CN set to acquire KCS but regulatory hurdles remain

After an ongoing theme of stops and starts and new developments, regarding the respective pursuits by Class I North of the Border railroads Canadian National (CN) and Canadian Pacific (CP) of Kansas City Southern (KCS), it appears that the train may be coming to a stop, with CN and KCS saying earlier today that they have reached a deal and have entered into a definitive merger agreement, which they said will “create the premier railway of the 21st century.”

In a joint statement, CN and KCS said that their respective Boards of Directors have signed off on the terms of the agreement, with KCS shareholders receiving $325 per common share based on CN’s $33.6 billion offer made on May 13. That figure, the companies said, included the assumption of roughly $3.8 billion of KCS debt.

As for next steps, CN and KCS said that the Surface Transportation Board (STB) and other regulatory authorities must approve control of KCS, with the completion of the acquisition expected to take place over the second half of 2022. And they added that when the deal is official that KCS will begin the integration process.

“We are thrilled that KCS has agreed to combine with CN to create the premier railway for the 21st century,” said JJ Ruest, president and chief executive officer of CN, in a statement. “I would like to thank the numerous stakeholders of both companies who have demonstrated overwhelming support for this compelling combination, and we look forward to delivering the many benefits of this pro-competitive transaction to them. I am confident that together with KCS’ experienced and talented team, we will meaningfully connect the continent—enhancing competition, offering more choice for customers, and driving environmental stewardship and shareholder value.”

And KCS President and CEO Pat Ottensmeyer said in the same statement that this combination will provide customers access to new single-line transportation services at the best value and also increase competition among the Class I railroads.

“Our companies’ cultures are strongly aligned, and we share a commitment to environmental stewardship, safe operations, reliable service and outstanding performance,” he said. “As a larger continental enterprise with complementary routes and an enhanced platform for revenue growth, capital investment, and job creation, we will be positioned to deliver on the transaction’s powerful synergies which will create new growth opportunities for our customers, employees, labor partners, communities and shareholders.”

This announcement was far from certain given the myriad moving parts related to the battle between CN and CP, for KCS, going back to when CP announced on March 20 that it was acquiring KCS for $29 billion, in a deal that it said, at the time, would establish the first freight railway connecting the United States, Canada, and Mexico. CP officials said that this $29 billion deal was a stock and cash transaction and included the assumption of $3.8 billion of outstanding KCS debt and values KCS at $275 per share, representing a 23% premium, based on the CP and KCS closing prices on March 19, 2021.

One month later on April 20, CN threw its hat into the ring, making what it called a “superior proposal.” That CN proposal was comprised of a cash-and-stock offer to acquire KCS for $33.7 billion, or $325 per share, which, it said, marks a 21% premium over the proposed CP offer, coupled with an expected EBITDA close to $1 billion annually, driven largely by the conversion of truck traffic, and combined annual revenues in excess of $13 billion.

The following weeks after CN made its interest clear, saw a whole host of back-and-forth statements issued by both CN and CP, mixed in with a decision from the Department of Justice, and another from the STB, as well as earnings calls and investor meetings, with the pursuit of KCS front and center for all of it.

And on Thursday, May 13, CN said that after submitting what it called an enhanced binding superior proposal agreement to the KCS Board of Directors that the KCS board determined that CN’s proposal is a “Company Superior Proposal.” With that decision, CN said that the KCS board announced its intention to terminate the previously executed merger agreement with Canadian Pacific on March 21. CN also noted that under the terms of the revised proposal, a wholly-owned subsidiary of CN has also agreed to reimburse $700 million to KCS in connection with their payment of the termination fee to CP under the merger agreement with CP.

But the next day, Friday, May 14, things again became less uncertain, due to a filing made with the STB, regarding the pursuit of KCS by both CN and CP, by the United States Department of Justice (DOJ), regarding CN’s proposed use of a voting trust in connection with its proposed combination with KCS.

CP said that the company is in agreement with the DOJ’s objection to CN’s application for proposed use of a voting trust, based on its contention that a CN merger with KCS presents “greater risks to competition” than the CP-KCS agreement.

“A CN-KCS transaction poses additional dangers to competition stemming from the potential elimination of direct, 'parallel' competition on routes served by both railroads, for example between Baton Rouge and New Orleans,” DOJ stated in the filing. “CN's proposed use of a voting trust would create “threats to competition [that] would be present immediately after the CN voting trust is consummated. It is particularly important to protect the incentives of CN and KCS to compete where, as here, CN and KCS appear to compete head-to-head on multiple parallel routes. On May 6, 2021, the Board approved the proposed CP-KCS voting trust in Finance Docket No. 36500. Notwithstanding this decision, the Board should not permit the proposed CN voting trust because CN's proposed acquisition of KCS appears to pose greater risks to competition than the risks posed by a CP-KCS merger.”

A decision made by the Surface Transportation Board (STB) on Monday, May 17, appeared to have dealt CN a setback in its pursuit of KCS.

