What Investors Should Know About the Largest Railroad Merger Ever

In this episode of Industry Focus: Energy, Motley Fool contributor Lou Whiteman joins the podcast to break down the record-setting pending merger between Kansas City Southern (KSU) and Canadian Pacific Railway (CP 2.12%) and to take a look at how a blockage in the Suez Canal could impact global trade.

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This video was recorded on March 25, 2021, before the blockage of the Suez Canal was cleared.

Nick Sciple: Welcome to Industry Focus. I am Nick Sciple. This week, we've got big news in the world of logistics and infrastructure with the largest railroad merger in history coming at the same time as one of the largest global shipping channels is facing a blockage that some experts think could extend for weeks. Joining me to break down both of these stories is Motley Fool contributor Lou Whiteman. Lou, thank you for joining me on the podcast as always.

Lou Whiteman: Always a pleasure to be here, Nick.

Sciple: Spring break is right around the corner. Any big plans? I know it's a big reopening season, Lou.

Whiteman: We are doing the COVID thing. We have got a house in the mountains so we're just going to go hide there instead of hiding in our house at home. But I'm looking forward to it. [laughs]

Sciple: Awesome, same thing. We're going to Ocracoke Island. Going to the island you can only reach by ferry, so trying to get off the grid a little bit. I hope folks to the extent they can do it safely are getting out of the house. I know I'm ready to get out of my apartment to the extent I can. We've got a couple of big stories today like I teased off in the intro. I want to start with this merger announcement on Sunday between Kansas City Southern railroad and the Canadian Pacific Railway. As I said in the intro, this is the largest combination of two railroads ever. But I think another aspect that folks may not realize is railroad mergers have been banned for a while or banned leading up to the past several years.

Whiteman: Yeah. Historically, railroads have been really bad at merging. So bad that their regulator, the Surface Transportation Board, stepped in in the late '90s. If you go back in time then in the late '90s, there were two deals going on, one on each coast, and neither of them went well. Union Pacific was trying to integrate Southern Pacific, and then Conrail, which was created by the government out of all the railroad bankruptcies in the '70s, was being split by Norfolk Southern and CSX. The net net was none of them did a good job. Stuff was sitting, produce was rotting, you had huge shipping customers like UPS demanding the government take action. The end result was a moratorium on deals that has lasted until about a week and a half ago, and will probably last another year because this is going to take awhile to work through.

Sciple: Right. Which brings us into the terms of this merger. What's going into this deal? It's an interesting structure but to account for some of these regulatory potential headwinds.

Whiteman: Yeah, it's a $29 billion deal by enterprise value. That's the largest railroad-railroad deal, as you say. It's slightly smaller than what Berkshire Hathaway paid for Burlington Northern but that wasn't a consolidation. Right now in North America, there are seven what we call Class 1 railroads. These are the two smallest of the seven. Even combined, they are going to be smaller than No. 5, Norfolk Southern, but this is going to be a massive railroad. We're talking 20,000 miles of combined rail employing about that many people, 20,000 people. Total revenue of $8.7 billion, if you combine it in 2020. Interestingly, as you say, because there was so much risk here, they are saying, they don't expect this deal to close until mid 2022 at the earliest, which that's a long time to wait. For that reason, they have structured it as a trust. There's actually, if all goes to plan, assuming Kansas City Southern shareholders approve the deal, which I think they will, they could get paid as early as this summer, and then the asset would sit in a trust for a year or so while the regulators work things out. But that's good news for Kansas City Southern shareholders because otherwise, you're sitting on your hand, hoping for the best for about a year and a half. As it stands, and I think it will be signed off by the regulator, you should have your, I believe, it's 0.489 shares of Canadian Pacific and nine dollars in cash as soon as late summer.

Sciple: Absolutely. Then the actual asset of Kansas City Southern will sit in this trust until it's approved by regulators. What are the arguments that these companies are going to make to regulators, for why this is good for the industry, and why they should allow this to take place?

Whiteman: Well, the big one is like I said, the revenues. These are two small companies, relative to their competitors. There's also no overlap. They two actually partner right now, they share a facility in Kansas City. But if you think of the maps, you basically have two puzzle pieces that you put together, you get North America. Kansas City Southern right now gets about half of its revenue from Mexico, half from the United States, but they don't have any tracks north of Chicago and only just up the spine. Canadian Pacific, meanwhile, has a huge Canada operation and then some track into especially the U.S., Northeast, and the Midwest. You put them together and you have a more complete puzzle that you can work on. This matters. As partners, they can combine and you can run a shipment right now with these partners going from Mexico to Toronto. But you're talking about a delay in a yard in Kansas City where they switch up equipment. The difference between that and a straight line where you really can compete with some of these others that are already offering this, there is a real benefit for shippers. Post deal we're talking about a company that's about 50% of its revenue is from Canada, but 30% from the U.S., the rest of Mexico. This is the first truly North American railroad.

