Sense of the markets: Where Ackman wants to take the railroad

If Canadian Pacific Railway Ltd. investors were left scratching their heads after hedge fund manager Bill Ackman's presentation on Monday, Feb. 6, it might be because the founder of $11 billion Pershing Square Capital Management LP was doing an excellent job of legerdemain.

Ackman has gone out of his way to present his activist campaign against the second-largest freight railroad system in Canada as a changing of the guard. Specifically, replacing the company's chief executive officer, Fred Green, with Ackman's candidate: lifelong railroader Hunter Harrison, who ran Canadian Pacific's rival, Canadian National Railway Co., from 2003 until his retirement in 2009.

Canadian National has a market capitalization of $39 billion as compared to Canadian Pacific's $13 billion.

More important, according to an analysis of fourth-quarter Canadian rail traffic by Raymond James Ltd., Canadian National's traffic increased by 6.5% year-over-year, while Canadian Pacific was up only 3.2%. In the all-important container shipping category, the contrast was even greater: Canadian National was up 13.4% year-over-year versus Canadian Pacific, which was down 5.8%.

The plan, rolled out by Ackman and Harrison at a town hall meeting Monday, was to get Canadian Pacific stock to almost double its current mid-$70's price and bring operating revenue down to the low 70% range, from its current 78%, in as little as three years through better performance metrics.

The problem is, Canadian Pacific already has a plan in place to achieve that metric. Raymond James analyst Steve Hansen says, "the question is whether Hunter can get there faster."

So, although Hansen says he's impressed with Harrison's pedigree, Raymond James is still maintaining a neutral rating on the company.

Canadian Pacific's share price has risen more than 20%, trading in the mid-$70 range since Ackman revealed his stake in October. But the company has put up a staunch fight and the board has, so far, backed Green.

Ackman even evoked his recent successful campaign at J.C. Penney Co., striving to equate the Harrison nomination with his success in persuading Apple Inc.'s Ron Johnson to become J.C. Penney's CEO.

But Ackman's ability to attract Johnson probably had more to do with J.C. Penney's desire to keep the hedge fund manager close and avoid a proxy fight, rather than anything Ackman had to say about retail efficiencies.

Harrison, on the other hand, in his many years on the rails, has made his enemies. Ron Tepper, the CEO of shipping company Consolidated Fastfrate Inc., showed up at the town hall to complain about Canadian National's customer service under Harrison's tenure, which he claimed spurred a government commission studying the shipping industry.

"And we don't want that," Tepper said.

What investors should be looking at is not what Ackman is directing them toward, but what he might do with the company from a debt standpoint, suggests Standard & Poor's credit analyst Madhav Hari.

"For Canadian Pacific, there's a lot of debt relative to the rest of the industry," Hari suggests, "so, from a credit perspective, we have to see what Ackman's goals might be."

Canadian Pacific's long-term debt to total capital ratio is 49.8% as of the end of 2011, according to data provider Thomson Reuters, as compared to Canadian National's 37.3% and an industry median of 26.6%.

So instead of looking where Ackman is pointing, such as an exciting new head of the company like J.C. Penney's Johnson, investors might do better to look elsewhere, namely at Ackman's interest in debt offerings.

In 2010, Ackman sunk $45 million into a complicated mezzanine debt structure in Stuyvesant Town, Manhattan's huge apartment complex, which owners Tishman Speyer Properties and BlackRock Inc. had to hand back to lenders after they couldn't pay the $3.7 billion mortgage on the property they bought in 2006 for $5.4 billion at the height of the real estate run-up.

Ackman thought he would be able to persuade a New York court that his investment gave him bragging rights to the 80-acre prime real estate. He found out otherwise, but he also got out with his investment intact, unlike many other institutional investors that backed the original owners.

Now, Ackman could be trying another debt play at Canadian Pacific, Hari says, with the intention to leverage the railroad to help drive results.

Hari notes that Harrison kept emphasizing the need for strong cash flow in his presentation, which made sense when viewed from a private equity perspective, rather than from an investor who claims he only wants to run the best railroad around.

"There's some low-hanging fruit as far as margin improvement," Hari says. But, as far as the proposal from Ackman and Harrison to lower operating revenue, "Canadian Pacific is not doing anything different."

Ackman may be sincere when he says about Canadian Pacific, "we're in to win." But winning can mean many things, and hedge fund managers have their own investors to answer to.