A Key Regulator Just Gave Canadian Pacific a Boost in a $30 Billion Takeover Battle

A proposed merger between Canadian Pacific (CP -0.62%) and Kansas City Southern (KSU) will not be judged under stringent guidelines for railroad deals put in place two decades ago, a huge boost to the Canadian railroad's effort to combine with the smaller target.

The two companies last month announced plans to combine in a $30 billion deal, the first major railroad merger since a 2001 deal moratorium put in place by the U.S. Surface Transportation Board (STB).

But on April 23, the STB granted a waiver exempting this deal from the tougher rules put in place along with the moratorium, saying it would consider only whether the deal is anti-competitive. Had they needed to meet the tougher guidelines, the onus would have been on the railroads to go beyond the competitive ramifications and to demonstrate why allowing the deal would be in the public interest.

The STB's decision could go a long way toward determining the fate of Kansas City Southern, which is also the target of a $33 billion bid from Canadian National (CNI 0.27%).

Image source: Kansas City Southern.

A big win for CP

Canadian Pacific has been dismissive of Canadian National's overtures for Kansas City Southern, arguing that its rival's offer was less likely to get the green light from regulators. The STB's decision boosts that argument.

The STB in its ruling noted that even combined, Canadian Pacific and Kansas City Southern would rank as the smallest major North American railroad, and there's little overlap between their rail networks.

"The interrelationship between the CP and KCS networks in fact appears to be end-to-end in nature, which likely raises fewer competitive concerns than a transaction that is not end-to-end," the board wrote.

It is far from certain the Canadian National (CN) offer will get the same benefit of the doubt. For one thing, Canadian National is much larger in terms of revenue. And CN already has track down the Mississippi River to the Gulf of Mexico that overlaps with much of Kansas City Southern's U.S. operations.

Data source: Yahoo! Finance.

The outcome is still far from certain

The STB's ruling came on the same day that Kansas City Southern's board voted to open talks with CN on its competing proposal. Though Kansas City Southern officially remains bound by the terms of the Canadian Pacific deal and has not determined that Canadian National's offer is superior, the board has determined there is the potential for a superior proposal. 

At face value, that seems like a pretty straightforward question. Canadian National was offering cash and stock worth $325 per share at the time of the announcement, which is about 20% above the initial CP offer. Both deals offer a mix of cash and stock, and both would use a trust structure to try to mitigate some of the regulatory risk faced by Kansas City Southern shareholders.

But Canadian Pacific has argued that one must look at more than just the offer prices to really evaluate the bids. During Canadian Pacific's April 21 post-earnings conference call, CEO Keith Creel argued that Kansas City Southern's board needs to weigh the added regulatory risks involved with going with the larger suitor.

"When it gets down to truly comparing the deals, it comes down to doability," Creel said. "It comes down to, can you get the deal done? It comes down to risk that you have to embrace to realize the value for your shareholder."

Canadian National disagrees, arguing that its deal can get done. Look for CP to play up the STB ruling as we await Kansas City Southern's next move, and in any decision by CP about sweetening its offer.

The DOJ could have its say

The Department of Justice is a wildcard in these proceedings. While it's not the primary regulator of railroads, it asserts a "statutory right to intervene" in big deals like this, and has already indicated a desire to step in here.

The Justice Department earlier this month sent a comment letter to the STB critical of CP's plan to put Kansas City Southern in a trust while awaiting approval, calling that scheme "a mockery of the Board's authority."

In that same letter, Richard Powers, the DOJ's acting assistant attorney general for antitrust, urged the STB not to issue a waiver.

"As the first major rail merger in over two decades, this proposed transaction presents important and novel competition issues that have the potential to significantly reshape the industry," Powers wrote. "The Board should seriously consider applying all of its 2001 rules to the review of this transaction, and in any event should carefully analyze the competition concerns raised by the deal and rigorously scrutinize any claimed benefits."

Image source: Canadian Pacific.

A foggy picture is now a bit clearer

In some ways, all the STB did was state the obvious: It's hard to look at the different sizes of the suitors and their route maps and not conclude there are more potential issues with the Canadian National proposal. But that fact that a regulator did say so adds significant weight to CP's argument.

Canadian Pacific might need to come back with some sort of a sweetener to get a deal done, but it is possible for Kansas City Southern's board to conclude the CP offer is superior even if it isn't the one with the highest price. Creel laid out the argument in his post-earnings comments, and now the STB ruling has made it easier for the Kansas City Southern board to justify that decision.

It is way too soon to call this a done deal, but the odds that Canadian Pacific will eventually buy Kansas City Southern are higher now than they were a week ago.