Analysis: Canadian Pacific-Norfolk Southern merger appears to be on track

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Juts how long are the odds that a merger between Canadian Pacific (CP) and US railroad operator Norfolk Southern Corp (NSC) will take place?

The deal would be based on terms put forward by CP in mid-November, when NSC said it had received “an unsolicited, low-premium, non-binding, highly conditional indication” of interest.

The suitor has room to lever-up in order to agree a friendly deal, although in doing so it may end up jeopardising its coveted investment-grade rating – particularly if, during the process of combining the two companies, its synergy targets turn out to be overly optimistic.

On the face of it, CP needs the backing of NSC shareholders to pull off one of biggest railroad deals of all time, although that doesn’t mean that agreeing on both the price tag and the financing mix will carry the deal over the finishing line.

In fact, regulatory hurdles could be insurmountable, and last year scuppered CP’s ambitious plans to consolidate the industry when preliminary talks with CSX – the biggest operator in the eastern US – collapsed.

Premium

The $28.4bn proposal for NSC, which is evenly split between cash and stock, comprises a $46.7 cash portion and a fixed exchange ratio of 0.348 CP shares per NSC stock, valuing the target’s equity at $94.9 a share.

NCS shares now trade just over $95, but rose to $98 soon after the deal became public, indicating that investors believe that CP will return with an improved offer – and there is good reason to believe it will.

The initial proposal carried “a premium of less than 10% based on closing prices today”, NSC said on November 17. Although it probably forgot to mention that speculation had already driven up its stock price by about 10% a week earlier, when rumours about a possible tie-up emerged.

So the premium to its undisturbed share price is already about 20%, but “it will have to surge to 30% to NSC’s unaffected share price in early November to get the green light from NSC shareholders”, a source close to the deal told me.

The strategic rationale is to create the first truly pan-North American intermodal operator – one with a rail network stretching most of North America and with port gateways on both Atlantic and Pacific coasts. NSC is the second-largest operator in the eastern US, but although much bigger than CP, it is less profitable both in terms of operating income margin and net income margin.

CP chief executive Hunter Harrison, who previously led CP’s rival Canadian National Railway, is two-and-a-half years into his job with a mandate due expire in mid-2017 – precisely the timeframe for the completion of the CP-NSC merger.

After failing to acquire CSX last year, CP became attracted to the slide in NCS’s share price.

In the wake of the commodity slump, NCS has been under pressure and “has suffered more than any other US railroad from sharp declines in coal volumes because exports from the Appalachian coal fields that it serves in Kentucky and West Virginia have fallen so sharply”, The Financial Times reported when the first rumours emerged on November 10.

While it’s possible that NSC is not worth much more than $28bn in the current environment – and it’s undeniable that CP would likely end up chasing another target in a quest for inorganic growth – it appears CP has little choice but to persist in its pursuit of NSC, bidding up to $31bn while fighting off regulators in order to convince them that the deal is in the public interest.

Not only a matter of price

The initial proposal leaves plenty of room for negotiation.

After all, the net present value (NPV) of projected synergies, which must cover the deal’s premium, comes in at over $11bn. That NPV assumes a tax rate at 30% and a cost of capital of 9%, and comfortably covers the $4.7bn premium for NSC equity based on its undisturbed price as of November 9. Upping the bid by a couple of billion should pose no problems, assuming CP retains a 60%-plus stake in the combined entity.

Furthermore, activist investor William Ackman – who has a long involvement in the railway sector and has been pushing for consolidation for a few years now – was also the man behind the appointment of Mr Harrison.

Mr Ackman has drawn some very bad publicity in recent times, and he must restore confidence among investors. “William Ackman woke up in a Toronto hotel room well before dawn on Tuesday last week in a state of distress,” The Wall Street Journal wrote in early November, when it became clear that his bet on Valeant was going badly awry.

CP has argued the NSC deal would offer unparalleled customer service and competitive rates for shippers, adding that it would receive the blessing of the US Surface Transportation Board (STB) and Canadian regulators, but this could be a stumbling block.

“The STB has a public interest test when considering whether to approve mergers, so a deal would not only have to address antitrust concerns but also result in improved service, economic efficiencies and public safety for those using the railways,” Reuters recently pointed out.

The most recent deal between US and Canadian (Class I) railroads was struck at the end of the 90s, when NSC and CTX joined forces to acquire and break up Conrail, in a much smaller cash and stock acquisition that valued the target at just over $8bn. The last major North American railroad acquisition was Warren Buffett’s $26bn purchase of Burlington Northern Santa Fe (BNSF) in 2010.

CP has already taken extensive legal advice and said the “feasibility of the proposed transaction [and] also our plan to ensure a smooth and expeditious review and approval process” had been confirmed by US regulatory counsel Stinson Leonard Street and its Canadian counterpart Bennett Jones.

And as far as financing is concerned, it has already received commitment of $14.2bn from J.P. Morgan Securities, which indicates, in my opinion, that it is very unlikely to be constrained financially.

If the bid ends in failure, most likely it will have the regulators to blame.