EXPRESS MAIL: Union Pacific’s Surprise Merger Bid

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In what may be the largest M&A deal of 2025 so far, Union Pacific ($UNP) has made a formal bid to merge with Norfolk Southern ($NSC). The proposed merger not only furthers the consolidation of the quasi-monopolistic railroad industry but also raises important questions about what it means for investors. Given the time we’ve spent highlighting Union Pacific as a model of dividend growth, we believe this surprise announcement warrants an early-stage analysis. 

In this Express Mail episode, Greg covers:

[01:12] Merger Details
Union Pacific makes a surprise $20B bid for Norfolk Southern—despite their past capital discipline.

[03:54] Financial Analysis: Debt, EBIT, and Credit Ratings
How the merger affects profitability, interest coverage, and debt loads.

[10:29] Lessons from Canadian Pacific’s Kansas City Merger
A similar deal that didn’t go quite as planned—and what it might signal for UNP.

[15:36] Dividend Outlook: What Now?
We break down whether the combined railroad can still deliver 7% dividend growth.

[17:59] Final Thoughts
Is Union Pacific now a total return story, not a dividend growth story? Why we’re holding through the uncertainty. 

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Transcript

[00:00:11] Greg Denewiler: 

This is Greg Denewiler, and you are listening to another episode of the Dividend Mailbox—A monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks. When they grow over time, a funny thing happens, you create wealth. 

Welcome to the Express Mail version of the dividend mailbox. We've done one of these before. Basically, if something comes up where we think it's relevant and it would be a good update, that's our version of Express Mail. And lo and behold, we had an announcement a few days ago that seemed to be a perfect time to put an update out there because about a year and a half ago, we went through an entire episode building the case for Union Pacific. 

We've mentioned it several times through the last year, plus its something that we really continue to watch and on weakness, love to accumulate more of it. So you might wanna go back and listen to the episode about a year and a half ago, because we did go through a lot of time and we even put together an entire report on Union Pacific. It's a great dividend growth story. And it's one of the more profitable railroads of the six major ones out there. 

One of the thesis of the whole Union Pacific story was that one of the reasons why this boring railroad had outperformed the S&P 500 by such a large amount in the last several decades is because they're very disciplined in capital allocation. It's hard for them to acquire because of regulation. That was part of our appeal to the story. 

Well, as things happen to go in life, the story changes. After making a big deal out of how disciplined their capital allocation is, what do we get? We get a merger. 

Union Pacific has made a formal bid to Norfolk Southern to combine the two railroads and make first transcontinental railroad to where somebody on the East Coast can ship something all the way over to LA to be shipped overseas to Asia or some version of that. From what I understand for this year, it is the largest merger that's been announced so far. Union Pacific's paying about a 25% premium and they're going to exchange one share of Union Pacific stock for each share of Norfolk Southern. There's a little over 225 million shares outstanding, and then they're going to also issue $88.82 cents in cash. Well, I can tell you right now, since neither one of these companies has a whole lot of cash on the balance sheet combined, (it's a little over $2 billion), most of it is going to come through debt, and it's probably going to be around $20 billion of debt. 

So our thesis at the moment is sort of being challenged. Well, I guess the question is, is it really being challenged? Has this story changed by a lot, a little bit? Should we really be nervous or see how it plays out? Well, the first thing to do is, how does that look with the combined company? And that's what we're going to hit. 

I think one of the big appeals to Norfolk Southern, and this is one of the things that I have to say, is probably something that is going into positives. Norfolk Southern is not as profitable as Union Pacific. Gross profit margins for Union Pacific are at 46% while Norfolk Southern is at41%. So there's roughly a 5% difference there. If you go down to income from continuing operations, that 5% gap holds. You get all the way down to EBIT (earnings before interest and taxes)—and the key thing here is before interest, which is what they're going to use to pay for this, to finance and to make this acquisition work—Union Pacific is at 43% while Norfolk Southern is at 39%. So they still have about a 4% advantage. 

