Description

Massive restructuring underway: The parts are worth more than the whole. While the stock trades around $35.90, Canadian Pacific’s shares are worth between $55 and $65 per share; it has five exceptional businesses with strong cash-flows; it is trading a significant discount to its sum-of-the-parts and take-out valuations; it has a strong balance sheet at 29% debt/cap; there are clear, potent catalysts that limit its downside. Management’s goal is clearly to unlock hidden value in the smaller (faster-growing) units and allow the individual companies to focus on single businesses, while gaining access to capital markets and enhancing growth potential. The break-up value is currently greater than the price of CP, and earnings should remain positive through the third quarter. The pieces are valuable to potential merger partners. The rail segment for example, has been transformed into a top-notch operation over the years. An asset-renewal program and a new operating plan have knocked 12.5 points off the expense ratio over the last six years, making margins comparable with those of the best railroads in North America. In addition, the Ships division is probably the most profitable ocean carrier in the world. Slowing global economies and new ship capacity may slow earnings growth from the strong first quarter. But improving efficiency is very impressive, and may be more important than shipping rates in the long run. Finally, the hotels and coal Fording businesses will continue to post good results over the next two years. Recent acquisitions and management contracts are contributing substantially to hotel earnings. And, after struggling for the last three years, Fording is seeing higher demand and prices for coal.

RAILWAY: provides rail and freight transportation services over a 14,400-mile network extending from Montreal to Vancouver, and throughout the U.S. Midwest and Northeast. Commercial alliances with other carriers extend Canadian Pacific Railway’s market reach beyond its own network. Serving ports on the east coasts of Canada and the U.S. and the Port of Vancouver, Canadian Pacific Railway links North America with European and Pacific Rim markets, moving large volumes of import and export goods across the continent. It is also a leading carrier in the intermodal industry with 24 terminals across Canada and the northern U.S. I looked at Railway primarily on an EBITDA basis. Applying the current railroad industry multiple of 6.2x 2002 EBITDA, which produced a valuation of approximately C$8.0bn. Specifically, Railway will earn approximately C$421 million of net income 2002. On an EV/EBITDA basis, Railway will earn C$937 million in operating income and generate C$345 million in depreciation for EBITDA of C$1.3 billion in 2002.

SHIPS: is a leading provider of international ocean and inland transportation for containerized cargo. Its seven shipping lines offer a worldwide network of regional services under their readily recognized brand names, Canada Maritime, Cast, Contship Containerlines, Lykes Lines, etc.. Their combined fleet of more than 75 ships transports nearly two million containers per year, which places Ships among the top six container shipping businesses worldwide. As for valuation and given that Ships will be the only publicly-traded North American pure-play container shipping company, a good comparable peer group is tough to find. Furthermore, comparisons to international competitors are complicated. Despite this warning I used five international competitors to value to division. The average EV/EBITDA multiple is currently 6.3x. I used a more comfortable valuation of 5.5x. Working through the numbers and applying this multiple on 2002 EBITDA estimate of C$392, you get to a firm value of C$2 billion. Given the economic environment, there will be earnings decline. Ships will offset some of the decline with its cost-cutting initiatives, which include changing from chartered to company-owned tonnage and consolidating the operations and IT systems of Ships' six brands, as well as the expectations for fuel prices to fall back to slightly lower levels.

PAN-CANADIAN (PCP): is one of Canada’s largest producers and marketers of crude oil, natural gas and natural gas liquids. Approximately 13% of PanCanadian stock is held publicly (the remainder is held by CP Limited), and is currently trading on the Toronto stock exchange at 5.4x EV/EBITDA, below the five-year ('96-00) historical averages of 5.7x and 6.5x. My 6.0x EV/EBITDA takes into account the option value of PCP's East Coast Deep Panuke and the recent North Sea Buzzard discovery. In addition, post reorganization, PCP liquidity should be significantly be enhanced. PCP has extensive exploration and production activities stretching from coast to coast in Canada and include a variety of international interests in the Gulf of Mexico, the United Kingdom, Australia and Africa. With nearly C$3bn in EBITDA expected, I estimated fair value for PanCanadian lies in the range on C$15bn to C$19bn, over 50% of the total value of Canadian Pacific.

