Canadian Pacific Railway: Avoiding A Trainwreck
Horizontal integration can bring new life to Canadian Pacific
Horizontal integration can bring new life to Canadian Pacific.
There are two class-one railways in Canada—Canadian National Railway (CN) and Canadian Pacific Railway (CP).
Classes are categorized by revenue, where class-one railroads represent the largest of the railroads. However, the competitive landscape of the industry has historically been one-sided. Formerly a crown corporation, CN was able to invest in infrastructure with government funding, and another cash infusion from its 1995 privatization allowed CN to further develop its infrastructure. Consequently, CN has long dominated long-haul transportation of goods across Canada. Competition has been tense, with both companies continuously making operational improvements. However, CP has never been able to catch up to CN, which now operates Canada’s largest and most expansive transnational rail line. CN has positioned itself well as a premier North American railway and the only one connecting Atlantic Ocean, Pacific Ocean, and the Gulf of Mexico. CN has had an industry leading operating ratio (operating costs divided by revenue) of 53.3 per cent in its most recent quarter. CP, on the other hand, has seen its revenue decline by 9.0 per cent year to date while lagging behind CN with an operating ratio of 57.7 per cent.
In order to compete, CP feels it has to take significant strategic action to compete with its sister railway, and has attempted acquisitions of two American railways. The two targets, Norfolk Southern Railway and CSX Transportation, are the two largest railways east of the Mississippi river, and thus the acquisitions faced heavy antitrust opposition. As a result, both acquisitions failed, leaving CP struggling to get ahead. Route expansion is highly attractive for railways because it provides access to business from both existing clients looking to transport to new locations, as well as clients from the new locations looking to transport to locations within the existing network. However, organically expanding existing routes may face issues of saturation—having multiple railways between the same locations, difficult regulatory approval, high and uncertain investment costs, and lengthy development. A successful acquisition, on the other hand, would bypass these issues. If CP can integrate the railway network and clientele of another major railway into the existing business, CP may finally realize the level of revenues and profitability it has been struggling to achieve.
Mapping The Routes
Railway companies in both the United States and Canada haul commodities and other items including grain, coal, crude oil, chemicals, plastics, and manufactured goods such as car parts and finished automobiles. These products are carried from their origins to markets all across North America. Railways are affected by the value of the commodities they transport which affects both the quantity the railroad can transport and the price they can charge. In general, transportation from Alberta to the Gulf Coast by rail cost around US$16-20 per barrel, while transporting crude oil the same distance by pipe would cost US$7 per barrel. Crude transportation by rail in Canada was historically viewed as an alternative to pipeline transportation and an attractive option given its insurance against pipeline constraints. However, with decreased oil prices and increased capacity from pipeline construction, the unit economics for transportation by rail have become less attractive. With producers opting for the cheaper pipeline alternative, there is an increasing need for rail operators to diversify their operations to different sectors.
Along For The Ride
CP has a market capitalization of US$20.7 billion as of January 2017, which has grown significantly during the past five years through significant share price appreciation. This success hasn’t been without significant challenges however.
From an infrastructure perspective, CP deals with handicaps that hinder its ability to run at competitive speeds. CN can achieve greater train speeds and frequencies than CP because it has implemented passing sidings every 15 miles – nearly half that of CP. Passing sidings allow for trains moving in opposite directions to pass or higher speed trains to pass lower speed ones. Moreover, on the critical Vancouver to Alberta route, connecting Canada’s biggest port to the rest of the networks, CP’s southern route to Calgary has significantly more curves in the track and faces higher grades (inclines) than CN’s route to Edmonton. CN’s straighter, flatter track allows it to travel at higher speeds and burn less fuel than CP, keeping its costs lower and allowing it to be much more competitive in the industry. These disadvantages have eaten at CP’s operating ratio historically, limiting its ability to fund significant investments in its infrastructure and overcome its inherent disadvantages. Even with these changes however, CP was not living up to its full potential and it took a leadership change to unlock its hidden potential.
In 2011, activist investor Bill Ackman’s hedge fund, Pershing Square, began purchasing shares in CP Rail. By 2012, Pershing Square was the company’s largest shareholder. Ackman hired former CN CEO Hunter Harrison to lead CP. Under Harrison’s leadership, the company was able to improve volume growth by investing in crude oil, bolstering capacity, and mitigating the geographic setbacks of the CP network through investment in infrastructure. In addition, management has been skilled in operating in an unfavourable energy environment. In Q3 of 2016, CP managed to achieve a net income of $347 million on $1.55 billion in revenue, and maintain a YTD operating ratio of 59.5 per cent compared to 60.0 per cent in the previous year’s first three quarters. These significant operational improvements have not been enough for CP. In order to overcome its inherent disadvantages, CP has felt the need for continued scale to compete with its rival CN. In 2014, the company tried and failed to purchase the Florida-based railway CSX and again in 2016, CP made a failed offer to buy Norfolk Southern Corp. Both offers failed amidst antitrust scrutiny from the Obama administration’s Department of Justice and the Surface Transportation Board on account of CSX and Norfolk Southern dominating rail transport in the eastern United States. Even though the deals with CSX and Norfolk Southern have failed, this does not mean that CP has hit a dead-end in its tracks. Instead, CP should acquire the Kansas
City Southern Railway (KSU), allowing CP to compete with CN on routes to the Gulf of Mexico, and become the only railway serving three North American countries.
