In the summer of 2011, after three months of 100-hour work weeks, a hedge fund executive in New York thought he had the Canadian train business all figured out. But his boss, Bill Ackman, to whom he'd soon present an activist investment idea for Canadian Pacific Railway, would have the final say.
Followers of Ackman's Pershing Square will know how that presentation went, and how the idea ultimately unfolded into what is widely considered one of the greatest activist investing campaigns in history, adding more than $25 billion in value in just over two years. But what few may know is how that executive, Paul Hilal, found and carried the Canadian Pacific thesis to its multi-billion-dollar payday.
And now, with talk of a possible merger of the Canadian rail giant and CSX, another North American railroad, Pershing Square and Canadian Pacific stand to rake in even more money if they can create a bigger, more efficient railroad.
"They've had everything go right," said Keith Schoonmaker, an analyst covering Canadian Pacific at Morningstar. In the 28 months the hedge fund has been advocating for change at Canadian Pacific, it has transformed what was a $7.1 billion company into one now valued at around $34 billion.
Not everything went Pershing Square's way, and particularly not the factors left to the gods. A grueling 100-year flood in Calgary and one of the worst winters on record both hit transport businesses hard in the last year. But Canadian Pacific still thrived, under the guidance of Pershing Square-appointed CEO Hunter Harrison. And even though the eventual completion of the KeystoneXL oil pipeline, long stalled by environmental concerns, could reduce some of Canadian Pacific's oil transport business, Schoonmaker says oil is not a make-or-break factor, given the company's other strengths.
"There's plenty of value in this railroad without the crude franchise," Schoonmaker said. "If it's diverted into pipeline, that's not a fatal problem for them. The oil development out of heavy crude in Alberta is much more difficult to move on the pipeline, it's somewhere between peanut butter and a hockey puck in consistency, so you'll need CP. There are also drilling materials, pipe, and frac sand to be shipped by rail to the most advantageous locations."
So just how did Pershing Square transform Canadian Pacific from the worst performing railroad in North America into one of the most efficient railways today, adding almost $1 billion in market value per month along the way? It all started with Paul Hilal's brother and a dinner party.
Hedge funders often throw "ideas" dinners to discuss investments that are going well and those that are falling short. It was at one such dinner in the summer of 2011 that Hilal's younger brother Phillip overheard a couple of guys bemoaning investments in a Canadian railroad that they were "just getting crushed" on. The younger Hilal called his brother the next morning, who decided to spend his August learning all about the world of Canadian trains.
"By early August, I took a look at the Canadian railroads, based on a lead, that some shareholders were frustrated with one of them," Hilal told BuzzFeed News. "There are seven class one rail roads in North America. Five of them are in the U.S. and their margins were roughly 30%. Canadian National was at about 40% and Canadian Pacific was at about 18%."
The problem, as he saw it, with Canadian Pacific? "They had convinced themselves and the investment community that unique structural -- i.e. prohibitively expensive or impossible to overcome -- challenges prevented them from performing as efficiently as the other railroads. So I spent August of 2011 trying to figure out whether these explanations were really excuses. In my opinion, they were. Cultural due diligence established that CN's team comprised hungry, motivated, results-oriented, go-getters. CP's alumni, by contrast, described it as crippled by a culture of slackers".
According to Hilal, Canadian Pacific claimed that their path through the Rocky Mountains was steeper and their tracks were curvier, and said that they had to deal with worse weather. Hilal decided that this wasn't exactly the case, at least not to the extent that it would cause such a serious disadvantage in efficiency. So he decided to take action.
"They had some relative disadvantages, but no more so than every other railroad," Hilal said. "All they needed was leadership and culture change, and some fresh perspectives on the board."
Hilal's conviction came at a time when the appetites of activist hedge funds are growing increasingly voracious, with an ever-larger universe of companies vulnerable to the activist technique: Find a company that looks like it could use a workout, become a major shareholder, gain full or partial control, whip it into shape, and make millions -- sometimes billions -- in the process.
