Refuting practically every purported benefit that Canadian Pacific has given, and citing substantial regulatory risks and uncertainties as well as many other negatives, Norfolk Southern on Dec. 4, 2015 loudly and firmly rejected CP’s proposal to merge the two railroads into a transcontinental.
The NS board “has unanimously rejected Canadian Pacific’s previously announced unsolicited, low-premium, non-binding, highly conditional indication of interest to acquire the company for $46.72 in cash and a fixed exchange ratio of 0.348 shares in a new company that would own Canadian Pacific and Norfolk Southern,” NS said. “After a comprehensive review, conducted in consultation with financial and legal advisors, the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to be overcome, and is not in the best interest of the company and its shareholders. The board believes that Canadian Pacific’s indication of interest is opportunistically timed to take advantage of a Norfolk Southern market valuation that has been adversely affected by a challenging commodity price environment, does not fully reflect infrastructure investments Norfolk Southern has made, and does not incorporate the upside from further improvements anticipated to result from the initiatives that the company is implementing.
“We believe in our ability to generate greater shareholder value through execution of our strategy—delivering efficient and superior service to build a more profitable franchise based on price and volume growth, implementing efficiency measures, and increasing returns on capital to strengthen our financial performance, all while maintaining our disciplined capital return strategy,” said NS Chairman, President and CEO Jim Squires. “Norfolk Southern has made growth investments, and we expect to realize the benefits of these investments in the years ahead, especially as our intermodal volumes continue to build. Specifically, we expect to achieve an operating ratio below 70 in 2016 with additional improvements over the next five years resulting in increasing ROE and an operating ratio below 65 by 2020. By maximizing our asset utilization, we believe we can achieve double-digit compounded EPS growth over this period. In short, Norfolk Southern is well positioned to deliver compelling value to our shareholders.”
“There is a high probability that, after years of disruption and expense, the proposed combination would be rejected by the Surface Transportation Board (STB),” Squires said. “We also believe the STB would reject Canadian Pacific’s proposed voting trust structure, and that there is no certainty that any other voting trust structure would be approved. Even if the proposed combination were ultimately to be cleared, it would be subject to a wide range of onerous conditions that would reduce the value of the stock consideration that has been proposed.”
“We believe that Canadian Pacific’s short-term, cut-to-the-bone strategy could cause Norfolk Southern to lose substantial revenues from our service-sensitive customer base. We also believe the proposed transaction risks harm to vital transportation infrastructure and the communities we serve. Any strategy that hurts our customers and the broader community is highly unlikely to receive regulatory approval and is inconsistent with the delivery of shareholder value over the long-term.”
NS: CP has it all wrong
While not specifically stating that NS would reject any further attempts by CP (or by any other Class I, for that matter) to merge, Squires went into great detail to explain why Canadian Pacific’s existing proposal is, essentially, a very bad idea, in NS’s opinion. He touched upon several areas.
“Regulatory review would not be complete for two years or more,” Squires said, citing “two required periods of public comment, with strong opposition expected from key stakeholders.” As well, “Norfolk Southern would remain in limbo during the entire review, likely interrupting focus and momentum in implementing our strategic plan.” Referring to CP’s proposed voting trust, Squires pointed out that “voting trusts must be approved in advance by STB under ‘public interest’ standards. No voting trust for a Class I railroad has been approved since new merger rules were adopted in 2001. A typical voting trust structure involves placing target shares in trust and insulating the target from control by the acquirer during the merger review process. CP’s proposal to have CP management at Norfolk Southern or otherwise have CP control or influence Norfolk Southern’s operations during the review process would violate the statutory bar against premature control, and we are confident it would not be approved by STB. There is no certainty that any voting trust, including typical structures, would meet the ‘public interest’ standard to be approved. Even if a voting trust were approved, CP stock consideration would be of uncertain value given the risk of the merger review and lack of interim operational control.”
Interpreting STB’s Major Merger Rules for Class I carriers enacted in 2001, Squires said that these “untested” rules (no major mergers have been attempted in the past 15 years) “create bias against consolidation. Merger review is a 16-month process after a formal application is filed, plus a pre-filing period. Even if the merger were approved, the STB would likely require a wide range of significant, onerous conditions that would undercut the value of the transaction, and the CP stock consideration. The Major Merger Rules establish a bias against approval based on concern that any transaction would not enhance competition, cause service disruptions and trigger further consolidations. A merger must serve ‘public interest,’ which is only achieved when ‘substantial and demonstrable gains in important public benefits—such as improved service and safety, enhanced competition and greater economic efficiency—outweigh any anti-competitive effects, potential service disruptions or other merger-related harms.’ The STB will review CP-Norfolk Southern as if it were the trigger for further consolidations, with difficult-to-predict implications for burdensome conditions. At minimum, however, the transaction, if approved, would be saddled with onerous, expensive conditions.”
Operationally and financially, a combined CP-NS won’t work nearly as well as CP claims, Squires stressed. “The deal presents grossly inadequate value and substantial regulatory risks,” he noted. “CP’s operating model would drive away service-oriented, truck-competitive traffic in an effort to lower the operating ratio. Norfolk Southern’s current strategic plan drives an improved OR ratio, delivers double-digit compound annual EPS growth and enhances long-term value.” The proposed merger “is a poor combination,” Squires stated. “Pairing the smallest of the four major U.S. railroads with the smallest major Canadian railroad creates a long-term network disadvantage. It would not enhance Norfolk Southern’s geographic reach to areas of freight growth. The Norfolk Southern/CP interchange is small—less than 3% of Norfolk Southern volume, and substantially smaller than Norfolk Southern’s interchange volume with BNSF, CN or UP.”
