Canadian Pacific Railway Ltd. (CP) will acquire Kansas City Southern (KCS) in a cash and stock transaction worth US$29 billion, the two Class I railroads announced early March 21. The combined entity will be named Canadian Pacific Kansas City (CPKC).
CP and KCS described the US$29 billion as “enterprise value” that includes the assumption of $3.8 billion of outstanding KCS debt. The transaction, which has the unanimous support of both boards of directors, values KCS at $275 per share, representing a 23% premium, based on the CP and KCS closing prices on March 19, 2021 (and $270 per share, representing a 26% premium, based on the respective CP and KCS 30-day volume weighted average prices (VWAP).
The two companies informally notified the U.S. Surface Transportation Board (STB) about the deal on Saturday evening, March 20. The STB will need to approve the transaction. If approved, the merger will be the first Class I transaction of its type since the late 1990s, when Norfolk Southern and CSX acquired 58% and 42%, respectively, of Conrail.
The STB, by statute, will have 16 months to issue a decision once the application is formally filed. Under 49 USC 11325, which governs a merger of two Class I’s:
1) Application is filed.
2) Within 30 days, STB accepts the application and issues Notice of the same (or rejects the application).
3) An evidentiary hearing must be concluded within 1 year of the Notice of acceptance of the application.
4) The STB has 90 days from the close of the evidentiary record to issue its decision.
CP will establish an independent voting trust to acquire the KCS shares. Former KCS President and CEO Dave Starling, Railway Age’s 2012 Railroader of the Year, has been appointed trustee. Upon shareholder approval of the transaction, and satisfaction of customary closing conditions, CP will acquire KCS shares and place them into the voting trust. This step is currently expected to be completed in the second half of 2021. Following the closing into a voting trust, common shareholders of KCS will receive 0.489 of a CP share and $90 in cash for each KCS common share held. KCS common shareholders are expected to own 25% of CP’s outstanding common shares, “providing the ability to participate in the upside of both companies’ growth opportunities. Following final STB approval, KCS shareholders will additionally participate in the realization of synergies resulting from the combination.”
To fund the merger’s stock consideration, CP will issue 44.5 million new shares. The cash portion will be funded through a combination of cash-on-hand and raising approximately $8.6 billion in debt, for which financing has been committed. As part of the merger, CP will assume approximately $3.8 billion of KCS’ outstanding debt. Following the closing into trust, CP expects that its outstanding debt will be approximately $20.2 billion.
CP and KCS said the combination “is expected to be accretive to CP’s adjusted diluted EPS in the first full year following CP’s acquisition of control of KCS, and is expected to generate double-digit accretion upon the full realization of synergies thereafter.”
Pro forma for the transaction, CP estimates its leverage ratio against 2021E (expected) street consensus EBITDA to be approximately 4.0x with the assumption of KCS debt and issuance of new acquisition-related debt. In order to manage this leverage “effectively,” CP will be temporarily suspending its normal course issuer bid program, and expects to produce approximately $7 billion of levered free cash flow (after interest and taxes) over the next three years. CP estimates its long-term leverage target of approximately 2.5x to be achieved within 36 months after closing into trust. The combined company “will remain committed to maintaining strong investment-grade credit ratings while continuing to return capital for the benefit of shareholders.”
The merger comes as trade between the U.S. and Mexico is expected to increase as the two North American nations are enjoying far better relations following U.S. President Joe Biden’s inauguration.
“The transaction will combine the two railroads to create the first rail network connecting the U.S., Mexico, and Canada,” CP and KCS said in a joint statement. “Joining seamlessly in Kansas City, Mo., in America’s heartland, CP and KCS together will connect customers via single-network transportation offerings between points on CP’s system throughout Canada, the U.S. Midwest, and the U.S. Northeast and points on KCS’ system throughout Mexico and the South Central U.S.
“The combined network’s new single-line offerings will deliver dramatically expanded market reach for customers served by CP and KCS, provide new competitive transportation service options, and support North American economic growth. The transaction is also expected to create jobs across the combined network. Additionally, efficiency and service improvements are expected to achieve meaningful environmental benefits.
“While remaining the smallest of six U.S. Class I railroads by revenue, the combined company will be a much larger and more competitive network, operating approximately 20,000 miles of rail, employing close to 20,000 people and generating total revenues of approximately $8.7 billion based on 2020 actual revenues.”
