Union Pacific Considering a Norfolk Southern Buyout, Report Says. Here’s What Will Matter.

A Union Pacific intermodal container train travels through East St. Louis, Ill. (Luke Sharrett/Bloomberg)

Union Pacific is in talks to merge with Norfolk Southern , The Wall Street Journal reported Thursday, in a deal that would shake up the railroad business in America.

The Journal cited people familiar with the matter. Union Pacific declined to comment. Norfolk Southern didn’t immediately respond to a request for comment.

The article followed a Semafor report from Wednesday night that Union Pacific had hired a banker to explore potential acquisitions.

Norfolk stock gained 2.5% in Friday trading, closing at $276.66 a share, while the S&P 500 finished flat and the Dow Jones Industrial Average fell 0.3%.

Norfolk stock gained 3.7% on Thursday. Union Pacific stock fell 1% after falling 1.6% in the previous session.

Buying a large company, potentially with stock, can push down shares of any acquirer. Union Pacific is worth about $140 billion. The smaller Norfolk has a market value of $61 billion.

Still, consolidation has benefited the U.S. rail business over time, helping boost efficiency and profit margins. Union Pacific’s operating profit margins have risen to about 40% from below 30% 15 years ago.

A Union Pacific/Norfolk merger would marry Western and Eastern rail carriers together, creating a stronger network.

“Whether all those potential efficiencies can be realized and accrue to shippers remains an open question,” wrote Baird analyst Daniel Moore in a Thursday report. “What is clear is that further consolidation would not only be strategically transformative, but it would also fundamentally reshape the competitive landscape.” He also sees the possibility of a second transaction occurring if a first one is announced.

Additional transactions could involve Warren Buffett’s BNSF, Canadian railroads, or CSX , which has a market value of about $65 billion. CSX stock fell 0.3% on Friday, closing at $34.39. The shares gained 3.7% on Thursday.

“Until there is a formal announcement or until the entire transcontinental narrative is sent to the glue factory, the stocks will trade as if the Western rails will look to buy the Eastern rails,” wrote Evercore ISI’s Jon Chappell on Friday. “That means investors will continue to lean into [Norfolk Southern] and CSX and fade the others.”

Consolidation is a sound idea on paper, but any rail merger would face regulatory scrutiny. “The rail industry regulator, the Surface Transportation Board (STB) effectively put an end to [large] rail M&A in 2000 after BNSF and Canadian National proposed a merger,” wrote Citi analyst Ariel Rose on Thursday. “According to rules that have been in place since 2001, any M&A between [large] railroads must enhance competition, with applicants required to demonstrate that a proposed transaction would be in the public interest.”

Since 2000, there has only been one Class 1 rail merger: the 2023 purchase of Kansas City Southern by Canadian Pacific. And in that case, the STB was persuaded to waive the tougher 2001 standards.

A merger between Union Pacific and Norfolk, or BNSF and CSX, would need to show that efficiencies and service improvements would outweigh disruptions and anticompetitive effects, according to a June study by UBS analyst Thomas Wadewitz. Neither of these two combinations would be as easy to rationalize as the 2023 merger, he said, because of overlaps between the remaining big railroads.

Union Pacific and Norfolk have seven interchange points today, while BNSF and CSX have five. Removing interchange points in a merger can improve fluidity and transit times, Wadewitz noted, adding that doing so will temporarily disrupt service and permanently reduce competition around the interchange.

Still, Union Pacific CEO Jim Vena first got merger rumors rolling in May by arguing that consolidation could help the rail industry compete against truckers, with faster service. A merger with Norfolk might let Union Pacific bypass the Chicago interchange—which today adds a day or two to any transcontinental rail shipment.

One more hassle for the shareholders of an acquired railroad is getting their money. Before the successful 2023 combination of Canadian Pacific with Kansas City Southern, the STB derailed a 2021 merger between Canadian National Railway and Kansas City Southern by rejecting a proposed voting trust that would have let Kansas City shareholders get paid while the STB considered the merger’s antitrust implications. The STB refused, for fear that those two railroads would compete less vigorously while Kansas City shares were in trust.

For Norfolk shareholders to get paid soon, the STB would have to approve any voting trust that Union Pacific may propose.

A large rail merger is an intriguing idea for creating shareholder value. Completing a deal, however, looks to be a long and expensive process.

Corrections & Amplifications: Regulators rejected a 2021 merger between Kansas City Southern and Canadian National Railway. An earlier version of this article incorrectly said that deal had involved Canadian Pacific, rather than Canadian National..

Write to Al Root at allen.root@dowjones.com