hierarchy and decision by committee, Harrison personally roams the company, dispensing teaching moments like a crusty professor or, in the next breath, baring his teeth with the menace of a junkyard dog.

    “Hunter is a big personality,” says Creel, an Alabama-born former U.S. Army officer, who claims to match his boss’s passion for railroading but admits his personality doesn’t quite fill up a room the same way.

    At times, it seems like the standard operating rationale among CP managers is “Hunter likes...” or “Hunter doesn’t like...” Hunter doesn’t like trackmobiles, the little buggies for moving tools and people along the rails, so they have been shut down. Hunter doesn’t like customer service centres—companies with big service departments are companies with service problems—so he downsizes the department. If Hunter said he didn’t like BLT sandwiches, the Last Spike Bistro at head office would no doubt ban bacon, lettuce and tomatoes. But the cuts are based on hard reality. Building a new head office for $40 million sounds like vanity, but CP would have had to pony up $20 million a year for a downtown Calgary lease.

    At every turn, Harrison preaches the gospel of his five core principles—give good service, operate safely, optimize assets, control costs and develop people. Any CEO would salute these priorities, but CP’s boss uses them as a hammer to pound change into his organization. In previous posts, he has published small books on the principles. At CP, he has instituted whiteboard sessions where managers blue-sky ideas. He has revived his Hunter Camps, first introduced at CN as three-day retreats that bring together people at all levels, including the occasional union leader, to learn the principles straight from Harrison’s mouth. The camps give Harrison a forum to communicate directly, thus cutting through the mud.

    And because CP is, at its heart, an operating railway, Harrison has begun to insist that general managers, superintendents and other senior people know the operating and safety rules of the railway. They take the standard rules test, and pass with a minimum grade of 90% on a closed-book basis. Creel has taken the test, but did he get the 90%? “I would be very disappointed in 90%,” he says.

    But beyond the management ideas, Harrison relies on emotion as a learning experience. He believes the biggest change comes through significant emotional events, which can be positive or negative, and, if necessary, he is willing to bring them on. All of which makes a company run by Harrison an unsettling place to work.

    Les Dakens saw it all unfold before as Harrison’s senior vice-president, people, at Canadian National. In selling change, the critical point of contact was the front lines, Dakens says, where people like mechanics and conductors could be coached. To find the right agents of change, CN had to replace 20% to 30% of its first-line supervisors. That often meant moving some supervisors back into the ranks—or out of the company—and elevating people who had got religion.

    At CP, Edwards says, that transition is happening right now as the company moves towards the CN turnover figure. His message is: “Don’t mourn it; the job has changed and it is not for everybody, and it does not mean they are not good people.”

    The criticism of the Harrison system is not limited to some quarters of the workforce. A number of customers are dismayed by how the intense focus on operating ratio is driving strategy at both CN and CP. Even before the grain-shipping crisis, Wade Sobkowich, executive director of the Western Grain Elevator Association, felt the cost-cutting push resulted in poorer service and, more broadly, a transfer of wealth to CP’s investors from shippers.

    The grain crisis underlined this issue. The move to leaner companies—with reduced workforces and rolling stock—had left no insulation against shocks to the system, says Sobkowich. He likens it to a power company that fails to maintain the capacity to deal with surges in demand.

    CN and CP are both guilty, he says—but then again, they have something in common. “When CN went through this process, Hunter Harrison was CEO. Now CP is going through this process, and Hunter Harrison is the CEO.” Sobkowich respects Harrison for what he has accomplished, but he welcomes Ottawa’s new regulation of an industry where both CN and CP are monopolies on their own networks.

    CP says it would be imprudent to invest heavily in capacity to meet rare moments of record crops and record winter weather.

    In any case, cost control is not the entire solution; in the drive to reduce the operating ratio, the company is also focusing on higher revenue. That puts the pressure on Jane O’Hagan, the senior vice-president in charge of marketing and sales, to get revenue up by the targeted 6% to 7% this year.

    “I am a survivor,” O’Hagan says, explaining she is one of three senior executives left over from the Fred Green days—the others are chief legal officer Paul Guthrie and Peter Edwards. Looking back, O’Hagan describes a senior team that wanted to change, but got bogged down in the mud. She had taken time off from the company some years ago, and came back because she loved the industry—but she was becoming frustrated with constant failure.

    That all changed at 8 in the morning of July 4, 2012, when Hunter Harrison arrived for his first meeting. While some colleagues were nervous, O’Hagan was excited. “I just knew that, No. 1, we had been trying so hard and we were not getting results and something had to change. I just wanted to be a part of it.” In front of the leadership group, Harrison asked her how she would feel about cutting deeply into intermodal cycle times.

    For O’Hagan, this was a signal that her new boss was committed to change by building up a service that had great potential but where CP was lagging. The intermodal service shifts containers among trains, trucks and ships; it relies on speed to make the economics work. CP has been able to take a day out of the old five-day cycles for Vancouver-Chicago and Vancouver-Toronto traffic, and it has focused on domestic intermodal service as a growth area.

    Another goal was to get salespeople out of the office and selling, which means, for the first time, they are being rewarded by commissions, as well as salary. It has motivated people like Caitlin Courteau, 26, who thrives as a regional account manager for energy and merchandise. Whereas sales used to be a transaction business conducted from a desk, she is out on the road meeting customers 80% of the time.

    The road is where you will often find the CEO, as well—he is out of the head office at least half the time. But if the CEO is at his Florida home, he is present in Calgary and elsewhere in spirit—and through phone calls to executives.

    The problem with this intensely personal leadership is this: What happens when the leader rides off into the sunset? If Harrison’s legacy is just short-term cost-cutting, it will be a failure. The Teamsters’ Bill Brehl says a low operating ratio is good for investors, and may even be good for the country. But it has to be achieved safely and with a satisfactory quality of life for workers or it won’t be sustainable. “A railway is measured not in quarters, but in centuries,” Brehl says.

    His Teamsters colleague Doug Finnson predicts that Harrison, in the short time he has left in the job, will continue to “cut and cut and cut.” And what will be left for Creel? There will be a hostile workforce, Finnson warns, and a management team that lacks experience and independent thought.

    Indeed, the results are mixed for companies that shift from a cult of personality to more conventional leadership. It took a long time for Jeff Immelt to implant his style at General Electric after replacing Jack Welch. Apple CEO Tim Cook is grappling with the identity of the company in the post-Steve Jobs era. CN may provide the best model. CEO Claude Mongeau has maintained the essence of Harrison’s precision railroading but, as one union leader says, has taken some of the heat off the workforce.

    In two years, CP’s destiny will be in the hands of Keith Creel, who portrays himself as no less consumed by railroading than his mentor, but “not quite as loud or as intense,” although he adds: “I’m not far off.” With him, CP gets “a little more level approach,” he says. By 2016, after four years of riding Hunter Harrison’s exhausting leadership, CP’s managers and workers may be ready for something a bit more level. 

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