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.