Introduction:
On the 21st of March 2020, Canadian Pacific Railway Limited (CP), a Canadian railway company, and Kansas City Southern (KCS), a US railway firm, announced an agreement through which CP will acquire KCS for $29 billion.
Through this deal, CP values KCS at $275 per share, representing a 23% increase with respect to KCS closing price on the 19th of March. Additionally, this transaction is both cash and equity-based, as each KCS shareholder will receive 0.489 of a KCP share and $90 in cash, for each KCS share held.
The transaction will create “the first rail network connecting the U.S., Mexico and Canada”. Besides the obvious advantage for customers, this deal creates large value for both companies. As a matter of fact, “The combined network’s new single-line offerings will deliver dramatically expanded market reach for customers served by CP and KCS”. Furthermore, local communities will benefit from this deal, especially during the pandemic, as the combined network will create new jobs opportunities. Finally, the new network will “shift trucks off highways”, thus lowering CO2 emissions. In this regard, this deal also reflects the changing in favor of sustainability.
Companies’ Overview:
Canadian Pacific Railway (CP)
Founded in 1881 and based in Calgary (Canada), the Canadian Pacific Railways is a Class 1 transcontinental railway, providing freight and intermodal services over a network of 12,500 miles of railways in Canada and the United States. Its most important railway is definitely Canadian Pacific, a railway that connects major ports in the west and the east coast.
The railway line operated by Canadian Pacific, which construction started in 1881, has been the first to connect the east coast with the west coast of Canada and played a crucial role in the colonization of the country during the XIX century. The company expanded its business outside the rail freight transportation sector. CP grew through a series of strategic acquisitions. In 1991, CP bought the Delaware and Hudson Southern. The acquisition allowed the firm to gain access to US Northeast ports like New York City.
Today the company is listed on the NYSE and the Toronto stock exchange. In terms of financial performance, CP generates around $5,8 billion in sales and an EBITDA margin of 53%.
One of the goals of CP, is to support the transition towards low-carbon emissions. Indeed, it has recently completed the installation of solar panels in Alberta, while developing the first North American line-haul hydrogen-powered locomotive. For all its efforts, in 2020 CP has been added to the Dow Jones Sustainability North America Index, an index that measures “corporate sustainability leaders’ performance through a comprehensive assessment of economic, environmental and social criteria” and that includes only the top performing ones.
Kansas City Southern (KCS)
The company was founded in 1887 by Arthur E. Stilwell. It is a class I rail carrier and operates about 3,400 route miles in ten central US states and Mexico. The firm started out its business by owning the Kansas City Suburban Belt Railway. Through several acquisitions, it expanded its operations in other states like Louisiana, Texas and Illinois. With the formation of the North American Free Trade Agreement, in 1994, a new possibility of expansion appeared. Indeed, the following year, thanks to the acquisition of a 49% stake in MexRail Inc., KCS expanded its railway system to Mexico and gained strategic access to ports both in the pacific coast of Mexico and the Gulf of Mexico. Additionally, thorough holdings in Mexico and Panama, KCS also provides ocean-to-ocean passenger transportation in the Panama Canal. It can be easily seen how much strategic KCS is for CP, as its network will allow it to link the “commercial and industrial centers of the U.S. Mexico and Canada”.
KCS is listed on the NYSE. In terms of financial performance, it generates revenues of $2.5 billion and has an EBITDA margin of 53%.
Industry overview:
Both companies are part of the $235 billion-a-year rail freight transport industry, which deals with the transportation of goods and materials on railways. At the turn of the century, this industry was the largest in the United States. The market can be differentiated by the fact that it is not administered by the government. In fact, it is managed by private companies which gives free rein to competition. Furthermore, the industry is highly consolidated, with market dominance based on regions.
The industry is most developed in China, with 3 trillion tonne-kilometres (tkm) travelled in 2019, followed by the USA with 2.8 trillion tkm, Russia with 2.6 trillion and India with about 2.45 trillion. The industry has exhibited a compound annual growth rate (CAGR) of slightly over 1.2% since 2015, fueled by the developing railroad networks in emerging economies of Africa, the Middle East, Latin America and, most notably, China and India. Globally, the sector is expected to display a CAGR of 2% up until 2025, with Asia-Pacific overtaking North America during the period.
