Canadian Pacific (CP):

Canadian Pacific is a short as it trades at 67x 2011 after tax free cash flow, recently lost their COO who was supposed to turn around the company and improve operations, and operates in a heavily regulated industry that will see increasing regulation in coming years. My target price is $32 per share which is 50% lower than the current stock price of $64 per share.

Background:  CP is a railroad operator in Canada and the United States with 43% of revenues coming from bulk shipments, 28% intermodal shipments, and 29% merchandise shipments. The company has a network of 14,800miles and is headquartered in Calgary, Alberta. In 2009 the company acquired DME railroad for $1.5bn, providing access to the Midwest for agricultural products, coal, and ethanol.

Total freight revenues for 2010 were $4.8bn and are broken down as follows:

Grain                                                                               23%

Coal                                                                                10%

Fertilizers                                                                        10%

Industrial and Consumer Products                                 18.5%

Forest Products                                                                  4%

Automotive                                                                         7%

Intermodal                                                                     27.5%

Thesis: My thesis is predicated on the following factors - 1. CP is the worst operator and the recent retirement of the COO who was supposed to fix the operations is significant, 2. Industry regulation is going to get tougher, not easier in coming years, and 3. The valuation makes no sense.

Departure of Ed Harris: CP and CSX have historically been thought of as the worst rail operators in the group, as evidenced by their operating ratios being above those of their peers. The operating ratio for CP in 2010 was  77.6%. This compares to Canadian National's 63.6%. The company brought in Ed Harris in April 2010, previously from CN to come in and fix the operations, integrate the DM&E and lower the operating ratio. It came as a surprise that early this month Ed abruptly retired. and later this month the company lowered Q1 EPS guidance to $0.12 - $0.22 per share from $0.70 - $0.75 per share due to bad weather. Quoting from an article that appeared in the Financial Post in early March on his resignation and the culture at CP:

"But his abrupt announcement this week that he would be retiring [and be replaced by the company's senior v-p of operations, Mike Franczak] added to the ongoing games of musical chairs at CP, which has either pushed out, shifted, or had several  of top executives leave in recent years under CEO Fred Green.

"Our assessment is that this certainly comes to a surprise to us and, without a doubt, the very short term nature of Mr. Harris' tenure was not properly communicated to investors - particularly judging by the level of surprise we have registered from the investment community," Mr. Spracklin said.

"The brief tenure also brought into question whether there may have been some level of friction between Mr. Harris and other members of the management team - however CP did not indicate that this was the case," he added.

Over his brief stint at CP, Mr. Harris' primary success has been to clean up the operations of CP's rail yards. Prior to his arrival, CP, unlike its rival CN, would allow its customers to keep railcars in its yards until they needed to shipped - free of charge.

It has since started to charge its customers for storing these railcars, and keeping track of each individual car, which has not only created another revenue stream at CP, but caused the rail cars and other shipments to be moved quicker through the yard.

Regulatory Change: The Surface and Transportation Board is planning the first review of railroad competition in over a decade in what is commonly called the "Access and Switching Hearings". These hearings are being brought by shippers who "want a law to mandate access to more than one railroad - at terminals or other connecting points along the shipment route - saying such a change was the only way to force major railroads to compete in freight rates and bring down high freight rates for captives" - Journal of Commerce article 1/11/11 (http://www.joc.com/government-regulation/stb-sets-hearing-captive-shippers-rail-access).

I have studied the issue and followed the railroads for a long time and I believe the shippers have a valid argument. Although it is impossible to handicap the outcome of the hearings, I think  the era of annual price increases of 4-6% are coming to a close. In 2010, railroad return on capital and return on equity were 9.5% and 12.2% respectively (http://www.aar.org/~/media/aar/Background-Papers/Rail-Earnings.ashx). Given the consolidated nature of the industry - there are only 6 class 1 shippers, and that they are all very profitable at current levels, I think there is a decent chance for revenue pressure and forced competition from the regulator. As CP is the least efficient operator, I think they have the most at stake in an adverse regulatory climate.

Valuation: Operating a railroad is a highly capital intensive business. Fortunately for the operators they get to capitalize annual maintenance investments and so investors who focus on earnings and EBITDA are missing a significant use of cash flow.

Who would value a business like this? Well, let's take a look at two sell side analysts valuation methodologies:

Analyst A, report 1/26/11: "Our Canadian Pacific (CP NYSE) price target of $77 (was $78) USD is based our CAD price target of $77 at an exchange rate of 1.004 CAD/USD (was 1.013). Our price target of $77 CAD is based on the average of applying a 15x P/E multiple on our 2012 EPS estimate of $5.10 and a 8x EV/EBITDA multiple on our 2012 EBITDA estimate of $2.0bn.

Analyst B, report 1/26/11: "We believe that with the stock trading down about 4.7%, the weak Q1 2011 guidance has been largely priced into the stock. We note that CP is trading at 16.0x our FY 2011 EPS estimate of $3.85, in line with the N.A. Class 1 rail peer group average of 16.2x. Based on 2012 estimates, CP is trading at only 12.5x our 2012 EPS estimate, and 12.2x consensus 2012F EPS of $5.05, whereas the N.A. Class 1 peer group average is trading at 13.6x. Aside from valuation, providing additional upside is CP's target of achieving a low-70s OR in 2 to 4 years (not in our estimates), which could offer strong earnings growth. Consequently, we see more upside potential than downside risk and, as such, with approximately 12% upside to our price target, we are upgrading our recommendation to BUY, from HOLD previously. Our $69.00 price target (unchanged) is based on 14x 2012 EPS."

I can go on, but the point is that I believe CP should be valued on the after tax free cash flow it generates. The earnings estimates for 2011 and 2012 are $3.89 and $5.08. Baked into the 2012 number is an improvement in the operating ratio and continued pricing gains. I don't believe that will happen, but regardless let's look at depreciation versus capital spending. Depreciation runs roughly $500mil per year and the company expects to spend $950 - $1,050mm of capex per year. Of the $1,000mm of capital expenditures per year, $680mm goes to basic track renewal, $200mm to volume & productivity enhancements, $80mm for IT systems, and $40mm for regulatory spending. Putting the numbers together gets you to:

PER SHARE          2011                       2012 (Street)

EPS                         $3.89                     $5.08                                    

D&A                       $2.94                     $2.94                                    

CapX                      ($5.88)                  ($5.88) 

FCF                         $0.95                     $2.14    

Multiple                      67x                         30x

Target Price: I value the company based at 15x after tax free cash flow, or $32 per share. I think that given the uncertainty over the future regulatory environment and the lack of institutional know how to improve the operating ratio warrants this lower price.