So the first thing to look at is, okay, combine the two as they are. Union Pacific's debt rating is currently at A-. Their earnings before interest and taxes: they earn 8.4 times more profit than they have in net interest expense. If you go over to Norfolk Southern, they basically earn 6.3 times their net interest expense, not quite as good. Their debt rating is BBB. If you combine the two companies and you have the interest expense for Union Pacific and then also for Norfolk Southern, you need another $20 billion of debt to pay for this acquisition. If they have a BBB rating, the interest cost is probably going to be around a little over 5%, and that would equate to another slightly more than $1 billion of interest expense. So if you combine these two, it adds up to a total of $3.06 billion of interest expense. The earnings before interest and taxes is going to come down to about 5x their interest expense, and that probably still leaves the debt rating at BBB. 

It's starting to get a little on the low side. It's starting to get into the margin of going into to BB, but I would think, and I've never worked for Moody's or S&P, but because it's a railroad and it's a quasi-monopoly sort of business, and the country needs them and they're not going anywhere, they'll probably give them the benefit of the doubt. I would think that the rating will stay at investment grade. So with that, all right, it's not disaster. It does mean that the balance sheet is going to be more leveraged. It definitely affects Union Pacific because they were at eight, Norfolk Southern was at six, so now they're down to five with a combined entity. 

Is there an appeal to this? I would assume the whole theory of this merger is that it's going to help them become more profitable and more efficient and potentially help them capture a little bit of business. 

So, we're going to make a couple of assumptions here. Number one, first of all, we're going to take the combined entity and we're going to take the EBIT margin up to 43% for the entire combined organization. That leaves Union Pacific at the same profitability, but it's going to move North Fork Southern up by about 4%. If they can bring Norfolk Southern up to theirs, it gives them an additional amount of cash flow of about $150 million. It's not a big number when you're talking about a total combined of $15 billion of earnings before interest in taxes. But it gives them a little bit more cash flow to, A, pay down debt or increase the dividend, which we are going to get to the dividend here later(because that's what this podcast is all about). 

We're going to make another assumption, and that is: it's going to be a transcontinental railroad. There's going to be some efficiencies. I mean, that's obvious because if you're shipping something from the east coast over to the west coast, you have to change carriers. There's a transition and the freight has to move from one carrier to another and back. So let's just say that the entire organization picks up a couple percentage points and it moves up to 45%, which would be a couple of percent above Union Pacific’s. Well now you're up to $16.4 billion, which now moves it up to 5.4 times. Not a big number, but it does start to move the needle higher. 

The more important thing is you've got an extra almost billion and a half of free cash flow, and there you start paying debt down a little bit more aggressively. I mean, they've already got a pretty big spread of free cash flow that they can use. But you know, it starts to make a little bit more sense. 

The average interest cost for Norford Southern on just what debt they have outstanding—going from 2029 to 2121, the interest rate is 5.2%. 

Now you have to step back and think about that. 2121. Nobody listening to this podcast is going to be alive, but somebody is going to have a bond that matures in 2121. Well, that was part of our original thesis, also. These railroads are the very definition of durable businesses. 

So to sum this up, it's not a disaster. There's cash flow that they don't have to save a bunch of money to make this work. It will work as it is. It does affect the balance sheets. It's putting more debt out there. But they are railroads. They are businesses that aren't going anywhere, which was a big part of our thesis on our original report. 

Could it help them long term? It's probably worth waiting around to see how this is going to play out. 

What may be a hint of what's coming with the Union Pacific merger is: we can go back to December of 2021 and look at the merger that Canadian Pacific executed, buying Kansas City Southern. 

There's always a great plan of how there's going to be synergies, how great the business is going to be when it's combined. When you've got something as complicated as logistics, moving freight all over the country, it's never going to be an easy task. And lo and behold, it didn't go smoothly. They had some issues with merging Kansas City Southern’s computer system, but it was a $31 billion merger. They had shares outstanding of 666 million. They increased it to 930 million. They had debt of $7.8 billion and they basically doubled it to $15.8 billion. Sort of the same scenario that Union Pacific is probably going to be doing. 

Now here's where we start to maybe get a hint, and if we haven't done a deep dive, because partly we don't know how this looks when it's done, what they may have to spin out or sell, or exactly what it looks like. But I can tell you Canadian Pacific had roughly the same profitability on their return on invested capital as Union Pacific does. They were running in the mid-teens. And next quarter March, it dropped down to 8%, and by the quarter after that, in June of 2022, and this is where they've been ever since, they've been running around five to 6% return on invested capital. That is the result of some dilution when you pay a premium for a business. 

