On Aug. 30, 2021—the day before the Surface Transportation Board rejected the voting trust for the proposed CN/Kansas City Southern merger—TCI Fund Management Ltd. filed a Schedule 13D form with the U.S. Securities and Exchange Commission to report that it had increased its stake in CN to 5.2%. TCI already is CN merger rival Canadian Pacific’s second-largest shareholder. Some industry observers found TCI’s move “interesting” and “critical” as the activist hedge fund has strongly objected to CN’s merger attempt with KCS.
Schedule 13D, also known as a “beneficial ownership report,” is a form that must be filed with the SEC when a person or group acquires more than 5% of any class of a company’s equity shares. There are several pieces of relevant information that must be disclosed within 10 days of the transaction.
On May 18, TCI, then CN’s sixth-largest shareholder with 3% of the railroad’s stock, posted an open letter on its website to CN Board Chairman Robert Pace demanding that CN abandon its pursuit of KCS. The letter, signed by principals Sir Chris Hohn and Ben Walker, went as far as calling CN’s financial commitment “negligent and hugely irresponsible.”
“TCI, through entities it manages, has been a CN shareholder since 2018 and currently owns more than 20 million shares of the company,” Hohn and Walker wrote. “TCI is also CP’s largest shareholder. It does not own a position in KCS. In light of the [May 17] ruling [in which STB decided that CN’s proposed merger with KCS would be reviewed under current merger rules and denied CN’s motion to approve a proposed voting trust agreement as incomplete, ‘without prejudice to filing a new motion’], we think it is negligent and hugely irresponsible for the CN board to commit C$2 billion of shareholders’ money on whether the STB will approve the voting trust for the CN-KCS transaction.“
“It is now clear that CN should abandon its pursuit of KCS unless the merger agreement is amended such that it is not conditional on a voting trust being approved,” Hohn and Walker said. “The STB is sending a clear signal and the CN board has a duty to listen. The risk that the voting trust is not approved is too great to ignore. In summary, the rules have changed. Therefore, there is no way the CN board can have any confidence in how these new rules will be interpreted because they have never been used before. Making what is essentially a C$2 billion bet with company money on this one, unknowable decision would be extremely reckless. Furthermore, and much more significant, even if the voting trust is granted, there can be no certainty on how the STB will evaluate the new rules when it comes to approving the deal. In this scenario, CN could be faced with an even bigger C$18 billion liability if ultimately the transaction is not approved and the trust has to dispose of KCS under potentially distressed conditions.”
In late 2020, KCS had a market cap of US$16 billion. “CN has offered to pay US$30 billion,” Hohn and Walker noted. “If the deal is not approved by the 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/C$18 billion. This would almost wipe out CN’s entire shareholders’ equity that it has taken more than 100 years to accumulate. It could also seriously jeopardize the future of the company. CN already has a tremendous North American rail network; it does not need KCS to prosper in the future. It is time to end this ill-advised misadventure. In the event that you and the board choose to ignore this recommendation and sign a merger agreement in its current form, but the voting trust is not approved, resulting in a loss of C$2 billion, we would expect the immediate resignation of you and the CEO.”
According to Wolfe Research, TCI’s Aug. 30 13D filing “noted potential for TCI to engage with CN with respect to the company’s operations, management, board, capital structure, etc. The timing of this filing is interesting ahead of the STB’s expected ruling on the CN-KCS voting trust. TCI is also the second-largest shareholder of CP, and it now has equal ~$4B stakes in the two Canadian railroads. TCI was also the original activist investor in the rail industry with its proxy fight against CSX in 2008.
“We expect the STB to announce its ruling on the CN-KCS voting trust [on Aug. 31], and KCS will then conduct its shareholder vote to approve the CN merger on [Sept. 3]. If the STB approves the voting trust, we expect that KCS shareholders will vote to approve the merger with CN, and CN will acquire KCS in trust in 4Q2021 and await STB merger approval sometime in second-half 2022 or perhaps early 2023.
“But if the STB rejects the voting trust, we see two potential outcomes. CN could try and raise the bid for KCS yet again to try to convince KCS to wait out full merger approval to get a higher price. Alternatively, if the voting trust is rejected and CN doesn’t raise the bid again, it seems likely to us that KCS shareholders will vote against the merger with CN, and then KCS can re-engage with CP [which upped its offer to $300 per share]. In that scenario, KCS would owe CN a $700 million breakup fee. Given the activist filing from TCI, it now seems less likely to us that CN would raise the bid again if the voting trust is rejected.”
“CN’s margins have declined for 5 straight years, and we estimate CN’s ~62% operating ratio this year will be worst in the group and nearly 700 basis points worse than CP’s,” Wolfe Research noted. “Over this timeframe when CN’ s margins have gone from best to worst in the industry, CN has also reported the worst EPS growth among the rails, and its stock has materially lagged all the other rails and the S&P 500. So, we believe CN now has the most turnaround potential among the rails. We don’t see signs that CN is becoming more focused on margins yet, but if CN doesn’t end up with KCS, we expect that management will start to refocus on margin improvement to help accelerate overall EPS growth. But if CN’s management team doesn’t deliver on its turnaround potential, continued margin and EPS underperformance could be a catalyst for activism.”
Now that the STB has unanimously rejected the CN-KCS voting trust, CN—provided the merger is abandoned—will have to pay a US$1 billion reverse break-up fee to KCS. This comes in addition to its reimbursement to KCS of the US$700 million break-up fee that KCS paid to CP after the CPKC deal was terminated.
Railway Age Capitol Hill Contributing Editor Frank N. Wilner recalls that “in 2008, when TCI emerged as an activist investor seeking CSX board seats, it was led by Stanford University MBAs Snehal Amin (Class of 2000) and Rishi Sunak (Class of 2006), who bonded while senior equity analysts at Goldman Sachs. They departed TCI in 2009 to form their own hedge fund, Theleme Partners. Since 2013, Amin has run his own hedge fund in Houston (Windacre Partnership, which currently has no railroad holdings), while Sunak was elected to the British Parliament in 2014 as a Conservative, and currently serves under Prime Minister Boris Johnson as Chancellor of the Exchequer.
“Notably, in 2007, Amin and Sunak challenged the STB’s use of historical rather than replacement costs in valuing a railroad’s investment base when computing return on investment (ROI), which is crucial in determining railroad revenue adequacy.
“Amin and Sunak argued that ‘In a business where you must reinvest at today’s costs, you must also evaluate returns at today’s cost. If you bought a home in Manhattan 50 years ago for $100,000, and it is now worth $1 million, would you accept an offer from a tenant who offered to pay you a fair rent based on the original purchase price, instead of a fair rent based on the value of the home today?’ When the Association of American Railroads the next year petitioned the STB to shift to replacement costs, the STB denied the petition, ruling the shift ‘cannot be practically implemented in a manner that we can be confident would produce accurate and reliable results.’”
In a May 2016 Railway Age Watching Washington column, Wilner quoted Amin—then heading Windacre Partnership— that CSX, Norfolk Southern and Union Pacific managements “are not being adequately challenged because they do not separate the roles of Chairman and CEO as do BNSF, CN and CP. An independent, industry-knowledgeable Chairman, responsible to shareholders, should be challenger-in-chief of the CEO. Combining the titles allows the Chairman/CEO to handpick a board of directors, encouraging perpetuation of the status quo and compensation less reflective of results. The best performing railroads have separate Chairman/CEO roles. I don’t think that is a coincidence.”
Wilner’s new book, Railroads & Economic Regulation, will be published in early fall by Simmons-Boardman Books.