Norfolk Southern officially rejects Canadian Pacific’s unsolicited indication of interest

The planned, large-scale Class I railroad acquisition of Norfolk Southern by Canadian Pacific, which has received a fair amount of attention in recent weeks, appears to have fallen off the tracks.

When it stated last month that it would carefully evaluate and consider CP’s indication of interest in the context of its strategic plans and its ongoing review of opportunities to enhance stockholder value through strategic, financial and operational measures and pursue the best interests of the Company and its stockholders, NS also made sure to point out that consolidation among Class I railroads in North America would face significant regulatory hurdles.

And earlier today NS said that its board of directors has rejected CP’s previous unsolicited offer of $46.72 per share in cash and a fixed exchange ratio of 0.348 shares in a new company that would own CP and NS. NS officials said that its board came to the conclusion that CP’s indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to be overcome, and not in the best interest of the company and its shareholders. 

“We believe the regulatory review process would take two years or more from now, with a very low likelihood of approval,” NS Chairman, President, and CEO James Squires wrote in a letter to CP CEO Hunter Harrison and Chairman Andrew Reardon. “Even in the unlikely event of approval, Norfolk Southern would be in limbo for this extended period, causing loss of momentum and disruption to our business and operations. In addition, substantial regulatory conditions would be required to win regulatory approval, adversely affecting the value of the combined company and the stock our shareholders would receive.”

The top NS executive added that CP’s proposed structure for the deal in which it would take control of NS’s management and operations is unprecedented and has never received STB approval, adding that regulators would not be likely to approve the voting trust structure.

And Squires also explained that the transaction would be “detrimental” to NS’s customer base, citing concerns from customers in regards to the transaction, coupled with NS losing substantial revenues from its service-sensitive customer base if CP were to implement its short-term strategy.

When CP confirmed its interest in NS last month, it said it believed the combined railroad would offer unparaelled customer service and competitive rates that would support the success of shippers and industries it serves and also satisfy U.S. Surface Transportation Board and Canadian regulators.

Other benefits of the proposed deal cited by CP included:
-a new approach to terminal access that would change the status quo in U.S. rail transportation, explaining that in the event the new company failed to provide adequate service or competitive rates, it would allow another carrier to operate from a point of connection over the combined company’s tracks and into its terminals, providing an unprecedented alternative to the affected shipper;
-the new company would give shippers the choice of where they can connect with another railroad along its network, bringing an end to the practice of “bottleneck pricing” to a large number of shippers in the U.S. while further enhancing competition; and
-a combination would alleviate the long-standing issue of congestion in Chicago, which seized into gridlock in the winter of 2014 and hobbled economic growth. By channeling rail traffic away from Chicago, CP would create fluid routes through under-utilized hubs and free up much-needed capacity for other railroads that pass through the city, providing them with new, efficient and competitive service options for their own customers, with a combined CP/NS creating capacity for all shippers without creating the need for more infrastructure

But NS officials made it clear that it was not on board with this outlook, explaining that the unilateral open access proposal would minimize the financial performance of the combined entity, degrade service, and dis-incentivize investment. It also said that CP’s “overstated” synergy targets imply reduction to investment and employment levels, which NS’s board of directors believe would hinder service levels and not gain STB approval.

Other objections raised by NS included:
-limited operating synergies because CP and NS networks serve different regions and only connect at five points;
-any near-term cost savings that might result from applying Canadian Pacific’s short-term focused operating model on Norfolk Southern would be offset by traffic diversions, service deterioration and loss of service-sensitive customers;
-open access has been widely documented to produce negative revenue synergies from traffic loss and rate compression while also increasing operating costs; and
-the transaction would not help Chicago-area congestion issues, as 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

In regards to the last objection cited above, NS said that much of the NS traffic with BNSF and UP currently avoids Chicago, with CP lacking efficient Chicago bypass routes, which would mean CP would have to route most of its traffic through Chicago, which would translate into substantial extra miles, costs, and time. 

Tony Hatch, principal of New York-based ABH Consulting said that CP’s proposal of directly offering up open access in the form of reciprocal switching/bottleneck accesses essentially mirrors the proposal the National Industrial Transportation League has made to the STB, which has been rejected by various parties, including the Association of American Railroads, as well as CSX and NS. Hatch called that approach a “stunner” in that if CP-NS service was not up to snuff or rates were not competitive, it would allow another carrier to operate over its tracks and into its terminals.
Other factors not working in the deal’s favor, explained Hatch, included how “in the last, and most, periods of service problems, additional access would have been, to say the least, counterproductive (in a congested region, more assets= more problems),” and that “in an ever-increasing service requirement business, added complexity isn’t optimal – is it?”

This does not mark the first time CP has tried to make a large-scale North American railroad acquisition.

In October 2014, it was reported that CP approached CSX about a potential merger but talks stalled out. Save for the Berkshire Hathaway $26 billion acquisition of BNSF Railway in 2010, railroad M&A has been largely quiet on that front.

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.