Another little bit of a of a hint: as we mentioned, because of the debt, they may focus more on getting debt down and making sure they stay in investment grade. Now, foreign companies tend to not have the consistent dividend payment schedule that US companies do. But in December of 2021, the quarterly dividend was 14.80 cents. In March of 2025, it was 13.20 cents. It actually declined a little bit. However, just recently they did increase it and now it's 16.5 cents. So after four years, we finally had a little bit of a dividend bump. 

Here's another interesting thing, even though return on invested capital basically was cut in half for the last several years because of the merger, the stock has underperformed Union Pacific since 2021, but not really by that much. They both have been somewhat relatively flat recently. But if they can’t improve profitability here in the not-too-distant future, the stock's probably going to start to lag more. 

You know, we don't know the full details of Union Pacific yet, but this does give us a little hint that we definitely wanna pay attention to how this thing develops over time. 

If this actually gets approved, and there are reasons why maybe it won't—Unions are afraid that they're going to lose some of their negotiating power. Or another fear is that the unions are going to negotiate and get stronger contracts to allow this merger to go through as a compromise, and Union Pacific's not going to get the efficiencies that they're hoping for. That's number one. And number two, they're going to be at a competitive advantage to the other railroads that have not merged. 

It would seem like if this merger does go through, CSX and Burlington Northern will probably be next on the list because it seems very hard to imagine that CSX and Burlington Northern, which is under Berkshire Hathaway, is going to sit there and let Union Pacific just continue to have that kind of a competitive advantage. It only seems natural that there would be another one right around a corner. This is a side note, I don't even remember if we put this into the first podcast on Pacific, but in talking to the investor relations people at Union Pacific more than a year ago, one of the comments that they made is that if Burlington Northern is ever spun out on its own, you should buy it with both hands because it is the least profitable, and the railroad that's got the most room for improvement. So if a deal is done with CSX, that's going to be something that's really going to be kind of interesting to watch, but we'll see how that plays out. 

Moving on here. How does this play into dividends? Well, we'll have to wait and see. I can tell you right now, we try to deliver 7% a year of predictable dividend growth. It very well could put that into jeopardy because, as we just went through, there's going to be more debt on the balance sheet of this combined entity. Another thing that we don't even know—and we're making a total assumption here, which I can virtually guarantee you is going to be wrong—they're probably going to have to sell something, so it's not going to be a dollar for dollar combination. There's going to be probably some assets that are sold and the numbers are going to move around. 

Are they going to put more emphasis on paying down debt in the short term? Are they going to continue to grow the dividend like they have in the past? I'm sure what'll happen is they will continue to raise it just because companies like the track record of a growing dividend. But will this grow at 7% a year? I mean, that's something that gets a little more complicated. At the moment, I would say the chances of us getting six or 7% dividend growth in the next few years—if this merger goes through—probably just dropped by at least 50%. I don't think there's a dividend cut, but this could become a great example of how do you balance dividend growth and total return. 

In this case, we've had dividend growth. It's been a good performer long term, but there may be a transition here. However, having a Transcontinental Railroad potentially becomes a little bit more of a growth story. So, is Union Pacific potentially a little bit better total return story down the road and we worry less about dividend growth? You know, everything's kind of a moving target at this point. Extremely early on, the position that we own, we're probably not going to sell it because railroads have just been great investments. But when this merger came up, I'm like, “you have to be kidding me.” These guys are not supposed to be doing anything. We made this big stand of how great it was, and here we are doing the Express Mail version because we have an acquisition that we never thought would happen. But, you know, that's how life goes. 

The good news is this is not going to be approved in the next two months. It's going to be a very long, drawn out thing, and you'll probably get a lot more details as this—I hate to do this—but as this train rolls down the track. 

So we got several takers on the dividend growth portfolio assessment, kind of what our viewpoint is. Keep that in mind if you want to take us up on it. And with that, look forward to episode number 50 coming up here in the next few weeks. 

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you'll find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com. 

Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.