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A view of the frozen Bow River and the Canadian Pacific Railway at Banff National park near Lake Louise, Alberta, on Dec. 6, 2013.JOE KLAMAR/AFP/Getty Images

Canadian railway stocks have long beckoned investors because of an attractive operating environment with few competitors. Now, Canadian Pacific Railway Ltd.’s proposed US$25.2-billion takeover of Kansas City Southern offers a new reason to take interest: The shares are down even as the longer-term outlook improves.

CP shares fell 5.4 per cent to $448.60 each on Monday, in the first day of trading after the deal between the two railways was announced on Sunday, as some investors fretted over the price of the deal and the way CP will pay for it. The railway will raise US$8.6-billion in debt and issue 44.5 million new shares, increasing total debt to more than US$20-billion and raising the share count.

The share price of Canadian National Railway Co. also fell, by 3.4 per cent – possibly because of competitive concerns or a belief that CN will strike a pricey deal of its own.

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Neither stock is cheap since they both recovered from an early pandemic sell-off last year and hit fresh record highs as recently as last Thursday, on rising shipping volumes and an improving economic outlook.

Last week, CN shares traded at 24.5 times 2021 estimated earnings from a consensus of analysts, according to data from Raymond James. That is well above the average valuation of 19.1 times estimated earnings, for data going back to 2015.

Similarly, CP shares traded at 22.8 times estimated earnings, also above the average valuation of 17.9 times earnings.

That puts the valuations of both railway stocks in line with the forward price-to-earnings ratio for the S&P 500, the pricey U.S. benchmark that has pushed many observers to look abroad for better deals.

But if you can get past the idea that you’re not exactly hunting for bargains here, CP in particular offers a compelling reason to ignore near-term valuation concerns and focus instead on the potential benefits of adding KCS’s rail network in the United States and Mexico, creating a significantly larger North American network.

Analysts have embraced the proposed deal because the combined entity comes with very little overlap, which should appeal to regulators. As well, one rail network through three countries means that CP can offer faster options to shippers within the trading zone of the United States-Mexico-Canada Agreement, driving greater efficiencies.

It also means that CP will look more attractive next to trucking, which accounts for about 70 per cent of the value of goods that cross the border between the United States and Mexico. There’s an upside for the environment here, too, which CP highlighted in its announcement: Rail is four times more fuel efficient than trucking, which looks like a competitive advantage as shippers take carbon emissions into account.

“While offering more rail options to shippers will contribute to the revenue synergies expected from this deal, arguably the biggest opportunity is gaining share from trucks,” Kevin Chiang, an analyst at CIBC World Markets, said in a note. He added that “taking a small market share provides a significant upside.”

The deal promises to increase sales by about US$600-million a year and lower costs by US$180-million a year within three years after the deal closes, according to CP’s estimates.

If CP’s share price reflects the promised benefits of the KCS acquisition before the deal even closes, analysts expect that CP’s share price can perform well over the next 12 months.

Mr. Chiang raised his target price to $560, up from his previous target price of $490, implying a gain of more than 24 per cent from the current share price. Benoit Poirier, an analyst at Desjardins Securities, increased his target to $520 from $486 previously.

“We are confident that the transaction should close and encourage investors to revisit the story and buy the shares,” Mr. Poirier said in a note.

Monday’s decline in CP shares merely adds to the long-term appeal.

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Follow David Berman on Twitter: @dberman_ROBOpens in a new window

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