Many investors liken railways to utilities and government bonds – relatively safe and predictable investments that are, well, maybe a bit boring. Investors considering adding Canadian Pacific Railway (NYSE:CP) to their portfolios should be cautious, and understand several factors that may make their investments far riskier.
In October 2011, when successful activist investor Bill Ackman's Pershing Square Capital announced that it had purchased a 12.2% stake in Canadian Pacific, investor anticipation for market-beating results began to grow. When Pershing Square's ownership stake subsequently grew to 14.2% two months later, expectations accelerated. And when Canadian Pacific CEO Fred Green and five board members were forced out to pave the way for the hiring of well respected Hunter Harrison, Canadian National Railway's past president and CEO, expectations climbed to new heights.
Today, Canadian Pacific's stock price fully reflects those sky-high hopes. It's valuation looks particularly expensive compared to Canadian National's, regarded by many as the premier railroad in North America. Today, Canadian Pacific's price-to-earnings ratio of 29.4 is nearly double that of Canadian National, and a significant premium to most first tier railroads, including Union Pacific (NYSE:UNP) , CSX (NASDAQ:CSX) and Norfolk Southern (NYSE:NSC). A similar story holds true for most other valuation metrics.
Have playbook, will travel
Harrison is bringing his successful playbook for improved operational and financial performance to Canadian Pacific. All that's left, some believe, is a small matter of execution.
Any plan to improve operational efficiency at Canadian Pacific will surely focus on cutting employee counts, running longer and faster trains, making better use of assets, and adopting new technologies to use less fuel and make workers more productive. And if the plan comes together as advertised, the result will be a dramatically lower operating ratio, significantly higher earnings, cash flow, and impressive returns for Canadian Pacific shareholders.
But the plan is flawed, and the implications significant for investors. At the end of 2012, Canadian Pacific's all-important operating ratio -- how much of its revenue goes toward funding operations -- was 77%. The company's goal is to reduce that figure to 65% by 2015. That's an incredible, some say impossible, objective to achieve in just three years.
Hunter Harrison took 12 years to accomplish a similar task at Canadian National, reducing its operating ratio from 77.3% in 1997 to 66.7% in 2009. Note that Canadian National made this progress during a robust economic environment, without a particularly strong competitor. Harrison can't claim that now, since approximately 50% of Canadian Pacific's track directly competes with Canadian National.
Risk vs. reward
When investors think of low-risk investments, railroads and utilities usually come first to mind. Unfortunately, Canadian Pacific doesn't quite deliver.
Beta measures the sensitivity (i.e., volatility) of a stock relative to the overall market. Higher beta stocks tend to be more volatile, and therefore riskier. But they provide the potential for greater returns than low-beta stocks.
Canadian Pacific's beta is 1.38. The average for the railroad industry is 1.15, with Norfolk Southern (1.13), Union Pacific (1.14) and Canadian National (0.97) all delivering less volatility. Canadian Pacific is one of today's most volatile railroad stocks, and given it's current valuation, unlikely to deliver the returns necessary to compensate investors for such a high level of risk.
When should you consider taking a ride?
Canadian Pacific must make significant and consistent improvements in its operational performance to justify the expectations driving its valuation, and deliver market-beating returns to shareholders.
Which signals will indicate that Harrison and the rest of Canadian Pacific's management team are beginning to deliver those improvements? When Canadian Pacific releases its Q3 results in October, look for:
- Improving employee productivity, as measured in gross ton miles per employee
- Improved locomotive productivity, as measured in gross ton miles per active horsepower
- A significantly lower operating ratio
If investors curb their expectations toward the same standards they'd set for other tier one railroads, and Canadian Pacific can consistently deliver stronger operations, you may want to take a second look at Canadian Pacific. But until then, I'd hesitate before climbing aboard this train.
Justin Lacey has no position in any stocks mentioned. The Motley Fool owns shares of CSX. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.