David Olive: In huge CN-CP bidding war over U.S. railway, maybe CP ought to have the inside track

Corporate bidding wars are seldom pretty.

But corporate Canada has seldom seen a slugfest as ugly as the battle between Canadian Pacific Railway Ltd. and archrival Canadian National Railway Co. to acquire Kansas City Southern (KCS).

KSC is a strategic jewel in the North American freight-rail industry. Merging KCS into CP or CN would create the first truly continental freight-rail network.

KSC’s 9,800 km of track runs the length of the U.S. heartland, from Chicago to New Orleans — and it includes the North American industry’s biggest Mexican rail network, which extends into Panama.

A CN-KSC or CP-KSC network would connect U.S. Midwest farms, Canadian resource producers and Mexican auto-assembly plants with KSC’s U.S. ports on the Gulf of Mexico and its Mexican ports on the Atlantic and Pacific oceans.

On March 19, CP and KSC unveiled a friendly $ 31.4-billion merger.

But on Tuesday, CN disrupted the biggest expansion plan in CP’s 140-year history with a $ 37.7-billion counterbid that offers a stunning 44 per cent premium to KSC’s price before CP put KSC in play, besting the CP offer’s 23 per cent premium.

CP has not responded with a still higher bid for KCS, which would be standard practice in bidding wars. Instead, CP has launched a campaign dismissing CN’s chances of winning U.S. regulatory approval for its proposed takeover, as well as attacking CN’s reputation.

Arguing that only its bid for KCS could earn regulatory approval, CP alleged that a CN-KSC combination would reduce competition and raise prices for shippers and their clients.

Then CP dragged CN through the mud, claiming that over the past decade, CN has delivered the lousiest shareholder returns of its peers among the six Class I railways (North America’s largest).

And CN’s safety and accident record has been “consistently inferior,” CP said, in contrast with CP’s 15 consecutive years as North America’s safest in Class I, according to the U.S. Federal Railroad Administration. (A word about the veracity of those claims later.)

The suitors’ ability to reward investors matters to KCS shareholders, because in CN and CP’s cash-and-stock offers they will become shareholders of the merged company.

And antitrust and safety are determining factors for the U.S. Surface Transportation Board (STB), whose approval is required for any deal. The STB played a role in deep-sixing three proposed Canadian takeovers of U.S. railways in the past two decades.

The reputational factors are CP’s high cards in winning KCS, and maybe its only ones. CN’s intended knockout bid is so high it’s tough to see CP topping it, and CP said on Wednesday it won’t try to, given what it sees as the improbability of a CN-KCS deal winning regulatory approval.

CN is offering “fantasy money” in a proposed takeover that is “not a real deal as far as I’m concerned,” Keith Creel, CP’s CEO, said on Wednesday.

Some market analysts expect CP to raise its bid just the same, or at increase raise the cash portion of it to match CN’s cash component.

The 134-year-old KCS will be a handsome prize for whoever wins it.

KCS is North America’s only remaining mid-sized Class I railway. It is CN and CP’s last chance at significant growth by acquisition.

The two Canadian companies are also betting on economic recoveries underway in the U.S. and Canada. And the Canada-U.S.-Mexico Agreement signed last year is expected to increase trade flows throughout the continent.

The two would-be buyers also see growth opportunity in a pandemic-driven return of manufacturing to North America, a nascent trend to strengthen supply chains called “on-shoring” or “nearshoring.”

CN and CP also believe that with KCS they can convert an estimated annual $ 10 billion in truck volume to rail. That sum equals about 70 per cent of CN’s 2020 revenues, and would increase the smaller CP’s revenues by 142 per cent.

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The reaction of all-important shippers to a CP-KCS merger has been cautiously positive. The industry journal FreightWaves lauds CP’s pledges to streamline some lines and create intermodal service on others. CP has amassed more than 700 letters of support from shippers for a CP-KCS merger.

Back of either deal’s attractive fundamentals is the bad blood between the rival bidders, whose interest in Kansas City Southern isn’t entirely economic.

Earlier failed CP bids for U.S. railways, in 2014 and 2016, fell victim to, among other factors, objections from competing Class I railways, including CN.

Last month, CN nervily objected to the CP-KCS deal, too, before making its own play for KCS.

In 2016, CN extracted a $ 25-million settlement from CP over alleged pilfering of customer lists by employees moving between the two companies. CN has coveted KCS on and off for two decades; winning it would be a bit of payback for CP.

And what of CP’s badmouthing of CN, noted above?

A CN-KCS combination could reduce competition, as CP argues. CN’s existing U.S. north-south corridor roughly parallels KCS’s U.S. mainline. Merging the firms means one owner of both corridors. (CP’s U.S. tracks extend no further south than Kansas City.)

CP also has a case about safety. CN’s Federal Railroad Administration train-accident ratio has risen from 2016’s 1.42 accidents per million train miles to 2.11 in 2019. By contrast, CP’s ratio has improved from 1.12 to 1.06 in the same period.

Meanwhile, CN’s operating ratio has been deteriorating for years. That’s the industry’s key benchmark for measuring operating cost per mile, a number that rail operators strive to reduce.

Last year, CP’s operating ratio was an exemplary 57.1 per cent, to CN’s 64.4 per cent — a troubling rise from 2018’s 61.6 per cent.

As a result, CP last year boasted the highest profit margin of its Class I peers, at 31.7 per cent, to CN’s 25.8. And CP has done a better job than CN in rewarding shareholders, with a 165 per cent gain in stock value in the past five years, to CN’s 79 per cent, lowest of the Class I freight railways.

But money talks. KCS shareholders won’t easily resist the 21 per cent premium CN is offering for their shares over CP’s bid. It’s understandable that CP is trying to dismiss CN’s bid as a regulatory non-starter, given that a higher bid from CP is tough to justify.

This struggle promises to be a drawn-out affair, with a Surface Transportation Board decision not expected until as late as 2023. The two bidders will spend that time appealing for support from shippers and local and state politicians across the continent.

In the annual Oscars contest, there are nominated films that deserve to win. And those that actually will. CP might not get the prize, but from the looks of things it deserves to.

TORONTO STAR