Canadian Pacific’s acquisition of KCS railroad back on track

After initially getting derailed earlier this year, Canadian Pacific Railways’ (CP) US$31 billion acquisition of rail operations Kansas City Southern (KCS) is back on track after another company rail firm Canadian National (CN) recently dropped out of the bidding war.

The deal could still face tough scrutiny from regulators at the federal Surface Transportation Board (STB), which hasn’t approved any major railroad mergers since the 1990s, but KCS shareholders will be set to get paid once shareholders of both companies and Mexican regulators approve it regardless of what the STB ultimately decides.

The US$31 billion deal includes 2.884 CP shares and US$90 in cash for each shareholder and the assumption of roughly US$3.8 billion in debt.

“We’re elated,” CP President and Chief Executive Keith Creel said. “No dull moments obviously, but it came to a conclusion where we intended it to in the beginning and believed it ultimately would end up.”

Canadian Pacific triumphed in the bidding war even though it offered less than Canadian National’s US$33.6 billion bid because federal regulators wouldn’t let CN set up a voting trust to acquire and hold Kansas City Southern during their prolonged review. Canadian National will receive US$1.4 billion in breakup fees for its trouble in the deal that has gone back and forth since CP and KCS first announced their merger agreement in March. CP will reimburse KCS for those breakup fees under the terms of their deal.

Canadian National CEO JJ Ruest said his railroad will focus on “profitable growth and opportunities for excellence.” CN had faced pressure in recent weeks from a major investor to abandon the deal and work on its own performance.

The London-based TCI fund, which owns about five per cent of CN’s stock, has already announced plans to call a special meeting to nominate four new directors who would help choose a new CEO for the railroad. A TCI spokesman said it will still push for leadership changes.

“Without much needed change on the board and in management, TCI believes the company’s operational and financial performance will continue to suffer to the detriment of CN shareholders. It is imperative that shareholders have a timely opportunity to vote on TCI’s proposals to put the company on a path to success.”

Shares of all three railroads were up after Wednesday’s announcements with CN posting the biggest gains with its stock trading roughly three per cent higher in the afternoon.

For more than two decades the railroad industry has been stable, with two railroads in the Western United States – BNSF and Union Pacific – two in the Eastern United States – CSX and Norfolk Southern – Kansas City Southern in the Midwest and the two Canadian railroads that serve part of the United States. Regulators have said that any merger involving two of the largest railroads generally needs to enhance competition and serve the public interest to get approved.

The only recent deal involving one of those major railroads is the 2010 purchase by Warren Buffett’s Berkshire Hathaway of BNSF, but that deal faced less scrutiny because it wasn’t a merger of two rivals.

Creel said he expects the STB will work to protect competition and the public interest when it reviews CP’s acquisition of Kansas City Southern, but he he believes the deal will meet those standards easily because there is little overlap between the two railroads and plenty of potential benefits. The two railroads expect to generate at least US$1 billion in synergies mostly by growing revenue while still keeping open all their existing connections with other railroads.

“I do not expect regulatory problems getting this deal approved,” Creel said.

Edward Jones analyst Jeff Windau agreed about the relatively straightforward regulatory review, but added that it will be interesting to see what sort of concessions Canadian Pacific and Kansas City Southern might have to make to address concerns raised by competitors and shippers.

Kansas City Southern made an attractive acquisition target because it was the smallest of the major railroads and the only one with direct lines into Mexico, so the new combined railroad will benefit from expanding trade across North America under the new trade agreement Canada, Mexico and the United States all signed. KCS President and Chief Executive Officer Patrick J. Ottensmeyer said the deal will “benefit KCS and our employees by enabling us to become part of a growing and truly North American continental enterprise.”

The new railroad will also be well positioned to benefit from companies deciding to move some of their manufacturing closer to their end markets in North America instead of relying so heavily on global suppliers

“Railroads are such a critical part of the backbone of supply chains. and this is going to be a very unique franchise to drive some of those investment decisions,” Ottensmeyer said.

The heads of both railroads don’t expect this deal to lead to more consolidation in the industry partly because the combined Canadian Pacific-Kansas City railroad will still be the smallest of the major railroads even though it will include roughly 20,000 miles of track and employ about 20,000 people.

“We are going to uniquely create a historic network through all three countries that won’t be replicated,” Creel said. “I think it stabilises the network. It creates competition west of the Mississippi, east of the Mississippi and in Canada. It puts us at a level playing field.”

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AP