Transcontinental M&A talk heats up with UP in the spotlight, but political and operational hurdles remain

When Canadian Pacific officially acquired Kansas City Southern in April 2023, in a $31 billion deal that established the first railway connecting the United States, Canada, and Mexico, the general sentiment among freight railroad stakeholders was that this deal would be the last railroad merger of that size going forward.

But in recent months the topic of another potential Class I freight railroad merger and acquisition (M&A) has picked up steam. That was made very clear in a report published yesterday by business publication Semafor, citing people familiar with the matter, that Omaha, Neb.-based Union Pacific (UP) “is working with investment bankers at Morgan Stanley to explore the acquisition of a rival.” The report stated that neither UP nor Morgan Stanley offered up comments regarding this development.

The report said the acquisition target was not made available. But a May report in Trains magazine stated that UP CEO Jim Vena said a transcontinental merger would improve service and lead to growth by eliminating the inefficient and time-consuming interchanges that occur at Chicago and other gateways between the Eastern and Western railroads, adding that railroads would become more competitive with trucks if it did not take 24-to-36 hours to hand off freight cars in Chicago. Vena also observed in the report that being able to provide fluid, single-line service from coast-to-coast, as is the case with CPKC, as well as Canadian National moving freight north into Canada and south into Mexico, like CPKC does, would allow U.S.-based importers and exporters to be more competitive on a global basis.

In a research note, Baird Equity Research analyst Daniel C. Moore wrote that some industry stakeholders maintain there are multiple benefits that could stem from a transcontinental merger, including: reducing interchange delays; allow management to reduce overhead costs; and deliver a more seamless service product.

“Whether all those potential efficiencies can be realized and accrue to shippers remains an open question,” wrote Moore. “What is clear is that further consolidation would not only be strategically transformative, but it would also fundamentally reshape the competitive landscape. We have also argued that if a deal is announced, we believe the probability of a second transaction occurring would be high and that there is likely to be a meaningful first-mover advantage. We believe a combination between Union Pacific and CSX likely makes the most strategic and operational sense. Both carriers are well down the road in implementing precision scheduled railroading (PSR), and many observers would argue their networks offer strong geographic and operational synergies. That said, Norfolk Southern remains a clear potential target as well.”

A research note issued by TD Cowen analyst Jason Seidl last month included key takeaways from a call with Daniel Elliott, former Chair of the Washington, D.C.-based Surface Transportation Board (STB), an independent adjudicatory and economic-regulatory agency charged by Congress with resolving railroad rate and service disputes and reviewing proposed railroad mergers.

In terms of a freight railroad transcon merger coming to fruition, Elliott pegged its chances at 20%-to-25%.

“Only a U.S. East-West/end-to-end combo is truly in play given 1) lack of overlap, and 2) geopolitical complications involved with a Canada-U.S. merger,” wrote Seidl. “A transcon merger would likely facilitate a second between the remaining U.S. players, and this possibility would weigh on regulators’ evaluation.”

As for the regulator evaluation, Seidl said that before any deal were to occur, a fifth Republican STB board seat will likely need to be filled, adding that it is far from a certainty that will happen by the end of the year, due to the lengthy Senate confirmation process.

What’s more, Seidl explained that with the STB board comprised of two Democrat members and two Republican members, that it makes the risk of moving forward with a merger too high, as it is likely the two Democrat members would vote against it.

In conversations with C-level freight railroad executives, Tony Hatch, principal of New York-based ABH Consulting said the takeaway from the majority of them is that the benefits from a merger are great, but that the risks are greater.

Regarding benefits, Hatch pointed to many, including: elimination of interline issues; service and capacity increases; global customers; reduced SG&A (selling, general, and administrative); repurposed midcontinent hubs, yards, and terminals; more focused IT spend; faster decision making; and address legacy succession.

As for the risks, he called out: how enhanced competition is not defined; mergers “open the books” on railroad practices; a new breed of shipper could get involved for the first time, citing Amazon, Walmart, UPS, FedEx, Target, and Amazon as possibilities; open access; and potential hostility from Canada and Mexico.

“If a merger happened, it could be a free-for-all,” said Hatch. “Some of these could cause major structural changes or it is going to be death by 1,000 cuts. It is a hot topic that has gotten hotter. I would have said that this is something that flares up every five years and now it’s over, but it is not over.”