North American Rail: CP & KCS merger
We have been writing about the growing expectations of an inflationary environment over the past weeks. During such periods we believe businesses that have strong pricing power and growing cash flow with an inflation-hedge feature, should be the place to allocate our capital. Railroads are such a business. They are an essential business with high barriers to entry and each year operators increase their freight rates above inflation.
Canadian Pacific Railway (CP) is one of the rail companies we have owned in our portfolio. We believe the management has done a phenomenal job turning one of the worst operated rail companies to one of the most efficient rail companies. More recently, CP announced it has reached a merger agreement with Kansas City Southern (KCS), a smaller North American rail company that operates in the US and Mexico. The regulatory review is expected to be completed by mid-2022.
- Please see a map of CP and KCS’ rail network below.
- Above, the red and blue lines represent CP’s and KCS’s networks respectively, which are highly complementary. The new entity will become the only railroad that spreads across Canada, the US and Mexico. The combined network will enable the operator to move products between Canada and Mexico directly, without switching tracks, and will improve customer services.
- A broader reach and more efficient network should make the combination more competitive, empowering itself to win business (Auto, Grain, Merchandise, etc.) over trucking and other railroads. Additionally, the transaction is well positioned for the growing trend of a supply chain reshoring – back to North America, especially Mexico.
- Regulation remains the key issue. Due to competition concerns, the authorities have rejected several multi-billion-dollar railroad merger proposals before. However, we expect the transaction has a good chance to be approved given their networks have limited overlap and the transaction is expected to improve customer service and increase freight competition.
“This means that” we believe the merger is constructive and unlocks significant growth opportunities. While we like the company and own it, the transaction is expensive. We are watching closely for an opportunity to buy more.
National Instrument 31-103 requires registered firms to disclose information that a reasonable investor would expect to know, including any material conflicts with the firm or its representatives. Doug Johnson and/or Pathfinder Asset Management Limited are an insider of companies periodically mentioned in this report. Please visit www.paml.ca for full disclosures.
*All returns are time weighted and net of investment management fees. Returns from the Pathfinder Partners’ Fund and Pathfinder Real Fund are presented based on the masters series of each fund. The Pathfinder North American: Equity Portfolio and The Pathfinder North American: High Income Portfolio are live accounts. These are actual accounts owned by the Pathfinder Chairman (Equity) and client (High Income) which contain no legacy positions, cash flows or other Pathfinder investment mandates or products. Monthly inception dates for each fund and portfolio are as follows: Pathfinder North American: Equity Portfolio (January 2011), Pathfinder North American: High Income Portfolio (October 2012) Pathfinder Partners’ Fund (April 2011), Pathfinder Real Fund (April, 2013), Pathfinder International Fund (November 2014) and Pathfinder Resource Fund (May 2018).
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