But with Canadian Pacific, this wasn't going to be an easy fight. While some businesses capitulate quickly, or welcome activist involvement, others can be harder nuts to crack. In this case, Pershing Square was dealing with a business that also happens to be something of a Canadian national treasure.
Canadian Pacific Railroad is steeped in the country's history and national pride. The railroad played a significant role in early nation building, with a mandate to link Vancouver to Toronto and thus connect the country. It has been a major corporate player ever since, and a seat on Canadian Pacific's board is coveted by the country's business elite. When Pershing Square started buying up its 14% stake, five of the company's 13 board members held the Order of Canada, the country's highest honor, and most of the others came with a "blue chip" pedigree.
"CP has a unique iconic status in Canada because it played a central role in forming the country, and because Canada's economy is so resource intensive," Hilal said. "The promise of a rail linking Toronto and Vancouver was how the Eastern provinces convinced British Columbia to federate with them to for Canada. Over time, it diversified into a massive conglomerate. It was the second largest company in Canada at one point. To many, a seat on the board of CP was the winner's circle of the social and business elite throughout Canada."
The first step was to pull the trigger on buying up 14% of CP around the time shares were about $44 each.
"As the stock drifted down, I began pounding the table, and Bill -- an extremely decisive guy -- agreed," Hilal said. "We bought about 14% of the company in just a couple of months, and drove the stock from $44 to $66. We were comfortable buying shares up 40% and 50% up because we were expecting to multiply the value of the company."
To do so, Hilal also had to find a stellar CEO candidate.
"I googled Hunter Harrison, found his phone number, and called him," Hilal remembered. "The guy is a genius. When [his wife] got pregnant when they were 19, he had to find work fast. So he dropped out of college and took the one job that was available -- greasing railcar axles. An operations savant, a great communicator and great leader, he moved his way up meteorically."
Faced with mounting aversion from the board, Pershing Square, with Harrison on board, set about presenting their plan for a CP turnaround in a big way, renting the largest hall in Canada to present their activist thesis. Then, Hilal spent the next three months leading up to the annual shareholder meeting flying around with Harrison meeting with every major shareholder and answering their questions.
In May of 2012, Pershing Square prevailed, getting all seven of its nominees onto Canadian Pacific's board by a wide margin and installing Harrison, a fresh-out-of-retirement railroad industry veteran, as its CEO. What followed was Pershing Square and the new board's cleaning house, replacing most of the company's top management and beginning an aggressive efficiency drive, which got fast results.
"CP remains the safest rail road in North America," Hilal said. "They're shipping more freight and faster than before, faster, and with better on-time performance. CP is shipping from Vancouver to Toronto in three days instead of four. And they're doing so with 25% fewer people than before."
The market has measured the results in the one way it knows how: The company that was valued at $7 billion prior to the campaign is now worth about $34 billion. "What you have is $31 billion of value creation from an $8 billion asset after two years and four months of work," Hilal said, speaking in terms of Canadian Dollars. "It's staggering."
Since Pershing Square bought its first shares of CP in the summer of 2011 at $44, the stock climbed to beyond $210 per share, and trades today around $200 per share.
Now Canadian Pacific, with Harrison at the helm, is pushing for even more efficiency in the form of a merger with CSX, which yesterday appeared to back away from a tie-up, saying it had terminated its exploratory committee assigned to consider the deal. The company isn't giving up just yet, and on Tuesday it will host an analyst call after its third-quarter earnings announcement on issues surrounding a merger, and why Harrison believes it will mean a more profitable rail industry.
"Hunter Harrison is the only person who's led three railroad turnarounds, and with Canadian Pacific he's done it an astonishing capacity and in a way that has increased profitability so tremendously," said Schoonmaker, the Morningstar analyst. "He has a vision that there should be additional consolidation in the industry, and I think he's earned his way to have a pulpit to have these kinds of positions. The way he has driven profitability and he has reduced numbers that suggests that this is a benefit to all stakeholders."