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Bill Ackman’s Big Winner: Stay In Or Exit?

Suzanne McGee

On the surface, the decision by activist investor Bill Ackman to unload 7 million shares of Canadian Pacific Railway (CP), or nearly 30% of his total stake in the company, looks like a savvy move. Less than two years after he bought his first few shares in the railroad and little more than a year after he first won a massive proxy battle to name a new CEO and followed that with a victory over the company’s unionized workers, who had attempted to strike, Ackman is taking some of his chips off the table. Why not, especially given that the stock trades at nearly double the valuation for the S&P 500 index as a whole?

CP Chart

NYSE:CP data by YCharts

The stock may have gained 150% since Ackman made his first purchase in late September of 2011, but the activist investor pointed out to investors in his Pershing Square fund in a recent letter that the sale is only “for portfolio management reasons.” Translated, that means the stock’s soaring price in both absolute and relative terms had meant that $1 out of every $4 in the fund was invested in the railroad, and Ackman didn’t like having any single investment – however successful – make up such a large proportion of the portfolio. He didn’t voice any concern at all about the run-up in the company’s share price or the fact that it now trades at a PE ratio of more than 30. “We expect to remain CP’s largest shareholder and for CP to remain one of our largest investments over the coming years as the turnaround story continues to play out,” Ackman wrote in his letter to investors.

Well, maybe. Some bears, however, have suggested that investors should not only follow Ackman’s lead and lighten up their exposure, but even consider walking away altogether from Canadian Pacific. Their argument focuses primarily on that hefty valuation, exceptionally rich for the kind of company that depends on a robust economy to fuel growth in earnings and profits. In the eyes of these skeptics, the turnaround story has already been fully priced into the share price.

Ackman, however, clearly believes that this isn’t the beginning of the end of the rally, but more likely to be simply the end of the beginning. Under the leadership of the new CEO that Ackman and Pershing Square fought a proxy war to install in the corner office, Hunter Harrison, the company has seen its financial performance improve dramatically. (Most recently, Canadian Pacific reported that its net income more than doubled to 1.43 Canadian dollars per share in the second quarter from 60 Canadian cents in the year-earlier period, while revenue hit a quarterly record of C$1.5 billion.)

Analysts at firms like Raymond James have boosted their ratings on the stock, betting that there is more good news to come. And Ackman is correct that the company is still in the early stages of its restructuring, having made significant cuts to the workforce and reduced overhead. (The second quarter report noted that CP had cut the number of employees to 15,471 from 17,327 in the year-earlier period.) The number of carloads of freight that Canadian Pacific is sending across its system has climbed, and the trains are longer and moving faster – all good for the company’s bottom line.

CP Operating PE Ratio TTM Chart

CP Operating PE Ratio TTM data by YCharts

Nonetheless, over the last six months, Canadian Pacific shares have lagged the S&P 500 as at least some investors have questioned their rich valuation, such as the analysts at Sterne Agee, who suggested that the improved pricing that the company has said will follow improved service may materialize, but not fast enough to make investors comfortable with those lofty valuations, in tandem with a relatively unimpressive dividend yield.

Indeed, the company’s operating PE ratio for the trailing 12-months has grown by at least double the rate of some its rivals over the last five-year period, which would appear to suggest that a significant part of that improvement has already shown up in CP’s stock price.

But there is a reason that Canadian Pacific is faring better than, say, CSX (CSX) or Kansas City Southern (KSU). Over the last five years, CP’s revenues have grown by 40%, while those of CSX are up only 4.45% and Kansas City Southern has seen an increase of 20.9%. A similar pattern can be seen with respect to EBITDA. Above-average growth in performance leads inexorably to a higher-than-average market multiple.


CP EBITDA TTM data by YCharts

That’s not to say that investors shouldn’t use Ackman’s decision to lighten up his exposure to Canadian Pacific as a suggestion to re-evaluate their own position. Clearly, Ackman got it right: CP offered plenty of potential for a turnaround in its operations and a rebound in its financial performance and stock price.

Now it’s time to question whether those will be as significant going forward. True, the railroad is likely to do well out of carrying crude oil to coastal refineries, in the absence of adequate pipeline capacity, but there is plenty of competition for the business. CEO Harrison commented earlier this year that this potential is so great as to “make people forget the Gold Rush in 1849.” What Harrison may himself have forgotten is that the gold rush was a ferociously competitive phenomenon, full of claim-jumping and other attempts to seize ‘market share.’

Also worth remembering is the fact that in the rush to cut costs and demonstrate how rapidly and efficiently its rail operations can get cargo from point A to point B, CP can’t afford to compromise safety. In its second-quarter report, the few metrics that didn’t reflect well on the company had to do with safety: personal injuries rose 22% in the first half of 2013 over the year-earlier period, while accidents per million train miles rose 26%.

The occasional train derailment is nothing to take lightly, which is why CP has said it plans to increase its capital spending this year, including investments in track improvements and upgrading its signal systems. These accidents may temporarily dent CP’s stock price while doing less damage to its profits, however, giving an investor who has evaluated the risk an opportunity to acquire the stock at a relative discount.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

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