Canadian Pacific Railway Ltd. (CP) and Norfolk Southern Corp. (NSC) are at loggerheads with regard to a possible merger transaction.
Management at Norfolk has effectively nixed the possibility of a friendly merger, highlighting the difficulty of convincing regulators to allow the transaction, as well as concerns with the approach of CP as a cost-cutter concerned primarily with efficiency.
Norfolk's response was actually quite measured, since both concerns are valid. Indeed, what was initially one of the most promising aspects of this deal, and the most important factor in the success of any merger transaction, is the skill of the CP management team.
CP has been exceptionally well led by E. Hunter Harrison, its CEO poached from rival Canadian National Railway (CNR). Harrison is known for his track record of building value through cost savings and efficiency.
Applying this model across not just the existing CP operations, but also those of Norfolk, could be very accretive to shareholder value. Given Harrison's record, value creation would likely be toward the upper end of analyst estimates, if the transaction were to go through.
However, a merger would unquestionably be damaging to the current employees of Norfolk. In particular, middle to upper management would be greatly affected, as well as rank-and-file employees to an extent. As such, there is a degree of self-preservation at play in the Norfolk response.
For CP shareholders, though, the successful closing of a merger would be a positive development. In this scenario the combined CP and Norfolk operations would become the largest railway operator in North America, with 55,000 kilometres of rail across the continent under a single owner. The question now becomes whether CP goes hostile and puts its offer directly to shareholders via a proxy fight.
CP ranks poorly across most momentum metrics tracked by Morningstar's CPMS division. The stock-price decline is one culprit, falling from a high of $240 late in the first quarter of 2015 to a low near $190 before the Nov. 17 announcement of the initial acquisition offer.
However, there are a few bright spots. CP's return on equity (ROE) is high, which could be attributed to the cost-cutting efforts Harrison has been implementing. Additionally, CPMS ranks CP as a "hold" for investors in growth-oriented stocks, which is one positive measure of good long-term value creation.
As for Norfolk, it rates as mediocre across nearly all metrics. It's neither a stellar performer nor at any risk of bankruptcy. This suggests that Norfolk management is off base in asserting that CP's offer is grossly inadequate.
In fact, before Norfolk's rejection of CP's offer, the price bump from the proposed merger had improved the metrics for Norfolk in terms of immediate price appreciation.
Acquisitions are often a cause for caution by investors, with most of them being determined to be overpriced several years later. However, in the current low-interest-rate environment, taking on more debt for the purpose of this acquisition appears attractive.
Importantly, there are strategic advantages that CP could gain from acquiring Norfolk. In many ways, a takeover of Norfolk has become a practical necessity for CP in order to improve the operational efficiency of its Chicago hub.
In evaluating CP, the main metric to be considered is the company's quarterly earnings momentum. Though it's above the industry average, earnings momentum is still poor, and would be likely to remain so even if the merger bid were successful.
Nor would a post-merger CP be a strong candidate for adding to a portfolio on the basis of value criteria. Similarly, not enough time has passed for growth metrics to begin improving either.
The reality is that an investment in CP isn't justified right now on the basis of momentum, value or growth fundamentals. Buying the stock at this time is essentially a vote of confidence in CP management's ability to convince Norfolk shareholders that a merger is in their best interests.
If CP were to win the proxy battle, and obtain regulatory approval for a merger, investors could expect improved fundamentals. While there are always merger risks, CP management would be well positioned post-merger to create shareholder value through cost savings, efficiencies and low financing costs. Stay tuned to see how merger developments unfold, because they will undoubtedly affect CP's ratings.
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