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Canadian Pacific Railway’s 8.4-per-cent year-to-date return has blasted through the “sell” indicator with a current RSI of 83. (DARRYL DYCK/THE CANADIAN PRESS)
Canadian Pacific Railway’s 8.4-per-cent year-to-date return has blasted through the “sell” indicator with a current RSI of 83. (DARRYL DYCK/THE CANADIAN PRESS)

CP, CN should consider takeover of Kansas City Southern: analyst Add to ...

Here’s an investment idea that could offer profits all around: a takeover by either of Canada’s two big railway titans of Kansas City Southern, a smaller U.S.-based rival.

Desjardins Securities analyst Benoit Poirier says such an acquisition would make a great deal of financial sense for either Canadian Pacific or Canadian National, which would both stand to gain huge economies of scale through a purchase. Shareholders of Kansas City would be rewarded handsomely, too, with a premium to the current stock price of about 20 per cent likely needed to get a deal done.

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Any acquisition would create a North American railway giant, with operations stretching from Canada to Mexico.

“We see significant upside should a Canadian railroad acquire KSC,” Mr. Poirier said in a recent note to clients, referring to the company by its initials. He estimated that an acquisition would add $17 a share in value for Canadian National stockholders or $15 a share at Canadian Pacific, based on the cost savings of nearly $1-billion that a deal would offer the companies.

The staid and boring railway business hasn’t historically been the scene of corporate merger mania, but that may be changing. Famed value investor Warren Buffett snapped up Burlington Northern Santa Fe three and a half years ago, while more recently, U.S. hedge fund manager Bill Ackman took a major position in CP and deposed its board.

The big allure of Kansas City is that the railway is a unique asset, with lines stretching through the U.S. and more importantly, in rapidly growing Mexico, the crown jewel of its operations. It is also part owner of a railway in Panama that stretches along that country’s canal linking the Pacific and Atlantic Oceans.

“We believe the acquisition of KCS, the largest railroad in Mexico, would create significant shareholder value for both CP and CN given the attractive long-term growth prospects in the country,” Mr. Poirier said.

Kansas City is also considered a relative small-fry in the railway business, with a market capitalization of only about $12.8-billion, a size that makes it easy prey for larger rivals. Canadian National, by contrast, has a stock market value of $44-billion and CP around $23-billion.

Investors have been tumbling over themselves to buy Kansas City, given its obvious takeover appeal to other North American railways, bidding up the value of the shares by more than 50 per cent over the past year.

Even at a further 20 per cent premium, a valuation Mr. Poirier concedes would be “rich,” he believes the price would be justified by Mexico’s strong growth prospects.

Mr. Poirier says Mexico is likely to grow at a faster clip than either Canada or the U.S., in part because the country is cost competitive in manufacturing with China. The automotive business, a heavy user of railways, is currently undergoing rapid expansion in Mexico. Kansas City also serves the busy Mexican port of Lazaro Cardenas, another growth driver.

Meanwhile, railways in Mexico only move about 27 per cent of the country’s freight traffic, far below figures closer to 40 per cent in Canada and the U.S. Mr. Poirier says he believes the railway share of the transportation market in Mexico is likely to rise in the years ahead, raising revenues significantly.

U.S. rivals might also be interested in Kansas City, but they face greater headwinds than the two Canadian railways.

Union Pacific Corp. is an unlikely contender because it would face corporate concentration issues. It is a part owner of Ferromex, another major Mexican railway operator.

Norfolk Southern and CSX Corp. both have higher leverage than their Canadian rivals, which may present financial hurdles. Meanwhile, Berkshire Hathaway may want to take a breather and digest its acquisition of Burlington Northern, before going on the takeover trail again.

Mr. Poirier says there would be some risks in a Mexican acquisition. The security situation in Mexico is deteriorating, and the country tracks the U.S. business cycle closely, so will have downturns that mirror those in the U.S.

But on the brighter side, he said that the most unsafe city in Mexico “is generally acknowledged to be Ciudad Juarez, which is currently served by Ferromex; thus, the risk for KCS is somewhat reduced.”

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