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CP investors too optimistic on turnaround: Analyst

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Investors may be getting ahead of themselves when it comes to Canadian Pacific's (CP-T) shares, according to an RBC Capital Markets analyst.

CP Rail shares surged around 6 percent yesterday after the company reported a 20-percent jump in third quarter profit and improved efficiency, providing evidence that recently-appointed CEO Hunter Harrison's plan to turnaround operations at the embattled railroad is taking hold.

Net income rose to $224 million, or $1.30 a share, from $187 million, or $1.10, the previous year -- outpacing analyst expectations for a profit of $1.23 per share.

The company also said its operating ratio -- a ratio of costs over revenue used to measure a railroad's efficiency, with a lower number preferred -- dropped to 74.1 percent, from 75.8 percent. Harrison's plan is to eventually lower that ratio to 65 percent in the next three years.

But analyst Walter Spracklin says investors may be too optimistic in their belief that new management will be successful in making the railroad more efficient.

"Several factors that could impede management's [operating ratio] target include: a sluggish economy, inclement weather or labour push-back. It is also possible that management may have miscalculated pension headwinds, restrictive customer contracts, or previously unknown network constraints," he says in a note to clients. "While we won't likely know whether these factors will come into play until later, investors should be keenly aware of subtle changes to [operating ratio] targets (65%) or the time-frame in which they are expected to be achieved (2015)."

Spracklin says the weather, in particular, has been favourable in recent years and may have slightly padded the operating ratio figure.

"By Canadian standards, we didn't have winter last year, and the Canadian rails benefited accordingly. But look no farther back than each of the two years prior for evidence of harsher weather conditions. The CEO indicated…that he is hopeful for another mild winter. We share that same hope, but we're certainly not throwing away our shovel," he says.

Spracklin says that if the company hits its ambitious operating ratio target of 65 percent in the next three years, that would lift the shares by 18 percent. But if the company hits his more reasonable operating ratio target of 70.4 percent, the shares would fall by 2 percent to $91.

"Finally, if unsuccessful -- and depending on the actual [operating ratio] -- the downside risk is much more pronounced at 30-40 percent," he says.

Spraklin is downgrading the stock to "sector perform" from "sector outperform," but has raised his price target to $91 from $86.

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