Game Over for CP+KCS? Maybe, Maybe Not (UPDATED)

Written by Marybeth Luczak, Executive Editor
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The activity involving Kansas City Southern and its two potential merger partners, Canadian Pacific and CN, took yet another turn late on May 13. CN appears to have come out on top, but don’t count CP out, at least not yet.

KCS on May 13 announced that its Board of Directors determined that a revised merger offer from CN constitutes a “Company Superior Proposal” as defined in KCS’s agreement with CP. KCS added that it has notified CP of its intent to terminate its merger agreement with CP and enter into a definitive agreement with CN, “subject to CP’s right to negotiate amendments to the merger agreement for at least five business days, and the KCS board’s further determination as to whether any such amendments would cause the CN proposal no longer to constitute a ‘Company Superior Proposal.’”

KCS noted that CN’s offer “is binding on CN and may be accepted by KCS at any time prior to 5:00 p.m. EDT on Friday, May 21, 2021.” The transaction would be subject to approval by KCS stockholders, by the Surface Transportation Board’s approval of a voting trust, receipt of other regulatory approvals and other customary closing conditions.

(To reiterate how this all began, KCS and CP announced on March 21 that CP would acquire KCS in a cash and stock transaction worth US$29 billion. On April 20, CN made an unsolicited counter-offer.)

CN Revised Proposal By the Numbers

CN’s revised proposal offers KCS shareholders US$325 per common share based on the May 12, 2021, closing price of CN shares, “which implies a total enterprise value of $33.6 billion, including the assumption of approximately $3.8 billion of KCS debt.” KCS shareholders will receive $200 in cash and 1.129 shares of CN common stock for each KCS common share, based on conversions between Canadian dollars and U.S. dollars at an 0.827 exchange rate as of May 12, a CN share price of US$110.76, and a CP share price of $391.87. KCS shareholders would be expected to own 12.6% of the combined company.

“This represents an implied premium of 45% when compared to KCS’s unaffected closing stock price on March 19, 2021,” CN said. “KCS preferred shareholders will continue to receive $37.50 in cash for each preferred share.” In addition, “a wholly owned subsidiary of CN has agreed to reimburse KCS $700 million in connection with its payment of a termination fee to CP under the merger agreement with CP.” As well, CN will pay KCS $1 billion if the STB rejects the voting trust structure CN has put forward to complete the deal.

(In comparison, CN valued its April 20, 2021 proposed cash-and-stock transaction at US$33.7 billion, or US$325 per share, based on conversions between Canadian dollars and U.S. dollars at an 0.799 foreign exchange rate as of April 19, 2021, and on CN and CP closing share prices on the NYSE of US$118.13 and US$365.37, respectively, as of April 19, 2021. Following closing into a voting trust, KCS shareholders would receive $200 in cash and 1.059 shares of CN common stock for each KCS common share. CN said on April 20 that its proposal of $325 per KCS share “represents a 27% premium to KCS’ closing share price as of April 19, 2021; a 45% premium to KCS’ closing share price as of March 19, 2021 (the last trading day prior to KCS’ announcement of its proposed transaction with CP); a 21% premium to the implied value of the proposed transaction with CP based on each of CN’s and CP’s closing share price on April 19, 2021; and $56 in additional value per share to KCS shareholders above the proposed transaction with CP. With greater than two-times more cash consideration, CN’s superior proposal delivers greater value and certainty to KCS shareholders, as well as participation in the significant upside of the combined company.”)

CN: ‘We Are Delighted’

CN President and CEO JJ Ruest

“We are delighted that KCS has deemed CN’s binding proposal superior, recognizing the many compelling benefits of our combination and expressing confidence in CN’s ability to obtain the necessary approvals and successfully close the transaction,” CN President and CEO JJ Ruest said. “Our proposal offers a clear path to completion and is structured in a way that gives KCS shareholders both greater immediate value and the opportunity to participate in the future upside of the combined company. Together, CN and KCS will seamlessly connect ports and rails in the United States, Mexico and Canada by providing superior service, enhanced competition and new market access to move goods across North America safely and efficiently. We are encouraged by the widespread support we have received for the transaction thus far and will continue to work closely with KCS and all relevant stakeholders to fully realize the benefits and opportunities available through a combined CN-KCS.”

