CP-NS: Voting trust and other conundrums

Levitation takes two forms among railroads—magnetic levitation relating to futuristic high-speed passenger transport, and stock levitation associated with bidding wars for asset control.

Stock levitation most recently was seen in 1997 when Conrail shares ascended within months from $85 to $115 during a bidding war involving CSX and Norfolk Southern (NS). It ended only after Surface Transportation Board (STB) Chairman Linda Morgan sent CSX and NS a message via Washington Post journalist Don Phillips that if they didn’t mutually agree on splitting Conrail assets, the STB would impose a third-party settlement neither might like.

Comes now the possibility of a new bidding war—for control of NS in the wake of Canadian Pacific’s (CP) initially unwelcome $28.4 billion solicitation offer called “too low” by NS. A previous unsolicited bid by CP for CSX was rebuffed by CSX management last year and then abandoned by CP amidst cost anxieties and festering concerns of rail congestion and service problems that made rail merger mavens chary.

Since, rail service-problem fears have faded while NS stock slid some 30% in price, with NS suffering worse traffic losses than its rivals. All this reenergized the still marriage-minded 71-year-old CP chief Hunter Harrison, who thirsts to create North America’s first transcontinental railroad.

As “no” rarely is heard as “no” among railroad CEOs whose testosterone levels soar when the word “merger” is uttered and a prey’s stock price is considered attractive, NS is now assumed “in heat.” In such an environment, CP best beware of another railroad, a rail holding company such as Berkshire Hathaway, or a non-railroad hedge fund entering the fray with higher offers.

Thus, CP is prepared to improve its bid to achieve—more certainly, more quickly and less expensively—a lock-up of a majority of NS shares so as to shut out other NS suitors pending a subsequent STB decision on a CP-NS merger application. As one Class I railroad may not exert operational control over another Class I railroad absent formal STB merger approval, the tendered NS shares would be placed in a voting trust pending regulatory finality.

A voting trust for railroads requires STB approval, which typically occurs in fewer than two months following a request. A subsequent decision on whether to permit a CP-NS merger could stretch more than a year, but no longer than 16 months, per statute, following filing of a formal merger application.

Requisite regulatory hurdles are significant and not confined to CP and NS. Responsive and inconsistent merger applications may follow a CP-NS merger submission. Kansas City Southern could seek inclusion as a condition of merger; other railroads might press for concessions such as line sales; while BNSF might make a play on CN, and Union Pacific one on CSX. Other permutations are possible.

Adding to the fog is that the top institutional shareholders of the major U.S. railroads, whose concurrence in any merger deal is essential, are largely the same—Capital Research, Vanguard Group, State Street Corp. and Black Rock Investment Trust.

The Voting Trust Issue

If CP and NS management reach a merger agreement in principal, CP will pay a yet-to-be-established premium above market value for NS shares—and the voting trust becomes integral to the holding of those shares while regulatory approval is sought for the merger.

Here is where CP shareholders assume a significant risk. As CP will pay a premium above market value for those NS shares placed in a voting trust, their value could plummet sharply should the STB subsequently deny the merger. A dissolution of the voting trust would follow, requiring sale by CP of the NS shares on the open market at whatever price is offered. CP shareholders could end up considerably poorer.

This is why Harrison wishes, under cover of a voting trust, to make a management swap—send CP President Keith Creel, and maybe even himself—to Norfolk to run NS as Harrison thinks it ought to be run; with NS CEO Jim Squires moving to Calgary to “learn” more about CP and the heralded Hunter Harrison productivity-enhancing management method. More in a moment on how this intended management swap could affect an STB decision on a voting trust.

The purpose of the management swap is to tamp down—sharply and quickly, before any STB decision on the merger application—the NS operating ratio, which would increase the value of NS stock substantially, notwithstanding how the STB rules on the merger application. (Operating ratio is a railroad’s operating expenses expressed as a percentage of operating revenue, and is considered by economists to be the basic measure of carrier profitability. The lower the operating ratio, the more efficient the railroad.)

