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Published: November 3rd 2009
Source: Financial Post
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Shares in Canadian railways jumped Tuesday on the news that Warren Buffet’s plans to acquire Burlington Northern Santa Fe Railway. It also renewed speculation that a smaller player in the sector, like Canadian Pacific Railway Ltd., might also be on the radar of would-be buyers in the current market.

The US$44-billion Buffet bid Tuesday at once served as another endorsement of the thesis that railways are a long-term investment and as a boost of confidence that the economy is beginning to claw its way out of the recession, said Fadi Chamoun, a UBS analyst.

“It’s really a play on the economy and a play on the rail business model,” he said in an interview. “I don’t see a lot of M&A in this sector. I think this is a unique situation with Berkshire privatizing BNSF. I don’t think there are a lot of $40-billion guys waiting to buy up railroads.”

But, he did acknowledge that CP, which is the smallest of the North American Class 1 rails, might attract some attention based on its size.

While Mr. Buffet has expressed admiration for the railway’s larger domestic rival, Canadian National Railway Co., investors are only allowed to own 15% of the former Crown corporation. CP has none of the same restrictions, making it the only real play in the Canadian rail sector.

Two years ago, when the so-called rail renaissance was at its peak, Toronto investment house Brookfield Asset Management Inc. was one of a handful of private equity players kicking the tires at CP when its stock was trading above $70 a share. A deal at the time was estimated to be worth more than $15-billion.

CP’s management, however, rebuffed Brookfield and the other players, and entered into an agreement in the ensuing months to use its stockpile of cash to acquire Dakota, Minnesota, & Eastern Railroad for nearly $1.5-billion in what was deemed at the time as a defensive move against future offers.

Ironically, the DM&E acquisition might make CP even more attractive this time around after Mr. Buffet’s bid for BNSF.

While the DM&E increased CP’s exposure to the ethanol trade, the real gem in the deal was the rights the regional railway had to build into the coal-rich region of the Powder River Basin, which straddles the Montana and Wyoming border and is the fastest growing region for thermal coal in North America used in the production of electricity. Currently, the basin is only served by BNSF and Union Pacific.

Mr. Buffet’s Berkshire Hathaway already owns MidAmerican Energy Holdings Co., and the BNSF offer was veiwed by some analysts as a way of vertically integrating the U.S. expansion into coal-fired electricity production.

“Apart from a bet on the broad U.S. recovery, Berkshire may also be looking for an indirect exposure to coal, specifically Powder River Basin coal,” said David Newman, National Bank Financial analyst. “While demand for thermal coal has moderated due to high stockpiles and reduced electricity generation, longer term, the prospects remain favourable.... The Powder River Basin coal is abundant, relatively clean, and cheap.”

Roughly a quarter of BNSF’s sales last year were derived from shipments of coal, of which 90% was pulled from the Powder River Basin.

CP has yet to decide whether it will push ahead with the development of Powder River Basin rail line, but it does come with a substantial price tag. Not only is the whole project expected to cost roughly $4-billion, but CP would have to pay an additional $1-billion to the former owners of the DM&E if it starts moving coal along those lines before 2025 as set out in its purchase agreement.

Still, even without the Powder River Basin project, CP might prove a shrewd acquisition at the 18 times projected 2010 earnings per share Mr. Buffet offered for BNSF. With all indicators suggesting freight volume declines are on the mend, that multiple paid may actually be 12 or 13 times actual earnings, Mr. Newman said.

“Who knows? This could serve as a catalyst for anybody that was sitting on the sidelines,” he said. “I was frankly surprised the last go around that ports were being taken over and other infrastructure was being targeted and railroads were not. It’s just a natural infrastructure target in my view, and a key one.

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