Analysis: will Norfolk Southern shareholders find CP's latest merger offer 'compelling' enough?

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Is it fair to say that Norfolk Southern (NS) shareholders are in the midst of existential crisis these days?

This is a legitimate question, given that Canadian Pacific (CP) is adamant it can extract billions of value from combining with the US railroad operator, while the NS board believes the deal won’t receive the blessing of the regulators – which could be a stumbling block.

War of words

“On December 7, the Norfolk Southern Corp posted to its website a ‘white paper’ authored by Chip Nottingham and Frank Mulvey, two former Surface Transportation Board (STB) members retained by NS,” CP recently said – and then claimed that Nottingham and Mulvey had never participated in the review of a major merger deal, and they assumed for the purpose of their analysis that “NS would be put in trust, when in fact CP intends CP to be in trust rather than NS.”

The deal is being orchestrated by activist investor Bill Ackman, who is pushing hard to get the acquisition done as soon as possible. To that end, he took centre stage on December 16, when he joined CP management to explain the structure of the deal before the investor community.

We’ll come to this investment vehicle and how it is intended to facilitate the deal, at least according to CP; but first you really have to read some of the key remarks made by Mr Ackman.

It’s a war of words that has only just started, and there is every sign that it will be a protracted battle, not one for the faint-hearted or those light on stamina – this is where deal-making gets really interesting.

Here’s an excerpt from Mr Ackman’s remarks on Mr Nottingham: “In fact, for the purpose of his analysis, Chip Nottingham assumed we were going to put NS in trust as opposed to CP.”

Mr Ackman added: “And if you want to get a sense of how these consultant reports are literally paid for, we dug up a transcript of a call that Chip Nottingham did with a Wall Street firm – an analytical firm. This was done in October of 2014, and the context was the CP-CSX transaction” (which fell apart last year).

“At that point, Chip wasn’t working for anyone. He was actually being paid to give his independent advice as to whether a transaction like CP-CSX could get approved. And here is what he said:”

‘If CP and CSX were to merge, it would create a scenario where you could have a third major competitor in that market, [he is referring to the Bakken volumes moving to the east coast] that would actually be able to seamlessly – with no handoffs and no handovers – avoid the Chicago bottleneck, which is a notorious delay point in shipping from east to west and west to east.

‘The CP-CSX network will be able to bypass Chicago, but also be able to do so with one carrier moving across the country from Pacific north-west to the east coast for the oil and gas exploration areas back and forth. Clearly, if you are just focused on the energy sector, it’s a merger that has some attractive points to it. The two railroads involved don’t have much overlap in track currently and that’s a plus if you’re looking at getting a merger approved.

‘So, very few, if any, rail customers currently served by both CP and CSX would face going from a two-carrier scenario to a one-carrier scenario. The resulting merger will create a large rail carrier, but that large rail carrier would not be significantly bigger than the Union Pacific or BNSF, so it would not create a dominant industry titan, would arguably add a third very large player to the two that already exist in UP and BNSF.’

And, Mr Ackman noted, the most interesting thing “about Chip’s statement made when he was not being paid by NS, but paid for his independent advice, is if you replace CSX with NS in this paragraph, you get to what we’ve been saying all along”.

CP’s “compelling offer”

CP describes its latest offer as “compelling”, based on a financing mix that now includes some insurance protection, as CP management calls a feature that would kick in if its projections about the value of the combined entity turned out to be erroneous. It’s hard to dispute the logic behind the latest offer that clearly seeks to secure the backing of the NS board, but CP could be making a big mistake in offering less cash than NS investors aim for.

Investors are more illuminated, true, and how the deal would be structured has been clearly explained, yet even the analysts who joined the call with CP management last week were puzzled about several elements of the merger, and I am not surprised NS has not welcomed the new terms, claiming the proposal did not “address the substantial regulatory risks and uncertainties inherent in the proposed combination”.

There are reasons to be concerned about this, one of the biggest railroad deals of all time. Although the CP management has obviously done its homework, I am not entirely sure CP understands the needs of NS investors, and it could also lose the backing of its own shareholders if it goes beyond acceptable limits.

Where we are

In mid-November, CP placed a low-ball proposal that clearly undervalued the equity of NS and comprised a $46.7 cash portion and a fixed exchange ratio of 0.348 CP shares per NS stock. Based on those terms, NS shareholders would have owned 41% of the new company.

That was described by NS as an “unsolicited, low-premium, non-binding, highly conditional indication of interest”.

