CP again makes case for Norfolk Southern acquisition on heels of rebuttal

While Norfolk Southern last week rejected an unsolicited $28.1 billion acquisition offer by Canadian Pacific, saying that CP’s indication of interest is “grossly inadequate, creates substantial regulatory risks and uncertainties that are highly likely to be overcome,” CP today offered up a rebuttal in explaining why a proposed deal would greatly benefit both Class I railroad carriers. 

In a letter to NS Chairman and CEO James Squires, CP CEO Hunter Harrison and Chairman Andrew Reardon explained that CP has improved its previous offer in three ways, including:
-dramatically reducing the regulatory risk for NSC’s shareholders;
-making it substantially more financially attractive by increasing NSC shareholders’ ownership of the pro forma company from 41% to 47%; and
-agreeing to complete due diligence in no more than three weeks while contremporaneously negotiation definitive documentation

Harrison and Reardon added that CP is prepared to close the transaction into a voting trust to soothe NSC shareholder concerns, with shareholders receiving a substantial cash payment and shares and the expectation that the closing of the deal would occur on May 1, 2016. And at closing, they said that the total value of stock and cash consideration would be worth $125-$140 per share, with NS shareholders receiving $32.86 in cash and 0.451 shares of stock in a new company that will own NS and CP.

NS subsequently issued a statement in which it explained it has rejected CP’s revised proposal, saying it is valued at $91.62 based on CP’s December 7 closing price, which is less than the previous offer made on November 17 of $92.06.

“Canadian Pacific’s revised, reduced proposal is not only less than what the Norfolk Southern board has already found to be grossly inadequate, it is even more uncertain and risky given the decrease in the cash consideration,” said NS’s Squires in a statement.  “In addition to being grossly inadequate, the proposal is based on a voting trust structure that we reviewed and do not believe would be approved by the STB. Yesterday we released a white paper by two former STB chairmen who believe that the STB would not approve any voting trust structure because there is no basis to determine that it would be in the public interest.”

The white paper, which was written by former STB commissioners Francis Mulvey and Charles Nottingham noted that rail carriers cannot assume control of another carrier without prior STB approval. 

“The STB’s approval process can last between 19 and 22 months,” they wrote. “Current STB regulations, adopted in 2001, set a high bar for approval of a proposed major merger and related voting trust based on an untested public interest standard.  In our expert opinions, the STB is not likely to approve CP’s proposed voting trust or the CP+NS merger.”

The former STB chiefs added there is every reason to expect substantial opposition to the merger from various concerns, including other railroads, shippers, labor interests, and community and environmental groups, while also citing CP’s drivers for the deal that that STB could view “with a large grain of salt.

These drivers include: Chicago congestion, which based on publicly available data they said presents limited opportunities for CP and NS to reroute traffic away from Chicago; terminal access and bottleneck proposals, with CP proposing a voluntary and unilateral open access condition to show the merger would enhance competition, with the former STB chiefs noting open access would destroy value from reduced revenues and degrade service from increasing operating complexities and costs; and improved metrics, with CP claiming it can boost NS’s operating ratio, while improved metrics can be achieved without a merger as done by CP, coupled with the dramatic reductions in NS’s network and asset base that CP has proposed to improve NS’s metrics might not be in the public interest and could also disenfranchise shippers by eliminating key service products, and compromise CP/NS ability to withstand operational or service disruptions and impair ability to sustain future traffic growth.

In a conference call earlier today, CP’s Harrison made his case for the rationale for making this type of acquisition.

“The rail industry came out of 2014 with a substantial amount of criticism about the lack of infrastructure and being able to handle traffic throughout North America,” he said. “We address those concerns very seriously and took a look at enhancing infrastructure and doing some things differently, and we found we were met with opposition from local communities with s NIMBY (“not in my back yard”) mentality, so as a common carrier we don’t have a choice about hauling these goods. At the same time people are opposing consolidations or merger actions, so the question becomes what do we do in the future and in the east and with additional growth if infrastructure cannot be added? As we went through those issues one of the things that quickly came up was potential consolidation.”

He explained CP could route any infrastructure and capacity east of the Mississippi River, with shareholders saying that with compelling operating and financial numbers perhaps CP should link up with an Eastern carrier, for example, and create even greater synergies to solve these issues, which led to its interest in NS, and try to engage with them and get into a dialogue with NS, which he said has no downside.

On the operational side, CP President and COO Keith Creel said on the call that based on the previous rebuttal of the offer from NS that it is clear to him that NS does not understand the facts of the transformational journey CP kicked off in mid-2012.

“NS does not understand the way we run an efficient railway day-to-day, shift-to-shift, week-to-week,” he said. “With this operating model, this franchise has gone from being an industry laggard to an industry leader, and it is done day-to-day by implementing a scheduled railroading operating model that focuses on sustainable principles…providing service and improving service for our customers, asset utilization and making assets more efficient, controlling our costs and not cutting costs to the bone.”

In addressing NS’s statements about how the proposed deal would not help Chicago-area congestion issues––saying that CP is the smallest Class I carrier in Chicago with less than 5 percent of all Chicago rail traffic, adding that the proposed transaction would be more likely to increase Chicago congestion, with CP increasing revenues by converting interline traffic between NS and both BNSF Railway and Union Pacific to single-line traffic in the proposed CP-NS system––Creel dismissed that notion.

“For any railroad to suggest that our customers or their customers would not benefit from rerouting and moving traffic away from that congested gateway…is not fact-based and is not substantiated,” he said. “Chicago depends on the belt carriers serving the heart of Chicago, with all of the major Class I carriers interchange traffic in Chicago and interchange in the belt. We are all dependent on the belt. When the belt runs well, Chicago has a chance of running well—or fragile at best. To take our suggestions and say we can improve efficiency and capacity ‘with a grain of salt’ as stated by the former STB commissioners is reckless.”

With the current balance of power in North America among the Class I railroads––two in the east, 2 in the west, one in the middle, and 2 in Canada––an industry stakeholder said in a previous interview that has created a very stable playing field, but were one of the legs of this “table” to be pulled, it would require some sort of response among the other members of the supporting cast, which he said is not likely in their best interests.

What’s more, the stakeholder said that deals like this tend to have limited value, coupled with a business case not strong enough to overcome other considerations. And on top of that the freight railroad sector has shrunk from 56 Class I railroads in 1975 to seven in 2005, according to a New York Times report.