DBRS Morningstar Places All Ratings of Canadian Pacific Railway Under Review with Negative Implications Following Agreement to Acquire Kansas City Southern

DBRS Limited (DBRS Morningstar) placed the BBB (high) Issuer Rating, Medium-Term Notes rating and Unsecured Debentures rating as well as the Commercial Paper rating of R-2 (high) of Canadian Pacific Railway Company (CP Rail or the Company) Under Review with Negative Implications following the announcement that CP Rail has agreed to acquire Kansas City Southern (KCS) in a stock and cash transaction valued at approximately $36 billion (USD 29 billion). Following the close, the combined entity will operate as Canadian Pacific Kansas City (CPKC). Under the agreement, each share of KCS will be placed into a voting trust and exchanged for 0.489 of a CP Rail share and USD 90 in cash. CP Rail will issue 44.5 million new shares to fund the share portion while the cash portion will be funded through a combination of USD 8.6 billion in new debt issuance and cash on hand. In addition, CP Rail will assume approximately USD 3.8 billion of KCS debt. The boards of directors of both companies unanimously approved the transaction, but it is subject to regulatory approval from the U.S. Surface Transportation Board (STB) and other applicable regulatory authorities, which is expected to occur by mid-2022.

The combined entity will operate an approximately 20,000 mile-long network uniquely spanning Canada, the U.S. Midwest, the Gulf Coast, and Mexico, but will remain the smallest Class 1 North American railway. In 2020, the combined entity would have generated approximately USD 8.7 billion in revenue and approximately USD 4.6 billion in EBITDA. The combined network will be well positioned to take advantage of improved trading relations in the context of the recent North American free trade agreement between Canada, the United States, and Mexico.

While the increased network size and reach, virtually non-existent overlap, more diversified book of business, and access to more origin and destination points all add positively to the business risk assessment, these improvements are not sufficient to compensate for the higher leverage over the next two to three years resulting from the additional debt. Based on forward-looking expectations for earnings and cash flows, the combined entity’s debt-to-EBITDA ratio will be around 4.0 times (x) while cash flow-to-debt will migrate below 20%, levels that are no longer commensurate with the current ratings, despite the expected improvements in the network’s size and reach, cost efficiencies, and additional revenues. CP Rail has indicated its intention to return to its pre-transaction leverage target of 2.5x debt-to-EBITDA but that it will not achieve this until at least 2023. Approximately USD 780 million in annual EBITDA synergies were announced, but these are not expected to start being realized until 2023 and hence will not contribute to deleveraging between now and 2023. In addition, CP Rail has indicated its intention to suspend share repurchases in order to generate higher levels of cash flows that could be applied to deleveraging.

DBRS Morningstar expects to resolve the Under Review with Negative Implications status once it is clear that the transaction will close as expected and that regulatory approvals, in particular by the STB, are granted. DBRS Morningstar believes that the Company should be able to maintain an investment-grade rating even in a case in which deleveraging would be slower than currently anticipated. However, a negative rating action could be limited to one notch based on the improved business profile if the Company is able to evidence that it can deleverage towards its stated target within a two-to-three year time frame.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

The principal methodologies are Rating Companies in the Railway Industry (January 26, 2021; https://www.dbrsmorningstar.com/research/372750) and DBRS Morningstar Criteria: Commercial Paper Liquidity Support for Nonbank Issuers (March 9, 2021; https://www.dbrsmorningstar.com/research/375002) which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at [email protected].

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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