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CANADIAN PACIFIC LTD: UNLOCKING

SHAREHOLDER VALUE IN A
CONGLOMERATE

SECTION A

GROUP MEMBERS:

DEEP RAY (16PGP078)

NIKITA PENDSE(16PGP096)

SAGAR KOTHARI (16PGP107)


CASE BRIEF:
The case talks about the issue of conglomerate discount in Canadian Pacific
Limited. Unlike other pure play companies, CPLs stock market capitalisation
of $13.2 billion reflected a conglomerate discount, estimated at 12 per cent to
35 per cent of the value if each business were a stand-alone entity. David O
Brien, the CEO of Canadian Pacific Ltd, was facing pressure from the
shareholders to continuously improve the stock price of the company.

There are three ways discussed to improve shareholders value. A divestiture is


one of the options where there is a sale of a business with tax implications for
the shareholders of the selling company. Other option is a spin off, which can
go tax less if implemented properly. And the third option is a spin-off of all the
businesses of CPL, through which CPL would cease to exist, and there would
be five independent businesses.

COMPANY BACKGROUND:

CANADIAN PACIFIC LIMITED (CPL)


CPL was one of Canadas oldest conglomerates with operations in railways,
shipping, natural resources and hotels. Canadian Pacific was an iconic Canadian
company. It was incorporated by an act of parliament on February 15, 1881 as
the Canadian Pacific Railway (CPR) with the goal of completing a
transcontinental railway to connect Canada from coast to coast. It was Canadas
seventh largest company by assets and Canadas largest private- sector
employer, with over 127,000 employees.

CPL BUSINESSES
CPL operated five businesses:

Pan Canadian Petroleum Limited


Canadian Pacific Railway
CP Ships
Canadian Pacific Hotels and Resorts
Fording Coal

CONGLOMERATE DISCOUNT :

By the 1980s and 1990s, conglomerates had fallen out of fashion and investors
preferred pure play companies, as they were easier to value and understand.
Conglomerates were trading at a discount of 15% to the sum of their parts on
average. The discount was higher in case of CPL due to poor coverage by
equity analysts. CPLs stock was covered either by railroad analysts or oil and
gas analysts, who had limited knowledge of CPLs other businesses.

BENEFITS OF A CONGLOMERATE STRUCTURE:

Access to cheaper capital through internal capital markets: Internally


generated cash flows across businesses lowered the cost of capital and
increased the ability to finance investments without relying on costly
public capital markets
More efficient capital allocation: Management is more informed than
investors and can identify and allocate capital more efficiently to superior
investment opportunities
Diversified and resilient cash flows: The portfolio of businesses is better
able to withstand shocks or economic cycles that harm the performance
of pure- play companies, lowering overall risk

DRAWBACKS OF A CONGLOMERATE:

Subsidization of poorly performing divisions: Critics argue that managers


tend to cross-subsidize poorly performing divisions with cash flows from
healthier businesses
Managerial Inefficiencies: It is difficult for a management team to operate
efficiently in multiple industries, as each can require a different strategy
and set of management skills
Poor analyst coverage: Equity analysts, who specialize in a specific
industry, find it challenging to follow and value the many businesses
operated by a conglomerate.

STRATEGIES TO RAISE STOCK PRICES & ELIMINATE THE


CONGLOMERATE DISCOUNT:

Divest one or more businesses: This strategy would alleviate CPLs


conglomerate discount by narrowing the focus of the management.
Shareholder voting would not be required in this method. It would also
generate funds to pay down debt and lower leverage across CPLs
remaining businesses or be given as dividend to shareholders or used to
repurchase shares. The major disadvantage of a divestiture is the taxation
issues. Since divestiture is a taxable event, CPL would pay capital gains
tax on the difference between the equity value of the assets and the
adjusted cost base.
Spin off one or more businesses: In case of a spin off, there is no actual
sale, i.e., there is no change in ownership. CPLs shareholders would
receive shares in two listed companies, with the shares trading a different
prices based on the value of the underlying businesses. Spin off has to be
approved by a vote of all the shareholders at a special meeting. In
Canada, tax free spin off is called butterfly reorganisation. In order to
do a tax free spin off, CPL would need to get a favourable tax ruling from
Canadian tax authorities. In this, there is a risk of the tax exemption being
denied. Or worse, a double tax could be triggered by actions taken after
the spinoff was complete. If Revenue Canada felt a spin off was designed
to facilitate a future acquisition of the newly listed entity, that transaction
would be taxable. This restriction could be for a period of two years.
Spin off all five businesses simultaneously: There was no precedent for a
five way butterfly transaction. Revenue Canada had to be convinced for
such a transaction and that could take months and would require much
faith in the agency. However, there is no certainty on how this matter
would be accepted by the financial markets. Also, there would be some
tough negotiations over how CPLs debt and overhead expenses would be
allocated amongst businesses. If CPL were split entirely, the existing
debt held at the holding company would need to be paid off or assigned,
together with an additional $1 billion in liabilities and restructuring
changes. Funds to pay these liabilities would need to be raised by issuing
new debt.

CONCLUSION/RECOMMENDATIONS:
Divestiture may not be a preferred method when it comes to maximising
shareholders value because of the tax penalty. And shareholders do not have a
vote in this process. In case of a spin-off, if it is structured appropriately, it
could be tax free. But, even a spin off could not receive a favourable ruling.
And if it did, actions in the future might trigger a retroactive double-tax. And
the starburst strategy of creating five separately listed companies would be
something too new for the markets; it could be too bold a move. Also, it would
involve a lot of negotiations with Revenue Canada and debt restructuring.

Canadian Pacific should go with Spin Off of one or more business strategy. In
this strategy, the shareholders have a vote. It would be easily understood by the
analysts and investors. If properly implemented and with a check on the future
actions, the strategy can be a butterfly reorganisation. It would make sense to
keep some of the related businesses together to preserve economies of scale and
maintain synergies.

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