Kansas City Southern on Track for Takeover: Real M&A

No North American railroad is a more alluring, or expensive, takeover target than Kansas City Southern.

The railroad is poised to boost sales by 48 percent through 2016, faster than every peer for whom estimates are available, according to data compiled by Bloomberg. The increase is being fueled by the $13 billion company’s operations in Mexico -- where the economy is expanding at almost twice the U.S. rate -- and booming American oil production that’s already sent crude shipments by rail to a record.

Kansas City Southern’s growth prospects may lure suitors even though it trades for the highest multiple to profit among peers, according to Hodges Capital Management Inc., which sees Union Pacific Corp. as a potential acquirer. Desjardins Group said Canadian National Railway Co. and Canadian Pacific Railway Ltd. are the most logical buyers, while FBR & Co. says Berkshire Hathaway Inc.’s BNSF Railway could be better positioned to buy the Kansas City, Missouri-based company.

“If you talk to anybody that’s familiar with this industry, it’s no surprise that KSU would be an attractive asset to almost any” major railroad, Justin Long, a Little Rock, Arkansas-based analyst at Stephens Inc., said in a telephone interview, referring to Kansas City Southern by its stock ticker. “They have a very attractive cross-border network that goes into Mexico, and there’s still a very long runway of growth.”

Biggest Rally

William Galligan, a spokesman for Kansas City Southern, didn’t respond to a phone message or e-mail seeking comment on whether the 126-year-old company would be open to a sale.

Kansas City Southern climbed 39 percent this year through yesterday, the biggest gain among railroads in the Dow Jones Transportation Average, after reporting record annual revenue of $2.2 billion for 2012. The company was picked yesterday to replace Dean Foods Co. in the Standard & Poor’s 500 Index, the benchmark measure of U.S. equities.

Today, shares of Kansas City Southern rose 0.8 percent to $117.16.

Kansas City Southern is the fifth-biggest U.S. railroad by sales and got almost half of 2012 revenue from Mexico, a country that exported a record $278 billion in goods to its northern neighbor in 2012. That helps Kansas City Southern, which operates an approximately 3,100-mile (5,000 kilometers) network in Mexico through Kansas City Southern de Mexico SA.

Mexico’s gross domestic product will expand 3.5 percent this year, compared with a 2 percent gain for the U.S., according to the median of economists’ estimates compiled by Bloomberg. Kansas City Southern is positioned to take advantage of that expansion and could be attractive to a suitor seeking to bolster its own sales, FBR’s John Mims said.

‘Very Attractive’

“It’s the only pure play for Mexico,” the Arlington, Virginia-based analyst said in a phone interview. “It’s got a very attractive growth profile. For those reasons, I think it could be a takeout candidate.”

A renaissance in U.S. energy production is also helping railroads such as Kansas City Southern. U.S. rail shipments of crude oil rose to a record 233,811 carloads last year, according to the Association of American Railroads. Kansas City Southern benefits by serving Port Arthur, Texas, home to refineries run by Motiva Enterprises LLC and Valero Energy Corp.

Sales at Kansas City Southern are forecast to jump 48 percent from last year to $3.3 billion in 2016, the biggest increase among North American railroads valued at more than $1 billion, according to analysts’ estimates compiled by Bloomberg.

Growth Prospects

Those growth prospects may be enough to tempt suitors to bid on the industry’s most expensive company, Eric Marshall, the director of research at Dallas-based Hodges, said in a phone interview. Kansas City Southern trades at 34 times its earnings from the past year, compared with a median multiple of 19 for the peer group, data compiled by Bloomberg show.

An acquisition of Kansas City Southern “would be a great opportunity,” said Marshall, whose firm oversees more than $1 billion, including Kansas City Southern shares. The railroad industry has “very high natural barriers to entry, and if anybody wants this capacity, the only way to do it is to go acquire somebody.”

The two biggest western U.S. railroads, Union Pacific and BNSF, the railroad unit of Warren Buffett’s Berkshire Hathaway, could make sense as buyers because their networks match up well with the smaller carrier’s system, and they would find its Mexican operations attractive, Marshall said.

Berkshire Hathaway

Hodges also owns shares of Union Pacific and invested in BNSF’s publicly traded predecessor, Burlington Northern Santa Fe Corp., before Berkshire Hathaway bought it in 2010.

BNSF is the most likely buyer, FBR’s Mims said.

“They have firepower, but they also don’t have short-term-oriented investors to answer to, so they can take a longer-term approach,” he said. “They can absorb the integration easier behind the curtain of Berkshire Hathaway.”

Tom Lange, a spokesman for Omaha, Nebraska-based Union Pacific, and BNSF’s John Ambler declined to comment on whether their companies would be interested in Kansas City Southern.

Canada’s two largest railroads, Montreal-based Canadian National and Calgary-based Canadian Pacific, could also be lured into bidding for Kansas City Southern because of the opportunity to expand geographically and increase shipments of oil, according to Brandon Snow, a money manager with CI Investments Inc.’s Cambridge Advisors unit.

‘Good Pathway’

Both Canadian railroads have lines that extend into the U.S. and connect with Kansas City Southern’s network.

“Strategically it makes sense for both,” said Toronto-based Snow, whose firm oversees more than C$4 billion ($3.9 billion), including shares of Canadian National. Kansas City Southern offers “a really good pathway to additional growth.”

Canadian National has more leeway than Canadian Pacific to take on debt to buy Kansas City Southern, according to Benoit Poirier, a Montreal-based analyst at Desjardins. Canadian National has a credit rating of A-, while Canadian Pacific is lower at BBB-, one level above junk, by S&P.

Still, Canadian Pacific shares have surged 38 percent this year amid a turnaround plan led by Chief Executive Officer Hunter Harrison, beating Canadian National’s 15 percent advance. That’s giving Canadian Pacific a stronger currency for use in a takeover, Poirier said.

Harrison “has convinced investors that he was going to do a turnaround, and he would be able to convince investors of the rationale of doing a deal like this,” the analyst said.

Antitrust Hurdles

Ed Greenberg, a spokesman for Canadian Pacific, and Canadian National’s Mark Hallman declined to comment on whether their companies are interested in Kansas City Southern.

Union Pacific and BNSF may face antitrust hurdles in bids for Kansas City Southern, Poirier said.

Still, among the major North American railroads, Kansas City Southern is the smallest by market value and a takeover may not trigger regulatory alarms, said Marshall of Hodges. A target of this size also would be digestible for its larger peers, he said.

Union Pacific is the largest North American railroad by market value at $73 billion, followed by Canadian National at $43 billion. Canadian Pacific fetches $24 billion.

Kansas City Southern “wouldn’t be that hard for those guys to swallow,” Marshall said. If a buyer wants “to have exposure to Mexico, KSU would be a great place. As attractive as the railroad industry is in the U.S., it’s even more attractive in Mexico.”

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