Harrison, described by a Canadian newspaper as a “tough, polarizing rail chief [with] a board of directors totally in his thrall,” peddles himself with Donald Trump-like bravado as a god-from-the machine, able to squeeze from a railroad every penny of waste and every ounce of improved productivity in order to send operating ratios tumbling. To his credit, Harrison did just that on Illinois Central (IC), Canadian National (CN) and CP.

In fact, when CN acquired IC in 1998, it was the only modern merger transaction not plagued by service failures. Harrison, then CEO of IC, became CN’s chief operating officer before becoming CN’s CEO—a fact that may be prominent in a CP-NS merger application that requires a service assurance plan. Harrison’s critics, however, assert that IC, CN and CP are all less complex in route structure and traffic diversity than NS.

Harrison’s scheduled railroad model

If history is a guide, and the CP-NS management swap occurs, Harrison will attempt to turn NS into a scheduled railroad, substituting high hourly pay for existing fixed trip-rates and guaranteeing train crews more predictable days off and starting times. Road and yard distinctions, as well as other costly work rules, would be eliminated and the work force trimmed significantly through attrition. Such a bundle of changes are intended to put productivity improvements on steroids, while annual wages could climb by as much as $30,000 in order to coax labor-contract changes.

There is, of course, no guarantee the Harrison model would work at NS—or work in time to protect NS share value should the proposed CP-NS merger be rejected by the STB. Time and pushback from rail labor—and even from a justifiably proud NS management—could work against Harrison.

For all of Harrison’s declarations of NS shortcomings, NS is the only major railroad that consistently has been found by the STB to generate revenue equaling or exceeding its annual cost of capital; and no railroad in modern times has posted a consistently better safety record. There are other sobering considerations to the optimism attending the Harrison aura. Former CN Chairman Paul Tellier, who adored Harrison’s abilities, nonetheless winced at Harrison’s oft abrasive personality. “We try to keep Hunter in a cage so he doesn’t bite,” Tellier once jested. “But he finds a way to get back out and we have to put him back in.”

Indeed. At CN, Harrison was derisively called “the ugly American” by train crews over his brusque manner in seeking productivity improvements. U.S.-based labor union senior officer Carl Vahldick, who had worked closely with Harrison at IC, once was dispatched north in an effort to quell an uprising by conductors.

The so-called Harrison productivity-enhancement model was, in fact, developed at IC with substantial input from United Transportation Union Vice President Corky Swert; yet twice rejected by the rank-and-file before productivity payments successfully sweetened the deal. More recently, conductors on CP’s U.S. subsidiary Soo Line rejected a Harrison hourly rate concept, while labor leadership on CP subsidiary Delaware & Hudson (parts of which have since been sold to NS) declined even to consider the concept.

Such are the hazards of assuming early productivity enhancements at NS.

Perhaps the greatest peril to STB approval of a voting trust is the envisioned management swap. Yes, voting trusts have been approved in the past—such as when Southern Pacific (SP) and Atchison, Topeka & Santa Fe (ATSF) sought merger approval, only to have it dissolved when the STB denied the transaction. Billionaire energy tycoon Phil Anschutz stepped in to purchase a financially struggling SP, later merging it with Union Pacific, while ATSF and Burlington Northern combined to create BNSF.

But as the proverb reads, “That which is past is dead.” Railroads and their regulatory agency have entered a new age with changed rules and perceptions.

Too Big to Fail?

Recall that when BNSF and CN sought merger approval in 2000, the STB put the transaction on hold for 15 months while formulating new merger rules to meet what the STB considered changed conditions in the rail industry—not the least of which is concern that U.S. railroads already had become “too big to fail,” as was proven with banks during the financial meltdown of almost a decade ago.

The BNSF-CN merger application voluntarily was withdrawn, meaning a CP-NS merger would be the first to be considered under the STB’s new more-stringent-than-ever merger rules, which contain a revised procedure for voting trusts—a privilege to be granted by the STB and not a right. With regard to voting trusts, the rules state:

“[W]e are responsible for ascertaining whether a proposed transaction would undermine the financial integrity of the applicant carriers. If prospective applicants make larger tender offers for controlling stock interests in other rail carriers, they risk having to sell these assets at a greatly reduced price if we do not approve the control application or if they choose not to consummate it.