Another key fact that should be noticed is that this industry is very cyclical. Which means that its correlation with the overall economy is high. In other words, the level of revenues generated by the firms operating in this industry tends to increase in prosperous economies while it is very vulnerable during economic downturns.
The pandemic-related downturn resulted in an 8% decline of the global rail market. In particular, North America saw a decrease of 10.5% in rail freight traffic during the first half of 2020. On the other hand, traffic from China to the West increased year-over-year, due to China’s Belt and Road Initiative – a trillion-dollar infrastructure plan that connects Asia, Africa and Europe to prompt economic development.
The US rail freight market topped around 2014 and has been declining at an annual rate approaching 3.5% ever since. As the fixed railway networks restrict head-on competition between carriers, the fall can be ascribed to the domination of the trucking industry, which transports an estimated 70% of the tonnage of goods and materials in America, as opposed to the 15% moving on railroads. Low oil prices in the last few years, combined with increased operational flexibility, make managing a fleet of company-owned trucks the preferred choice for short- and medium-distance hauls. However, with heavier cargo and longer distances, trains become markedly more efficient, hence the larger tonne-kilometre figures for rail freight. Nowadays the industry generates an excess of $70 billion per year in revenue, employs around 167,000 people and total routes cover over 140,000 miles.
The US Department of Transportation forecasts a 40% increase in freight demand by 2045, meaning that the sector will have a chance to capture newly developing market segments. As of now, the biggest opportunity for rail freight transport is the transition to a sustainable economy.
Since trains are up to four times more fuel-efficient than trucks, the industry could be the key to reach sustainability targets. Other notable opportunities include intermodal freight (combining land, sea and/or air transport) and using automated solutions like robots and big data to streamline operations, increase safety and coordinate the train network.
Deal Structure:
CP has agreed to buy KCS in a stock and cash transaction for a total enterprise value of approximately $28.9 billion, which includes $3.8 billion of KCS outstanding debt in the largest takeover deal this year. With an exchange ratio of 0.489, common shareholders of KCS will receive 0.489 of a CP share and $90 in cash for each KCS common share owned. Preferred shareholders will receive $37.50 in cash for each KCS preferred share held. The fixed exchange ratio implies a price for KCS of $275 per share, representing a 23% premium, based on the CP and KCS closing prices on March 19, 2021, which were respectively $378.50 and $224.16. After the transaction, KCS common shareholders will own 25 percent of CP’s outstanding common shares.
CP will issue 44.5 million new shares to fund the stock consideration of the acquisition. Despite this, the combination is expected to be accretive to CP’s adjusted diluted EPS already in the first full year after the acquisition. The cash consideration will be funded through the use of cash-on-hand and raising approximately $8.6 billion in debt. As part of the deal, CP will assume $3.8 billion of KCS’s outstanding debt.
The transaction will occur in two steps: at first, shares of KCS will be put into a voting trust created ad hoc. KCS shareholders will receive their consideration, but KCS will keep operating as an independent company. This step will finalize in the second half of 2021, and it is a necessary step because the acquisition is subject to the approval of the U.S. Surface Transportation Board, whose review is not expected to be completed before 2022. If the approval is released, the second step will consist of the full integration of the two companies, which would combine in a new entity to be called Canadian Pacific Kansas City, with the current CEO of CP to become the CEO of the new company.
If the STB was to reject the combination, CP would have to sell KCS shares which could be either sold to private equity funds or be relisted in the stock market. KCS shareholders instead would keep the consideration received.
The financial advisors for Canadian Pacific are BMO Capital and Goldman Sachs, while BofA Securities and Morgan Stanley act as financial advisors for Kansas City Southern.
Deal Rationale:
Uniting in Kansas City, CP and KCS would create the first rail network connecting the United States, Canada and Mexico. The adoption of the new USMCA (United States Mexico Canada Agreement) was one of the main reasons behind CP’s interest in KCS. By removing the threat of trade tensions, which had been mounting during the mandate of President Trump, the trade agreement among the US, Mexico and Canada has emphasized the importance of integrating the supply chains of the three countries. Despite KCS being the smallest of the main US freight railroads, it is the only one with operations in Mexico, and thus USMCA demonstrated its suitability as a promising target.
