Tuesday, January 14, 2020

Conrail Case

Conrail G455: Corporate Restructuring Team 7 1) Why does CSX want to buy Conrail? In an industry beset by limited options to consolidate domestic rail traffic, CSX looked at Conrail as an avenue to increase market share and gain access to the North East rail network. With air travel, road travel and trucking taking an increasing share, significant revenue growth became difficult. As Conrail became profitable, Congress explored ways of privatizing it, giving CSX an opportunity to acquire Conrail.Though Conrail suffered from performance inefficiencies it had certain strengths relative to CSX and Norfolk with respect to highest revenue per mile of track operated, per carload originated etc. Conrail with operating revenue of $3,686 million and 29. 4% of Eastern rail freight traffic was attractive enough for CSX to consider the merger. The joint entity would have $8. 5b in rail revenue and would control the Eastern market with a market share of 70%.CSX estimated the acquisition to also cr eate synergies resulting in consolidation of overlapping operations and not only increase the joint entity’s revenue through service improvements, but also the operating incomes through economies of scale. Cost synergies was expected to help in increasing the annual operating income by $370m and revenue increases was expected to help increase annual operating income by $180m. (Based on valuation of synergies, taking PV of terminal value, we estimate the gains in Operating Income to be equal to $3,047. 13. CSX expected the acquisition to improve the joint entity’s competitive position vis-a-vis Norfolk Southern as the joint entity’s rail networks would facilitate long-haul, contiguous and therefore low cost service. As Norfolk Southern lacked access to Northeast market it would be less able to provide long-haul routes from South or Mideast. The purchase of Conrail would thus provide CSX with control of the Eastern rail network. From a financial perspective, the p rojected revenue gains and cost savings was expected to make the joint entity become more efficient than Norfolk Southern.Likelihood of a rival (Norfolk Southern) acquiring Conrail, resulting in competitive disadvantage for Conrail was also a factor. 2) Based on multiples and a premiums paid approach, how much should CSX be willing to pay for Conrail? We took Sales, EBITDA, Book Value Multiples and Four week acquisition Premiums from Exhibit 6. We use number of Conrail’s shares outstanding as 90. 5 million at the share price of $32. 46 from the same Exhibit 6. Conrail's Value Sales EBITDA Book Value Premium % $3,722 $1,017 $32 $6,516 Multiples High Low 3. 6 1. 7 13. 1 8. 5. 5 1. 7 73. 0% 34. 0% Conrail Market Price Low Average $ 1,032 $ 3,712 $ 3,350 $ 5,465 $ (301) $ 5,398 $ 8,731 $ 9,986 High $ $ $ $ 8,104 8,028 10,862 11,273 See ‘Calculations’ spreadsheet for details. As the Conrail is fairly attractive resource for CSX it should be willing to pay on the high side of the Conrail Market Price. We have highlighted the High Price in the above table. We 2 have also calculated the price by various methods (sales ratio, EBITA, etc). The price calculated by these methods is reasonably close to the bid price of CSX.Within the high price too, there seems to quite a difference in valuations. The multiple analysis methodology assumes that all companies within an industry have similar characteristics. As expected there is wide variance is between low, high and average. Within the rail industry there is wide variance in capital structures, profitability etc, which is reflected in Conrail Market Price. Other than multiple and premium methods, CSX should be detailed financial analysis based on synergies etc. to come up with the price. The synergies given in the case are stated as â€Å"Gains in Operating Income. This is not an unambiguous term. For purposes of this and subsequent questions, assume that these synergies are net of costs (COGS and Capita l Expenditures) and the after-tax payment to bondholders. The term operating income is likened to net income or the taxable income to stockholders. Further assume that none of these acquisitions will affect the acquirer’s equity cost of capital. 3) Based on the data in Exhibit 7 and the definition of operating income gains given above, how much should CSX be willing to pay for Conrail? Support your answer with appropriate analysis.According to operating income gains we can value a firm’s market price as its pre-merger value and the present value of gains in operating income. Let’s assume that value of Conrail before the merger is equal to its market cap. Then taking Conrail share price as $71. 