Railroad Stocks: Merger Activity Highlights the Value of Infrastructure Assets

June 3, 2021

The Reaves Long Term Value Strategy1 began investing in railroad stocks starting in 2011. The reasons are straightforward: rail networks possess many of the characteristics we seek in our essential infrastructure portfolios including high barriers to entry, limited competition, low risk of bankruptcy and durable cash flow generation to support share repurchase programs and dividend growth.

Railroad networks are truly unique infrastructure assets; new rail systems are near impossible to build on account of modern population density and ensuing construction limitations, why most of the current North American network was built in the latter half of the 19th century. The result is a modern oligopoly of only seven North American operators as noted in our previous blog. Also discussed in our prior blog, improvements in operating ratios over the last decade have led to more efficient systems and, in turn, increased free cash flow generation.

The current market value of railroad networks has been on full display in 2021. Canadian Pacific Railway (CP) announced on March 21st that it had agreed to acquire Kansas City Southern (KSU)2 in a $29 billion transaction creating the first North American railway system spanning the United States, Mexico, and Canada3. However, the CP offer was upended a month later when Canadian National Railway (CNI)4 announced a competing offer which valued KSU at $33.7 billion or $325 per share. CNI’s CEO highlighted that the deal would create “…highly complementary networks with limited overlap that will enable them to accelerate growth in single-owner, single-operator, end-to-end service across North America.”5

On May 21st, KSU agreed to accept CNI’s higher offer. The terms specify that CNI will pay $200 per share in cash and exchange 1.129 shares of its stock for each share of KSU.6 The stock price chart below illustrates the performance of KSU since January 2020 and highlights the dates of each company’s bid.

 

2021.06 Reaves Blog 54 Chart

When a portfolio holding is involved in a transaction of this type, our investment team must consider various questions when deciding what actions, if any, need to be taken. These may include: what are the regulatory hurdles for the deal, how long will it take for the transaction to close, should the shares of the acquired company be sold, what are the tax implications of selling the acquirer or acquiree, are the combined entities’ synergies and guidance goals attainable, and what, if any, management changes will the deal create?

The management teams of both CNI and KSU have made detailed filings in support of the proposed merger with the Surface Transportation Board (STB) in order to gain regulatory approval. Assuming approval is received, as proposed, the Reaves team is optimistic about the future growth of the combined entity and its potential contribution to the competitive returns we seek to achieve in our essential infrastructure portfolios.

Over the next year we will be carefully monitoring the progress of this transaction while continuing to assess each company’s operations. Based on the deal terms and the current share prices, if we take no action, upon closure the newly combined company could be one of the largest positions in some of our Long Term Value portfolios. As noted above, KSU shareholders will be receiving shares of CNI plus cash. Once the merger is completed, the Reaves investment team will be tasked with redeploying the cash received into one or more securities to support our investment objectives of low double-digit total return with lower volatility.

To learn more about Reaves’ essential infrastructure portfolios or schedule a call with our investment team please click graphic below.

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Disclosures:

Reaves Asset Management is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration does not imply any skill or training. Reaves is a privately held, independently owned “S” corporation organized under the laws of the State of Delaware.

The information provided in this blog does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. Investors should consider the investment objective, risks, charges and expenses of all investments carefully before investing. Any projections, outlooks or estimates contained herein are forward looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur.

1Beginning December 2019, Reaves LTV Strategy is represented by the LTV SMA Wrap Composite. This composite contains those LTV discretionary portfolios with wrap (bundled) fees. Wrap accounts are charged a bundled fee which includes the wrap sponsor fee, as well as, Reaves’ investment advisory fee. Due to compliance requirements, the net-of-fees calculation is computed based on the highest annual fee assigned by any wrap sponsor who utilizes this portfolio in an investment wrap program (300 basis points from 1/1/03 through 12/31/16 and, effective 1/1/2017, 250 basis points). The LTV SMA Wrap Composite performance consists of money-weighted, time-weighted returns and it includes the reinvestment of all dividends and other earnings. The inception date of the composite is December 2002; however, the composite was created in January 2013. This composite has been managed in a similar manner to the LTV ERISA Composite which ended in December of 2019. The LTV SMA Wrap Composite does not represent all of Reaves’ assets under management.

2As of Reaves’ 13F filing on 3/31/21, Kansas City Southern was held in some portfolios managed by Reaves Asset Management.

3Link to Source: https://www.railway-technology.com/news/canadian-pacific-kansas-city-southern/

4As of Reaves’ 13F filing on 3/31/21, Canadian National Railway was held in some portfolios managed by Reaves Asset Management.

5Link to source: www.railway-technology.com/dashboards/deals-dashboards/canadian-national-railway-acquire-kansas-city-southern/

6Link to source: https://www.railjournal.com/regions/north-america/kansas-city-southern-board-accepts-cns-merger-proposal/

Past results do not guarantee future performance. Further, the investment return and principal value of an investment will fluctuate; thus, investor’s equity, when liquidated, may be worth more or less than the original cost. This document provides only impersonal advice and/or statistical data and is not intended to meet objectives or suitability requirements of any specific individual or account.

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