Rumored CP-CSX deal faces high hurdle in Washington, Ottawa

Has E. Hunter Harrison, arguably the finest rail operator in the world, fired the first shot in what could be the final round of consolidations in his industry?

Harrison is the CEO of Canadian Pacific Railway (CP), which has made a merger proposal to CSX Corp. that the U.S. East Coast railroad rebuffed, according to a report in The Wall Street Journal that appeared over the weekend. No details about the proposal, which was reportedly made in the past two weeks, were available, and neither company would comment.

Calgary, Alberta-based CP operates over a network stretching across Canada and extending into parts of the U.S. Northeast and Midwest. CSX's network covers virtually all of the Northeast and goes as far west as Illinois and Ohio. CP and CSX serve Chicago, as do all of the five other major "Class I" railroads, except for Kansas City Southern Railway. The CP and CSX networks overlap slightly in Ontario, Canada; New York state; and Pennsylvania.

A CP-CSX combination would be the first merger of Class I rails since Canadian National Inc. (CN) bought the Illinois Central Gulf (ICG) Railroad in 1998. Harrison, who was head of ICG at the time, would eventually become head of CN.* The next year, CN with Harrison at the helm, proposed a merger with BNSF Railway. That deal was scuttled following widespread protests by other railroads and shippers, and after the U.S. Surface Transportation Board, the successor agency to the Interstate Commerce Commission and the bureau responsible for what's left of rail economic regulation, declared a 15-month moratorium on consolidations while it drafted new merger guidelines.

A CP-CSX combination would have to be approved by U.S. and Canadian regulators, a tall order because, unlike previous eras when companies could argue a merger was necessary to rescue a failing railroad, all of the remaining carriers today are financially and operationally healthy, albeit to varying degrees. Regulators might also take a dim view of further consolidation in a marketplace with only seven large carriers (two of them being Canadian rails with U.S. operations).

Shippers, for their part, want nothing to do with a shipping world that could have as few as two transcontinental railroads. "We've had a long-held view that no further consolidation is appropriate or necessary in an already highly consolidated industry," said Bruce Carlton, president of the National Industrial Transportation League, a shipper group whose members are heavy rail users.

A CASE OF BAD TIMING?
The timing of a CP-CSX transaction would also prove a challenge as the industry has spent the past year fielding customer complaints over an increase in congestion and slow networks—problems created by terrible winter weather, a deluge of crude oil shipments that has led to equipment shortages for other commodities, and a surge in imports hitting U.S. shores earlier than normal as retailers concerned about possible port labor disruptions along the West Coast scrambled to get holiday shipments into U.S. commerce. More than 13,000 workers represented by the International Longshore and Warehouse Union (ILWU) have been working without a contract since the prior six-year pact expired July 1. They have remained on the job as ILWU continues talks over a new pact with the Pacific Maritime Association (PMA), which represents ship management.

John G. Larkin, lead transport analyst at investment firm Stifel, Nicolaus & Co., said in a note today that regulators may block any CP-CSX deal on grounds that a bogged-down network doesn't need the added stress associated with the "rapid-fire integration" model that is favored by Harrison.

Lawrence H. Kaufman, a veteran rail executive, consultant, and author, added that no railroad "wants to deal with the political fallout" of a merger attempt. He also questioned why CP would proceed with a multibillion dollar mega-merger to fix one or two operational problems, the most notable of which would be congestion in Chicago, a major point of North American rail interchange.

In 2008, the Harrison-led CN purchased the Elgin, Joliet and Eastern Railway Co. from U.S. Steel for $300 million to create a bypass around Chicago and alleviate the severe bottlenecks for traffic entering and exiting the city's freight yards. A merger with CSX may serve the same purposes, as CSX owns a small railroad, the Baltimore & Ohio Chicago Terminal Railroad, that could be used as a way for CP to bypass Chicago.

Anthony B. Hatch, a long-time rail analyst, said in an e-mail today that while rail mergers in the 1990s mostly involved parallel networks where the purchasing carrier could achieve economies of scale, a combination with little operational overlap, known in the trade as an "end-to-end" transaction, offers relatively little scale. Aside from improved IT capabilities, not much has changed in the competitive rail landscape since the turn of the century, Hatch said. The analyst opposes further consolidation, arguing that the economic, operational, and political risks far outweigh any potential benefits.

Harrison has said publicly that he supports continued consolidation as a means of reducing rail congestion. He may also see a deal with CSX as a mechanism to expand CP's crude-by-rail penetration. CP expects to haul 200,000 carloads of crude next year, up from 120,000 in 2014, according to estimates from Robert W. Baird & Co., an investment firm. Most of that crude comes from Alberta's oil sands and the Bakken Shale fields in Saskatchewan and North Dakota. CSX, in turn, serves refineries in the Northeast U.S. and mid-Atlantic markets.

Harrison's thoughts aside, the decision to further pursue CSX is likely to fall to William A. Ackman, whose hedge fund, Pershing Square Capital Management LP, is CP's largest shareholder. In May 2012, Pershing Square revamped CP's board and installed a new slate of directors. Ackman then brought in Harrison, who had been in retirement, to revive what many thought was an underperforming business.

Much has changed since then. For example, revenues in the second quarter rose 12 percent from year-earlier figures, while operating income jumped 40 percent year over year. Perhaps most significantly, operating ratio—the ratio of expenses to revenues—stood at 65.1 percent, a near 7-point drop from the year before. A lower operating ratio means greater profitability for the carrier as it takes less of every dollar to run the business.

To put CP's second-quarter operating ratio in perspective, its ratio through the first quarter of 2012 stood at 80.1 percent. The prior management team had hoped to reduce the ratio to between 68 and 70 by 2016.

*Editor's note: An earlier version of this article incorrectly said that Harrison was head of Canadian National (CN) at the time of its merger with Illinois Central Gulf Railroad.