Thursday, March 25, 2021

How Likely Is a Merger Between CP and Kansas City Southern?


                                                Photo courtesy of Kansas City Southern

By Michael Hooper

The U.S. Surface Transportation Board will review the proposed sale of Kansas City Southern (KSU) to Canadian Pacific Railway (CP).

The STB has broad economic regulatory oversight of railroads, including rates, service, the construction, acquisition and abandonment of rail lines, carrier mergers and interchange of traffic among carriers.

Based on my previous coverage of these issues, I expect the STB will examine whether the deal improves or harms service and competition. Former Surface Transportation Board member Deb Miller spoke at length about railroad mergers in this 2014 article I wrote during her time on the board. Hunter Harrison had tried to get some merger activity going at CSX (CSX) with Canadian Pacific in 2014 but without much luck.

At that time, she said, the STB would look hard at whether any merger would improve service and competition.

"We would be very reluctant to do anything to make service issues worse," Miller told me.

I don't see any reason for major shipping delays as a result of the merger of CP-KSU. They don't overlap. 

Mergers were common in the rail industry in the 20th Century. It was either get larger or die trying to compete. Yet mergers haven't been so frequent in the past 20 years. Now there are just seven Class 1 railroads.

There is no guarantee the Surface Transportation Board will approve a merger. In 1999, BNSF Railway and Canadian National Railway (CNI) proposed a merger that would have created the largest transcontinental railway in North America. The Surface Transportation board imposed a 15-month moratorium on new rail mergers. Months later the two railroads called off the merger. Back then shippers complained that past mergers -- Union Pacific's 1996 acquisition of Southern Pacific Rail Corp. and 1999's splitting of Conrail Inc. between Norfolk Southern Corp. (NSC) and CSX -- had caused massive delays and poor service.

The CP acquisition of Kansas City Southern is unique because it involves trade between three countries, Mexico, the United States and Canada. KSU owns Kansas City Southern de Mexico, based in Monterrey. Canadian Pacific will be expanding its global reach across the Midwestern United States and Mexico and giving KSU access to points in Canada and the North and Northeast. This is strategically a good move for CP and generally a win-win for both companies. There is no overlap in rail, no duplication. Indeed, a single-line company moving product over three countries is opening up new markets. 

CP and KSU are among the many beneficiaries of the North American Free Trade Agreement, which eliminated all tariffs and quotas on US exports to Mexico and Canada.

The CP-KSU combination would not eliminate competition. A primary competitor in the NAFTA business is Union Pacific, which has the most connections with Mexico of any railroad in the U.S. UP serves the six border crossings of Brownsville, Texas; Laredo, Texas; Eagle Pass, Texas; El Paso, Texas; Nogales, Ariz. and Calexico, Calif.

In a way, the proposed CP-KSU merger reminds me of the Canadian National Railway acquisition of the Illinois Central in 1998. That acquisition gave CN ownership of a Chicago-New Orleans route, thus giving CN access the Gulf Coast waters along with already longtime historic connections to the Pacific and the Atlantic in Canada.

On March 21, Canadian Pacific and Kansas City Southern announced they have entered into a merger agreement, under which CP has agreed to acquire KCS in a stock and cash transaction representing an enterprise value of approximately USD $29 billion, which includes the assumption of $3.8 billion of outstanding KCS debt. The companies said they were offering 23% premium, based on the CP and KCS closing prices on March 19, 2021, but CP's price fell 7% after the deal was announced while KSU stock was up 10%.

Shareholders of KCS will receive 0.489 of a CP share and $90 in cash for each KCS common share held, according to a joint company statement.

Joining in Kansas City, Mo., the statement said the combined company will connect customers via single-network transportation offerings between points on CP’s system throughout Canada, the U.S. Midwest, and the U.S. Northeast and points on KCS’ system throughout Mexico and the South Central U.S., the companies said. 

The combined company will operate approximately 20,000 miles of rail, employ close to 20,000 people and generate total revenues of approximately $8.7 billion, the companies said.

The companies expect synergies of approximately $780 million over three years.

To fund the stock consideration of the merger, CP will issue 44.5 million new shares. The cash portion will be funded through a combination of cash-on-hand and raising approximately $8.6 billion in debt, for which financing has been committed. As part of the merger, CP will assume approximately $3.8 billion of KCS’ outstanding debt. Following the closing into trust, CP expects that its outstanding debt will be approximately $20.2 billion, the companies said.

Stockholders betting on a merger are taking a calculated risk. This deal does not have much overlap in rail lines and will create longer single-line delivery methods for customers. CP will gain valuable access to Midwest US and Mexican rail lines, giving customers more destinations for delivery.

As of this writing, KSU stock was trading at a 6% discount to the acquisition price. We may see a trading discount due to the long regulatory process typically involved in a deal of this scale. Whether the deal goes through, I think shareholders are wise to hold onto their assets. There aren't many Class I railroads available for public ownership, so it's best to own what we can. Margins have improved in recent years in the rail sector, making them attractive investments. 

If KSU stock gets folded into CP, that is one less investment possibility in the rail investment world. And for investors like me who like railroads, that will be a disappointment. Nevertheless, I give the CP-KSU merger a 51% possibility. This deal will create new shipping options for customers because one company will cover three countries under the North American Free Trade Agreement. This deal could lead to new or expanded markets for customers.

Editor's note: The Author owns shares in UNP, NSC, CNI and BRK.B.

