Railway to riches? CP vs. CN

But despite their long history in this country (CP was founded in 1881 to physically link Canada's populous eastern provinces with the West), it's only been recently that the rails have also been viewed as a vehicle for deep-pocketed investors to make carloads of money. Railroads, which haul everything from grain and iron ore to automobiles and refrigerators, offer exposure to the overall economy, not to mention a rare opportunity to invest in a near-monopoly business (you don't hear about many new railroads being launched). The largest shareholder of CN, the bigger of Canada's two railways, is none other than Microsoft co-founder and former CEO Bill Gates, who owns about 10 per cent of CN's stock. And two years ago, Warren Buffet paid US$26 billion for Burlington Northern Santa Fe, the second largest railroad in the U.S.

Now it's CP's turn. New York hedge fund Pershing Square Capital Management LP recently revealed that it had taken a 12.2 per cent stake in CP, which has lagged other North American railroads' performances in recent years--particularly CN. Led by Bill Ackman, Pershing has a reputation for taking stakes in underperforming companies and working with their management teams to bring about changes. Pershing, which pressured Wendy's to spin off Tim Hortons in 2006, said in its filings that it intends to "engage in discussions" with CP's management, board and other stockholders about the railroad's business and its future.

While Ackman has said that he doesn't plan to push for a sale of CP, some analysts have suggested that he may find it difficult to orchestrate a turnaround of a 130-year-old business that was once part of the sprawling Canadian Pacific conglomerate, which owned everything from hotels to shipping lines. On the other hand, it's doubtful that Pershing decided to invest US$1 billion of its investors' money just to sit quietly in the passenger seat while CP's executives continue to drive the train. "There's concern in the ballast of the boardroom," says William Brehl, the president of the Teamsters Canada Rail Conference Maintenance of Way Division, which represents some 3,500 CP workers, referring to the crushed stone that provides the foundation on which rail tracks are laid. "The employees recognize incompetencies and room for improvement. We all do."

It's not the first time CP has been targeted. In 2007, the railroad was approached by a private equity consortium led by Brookfield Asset Management about a possible sale, but CP rebuffed the overture and Brookfield lost interest when the market crashed in 2008. There has also been speculation that CP could be scooped up in a wave of industry consolidation.

So far there's been no word from CP's Calgary headquarters on how it plans to deal with its latest uninvited boardroom guest. Spokesman Ed Greenberg said the company has decided not to comment on the matter, calling it a private shareholder issue. However, the company said in a memo to employees that "we will speak with Pershing Square to hear their input into our plan, already targeted at realizing greater efficiency and improved service reliability."

Becoming more efficient has been a long-standing goal for CP. The railroad's operating ratio, a key measure that expresses expenses relative to revenue, is about 75 per cent, relatively high by industry standards. By contrast, CN managed to transform itself from a bloated government utility into a lean, mean transportation business after it was privatized in 1995. It now boasts an industry-leading operating ratio of under 60 per cent, although simple geography has made CN's job easier. Unlike CP, whose network stretches from Vancouver to Montreal and down through the American Midwest, CN has evolved to become more of a continent-wide player, with tracks that stretch from coast-to-coast in Canada and all the way down to the Gulf of Mexico. That means a significant chunk of CN operations is spared the extra costs associated with operating in Canadian winters--a lesson CP learned the hard way earlier this year when a series of winter storms in Western Canada hammered its operations and led it to post a 67 per cent drop in first-quarter earnings.

Such dismal performances have frustrated investors and raised questions about whether CP's executives are doing enough to realize the company's goal of running the "most fluid railway in North America." CEO Fred Green, who has been with CP for 33 years and was appointed to the top job in 2006, has taken steps to streamline the railroad's bloated management ranks and improve infrastructure--particularly in Western Canada. Another billion dollars' worth of capital investments are planned for 2011.

But so far the moves have done little to lift CP's shares, which have been stuck in neutral for the past five years. Meanwhile, CN has enjoyed a nearly 50 per cent gain over the same period. "Pershing's interest in a more aggressive operational turnaround does not surprise us," wrote Tasneem Azim, an analyst at UBS Investment Research, in a recent report. "Next steps could include a shakeup of senior management, sale of non-core assets and more aggressive pricing." But others, like RBC's Walter Spracklin, question whether Pershing will run up against a brick wall that consists of a stiff Canadian regulatory environment, CP's roughly $9 billion in employee pension obligations, and a highly unionized workforce. "It is uncertain how radical the changes from Pershing Square could be," Spracklin wrote.

James Nolan, an associate professor of agricultural economics at the University of Saskatchewan, says Pershing could also be positioning itself to take advantage of Ottawa's proposed dismantling of the Canadian Wheat Board's monopoly over grain marketing. He says the move to a free market system could also signal the end of Ottawa's caps on the total amount of revenue CN and CP are allowed to generate by hauling grains regulated by the wheat board. Grain accounted for about $1.1 billion of CP's nearly $5 billion in 2010 sales, about half of which was regulated grains. Based on the U.S. market, Nolan predicted freight rate increases of anywhere from 25 to 50 per cent if the caps are ultimately removed. "That's a chunk of change," he says.

From his perspective at track level, Brehl says there are lots of things CP could do better in the meantime. He points, for example, at CP's inability to cope with last season's winter storms, which left tracks impassible, train yards buried and crews unable to reach trains. Green called the conditions "extraordinary" and an "anomaly," although several observers noted that CN, which also operates in Western Canada, didn't suffer nearly as much. Brehl says he believes CP's top brass effectively got caught trying to run the railroad too lean at a time when customer demand was ramping up, thanks to a recovering economy. "Canadian Pacific was founded in 1881," says Brehl, noting that CP is planning to hire additional staff this year and bring on line extra locomotives and snowplows. "That's a helluva lot of winters to handle."

Maclean's November 21, 2011