Why CP’s lower bid for Kansas City Southern could prevail

Keith Creel wants everyone to know he’s telling the truth when he says Canadian Pacific Railway Ltd. can win Kansas City Southern , despite tabling a US$25.2-billion takeover bid that’s US$4.7-billion shy of an offer from rival Canadian National Railway Co.

That’s why CP Rail’s chief executive officer used the word “truth” more than 100 times in talking up his offer during a recent conference call. The “undeniable truth” about CP Rail’s union with KCS is it encourages competition. Another “undeniable truth” is this deal can win over U.S. regulators, a tough bunch who have shut down numerous other planned marriages between North America’s largest railways.

The truth about rival CN Rail’s bid, according to Mr. Creel, is it is anti-competitive. And debt-heavy. And bad for the environment. And, well, CP Rail’s boss had a long list of other “truths” about his rival’s failings.

For Mr. Creel, speaking his truth just might make it so.

In the opening stage of what is likely to be a year-long race for KCS’s networks in the southern United States and Mexico, institutional investors say CP Rail has built a significant lead. Arbitrage fund managers, who invest in takeover situations and are forbidden by their companies to speak on the record, say Calgary-based CP Rail has a realistic chance of acquiring KCS despite offering significantly less than Montreal-based CN Rail.

That sentiment goes against the dynamics of most deals, where the highest bid wins. It explains why KCS shares trade well below CN Rail’s US$325-a-share offer – the stock closed Friday at US$292.21.

Arbitragers are focused on an April 23 ruling from the Surface Transportation Board, the U.S. railway regulator. The STB confirmed KCS qualified for a waiver on elements of the regulator’s review of CP Rail’s offer, making it easier for the Canadian company to close the deal.

Two lines in the STB’s ruling caught the attention of fund managers. The regulator said: “A merger of the CP and KCS networks would appear to result in the fewest overlapping routes when compared to a merger between KCS and any other Class 1 carrier.” The remaining Class 1 carriers include CN Rail.

The STB also said: “The interrelationship between the CP and KCS networks in fact appears to be end-to-end in nature, which likely raises fewer competitive concerns than a transaction that is not end-to-end.” Again, CN Rail can’t make this claim: Parts of its network overlaps KCS routes in the southern U.S.

One fund manager who owns shares in the U.S. railway said the STB review has given KCS’s board cover to accept a lower offer from CP Rail because of its lower regulatory risk. The Globe and Mail is not identifying the manager because they were not authourized to speak publicly on the matter.

Mr. Creel may be speaking truth when it comes to issues like competition and customer sentiment around the KCS takeover, but there’s another “undeniable truth” when it comes to CP Rail’s current US$275-a-share offer – it’s below what investors seem willing to accept. With KCS shares now trading north of US$290, the market is signalling an expectation CP Rail will bump its bid. However, investors are not saying Mr. Creel needs to match CN Rail’s offer.

If CP Rail can win KCS, for less than CN Rail is offering, it will flip cross-border takeover traditions on their head. The battle for KCS is governed by U.S. laws, and American regulators and courts have consistently ruled that boards are required only to focus on what’s best for shareholders, which is getting top dollar for the company. Yet KCS’s directors may decide the best offer is one that suits the interests of other parties – customers and regulators.

Canadian rules, on the other hand, allow boards to consider the interests of all stakeholders. However, in virtually every contested Canadian deal, the highest offer won out. CP Rail may mint a new version of truth in takeovers.

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