“This transaction will be transformative for North America, providing significant positive impacts for our respective employees, customers, communities, and shareholders,” said CP President and Chief Executive Officer Keith Creel. “This will create the first U.S.-Mexico-Canada railroad, bringing together two railroads that have been keenly focused on providing quality service to their customers to unlock the full potential of their networks. CP and KCS have been the two best performing Class 1 railroads for the past three years on a revenue growth basis.
“The new competition we will inject into the North American transportation market cannot happen soon enough, as the new USMCA (United States-Mexico-Canada) Trade Agreement among these three countries makes the efficient integration of the continent’s supply chains more important than ever before. Over the coming months, we look forward to speaking with customers of all sizes, and communities across the combined network, to outline the compelling case for this combination and reinforce our steadfast commitment to service and safety as we bring these two iconic companies together.”
“KCS has long prided itself in being the most customer-friendly transportation provider in North America,” said KCS President and Chief Executive Officer Patrick J. Ottensmeyer. “In combining with CP, customers will have access to new, single-line transportation services that will provide them with the best value for their transportation dollar and a strong competitive alternative to the larger Class I’s. Our companies’ cultures are aligned and rooted in the highest safety, service and performance standards.
“Importantly, KCS employees will benefit from being part of a truly North American continental enterprise, which creates a strong platform for revenue growth, capital investment, and future job creation. Customers, labor partners, and shareholders will all benefit from the inherent strengths of this combination, including attractive synergies and complementary routes.”
Creel and Ottensmeyer jointly concluded: “We have been champions for the environment recognizing the important role rail plays in lowering overall transportation emissions. This combination advances our shared science-based pledges in-line with the Paris Agreement to improve fuel efficiency and lower emissions in support of a more sustainable North American supply chain.”
In their joint statement, CP and KCS outlined additional particulars:
“The combination will provide an enhanced competitive alternative to existing rail service providers and is expected to result in improved service to customers of all sizes. Grain, automotive, auto parts, energy, intermodal and other shippers will benefit from the increased efficiency and simplicity of the combined network, which is expected to spur greater rail-to-rail competition and support customers in growing their rail volumes.
“Following final regulatory approval, a single integrated rail system will connect premier ports on the U.S. Gulf, Atlantic and Pacific coasts with key overseas markets. The combination of CP and KCS networks will offer unprecedented reach via new single-line hauls across the combined company’s continent-wide network.
“Importantly, no customer will experience a reduction in independent railroad choices as a result of the transaction. Additionally, with both companies’ focus on safety and track records of operational excellence, customers will benefit from a seamless integration of the two systems without service disruption.
“CP and KCS interchange and operate an existing shared facility in Kansas City, Mo., which is the one point where they connect. This transaction will alleviate the need for a time-consuming and expensive interchange, improving efficiency and reducing transit times and costs. The combination also will allow some traffic between KCS-served points and the Upper Midwest and Western Canada to bypass Chicago via the CP route through Iowa. This will improve service and has the potential to contribute to the reduction of rail traffic, fuel burn, and emissions in Chicago, an important hub city.
“In addition to providing new competition against other railroads, the new single-line routes made possible by the transaction are expected to shift trucks off crowded U.S. highways, yielding reduced highway traffic, lower emissions, and less need for public investments in road and highway bridge repairs. In the Dallas to Chicago corridor alone, the synergies created by this combination are expected to result in meaningful reduction in truck traffic on publicly funded highways.
“Rail is four times more fuel efficient than trucking, and one train can keep more than 300 trucks off public roads and produce 75% less greenhouse gas emissions. CP is committed to sustainability and is currently developing North America’s first line-haul hydrogen-powered locomotive.
“CP and KCS operational expertise and track records as PSR railroads, coupled with the hand-in-glove fit of the two networks, will help ensure a smooth, safe and efficient combination of the two railroads. In combination with KCS, CP will continue to build on its record as North America’s safest Class I railroad for 15 consecutive years based on Federal Railroad Administration-reportable train accident frequency.
“By accelerating the combined growth strategies of the two fastest-growing Class I’s with new efficiencies for customers and improved on-time performance under their respective PSR programs, the combined company under CP’s control is expected to create annualized synergies of approximately $780 million over three years.”
Two-Step Process to Complete Transaction and Merger
CP’s ultimate acquisition of control of KCS’ U.S. railways is subject to the approval of the U.S. Surface Transportation Board (STB).
