The yearlong saga by Kansas City Southern (KSU) to find a buyer came to an end on Dec. 14, when Canadian Pacific Railway (CP 0.46%) completed its deal to acquire Kansas City stock for $31 billion. But what happens next for the railroads is far from clear, and investors need to remain on alert as the next year plays out.
Kansas City Southern shareholders received $90 in cash and 2.884 Canadian Pacific shares for each share they held. As a result, Kansas City Southern no longer trades on the New York Stock Exchange. But the railroad itself will not come under Canadian Pacific control for at least a year. Rather, the operations will roll into a special voting trust that's required to be arm's length from Canadian Pacific while regulators decide if a merger should be allowed.
The convoluted trust structure is awkward, at best, and could lead to some real issues for Canadian Pacific through the end of 2022. Here's what investors need to know about North America's potential new railroad company and how long it might take until we find out if the deal was worth the risk.
A long and winding road
Kansas City Southern put itself on the block more than a year ago, initially negotiating with private equity firms. The company is the smallest of the seven large North American railroads, with an attractive route network that runs down the spine of the continent to a deepwater port in Lazaro Cardenas, Mexico.
The United States put a moratorium on large U.S. railroad deals about two decades ago, but Kansas City Southern, due to its size and unique route map, has always been the possible exception to the ban. Last March, Canadian Pacific decided to test the regulatory waters, offering $275 per share and winning approval from Kansas City Southern's board.
In an attempt to alleviate regulatory uncertainty and win Kansas City Southern approval, Canadian Pacific suggested the voting trust structure that is now in place. The trust allows for Kansas City Southern shareholders to receive their payday well ahead of a prolonged regulatory-approval process. The risk falls on Canadian Pacific, which was forced to pay out for the railroad ahead of regulatory action and could book a loss if the merger is ultimately rejected and it must sell the asset back onto the market.
But in May, Kansas City Southern reversed course, declaring that a rival $325 per-share bid offered by Canadian National Railway (CNI 0.92%) was superior. Kansas City Southern returned to Canadian Pacific in September after the U.S. Surface Transportation Board ruled that it would allow Canadian Pacific to use the trust structure but not Canadian National, a clear indication that the regulator had significant concerns about Kansas City Southern combining with the much-larger Canadian National.
With the trust deal now complete, Canadian Pacific will wait on final approval from the Surface Transportation Board. That's unlikely to happen before the second half of 2022 at the earliest.
Investors still face a wait
For Canadian Pacific investors, there's a lot of uncertainty on the track up ahead. Past railroad mergers have been notoriously tricky to integrate, which in part explains why there was a moratorium in place. Add in the risk that comes with a prolonged review and the one-year delay for integration of the two companies, and there's a lot that can go wrong from here.
There's reason to believe the combination, to be called Canadian Pacific Kansas City Ltd., will win approval. The deal would create a true North American railroad with the ability to run cargo from southern Mexico to the Gulf of Mexico, U.S. Midwest and Northeast, and all of Canada without having to transfer between carriers. Canadian Pacific and Kansas City Southern were the two smallest major railroads prior to the deal, a fact not lost on regulators.
Assuming the deal does go through, the combination, on paper at least, looks powerful. The two railroads have worked together in the past, which should aid in the integration process, and the combined route map and reach would make it a formidable competitor, compared to its more geographically constrained rivals. But investors interested in participating in that eventual upside have a long year of Congressional hearings, regulatory grilling, and economic uncertainty to look forward to, and a couple of years worth of integration after that.
It's okay to hop a ride on the new Canadian Pacific Kansas City and hope for exciting times ahead. Just be warned that, even after the stock and cash traded hands this week, we're still in the early days of what promises to be a long journey.