CN Counters CPKC with a ‘Superior Proposal’ (UPDATED)

Perhaps not so surprisingly, almost exactly one month to the day after Canadian Pacific and Kansas City Southern announced their intent to merge into CPKC (Canadian Pacific Kansas City), CN made a counter-offer it said is a “superior proposal” that “will result in a safer, faster, cleaner and stronger railway.” CN’s proposal of $325 per KCS share “represents a 21% premium over the implied value of the CP transaction and values KCS at an enterprise value of $33.7 billion.”

Combining CN and KCS “will create the premier railway for the 21st century, connecting ports in the United States, Canada and Mexico to facilitate trade and economic prosperity across North America … providing superior service, enhanced competition and new market access to move goods across North America efficiently and safely,” CN said. “This rail and logistics network would reduce traffic congestion and prevent thousands of tons of greenhouse gas emissions from entering the atmosphere every day. This combination will also significantly expand the combined company’s total addressable market and provide growth opportunities across the rapidly growing USCMA network.”

“The combination of CN and KCS will create significant new revenue opportunities by connecting North America’s industrial corridor that will further accelerate CN’s industry-leading growth profile,” CN said in a letter to KCS shareholders (downloadable below). “We expect the combination to expand the total addressable markets by approximately $8 billion across the Canadian transborder, the U.S. domestic, and the rapidly-growing Mexico-U.S. markets. The combined network and the deployment of CN’s innovative, advanced technologies will produce unparalleled stakeholder benefits. We intend to add more fluid, rapid and cost efficient options across network points like Laredo, Michigan, Southern Ontario and Detroit, for both new and existing customers. The expanded market opportunity and improved network efficiency is expected to generate strong and high quality new revenues for the combined company primarily by converting trucking shipping volumes onto rail.”

Download CN’s letter to the KCS board here:

CN noted that it and KCS “have highly complementary networks with minimal overlap. Customers of both companies will benefit from faster, more direct and more efficient service for North-South trade. CN and KCS will have a robust network of end-to-end single-line services … with less than 1% overlap … from Mexico to Canada, with an enhanced ability to connect ports in the Atlantic, Pacific and the Gulf of Mexico. The combined company will be the premier service-competitive railway to Michigan and Eastern Canada, resulting in better efficiency both in terms of fuel and customer service.”

The Numbers

CN is valuing its 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 a 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 will receive $200 in cash and 1.059 shares of CN common stock for each KCS common share. 

CN said 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 said it currently estimates that the combination “would result in EBITDA synergies approaching $1 billion annually, with the vast majority of synergies coming from additional revenue opportunities, with a significant proportion expected from converting truck traffic from busy interstates and highways for better fuel efficiency at a lower cost. CN anticipates the transaction to be accretive to CN’s adjusted diluted earnings per share, excluding incremental transaction-related amortization, in the first full year following CN assuming control of KCS, and is expected to generate double-digit accretion upon the full realization of synergies thereafter. These are conservative estimates based on publicly available information and would be refined during the due diligence process.” 

CN noted, in its letter to KCS’s board, that “the cash portion of the consideration will be funded through a combination of cash-on-hand and approximately $19.3 billion of new debt. Upon closing of the transaction and including the assumption of approximately $3.8 billion of KCS debt, we expect to have outstanding debt of approximately $33.6 billion, representing a leverage ratio of 4.6x pro forma 2021E EBITDA (an adjusted debt-to-adjusted EBITDA multiple, assuming closing into trust at end of 2021). We expect to maintain an investment grade credit rating. Based on the proposed exchange ratio and CN’s current quarterly dividend of C$0.615 per share, KCS shareholders are expected to receive the equivalent of $2.08 in annual dividends per KCS share, an amount that is approximately 40% higher than the pro forma dividend per share under the CP proposal.”

CN has engaged J.P. Morgan and RBC Capital Markets as financial advisors, and said it has finalized $19.3 billion of financing commitments from them “that they are prepared to execute upon entry into a definitive merger agreement. Our legal advisors are prepared to share these commitment papers concurrently with sharing a draft merger agreement. Consummation of our Proposal would require the same regulatory approvals as those required under the agreement with CP and we are confident in our ability to successfully obtain them on a timeline consistent with the proposed CP transaction.”

