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CN Rail looks set to prevail in its battle with CP to acquire Kansas City Southern. But will regulatory concerns cause the proposed merger to become derailed? Anthony Okolie speaks with David Mau, Portfolio Manager, TD Asset Management, about the bulls and bears case for CN.
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- CN Rail and CP are locked in a battle for US Railway Kansas City Southern. But a superior bid has now put CN in the driver's seat. But CN's shares have lagged CP's over the past year. So does CN's recent stock dip represent a buying opportunity. Or is it a sign of a bumpy road ahead?
Today, we look at the bulls and bears case for CN. David, its core business is performing well.
- Yeah. Listen, the demand for transport is strong. The outlook is positive for the Canadian economy. The economies around the world continue to reopen. Indicators for industrial production, consumer demand are quite robust. And the company itself is forecasting double-digit earnings growth this year, which would put it ahead of where it was in 2019. So we're basically in a full-on recovery and growth mode.
- OK. Next, talk about the benefits of a Kansas City Southern acquisition.
- As you know, CN is in the midst of trying to acquire Kansas City Southern. And if this acquisition is successful, CN would arguably have the strongest rail network in North America. And what this will do is it's going to allow them to win market share from their competitors. It's going to allow them to win new business from shippers who aren't currently using rail as their main mode of transport.
And this is going to be possible because CN has the best rail network in Canada, while Kansas City Southern has a really strong presence and footprint in the southern US and in Mexico. So if they're able to combine these two networks, it's going to be a second-to-none North American rail network.
- Finally, if the KCS deal doesn't go through, you see some short-term gains for the stock?
- I mean, look, CN's stock has performed OK in the last year. Over the last six months, it's been trending a bit sideways. And ever since CN announced the KSU acquisition back in April, the stock is actually down about 10% or 11% since that announcement came out.
And the reason for that is because CN has to wait for a lot of regulatory approvals. It's going to take a lot of time. Markets don't like uncertainty. Right? So the stock has been down. It's been underperforming.
I think the sooner we find out whether or not this merger is going to be allowed to proceed, it will be better for the stock. And even if the merger is rejected, I think CN's stock will see a significant pop just because of the removal of the uncertainty.
- Some strong factors to CN being bullish. Now let's take a look at the bear case. CN incurs a cost if the KCS deal falls through.
- Look, CN is going to be on the hook for $1.7 billion US if the Kansas City Southern deal fails. And that's going to be coming in two parts. The first part is, CN is paying $700 million US to CP because CP originally had a merger agreement with Kansas City Southern, which Kansas City Southern broke. And CN will pay that break fee to CP.
And the second part of that $1.7 billion is a billion-dollar payment to Kansas City Southern if the regulator rejects the deal. So that's $1.7 billion US, which is over $2 billion Canadian. And in 2021, CN is forecasted to earn somewhere around just over $4, $4.2, $4.3 billion. So for half of this year's earnings to simply disappear over a failed deal-- and this is money that CN really has no way to recoup, so, I mean, it's a significant amount of money. It's quite material to their financials. So that would definitely weigh on the stock.
- Next, talk about CN's debt load after the acquisition.
- If CN is successful in acquiring KSU, they're going to fund this deal through a combination of shares and cash. And that cash is going to be borrowed. Right now, it looks like CN is going to end up with balance sheet leverage of about 4 and 1/2 to maybe close to 5 times. And that's extremely high for a rail.
So what this means is that CN is going to need to flawlessly integrate this acquisition. There's not going to be much room for error. And that's going to put a lot of pressure on the company. And it could keep some investors away, investors who are a bit shy of leverage.
- OK, and finally, CN's share price could lag until a decision is approved.
- Right now, the way this merger is kind of being put together, CN needs two levels of approval. The first approval is for the US Surface Transportation Board to allow CN to take the KSU shares into a trust. And that decision will probably come sometime maybe the end of July.
And what that allows CN to do is to own all of the shares of Kansas City Southern. They won't be exercising any management control over the company. So Kansas City Southern will still be a separate entity. But CN will own them.
The second level of approval that they need from the US Surface Transportation Board is an actual approval of the merger. And that won't come until another year, possibly even longer. There's probably at least 12 to 18 months of uncertainty ahead. And that then may keep some investors away from the stock because the outcome is unknown. It'll be an overhang for a little while.
- So with all these factors in mind, where do you net out on CN?
- Look, I mean, I think that both Canadian rails, CN and CP, are great businesses. These are core infrastructure assets in Canada that cannot be replicated. And the fundamentals for both companies, for both businesses are still strong. So I'm generally quite positive on the rails including CN.
