Canadian Pacific pitches merger with Norfolk Southern rail line

Canadian Pacific Railway Ltd. has proposed a takeover of U.S. railway Norfolk Southern that would create the largest rail company in North America.

CP confirmed in a release after stock markets closed Tuesday that it had sent an offer letter to Norfolk Southern Corp. proposing a business combination.

CP claimed a merger would "create a transcontinental railroad with the scale and reach to deliver improved levels of service to customers and communities while enhancing competition and creating significant shareholder value." 

The release didn't specify what CP was offering to purchase Norfolk Southern's outstanding shares, but said it would offer a "sizable premium in cash and stock."

The reaction from Norfolk was cool at best. In a release it said that it had "received an unsolicited, low-premium, non-binding, highly conditional indication of interest from Canadian Pacific (CP.TO)."

Norfolk said the offer was for $46.72 in cash and a fixed exchange ratio of 0.348 Canadian Pacific shares per Norfolk Southern share, representing a premium of less than 10 per cent based on closing prices Tuesday.

Both companies are trading higher today, although as of late morning Norfolk Southern (NSC:NYSE) was trading slightly under the offer price.

At the close of trading on Tuesday, CP is worth $28 billion Cdn. Norfolk Southern is worth $26 billion US. Based on those prices, the proposed deal would be the largest takeover by a publicly traded Canadian company of a U.S. one.

Investors seemed to like the deal. CP rose 5.6 per cent on Wednesday, to $194.94 Cdn.

Rail industry consolidation

Barry Schwartz, chief investment analyst at Baskin Wealth Management, said the time is ripe for this kind of consolidation in the industry.

"There are too many railroad companies and these guys are having tough years. In the U.S., they're having trouble because coal is falling off a cliff, and in Canada, they're having trouble because no one is moving oil by rail car as much as they were when oil was $100," he said in an interview with CBC News.

But interest rates are low and rail stocks are beaten down, so it is an opportune time, though CP will have exchange rate risk, he added.

CP is a strong company under Hunter Harrison's management and has greatly improved its operating ratios, which the U.S. partner may well need, Schwartz said. 

On paper, the deal would make sense for both sides. CP's network is much smaller than rival Canadian National's with just over 22,000 kilometres of track predominantly in Western Canada. Norfolk Southern, meanwhile, has more than 32,000 kilometres of track predominantly in the U.S. southeast.

A combined company would become the largest rail operator in North America, with access to three major tidewater transport hubs — the Pacific Ocean in B.C., but also the Atlantic Ocean and Gulf of Mexico via Norfolk Southern's network.

Chicago bottleneck a factor

It would also give the company the ability to bypass Chicago, which is currently the main hub of the whole network but one that has become so crowded with traffic that it can take more than a full day to merely move a railcar through the terminal and on to its next line.

"The railroad industry, from a capacity standpoint, we've got this one problem," CP president Keith Creel said at an investor conference in Toronto before news of the proposed merger came out on Tuesday. "Chicago [is] the Achilles heel for the industry and it will be until somebody does something about it."

A CP/Norfolk Southern merger would do just that by giving the company a coast-to-coast rail line that could bypass Chicago altogether. That could be good for other rail companies too by reducing demand in Chicago and unclogging the bottleneck.

The deal is far from a sure thing, however. CP's main Canadian rival, CN, tried a similar merger in 1999 with Burlington Northern Santa Fe that was ultimately rejected by the U.S. Surface Transportation Board on competitive grounds.

Analyst view

Canaccord Genuity analysts David Tyerman and Tao Ding think a Canadian Pacific and Norfolk Southern merger would have a better shot, since the industry has changed since then and the deal "could be regarded as a more acceptable merger given the very little overlap of the two entities," they said in a recent research note on the deal's prospects. 

"But the size of the two railroads may still raise concentration concerns."

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Analysts Benoit Poirier and Charles Perron-Piché at Desjardins agree, saying in a recent note that "by merging the two networks, the company would be able to eliminate some interswitching delays and increase the train speed across the network, which would result in quicker trips and would likely resolve some of the congestion issues around the Chicago area."

It would be especially beneficial for shipping oil by rail as the combined network would connect both the Bakken and oilsands regions with the refineries on the U.S. east coast. But the analysts feel the deal could be a tough sell. "While we would be favourable to such a transaction, the process would be long and would face significant hurdles."