Congestion relief in Chicago? Again, CP got it wrong, Squires said. “CP incorrectly claims that the merger would alleviate congestion in Chicago,” he pointed out. “CP accounts for less than 5% of Chicago traffic and thus any rerouting would have minimal impact. Less than one Norfolk Southern/CP train per day can be efficiently rerouted around Chicago. The proposed merger would likely increase rail traffic congestion in Chicago. We expect CP to convert interline traffic (BNSF/UP) to single-line traffic. CP does not have efficient Chicago bypass routes; consequently, any diverted rail traffic would flow through Chicago. This would only exacerbate Chicago congestion issues.”
Hunter Harrison has proposed a form of open access. Keeping in step with the AAR’s official position on this highly controversial topic, Squires said open access would “result in revenue loss. Service would suffer, increasing costs and compromising shareholder value creation. There would be a disincentive to investment, placing the combined company at a severe competitive disadvantage. More intermediate handlings increase costs, and shippers choosing interchange points disrupts the network and drives up costs. Even CP admits service will suffer.”
Squires said that, in a March 2014 press release, CP said open access will “slow down the supply chain, negatively impacting transit times.” And using Harrison’s own words at CP’s first-quarter 2014 Investor Call to drive home the point, Squires quoted Harrison as saying, “I remember the old days of reciprocal switching. Was it good for service? No. Was it good for costs? No. What was it good for? I couldn’t figure it out.”
“CP’s unilateral open access proposal is not contingent on other railroads taking similar steps, and it exposes up to 60% of Norfolk Southern traffic under the terms suggested,” Squires said.
“Norfolk Southern is successfully executing on its strategy,” Squires concluded. “Our management team is successfully executing a number of revenue growth initiatives focused on pricing discipline and growth in merchandise and intermodal market opportunities. Our strategic plan is focused on providing superior customer service, continuing the recent improvement in network performance, and implementing efficiency measures, including managing headcount, increasing locomotive productivity, and integrating technological innovations. It provides for double-digit compounded EPS growth over the next five years, increasing return on investment, and, by 2020, an operating ratio below 65. Norfolk Southern is committed to pursuing a disciplined capital allocation strategy while investing appropriately in our network. During the past 10 years, since the inception of its share repurchase program, the company has distributed nearly $15 billion to shareholders, consisting of an average of approximately $1 billion in share repurchases per year and a steadily increasing dividend with a 10-year annual compound growth rate of 14%.”
What could potentially happen next raises lots of questions. Will Canadian Pacific sweeten the deal? Is this all part of a long-term cat and mouse game that will continue until the Norfolk Southern board is satisfied that Canadian Pacific’s offer is worthy of consideration? Or, like it did with CSX in 2014, will CP give up and retreat? Hunter Harrison, who many observers believe wants his legacy to be a transcontinental railroad, doesn’t give up easily. Neither does Bill Ackman, CP’s largest shareholder and principal of hedge fund Pershing Square Capital Management. If Ackman is the type to fold, he probably wouldn’t be running a hedge fund. Then again, Canadian Pacific was an easy target for Ackman a few years ago, one that Hunter Harrison was quickly able to turn around.
Norfolk Southern is a different story entirely. In this editor’s opinion, it’s a great railroad with a great legacy and superb management. While there is certainly room for improvement, as Jim Squires himself has stressed, Norfolk Southern does not need to be “turned around.” But that’s not what this merger attempt is about. Yet, one has to ask, are Canadian Pacific’s purported merger benefits that far off-base, as Norfolk Southern is now claiming? Hunter Harrison is without a doubt one of the best operating men in the business. It is hard to imagine that he would be capable of making such strategic mistakes.
Interestingly, in all of these pronouncements, there is nothing that suggests Norfolk Southern’s emphatic “No” of Dec. 4, 2015 is its final answer. During the webcast that followed NS’s official announcement, Jim Squires was asked if any future merger attempt by a Class I other than Canadian Pacific would be considered—or ruled out. Squires responded by saying that any merger attempt would be faced with the same risky regulatory hurdles that the proposed combination with Canadian Pacific would face. When asked if Norfolk Southern’s pronouncements about practically guaranteed regulatory hurdles resulted from direct consultations with the STB, Squires skirted the question.
CP responds
Canadian Pacific did not respond to Norfolk Southern until after the New York and Toronto stock exchanges had closed at 4:00 pm EST.
CP’s official statement was brief and contained no surprises: “Canadian Pacific is disappointed with Norfolk Southern Corp.’s rejection of its proposal to create an end-to-end North American rail network that would enhance competition and generate significant shareholder value. CP takes exception to the claims, misdirection and mischaracterization of its offer and the benefits such a combination would provide to customers, shareholders, the industry and the public. CP will hold a conference call Tuesday, Dec. 8 to discuss our offer and deliver clarity, context and detail to the proposed transaction. CP will also address all concerns about timely regulatory approval raised by NS and correct every inaccuracy. CP is committed to this transaction and looks forward to engaging with the NS leadership team, its board and its shareholders. Details for the call will be disseminated in due course.”
CP, it’s your move.
For additional analysis, see Comtributing Editor Frank N. Wilner's blog, "CP-NS: Voting trust and other conundrums."