Why CP Rail and CN Rail takeover debt is scaring rating agencies

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Trains in the CN Rail Brampton intermodal terminal yard in Brampton, Ont., Nov. 19, 2019.Mark Blinch/Reuters

Rating agencies are sounding the alarm over the billions of dollars in debt tied to the bidding war between Canada’s two major railways for Kansas City Southern, pouring cold water on the many benefits projected by the rival bidders.

Three leading rating agencies – Moody’s, Standard & Poor’s and DBRS Morningstar – have placed Canadian Pacific Railway Ltd. and Canadian National Railway on watch for debt downgrade. Moody’s has already lowered its rating on CP, citing a near doubling of its debt-to-earnings before interest, tax, depreciation and amortization (EBITDA) ratio under its proposed buyout.

While ratings agencies predict synergies from a combination of CP or CN with KCS, many of which are expected to come from the extension of a Canadian railroad in Mexico, they remain concerned about debt levels needed to secure a deal – especially for CN, which will fund its bid with US$19 billion in debt.

The benefits of such a deal, including a larger network and more diverse business, are compelling, DBRS Morningstar wrote in a note warning of a possible CN debt downgrade, “but these improvements are not enough. compensate for the much higher leverage over the next two to three years.

By their very nature, rating agencies are obsessed with debt, while different stakeholders may consider other takeover variables. Yet the heavy debt burden resulting from overzealous mergers and acquisitions has troubled far too many companies over the years, and repairing the balance sheet when things go wrong is no easy task. Ask miner Barrick Gold.

As it stands, CP is ready to add $8.6 billion of debt to its balance sheet, as well as assuming KCS already has $3.8 billion on its books. By doing so, the railroad’s leverage will increase to 4.5 times its EBITDA, according to Moody’s, from 2.5 times at the end of 2020.

CN will finance its outbidding with a lot more money. If successful, the company will add US$19 billion of new debt to its balance sheet, plus the US$3.8 billion KCS has outstanding, doubling its leverage to 4.5 times EBITDA. according to Moody’s, compared to twice at the end. of 2020.

Rather than focusing on debt, the railroads touted the revenue opportunities of a combined company, a stance taken by many analysts. Autos and parts produced in Mexico can travel more easily to the US Midwest and southern Ontario, and grain and oil from Western Canada can travel south with fewer bottlenecks.

Credit agencies recognize these benefits, but they temper their expectations from what equity analysts and the companies themselves are projecting, Moody’s analyst Jamie Koutsoukis said in an interview. The synergies are real, but “they take time to materialize…as opposed to adding debt at this precise moment.”

The multi-year schedule also adds economic uncertainty to the equation. “Whichever deal prevails will not generate synergies until 2023,” DBRS Morningstar analyst Amaury Baudouin said in an interview. “A lot of things can happen. The economy can change. … We’re just coming out of a pandemic, and who knows when we’ll get back to normal.

Unlike Barrick Gold, whose revenues relied heavily on a single product, CP and CN have diversified businesses and they have several strings to pull to help pay down their debt, such as suspending stock buybacks. The North American industry is also an oligopoly, so it can naturally grow by raising prices – instead of being subject to a single volatile commodity.

But, rating agencies warn, the next recession could still be around the corner – and leverage isn’t going away. “These companies, regardless of the environment, have to service the debt,” Ms. Koutsoukis said.

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