94 (average of year end and high stock price) and number of shares outstanding as 90. 5 million shares (Exhibit 6) we get Conrail market value equal to $6,510. 57 million ($71. 94 x 90. 5 million). We assume G =3%, MRP = 7%. We take risk free as 30-year maturity US Bonds r ate, which is 6. 3% (Exhibit 8); merged CSX-Conrail equity beta as average of CSX and Conrail equity betas, which is 1. 33. rE = rf + MRP ? E = 6. 83% + 7% x 1. 33 = 16. 11% Now we can find Conrail’s synergy value as present value of gains in operating income. 1997 Total Gain in Operating Income Total Gain in OI after 40% Tax Gain in OI (discounted @ rE) $ $ $ 1998 $ 88 $ 12. 80 $ 7. 15 $ $ $ 1999 396 237. 60 176. 26 $ $ $ 2000 550 330. 00 210. 84 2001 $ 567 $ 340. 20 $ 187. 21 Value of estimated gains = $671. 46 Terminal value = $2,673. 83 Present value of Terminal Value = $2,365. 67 Conrail’s Synergy Value is equal to $3,047. 13.See ‘Calculations’ spreadsheet for details. The maximum price, which CSX should be willing to pay for Conrail is $6,510. 57 + $3,047. 13 = $9,557. 70 3 The optimal price of the merger is somewhere in between of $6. 5 and $9. 5 billion. We’d advise a price closer to Conrail’s market value rather than the average of t hese two figures. In this case both Conrail and CSX shareholders win from the merger. If they take price closer to the high CSX shareholders can lose due to over estimated synergy gains. 4) Analyze the structure of CSX’s offer for Conrail. CSX offered a two-phased deal for Conrail worth $8. 3 billion at the nnouncement. CSX would purchase 90. 5 million (100%) of Conrail shares to complete the deal. In the first phase, CSX originally offered $92. 50/share for 40% of Conrail’s shares. This front-end offer would be completed in two stages for regulatory reasons, purchasing 19. 7% in stage one and the other 20. 3% once approved by the shareholders. Once all of phase one was completed, CSX would purchase the remaining 60% of Conrail’s shares by exchanging shares in a ration of 1. 85619:1. 0 (CSX: Conrail), yielding shareholders roughly $89. 07/share (blended value) based on recent Conrail and CSX stock performance.In addition, the merger agreement contained provision s related to break-up fees, lock-up options, poison pills, and â€Å"no talk† clauses. These provisions provided some level of protection against advances from NorfolkSouthern or other competitors looking to purchase Conrail. Notably, the no-talk clause required Conrail to abstain from any conversations related to buy-out with other firms; though this could be disputed where the board’s fiduciary duty to protect investors superseded said restrictions. 5) Why did CSX make a two-tiered offer? What effect does this structure have on the transaction?Pennsylvania’s fair value statute required all bidders holding 20% or more of stock to offer the same price to all shareholders unless target shareholders agreed to explicitly nullify this position. Also the same statute limited any shareholders (with a 20% or larger stake) voting rights unless management approved it. Finally, the law required management to consider and protect the interests of employees and the communit y. This two-tiered structure affected the timing and the cost of the deal. As a result of the deal’s structure, Norfolk Southern had two opportunities to block with a hostile takeover driving up the price of the acquisition.By close of business prior to the shareholder votes to opt-out of the fair value statute, CSX’s bid was up to $110/share, resulting in an offer that was $321,500,000 more than originally planned for the remaining 20. 3% in phase I. The structure of the deal also allowed CSX to pay for 40% of Conrail in cash (in two phases) while paying for the remaining 60% of the target with CSX stock. This meant that changes to CSX or Conrail’s stock price prior to the transaction completing could impact the cost of the entire deal 6) Why did Norfolk Southern make a hostile bid for Conrail? Conrail is considered a â€Å"scarce jewel†.Conrail was the sole class I railroad serving the Northeast market of the United States with control of 29. 