“Therefore, we believe that, with only a limited number of major railroads remaining, we must take a much more cautious approach to future voting trusts in order to preserve our ability to carry out our statutory responsibilities.”

The STB seeks to assure that, going forward, it does not act as an enabler of financial risk compromising CP’s ability to fund future capital investments and normalized maintenance for itself, or for its U.S. subsidiaries—Dakota, Minnesota & Eastern, Delaware & Hudson and Soo Line.

Jiggery-Pokery?

Comes now the more problematic hitch. The STB’s voting trust procedures require independence in the operation of the railroad held in trust. If the Harrison-intended management swap, perhaps essential to protecting the share value of NS should a merger be rejected by regulators, is viewed as jiggery-pokery by the STB—an attempt to circumvent required NS operational independence—voting trust approval could be in deep doo-doo.

As Harrison sees things, during STB deliberations on the 1998 successful CN-IC unification, the STB allowed a voting trust for IC during which time Harrison, then IC’s CEO, was sent to CN as chief operating officer. So why not now? Well, IC was a relatively small railroad during a different era. Times have changed—that which is past is dead—and new regulators sit in judgment.

So last week, Harrison hinted he might, instead, place CP in voting trust rather than NS. Some attorneys say such a tactic might avoid required STB approval of a voting trust of NS, while still allowing CP to lock up control of a majority of NS shares and make the management swap. It could be a perilous strategy, as seeking to involve the STB in a three-card Monte game run by Hunter Harrison’s creative attorneys might not be the sanest of strategies to gain voting trust or merger approval.

What CP should not be inviting in this effort is an unnecessary court challenge and its attendant delay. As CN and BNSF learned when fighting the 15-month merger moratorium in 2000 that cost them their merger, investors providing the acquisition cash are prone to having second thoughts when the calendar drags.

As for Open Access

While a discussion of pro-competitive elements required by the STB for approval of mergers under its current rules is beyond the intent of this column, there is one curious element of this proposed transaction that could bite shippers more than railroads, notwithstanding that most railroads stand in opposition.

Harrison promises that if a CP-NS combination fails to provide adequate service or competitive rates, he would allow a competing railroad to utilize CP-NS tracks to reach otherwise sole-served customers (open access), and quote line-segment rates in bottleneck situations. Such are opposed by most railroads while craved by most shippers.

Yet giving previously sole-served shippers access to another railroad could eliminate the second of two required pre-conditions for bringing a rate challenge before the STB—a ratio of revenue to variable costs exceeding 180% AND evidence that the shipper has no effective transportation alternatives. Most, if not all, potential rate challenges by aggrieved shippers could thus be eliminated were open access a condition of the merger’s approval—but just on CP-NS.

Thus, railroads other than CP-NS would NOT be required to provide open access and elimination of bottleneck pricing. CSX, for example, could then poach on NS sole-served points without fear of similar poaching by NS. The investment funds whose holdings are spread among numerous U.S. railroads may not cotton to such market destabilization and withhold their shares in NS from CP.

As for the extension of open access and bottleneck pricing to other railroads as a condition of other mergers, many railroads and investors assert it could chill future investment in affected facilities. They stand in disagreement with economists over the theory of “conscious parallelism,” which predicts two competitors will not destabilize the status quo; that a third competitor, not contemplated by open access, is required for market destabilization.

DraftKings and FanDuel promise big payoffs for predictive-skill talent involving professional sports. That’s small potatoes compared to wins and losses faced by those with cash in this game. Interesting times, indeed.

Frank N. Wilner has chronicled every merger since the mid-1850s in his book, Railroad Mergers: History, Analysis, Insight, available from Simmons-Boardman Books at http://www.transalert.com/cgi-bin/details.cgi?inv=BKMERG&cat=14.