KCS Part II: The minnow can swallow a whale

Posted by Fred Frailey
on Wednesday, May 22, 2013

In a response to my last blog, D.Carlton this morning jolted me wide awake. He said, in regard to which railroad might buy Kansas City Southern: “You have it backwards. The question is: Who is KCS going to buy?” Damn! That Mrs. Carlton sure raised a smart boy. In essence, what D. is saying is that the inflated stock price of KCS is a huge gift that translates into enormous buying power if that railroad went shopping for a bigger partner. It completely turns the table on the usual way business is conducted, in which the larger company buys the smaller one. So let me explain.

I took Carlton’s idea to a friend who is in the money biz and good with numbers. I’ll call him Slim. Slim played around with the numbers and reported back that D. is absolutely right. Let’s pretend that Norfolk Southern and KCS agreed tonight to an all-stock merger. It would make sense, after all. The two railroads fit together wonderfully, and there is no tried and tested successor to chief executive Wick Moorman, 60, who faces mandatory retirement in a few years.

Okay, analysts estimate that NS will earn $2.4 billion in 2015 and KCS $640 million. This would give a combined railroad $3 earnings in income if no savings were achieved and no business was lost to competing companies. In terms of earnings per share, this translates to $7.10 for NS and $5.80 for KCS.

Let’s keep this simple. First, assume NS bought KCS with stock, at no premium price. It would have to issue 158 million shares, on top of the present 338 million. So the combined profit of $3 billion divided by 496 million shares, brings the 2015 earnings per share for NS from $7.10 down to $6.12. That’s called dilution. I question whether NS shareholders would approve such a deal.

Now turn the tables and have KCS be the buyer. KCS shares are valued by investors as being worth, per dollar of earnings, twice what those of NS are. To buy NS at last night’s closing price of $79.23 per share would require KCS to issue 237.4 million new shares in addition to the 111.1 million shares currently outstanding.

The surviving company, Kansas City Southern, would now have that same $3 billion of earnings. Its earnings per share would rise, from $5.80 to $8.72 a share. KCS shareholders would love such a union.

Realistically, KCS would have to pay NS shareholders a premium of 20-30 percent to get them on board. But even then the math still works for KCS.

What you’ve just read is Slim’s analysis, and it passes my hee-haw test.

On the other hand, what would be the consequences? If BNSF Railway is opposed to this deal, there is not a lot it can do. NS and KCS jointly own the Meridian Speedway, the east-west line between Meridian, Miss., and Shreveport, La. KCS then goes west to Dallas and south to Laredo, Tex., and Mexico. The Meridian Speedway deal and executive chairman Mike Haverty’s suggestion to BNSF that they do a similar project between Shreveport and Dallas drove BNSF right into the arms of CSX for southwest-southeast traffic. To my knowledge, BNSF doesn’t do a whole lot of business with KCS or with NS in the Southeast.

Now let’s suppose Union Pacific hates this idea. It does run its intermodal trains over the Speedway to reach Norfolk Southern. Could it divert traffic to CSX? Not easily. It can reach CSX in Memphis and New Orleans, but these are inferior interchange points compared to Shreveport and the Speedway; UP would be cutting off its tail.

Is this something that Kansas City Southern has considered? Probably. Could it succeed doing an unfriendly offer for NS? I don’t know, but at a 30 percent premium to the present price it would be hard for NS shareholders to turn it down. And do I think this might happen? I have no idea at all. But it’s something to think about.

And the amazing thing, when you do think about it, is how the game has changed. Kansas City Southern was always the poor relation at the railroad dinner table, the brother that the bigger, older, stronger Class I railroads ignored, insulted, or made fun of. Today, they do that at their own peril.

Thanks to D. Carlton and Slim for their input. — Fred W. Frailey

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