A Look At The Benefits And Potential Stumbling Blocks Of The Proposed Canadian Pacific-Norfolk Southern Merger

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Norfolk Southern Corporation (NYSE:NSC) has announced the receipt of a takeover offer from Canadian Pacific Railway Company (NYSE:CP). Canadian Pacific is offering Norfolk Southern shareholders $46.72 in cash in addition to 0.348 shares of Canadian Pacific for every share of Norfolk Southern, which represents a premium of around 10% based on closing prices on November 17. [1] Norfolk’s response to the offer has been tepid at best, with the company terming Canadian Pacific’s offer ‘unsolicited, low-premium, non-binding, and highly conditional’ in a press release. [1] In this article we will look at the benefits of a potential merger and the stumbling blocks that could prevent it from being realized.

Complemental Networks

Canadian Pacific is one of Canada’s largest railroad companies with a 13,700 mile network extending from Canada’s West to East coast and also covering parts of the U.S. Midwest and Northeast regions.

Canadian Pacific Rail Network, Source: Canadian Pacific 2014 10-K

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Norfolk Southern is the second largest railroad company in the Eastern U.S. in terms of both revenues and network length with a 20,000 mile rail network.

Norfolk Southern Rail Network, Source: Norfolk Southern 2014 10-K

As illustrated by the two diagrams shown above the rail networks of Canadian Pacific and Norfolk Southern are complementary with very little overlap. A merger of these two companies would result in the largest rail network in North America, giving the combined entity access to major ports and business centers on the U.S. East Coast and Gulf Coast, in addition to both the Canadian East and West Coasts. Further, a combined Norfolk Southern-Canadian Pacific network would help trains bypass the congested Chicago hub, a major bottleneck on the U.S. rail network. The freight trains of several east or west bound rail operators meet at Chicago and hand off cargo, a process that is fairly time consuming. [2] Six out of the seven largest U.S. railroads pass through Chicago, resulting in major congestion at this point on the network, negatively impacting locomotive speeds and travel times. [3] The combined Norfolk Southern-Canadian Pacific rail network will have coast to coast access while at the same time bypassing Chicago, saving travel time, and improving operational efficiency.

Cost Savings

Rail traffic has declined over the past twelve months, with shipments of commodities, such as coal and crude oil, suffering as a result of low gas prices and low oil prices respectively. The economies of scale of a combined Norfolk Southern-Canadian Pacific network could help bolster the profitability of the combined entity. As per estimates made by Canadian Pacific, the combined entity would realize $1.8 billion in annual operating cost savings over the next several years. [4] Further, Canadian Pacific management has been far more successful with improving the efficiency of its operations. This is illustrated by the following chart, which shows the operating ratio (operating expenses as a percentage of revenues) of both companies.

Operating Rations for NSC and CP, Source: Bloomberg

The combined entity could benefit from a renewed focus on cost reduction and improvement in operational efficiency. Further, the combined entity could also realize significant tax savings. With Canadian Pacific subject to a lower effective tax rate as compared to Norfolk Southern, depending upon the corporate structure of the merged entity, there could be significant tax savings as well. [5]

Regulatory Hurdles

The biggest stumbling blocks for a potential Norfolk Southern-Canadian Pacific merger are regulatory approvals from both U.S . and Canadian authorities. The U.S. Surface Transportation Board has previously scuppered efforts for mergers between major rail companies, with increased competition one of the major criteria for approving any deal. [6] It appears evident, moreover, that other participants would be strongly opposed to the combination.  ((CP’s $28 Billion Proposal To Buy Norfolk Faces Hurdles, Wall Street Journal))  Regulatory hurdles prevented a Canadian National Railway-Burlington Northern Santa Fe merger back in 2000. [4] Canadian Pacific contends that the merged entity would provide superior customer service at competitive rates to shippers, with the Canadian rail operator confident that the deal would satisfy both U.S. and Canadian regulatory authorities. We would be eagerly looking out for more details pertaining to this potential deal in order to understand how Canadian Pacific proposes to get the necessary regulatory approvals for the transaction. Should the deal eventually go through, it would create a railroad behemoth which would alter the competitive landscape of railroads in North America.

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Notes:
  1. Norfolk Southern Board of Directors to evaluate unsolicited, low-premium, non-binding and highly conditional indication of interest from Canadian Pacific, Norfolk Southern News Release [] []
  2. Norfolk Southern hostile to Canadian Pacific’s $28.4 billion bid, Reuters []
  3. Freight Train Late? Blame Chicago, The New York Times []
  4. Canadian Pacific Goes Public With $28 Billion Norfolk Offer, Bloomberg [] []
  5. Canadian Pacific Could Ride Hundreds Of Millions In Tax Savings With Norfolk Southern Deal, Forbes []
  6. Canadian Pacific Outlines Norfolk Southern Merger Proposal, Wall Street Journal []