Sciple: So when you read the press releases from this company, one of the big catalysts they talk about is this USMCA, this new NAFTA, the idea that they can link Mexico, Canada, and the United States through that channel in Kansas City where they interchange. One of the areas that I think is an obvious beneficiary of this deal is right at the start of the Biden administration, we had the Dakota Access Pipeline shutdown that was going to take oil from Canada down to the Gulf Coast of the United States south into the United States. That project has since been canceled, but there is still demand to bring that product to market. If you look at the routes that this railroad will service, you can plug right into that network and connect the Gulf Coast with Canada. Is that you see as a justification for this deal like those routes connecting those markets?

Whiteman: Absolutely. The oil route is a neat one because Canadian National already has that track from buying the Illinois Central way a long time ago. They can go right down the Mississippi. This is another option which is pro shippers. Also, let's be honest, we are not building anymore railroad tracks, we have to make better use of the railroad tracks we have. This merger on paper should alleviate some of the pain and some of the biggest choke holds in the North American system. Chicago, for example. Right now, Chicago is where trains go to [laughs] sleep for a long time. This will offer a direct line from the Gulf of Mexico into Canada for ag & oil that goes through Iowa and Minneapolis, which is a big deal. It also because of the extensive port operations Kansas City Southern has down in Mexico, that is a deepwater port. Right now, you can go in there and bypass really, really heavily congested ports in Southern California. However, whatever you gain in quicker offload, you tend to lose in that Kansas City yard if you're heading for say, New York or something or you're heading on to Canadian Pacific. Once this deal was done, that's a straight line track into Chicago and beyond. That's a real benefit for shippers. 

The analogy for us consumers is different between a nonstop flight and a one-stop flight where you might not have to get off the plane, but you still have to stop. That matters. There's an environmental thing here too. Yes, maybe more oil. There's a lot there, but rail is more efficient. Right now you have a lot of the congestion on the so-called Chicago-to-Dallas auto corridor is cargo that is forced to go by trucking because the trains are just so overwhelmed. One train line could keep 300 trucks off the road. So if you can turn this into a viable competitor on that spine of the U.S. route where you don't have to switch trains, you don't have to switch engines, you can just go through, there is a real measurable environmental benefit there. That's not just PR from the press release.

Sciple: Absolutely. I think you run through the press release, they give us some justification that makes sense. I put them into the bullet points. So No. 1, as we talked about combining these two networks together, will help expand the market and make things easier for their customers. Obviously, adds new competition to the market as you have more service available and more seamless linking. You can make the case for environmental efficiency, benefits there. The efficiency of trains versus autos is well documented, and now you can say the pipelines are even more efficient, but we will get into that debate right now. Now, there was one area I see them arguing it is a benefit, and I'm not sure that makes sense to me, one is they said that they're going to create jobs across the combined network. From my perspective, if you're taking out the people who are working at the interchange and doing what they need to squeeze efficiency, when I think efficiency, that tends to align with reducing headcount. Do you think that is more of a PR thing or do you see a case where they can deliver that?

Whiteman: I'm always skeptical about promises that there won't be job losses in mergers regardless. I mean, that's just the nature of the beast. I do think that there is a good case to be made here. They talked about $800 million in revenue synergies, added business that they think they can bring in just as being one network instead of two. I think for the reasons we've talked about, I think there's something to that, and maybe hopefully that offsets whatever job losses in the back-office. That switching yard, it's still going to be a valuable rail yard, so it's not just going to disappear. I don't think if you're a regulator, you approve this on the promise of huge, robust job creation, but I think there's a reason. Both of these companies are well-run. There's not a lot of "fat" to trim. I'm hopeful that it won't be a huge job-loss event, but no, I would be skeptical about any claims for huge employment gains.

Sciple: Right. If you wanted to make the counterargument, what you would say is this lower cost of shipping is going to allow more businesses to thrive because their costs go down, and as a result, maybe you lose some employment on the railroad side. But on some of these areas of the railroad services, maybe there's more breathing space for businesses to exist. These are all one for one. It's how these changes in the market, can create opportunities or closing off opportunities in other places. One last thing on this railroad deal that I thought was interesting, maybe two things. No. 1, when you look at this combined company, is this something you find compelling to invest in today? Then second off, what do you think of as the read through to the broader railway industry? Kansas City Southern just got taken out at a +20% premium to where it was previously trading. Does that suggest that maybe there's some opportunity in other railroad companies?