HOTELS & RESORTS: is Canada’s largest hotel management company, operating 70 properties with over 29,000 rooms in Canada, the United States, Mexico, Bermuda, and Barbados. It holds a 67 percent controlling interest in Fairmont Hotels & Resorts, North America’s largest luxury hotel management company. Fairmont Hotels manages 36 distinct city center and resort hotels such as The Plaza in New York City, The Fairmont San Francisco, Banff Springs, Le Château Frontenac and The Fairmont Scottsdale Princess. I value Fairmont using an EV/EBITDA multiple of 8 to 10 times estimated 2002 EBITDA. This approach results in an equity valuation of C$2 billion to C$4 billion. The company expects to have a long-term EPS growth rate of at least 18%. Internal growth will come primarily from renovating its existing portfolio and from increasing incentive management fees as more of its management contracts meet their fixed incentive fee thresholds. It will generate external growth primarily from acquisitions and new management contracts. Fairmont currently earns more than 70% of its total EBITDA from its owned portfolio so we think other owner/operators like Starwood, Hilton, and Orient Express should be used as comparables for valuation purposes. These three companies are currently trading at an average EV/EBITDA multiple of 8x based on 2002 estimates. Fairmont should receive a premium multiple to these companies because it has a higher projected growth rate, an underutilized balance sheet, and high quality properties. CP-Hotels also holds a 100 percent interest in Delta Hotels Limited, which manages a portfolio of 34 first-class urban and resort properties across Canada. In addition to hotel management, Canadian Pacific Hotels & Resorts holds real estate interests in 19 properties and a 34 percent investment interest in the Legacy Hotels Real Estate Investment Trust, which owns 17 hotels. The risk with this segment is (of course) the economy—which I never have been good commenting on, but only to say that that I am using economically depressed EBITDA numbers (i.e., comfortably below normalized levels).

FORDING: is Canada’s largest and lowest-cost producer of export coal. Its three mines in southeastern British Columbia produce primarily high-quality metallurgical coal for the international steel industry. Its operations in Alberta include two mines supplying thermal coal to electric utilities, and an oil sand overburden removal operation. Fording is also the world’s largest producer of certain industrial minerals. The case for coal: The weak domestic manufacturing economy has greatly reduced demand for economically sensitive products, like chemicals, metals and paper. High natural gas and oil prices, however, have led many utilities to use coal as an alternative fuel source, greatly increasing demand for coal deliveries. I believe Canadian Pacific stand to benefit the most from this increase in traffic. In addition, currently utilities are operating at very low inventory levels; therefore it is reasonable to assume that the demand for coal should remain extremely high, at least through the first half of 2002, as coal usage continues to climb. What I have also found out is that as coal contracts come up for renewal in the coming months, the carriers will likely be able to implement rate hikes, since the commodity remains in short supply, and very little new capacity will come on line in the next few years. Fording will earn C$207 million in operating income and generate C$81 million in depreciation for EBITDA of C$288 in 2002. Applying the current coal industry average multiple of 4.5x to 2002 EBITDA, yields a current firm value of C$1.3 billion.

Valuation summary:

2001 EBITDA Mult. Value
RAILWAY C$1.3bn 6.2x C$ 8bn
SHIPS C$0.4 5.5x C$ 2
PAN-CANADIAN (PCP) C$2.9 6.0x C$17
HOTELS & RESORTS C$0.4 8.2x C$ 3
FORDING C$0.4 4.5x C$ 1
C$31bn
Net Debt C$ 3
Equity C$28bn
Shares 316
Value C$89bn
Currency Trans. 0.68
$61

Catalyst

Catalysts:
1. Breakup into five companies—shareholders meet on Sept. 26 and the spin-offs are expected in October. The five segments are Railway, Ships, PanCanadian, Hotels/Resorts, and Fording and the value breakdown is as follows: Railway is worth about $12 to $15 per CP share, Ships contribute about $5 per share, PanCanadian $35 per share, Hotels/Resorts approximately $3 to $7 and Fording $2 to $6 per share.
2. Increase in liquidity. For example, CP owns 87% of PanCanadian (PANCF)—no liquidity for investors. Once the spin-off occurs, PANCF will trade on the NYSE with approximately 254 million shares outstanding.
3. Higher oil/gas price should increase coal shipments;
4. Free independent management teams should allow them to execute their current; growth strategies and provide an increased access to growth capital.