Gloves are off in battle for U.S. railway
Analysts expect lucrative opportunity for KCS may unleash CP-CN bidding war
Canadian National Railway Co. on Thursday accused Canadian Pacific Railway Co. of trying to “distract investors” after the chief executive of CP called CN'S competing offer for Kansas City Southern “fool's gold.”
Canada's biggest railways have been sparring over KCS, a U.S. rail operator, since Tuesday, when CN trumped a previous Us$25.2-billion bid from CP with a Us$33.7-billion offer of its own. In a letter to the KCS board on Thursday, CN CEO Jean-jacques Ruest said that CP was distracting investors with “inaccurate and unfounded assertions.”
“CP'S claims are not intended to benefit KCS shareholders, but to advance CP'S own interests and to deprive KCS shareholders of the full value for their shares,” Ruest said in the letter.
The statement came in response to CP chief executive Keith Creel's remarks during the Calgary-based company's first-quarter earnings call on Wednesday evening. Creel listed more than 20 “truths” that the company believes demonstrate the benefits of CP'S offer and the downsides of CN'S bid.
Creel argued that CP is the only company that can execute the deal, saying that CN'S higher offer is unachievable because it relies too heavily on debt to finance the acquisition and that it will face insurmountable regulatory hurdles. As a result, there's no need for CP to raise its bid, he said.
“It's nothing that we're considering at all,” Creel said.
“I frankly don't believe that's the right value proposition for our shareholders, to put our balance sheet at risk to use all of our capacity and our powder to respond to shots in the market — I just don't think that's a healthy place to go to at this point. And in all honesty, I don't have to think about that because it's not a true alternative.”
The competing offer from Montreal-based CN came one month after CP struck a friendly agreement to buy the U.S rail operator for US$25.2 billion. The deal would allow either railway to extend their rail networks to the Pacific Gulf and into Mexico, enhancing access to key trade routes. CN'S offer represents a 20-per-cent premium to CP'S.
Either deal would create a truly North American network that touches the United States, Mexico and Canada and gives the winner access to auto plants, ports and grain and petroleum products.
Creel said that he was not surprised that CN jumped in on the opportunity, but that the sticker price was a shock.
“Were my eyes open when I read (CN'S) press release yesterday? The truth is, yes. That value number was undeniably eye-opening,” Creel said Wednesday. “But the reality is that it only matters if it's attainable.”
While CN'S bid is higher, analysts noted that CP'S offer provides KCS shareholders with a larger opportunity to participate in the company's future. Both railways offered cash-and-stock deals, but they're weighted differently. KCS shareholders will have to decide whether they would prefer to take more upfront in cash with the CN deal, or more in equity that could pay off in the long-term — or fall flat depending on the combined company's performance.
CN'S said that its bid represents a 27-per-cent premium to Kansas City Southern's closing price of US$256 on Monday and a 45-per-cent premium to the price prior to CP'S offer. As part of its Us$325-per-share offer, US$200 is cash.
CP'S bid checks in at US$275 per share, but with US$90 in cash it provides shareholders with a larger equity stake, which also comes with the risk or reward of betting on the combined company's future.
Though smaller, CP'S offer could be enticing enough to avoid raising its offer, some analysts say.
“While CN'S bid is financially superior to CP'S bid, it does face more regulatory risk,” CIBC analyst Kevin Chiang said in a note.
“As such, we do not believe CP'S bid needs to match CN'S proposal if it does decide to raise its offer. We also believe that CP does have the financial flexibility to raise its bid if needed.”
In the letter to the board, Ruest denounced CP'S claims that regulators would not approve CN'S proposal. “CN is confident that the (STB) will not subject CN'S proposal to any different standard or scrutiny in approving the voting trust than would be applicable to CP'S proposal,” Ruest said.
“CP'S deliberately misleading claims to the contrary are not correct.”
To fund the deal, both railways are taking on billions of dollars in debt. While CP will add Us$8.6-billion of debt to its balance sheet, CN will accrue more than double that at Us$19.3-billion.
“They're prepared to go to a 4.6x balance sheet, locking up their capital and the money they would need to invest in this proposed combination,” Creel said. “The headline value could be 500-per-cent more than our real, attainable value — it's fantasy money. It's fool's gold.”
But the opportunity is too lucrative to lose, and a bidding war could be the only way forward, according to some analysts.
“We fully expect a counter bid from CP as (KCS) appears too good of a property to give up without a fight,” Cowen and Co. analyst Jason Seidl said in a note in advance of the earnings call. “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.”
CP'S rail system currently runs coast to coast in Canada, but only as far south as Kansas City in the U.S. The deal would provide it access to high-traffic ports in the Gulf of Mexico.
CN, meanwhile, now reaches as far south as New Orleans, 40 miles east of KCS'S tracks. Sixty-five miles of CN'S 7,500 miles of track overlap with KCS, which Creel and some analysts say could trigger competition concerns with U.S. regulators.
The deal requires the approval of CP and KCS shareholders, as well as the Surface Transportation Board, a U.S. regulator that requires that mergers enhance competition and avoid reducing choices for customers seeking to transport goods to market.
By revenue, the combined company under CN would create the third-largest Class 1 railroad in North America, while a KCS merger with CP would still make up the smallest of big railroads.
“Regulatory risk is somewhat greater for CNR than for CP, in our view,” Desjardins analyst Benoit Poirier said in a note. “For CNR, we believe the network overlap with (KCS), albeit limited, and the size of the combined entity will impact the STB'S final decision.”
CN projects that the merger could yield US$1 billion annually in new revenue opportunities, and analysts expect each railway to put up a fight for the routes to Mexico.
“The gloves have been dropped,” Seidl said.