Whiteman: Generally, I like both of these companies as individual investments. I'm hopeful they can make a real dynamite company out of it. So if I held either of these stocks, I certainly wouldn't sell on these. With mergers, this is a complex merger, it's going to take a long time. I'm always a little nervous buying in right on a deal. I'd rather let the integration play out, especially in this case when you're talking over a year. I would probably prefer maybe the Canadian National as the arrival there or even Union Pacific. I don't like the East Coast railways as much. As far as valuations, we've come a long way and we're in a real good market for freight. If you look at these companies, the deal is priced around 28 times forward earnings. Most of the rest of the industry is trading between 21 and 24. I think a lot of this premium is just because of the risk and you have to talk companies in this industry into signing on the dotted line. Canadian Pacific has made a run at two or three other railroads in the last 10 years that they didn't get. I think the premium is more just the risk premium of taking on this adventure than it is a revaluation. Generally, I think rail is an attractive long-term investment and there are good opportunities.

Sciple: Absolutely. I think all these Class 1 railroads, we talked about the seven of them, are systemically important to trade and all those sorts of things. So I think owning some of those arteries, you could do a lot worse than owning some of these systemically important companies. On the topic of systemically important transportation infrastructure, that brings us to our second story for today. Global shipping has really been thrown for a loop this week, as on Tuesday the container ship Ever Given ran around in the Suez Canal after being hit by severe winds, blocking the entirety of the Suez Canal today. Lou, what does this mean for just the broader economy, markets of the world?

Whiteman: We are getting a first-hand, painful maybe, education on how important the Suez Canal is and how many potential choke points there are. The Ever Given is a huge ship, one of the biggest ships in the world. We'll find out all of it. This Suez Canal, which is now blocked; and there's great pictures, if you can see like satellite data, there are hundreds of ships on either side just trying to get by. Suez Canal accounts for something like 12% of global trade, nine percent of total seaborne traded petroleum. There is so much that goes into this and it's now appearing it could be weeks. I saw something before we came on that some of the biggest shipping companies are considering rerouting through the Cape of Good Hope, South Africa. That's adding 10, 15 days, significant fuel expense. If you can wait a few days and see this disappear, you are not going to do that. That is the industry signaling that they are at least getting worried that this is going to be weeks, not days. You are going to see a trickle-down. Energy's the obvious, but in all sorts of global trade, retail, this is a big deal, especially for trade between Europe and Asia because that's the main pathway between the two.

Sciple: Right. Our folks that are watching live with us on Fool Live, I'm showing a flashing of a picture from vesselfinder.com. For the podcast listeners, I'll drop a link in the podcast description. Or if you go to that website, you can really see how traffic is just absolutely backed up in the Suez Canal as a result of this blockage. You can also look at, coincidentally if you're just curious, at some other areas around the world. In addition to the Suez Canal, other really important, systemically important places like the Strait of Hormuz  coming out of the Middle East, and those areas, as well as I talked back in September, Daniel Yergin talking about the Strait of Malacca, which goes right past Singapore, is a very systemically important trading channel. Then obviously, many folks are familiar with the Panama Canal. All of these areas, massively important for global trade. 

To go into some numbers on the Suez Canal, 12% of global trade travels through the Suez Canal, about 9% of total seaborne-traded petroleum, including crude oil and refined products, which makes sense. This is the sea route that can take oil from the Middle East to Europe, one of the biggest demand centers in the world . As far as the impact right now on trade according to estimates from Lloyd's List which included Bloomberg, looking at $49.6 billion per day of trade going through the Suez Canal, 185 ships are currently waiting to transit the waterway. 

As you mentioned, Lou, they've been working to try to excavate, refloat the ship. I've learned this new term, I didn't realize this is the term you use. When the ship runs aground, they need to refloat it. But anyway, they have been trying to refloat the ship for the past couple of days. When you look at quotes from some of the people working on the project, it sounds like it could extend for weeks when there's only so many ships there out on the ocean and having to reroute around Africa. You can see how the global supply chains already stretched by COVID are going to be stretched even more.

