UPDATE: CP revises offer for Norfolk Southern, NS balks

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Two CP trains with a mix of power meet near Oconomowoc, Wis.
Brian Schmidt

Canadian Pacific today upped the ante in its bid to take over Norfolk Southern — and was quickly rebuffed.

CP would offer NS shareholders 0.451 shares in the new company, plus $32.86 in cash in May 2016, when it would put either NS or CP into an independent trust. This is down from $46.72 in cash in CP’s initial offer, but it would put the money in investors’ pockets 18 months sooner.

CP said the new offer would reduce regulatory risk for NS shareholders and increase their stake in the new company to 47 percent — up from 41 percent in CP’s initial offer. The latest offer would be worth between $125 to $140 per share at the closing of the transaction in May 2016, a premium of 37 to 53 percent based on Monday’s closing price of $91.52 per NS share, CP says.

NS almost immediately rejected the offer.

"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," NS CEO James Squires said in a statement.

Squires also says CP’s latest offer is fatally flawed because the U.S. Surface Transportation Board would not approve of placing NS in a voting trust. On Monday evening, NS released a white paper from two former STB chairmen, who argue that the trust would run afoul of regulations and that the merger itself would be rejected because it’s not in the public interest.

In a conference call Tuesday morning, CP says the voting trust structure would insulate the railroads from unlawful control and that it is leaning toward the unusual step of putting CP in trust. CP CEO E. Hunter Harrison would sever ties with CP and become CEO of NS, much like what he did when he left Illinois Central to become chief operating officer of Canadian National while the CN-IC merger was being reviewed.

Harrison would then implement CP’s operating plan at NS, driving improvements in fuel efficiency, train velocity, locomotive and railcar productivity, and yard and terminal operations. These improvements — which would occur before the merger review process is complete – would account for 72 percent of the $1.8 billion in synergies that CP has identified. The balance would come from post-merger synergies such as extended reach and longer length of haul, market share gains, and interline efficiencies.

“We’re not shooting for the moon here,” Mark Erceg, CP’s executive vice president and chief financial officer, says of operational efficiencies. “We’re just looking to bring NS up to industry standards.”

NS has said that CP’s “cut to the bone” operating practices would chase away its service-sensitive, truck-competitive traffic.

Keith Creel, CP’s chief operating officer, disputed those claims.

“NS does not understand the way we run an efficient railroad,” Creel says. He says CP’s focus is on sustainable practices, disciplined operation, and effective cost control – not cutting to the bone.

Since 2012, CP has dramatically reduced its operating ratio, increased capital spending, and improved transit times. This has resulted in 20 percent growth in domestic intermodal, Creel notes. “To suggest that we don’t understand competitive, truck-sensitive traffic is not fact-based,” Creel says.

In making its case for approval of a CP-NS combination, CP said the merger would exceed the public interest standard for mergers, citing service and safety improvements and substantial economic and environmental benefits. The merger would enhance competition because it’s an end-to-end combination, CP says. CP also would offer various open access provisions to allay shipper concerns. Significantly, a CP-NS combination would not trigger additional industry consolidation, says Paul Guthrie, CP’s special counsel to the CEO.

Activist investor Bill Ackman, whose Pershing Square hedge fund owns 9 percent of CP, said NS shareholders would come out ahead if they go along with CP’s plan. He said investors had a choice to go with CP’s successful management or Squires and his untested team.

“Pursuing a merger with CP offers vastly superior value and lower risk to NS’s new standalone plan, even if the merger is ultimately not approved,” Ackman said in his presentation, which broke down the financials behind the proposed combination.

If NS follows the plan Squires outlined on Friday, the railroad’s stock would tread water and be worth around the same $90 in mid-2016 as it is today, Ackman says.

But if Harrison takes the reins at NS and makes operational improvements, NS would be worth $125 per share by mid-2016, Ackman contends. And if the merger is approved, NS shares would be worth $140, he says.

Investors and Wall Street analysts are skeptical of Squires’ plan to improve operations, grow revenue, and cut costs, Ackman says. He called Squires an unproven executive and says “it’s a real leap of faith...to believe the company now has a plan to get to a 65 OR.”

Harrison agrees. He recalls stepping onto an NS office car at Augusta, Ga., in 2006. NS officials told him they were looking forward to having a quarterly operating ratio in the 60s. “That was 10 years ago and they are still trying to get to the point of starting with a 6,” Harrison says, which calls into question whether NS can reach its target of a 65 operating ratio by 2020.

Ackman praised Harrison, who transformed Illinois Central, Canadian National, and Canadian Pacific into lean, efficient operators that lead the industry. And, he points out, CN has continued to thrive after Harrison retired. “These are not short-term improvements,” Ackman says, disputing NS’s contention that Harrison has a short-term focus.

Squires, in contrast, lacks an operational background and is part of an NS management team that has underperformed for years, Ackman says.

What will CP’s next move be amid continued opposition from NS?

“Our interest right now is to try to engage in dialogue with Norfolk Southern,” Harrison says. He says he doesn’t want to create adversarial relationships because it wouldn’t be healthy for a combined CP and NS and wouldn’t speculate about what might be next.

Ackman, however, encouraged activist investors to buy NS stock and force a proxy vote at the railroad’s annual shareholder meeting in the spring. “If I were not on board of CP, I would be buying stock today in NS and put up slate of directors,” Ackman says.

But a proxy fight may not be required. “The big shareholders at Norfolk Southern are going to pick up the phone, speak to the board, and people will come to their senses,” Ackman says.

UPDATED: Dec. 8, 2015, quotes and comments from Canadian Pacific executives through the first 1 hour and 30 minutes of a morning conference call.

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