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Canadian Pacific Railway Ltd. has a week to get back in the fight for Kansas City Southern, but the prospect of a higher offer is undercut by CP’s stated aversion to a bidding war that would saddle it with new debt.

KCS on Thursday rejected CP’s US$25.2-billion takeover offer in favour of a US$29.9-billion bid from Canadian National Railway Co., giving CP until May 20 to improve its deal. CN is also reimbursing KCS for the US$700-million fee the U.S. railway will owe CP for breaking the deal.

In a statement on Thursday CP said it planned to respond to KCS, but would not enter a bidding war. “Our mutually negotiated agreement with KCS represents compelling short-term and long-term value for shareholders that is actually achievable,” CP said.

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If CP were to raise its offer, analysts say CP’s options include taking on an equity partner to raise money without debt, increasing the share component of its bid, or borrowing more money to fund the acquisition.

Eventually, CP could also be a buyer of rail lines or other assets if the U.S. regulator requires CN to sell them as part of the takeover’s approval, analysts said.

CN and CP are offering enormous sums for Kansas City Southern, but history suggests the payback will be robust

The unfolding of the Kansas City Southern takeover saga

Christian Wetherbee, a stock analyst at Citigroup in New York, said CP’s strategy is unclear, but pointed to recent comments by Keith Creel, CP’s chief executive officer. Mr. Creel said he would not make an offer that required boosting the company’s ratio of debt to earnings to 4.6, which is CN’s ratio under the deal.

CN said the deal will leave it with a debt worth US$33.6-billion, including the assumption of US$3.8-billion in KCS debt. Under the deal CP had reached with KCS, CP said its debt would reach US$20-billion, including KCS’s debt, for a leverage ratio of 4.0.

Anthony Hatch, an analyst at New York-based ABH Consulting, said there is a small chance CP will raise its offer, although he doubts that will happen. “They have repeatedly said they wouldn’t, and that the CN offer was too big, and required too much leverage to pay off,” Mr. Hatch said. “Hard to walk that back.”

CN and CP declined to make executives available for interviews on Friday.

CN’s takeover requires approval by KCS shareholders and the U.S. regulator, the Surface Transportation Board. The STB must also approve CN’s plan to place KCS shares into a voting trust before seeking regulatory approval of the deal. The trust structure, common in the rail industry, is intended to preserve the independence and operational integrity of the company being purchased while the STB conducts its investigation of the deal, a process expected to last well into 2022.

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The STB has already approved CP’s voting trust, a fact CP points to when it says its own, lower offer carries less regulatory risk than that of CN. Unlike CP’s, CN’s bigger network overlaps in some places with KCS, raising the likelihood of closer scrutiny at the STB, which requires rail mergers to be in the public’s interest and foster competition.

A takeover of KCS – the smallest of the seven Class One railways – would be the first to come before the STB in 21 years.

The winner of the battle for KCS grabs a rare chance to expand a railway in a highly concentrated industry. KCS has an 11,400-kilometre rail that begins in Springfield, Ill., and extends south through Mexico, a network that offers the victor end-to-end access to ports, mills, mines and factories in three countries that are covered by a free-trade agreement.

The loser misses a chance to reach new markets, and has to watch their rival reap the rewards. The last major rail takeover in the United States happened in 1999, when CN bought Illinois Central. In 2000, the U.S. regulator effectively put an end to CN’s plan to merge with BNSF Railway by calling a moratorium on large railway takeovers.

Mr. Hatch said all three railways are well-run and profitable, operating on the precision railroading model pioneered by the late Hunter Harrison, a former CEO of CP and CN. “But if CN were to get [KCS], it would be more troublesome for CP than vice versa,” Mr. Hatch said. “A much bigger CN is more injurious to CP than vice versa.”

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