By Theo van de Kletersteeg
On October 20, Canadian Pacific Railway announced that exploratory merger talks initiated with CSX Corporation have terminated, and that no further talks are planned. Thus ended, for the moment, speculation that CPR is looking for a U.S. partner.
Timidity is a word that does not exist in E. Hunter Harrison’s vocabulary. A life-long railroader who started his career at the bottom, as a carman-oiler with St. Louis-San Francisco Railway in 1964, Harrison was obsessed with doing things right, doing them better and doing them at lower cost. After a long string of promotions at Burlington Northern (which had acquired St.Louis-San Francisco), Harrison left Burlington Northern in 1989 to become Vice-President and Chief Operating Officer at Illinois Central (IC). At IC, he was appointed President and CEO in 1993, in which position he remained until 1998 when Canadian National (CN) acquired IC. At CN, Harrison was appointed Vice-President and Chief Operating Officer, but was appointed President and CEO upon Paul Tellier’s retirement on January 1, 2003, and remained in that position until his retirement at the end of 2009. While at CN, Harrison was widely credited for continuing the turnaround that had started under his predecessor, and for changing a massive cultural shift from that of a sleepy government department to an aggressive and highly efficient business enterprise.
After activist shareholder Bill Ackman, through Pershing Square Capital Management, acquired a stake of close to 15 per cent in CPR in 2012, and was able to engineer the resignation of CPR’s President and most of CPR’s Board, it was no surprise he came knocking on Harrison’s door to lead the transformation of this under-performing railway. Harrison joined CP on June 29, 2012 as President and CEO under a four-year contract (which has since been extended by one year), and did not lose much time re-engineering the once mighty railway. He vowed that by June of 2016, CPR’s operating ratio (the direct cost of its operations as a percentage of revenues) would decline to 65 per cent, making CPR one of the most cost-efficient railways in North America.
CPR’s operating cost ratio had been 90.6 per cent during the first quarter of 2011, which was 21.55 points higher than the comparable number for CN (66.2 per cent), during the same quarter. A year and a half later, during the first quarter under Harrison’s leadership, CPR’s operating ratio had been reduced to 74.1 per cent, while CN’s had been reduced to 60.6 per cent. During the most recent quarter ended September 30, 2014, CP’s operating ratio stood at 62.8 per cent, compared to CN’s 58.8 per cent. Clearly, CP has made remarkable progress in very little time.
With annual revenues in the order of $6.5 billion, CP remains among the smaller class 1 railways. In addition, although its shareholders’ equity at $7.1 billion has risen substantially since Harrison took over, its balance sheet is of “average” strength. On the other hand, CPR shares have done very well since Pershing Square Capital Management started accumulating its position, and have been on a tear since Harrison took on the helm at CPR, rising from $75 per share to $225 per share on October 17.
CPR approached the management of CSX Corporation, a major U.S. class 1 railway, to seek out a merger between CPR and CSX, creating the third largest railway in North America after BNSF Railway and Union Pacific Railroad, with annual revenues of some $19 billion. Transportation of crude oil has become a rapidly growing business for both railways and a merger between CPR and CSX would allow for more efficient transportation of Alberta, Saskatchewan and North Dakota oil to refineries in the eastern U.S. Although exploratory discussions have ended, it seems that the die has been cast, and it is reasonable to speculate that Harrison’s team has its eyes set on expanding CP’s footprint, perhaps by acquiring CSX and, if not, then perhaps another railway. Meanwhile, rival CN must protect its turf and cannot allow CPR to gain strategic advantage by acquiring a railway that could provide a platform through which it could gain significant additional opportunities for growth and efficiency. Moreover, now that a U.S. class 1 railway was involved in an approach to change the competitive railway landscape in North America, we should assume that all major railways have dusted off old strategic plans that were thought to be unrealistic in view of the widely held belief that the U.S. Surface Transportation Board (STB) would not permit a major rail carrier merger to take place. Harrison clearly feels that there may be ways to accommodate the STB, which is why every rail CEO is likely consulting with lawyers and other advisors to figure out whether their past apprehensions about regulatory roadblocks continue to be realistic. With the rail transportation industry performing well, and with plenty of potential for additional gains by increasing network efficiency, we should expect CP’s forays into re-organizing North America’s rail network to represent only the opening salvo.