What happened

The Biden administration is reportedly displeased with the level of consolidation in the railroad sector, and that's weighing on the railroad stock, which is currently the target of a $33 billion acquisition. Shares of Kansas City Southern (NYSE:KSU) fell as much as 8.7% on Thursday as investors try to figure out the odds of the railroad's planned sale winning approval from regulators.

So what

Railroads have a lousy history when it comes to consolidation. So bad, in fact, that the U.S. Surface Transportation Board (STB) in 2000 imposed a moratorium on major deals. But Kansas City Southern, as the smallest of the major North American railroads, has always been seen as the possible exception, and earlier this year the company was the subject of a bidding war between Canadian National (NYSE:CNI) and Canadian Pacific (NYSE:CP).

Two Kansas City Southern trains passing each other.

Image source: Kansas City Southern.

In May, Canadian National won the bidding war, and now the merger partners are waiting to hear back from the STB on a plan that is designed to relieve some of the regulatory risk faced by Kansas City Southern shareholders. Canadian National has proposed setting up a trust that would buy Kansas City Southern while regulators weigh the merits of the deal, allowing shareholders to get paid well before any decision is reached.

While the trust decision is separate from an ultimate merger approval, it is seen as a good gauge of what the merger partners are up against as regulators consider their deal.

The Department of Justice has already urged the trust not be approved, calling it a "mockery" of STB regulatory authority. On Thursday, the Wall Street Journal reported that Biden will issue an executive order pushing regulators to confront consolidation in key industries including rail.

Although there is nothing in the report suggesting the executive order would directly address the Kansas City Southern merger proposal, a strong anti-consolidation statement from the White House would presumably factor into the STB's thinking as it considers the trust and eventually the deal.

Now what

Terms of the Canadian National deal call for Kansas City Southern holders to get $200 per share in cash and 1.129 shares of CN for every share held. At current prices, that's a total of about $319.16 per share. But Kansas City Southern is trading just above $262, implying the market is extremely uncertain the deal will get done.

All's not lost for Kansas City Southern, even if the STB comes out against the Canadian National deal. Canadian Pacific has already won approval for a similar trust, and a Canadian Pacific/Kansas City Southern combination on paper would be a much easier sell to regulators. Canadian Pacific and Kansas City Southern are the two smallest major North American railroads, and combined their total revenue is still less than Canadian National alone. It could still be possible Canadian Pacific would be allowed to buy Kansas City Southern even if Canadian National is not. 

We've known for a while that intense regulatory scrutiny of this deal was likely, and Thursday's report is little more than a reminder of the uphill battle Canadian National faces. Investors should prepare themselves for a bumpy ride ahead.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.