DBRS Comments on Canadian Pacific Railway’s Business Combination Proposal with Norfolk Southern

DBRS Limited (DBRS) today notes Canadian Pacific Railway Company’s (CP or the Company) announcement that CP has proposed a business combination with Norfolk Southern Corporation (NSC). With limited details on the financing plan, the announcement indicated that the offer includes a premium in cash and CP’s shares offered to NSC’s shareholders. On a pro forma basis, DBRS estimates that the combined operations could generate revenue and EBITDA of approximately USD 16 billion and USD 7 billion, respectively, for the last-12-months (LTM) period ended September 30, 2015, making it potentially the third-largest Class 1 railroad in North America. DBRS understands that NSC’s Board and shareholders have not yet expressed their position regarding the offer. In the event an agreement is reached between the parties, the transaction will still require approval by regulators in both the U.S. and Canada, which could be a lengthy process. Hence, given limited disclosure on details of the transaction and CP’s intended financing plan, as well as uncertainty regarding NSC’s reaction to the offer and the duration of the regulatory process, DBRS believes that action on CP’s ratings (BBB (high) with Stable trends) at this stage is premature.

If the transaction materializes, DBRS believes it could bring a number of benefits to CP’s operation. CP could benefit from an expanded track network that allows the Company to directly ship its cargos to and from Eastern and Southern United States without having to hand them over to other U.S. railroads. The network could also give CP access to busy ports on the U.S. East Coast (particularly in the states of New York and New Jersey) and NSC’s vehicle distribution facilities, which could materially increase the Company’s penetration in the intermodal and automobile segments. Finally, the larger scale could also provide an expanded revenue base to absorb its fixed overhead costs.

These benefits could be partly offset by a number of challenges. NSC’s material exposure to the coal segment (accounting for 17% of its originated carload and 20% of its revenue in 2014) could increase CP’s overall exposure to this segment, which is on a fundamental declining trend. NSC’s operating ratio (OR) ranged from 69% to 71% between 2011 and LTM September 30, 2015, while the industry’s average OR improved to 65% from 72% during the same period. DBRS believes that NSC’s stalled OR was at least partly a result of the fact that NSC’s track operates through the more populated (and therefore congested) Eastern United States. DBRS also estimates that the OR of the combined entity for LTM September 30, 2015, would be 68%, compared to CP’s 61%. Although CP has demonstrated its ability to significantly improve its own OR over the past years, whether similar improvements can be made on a larger scale operation remain to be seen. Based on the above assessment, DBRS preliminarily estimates that the business combination could provide only an overall modest to limited improvement to CP’s business risk profile.

At this stage, DBRS believes that it is premature to make any assessment of the transaction to CP’s financial risk profile, in the absence of any detailed financing plan. However, DBRS reiterates its view expressed in its press release published September 1, 2015, that (1) following CP’s recently expanded share repurchase program, the cushion against further weakening of financial metrics at this rating level is now minimal; and (2) sustained deviation from the Company’s internal leverage target (unadjusted debt-to-EBITDA ratio of 2.5 times or lower) could pressure the ratings. DBRS could consider placing CP’s ratings Under Review when the Company and NSC manage to reach and enter a sale and purchase agreement for the transaction (subject to regulatory approval) and will evaluate the impact of the transaction and CP’s financing plan to its financial risk profile and ratings.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Companies in the Railway Industry, which can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

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