On Wednesday, in the latest twist to the great North American railroad merger saga, Kansas City Southern (KSU, Financial) announced that it has terminated its deal to be acquired by Canadian National Railway Co. (CNI, Financial). Instead, it plans to merge with Canadian National’s rival, Canadian Pacific Railway Ltd. (CP, Financial).
Canadian National and Canadian Pacific have been in a bidding war to acquire Kansas City since this past March. The first offer, a $25 billion cash-and-stock bid, came from Canadian Pacific, but Canadian National swooped in with a deal valued at $33.7 billion – a bid that seemed almost too good to be true.
In fact, while Canadian Pacific didn’t give up on its attempts to regain the merger deal, the company said it would not raise its offer to continue a monetary bidding war. Canadian Pacific CEO Keith Creel said the rival offer was "not a real deal,” and the company proceeded to wait until regulatory objections to the deal mounted before upping its offer to $27 billion.
Kansas City tried to cling to the “superior” Canadian National deal until the U.S. Surface Transportation Board (STB) ultimately rejected the special voting trust structure that would have allowed the acquisition to bypass the tougher railroad merger rules that the regulator put in place in 2001. With the U.S. Department of Justice also saying that Canadian National’s bid posed greater risks to competition than Canadian Pacific’s did, Kansas City ultimately changed its mind and decided that the safer deal was the better deal.
What’s interesting to note is that, following the announcement, shareholders bid up the price of Canadian National shares as much as 3%, while gains for Kansas City and Canadian Pacific remained near or below the 1% mark.
There is always more to consider in a company’s future than “merger equals growth.” Going forward, will the Kansas City and Canadian Pacific combo turn out to be the better investment, or could Canadian National turn out to be the real winner?
A railroad to span North America
Now valued at $31 billion, Canadian Pacific’s cash-and-stock offer for Kansas City is set to create a railroad network that spans the U.S., Canada and Mexico. The merger is expected to be completed sometime in the second half of 2022.
Farm groups have shown enthusiastic support for the prospect of such a railroad network, which would smooth the flow of goods to market. It also has the potential to boost farm sales. According to Mike Steenhoek, executive director of the Iowa-based Soy Transportation Coalition, the deal could increase market access for customers:
"Many current Canadian Pacific customers currently only have access to export terminals in the Pacific Northwest. Similarly, current Kansas City Southern customers may enjoy new access to markets served by the Canadian Pacific network."
Analysts and regulators alike seem to consider the deal with Canadian Pacific to be a good thing both for shipment volumes and price competition. Regulators have already approved a voting trust structure for the Canadian Pacific deal.
"This is by default negative for the other railroads, including Canadian National, which faces a longer haul competitor into the Gulf Coast and Midwest," JPMorgan (JPM) analyst Brian Ossenbeck said in a research note.
With a market cap of $83 billion compared to Canadian Pacific’s $46 billion, Canadian National is undoubtedly the more dominant railroad between the two, with a network spanning most of North America and three major coasts. That’s why regulators are far more keen on having Canadian Pacific acquire Kansas City, and it’s also why this deal has higher potential to increase shipment flow, thus helping the newly-merged company start off on a positive note.
Canadian National’s strategy
Canadian National CEO J.J. Ruest seems comfortable with the possibility of not pursuing the deal further, though he did say he was disappointed that the deal did not go through. He said it was a bold move, and even if it didn’t work out, it still resulted in positive outcomes for the company:
"We believe that the decision not to pursue our proposed merger with KCS any further is the right decision for CN as responsible fiduciaries of our shareholders’ interests…CN will continue to pursue profitable growth and opportunities for excellence as a leading Class I railroad, and we look forward to outlining more details on our strategic, operational and financial priorities in the near future.”
Given how many times the situation has changed, it seems possible that more twists and turns could be in the cards. Perhaps Canadian National will try to re-enter the bidding war again, despite regulatory challenges. However, at this point, it seems like doing so would be akin to hitting its head against a brick wall.
In fact, Canadian National has faced considerable blowback from TCI Fund Management, one of its biggest shareholders, over its decision to bid for Kansas City. The U.K.-based hedge fund, led by Christopher Hohn, has even called for Ruest to be replaced. Hohn had the following to say in a statement:
"The bid for KCS exposed a basic misunderstanding of the railroad industry and regulatory environment…The board consistently misjudged the STB and displayed flawed decision making, committing billions of dollars to an ill-conceived pursuit of an unattainable asset. CN should focus on getting better rather than bigger."
While it’s undeniable that if Kansas City and Canadian National could clear regulatory approval for a merger, it would greatly benefit both companies, it seems that this was too much of a reach given Canadian National’s prominent existing market position. Combined, the market value of Kansas City and Canadian Pacific still amounts to only about three quarters of Canadian National.
As Hohn and Creel both predicted from the start, Canadian National’s bid will likely turn out to be a wasted effort. However, finally saying goodbye to the bid will allow the company to refocus on its own growth prospects, which certainly aren’t inferior to Kansas City and Canadian Pacific’s.
All things considered, healthy competition seems to be heating up among the North American railroads, with the Kansas City acquisition and improvements in technology across all competitors poised to drive improvements to efficiency and increases in shipments.
Railroads have long been considered excellent assets to hold over the long term, since they provide an essential service that would be extremely difficult to replace. It’s estimated that Canadian National’s assets alone would cost about $100 billion to replace. As the population and average GDP of North America continue to grow, so too will railroad shipments and profits, and the only ways to gain market share (outside of the rare acquisition) are to build out new routes and attract more customers by providing the best service.
Canadian National is the only railway to boast a network connecting Canada’s eastern and western coasts to coasts in the U.S., and if Canadian Pacific successfully completes its acquisition of Kansas City, it will become the only railway to boast a network connecting the U.S., Canada and Mexico. Given these advantages and powerful macro and tech trends for the industry as a whole, it’s easy to see why investors have bid up shares of railroad stocks over the past year.