First, CP will establish a “plain vanilla” independent voting trust to acquire the shares of KCS. Upon shareholder approval of the transaction, and satisfaction of customary closing conditions, CP will acquire KCS shares and place them into the voting trust. This step is currently expected to be completed in the second half of 2021, at which point KCS shareholders will receive their consideration.
CP’s placement of KCS shares into the voting trust “will insulate KCS from control by CP until the STB authorizes control. KCS’ management and Board of Directors will continue to steward the company while it is in trust, pursuing KCS’ independent business plan and growth strategies.”
The second step of the process is to obtain control approval from the STB and other applicable regulatory authorities. The STB review is expected to be completed by the middle of 2022. Upon obtaining control approval, the two companies “will be integrated, unlocking the benefits of the combination.”
Board, Management, and Headquarters
Following STB approval of the transaction, CP will acquire control of KCS and Creel, whose contract has been extended to 2026, will serve as the Chief Executive Officer of the combined company. Calgary will be the global headquarters of CPKC, and Kansas City, Mo. will be designated as the U.S. headquarters. The Mexico headquarters will remain in Mexico City and Monterrey. CP’s current U.S. headquarters in Minneapolis-St. Paul “will remain an important base of operations.”
Four KCS Directors will join CP’s expanded Board at the appropriate time, bringing their experience and expertise in overseeing KCS’ multinational operations.
BMO Capital Markets and Goldman Sachs & Co. LLC are serving as financial advisors to Canadian Pacific. Sullivan & Cromwell LLP, Bennett Jones LLP and the Law Office of David L. Meyer are serving as legal counsel. Creel-García-Cuéllar, Aiza y Enríquez, S.C. are serving as Mexican legal counsel to Canadian Pacific. Evercore is serving as the Canadian Pacific Board’s financial advisors and Blake, Cassels & Graydon LLP is serving as the Board’s legal counsel.
BofA Securities and Morgan Stanley & Co. LLC are serving as financial advisors to Kansas City Southern. Wachtell, Lipton, Rosen & Katz, Baker & Miller PLLC, Davies Ward Phillips & Vineberg LLP, WilmerHale, and White & Case, S.C. are serving as legal counsel to Kansas City Southern.
Additional information on the transaction and the benefits it is expected to bring to the full range of stakeholders is online at www.FutureForFreight.com. This website will be updated over the coming months with new information.
CONSECUTIVE RAILROADERS OF THE YEAR
KCS President and CEO Pat Ottensmeyer, Railway Age’s 2020 Railroader of the Year, said in our March 2021 issue:
“We are entering a new era for North America. The new USMCA (United States-Mexico-Canada Agreement, which “officially entered into force in 2020) assures 16 years of clarity for private-sector enterprise to make the investment needed to further develop stronger, more resilient … North American supply chains. President Biden and Mexican President Andrés Manuel López Obrador have conducted their first (virtual) bilateral meeting. They did not miss the opportunity to establish the necessary framework for a high-level, dynamic engagement (HLED) to keep USMCA current, relevant and properly aligned with the best interests of our societies, as they agreed to re-start the HLED to further mutual goals. They agreed to strengthen supply chain resilience and security. The region’s economic recovery and long-term prosperity depend on a healthy bilateral relationship, with private-sector participation and an eye toward creating a more resilient manufacturing and supply chain strategy for North America.”
In that same Railway Age issue, CP President and CEO Keith Creel, Railway Age’s 2021 Railroader of the Year, discussed growth:
“It’s fitting that we’d talk about growing the top line as 2021 gets under way. Last year, due to the COVID-19 pandemic, every Class I railway saw volumes decline. At CP, our volume fell 2% and our revenue 1%. Despite the challenging year, it was an industry-best performance I’m very proud of. As we begin this year and celebrate the 140th anniversary of CP’s incorporation, I know that the future holds great opportunity for us.”
He noted: “Today, I can confidently say that our value proposition lies in the service we provide. We don’t try to be everything to everyone. By combining a compelling service with the most direct routes in key lanes, we offer value to our customers. If we can cycle their cars faster than our competitors and build an expectation of reliability, we win alongside our customers.”
ON THE RECORD
Railway Age Editor-in-Chief William C. Vantuono spoke with Keith Creel and Pat Ottensmeyer soon after the merger was announced.
