CP and CN keep their eyes on the (KCS) prize, following STB ruling

Momentum continues to roll down the tracks, with the final destination being an acquisition of Class I rail carrier Kansas City Southern. But the question remains as to whom will be the company that ends up driving that acquisition train. It comes down to the two Class I railways north of the border—Calgary-based Canadian Pacific (CP) or Montreal-based Canadian National (CN).

As previously reported by LM, CP said in late March that it is acquiring KCS for $29 billion, in a deal that will establish the first freight railway connecting the United States, Canada, and Mexico. But a few weeks later, CN joined the fray, making an unsolicited—and what it called a “superior offer—to acquire KCS for $33.7 billion. In the subsequent days, both CN and CP each made their cases for why they have the better respective offer on the table.

Since then, the wheels have continued to turn, with CN announcing on Saturday, April 24 that it looks forward to engaging with the KCS board of directors to “complete confirmatory due diligence and create the premier railway for the 21st century,” adding that “CN welcomes the determination by Kansas City Southern board of directors that CN’s proposal to combine KCS could reasonably be expected to lead to a ‘Company Superior Proposal’ as defined in KCS’ existing merger agreement with [CP].”

What’s more, on Friday, April 23, the Surface Transportation Board (STB) issued a decision in which it stated that a waiver it granted to KCS in 2001 applies to the potential transaction between CP and KCS.

STB explained that this merger regulation granted a waiver allowing a merger involving KCS and another Class I railway carrier to be considered under the board’s pre-2001 merger regulations and subject to the Board’s review as well.

And the STB filing said: “The Board makes this finding for several reasons. If approved, the combination of CP and KCS, the sixth largest and seventh largest Class I railroads, respectively, would still result in the smallest Class I railroad, based on U.S. operating revenues. In addition, a merger of the CP and KCS networks would appear to result in the fewest overlapping routes when compared to a merger between KCS and any other Class I carrier. 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. In sum, the Transaction appears to fall neatly into the Board's rationale for adopting the waiver in the first instance.”

But things continuing to shift from there, with KCS saying on April 24 that its board of directors has unanimously determined, after consultation with the Company’s outside legal and financial advisors, that the unsolicited proposal received from CN could “reasonably be expected to lead to a “Company Superior Proposal” as defined in KCS’ existing agreement with CP.

KCS added that it intends to provide CN with nonpublic information and to engage in discussions and negotiations with CN with respect to CN’s proposal, subject in each case to the requirements of the CP merger agreement. But that does not mean anything is formal, or that CP is out of the picture, as it said “KCS remains bound by the terms of the CP merger agreement, and KCS’s Board has not determined that CN’s proposal in fact constitutes a Company Superior Proposal as defined in the merger agreement with CP. In addition, KCS notes that there can be no assurance that the discussions with CN will result in a transaction.”

CN responded to the KCS declaration by saying it looks forward to working with the KCS board of directors to complete confirmatory due diligence and finalize a definitive merger agreement to create what it called the premier railway for the 21st century.

“We are pleased that KCS has acknowledged the value that a CN-KCS combination would bring as the premier railway for the 21st century,” said JJ Ruest, president and chief executive officer of CN, in a statement. “Together, CN and KCS will connect North America in a safer, faster, cleaner and stronger way for the benefit of both companies’ stakeholders. CN looks forward to completing its confirmatory diligence and finalizing its merger agreement with KCS promptly.”

CP subsequently issued a statement about that development, noting that KCS is meeting its obligations under its merger agreement with CP and also fulfilling its fiduciary duty to its shareholders by assessing the CN offer. It added that this is the correct process and is clearly required by the merger agreement, saying that it is encouraged KCS is taking a “hard look” at the details of CN’s proposal, which it said it believes will lead KCS to question the true value and deal certainty of the proposal.

“We fully support the board of KCS in reviewing CN's offer,” said CP President and CEO Keith Creel in a statement. “We are confident through this process that they will recognize this unsolicited bid is fraught with challenges, uncertainties and regulatory risks that are not present in the seamless, pro-competitive and pro-service CP-KCS combination.”

And CN also said that CN will need to answer several questions for the KCS board, including: is its unsolicited bid for KCS real or just an attempt to thwart the agreement that KCS signed with Canadian Pacific?; how does CN plan to get approval to create the third largest Class I railroad with numerous overlapping connections across the U.S. when the STB in 2001 purposely changed its merger rules to prohibit such anti-competitive deals; and why should the KCS board abandon the agreement with Canadian Pacific when it is the only one that fits any of the merger conditions that the STB has set?, among others.

On CP's first quarter earnings call last week, Creel said that based on the merits, the facts of its proposed combination in partnership with the KCS, the combination, CP-KCS is the only true USMCA network and opportunity.

“It's the only possible Class 1 combination that answers the STB's public interest test,” he said. “The only, not one of many, the only. Why do we say that? Why is that true? Why is that undeniable? Well, number one, let's start with truth. Number two, it's pro-competitive. Multiple fronts, new routes, new markets, new competition introduced. Customers get reached today with this combination, when approved and we believe it will be, that quite frankly without it is impossible. New competition is introduced, be it with BNSF, be it with UP, be it with CN, that simply doesn't exist today that's enabled by this combination.”

Credit Suisse transportation analyst Allison Landry observed in a research note that the STB decision to allow the KCS exemption is in the firm’s view a positive signal for the CP transaction, insofar as the likelihood of ultimate deal success.

“In particular, we think the language that the STB used in its decision is telling….specifically as it relates to the comments that the CP/KCS combination appears to be truly end-to-end, which, consequently, raises less competitive concerns than would a transaction with another Class I,” she wrote. “While we stop short of saying that the STB is expressing bias in any way (noting that the regulator does not have the full set of facts in front of it as yet), the language is, at the very least, revealing enough for one to draw a reasonable conclusion that the merits of the merger (presented thus far) are sufficient to achieve approval. All of this, of course, is very much predicated on where the KSU Board shakes out with respect to whether or not the CN offer is a superior proposal; which in our view hinges on the regulatory risk of the transaction itself, and less so if the voting trust can get approved.” 

Supply chain consultant and LM Contributing Editor Brooks Bentz said that it’s striking how much money CN is willing to spend to keep this out of the hands of CP.  

“It’s almost as though CN feels they can’t let CP gain any kind of edge, no matter what,” he said. “I presume that in a bidding war, CN could out-muscle CP, but I can’t help but think of advice I got early in my career from a very sage buyer of transportation companies who said 'If you overpay for a company on the front end, it’s a millstone around your neck forever.'  Mike Haverty, Dave Starling after him and now Pat Ottensmeyer have done an exemplary job of revitalizing KCS and making it a solid performer.  I believe history will judge their aggressive move into the Mexican market as visionary.  I do have trouble believing that whomever wins the prize that it will trigger another round of mergers or acquisitions.  There’s no overpowering business case to support such a strategy at this point.  No matter the outcome, it will be an interesting drama to watch unfold.”