Mergers and acquisitions still likely for Class I railroads

A photograph of a train at a station.

Mergers and acquisitions could happen among the Class I railroads within the next decade if regulatory and economic factors drive railroads to see mergers as a path to greater efficiency and expanded capacity, according to industry observers.

“I just feel it’s inevitable at some point. It’s a natural evolution if capacity is going to be limited. And it is. It’s limited when you have two separate networks,” said Canadian Pacific (NYSE: CP) CEO Keith Creel at the Barclays investor conference Feb. 19. “When you create one bigger network, you create more capacity. And for the railroads to handle the growth that’s going to come…we have to have more capacity.”

One driving factor for a merger among the Class Is could be regulations that would compel the railroads to join forces as a means to make up for lost efficiencies, said Todd Tranausky, vice president of rail and intermodal services for FTR, a consulting firm. This would be the case if railroads feel the Surface Transportation Board is mandating open access, or allowing freight rail companies to operate over tracks normally restricted to service only by a competing carrier.

“I could see the carriers going ahead with mergers as a way to make up the efficiencies they would lose from an open-access regime,” Tranausky said. “Essentially if the carriers feel like the regulatory efficiency drag is too great, they could use mergers as a way to try and generate additional efficiency.”

He continued, “That said, I don’t think there is any political will on the part of the carriers or the board to undertake the next round of mergers if the status quo is maintained. It would take a shock to the system like open access to kick that off.”

Another impetus for a merger is if the Class I railroads feel their companies would be better served if they expanded their network footprint. Because the existing rail network is finite, one way to create more rail capacity is by joining resources.

“Eventually, you get to a place [where] to create … capacity without an ability to build more railroads … you got to have a better-running network,” Creel said.

While the adoption of precision scheduled railroading (PSR) by all the Class I railroads except BNSF has expanded the rail capacity of individual railroads, according to company officials, the adoption of a similar operating model among all the companies might make for a smoother transition post-merger.

But discussions about mergers might happen in the next five to 10 years rather than within the next five years because of the adoption of PSR, Creel said.

A merger “will depend on chemistry” and timing, said Canadian National (NYSE: CNI) CEO JJ Ruest at the Citi investor conference Feb. 20. Ruest also said the advantage of a merger with an Eastern U.S. railroad is access to major population centers, whereas a Western U.S. railroad has a geographic advantage because of the longer distances and a lack of competition from the rivers and the barge market.

However, despite talk of expanded capacity, some question whether the railroads’ intentions for mergers are more about gaining market share.

“There is nothing technical about a Class I merger that would help grow capacity. Capital investment to grow capacity is a choice by railroad management and their investors,” a transportation consultant said.

The consultant continued, “It is to the railroads’ advantage to keep capacity constrained. Careful control over capital investment to expand capacity reduces the chance that they will really compete with each other for market share to fill the capacity — the last thing that investors want. The game for 25 years has been cut costs and increase prices above inflation. Volume hasn’t grown much in that time. I think they are running up against the limitations of that strategy. All a merger would accomplish would be to improve the merging carriers’ market power, which would let them raise prices more rapidly above inflation and keep the current game going for a while longer.”

Whatever the railroads’ true motivation, the current environment doesn’t appear to support a merger and acquisition anytime soon, Tranausky said.

“Let’s also remember that there has never been a well-executed rail merger. Whether it is UP-SP [Union Pacific-Southern Pacific], the Conrail split between [Norfolk Southern] and CSX, or even CP’s acquisition of the Rapid City, Pierre and Eastern [short line]. So, I think it is a decision that would not be undertaken lightly and is probably off the table unless something drastic changes in the economic regulatory landscape,” Tranausky said.