Railway Age: Well, I think this announcement caught a lot of people by surprise. It certainly surprised me, though I must admit I’m not that surprised. I’ll cite, for an opening question, a 1928 George and Ira Gershwin tune from the Broadway musical Funny Girl: “How Long Has This Been Goin’ On?”
Keith Creel: I’ve had my eye on KCS and the team for a very long time. We made contact late last year, discussions that culminated into a very exciting announcement today.
Pat Ottensmeyer: Keith and I know each other, do a lot of business together. It was clear there is a good relationship between our companies at all levels. Late last year, we started taking that relationship in a different direction.
Railway Age: With all that’s happened in the past year, did the stars just align? Now’s the right time?
Keith Creel: That’s exactly what has transpired. Often the stars have to align. The timing is ideal. You’ve got two companies that have been stars in the industry from a growth perspective. Two like-minded CEOs, committed to customer service. The opportunity to put these two networks together checks all those boxes. It allows reach to be extended, service to be enhanced, seamless single-line moves, and creates compelling value that’s unparalleled for customers. It drives job growth, positive for both companies, investment in those communities. Plus something that’s very important: environmental benefits, to be able to create something with a compelling opportunity to take trucks off the road, which uniquely benefits the environment. It’s powerful.
Pat Ottensmeyer: There are more aligned stars: USMCA. Near-shoring. De-risking the supply chain. Look at this network. Look at the map (see above). There is no other North American rail network that comes close to matching this combination.
Railway Age: Railway Age Contributing Editor Jim Blaze made this observation: “Railroads as networks have this inner drive to expand their coverage. Their network extent is essential to providing ‘place utility’ to customers. The most important link going forward for the proposed CPKC will become Kansas City to Shreveport, a long, thin north/south line in the heart of the U.S. Geopolitical winners, I believe are shippers/receivers at both ends in Mexico and Canada. And the combination into CPKC means that both CP and KCS are no longer the individual weakest of the Class I carriers as a network.” Your thoughts on Jim Blaze’s observations?
Keith Creel: We believe there’s a lot of truth in those statements. Fits in very nicely with the logic, the value of this combination.
Pat Ottensmeyer: I couldn’t have said it any better. The uniqueness that this network combined creates, the ability to drive investment, safety and efficiency is unparalleled. You have the two smallest railroads that, as strong as we are, when you put them together, what that unlocks isn’t possible, standalone. It’s extremely compelling in today’s world. Truly, no people suffer. It’s about growth and value creation. There is not a single customer or market where you have a 3-to-2 or 2-to-1. In fact, if you look at the new network that we’re creating here, Mexico and Texas to upper Great Lakes, Chicago Detroit, we are creating a 2-to-3 situation. It fits nicely with the STB’s mindset of enhancing competition, creating a new competitive option that doesn’t exist, a new option for truck to rail conversion. There’s a really powerful story there.
Railway Age: Contributing Editor Frank Wilner commented to me, “In publishing new merger rules in 2000 (Ex Parte No. 582 (Sub-No. 1, served June 7, 2000), the STB expressed ‘concern’ over the use of voting trusts, were the acquiring firm not able to find an alternative buyer, were the merger application denied. The STB said it would ‘take a much more cautious approach to future voting trusts in order to preserve our ability to carry out our statutory responsibilities.’ However, KCS, the smallest of Class I railroads, was singled out, the decision providing that ‘for a merger proposal involving KCS and another Class I railroad, we will waive application of the new rules and apply the rules previously in effect unless we are persuaded otherwise.’ This will be the first opportunity since that decision for the STB to consider a voting trust.” Your thoughts?
Pat Ottensmeyer: Note that David Starling is the trustee. Dave is supremely independent, had great success as CEO of this company (KCS) for several years. That we have a trustee who served as this company’s CEO during a period where we enjoyed great success is an important factor in showing the STB that we have a structure that preserves its independence and its ability to perform as a separate, standalone entity. This combination brings three of your Railroaders of the Year under one umbrella. An exemption exists because of the environment at the time. There was massive consolidation in the industry and a reflection of the need to handle KCS differently. The two companies here are the two smallest of Class I’s, arguably the two with the best growth profile. When we combine, we will still be the smallest in the industry. A comparison to some of the prior mergers that were done in a different era is one that we hope to avoid. This is a different transaction, a different time.