Though past proposals have suffered from regulatory backlash, this proposed merger is different. First, CP and KSU are the two smallest class-one railroad companies in North America. Further, combining both companies would allow them to expand their capabilities and compete with the larger players using complementary networks, whereas other prospective buyers would effectively eliminate competition through substantial network overlap. CP-KSU also stands to see combined revenues of $9.1 billion and an operating ratio of 56 per cent if the combined entity could cut operating costs by 10 per cent through eliminating redundancies and realizing economies of scale and integration.
On New Tracks
With news of Donald Trump becoming the President-Elect, investors heavily shorted the peso and Mexican-exposed stocks with the expectation that Trump’s protectionist trade policies and anti-Mexican rhetoric would discourage US-Mexico trade. KSU, with 48 per cent revenue exposure to Mexico, suffered a stock price fall of 14 per cent as investors priced in the geopolitical risk.
A merger between CP and KSU will diversify combined entity shipments. KSU has the immense opportunity of being able to access the large shipments of grain that CP exports, at roughly 16 per cent of their total shipments. Meanwhile, CP can take advantage of KSU’s heavy focus on industrial/consumer goods and chemical/petroleum-making up 23 per cent and 20 per cent of their total revenue respectively. Also, the post-merger will see their geographic reach increase. CP’s 12,500 track network is comprised of 7,600 miles across Canada, with 4,500 miles in the U.S. Midwest and 400 in the U.S. north east. Meanwhile, KSU has 3,400 miles of track across the U.S. Midwest and southern U.S., including 635 miles of trackage rights that permit KSU to operate trains over other railroads tracks. Moreover, KSU has 3,200 miles in Mexico with an additional 550 trackage rights.
Through the expansion, CP will have a newfound access to the Mexican corridor and the Southern US. Meanwhile, KSU will benefit from new shipments coming through the Midwest and Canada – something they previously fell short on. From a geographic perspective, the deal diversifies their routing options. However, the success of this strategy is contingent on the import and export outlook of Mexico and the U.S. going forward. Currently, Canada’s main exports to Mexico are transportation and agricultural products, while Mexico’s main exports to Canada are machinery and transportation equipment. While there is uncertainty with what could happen with NAFTA if a deal between Canada and Mexico was formed, it would promise to bring increased trade. This would allow CP and KSU customers to take advantage of streamline trade and would allow KSU to increase its automobile trade between the auto factories in Mexico and with the factories in Canada.
Reach Across Countries
If CP acquires KSU at a premium of 20 per cent, this implies a per share value of US$143. The acquisition would be carried out using 95 per cent equity and five per cent debt. For the deal to be accretive, CP needs to realize breakeven synergies of US$120 million in 2017. Overall, this represents a 1.3-per-cent improvement in the operating ratio of the pro-forma entity. Given the opportunities for cost synergies from the scalable nature of the rail network, operational efficiencies from a connected line from Canada to Mexico, and the revenue opportunities from the increased geographic and sector diversification, it is likely CP will be able to achieve these targets. This is especially the case given CP’s recent remarkable improvement in operational efficiency. Overall, an acquisition of KSU is attractive from both a qualitative and quantitative standpoint for both management and investors.
The key risks for this acquisition fall into two categories: antitrust risk and political risk. First, CP’s previous attempted acquisition of Norfolk Southern Corp. (NSC) was faced with antitrust concerns from the Obama administration. An acquisition of KSU may also face similar concerns. However, a major differentiation is the size of the two companies. NSC’s market cap of US$23 billion at the time of announcement is significantly larger than KSU’s market capitalization of $9 billion. Antitrust laws exist to promote competition. With KSU’s smaller market capitalization and status as one of the smallest class-one railways, it is unlikely for an acquisition of KSU to be considered detrimental to competition.
Second, the proposed merger is sensitive to sovereign trade policy within Canada, the U.S., and Mexico, as the post-merger entity would be significantly exposed to trade between the NAFTA countries. Though policy has been consistent throughout the past decades, Trump’s recent electoral victory threatens to upend the established North American order. Trump’s protectionist campaign promises, if carried into law, would materially discourage trade and transportation between NAFTA countries. Declining trade between Mexico and the U.S. would negatively impact KSU’ Mexican infrastructure. However, this decline may allow for Canada to become a partial offsetting substitute for Mexican exports, a scenario wherein the proposed combined company would possess a uniquely valuable Canada-Mexico infrastructure network.
CP Rail will be able to reach new heights with the Kansas City Railway as part of its network. This deal can put CP closer towards meeting its full potential. For CP, this deal can result in new cost synergies, a diversified revenue stream, and access to a completely new market. CP will then have access to the same American markets as CN, but with a Mexican advantage that CN will never be able to replicate. Overall, the deal will enable CP to better compete in the changing rail landscape and begin laying the groundwork for long-term success.