Canadian Pacific (CP) is back on the hunt for consolidation. After regulators shot down a proposed deal for CSX (CSX) last year, the firm is reportedly in preliminary talks with Norfolk Southern (NSC) concerning a merger that could be worth more than $24 billion. The fact that there are so few railroad operators in the US suggests that a deal will be very difficult to get past regulators, and if a deal does in fact get done, it will likely be the last of its size in the industry.
The two companies have complimentary cargo markets and little geographical overlap, in our birds’ eye view of their respective route networks. Norfolk Southern generates 22% of its revenue in intermodal shipments, 21% from coal, and 9% from auto parts, while Canadian Pacific generates the highest portion of its revenue, at 28% of total revenue, from industrial and consumer product shipments. Both companies have faced significant pressure in 2015 due to decreased shipments in oil and coal, among other things.
Canadian Pacific has not been shy about its desire to consolidate to gain access to the Eastern seaboard of the US and create a transcontinental railroad operator. This is a large part of the reason the firm went after CSX, and Norfolk Southern offers Canadian Pacific a very similar geographic expansion opportunity. The two companies currently have access to the major rail hub in Chicago, while Norfolk Southern’s reach is generally concentrated to the east of Chicago and Canadian Pacific’s is generally north. The firms also have overlapping footprints in the Kansas City region and the New York and Pennsylvania area.
Below are two maps showing the rail systems of each company.
Some past comments and recent developments may indicate that Norfolk Southern would be willing to work amicably towards a deal with Canadian Pacific. The railroad industry recently lost an appeal with the US Department of Transportation concerning crude oil rail shipping regulations that will now require operators to install expensive new brakes on trains hauling hazardous or flammable materials. Earlier this year, when the situation began to unfold, Norfolk Southern’s CEO Wick Moorman expressed his concern that the new regulations could make shipping crude oil by train prohibitively expensive.
Perhaps consolidation is Norfolk Southern’s answer to these regulations. It certainly is interesting timing, as the reports of preliminary deal talks between Canadian Pacific and Norfolk Southern come the day before the official announcement of the rail industry’s appeal being denied. Further supporting the idea that this consolidation may be centered on crude oil by rail shipment is the rejection of the Keystone XL pipeline by the US government just days earlier. This suggests that crude-by-rail shipments could become an important part of Canadian Pacific’s operations, and an important reason why the company would want exposure to the Eastern seaboard and export markets.
Looking across the rest of the industry, Kansas City Southern (KSU) had once been considered a key takeout candidate thanks to its exposure to growth in Mexico, but we doubt it is a good fit for Canadian Pacific given the latter’s preference for exposure to the Atlantic states. If the rumored deal between Norfolk Southern and Canadian Pacific does go through, the likelihood of Kansas City Southern being taken out shortly thereafter may be reduced. Political concerns with respect to Kansas City Southern’s routes in Mexico may make a potential deal with likely suitors Union Pacific (UNP) or Berkshire Hathaway’s (BRK.A, BRK.B) Burlington Northern less than ideal.
All things considered, the closure of any deal likely won’t happen anytime soon given the current stage of the talks and the amount of regulatory hurdles firms will have to overcome, but Canadian Pacific is on the hunt! We generally don’t seek out takeout candidates with our tried-and-true valuation process, and at the moment, we’re comfortable with Union Pacific as our favorite idea in the railroad industry on a fundamental basis; it remains a holding in the Best Ideas Newsletter portfolio. Download Union Pacific’s 16-page report