Railway Age: Actually, if you think about it, there are five Railroaders of the Year that are connected to this transaction in one way or another: Mike Haverty, who took KCS into Mexico in the 1990s under NAFTA, and Hunter Harrison, whose dream was to create a transcontinental railroad. Keith, what do you think Hunter would say?
Keith Creel: Hunter would be proud. He was about value creation, customer solutions, simplicity, taking out hauls. This is positive for assets, positive for efficiency, positive for service. You reward your shareholders, your customers. Hunter is elated now.
Railway Age: No doubt, he’s smiling down on you both. Thank you so much for sharing your thoughts with us.
“Pending regulatory approval, mid-2022 close timeline, we are very encouraged by potential value creation and synergies assumed in the merger, and reiterate Outperform for CP and KSU,” Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl noted in his analysis of the deal.
“The combination should create customer growth in North America, efficiencies in new single-line routes, increased market reach, and notable synergies,” Seidl said. “Management anticipates $780MM of annualized synergies within three years, a number they admitted could be conservative on their March 21 conference call with the Street. The merger should diversify business mix and geographic exposure. Canadian Pacific Kansas City (CPKC) will generate ~50% of sales from Canada, ~30% from the U.S., and the remaining from Mexico. Leveraging its network, the combination will allow for KCS traffic to bypass Chicago via CP’s route in Iowa, reducing congestion, fuel burn, and emissions. We are confident in management’s ability to execute. Keith Creel studied under Hunter Harrison, and CP is a well-respected operator in the rail space. KSU’s management team will remain on through the end of the merger. We have upmost respect for KSU management, as they have been successfully implementing PSR and posting good results while navigating through the difficulties of 2020.
“In aggregate, we see a low level of risk associated with the deal. The STB updated its merger regulations in 2001 but gave KSU an exemption. Unless the STB reverses its prior ruling, we would expect it to ultimately support the combination, in our view. The Committee on Foreign Investments in the United States (CFIUS) will have to approve of the merger, which we do not see as a high level of risk given they have supported prior foreign entities owning rail companies, including prior Canadian ownership of the DM&E, Illinois Central and Wisconsin Central as well as Ferromex’s (a Mexican company) purchase of the Florida East Coast in March 2017. There also could be risk inherent in the operation itself once CP takes ownership. Indeed, KCS does not own its highly sought after Mexican operations outright. Rather it has an operating concession with the Mexican government that expires in 2047, with exclusivity rights coming under review in 2027. Additionally, new legislation by Mexico’s congress would potentially prohibit outsourcing employees to third parties and insourcing employees from related companies. This would entitle Mexican employees (under Mexican GAAP) to receive profit sharing. We note that this legislation has been delayed multiple times, and that KSU already pays a set bonus to union employees (smaller than 10% of total profits), so if this does become law, the company would likely drop that bonus plan.
“Once the transaction is completed, the new railroad will likely have impacts across the supply chain. We don’t believe this deal will cause the final round of rail mergers in the industry necessarily, for two reasons. The first is that any other mergers will likely be met with far greater scrutiny from the STB, as KSU is the only railroad that has an exemption from the 2001 rulings. The second reason stems from the fact that this merger is largely a north/south play and does not create a U.S. transcontinental operation. Hence, the acquisition of NSC or CSX by another railroad would not likely be a necessary response.
“Once completed, however, this transaction could get other railroads thinking about the urge to merge. Aside from other mergers, CPKC is targeting nearly $800MM in revenue synergies by 2025. These are likely to be spread fairly evenly over the time frame and come from three main buckets: intermodal/automotive, bulk and carload. Some of these wins will undoubtedly be taken off the highway as a complete interline service should make for a more reliable rail product. On its deal call, management mentioned that it plans to offer new services as well, due to the increased reach, and specifically mentioned some routes east of Chicago. Some of these could be taken from other rail operators in our view.
“We update our CP model to reflect the merger, beginning in 2H22. With management’s expectations of $780MM within three years, and top-line growth opportunities, we roll forward our model to 2023 and model a consolidated adjusted OR of 52.4%. Using our new 2023 EPS estimate of US$20.50 and a 20x multiple—down a turn to be more conservative—our price target goes to US$410 from $378, and reiterate Outperform. We update our price target for KSU to $290 from $246, using our new CP price target and 0.489 share conversion + $90 cash, per terms of the deal.”