Is this merger doable (or worth it)?

Posted by Fred Frailey
on Wednesday, November 11, 2015

Will they or won’t they? More to the point, should they? They of course are Canadian Pacific and Norfolk Southern railways, reported this week to be considering a merger in which CP would buy the Virginia-based NS. CP’s traffic growth has sort of flatlined, meaning that the best way to grow may be to buy the carloads, in this instance, a whole railroad. Norfolk Southern is not in an enviable position. It’s top executives are all new to their roles, and I sense there is some drift about how to reorient the railroad away from its fast-declining coal franchise and toward the intermodal business—or even whether this is necessary. There are people within NS, for instance, who believe coal will bounce back strongly. So NS seems to hesitate, which is a terrible position to occupy when you’re in another company’s crosshairs.

Hunter Harrison, the chief executive of Canadian Pacific, and his protege Keith Creel, CP’s president, are anything but adrift. You can love them or hate them, but you’ll not find two more experienced and hard-charging operating guys in this business. They possess the business focus that NS appears to lack. And for that reason, I sense that Norfolk Southern will agree to a combination. Whether an agreement will last long enough to reach the Surface Transportation Board, and whether the STB will approve it, are other matters. After all, several of the other Class I railroads could counter with better offers for NS.

But as I scanned the output of rail analysts today, there is a distinctly different tone than a year ago, when almost nobody cheered on Harrison when he courted Michael Ward of CSX Transportation.  As opposed to then, railroad traffic is on the decline and stock prices are somewhat lower. Plus, service is improved even if nothing to brag about, so the mood of shippers is friendlier.

Analyst Scott Group of Wolfe Research is among those who think a CP-NS merger could be approved by the STB, particularly if CP agrees to reciprocal switching, which Harrison has said he would. Plus, Group believes there could be “significant” earnings per share gains from a merger. Concludes Jason Seidl of Cowen & Company: “Shareholders may view this as a rare opportunity maximize their value in an otherwise weak market, and shippers may be less vehemently opposed to a merger today than the were a year ago . . .” Translation: NS shareholders will have a chance to cash out at a much higher stock price. Moreover, Seidl believes NS is less likely to spurn CP’s attention than CSX was a year ago. He says that if rebuffed, CP’s tenacious management might resort to “other means for making the deal happen,” perhaps including a proxy fight to install merger-friendly directors.

I really cannot tell how Anthony Hatch, an independent analyst, comes down on this. He says the cost savings would be marginal because this would be an end-to-end merger. Tony goes on to say shipper support would be needed (and that shippers are not enamored of CP under Harrison and Creel), that the process would be drawn out, that NS has done a lot already to get its house in order, and that hostile mergers “won’t fly in the railroad business.” Sounds like he think the whole idea has bad odor. But then Tony says to never underestimate E. Hunter Harrison. So go figure.

So should they? There is a lot of business to get gotten near where the Class I lines intersect, left there because one of the railroads would get the short haul and cannot be bothered. This is something the analysts all appear to miss. And railroads are a network business, meaning that they beg to be national in scope. Every time you interchange cars or entire trains, there is friction that can gum up the works.

And yet, and yet . . . look at what a lousy job the Class I lines do today serving their customers. It’s a scandal, and preventable. In a race to see who can save the most money and achieve the lowest operating railroad, they are forgetting who really comes first: the customer. Serve the customer well, and more will follow, ultimately making the shareholders even richer. That’s classic business doctrine. But it requires patience, which investors (meaning, owners) have little of. So we get a railroad industry that has lost its way. Do I want the big railroads to get even bigger and compound the poor service already being offered? I wish that first, the Canadian Pacifics and Norfolk Southerns of this world would demonstrate they can manage the railroads they already have, before doubling in size and perhaps arrogance.—Fred W. Frailey

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