CN Chairman Robert Pace added: “We are the better bid, better partner, better railway and best solution for KCS, and are pleased that the KCS Board of Directors has recognized the superiority of our proposal. We look forward to continuing to engage constructively with KCS’ Board to execute a definitive merger agreement in the near term and deliver the benefits of this transaction to both companies’ stakeholders.”

CP: ‘Nothing New Here’

Following the KCS and CN announcements, CP said:

“It is not surprising that CN would raise its offer, and it only highlights CN’s recognition of the significant regulatory risk/challenges associated with its anti-competitive bid.

“There is nothing new here; this doesn’t make it any more likely that the CN proposal can close into a voting trust. The Surface Transportation Board (‘STB’) already approved CP’s use of a voting trust for its pro-competitive combination with KCS.

“We believe that CP’s negotiated agreement with KCS is the only true end-to-end Class I combination that is in the best interests of North American shippers and communities. CP-KCS is a once-in-a-lifetime opportunity to not only protect all existing shippers options but to inject new competition and capacity into the North American transportation system.

“As we’ve said repeatedly, we are not going to enter into a bidding war. Our mutually negotiated agreement with KCS represents compelling short term and long term value for shareholders that is actually achievable.

“We will respond to KCS within the allotted time.”

(BofA Securities and Morgan Stanley & Co. LLC are serving as financial advisors to KCS. Wachtell, Lipton, Rosen & Katz, Baker & Miller PLLC, Davies Ward Phillips & Vineberg LLP, WilmerHale, and White & Case, S.C. are serving as KCS legal counsel.)

COWEN INSIGHT: ‘Game, Set But Not Yet Match’

Jason Seidl

“CNI’s new offer to the Kansas City Southern Board of Directors that valued KSU’s shares at ~$325 has been deemed a ‘Company Superior Proposal’ as defined in KCS’s merger agreement with CP,” said Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl. “The offer from CNI consists of $200 in cash and 1.129 shares of CNI stock, which closed at ~$111 yesterday. This represents nearly a $40 premium to CP’s offer that stands at ~$286 per share, based upon current share prices. Additionally, CNI has agreed to reimburse KSU’s $700MM termination fee with the CP.

“KCS has notified CP that it intends to terminate its merger agreement with them and enter into the definitive agreement with CNI as outlined above. This is all subject to CP’s right to negotiate amendments to the merger agreement for at least five business days. CP has responded to this news by renewing its mantra of “we will not enter into a bidding war,” but stated it would issue a more official response within the 5-day period. CP also highlighted its belief that it has the more pro-competitive merger and continued to cast doubt on CNI’s ability to close into a voting trust (recall that CP recently received approval for its voting trust).

“CNI’s voting trust structure is virtually identical to CP’s, and it even has the same independent trustee (Dave Starling). Now, it would seem a foregone conclusion that CNI’s trust will receive approval from the STB. However, KSU was granted the exemption in the CP deal and only required an informal review of its trust. The STB stated it chose to do a more formal review instead. However, what is not known (and we have asked STB staff, but they were unable to give a definitive answer) is whether CP’s trust was approved using the public interest clause. If it was, CNI’s voting trust is likely to get approval, but if it was not used there is a chance it could not. The STB took 45 days to approve CP’s trust and could take that long if not longer to approve CN’s (a public comment period could elongate the process).

“CP appears ready to walk and roll the proverbial dice with the STB. If the STB denies CNI the voting trust, then CP is back in the running (and $700MM richer). If the STB grants CNI the voting trust, then we believe CP is officially out of the running. The granting of the trust could potentially open the door to another bidder. However, the two most obvious bidders (Union Pacific and BNSF) may not be as obvious as some think. UNP’s management appears anti-rail consolidation and also holds a stake in Ferromex (KSU’s largest competitor in Mexico). Meanwhile, the BNSF is owned by Berkshire Hathaway. Berkshire and its Chairman and CEO Warren Buffett are long-time value investors who normally do not engage in bidding wars.

‘The true power in this saga remains where it always has been—with the STB.’

“Given that CNI’s accepted bid is nearly 4% higher than KSU’s closing price and the fact that the door is slightly  open for a counter offer from CP, we feel the stock could have a marginally positive reaction to the news. Now, investors will have to wait for the STB to render its decision. Hence, the true power in this saga remains where it always has been—with the STB.”

STB Chair Marty Oberman: The ball is now in his (and the STB’s) court.

