Kansas City Southern chooses larger, riskier rail deal with Canadian National

Kansas City Southern said May 21 it chose the larger, riskier $30.5 billion acquisition offer from Canadian National Railway after the smaller rival Canadian Pacific opted against engaging in a bidding war for the American railroad.

The Canadian railroad war saw CN competing with its smaller rival, CP, to buy KCS and create the only Canada-to-Mexico rail network in North America, that could move Canadian crude exports to the US Gulf Coast and refined products to Mexico. That combination is expected to prove more beneficial thanks to the revised United States-Mexico-Canada Agreement trade deal. With only CN having rail routes stretching from Alberta to the US Gulf Coast now, adding KCS would allow CN to further dominate the crude-by-rail market.

"KCS is the ideal partner for CN to connect the continent, helping to drive North American trade and economic prosperity," said CN Chairman Robert Pace in a statement. "We are confident in our ability to gain the necessary regulatory approvals and complete the combination with KCS."

Despite the termination of its initial $25 billion agreement, Canadian Pacific said May 21 it will still stand ready to move forward with KCS, arguing the CN deal likely is doomed to failure because it will struggle to pass regulatory muster. CN, on the other hand, has vehemently contended it can close the deal.

CP essentially argued it would be bidding against itself if it raised its bid because CN's "extreme" offer is "anti-competitive" and will not come to fruition.

CN has agreed to pay the $700 million termination fee to CP as part of its deal.

The next step is whether the regulatory US Surface Transportation Board will approve CN's second application to create a voting trust to close the deal. That ruling could come in June.

Both CN and CP were counting on voting trusts for their competing deals. Part of CN's argument is KCS shareholders have nothing to lose because they would be paid from the trust even if the deal fails to receive regulatory approval.

CN and KCS said the plan is to close the deal within the voting trust by end of 2021, but not combine until late 2022 upon STB approval. If the merger falls through, CN would owe KCS a $1 billion break-up fee.

The STB already approved a voting trust for CP, but rejected it for CN, arguing that CN did not yet have an acquisition agreement in place with KCS, so a second application is being filed May 21.

So CN's acquisition of KCS could still fall apart if the voting trust is denied, and that is what CP is counting on.

"Were KCS presented with the question of how to proceed following a decision by the [STB] not to approve CN's proposed use of a voting trust, CP anticipates being available to engage with KCS to enter into another agreement to acquire KCS," wrote CP attorney David Meyer in a May 21 letter to the STB.

CP CEO Keith Creel made a similar contention on May 20 at an industry conference.

"It's not necessary to engage in a bidding war to match CN's value, which is not achievable, there is no path to deal certainty. In fact, it's a path wrought with deal uncertainty," Creel said. "Our deal is the only achievable deal."

CN contends its deal would create more customer choices, better rates, and steal market share from the trucking industry.

But CP and KCS have no overlap, and their rail networks meet neatly in Kansas City, Missouri.

The US Department of Justice also has intervened asking the STB to reject CN's request for the voting trust under the same concerns.

CN said it is well prepared to follow the more stringent regulatory route.

Regulatory questions

In question are the STB's updated merger regulations from 2001 that require major deals to show they are in the public interest. Since then, no major rail mergers have come to fruition, not counting Berkshire Hathaway's 2010 acquisition of US leader BNSF, including failed flirtations from CP to merge with CSX in 2014 and with Norfolk Southern in 2016.

The STB already has said a waiver to the 2001 regulations would apply to the CP deal with KCS because KCS is the smallest major US railroad and is more regionally focused with less overlap with competitors. CP's argument is that its proposal would combine North America's sixth- and seventh-largest railroads, leaving the combined company as still just the sixth-biggest.

CN noted it would only have the fifth-largest rail network in the US if it acquires KCS. However, within all of North America, CN would grow large enough to rival the two biggest railroads, BNSF and Union Pacific.

Creel also argued that -- if STB approves the CN-KCS deal -- it would set a precedent for potentially anti-competitive rail deals, trigger more railroad consolidation. In such a scenario, he acknowledged CP could become an acquisition target. The bottom line, Creel said, is CP simply could not match a bidding war with its larger rival.

"My balance sheet against their balance sheet, my ability to pay is not the same. Our ability to get into a bidding war to outbid is not even a remote consideration," Creel said May 20. "They've decided to weaponize their balance sheet, to lever up, to use debt to balance the competition and snuff it out."

While either of the competing deals might offer cheaper shipping rates for Canadian heavy oil sands, analysts said notably greater crude-by-rail volumes would only come if major oil pipelines are shuttered, such as the in-progress Line 3 replacement project, the four-year-old Dakota Access Pipeline and the pending Trans Mountain Pipeline expansion.

Canadian oil production has recovered to its pre-pandemic volumes of about 5 million b/d of crude oil, condensate and diluent, while US production is still down by about 2 million b/d from its pre-pandemic volumes.

However, crude-by-rail volumes have not yet recovered and may not rebound for quite some time.

The merger would also have an impact on coal. KCS handled 125,435 coal carloads last year compared with 237,336 for CN, putting the combined 2020 total at 362,771 carloads, well behind Norfolk Southern, the fourth largest railroad by coal volume last year, with 551,304 carloads.

John Ward, the executive director of National Coal Transportation Association, said his organization has not taken a stance on the deal, but had joined other shippers in encouraging the STB to evaluate the proposals under the stricter 2001 merger rules.