Like CP and KCS, CN has deployed a website on its proposal, Connected Continent: Safer, Faster, Cleaner, Stronger. CN’s investor presentation can be downloaded here:

“CN is ideally positioned to combine with KCS to create a company with broader reach and greater scale, and to seamlessly connect more customers to rail hubs and ports in the U.S., Mexico and Canada,” said CN President and CEO JJ Ruest, Railway Age’s 2019 Railroader of the Year. “CN and KCS have highly complementary networks with limited overlap that will enable them to accelerate growth in single-owner, single-operator, end-to-end service across North America. With safer service and better fuel efficiency on key routes from Mexico through the heartland of America, the result will be a safer, faster, cleaner and stronger railway.” 

“We firmly believe our proposal is far superior to KCS’s existing agreement with CP because it offers superior financial value over the immediate and long-term, a more complementary strategic fit, greater choice and efficiencies for customers and enhanced benefits for employees and local communities,” added CN Chair Robert Pace. “We look forward to engaging constructively with KCS’s Board and all relevant stakeholders to deliver this superior transaction.” 

KCS Responds; Support for CPKC Reiterated

Kansas City Southern, whose share price skyrocketed more than 18% on the NYSE after CN’s bid, closing at $295.50, responded only by stating the facts: That it “has received an unsolicited proposal from Canadian National Railway to acquire KCS in a cash and stock transaction valued by CN at $325 per KCS share.”

“The KCS board of directors will evaluate CN’s proposal in accordance with the terms of KCS’ merger agreement with CP, and will respond in due course,” KCS said in a statement released shortly before 1:00 p.m. EDT. “The KCS board of directors has not made any determination with respect to CN’s proposal at this time.”

Shortly after KCS’s brief response, KCS and CP separately issued identical press releases stating that support for their merger had grown to 405:

“Bartlett Grain, Port of Milwaukee, Asociación Mexicana de la Industria Automotriz A.C. (AMIA) were among stakeholders that filed statements with the Surface Transportation Board in support of the planned combination between the two companies. They join more than 405 supporters across the broad spectrum of the transportation supply chain that have filed letters with the STB …  Shippers and supporters stated they expect the combination of CP and KCS would, among other benefits, invigorate transportation competition, expand access to existing and growing markets and provide new service offerings that would improve transit times and reliability.

“Many of the supporters also requested the STB to review the transaction as efficiently as possible so the systems could be integrated, and the end-to-end benefits of this combination can be realized for the benefit of all stakeholders. The CP-KCS combination is expected to provide an enhanced competitive alternative to existing rail service providers and is expected to result in improved service and efficiency to customers of all sizes. When combined, the CP-KCS network would remain the smallest of six U.S. Class I railroads by revenue.”

CP Responds: CN Proposal ‘Unsolicited, Anti-Competitive, Illusory, Inferior’

CP was totally unrestrained in responding to CN’s counter-proposal, calling it “illusory and inferior because it creates adverse competitive impacts and raises other serious public interest concerns” and “increases regulatory and anti-trust risk for KCS shareholders and decreases benefits for customers, employees and other stakeholders.”

“CN’s proposal is massively complex and likely to fail,” CP said, guns blazing in a press release issued late on April 20. “[It] would create the third-largest Class I railroad [after UP and BNSF] and destabilize the competitive balance in the North American rail industry. The only combination involving KCS that is clearly in the public interest is the one that Canadian Pacific has proposed, which has already garnered support from more than 400 shippers and other stakeholders. While remaining the smallest of the six U.S. Class I railroads by revenue, a combination [of] CP and KCS creates stronger single-line competition against existing Class I routes.”

CN’s proposal “would reduce competition and negatively impact shippers,” CP said, and for the following reasons:

• “Between the upper Midwest and Gulf Coast—in corridors like the Twin Cities to New Orleans—the CN proposal would reduce the number of independent routing options from four to three.
• “CN’s proposal would eliminate head-to-head competition for large numbers of shippers at numerous locations across KCS’s system. The STB has previously recognized that CN and KCS ‘compete aggressively for traffic.’ 
• “CN’s suggestion that competition is limited to a handful of shippers between Baton Rouge and New Orleans is false. CN and KCS’s parallel lines between those points serve large numbers of shippers and their proximity has prompted build-in/build-out competition in the past. 
• “In addition, both CN and KCS serve large numbers of shippers in western Iowa and eastern Nebraska, at Jackson, Mississippi, East St. Louis, Illinois, Springfield, Illinois, and both reach the port of Mobile, Ala.”