- David, thank you for your insights.
- Thanks, Anthony.
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- CN Rail and CP are locked in a battle for US Railway Kansas City Southern. But a superior bid has now put CN in the driver's seat. But CN's shares have lagged CP's over the past year. So does CN's recent stock dip represent a buying opportunity. Or is it a sign of a bumpy road ahead?
Today, we look at the bulls and bears case for CN. David, its core business is performing well.
- Yeah. Listen, the demand for transport is strong. The outlook is positive for the Canadian economy. The economies around the world continue to reopen. Indicators for industrial production, consumer demand are quite robust. And the company itself is forecasting double-digit earnings growth this year, which would put it ahead of where it was in 2019. So we're basically in a full-on recovery and growth mode.
- OK. Next, talk about the benefits of a Kansas City Southern acquisition.
- As you know, CN is in the midst of trying to acquire Kansas City Southern. And if this acquisition is successful, CN would arguably have the strongest rail network in North America. And what this will do is it's going to allow them to win market share from their competitors. It's going to allow them to win new business from shippers who aren't currently using rail as their main mode of transport.
And this is going to be possible because CN has the best rail network in Canada, while Kansas City Southern has a really strong presence and footprint in the southern US and in Mexico. So if they're able to combine these two networks, it's going to be a second-to-none North American rail network.
- Finally, if the KCS deal doesn't go through, you see some short-term gains for the stock?
- I mean, look, CN's stock has performed OK in the last year. Over the last six months, it's been trending a bit sideways. And ever since CN announced the KSU acquisition back in April, the stock is actually down about 10% or 11% since that announcement came out.
And the reason for that is because CN has to wait for a lot of regulatory approvals. It's going to take a lot of time. Markets don't like uncertainty. Right? So the stock has been down. It's been underperforming.
I think the sooner we find out whether or not this merger is going to be allowed to proceed, it will be better for the stock. And even if the merger is rejected, I think CN's stock will see a significant pop just because of the removal of the uncertainty.
- Some strong factors to CN being bullish. Now let's take a look at the bear case. CN incurs a cost if the KCS deal falls through.
- Look, CN is going to be on the hook for $1.7 billion US if the Kansas City Southern deal fails. And that's going to be coming in two parts. The first part is, CN is paying $700 million US to CP because CP originally had a merger agreement with Kansas City Southern, which Kansas City Southern broke. And CN will pay that break fee to CP.
And the second part of that $1.7 billion is a billion-dollar payment to Kansas City Southern if the regulator rejects the deal. So that's $1.7 billion US, which is over $2 billion Canadian. And in 2021, CN is forecasted to earn somewhere around just over $4, $4.2, $4.3 billion. So for half of this year's earnings to simply disappear over a failed deal-- and this is money that CN really has no way to recoup, so, I mean, it's a significant amount of money. It's quite material to their financials. So that would definitely weigh on the stock.
- Next, talk about CN's debt load after the acquisition.
- If CN is successful in acquiring KSU, they're going to fund this deal through a combination of shares and cash. And that cash is going to be borrowed. Right now, it looks like CN is going to end up with balance sheet leverage of about 4 and 1/2 to maybe close to 5 times. And that's extremely high for a rail.
So what this means is that CN is going to need to flawlessly integrate this acquisition. There's not going to be much room for error. And that's going to put a lot of pressure on the company. And it could keep some investors away, investors who are a bit shy of leverage.
- OK, and finally, CN's share price could lag until a decision is approved.
- Right now, the way this merger is kind of being put together, CN needs two levels of approval. The first approval is for the US Surface Transportation Board to allow CN to take the KSU shares into a trust. And that decision will probably come sometime maybe the end of July.
And what that allows CN to do is to own all of the shares of Kansas City Southern. They won't be exercising any management control over the company. So Kansas City Southern will still be a separate entity. But CN will own them.
The second level of approval that they need from the US Surface Transportation Board is an actual approval of the merger. And that won't come until another year, possibly even longer. There's probably at least 12 to 18 months of uncertainty ahead. And that then may keep some investors away from the stock because the outcome is unknown. It'll be an overhang for a little while.
- So with all these factors in mind, where do you net out on CN?
- Look, I mean, I think that both Canadian rails, CN and CP, are great businesses. These are core infrastructure assets in Canada that cannot be replicated. And the fundamentals for both companies, for both businesses are still strong. So I'm generally quite positive on the rails including CN.
- David, thank you for your insights.
- Thanks, Anthony.
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