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

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.

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.

 

 

 

 

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.

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.

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.

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.

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.