CP Limited – Putting the Price Cart Before the Earnings Horse

The shares of CP Limited have risen strongly since their lows in October of 2011, first because they were certainly on the cheap-ish side back then, but second, because in recent days, hedge fund manager, Bill Ackman, has been attempting to take control of the board in an attempt to ‘revitalize’ the company which apparently scores poorly in tests measuring the operating efficiency of CP relative to its peers. Ackman proposes to bring former and now retired CNR CEO Hunter Harrison out of retirement to ‘work his magic’ in reforming the operations at CP. The question for investors at this time is, should we be piling into this stock ifHarrisonis brought in because good things will happen and we will make a bundle?

The short answer is no, you will not make a bundle in anything less than the quite long term. The stock market has become so excited about another Harrison miracle that it has already increased the valuation of CP back towards the levels at which the rest of the industry trades, but long before any ‘miracles’ have been wrought. The average railroad today trades in the stock market at about 2½ times adjusted book value and CP is already up above 2 times book – and all without benefit of a single change at the company, or even the certainty that Harrison will be taking over. At best, therefore, current shareholders can look forward to another 22-25% up move in the stock, but that is assuming that Harrison takes over and he spends some time, probably even a fair amount of time, in making the company more efficient – at the very least, a debatable proposition.

We looked at the return on equity of the various railways in our coverage and found that – based on 2012 earnings – the average railroad appears to offer about an 18-20% ROE, the best being 22%. CP offers quite a bit less at roughly 12.8%, so there is certainly lots of room for improvement: Ackman is correct in this assessment. However, the length of time required to make those changes will not be overnight and in the meantime, we have markets and business cycles to contend with. CP is also currently trading at a 22 times PE multiple versus an average PE ratio for the comparison railways of 13.

So…if you are rushing out to buy today on all the glorious news about a big turnaround at CP, you can forget about being rewarded in any but the very short term when over-enthusiastic investors overpay for changes in the short term which may or may not take place and which may or not even be possible. After that, we are likely to be disappointed under either scenario that we can see.

First, if the CP board tells Ackman to take a hike and they beat him back, there will be no Harrison and no ‘big’ turnaround. In this case, we are sure that CP will do its best to improve results and find additional ‘efficiencies’ because they will remain under critical scrutiny. But we also suspect that anyone who thinks that current CP management has not been shaking the tree for all the efficiency fruit that it can muster is probably dreaming. That is a pressure that every management faces these days.

Second, Ackman wins this game andHarrison does take the reins at CP. How long it will take him to work his supposed magic is anyone’s guess, but it will be far from over night. In the meantime, CP is very expensive relative to the rest of the rails and even if he increased earnings by 30 or 40%, the PE of CP would then only catch up with the rest of the industry.

In the very short term, perhaps investors will be silly enough to run the price of CP up to the average price/book of the industry, another 22% in price terms, but by then, the PE will be even more extended and the probability of a crash-and-burn price outlook, should weak markets prevail, would become extremely high.

The bottom line is, caveat emptor as far as CP is concerned. The market is already paying more than full freight for a turnaround in earnings, and about 80% of the freight in price/book terms. The risk/reward ratio is not favourable to investors and we would consider the shares as speculative at best.

If we owned the shares, we would hold them at the moment, as the price is above 2 times its adjusted book value and we cannot, of course, guess just how much speculation might be forthcoming on the Ackman/Harrison skirmish. But we would also use a failure of the stock price to hold at that level as a sell signal, as the market awakens to the risks that it has undertaken.


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