CP didn’t stop there, taking aim at what it called CN’s “history of over promising and underdelivering” and “inferior safety and accident performance,” even getting a bit personal:

“The CN management team has significantly underperformed over a decade and has a track record of underdelivering against its own projections. Specifically, CN has been the worst performing Class I railroad over the past 10 years by total shareholder return. This calls into question the financial projections they have made regarding a CN/KCS combination and puts significant value at risk for KCS shareholders.

“Importantly, CN has consistently delivered inferior safety and accident performance. In contrast, Canadian Pacific has been North America’s safest Class I railroad for 15 consecutive years based on Federal Railroad Administration-reportable train accident frequency.

“Canadian Pacific and its management team, led by CEO Keith Creel, have consistently outperformed the industry with a track record of exceeding expectations. In addition, Keith Creel, a native of Alabama, brings deep knowledge of the U.S. rail networks and extensive operating background, essential to making a combination with KCS successful.”

Bringing the two largest Class I’s, Union Pacific and BNSF, into its argument, CP said that “a combination of CP and KCS enhances competition, creating new and stronger competitive options against existing UP, BNSF and CN single-line routes, as well as trucks. One prime example: It would benefit the U.S. Upper Midwest grain-growing regions of the Dakotas, Minnesota, and Iowa, where CP/KCS will inject new competition for shippers now beholden to UP and BNSF to reach the Gulf and other end markets. The CN proposal would not bring these benefits.

“The CP/KCS combined network’s new single-line offerings would deliver dramatically expanded market reach for customers served by CP and KCS, provide new competitive transportation service options, and support North American economic growth. Importantly, no customer will experience a reduction in independent railroad choices as a result of the transaction. The transaction is also expected to create jobs across the combined network, and efficiency and service improvements are expected to achieve meaningful environmental benefits.”

SIG Analysis: ‘Three’s a Crowd’; 4 Scenarios 

Long-time rail industry analyst Bascome Majors, CFA, Senior Equity Research Analyst – Industrials at Susquehanna International Group, with SIG colleagues Ann Marie Ott and Jeff Johnson, offered several observations and four possible scenarios about the events that continue to unfold:

“CNI’s offer for KSU is financially superior to CP’s bid, and carries only modestly more regulatory risk (not true end-to-end like CPKC, but minimal overlap),” SIG said in its Three’s a Crowd analysis. “Our sense is CP is more likely to raise its bid than walk away (room for more leverage, benefits from ~$700 million break-up fee if KSU walks), and KSU will ultimately merge with a Canadian rail. That said, an entry of BNSF or UNP’s greater firepower into the process could complicate things for CNI and CP.

“On financial terms alone, the CNI bid is clearly superior to CP’s, even considering the $700 million (~$7.70/share) break-up fee KSU would have to pay CP for accepting another offer. Based on deal terms and intra-day [April 20] share prices, the CP bid is ~$265/share, and the CNI bid is effectively ~$310 per KSU share (gross consideration ~$317 [$200 cash, $117 stock], less ~$7.70/share KSU would owe to terminate the CP merger agreement).

“Scenario 1: CP Matches CNI Bid: Being left at the altar by KSU for competitor CNI would be a strategic blow to CP, leaving it as the only notably smaller Class I in terms of revenue and network reach, despite having the industry’s consensus top CEO in Keith Creel. That suggests a willingness to defend its deal terms for strategic reasons, even with less balance sheet firepower than CNI brings to the table, and higher financial deal risk from greater leverage and lower accretion than their initial bid anticipated. Our math suggests CP could raise their offer to an effective ~$315-$320 range to compete with CNI’s bid by increasing the cash consideration +$55 to $145 and leaving the share exchange ratio steady (0.489), which would require an extra ~$5 billion in new debt and take pro-forma leverage near the ~4.5x range for 2021E. We estimate this would drive immediate pre-synergy EPS dilution higher (to mid-to-high single-digit dilution for 2021-22), and mute longer-term post-synergy accretion (from double-digit to mid-single-digit). To be clear, CP’s balance sheet capacity is outmatched by CNI and both [UP and BNSF], but our sense is a CNI bid for KSU was not a surprise to CP (run by former CNI executives), and outside capital could potentially add to CP’s firepower in more extreme scenarios (private equity interest in KSU is public knowledge, and recent bidding wars in other industries have seen private equity partner with strategic acquirers).