THE BLAZE PERSPECTIVE

Railroad economist and Railway Age Contributing Editor offers his analysis of what could happen next:  

Jim Blaze

“First, KCS shareholders must still vote to officially approve the CN deal with these financial terms: $200 per share in cash plus 1.129 shares of CN common stock, and an estimated total value of $325 per share, based on CN’s May 12 closing price (equal to a 45% premium on the value of KCS shares on March 19). However, KCS shareholders will not receive their cash and shares until the company is put into an independent voting trust, which the STB has yet to approve. How soon that will happen is unclear, though it could come by May 31.

“If CP does not up its bid offer, then CN will have to reimburse KCS for the $700MM termination fee, payable to the CP. CN has said it is prepared to do this.

“Sometime in the next two to three months, CN will likely file its detailed merger plans to the STB. That will document its proposed future operations, marketing strategy, facilities plans, financial pro forma income statements, cash flows and balance sheet changes from its combination with KCS. Visually, we all then get to see where there will be geographic changes in daily trains per day, operating tonnage, and proposed service delivery times. 

“This will be followed by a discovery process in which opponents to the merger or even independent potentially impacted parties can examine the CN’s plans and calculations. They will be looking for, or disputing, CN’s calculation of public benefits vs. private railroad company benefits.

“CN expects the STB to approve the merger later in 2022. However, the STB regulatory review might take as long as late into 2023. It’s too early to predict, and it’s not yet clear what judgement standards the STB regulators will use during their review process. During the two-year-or-more estimated STB review regulatory process, KCS would be run independently of CN, with former KCS CEO David Starling acting as trustee. 

“Wildcards? It has been speculated that CN might somehow ask for regulatory review by Mexican government officials of Kansas City Southern de México (KCSM). 

“After the above processes have been completed, CN can then begin to execute the merger with KCS. From my experience, mergers of such-sized railroad networks can then take two to three more years to fully implement.”

Adds analyst Chris Rooney of Vanness Company, “there is the dimension of the time value of money. CN is offering additional compensation of $1 billion over and above the $33.6 billion, or a 3% consideration, if the STB does not accord the CN transaction the same voting trust structure allowing for expedited payments in the CP transaction. In other words, the CN new terms appear to anticipate to compensation for the time value of money for the possibly deferred  receipt of funds in the CN transaction. This raises a number of issues for arbitrage to think through, but certainly the concept is helpful to CN’s position, I suppose. 

“Another matter is the effect the structure of this transaction will have on the transfer of the Mexican concession to CN. It looks like the CP + KCS transaction has been structured so that KCS continues to be the contracting party with Mexico. It’s unclear whether the structure CN contemplates produces the same result.

Adds analyst Chris Rooney of Vanness Company, “there is the dimension of the time value of money. CN is offering additional compensation of $1 billion over and above the $33.6 billion, or a 3% consideration, if the STB does not accord the CN transaction the same voting trust structure allowing for expedited payments in the CP transaction. In other words, the CN new terms appear to anticipate to compensation for the time value of money for the possibly deferred  receipt of funds in the CN transaction. This raises a number of issues for arbitrage to think through, but certainly the concept is helpful to CN’s position, I suppose. 

“Another matter is the effect the structure of this transaction will have on the transfer of the Mexican concession to CN. It looks like the CP + KCS transaction has been structured so that KCS continues to be the contracting party with Mexico. It’s unclear whether the structure CN contemplates produces the same result.

Chris Rooney

Adds analyst Chris Rooney of Vanness Company, “there is the dimension of the time value of money. CN is offering additional compensation of $1 billion over and above the $33.6 billion, or a 3% consideration, if the STB does not accord the CN transaction the same voting trust structure allowing for expedited payments in the CP transaction. In other words, the CN new terms appear to anticipate compensation for the time value of money for the possibly deferred  receipt of funds in the CN transaction. This raises a number of issues for arbitrage to think through, but certainly the concept is helpful to CN’s position, I suppose. 

“Another matter is the effect the structure of this transaction will have on the transfer of the Mexican concession to CN. It looks like the CP + KCS transaction has been structured so that KCS continues to be the contracting party with Mexico. It’s unclear whether the structure CN contemplates produces the same result.

“As to merger implementation time, I’ve seen CN in action before and believe it has the depth and reserves to pull it off with a high level of confidence. On the other hand, CP is perhaps leaner, but perhaps the link-up is inherently simpler.”

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