While the merged company will still remain the smallest of the Class I US railroads by revenue, the transaction will serve Canadian Pacific to expand its footprint dramatically. The combined business Canadian Pacific Kansas City (CPKC) would operate around 20,000 miles of rail and generate expected revenues of approximately 8.7 billion USD per year. The acquisition aims at building a solid base for sustainable growth by pursuing a strategy of diversification of the business mix and market exposure. To this day, CP earns 76% of its revenue in Canada and the remaining 24% in the United States. On the other hand, KCS generates 53% of revenues in the United States and 47% in Mexico. The merged entity is expected to earn more than half of its revenues in Canada, one-third in the US and the remaining share in Mexico. Simultaneously, the expected business mix of CPKC reveals a greater push towards merchandise with respect to the current exposure of CP.
The merger will benefit the industry and help expanding the current network: the continent-wide network will connect important ports of the US Atlantic and Pacific coasts with the largest industrial cities overseas, thereby expanding market reach for customers and offering competitive transportation options. KCS is regarded as the most customer-friendly transportation provider in the region, and the merger with CP will provide customers with a competitive alternative to other larger Class I railroads. Notably, customers will benefit from a smooth and efficient integration of the systems, since, given the fit of the two networks, service disruptions will be minimized. Additionally, the transaction will create a platform for capital investment and job creation. By providing a solution for manufacturers to shift their factories away from low-wage countries in Asia, following the supply chain disruptions arisen with the pandemic, the merger will support the economic growth of the North American region.
The new single-line routes will increase the direct competition with the trucking industry. By shifting trucks away from crowded US routes, CPKC expects to achieve increased efficiency in terms of transit times and costs reductions, as well as improved traffic conditions in important hubs. Additionally, “Both CEOs have been champions for the environment, recognizing the important role rail plays in lowering overall transportation emissions.” As a future step, the climate goals can be reached more easily and even faster. Both CP and KCS have implemented actions for improving fuel efficiency and lower emissions. Rail being one of the most environmentally responsible alternatives for moving freight, the development of single-line routes reducing the number of trucks on US highways is expected to generate a significant reduction of greenhouse gas emissions. Simultaneously, to support safety and capacity, the combined entity will realize investments in technology and public safety.
Thanks to the new size of the merged company economies of scale will occur. This merger will enable the two companies to become a certain size, which is needed in order to increase competitiveness: the transaction is expected to generate annualized synergies of $780 million over three years. Of the anticipated synergies, $600 million derive from EBITDA growth and market opportunities, driven by the expanded market reach and the planned capital investments. More specifically, the expected achievements in each of the three main areas of the business mix are the following:
- Bulk: New single-line shipments for grain from Canada and the Upper Midwest to Southern US and Mexico
- Merchandise: New single-line competition for shipments of energy, chemicals and plastics and merchandise between the US, Canada and Mexico
- Intermodal: New head-to-head single-line competition for shipments between Mexico and the Upper Midwest and Canada
The remaining expected synergies of 180 million USD are linked to efficiency improvements, such as improved fuel efficiency or cost-cutting for G&A, equipment and rent.
The Merger between CP and KCS and the new single line offering which comes with it will not only expand the market reach of the two companies, but also of its customers. Therefore, new competitive transportation solutions will be offered to them, and the customer base is expected to grow accordingly.
References: CP website, KCS website, FT, Bloomberg, Reuters, Business Wire, Global Railway Review, Transport Topics, Railway Age, U.S. Department of Transportation, Association of American Railroads, Value Line, Statista, Eurostat, Yardeni Research, UNIFE, IBISWorld, CGTN, Mordor Intelligence, Trains.com
To contact the authors:
Mariarosaria Aruta
Luca Crippa
Martin Makariev
Luca Matucci
Carlo Anselmi
Matteo Contadini
Georg Giulini
Enrico Hu Sie Jie
Bocconi Students M&A Circle 