How Likely Is A Merger Between CSX And Canadian Pacific?

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Includes: CNI, CP, CSX, NSC, UNP
by: Michael Hooper

Summary

E. Hunter Harrison, CEO of Canadian Pacific, wants to merge with CSX Transportation and acquire two Chicago switching companies.

A look back on the Surface Transportation Board's handling of proposed merger of BNSF Railway and Canadian National Railway. Why the deal fell apart.

CSX is growing flow of intermodal containers and trailers.

There is a lot of talk today about a proposed merger between CSX Transportation (NYSE:CSX) and Canadian Pacific Railway (NYSE:CP). The likelihood of a merger seems slim at this point, but I wouldn't rule it out.

Canadian Pacific Railway recently approached CSX about a merger that would create a company worth more than $60 billion, The Wall Street Journal reported last week.

While the two companies have begun to discuss the possibility of a transaction, CSX was cold to the idea, and it is too early to tell whether they will pursue one, WSJ reported.

History tells me that while this merger may be beneficial to the transportation industry, it is likely to be met with skepticism by the Surface Transportation Board, which oversees and regulates railroads. I believe a merger might cause delays in the short term due to different systems, but over time, the two railways would build a much larger transcontinental railway that would be more efficient in the long run. CSX owns rail to key ports on the Atlantic Coast and penetrates most major metropolitian areas located in the eastern third of the United States. CP owns rail from Vancouver to Montreal with lines to Chicago and Kansas City.

A transcontinental dream that went bust
In 1999, BNSF Railway and Canadian National Railway (NYSE:CNI) proposed a merger that would have created the largest transcontinental railway in North America. The synergies between these two railroads would have been phenomenal. There was very little overlap between the two. BNSF Railway, which serves the western two thirds of the United states, would have connected with CN, which spans both east and western Canada and owns a great north-south route from Chicago to New Orleans. Immediately after proposing the merger, shippers complained that past mergers -- Union Pacific's (NYSE:UNP) 1996 acquisition of Southern Pacific Rail Corp. and 1999's splitting of Conrail Inc. between Norfolk Southern Corp. (NYSE:NSC) and CSX -- had caused massive delays and poor service.

On March 17, 2000, the Surface Transportation Board imposed a 15-month moratorium on new rail mergers, presumably to prepare new rail merger guidelines. The moratorium, upheld in a ruling July 14, 2000, by the U.S. Court of Appeals for the District of Columbia, prevented the companies from filing a common control application with the board until mid-June 2001. As a result, a regulatory decision on the CN/BNSF combination would be unlikely before late 2002.

In July 2000, CN and BNSF released a joint statement calling off the merger because of the delays: "CN and BNSF are both shareholder-driven organizations, and we have concluded it is not in the interests of our shareholders to assume the risks involved in waiting up to 2 1/2 years for a decision on our transaction by the regulator in the United States."

Over time, UNP and Southern Pacific worked out their problems and delays. The same is true for Norfolk Southern and CSX with Conrail. Consolidation, in the end, made shipping by rail more efficient.

Harrison on the hunt
E. Hunter Harrison, CEO of Canadian Pacific, has made great strides in creating efficiencies at CP over the past two years. Now he is ready to make an acquisition. He has actually talked about a second deal. He has offered to buy the switching companies that interchange trains in Chicago, the busiest railroad intersection in the country, where East meets West and North meets South.

Harrison said a single company would be able to focus on improving Chicago's railroad interchange.

The Indiana Harbor Belt Railroad, and the Belt Railway Company of Chicago are currently owned by consortia of major railways, including CP.

Harrison had tried to buy Indiana Harbor and the Belt Railway when he was at CN, but could not create a deal. Instead, CN bought the Illinois Central Railroad in 1998. That line goes around Chicago and south to East St. Louis and New Orleans.

Harrison likes CSX. CSX is growing business on several fronts, including grain and intermodal. Intermodal growth of 7% in the second quarter set an all-time quarterly volume record, driven by conversions of freight from highway to rail and continuing economic expansion. The company opened in the second quarter a new terminal in Winter Haven, Fla., which anchors a proposed 900-acre logistics center serving Central Florida. CSX is also making progress on a new terminal in Montreal. Combined, those two terminals will increase the annual lift capacity of CSX's intermodal network by 350,000.

CSX stock has lagged the stock performance of UNP, CP and CNI. The financial metrics show Union Pacific and Canadian Pacific have traded at a premium over CSX and Norfolk Southern.

Railroad

Trailing P/E

Price/Book

CSX

16.83

2.75

NSC

16.61

2.62

UNP

19.75

4.24

CNI

21.42

5.24

CP

36.24

5.22

KSU

27.28

3.51

Charles Schwab Research through Oct. 13, 2014.

I expect North American railroads to report record financial results for third-quarter 2014, while coping with big increases in the movement of grain, oil, autos and intermodal containers and trailers.

Conclusion
Keep your eye on CP's Hunter Harrison, he is ready to make deals. However, at a time when railroad traffic is congested in the Dakotas and Chicago, I expect the Surface Transportation Board to review any large scale merger proposal with a hard look before allowing it to go forward. Critics will complain that a CP-CSX merger may compound delays already in the system, but it's possible the merger would eventually increase efficiencies over the long term. If there is a merger down the road, you got to be in the game to benefit. I'm staying long railroads and may pick up a few more shares in the near term.

Disclosure: The author is long UNP, CP, CNI, NSC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.