Canadian Pacific Railway CEO and Director E. Hunter Harrison told investors last week that he expects rail consolidation among the largest North American railroads within six years, but the scenario he laid out was far bolder than what’s been swirling around the industry for years.
The conventional wisdom around consolidation is that Kansas City Southern Railway, the smallest of the major railroads, will get scooped up by one of the five other Class I carriers or a third-party that merges two railroads. The major benefit to a KCS buyer would be gaining the only cross-border rail network that connects the U.S. to Mexico’s rapidly growing manufacturing base.
Harrison, however, envisions “a merger across the Mississippi River,” in which each of the western U.S.-based Class I railroads — BNSF Railway and Union Pacific Railroad merge with an eastern counterpart, according to a Seeking Alpha transcript. BNSF or UP, for example, could merge with CSX Transportation or Norfolk Southern Railway.
“I do think there will be consolidations in the future … I’m not suggesting it’s going to be in the next two or three years, but I do think, given capacity issues at each point, environmental concern, you’re not going to build any more railroad, that really if you look at the U.S., for example, you split up East and West, you got two in the East, you got two in the West. And a merger across the Mississippi River is not going to impact the competitive environment,” Harrison said.
Such a merger wouldn’t “impact the competitive environment,” and shippers would gain better service by having two transcontinental lines, Harrison told investors during the railroad’s fourth quarter earnings call on Jan. 29. Shippers with access to only one line, who refer to themselves as “captive shippers,” could benefit as well.
“If mergers were allowed, I think there’s a model that we had that said, if somebody thinks they’re captive and they don’t think that we’re giving them the right service or the right price, then you’d have to allow brand x to come in to provide that,” Harrison said.
The creation of two U.S.-based transcontinental railroads wouldn’t reduce shippers’ choices because most shippers generally have only two choices now, said Keith Schoonmaker, director of industry equity research at Morningstar, a Chicago-based investment research firm. Canadian shippers can choose Canadian National Railway or Canadian Pacific Railway, while Mexican shippers have either Kansas City Southern de Mexico or Ferromex, he said. Within the U.S., western shippers can tap BNSF or UP, while eastern shippers have CSX or NS.
This is generally true for most shippers, but not for all. Carload shippers moving freight through Port Metro Vancouver, for example, can use BNSF, along with CN and CP. Similarily, the networks of CP, and, particularly CN, reach U.S. destinations, and CSX’s line reaches Quebec.
Under a dual transcontinental merger scenario, the need for handoffs at the Mississippi River or in Chicago would be reduced, speeding up transit times, said Schoonmaker, who asked Harrison about the prospects of consolidation during the earnings call. The mergers also would reduce corporate costs, because two sets of management would be redundant, and some railyards could be consolidated, he said.
“Only one CEO would be needed after each merger, so a leader willing to step down (probably in exchange for a lucrative change of control compensation) would facilitate the deal,” Schoonmaker said. “Perhaps, a likely catalyst would be an activist shareholder.”
The potential mergers also would have to get the blessing of the Surface Transportation Board, the U.S. rail regulatory agency. CN and BNSF pulled back from merger plans after the STB in March 2000 ordered a 15-month moratorium on railroad mergers.
Tony Hatch, an independent railroad analyst, said the STB would never allow a transcontinental merger, and he noted any such merger or acquisition attempt could spur Congress to try to re-regulate the rail industry. A transcontinental merger wouldn’t create major cost savings, nor would it greatly improve service, because interline traffic generally runs smoothly, he said. Railroads’ differing cultures would only complicate a process with political and financial risks, Hatch said.
It’s not as if the rail industry needs a merger to increase profitability, either. Railroads have consistently boosted profits through strong pricing and efficiencies, and despite moderate growth in volume. CSX, NS, KCS and UP raised their total profit in the fourth quarter by 11.9 percent year-over-year, compared to an 11.3 percent year-over-year gain in third quarter.
The four U.S.-based Class I railroads increased total revenue 6.7 percent in the fourth quarter on a 1.6 percent gain in volume, according to a JOC analysis of Securities and Exchange Commission filings. Fourth quarter and full-year profit at BNSF won’t be made public until its owner, Warren Buffett’s Berkshire Hathaway, reports its financials in February.
There is also the question whether the current executive leadership wants to take on the risk and hassle of seeking a merger or acquisition, after guiding their companies through a dismal global recession and slow recovery. Matt Rose in December moved from CEO of BNSF to executive chairman, a move some saw as the next step to his succession of Buffett at Berkshire Hathaway. NS CEO and Chairman Wick Moorman is also expected to make an exit within the next several years.
The more likely consolidation scenario is a merger or acquisition involving KCS, but the railroad’s high valuation likely is keeping suitors at bay, said Eric Marshall, a senior vice president, portfolio manager and director of research at Hodges Capital Management.
Acquiring or merging with KCS seven or eight years ago before the railroad’s cross-border business began to take off would have made sense. But now the railroad’s valuation is much higher and trades at higher multiples than some of its larger counterparts, said Justin Long, a research analyst at Stephens, a Little Rock, Ark.-based financial services firm. KCS has a price-to-earnings ratio — the market price per share divided by annual earnings per share — of 21.9 for 2014 and 18.6 for 2015, Long said, quoting consensus estimates provided to FactSet at the end of trading on Feb. 4. The industry average for the price-to-earnings ratio was estimated at 16.1 for 2014 and 14.2 for 2015, he said, quoting consensus estimates from the financial data and software company.
But if the optimism about KCS’s growth is overhyped, then the valuation could fall, making a merger or acquisition a better deal for potential suitors. Some of the shine around KCS came off last month when the company told investors that a surge of business from three new Mexican automotive plants would come later than originally expected. The company’s stock fell 15 percent following the Jan. 23 fourth quarter earnings call.
The fourth quarter earnings call wasn’t all bad news, though — far from it. KCS’s profit rocketed in the fourth quarter by 24 percent year-over-year to $144 million, even though full-year profit fell nearly 6.9 percent. The company also achieved investment-grade status and used its new rating to restructure debt.
“This restructuring benefited us significantly in 2013 by lowering our interest expense by $20 million over 2012, and by strengthening our balance sheet,” KCS President and CEO David Starling said in a statement. “Moreover, KCS is a stronger company going forward given its expanded financial flexibility.”
The greatest potential for rail consolidation isn’t in the Class I industry but within the small lines that connect to the major railroads, Long said. Genesee & Wyoming, an owner and operator of short lines and regional freight railroads, is best poised to swallow up other lines because the company has access to some $400 million in capital and is the largest strategic player, according to a Stephens research note. Of the 459 privately owned U.S. regional and short lines, which make up about 80 percent of the market, G&W’s network connects with 48 of the lines. Like the larger railroads, many of G&W lines, which total 98 in North America, are seeing intermodal traffic growth.
Contact Mark Szakonyi at firstname.lastname@example.org and follow him at twitter.com/szakonyi_joc.