In its decision, the STB said that application of the waiver provision to the potential transaction between CN and KCS is not warranted.

“Per the Board’s decision, the agency’s review of the transaction will be governed by the regulations set forth at 49 C.F.R. part 1180, as adopted in Major Rail Consolidation Procedures, 5 S.T.B. 539 (2001),” said the STB. “The Board also denied CN’s motion to approve a proposed voting trust agreement as incomplete, without prejudice to filing a new motion.

After this decision was issued, CP released a statement indicating that it supports the STB’s decision to apply the newer, more stringent merger rules to CN’s proposed acquisition and its effort to obtain approval to use a voting trust in connection with its proposed combination with KCS.

But that was not enough to deter KCS from saying on Friday, May 21 that its Board of Directors unanimously determined that the CN proposal remains a “Company Superior Proposal.” It also noted that CN will reimburse KCS for the $700 million breakup fee it paid to CP and that KCS will be obligated “to refund this amount under certain limited circumstances, including if KCS terminates the CN merger agreement to accept a superior proposal.”  

As for CP’s reaction to these developments, in a letter from its President and CEO Keith Creel to the KCS Board of Directors, the top CP executive explained that since the KCS Board received CN’s unsolicited proposal on April 20 that CP understood that KCS needed to fulfill its fiduciary duties to its shareholders and gain a better understanding of the CN offer.

“However, as you know, CP has always believed that CN's proposal is illusory and simply an attempt to dismantle the unique, pro-competitive deal that CP and KCS have agreed upon, a deal which provides compelling short-term and long-term value for our shareholders—value that is actually achievable,” wrote Creel. “While we respectfully disagreed with the KCS Board's decision last week to deem the Revised CN Proposal a Company Superior Proposal, we could understand how the KCS Board might come to that decision given its fiduciary duties.  Nevertheless, we have remained confident that the Surface Transportation Board would ultimately reject CN's proposal to use a voting trust, given that allowing CN to close into trust would not be in the public interest.”

The top CP executive also pointed out that the May 17 STB decision exemplifies how the STB’S views on CN’s proposed voting trust are in line with the DOJ’s—in that it is a threat to freight railroad competition, as well as a threat to public interest.

“We believe that the KCS Board has a clear path to conclude that the level of risk surrounding a CN-KCS transaction and CN's ability to close into voting trust are too high in order for the Revised CN Proposal to continue to constitute a Company Superior Proposal,” wrote Creel. “Recently one of CN's largest shareholders, TCI, also came out publicly to say that CN's proposal is unlikely to receive regulatory approval and to recommend to CN that ‘it is time to end this ill-advised misadventure.’  As we have been saying from the start, CN's proposal is illusory, and the KCS Board, in fulfilling its duties to its shareholders to explore the proposal, has helped shine additional light on this fact.  We respectfully believe there is no longer any basis to terminate the CP-KCS Merger Agreement. The best way for the KCS Board to fulfill its fiduciary duties in light of recent developments would be to continue to pursue the CP-KCS combination, which already has the benefit of STB approval to use a voting trust.”

In a research note, Tony Hatch, principal of New York-based ABH Consulting expounded on Creel’s sentiment on an investor call that the CN proposal is destabilizing for the railroad sector.

“Keith really focused his ending on this – if the CN deal is allowed, what deal can be stopped?” observed Hatch. “While CP has a great intermediate term outlook (agreed), as the smallest, it would make for an attractive target.”

Larry Gross, president of Gross Transportation Consulting, said that even though CN and KCS have come terms on a deal, there are still some significant questions regarding regulatory approval.

“The next hurdle is whether or not the STB will approve the placement of KCS into a voting trust, which will essentially allow the merger to proceed during the approval process, which is quite lengthy,” he said. “CN would own KCS but would be able to sort of affect its operations. Call it a state of suspended animation. It is conceivable that if the STB is uncomfortable with the deal, it may not approve it, with CN liable for a $1 billion breakup fee.

As for next steps regarding the STB, Gross said it is hard to say what the next steps may look like, calling it a considerably heavier lift, from a regulatory standpoint, for a CN deal than a CP deal.

“If the deal goes through, there will be conditions placed on the merger, and you could easily end up with a split scenario, where the STB says one piece [of KCS] goes to CN, and CP has an overlap somewhere else, and maybe co-own and operate the Mexican piece,” he said. “The biggest STB issue is that I suspect it is somewhat concerned that a CN-KCS merger is destabilizing, because it leaves CP kind of like an orphan out in the cold…and essentially a sixth railroad among five giants. It could seek inclusion in one of the other four U.S. railroads, which is potentially a destabilizing event. That may color STB’s thinking in terms of how they color the merger.”

From a shipper perspective, having either CN or CP acquiring KCS is fine, according to Gross. And, from an intermodal perspective, the cross-border market has been an underperformer and should not be the case, as it is a long-haul market that should be an intermodal sweet spot. The reason it has underperformed, he said, is that there is no single-line service, and railroads typically don’t fare well when they have to interchange.