Railroads Haul More Containers in Q1

BNSF Railway Shops, Topeka


By Michael Hooper


A review of the weekly volume reports at BNSF Railway, Union Pacific and Norfolk Southern (NSC) shows that while carloads may be down so far in Q1, container and trailer volume is up. Ports have been backlogged with ships waiting to unload containers.

At Norfolk Southern (NSC) intermodal volumes -- containers and trailers -- were up 5% Year To Date through Week 9, ended March 6.

At BNSF Railway (owned by Berkshire Hathaway (BRK.B), container and trailer volume were up 14% YTD through Week 10, ended March 13. For many months there has been a backlog at the Los Angeles and Long Beach ports, where BNSF Railway and Union Pacific pick up freight and haul to Chicago and other places.

The ports in Los Angeles and Long Beach have been dealing with delays since June 2020, according to Ian Putzger in the Loadstar.

Container and trailer traffic at Union Pacific was up 8% YTD through Week 11, March 20.

Winter storms slowed down volumes of freight for the railroads in February, this harsh weather event, that included many days of freezing weather, will most likely affect first quarter earnings.

Union Pacific is trading with a 27 P/E ratio and a forward P/E of 19.9. The dividend yield on this stock is 1.82%. Historically, the yield on the stock is around 2% to 2.5%.

I expect volumes should be improving into the summer months.

Union Pacific, BNSF Railway, Canadian National Railway and Canadian Pacific will be the beneficiaries of all that freight coming into the west coast ports from Asia. Norfolk Southern and CSX (CSX) benefit from freight on the East Coast ports.

Railroad margins have improved in recent years, making these attractive investments. Net profit margins at Norfolk Southern (NSC) and Union Pacific (UNP) are around 26%.

There's so much pent-up demand among consumers; this demand will translate into more freight and merchandise being moved over rail and road. Financial metrics such as P/E ratio, yield and price-to-book ratios indicate these railroad stocks are trading above their historic averages, but there is a good reason to hold. There are just seven Class I railroads in the United States and Canada. Only six of them are publicly owned. With the potential for Canadian Pacific (CP) acquiring Kansas City Southern (KSU), there will be one less publicly-owned Class 1 railroad stock if the deal goes through.

Conclusion

I am bullish on rail stocks. Shippers will move steady-to-growing amounts of freight as we head into the summer months. These railroads are big cash machines with the ability to ebb and flow with the economy. The economy contracted during the pandemic of 2020, yet these railroad stocks were up. Railroads remain profitable and did not have to cut their dividends. I recommend holding these railroad assets for dividend income and modest growth in 2021.


Editor's note: The author owns UNP, NSC, CNI, BRK.B.

Thursday, March 4, 2021

Brad Garlinghouse Fights SEC Lawsuit Over Crypto Sales


Brad Garlinghouse speaks at Topeka High School in 2017

By Michael Hooper

Brad Garlinghouse, CEO of Ripple Labs Inc., plans to file a motion to dismiss a lawsuit against him by the Securities and Exchange Commission over the sale of his XRP cryptocurrency.

Garlinghouse, a graduate of Topeka High School, has been fighting this lawsuit for two and a half years.

"After a 30-month investigation and after the production of more than 200,000 pages from the defendants and third parties, the best the SEC can do is allege that Mr. Garlinghouse was generally aware of the risk that some digital assets could possibly be deemed to be securities but that he worked hard to ensure that XRP did not even appear to have those features," says a letter by Matthew Solomon, on behalf of Brad Garlinghouse.

The SEC alleges Garlinghouse sold over 357 million of his XRP for approximately $159 million and that these transactions occurred at various digital asset trading platforms. Garlinghouse also directed sales of some of his company's XRP. Garlinghouse attorney Solomon says those platforms alleged by the SEC seem vague and seem to obscure what the SEC knows but merely hints at with passing reference to Mr. Garlinghouse's worldwide sales. The truth is that the vast majority of Mr. Garlinghouse's XRP sales were made on foreign exchanges and those transactions do not and cannot violate the federal securities law, Solomon wrote.

Yesterday on Brad Garlinghouse Twitter account, he posted a tweet saying, "Today, a letter was filed on my behalf indicating my intent to file a motion to dismiss in response to the SEC's amended complaint against me. Simply put the SEC's allegations are regulatory overreach."

The SEC says that XRP is a security and should have been registered with the SEC as such. The SEC says XRP is a security because of "an investment contract."

Yet Solomon says the SEC fails to understand the XRP market for the past eight years. XRP, he says, is a digital asset used to make faster, cheaper, and more efficient payments and money transfers. That is the business model at Ripple.

Garlinghouse has said Ripple sells a blockchain technology to banks and payment providers to do real time settlement between banks. He says the current banking system for settlement between U.S. and foreign banks is lengthy and time consuming.

I know Bitcoin is considered a commodity by the SEC. Why would XRP be any different? XRP is listed as one of the top cryptocurrencies in the world by market capitalization on the top cryptocurrency websites, such as coinmarketcap.

Garlinghouse, the son of Kent and Susan Garlinghouse of Topeka, is a graduate of University of Kansas and Harvard Business School.

When XRP was trading around $2.50 to $3.00, Forbes published an article in January 2018, saying Garlinghouse was worth $9 billion. But XRP fell from those highs to $0.47 cents in recent trading.

Brad Garlinghouse was inducted into the Topeka High School Hall of Fame in 2017. Here is an article about that event.