2% of the rail freight market east of the Mississippi river. Although Conrail was inefficient and not very profitable, its revenue per mile of track operated, per carload originated, and per ton originated were the highest in the industry. If the merger between CXS and Conrail succeeded, Norfolk Southern would be negatively impacted with estimates of up to $320 million by 2001. This is clearly a battle Norfolk can not afford to lose as it may impact its very existence in the long run. 7) How much is Conrail worth? In a bidding war, who should be willing to pay more, Norfolk Southern or CSX? Again, note the previous definition of operating income when interpreting the data in Exhibits 6a and 6b. We use the same logic of gains valuation as we did it in question #3. Assumptions for CSX-Conrail Merger: We assume the same G =3%, MRP = 7%. We take risk free as 30-year maturity US Bonds rate, which is 6. 83% (Exhibit 8); merged CSX-Conrail equity beta as average of CSX and Conrail equity betas, whic h is 1. 33. rE = rf + MRP ? E = 6. 83% + 7% x 1. 33 = 16. 1% Now we can find CSX-Conrail synergy value as present value of gains in operating income. 1998 240 144. 00 (66) 210. 00 1999 521 312. 60 (123) 435. 60 323. 14 $1,260. 76 $5,086. 73 $4,655. 08 $5,915. 84 $12,426. 41 2000 $ 1,811 $ 1,086. 60 $ (189) $ 1,275. 60 $ 400. 60 2001 $ 752 $ 451. 20 $ (196) $ 647. 20 $ 356. 15 Total Gain in Operating Income Total Gain in OI after Tax (40%) CSX Total Loss in OI CSX Total gain in OI from merger Total Gain in OI (discounted @ rE) Value of estimated gains in OI Terminal Value of estimated gains in OI PV of TV Total value of gains in OI for CSX Value of Merger for CSX $ $ $ $ $ $ $ $ $ 180. 87 Assumptions for Norfolk Southern–Conrail Merger: We assume the same G =3%, MRP = 7%. We take risk free as 30-year maturity US Bonds rate, which is 6. 83% (Exhibit 8); merged Norfolk Southern–Conrail equity beta as average of Norfolk Southern and Conrail equity betas, which is 1. 23. rE = rf + MRP ? E = 6. 83% + 7% x 1. 23 = 15. 41% Now we can find Norfolk Southern–Conrail synergy value as present value of gains in operating income. 1998 $ 231 $ 139 $ (130) $ 269 $ 233 1999 $ 429 $ 257 $ (232) $ 489 $ 367 $1,468. 67 $6,044. 6 $5,531. 72 $7,000. 39 $13,510. 96 2000 $ 660 $ 396 $ (308) $ 704 $ 458 2001 $ 680 $ 408 $ (320) $ 728 $ 410 Total Gain in Operating Income Total Gain in OI after Tax (40%) Norfolk Southern Total Loss in OI Norfolk Southern Total gain in OI from merger Total Gain in OI (discounted @ rE) Value of estimated gains in OI Terminal Value of estimated gains in OI PV of TV Total value of gains in OI for CSX = Value of Merger for CSX 5 From the calculation above we see that value of Conrail acquisition is much, over 1 billion higher for Norfolk Southern than for CSX.Moreover, the loss in acquiring Conrail leads to significant loss in revenues and market share for both of bidders but more for Norfolk Southern. Not surprisingly that they have seri ous intention to wage a bidding war. 8) As a shareholder, would you vote to opt-out of the Pennsylvania anti-takeover statute? In the case of conrail as a shareholder, we would not vote to opt-out of the Pennsylvania antitakeover statute. The PA statute provides Conrail shareholders with a fair value statute provision on their stock ownership.Specifically, bidders holding 20 percent or more of a company’s stock are required to offer all shareholders the same price unless the target shareholders opt-out of the statute. The CSX two-staged offer had a blended value which clearly demonstrates that Conrail shareholders would have been given different pricing for each stage in the offer. The poison pill provision under the CSX and Conrail merger agreement does not give Conrail shareholders the rights to buy discounted shares since the merger agreement required Conrail to suspend its poison pill.Therefore, the poison pill favors the acquirer and not the Conrail shareholders. Finally , as a shareholder, the best strategic position is to allow the bidding war to commence and observe how CSX and Norfolk Southern compete against one another for the Conrail business. It is obvious that there will be an acquisition and it is obvious based on both acquisition proposals, that each company will issue multiple offers in an effort to acquire Conrail due to its strategic location in the Northeast United States. In general, however this statute could be disadvantageous to shareholders in certain cases.The statute tries to protect the interests of employees and community where the target company was located in addition to meeting their fiduciary duty to the shareholders. The statute frees companies from any obligation to sell itself to the highest bidder. Conrail used the statute to blunt Norfolk’s offer though it was better for shareholders. The ‘fair value statute’ aspect helped the shareholders of Conrail (as parties in support of merger still needed 1 4. 6% of acquisition shares to vote in favor of opting out. ) 6

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