Whiteman: Yeah, and COVID, that's a great point. We should back up and talk about what was going on leading into this. With the pandemic, a lot of trade froze or slowed down, a lot of these ships were returned to home ports, sent places. So as things began to open up, you had an imbalance of supply and demand where it was needed, which has become worse because due to COVID and restrictions, like in L.A. just isn't unloading as many ships as they would normally, there's a lot more restrictions there. Container rates were already up in some markets like the transpacific market, it's 3X over a year ago. You have demand from China being so impressive that shippers were just not even waiting to reload, they would just send their ships empty back to China because they can get so much money. That has screwed up agricultural exports. There is a real just supply-demand imbalance right now going on even without this. This is going to just make things even more crazy. That's going to ripple down to a lot of industries that rely on this so we're going to see their costs go crazy with shipping over the next year or so or in the next few months. Look, these are big ships that are hard to move, these are hard problems to solve quickly. Once this system has been jerked or thrown off the kilter, any one of these things could have a ripple effect for a couple of months. You throw all of these together and this could honestly weigh on supply chains for a lot longer than we realized -- through the year, maybe even a little longer.

Sciple: This is one of the half-dozen most important choke points in the world and to have that blocked off really, really significant. One of the other things we talked about, Lou, is if you look at trends over the past several years or the past several decades, these container ships have become larger and larger over time, global trade continues to grow, and we need to get these goods around the world. These ships are made specifically to fit in these canal. There's the Panamax that goes through the Panama Canal, there's the Suezmax that goes through the Suez. We talked about railroads earlier. I think you can think about these canals just like the railroad gauge for ships. This is the size you have to be able to make it to fit through these channels. But there has been some talk about as these ships get bigger, should we be expecting more of this in the future? What are the potential implications for this going forward?

Whiteman: Yes, I think this is fascinating, and it's obviously speculative because who knows. But as you said, the Ever Given can hold about 20,000 containers. Just for some comparison, the larger ships back in 2007, just 13 years ago, held about 8,000 containers, so it's twice as big. According to Drewery, there are 47 more of these Ever Given sizes or larger, 25,000 container ships on order right now. This was supposed to be future shipping because obviously, the more you can shovel in, the more efficient you can be. These ships already can't go through the Panama Canal; most of them can't unload in the U.S. ports; it's going to take billions of investment to do that. These ships are primarily going between Asia and Europe, specifically Asia and Rotterdam, because there's not many places you can unload it even there. 

I think that there is going to be some talk out of the Suez people now, this is basically stretching them out. They're the only one in the world that can handle it, and obviously we are seeing they can't handle it well. It didn't take much. It took a gust of wind and a sandstorm for this to happen. There is, I think, a possibility that they say, "We don't want these ships, either," and then that would really change the economics of where shipping was supposed to be going as far as bigger boats, more cargo to smaller boats. It's hard to say exactly what happens here. I may be overreacting and Suez may gladly take the fees or figure out a way to do these better or just widen. But you do wonder if this trend toward the ever bigger ship, we are learning the hard way the downside for that, and I am curious if the industry doesn't reassess, and if they do, that is going to change their cost structure, which is going to change the cost structure for everyone who relies on them. So there is real global economic impact if this changes things.

Sciple: I think it just goes to show we're in this increasingly tech-ified world, but still some very low-tech things are really underlying this entire global economy that we're benefiting from today. If there was infrastructure week constantly for the past few years, I think we're going to keep on with infrastructure week. It's very, very important and we are reaching the point that we are stretching the limits of a lot of our infrastructure, whether that's the Suez Canal this week, or a few months ago, we were talking about the energy grid in Texas. There is certainly a lot of investment that is needed to be made in our infrastructure, and we're seeing some of it be stretched about as far as it wants to go.

Whiteman: Yeah, I think that's the big picture takeaway that binds these two stories together, is that infrastructure is a scarce resource and it deserves to be valued that way when we are considering these companies, these investments. There is something of value in the railroads that they just are railroads and they have that railroad track. There is value in the shipping lanes. It doesn't make these 30-times-sales tech investments necessarily, but I think it is underappreciated as people analyze these companies, the rail lines, the infrastructure is taken for granted. We are getting some tough education on we shouldn't take these things for granted, that it is a scarce resource with value.

Sciple: Absolutely. We'll continue following these stories as they develop, the Suez story, as it continues to play out, and even further in the investment world, to the extent we can find opportunities of companies that are going to benefit from the dollars that need to be invested in what we need to do to maintain this infrastructure or bring it up to the standards we need. That will be something we'll be talking about on the show as well. Lou, thank you as always for joining me on the podcast, and can't wait to have you on next time.

Whiteman: Always a pleasure to be here.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show, for Lou Whiteman, I'm Nick Sciple. Thanks for listening and Fool on.