CP claimed the proposal was fair, and represented “a substantial initial 23% premium to NS’s 45-day VWAP [volume-weighted average price] of $79.14”.

But NS didn’t blink.

On December 8, CP returned and offered NS shareholders $32.86 in cash and 0.451 shares of stock in a new company that would own NS and CP. That’s right, CP offered less cash and a higher stock component to seal the deal, even though NS shareholders wanted less equity and more cash.

CP thinks the allure of synergies and the promise of value realisation – a repeated theme is how very badly run NS is – could do the trick, but as a retail investor pointed out to me: “I bought NS and I want to stay invested because I trust the NS folks, but I’d take cash and then I’d decide where to put my money.”

A couple of fund managers who have invested in NS share the same feelings. After all, they argue, if CP is confident about its projected synergies, which total $1.8bn, and regulatory hurdles are not a problem, it’s really hard to understand why CP wouldn’t simply pay a higher cash premium to receive the backing of the NS board.

“We estimate the total value of the stock and cash consideration to NS shareholders to be worth $125 to $140 per share at the closing of the transaction in May 2016,” CP said in its second proposal. The revised transaction offers a 37% to 53% premium to today’s closing price of $91.52 and a 58% to 77% premium to the unaffected price of $79.14 per share,” it added.

Those estimates are good on paper, yet estimates can end up being quite off the mark in deal-making.

So, once again, that second proposal was rejected, although it offered NS shareholders a higher stake of up to 47% in the combined entity.

Then, in a less dramatic twist, given the final financing mix, a third approach emerged: one based on the same cash and stock split, but also including a so-called “contingent value right” (CVR) component.

If you are confused now, you are in good company.

CVR and trust

BMO Capital Markets analyst Fadi Chamoun, who opened the Q&A session on December 16, asked: “First, how does this process move forward? Is there an avenue to call for a vote before the AGM? And secondly, why did you feel that this CVR structure was necessary?”

“A CVR is essentially a security that would trade like an option. It will be highly liquid, based on the total number of units that should be traded, and, in this particular situation, it could be worth anywhere between $0 and $25 if some of the core assumptions made by CP are not met.”

To paraphrase Bill Ackman, this is essentially a ‘put spread’ – so, the higher the stock price, the less valuable the put spread becomes.

The inclusion of a CVR makes sense, in my view – but then CP added another element of uncertainty to the deal, as if things were not complicated enough already.

Mr Ackman said that investors should think about the CVR as a long-life insurance policy on the trading price: “You will get a payment if the stock price is below $175 a share.”

After all, once that risk is minimised, “the only thing required, again, is a trust approval, which we expect in 60 to 90 days,” Mr Ackman said, while adding that the merger was not guaranteed to be approved by the STB, so would be a process that will take “12 or 15 months for an approval, but it’s additional upside and we think it is likely to get done”.

Is Bill Ackman unstoppable?

He said: “This transaction is about the value of the combined company. What’s it worth? And the CVR is a way of calling the question. Canadian Pacific is basically putting down $3.4bn of chips on the table and saying we’re willing to bet $3.4bn that this stock is above $175 a share.”

I’m not sure the market is convinced, and NS stock currently trades at $84. The deal – which would create the first transcontinental railroad in North America – hinges on a multitude of factors, but the approval of the investment trust is a key element.

A trust is a vehicle that should facilitate the deal and help the combined entity minimise regulatory risk, given that the trust would guarantee the rights of all the shareholders until formal approval is granted by regulators.

CP said: “Voting trusts have long been held to be an effective and lawful means of insulating a carrier from unlawful control pending regulatory approval.”

If the STB does not approve the transaction, then the holding company – which would be called CP-NS – would to have to separate CP from NS, and “it will either spin CP to shareholders or spin NS to shareholders, but these will go back to being publicly traded companies,” Mr Ackman said.

CP chief executive Hunter Harrison, described by Mr Ackman as “a railroad executive that has the best record in the history of railroading”, will lead the combined entity if the deal goes through.

As far as trust approval is concerned, Mr Harrison said: “Since the Staggers Act of November of 1980, there have been 144 requests to the Surface Transportation Board for a trust. 144 have been approved, so the odds are pretty good that we could get a trust structure approved.”

CP does have a Plan B. If the trust is not approved it may still raise the cash component of the bid – but I wonder, again, if it has underestimated the impact that lengthy negotiations could have on the value of CP shareholders’ holdings.

With Mr Ackman on the front line, CP stock has lost 15% of value since December 1.