“Scenario 2: Berkshire Hathaway and BNSF Join the Fun: Berkshire’s $138 billion cash balance and clear synergies between the BNSF and KSU networks suggest the potential to make a cash offer that no other railroad could compete with (CNI’s offer comes to a $29 billion price for KSU’s equity at intra-day range). That said, Berkshire’s reluctance to dive into megadeals in recent years and historic aversion to competitive bidding situations suggest this isn’t as probable as it is possible. Berkshire’s last mega-acquisition was Precision Castparts Corp. for $37 billion EV in 2016, which Warren Buffet described in February 2021 as a ‘big’ error for which he paid too much, leading to an ‘ugly’ ~$11 billion write-down in 2020. Given the competitive nature of this transaction and even greater capacity on Berkshire’s balance sheet, we wouldn’t be surprised to see BNSF bide its time as KSU irons out the STB’s regulatory kinks, with BNSF potentially pursuing a larger negotiated east-west merger later in 2022 or 2023. 

“Scenario 3: There’s Room for UNP, Too: While UNP doesn’t have Berkshire’s cash balance, its size and balance sheet offer plenty of financial firepower to compete with CNI or CP in a KSU bidding war. More specifically, we estimate UNP could match CNI’s ~$200/share cash portion by taking pro-forma 2021E leverage to a manageable 3.5x, or stretch to an all-cash superior offer in the ~$330/share range at ~4.2-4.4x EBITDA. To be clear, we’re not arguing UNP should enter this competition, given the steep price for KSU and higher bar for regulatory risk than either CP or CNI would have (note UNP-KCS’s existing network overlap in the U.S., and the need to somehow divest Mexican railroad interests as UNP already owns [26%] of KCS de México’s only Class I competitor, Ferromex). We’re simply saying that by the numbers alone, UNP certainly could play. 

“Scenario 4: Everyone Gets a Slice: After a bidding war for Conrail in the late 1990s, remaining Eastern Class I’s CSX and NSC settled on splitting Conrail’s assets between them. While not impossible, this feels less probable in today’s KSU situation, particularly with CP offering a true end-to-end proposal and CNI offering very minimal network overlap. If BNSF and UNP were to engage with their own offers, the situation could of course change.”

Cowen Insight

“We suspect CN’s competing bid will not be the last offer made for KSU, given the opportunities/synergies associated with the combination,” said Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl. “At this point, we put our KSU price target under review and await a potential counteroffer.”

“Under the terms of the deal, CNI will acquire KCU in a transaction that values the company at $325, based on the April 19 closing price of CNI stock. KSU shareholders would receive C$200 in cash and 1.059 CN shares for every KSU share, implying an EV of C$33.7B. This represents a ~20% premium when compared to CP’s offer (based on CP and CNI closing price April 20), and $110 more in cash per share. To fund the merger, CNI would raise C$19.3B in debt, which would bring its leverage to 4.6x in 2021 and 3.5x in 2023, per CNI. The deal would offer an identical voting trust to what CP proposed, with the intention of closing into voting trust in 2H21, and gaining approval and closing the acquisition by 2H22. The only difference is CNI does not require shareholder approval, which we do not view as significant. 

“This merger would connect ports of U.S., Mexico and Canada, and similar to CP’s proposal, would reduce bottlenecks in the Chicago area. CNI expects to achieve $1B in EBITDA synergies within 3 years of integration, ~80% of which will be revenue related, with about 75% of the revenue synergies coming from the intermodal side. CNI highlighted the largest efficiency created will be the eventual benefits tied to long-haul truck to the rail supply chain that would create the third-largest intermodal network in North America, behind BNSF and NSC. The remaining 20% of synergies would come on the cost side. Management stated some capex will need to be committed but will end up around ~20% of revenue, especially as the port of Prince Rupert continues to grow with 450K TEUs likely to come onboard over the next few years. 

“Comparing the synergies that CP highlighted when the initial merger was announced, CP management cited $780MM of annualized revenue synergies within three years, slightly less than what CNI stated ($800MM in revenue synergies), although we note that CP’s synergies are likely a conservative number. CNI has a small amount of north/south exposure that poses some slight overlap with KSU, with tracks that are 40 miles apart, serving different markets and customers. 1% of networks between KCS and CN overlap, 65 miles out of 7,500. 

