RPT-BAY STREET-Railroad CP on track for revamp although risks remain

Mon Nov 19, 2012 7:14am EST

* CP stock is up 20 pct since end-June
    * CP has second highest PE ratio of North American railroads
    * CEO Harrison to lay out turnaround strategy Dec 4-5
    * Harrison targeting big improvement in operating ratio
    * Economy, weather could hamper turnaround

    By Nicole Mordant
    VANCOUVER, Nov 18 (Reuters) - Less than five months into the
appointment of a hard-driving chief executive, industry laggard
Canadian Pacific Railway Ltd is already showing signs of
a turnaround, and investors have piled into the stock.
    The rapid rise has made the stock too rich for some
investors concerned that the shares could tumble if Canada's
second-biggest railway fails to reach its target of becoming one
of North America's most efficient railroads in four years. An
economic slowdown, a harsh winter, or renewed labor strife:
analysts say plenty of things could still go wrong. 
    "Our view is that it is not going to be a smooth road making
the improvements that they want to make. We decided to take our
profits and move on," said Michael Sprung, president of
Toronto-based Sprung Investment Management, which sold its CP
stock after a proxy battle ended in May with the ouster of the
former CEO.
    CP stock rose to a record high this month, and it's up a
whopping 20 percent since late June, when Hunter Harrison, a
50-year veteran of the railroad industry was appointed CEO.
    For the year, the stock is up 46 percent, dwarfing rival
Canadian National Railway's 6 percent rise and the 2.4
percent fall on the Toronto Stock Exchange's benchmark S&P/TSX
composite index.
    To be sure, many investors are likely to give Harrison, who
is lauded for turning around two railroads in his lifetime,
enough time to see his plans through. 
    "As long as the investing community sees that he is able to
make changes, the stock is likely to float with a little bit of
elevated loftiness above where intrinsic value would be," said
Morningstar analyst Keith Schoonmaker.
    Harrison is the former CEO of CP's larger rival Canadian
National Railway (CN). He was handpicked for the CP job
by the company's biggest shareholder, William Ackman's Pershing
Square Capital Management Ltd, a New York-based hedge fund that
owns some 14 percent of CP.
    Ackman launched a proxy contest in January to shake up CP's
board and replace its CEO, whom he blamed for the company's
longstanding underperformance. Both the former CEO and chairman
quit in May, along with several board members. 
    
    INVESTOR DAY 
    The first big test for Harrison will come when he lays out
his operating and financial strategy for CP at a meeting with
industry analysts in New York Dec. 4-5.
    What the market most wants is a detailed road map of how
Harrison plans to meet his promise of slashing CP's operating
ratio from 74.1 percent in the third quarter to 65 percent in
four years. The ratio is the gold-standard measure of efficiency
in railroading.
    The lower the ratio, which measures a company's operating
expenses as a percentage of its revenue, the more efficient the
railroad. CP is the least efficient of North America's big six
railroads. CN, with an operating ratio of 60.6 percent in the
third quarter, is the industry leader.   
    "That is going to be the critical test, when he will
announce his plans," said independent railway analyst Tony
Hatch.
    "I feel pretty good that he will not disappoint, that he
knows what is expected of him, he knows how to beat
expectations...," said New York-based Hatch, who has followed
the rail sector for 25 years.
    
    SOME DOUBT
    Although RBC Capital Markets analyst Walter Spracklin
regards Harrison as "an exceptional operator," he sees the ratio
target as a challenge.
    At current levels, it "makes the shares vulnerable to
disappointment should that target not be realized," he said in a
recent note to clients.
    In 2011, harsh winter weather, including avalanches in
British Columbia and heavy snow on the Prairies, knocked down
CP's first-quarter profit. This year, second-quarter earnings
fell partly due to a nine-day strike by locomotive engineers.
            
    RAPID CHANGE
    Harrison has not rested on his laurels since taking the
reins at Calgary-based CP, which operates 15,000 miles (24,000
kilometers) of track across Canada and into the United States
and employs nearly 14,500 people.
    He has taken over the role of chief operating officer
himself, named a new chief financial officer, closed inefficient
railyards, increased train speeds, simplified CP's intermodal
network and cut headcount, especially at the head office.     
   "The pace of change is phenomenal. In my lifetime I have
never seen someone grab hold of a company so quickly and wrestle
it to the ground," said Trains magazine writer Fred Frailey, who
has been writing about the industry for 34 years. 
    Although CP was already showing improvement under the
previous management's growth plan, its progress has become more
pronounced under Harrison. In his first quarter as CEO, CP's
profit increased by 20 percent.
    As CP's share price has climbed, so has its price/earnings
ratio, which is now the second-highest among North American
railroads. At 21 times consensus earnings for 2012 and 16 times
2013 earnings, according to Thomson Reuters data, CP's PE ratio
is above that of CN, a much more efficient railroad. CN trades 
at 15 times earnings for 2012 and 13 times 2013 earnings.
    The big valuation has given rise to red flags that may give
investors second thoughts. 
    Euro Pacific Capital analyst Mark Suarez believes CP's stock
has peaked for now. "I think the economy is decelerating.
Fundamentally for any train operator it is difficult to make
drastic cost cuts when your volumes are going down," he said.
    "I think we are beginning to see the correction already over
the last two weeks," he added. 
    CP's stock hit a record high of C$94.44 on the Toronto Stock
Exchange on Nov. 2. It closed at C$90.20 on Friday, down 25
Canadian cents.
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