Canadian Pacific Railway (CP -6.60%) is looking to the south for growth, announcing plans to acquire Kansas City Southern (KSU) for $29 billion.
The deal is the largest ever between two railroads, though the price does fall just short of the total valuation of Burlington Northern Santa Fe when that company was acquired by Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B).
It's also a rarity for an industry where large-scale consolidation has essentially been off the table since 2000 due to regulatory concerns.
More than two decades after a merger moratorium was issued, Canadian Pacific (CP) and Kansas City Southern (KCS) are going to try their luck. It's no slam dunk, but investors actually have very little to lose from the effort. Here's a look at the deal structure, and why I think this transaction will eventually be approved.
Image source: Canadian Pacific.
For Canadian Pacific, it's a matter of trust
Railroad deals were shelved in 2000 when the U.S. Surface Transportation Board (STB) issued a moratorium on mergers in response to issues that plagued the consolidation going on at the time. Specifically, Union Pacific's acquisition of Southern Pacific and efforts by Norfolk Southern and CSX to divide and integrate Conrail had led to operational meltdowns and significant delays.
The companies are going to have an uphill battle convincing the STB, with Canadian Pacific saying it does not expect to win regulatory approval until mid-2022. That's a lot of time for shareholders to be left waiting for an uncertain payout.
Mindful of that long wait, the companies have structured the deal in a way that should alleviate most of the risk for Kansas City Southern shareholders. Canadian Pacific intends to establish an independent voting trust that will acquire the shares once KCS holders approve the deal, and before regulators have sounded off. That's likely to happen as soon as this summer, and at that point, holders of KCS shares will get their consideration even though CP will not yet officially own Kansas City Southern.
Assuming the STB eventually does sign off on the deal, Canadian Pacific would then buy the trust. If regulators block the merger, the trust will likely go public. Either way, KCS shareholders should get their payoff later this year, and not in 2022.
This deal is pro-shippers
Logistics companies and large shippers have long memories, and their voices have kept the STB staunchly anti-consolidation in the years since the late 1990s meltdown. But CP arguably has a good story to tell customers on why this deal would be different.
For one, the railroads have almost no overlap. The two networks only meet at one location: a facility in Missouri the two companies already operate jointly. And the combination, by linking KCS' Mexican and Gulf Coast focused network with CP's transcontinental reach, has the potential to alleviate pressure at some of the worst choke points in the North American rail system.
The post-merger route network. Image source: Canadian Pacific.
The combination has track through Iowa and Minnesota connecting to an east-west network that will allow some traffic to avoid Chicago, which has perhaps the tightest, most crowded rail lines on the continent. And by leveraging CP's infrastructure at the port of Vancouver, British Columbia, with KCS' Lazaro Cardenas, Mexico, operations, shipping customers will have opportunities to bypass crowded U.S. Pacific ports and still be able to reach most of the United States.
It's even pro-environment
The congestion around Chicago today is so bad that shippers at times rely on trucks to move freight on the Dallas-to-Chicago corridor. Right now, neither Canadian Pacific nor Kansas City Southern can do much to help, as neither service has track spanning the entire route.
With this merger deal, that would change, creating a new single-line route from Texas to Chicago without forcing shippers to deal with two rail companies and possible delays at a switching yard.
Rail has long been seen as part of the answer on greenhouse gas emissions, with one train able to keep more than 300 trucks off the road and produce 75% less emissions. Canadian Pacific is trying to add to those efficiency stats by working on hydrogen-powered locomotives. But there is only so much capacity rail lines can handle, and little appetite by governments to allow new track.
That means the only way to add capacity absent a merger is for competing railroads to work together and do their best to coordinate operations. Bringing two incomplete central U.S. routes under one owner should help make that combined north/south line a better alternative to truckers.
This deal (eventually) gets through
There are currently seven major North American railroads. Of those, KCS has always seemed the most likely target due to its small size and unique north/south network.
This deal would combine the two smallest major railroads by revenue, creating a company that is still smaller than fifth-place Norfolk Southern's $11 billion in sales. Just as important, the deal would not impact the current competitive situation in any region. Union Pacific and BNSF would still compete in the U.S. west, Norfolk Southern and CSX in the east, and CP and Canadian National to the north.
Investors should be warned that regulatory approval is no given, but of all the possible North American railroad combinations, this deal makes the most sense.
If completed, Kansas City Southern shareholders would get both a cash payout and a stake in what might be North America's most impressive rail network. If the deal doesn't get done, the shareholders are still likely to get paid thanks to the trust structure. There's a lot of reason for investors to be excited about this transaction.
