Is KCS buyable, and by who?

It’s silly time on Wall Street again. Bloomberg Businessweek calls Kansas City Southern, North America’s smallest Class I railroad, both alluring and expensive to acquire. It then goes on to explain which larger railroads may find it attractive. Among securities analysts surveyed by the publication, all but two Class I lines are named as a potential buyer. But I think Businessweek and its sources have it mostly wrong. The larger railroad nobody mentions, I maintain, has the most to gain by buying KCS. But because of its expensive stock price, Kansas City Southern is probably too costly for anyone to buy. And besides, there are other issues, including the fact that KCS is not indicating it wants to be bought. So I’ll summarize what Businessweek reports, and then give you my take.

Traffic on the KCS network is growing like a weed, with sales poised to expand by almost 50 percent between now and 2016, according to Bloomberg. Moreover, its 3,100-mile network in Mexico is beginning to solidify around a bevy of automotive assembly plants. It carries frack sand and pipe to shale drillers in South Texas, and is exploring a massive movement of crude oil from northern originations to Port Arthur, Texas. Meanwhile, movement of coal from the Powder River Basin to more than half a dozen on-line power-generating plants is recovering nicely from a dive in 2012.

There are so many things to like about KCS, in fact, that Businessweek doesn’t get around to listing them all. Case in point: In 2009, at the absolute depth of the Great Recession, most of its debt matured and had to be refinanced on a short term basis at a yield to maturity of an outrageous 16.5%. It was swallow hard and do it or risk bankruptcy. Recently the company completed a refi of its entire debt at an average cost 3.5% and average maturity of 14 years. So how to you like them apples?

Businessweek correctly concludes that in the perfect world everybody, or almost everybody, would like to gobble up this railroad. The research director at Hodges Capital Management in Texas, which runs some snazzy mutual funds, sees Union Pacific as the most obvious acquirer. Desjardins Group says no, the most natural fit is with Canadian Pacific (the two railroads meet in Kansas City) or Canadian National (they market jointly through Jackson, Miss.).

FBR, an investment bank in Arlington, Va., finds BNSF Railway is the most likely buyer. BNSF, a Berkshire Hathaway subsidiary, has the financial power of its parent, is under no short-term pressure from investors, and can integrate KCS into its network behind a curtain, so to speak.

Fred says baloney to all this. Forget Union Pacific as a buyer. The antitrust barriers are insurmountable even if UP is gutsy enough to try. UP already owns Texas — next to it, BNSF is barely a presence — and if it got KCS would own Mexico, too. And BNSF would pull out all the stops, provoking a nuclear winter in railroading, to hold its traditional rival at bay.

Forget the Canadian railroads, too. True, CP and KCS join at Kansas City, but aside from grain, the traffic potential between them isn’t that great. Besides, CP’s Hunter Harrison has his hands full whipping his railroad into shape. As for CN, it’s an even clumsier fit than KCS + CP. As for CSX Transportation, there’s no there there between it and KCS.

No, the railroad that would benefit the most owning KCS is Norfolk Southern, which of course Businessweek doesn’t even mention. Trust me (because I’ve seen parts of the data), there is a huge flow of goods between Mexico and the eastern half of Texas on the one hand, and the NS service area on the other. Connecting to this groundswell of potential intermodal business is the whole point of Norfolk Southern’s Crescent Corridor, which officially launched this January 20.

But I don’t see much happening between NS and KCS. First, I question whether NS CEO Wick Moorman would want to take this on; he’s got a lot to occupy his energies, trying to deal with the decline of Appalachian coal traffic. Second, KCS is hyper-expensive to buy. As I write this, its shares trade for 28 times estimated 2013 earnings, 23 times 2014 estimates, and 20 times 2015 guesses. The price-earnings ratios of NS are half that. And any buyer would have to offer a premium! No matter how logical a fit, buying KCS would seriously dilute NS earnings and current shareholders would revolt.

So what might work? I’ll offer two ideas.

First, Norfolk Southern would buy not only KCS but its new CEO, Dave Starling, as well. This would give KCS an incentive to deal with NS. I don’t know Starling, but people who do say he is the best in the business at what he does. Let’s assume that Moorman’s CEO-in-waiting, newly installed NS president Jim Squires, is judged by the board of directors as not up to the top job when the time comes in a couple of years. NS could buy KCS and install Starling as chief executive. A long shot, yes, but isn’t that what Burlington Northern did when it bought the Santa Fe Railway, giving the corner office to Santa Fe’s Robert Krebs?

And let’s go back to BNSF. The people at FBR have a point. If owning KCS is a big enough long-term plus to the railroad’s Matt Rose and Berkshire’s Warren Buffett, this acquirer has the money at its fingertips, and the dilution to earnings will be lost inside Berkshire’s huge tent.

Both NS and BNSF are virtually end to end with Kansas City Southern and barely compete with the smaller railroad anywhere, lessening the risk of lost competition should they acquire it. And (not mentioned by Businessweek), the Surface Transportation Board long ago said the regulatory barriers to buying KCS would be far lower than a combination between the larger Class I railroads.

Summing up: Odds are KCS will still be its own boss five years hence. But if it is not, I think Norfolk Southern and KCS make the best fit and the most business sense, but unless KCS stock gets hammered relative to that of NS, the larger railroad will not have the nerve to act. In that case, the most likely buyer, if any, turns out to be the folks from Fort Worth, financed by the wallet of Mr. Buffett in Omaha and abetted by the man’s infinite patience for making things work out right. — Fred W. Frailey