A Canadian Pacific train leaves the railyard in Calgary on Aug. 8, 2021. Canadian Pacific Railway renewed the battle for Kansas City Southern on Tuesday with a new bid that is cheaper than Canadian National's but offers what the Calgary railroad says is greater assurance its deal will win regulatory approval.Gavin John/The Globe and Mail
Nervous investors may want to get off the train before the race between Canadian Pacific Railway Ltd. and Canadian National Railway Co. reaches its final stage.
The two Canadian railways are locked in a ferocious bidding war for Kansas City Southern , a rail network that runs from the U.S. Midwest to Mexico. Both seem intent on ignoring the gathering regulatory clouds.
The growing possibility that U.S. policy makers might raise obstacles to a takeover suggests there could be a bumpy end to what began as a promising journey.
CP took the latest step in that journey on Tuesday when it raised its cash-and-stock offer for KCS to about US$27-billion, not including assumed debt, or US$300 a share. That is a significant increase from its previous bid, which worked out to about US$275 a share.
However, it still falls short, in strictly financial terms, of CN’s competing cash-and-stock bid, which works out to about US$30-billion, or US$325 a share. The CN offer also includes far more cash – US$200 a share compared to US$90 a share in the CP offer.
The one thing that might deter some KCS shareholders from accepting the more lucrative CN offer when they vote on it on Aug. 19 is the possibility that the CN proposal will be incapable of winning regulatory approval given the level of corporate concentration it would create. A link-up between CN and KCS would result in the third-largest rail operator in North America. In contrast, a merger between the significantly smaller CP and KCS would form only the sixth-largest rail company on the continent.
But investors in either Canadian railway should be wary. Taking over KCS was always going to be an expensive proposition. Back in early May, however, a deal still seemed capable of generating a decent long-run return, given the attractive fundamentals of the rail business. The problem now is the growing risk that U.S. regulators may simply reject any merger at all.
That would be in keeping with recent signals from Washington. President Joe Biden issued an executive order on July 9 setting up a White House Competition Council. The order proclaimed the administration’s determination to reverse the growing consolidation of power in certain sectors of the U.S. economy.
One of the areas cited for particular attention was rail. The executive order urged action “to further competition in the rail industry.”
This would not appear to bode well for any company seeking to consolidate the sector.
Neither does a statement, also on July 9, from Martin Oberman, chairman of the Surface Transportation Board (STB), which regulates the U.S. rail industry. Mr. Oberman’s statement trumpeted his concern that the concentration of power in the sector has gone too far.
“During my time on the Board, I have been continually concerned with the significant consolidation in the rail industry that happened as a result of a series of mergers decades ago, which dramatically reduced the number of Class 1 carriers,” he wrote.
“It is apparent that while consolidation may be beneficial under certain circumstances, it has also created the potential for monopolistic pricing and reductions in service to captive rail customers.”
It is difficult to square the official statements with any scenario in which a takeover of KCS would win speedy approval from the STB. Mr. Oberman’s statement also raises the possibility an acquisition might not be approved, period.
And that is just one part of the regulatory uncertainty. CP’s original bid, back in March, was premised on setting up a voting trust to hold KCS until a regulatory approval process was completed. During that time, KCS would continue to operate independently from CP. The regulators at the STB gave their blessing to the CP voting trust proposal.
CN has put forward a similar voting trust structure, but the STB has yet to okay its proposal. The board said Tuesday it will announce its decision by Aug. 31. If the regulators were to rule against the voting-structure proposal, CN’s bid would be thrown into disarray.
CN’s willingness to embrace that level of regulatory risk drew a furious response in May from TCI Fund Management Ltd., a U.K. money manager that had built up major holdings in both CP and CN. TCI wrote an open letter to CN management, demanding it drop its bid for KCS because of the possibility the STB will not approve the voting trust structure. This would put CN on the hook for close to $2-billion in breakup penalties and other costs.
TCI also highlighted how the bidding war between CP and CN had doubled the value of KCS shares. It warned of the risk the STB would not ultimately approve any acquisition, leaving CN as the owner of a trust that would have to dispose of KCS shares at what could be fire-sale prices.
“Six months ago, KCS had a market cap of US$16-billion,” TCI wrote. “CN has offered to pay US$30-billion. If the deal is not approved by STB, CN would be a forced seller of KCS so it is quite possible that CN could face a loss in excess of US$15-billion.”
That, to be sure, is a nightmare scenario. The robust share prices of all three rail companies suggest most investors are confident an acquisition will eventually be approved. Still, the risks are there. Shareholders in the Canadian railways should be sure they are ready for whatever the final stage of this journey may bring.
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