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3 Reasons to Avoid Canadian Pacific Rail

Starting in the latter part of 2011, shares in Canadian Pacific Rail (TSX: CP)(NYSE: CP), have performed as well as any on the TSX. A big reason for this outperformance is CEO E. Hunter Harrison, wooed out of retirement by activist investor Bill Ackman. Harrison was the former CEO of rival Canadian National Railway (TSX: CNR)(NYSE: CNI), and has more than 40 years experience in the industry. He came in, cut costs, and CP Rail’s investors obviously liked what they saw.

But as I take a closer look at Canadian Pacific, I see a few cracks in the armor. I still think it’s a world-class railroad, run by a terrific executive team. It still remains a jewel of Canadian business, for both its history and its current operational expertise. I just wouldn’t invest in the shares at these levels. Here are three reasons why.

Valuation

Ultimately, it always comes back to valuation. And with CP, it’s just too expensive.

The stock trades at a trailing P/E ratio of almost 32 times earnings. Compared to rival Canadian National’s 19 times trailing earnings, this looks expensive. Yes, analysts do expect CP to grow those earnings significantly in 2014, but the company is still more expensive than its rival, which currently trades at a forward P/E of just 17 times.

Canadian National is also aggressively buying back stock, eliminating 3% of the shares outstanding in 2013. Canadian Pacific is also buying back stock, having just announced a buyback instead of big dividend increases, but one could argue that buying back shares when the stock is at a record high is bad timing. At least Canadian National has consistently bought back shares for years.

One metric I like to look at is insider activity. If insiders are buying, I’m more inclined to think a stock is undervalued. After all, who knows the business better than an insider? Over the past year, CP executives have sold $142 million worth of shares, and purchased just $3.3 million. That’s telling.

Is growth overstated?

The future looks bright for transporting goods by train. Record crop yields have kept both Canadian rail carriers busy. Rail continus to be one of the go-to options for transporting oil. It’s cheaper to ship most everything on a train compared to a truck.

And yet, I think there are a couple reasons why growth could slow going forward.

Shipping grain is always going to be a good business for both Canadian railway companies. But investors are forgetting just how good crop yields have been over the past few years. Crop yields in 2013 were at record highs, and 2011 and 2012 were also good years. I’m no meteorologist, but I’ll just say that perhaps Canadian farmers could expect lower yields in 2014. Crop yields do have a tendency to revert to the mean.

Even the much talked about oil by rail business is starting to show cracks. Environmentalists are protesting the frequent derailments, which is just one of the things that will cause oil companies to move to pipelines. And while it won’t happen overnight, both upgrades in existing pipelines and building new capacity will slowly start to hurt the oil by rail business. It’s only a matter of time.

Lac Megantic

Like many Canadians, I watched the news coverage of the Lac Megantic rail disaster with a heavy heart.

Unfortunately for CP, Lac Megantic could potentially become a big financial disaster as well. The company refused an order to pay for the cleanup back in August, stating it didn’t think it was financially responsible. Even though CP handed off the train to a smaller company in Montreal, the Quebec government still considers CP responsible for some of the disaster, and continues to go after the company for cleanup costs.

Estimates suggest the clean up costs on Lac Megantic could reach as high as $200 million. But the bigger issue may be the precedent. Will the government force rail shippers to increase insurance or take other safety measures? What’s good for the safety of innocent bystanders is often bad for the bottom line.

Foolish bottom line

CP Rail is a world-class company. I’m not debating the quality of the company or the competency of management. I just think the stock has some headwinds going forward, and because of them, I’d avoid the stock right now.

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Fool contributor Nelson Smith has no positions in any stock mentioned in this article. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Canadian National Rail is a recommendation of Stock Advisor Canada.

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