DBRS Morningstar Places All Ratings of Canadian National Railway Under Review with Negative Implications Following Proposal to Combine with Kansas City Southern

DBRS Limited (DBRS Morningstar) placed Canadian National Railway Company’s (CN Rail or the Company) Issuer Rating of “A”, Unsecured Bonds, Debentures & Notes rating of “A”, and the Commercial Paper rating of R-1 (low) Under Review with Negative Implications following the announcement that CN Rail has made an offer to combine with Kansas City Southern (KCS) in a stock and cash transaction valued at approximately $42.4 billion (USD 33.7 billion). CN Rail’s proposal to merge with KCS follows last month’s offer by Canadian Pacific Railway Company (CP Rail; rated BBB (high), Under Review with Negative Implications by DBRS Morningstar) to acquire KCS for an implied value of approximately $36 billion (USD 29 billion). The combined entity would operate under the KCS brand name in the U.S. and Mexico. Under the proposal, each share of KCS would be placed into a voting trust and exchanged for 1.059 of a CN Rail share and USD 200 in cash. The cash portion is to be funded through USD 19.3 billion in new debt issuance for which commitments have been secured. In addition, CN Rail would assume approximately USD 3.8 billion of KCS debt outstanding. The merger is subject to regulatory approval from the U.S. Surface Transportation Board (STB) and other applicable regulatory authorities, which is expected to occur during the second half of 2022.

The combined entity would operate an approximately 26,000 mile-long network uniquely spanning Canada, the U.S. Midwest, the Gulf Coast, and Mexico, and would become the third largest Class I railway based on the 2020 revenues of both railways. In 2020, the combined entity would have generated approximately USD 12.4 billion in revenue and approximately USD 6.6 billion in EBITDA. Due to the unique access to the three largest North American economies, and similarly to CP Rail’s offer, the combined network would be well positioned to take advantage of improved trading relations in the context of the free trade agreement between Canada, the United States, and Mexico (USMCA).

The increased network size and reach, very little network overlap, more diversified book of business, and access to more origin and destination points are all positive factors to the business risk assessment, but these improvements are not sufficient to compensate for the much higher leverage over the next two to three years resulting from the additional debt needed to fund the transaction. Based on forward-looking expectations for earnings and cash flows, the combined entity’s debt-to-EBITDA ratio will be just above 4.5 times (x) while cash flow-to-debt will decline below 20%, levels that are no longer commensurate with the current ratings, despite the expected improvements mentioned above. CN Rail’s intention is to reduce its leverage and it has indicated that it will pause its share repurchase program in order to generate higher levels of cash flows for deleveraging purposes until such time that debt-to-EBITDA reaches the 2.5x-3.0x range. This is likely not to happen before 2024. Approximately USD 1 billion 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.

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. Considering the fact that CN Rail’s proposal to merge with KCS comes a month after CP Rail’s offer to do the same and that it is unsolicited, DBRS Morningstar views the transaction as carrying a material degree of uncertainty and will continue to monitor any further developments. DBRS Morningstar believes that in the context of the current offer, any potential negative rating action is reasonably unlikely to exceed two notches due to the strength of CN Rail’s business profile despite the significant amount of debt to be issued to fund the proposed transaction.

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), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (January 14, 2021; https://www.dbrsmorningstar.com/research/372344) 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).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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 info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had 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 info@dbrsmorningstar.com.

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