CP Coast-to-Coast Railroad Vision Puts CXS in Play

Hunter Harrison sketched a vision of railroad consolidation for analysts earlier this month, saying mergers would ensure the seamless movement of oil, coal, grain and other goods from the Atlantic to the Pacific.

Within days, Canadian Pacific Railway Ltd.’s chief executive officer was putting that idea into action.

Canadian Pacific made a merger proposal last week to CSX Corp., the biggest U.S. eastern railroad, for just such a transcontinental tie-up, only to be rebuffed, people familiar with the matter said. The Calgary-based railroad could try again with CSX or may consider a new target, said one of the people, who asked not to be identified because the talks are private.

For cargo traveling between the coasts, a railroad spanning the width of North America would eliminate the need for competing railroads to hand off cargo in congested Chicago. Long discussed by the railroad industry, east-west mergers haven’t gone forward in the face of regulatory opposition.

“They’re laying the groundwork for something that they realize will take a long time,” said Allison Landry, a Credit Suisse Group AG analyst in New York. “Maybe they’re just trying to test the waters a little bit and see what can happen.”

Canadian Pacific and CSX both declined to comment yesterday on any discussions. Harrison didn’t say at his Oct. 1 meeting with analysts whether Canadian Pacific was pursuing a deal, while asserting that consolidation in the North American industry “makes too much sense” and will happen eventually.

Ackman’s View

Harrison’s argument was buttressed today by activist investor Bill Ackman, whose Pershing Square Capital Management LLP is Canadian Pacific’s second-largest shareholder. Further combinations would help carriers struggling with traffic jams on their tracks, he said.

“There’s serious congestion,” Ackman said in a Bloomberg Television interview. “A lot of that can be dealt with through some mergers that are actually pro-competitive.”

Combining Canadian Pacific with CSX, the third-biggest U.S. railroad, would create a company with a market value of about $62.5 billion, according to data compiled by Bloomberg. A merged carrier would have transcontinental reach, connecting CSX’s network in the eastern U.S. with a Canadian Pacific system that runs the breadth of Canada.

CSX surged 5.9 percent, the most since March 2012, to $31.70 at the close in New York. That also marked the biggest gain among stocks in the Standard & Poor’s 500 Index. Canadian Pacific’s U.S. shares slid 2.3 percent to $184.97. Today is a holiday in Canada.

Regulatory Scrutiny

A proposed deal would face regulatory scrutiny because there are so few major North American railroads -- four in the U.S. and two in Canada. Along with BNSF Railway, Canadian Pacific was ordered this year to make regular reports on its U.S. service because tie-ups on some tracks are slowing trains.

Canadian National Railway Co. and BNSF, which is now owned by Warren Buffett’s Berkshire Hathaway Inc., abandoned a planned merger in 2000 amid opposition from the U.S. Surface Transportation Board. The board later rewrote acquisition rules to make it tougher for large railroads to combine.

“Since then there has been no attempt to consolidate the large rails,” said Ben Hartford, an analyst with Robert W. Baird & Co. in Milwaukee. “This merger is unlikely given the position the STB has taken in the past.”

Canadian Pacific probably has good insights into the regulatory challenges, because director Linda Morgan served on the Surface Transportation Board, Credit Suisse’s Landry said. Morgan was on the STB and its predecessor, the Interstate Commerce Commission, from 1994 to 2003.

Chicago Pressure

Putting two East and West railroads would create capacity by eliminating switching and “take pressure off Chicago,” Harrison said in the meeting two weeks ago. Chicago, the busiest railroad interchange, dragged more than usual on train speeds and service during this year’s harsh winter.

“I think it’s going to happen two years, five years,” Harrison said. “I’m an outlier. Nobody else believes it.”

Harrison had said as early as 2007 that investor pressure on the continent’s largest railways to merge would mount in the following years.

“Hunter has made the case for consolidation in the industry,” Ackman said today on Bloomberg Television.

Harrison, 69, the former CEO of Canadian National Railway Co., was hired out of retirement in 2012 after Pershing Square began buying shares in Canadian Pacific and Ackman started pushing for the ouster of incumbent Fred Green.

CP Turnaround

He has led a turnaround at Canadian Pacific, which had long been saddled with a reputation as North America’s least-efficient major railroad. It’s still smaller than Canadian National and the four railroads that dominate the U.S. industry: CSX and Norfolk Southern east of the Mississippi River and Union Pacific Corp. and BNSF Railway in the west.

CSX, run by CEO and Chairman Michael Ward, is more than twice Canadian Pacific’s size when measured by sales, with $12 billion in 2013 revenue. Canadian Pacific’s total was C$6.13 billion ($5.49 billion).

“Why CSX? I think valuation is attractive, more attractive than at other railroads,” said Keith Schoonmaker, a Chicago-based analyst with Morningstar Inc., in a telephone interview. “CSX has really been punished by the market because of its very high exposure to coal.”

Railroad Valuation

Canadian Pacific trades at 28.9 times earnings while CSX trades at 16.5 times, according to data gathered by Bloomberg. Coal accounted for $744 million of CSX’s $3.24 billion in third-quarter revenue, according to data compiled by Bloomberg Intelligence. That was the most for any one type of cargo.

Given that Canadian Pacific has a higher valuation based on its price-to-earnings ratio, it’s enough “for the merger math to potentially work,” said John Larkin, a Baltimore-based Stifel Financial Corp. analyst.

If such a merger eventually goes through, it would vault Canadian Pacific from its place as the smallest of the major North American railroads into the senior position in the east of the continent, said Steven Paget, a Calgary-based analyst with FirstEnergy Capital Corp.

It would also set off a wave of mergers that could bring the industry down to two mega-railroads, Paget said. “This looks like the first start in what might be the final consolidation of North American railroad companies.”

At Canadian Pacific’s analyst event, Harrison suggested that he might be ahead of the rest of the industry in seeing a merger opportunity now. The rest of the North American industry, he said, appeared disinclined to explore a deal.

“You got to have somebody to dance with,” Harrison said. “And I don’t know anybody who wants to dance now.”

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