On Jan. 18, The Wall Street Journal indicated that Hunter Harrison is joining former Pershing Square investor Paul Hilal, who led the CP investment for Pershing and left in 2016 to launch his own Mantle Ridge fund, in an attempt to influence CSX (CSX). The WSJ indicates that Hilal has raised $1 billion for a single investment, with investors locked up for five years. Earlier on Jan. 18, CP announced that CEO Harrison, 72, will depart the firm immediately and Keith Creel, 47, will assume the helm on Jan. 31. He approached the board to discuss modifications to his postemployment agreement to pursue opportunities involving other railroads, and forfeits CAD 118 million in benefits and equity awards, but the board agreed to waive his noncompete obligation without waiving his nonsolicitation restrictions concerning senior CP employees.
We incorporated fourth-quarter results and raised our CSX fair value estimate to $41 from $37, with about half of the increase due to the time value of money and half due to better pricing than we previously projected, particularly in the still-significant coal market. Coal revenue per unit increased 6.2% in the fourth quarter and was down just 80 basis points in full 2016 (we projected a 5% decline). Also, owing to a strong fourth quarter, our full-year 9% volume decline was too bearish. The market may reward CSX shares based on the possibility of Harrison's engagement, but in our DCF model, holding all else equal, improving the operating ratio from our currently projected 65% in 2020 to 60% increases our fair value estimate by $5 to $46, and gradually improving the OR to 58% (CP's 2016 OR) increases our valuation to $49.
Another ramification could be openness to railroad mergers. We've long posited that two transcontinental railroads make sense in the U.S. We don't view this as reducing competition, as shippers already generally choose between just two originating railroads in U.S. regions; Canada has had two transcon rails for decades.
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Keith Schoonmaker, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.