“In terms of business mix and geographic revenue, combined revenue mix would be 56%/35%/9% among Canada, U.S., and Mexico, respectively for CNI/KSU, in the similar ballpark of CP’s combined of 53%/33%/14%. Both business mixes offer a more diversified portfolio

“In a directly worded response that echoed of days past where both railroads competed with more of an edge, CP issued a comment in response to CN’s bid. CP described its rival’s proposal as ‘illusory and inferior because it creates adverse competitive impacts and raises other serious public interest concerns.’ The response goes on to highlight the negative impact on shippers, destabilizing the competitive balance, and CN’s ‘history of over promising and underdelivering.’ The gloves have been dropped, and at this point, we expect more news in the coming weeks regarding the intended merger, given both CNI and CP appear to be fully invested in KSC. CP’s response did not mention any review of its previous deal terms or whether they intend to post a counter offer. 

“We fully expect a counter bid from CP as KSU appears too good of a property to give up without a fight. Hence, we expect bids to go up from here, and can envision a scenario where one railroad significantly ups the cash portion of the offer.”

Editor’s Commentary

Are we having fun yet? Today (April 20), has been a long one. I well-remember the mega-mergers of the 1990s that concluded with the battle for Conrail, and the privatization of Mexico’s national railway that led to KCSM and Ferromex. So, as legendary New York Yankee Yogi Berra said, “It’s deja vu all over again.” Here, for what they’re worth, are a few observations.

Interestingly, there are three consecutive Railway Age Railroaders of the Year involved in this unfolding game of full-size Railroad Monopoly: CN President and CEO JJ Ruest, 2019 Railroader of the Year, followed by KCS President and CEO Pat Ottensmeyer in 2020 and CP President and CEO Keith Creel in 2021. Outstanding leaders and good people, all three, running three excellent railroads. Bear that in mind as the war of words and dollar signs escalates from what started on March 21 as a happy, all-smiles betrothal of two willing partners to what’s beginning to look like the railroad version of My Big Fat Greek Wedding.

Pat Ottensmeyer was instrumental in shaping USMCA, the United States-Mexico-Canada Agreement, the successor to NAFTA that’s often called “NAFTA 2.0.” Both proposed mergers, CPKC and CN/KCS, which doesn’t have a formal proposed name (yet), are being informally called the “USMCA Railroad.” You can add two former KCS CEOs and Railroaders of the Year to the timeline: Mike Haverty (2001), who started the ball rolling by winning Mexico’s Northeast concession, today’s KCSM (the “NAFTA Railway” back in the day); and Dave Starling (2012), who picked up where Haverty left off and continued the growth. Starling is trustee of the CPKC transaction’s voting trust, if and when it gets under way.

“Things,” as of late on April 20, were starting to heat up, with CP hauling out the heavy artillery and engaging, as expected, in a frontal assault. I wonder what Hunter Harrison, Railway Age’s two-time Railroader of the Year (2002 and 2015) must be thinking from his observation post in the afterlife. Hunter worked with Keith Creel and JJ Ruest at CN, and Keith left CN to work with Hunter at CP, as his heir-apparent. Perhaps Hunter is saying, “Ya’ll play nice, now!”

But that ain’t happenin’, Hunter. “Unsolicited, anti-competitive, illusory, inferior”? Hell, they be fightin’ words, what CP just hollered. They be as strong as two shots of Canadian Club or Wild Turkey (take your pick), straight up, no chaser. But they’re just words, and it’s only money. Easy for me to say, eh?

Let’s be clear: Our 2021 Railroader of the Year, Keith Creel, is a seasoned combat veteran, a former commissioned U.S. Army officer who served in the Middle East. He’s prepared for battle. He also learned from arguably one of the best tacticians in railroad history, Hunter Harrison. But at the same time, Keith Creel lives and breathes duty, honor, respect and service, as a tried-and-true railroader—fiercely loyal to CP and its people, but also to this industry.

But here’s something else to consider, for the longer term. First, two facts: CPKC would be the smallest of six North American Class I’s. CN/KCS would be the third-largest. In my opinion, the latter is more likely to trigger additional consolidation than the former. If that should happen, the industry could be exposing itself to additional regulatory risk—something that no railroader, as least as far as I know, wants. We must ask ourselves where we want to devote our resources: to growth, or to fighting reregulation? None of this is certain, of course. It’s merely a possibility.

Remember folks, this isn’t war. I trust that the good people of this industry will make decisions based, in part, on objectively considering the risks and the rewards. Right?

As for me, I will follow the great Yogi Berra’s insightful quip that “you can observe a lot by watching.” I’ve come to a fork in the road. I think I’ll take it.

– William C. Vantuono, Editor-in-Chief