Report: CP overture to merge with CSX is rejected

While there has been a fair amount of merger and acquisition (M&A) activity in the freight transportation and logistics sectors in recent years, the freight railroad sector, save for the Berkshire Hathaway $26 billion acquisition of BNSF Railway in 2010, has been largely quiet on that front.

But that may be changing based on various reports stating that Canadian Pacific Railway (CP) contacted CSX about a merger.

The Wall Street Journal reported that this merger, which would have brought together two of North America’s largest rail operators, was rejected by CSX, adding it was not clear if CP would continue to make further efforts.

If this deal were eventually consummated, the total market value of CP and CSX would be $62 billion, according to the WSJ. This development comes at a time when the railroad sector, despite various service-related issues, is doing very well, due in large part to the ongoing emergence of crude oil-by-rail (CBR), which has seen volume gains throughout the sector, as evidence by the U.S.-based Class I railroads generating $2.15 billion in moving CBR in 2013, which is far ahead of 2008’s $25.8 billion, according to federal data cited in the WSJ report. 

This merger would likely face multiple obstacles should CP continue to pursue CSX, due to intervention from the U.S. Department of Transportation’s Surface Transportation Board (STB). This occurred in 2000, when a proposed merger Burlington Northern and CP was halted due to resistance from the STB, according to the WSJ report. Other obstacles cited included national security concerns, given that national security officials would be expected to closely examine any proposed deal “under laws governing foreign ownership of infrastructure such as railroads that is deemed critical.”

The WSJ report said CP CEO E. Hunter Harrison recently stated at an investor conference that M&A in the railroad makes sense as it would help in aiding Chicago interchange congestion issues, which is the key rail connector between East and West Coast Ports. 

Tony Hatch, principal at New York-based ABH Consulting, said in a research note that while CP’s management team is pro-consolidation, the Class I rail consensus is against, with BNSF unclear.

“We stand with the consensus here – the risks – economic, operational and, enormously, political (especially now) outweigh the benefits,” Hatch wrote. “The prior round of mergers in the ‘90s had something like a 9:1 economies to synergies ratio in theory (and, recall, they were all years late in achieving accretion, regaining operational equilibrium, while the next potential round, being more end-to-end (like CP and CSX) might have less political opposition (not in today’s world) but far fewer economies of scale.  The only thing that has changed from the days of the rejected BNSF-CNI (and Hunter Harrison) merger and the ensuing “Moratorium” (1999-2000) is improved IT capability, but the other negatives still apply.  [It is] Not worth the risk!”

Hatch told LM that should talks between CP and CSX proceed, the strings attached would be like battleship chains.

Stifel Nicolaus analyst John Larkin said in a research note that were this merger to move forward and take effect it would give CP a way to run around Chicago, which has long been coveted by Harrison.

“CSX has been struggling operationally of late and could benefit more than any other railroad from the intensive operational overhauls that have made Mr. Harrison a legend among investors and railroaders, alike,” wrote Larkin.

Other benefits he cited were same-line crude by rail service that could be offered from the Bakken Shale to eastern U.S. destinations and duplicate overhead could be eliminated.

What’s more, a deal between CP and CSX could potentially spur competitor Norfolk Southern to merge with another carrier to remain on a competitive level playing field, adding that “two simultaneous mergers of this magnitude would likely make the regulators north and south of the border that much more nervous.”

While there may be a good rationale behind this proposed merger, Brooks Bentz, LM contributing editor and supply chain consultant, said that there is not a clear value proposition or business case that makes it compelling.

“I may be missing something, but the perceptible synergies between the two companies eludes me,” Bentz said.  “I can’t see what either company gains that is worth the pains, political, cultural, organizational or operational.  Those executives who have change of control provisions in their employment agreements are likely to do very well personally, but I don’t see a big uptick for the shareholders of either company, nor for the customers.”

And with the current balance of power in North America among the Class I railroads––two in the east, 2 in the west, one in the middle, and 2 in Canada¬¬––Bentz explained that has created a very stable playing field, but were one of the legs of this “table” to be pulled, it would require some sort of response among the other members of the supporting cast, which he said is not likely in their best interests.

“I can’t say I’ve ever been much of a fan of the status quo, but given the conditions in the market place, the capacity and service issues, the noise about ‘re-reg’ and the limited value, I think the timing is wrong and the business case is not strong enough to overcome other considerations,” Bentz said.