Conrail Case Study Essay Example

Conrail Case Study Essay The Railroad revolution in the united States began in the early 1 sass. The developed infrastructure was used for freight transportation business. In the mid-sass the industry experienced explosive growth, followed by significant consolidation in 1870. The rail road companies initiated expansion through acquisitions in attempt to reduce marginal costs and increase their market share. As a result of this competition, a number of cartels were formed; therefore the federal government intervened and established regulation on railroad mergers, infrastructure construction and divestment. On the other hand, the government initiated enormous investments in highway infrastructure, which resulted in the emerging of the trucking industry. Together with innovations in motor and tire technologies, the trucking industry began gaining significant market share of the freight transportation business from the rail road companies. As a result, the six largest railroads in the Northeast filed for bankruptcy. In response to the failures, the Congress passed the Staggers Rail Act of 1980 in order to deregulate the railroad industry, which resumed the mergers and acquisitions activity. The following analysis will investigate the economics of the offer for Consolidated Rail Corporation (Conrail) by CSS Corporation (CSS) and Norfolk Southern Corporation (Norfolk). The stand-alone bidders, CSS and Norfolk would value the target, Conrail, based on its fundamentals, however if both bidders are present they would enter price wars and legal battles, therefore this would inflate the offered price for the target. In particular the acquirers have to take into account of the opportunity cost of losing the bidding war (I. E. Going significant proportion of their revenue going forward) as calculated in Question 3. According to our analysis, the value of opportunity cost of losing the bid war can be as high as 13% of total offer price (calculated in SQ). In this case, although the synergy impact between Norfolk and Conrail is lower compared to that with CSS, the value of opportunity cost of Norfolk losing the bid is significantly higher, which brings Norfolk potential offer pric e higher than that of CSS (1 16. 84 vs.. 114. 36) -? calculated in SQ. We will write a custom essay sample on Conrail Case Study specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Conrail Case Study specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Conrail Case Study specifically for you FOR ONLY $16.38 $13.9/page Hire Writer If they were stand- alone bidders, Coxs potential offer price is significantly lower (105. 44), and Norfolk offer price is c. 102. However, since CSS, Conrail and Norfolk are in tauter market with high concentration of market power, believe the bidding war is naturally the product of this market structure. The following analysis would provide further details of the synergies of the potential deals. In 1 973, following the Regional Reorganization Act, the government established Conrail (the target), out of the remains of the six bankrupt, Northeastern railroads. The company became the 2nd largest in the region and it was privatized in 1987, via PIP (the largest in LOS history at the time). On 15 October, 1996 the CEO of CSS announced $8. Ban merger with Conrail. Due to he friendly nature of the offer, both management boards claimed significant synergies, including operations improvement, cost efficiencies and compatible cultures. This horizontal merger would create value by consolidating overlapping operations. CSS, the largest company in the East (freight transportation market share 38. %) operated 1 8,645 track miles and 29,537 employees. Conrail possessed 29. 4% of the Eastern freight transportation market with 1 0, 701 track miles and 23,51 0 employees. The network expansion would link Midwestern, Northeastern CSS cities with Canadian cities; therefore the CSS-Conrail company would also capitalize on North American Free Trade Agreement NONFAT(1 994). The merger CSS-Conrail would result in significant operating synergies, in particular in completeness of the distribution network. Although Coxs had important presence in the railroad business, the company also provided diversified transportation services, including ocean container shipping, barging and contract logistics services. The combination of intermediate services (transportation of truck trailers and container by rail-car) and network expansion would result in higher operation efficiency to compete with the trucking industry. In addition, he maritime and the railroad presence of the merged company would result in economies of scope. The universal container would promote better branding and it would open the business to international trade. The industry consolidation and the merger of CSS and Conrail would create the 2nd largest company in US and the largest in the Eastern region; therefore the company would increase its market power in the freight transportation business, gaining revenues from its competitors Norfolk and the trucking industry companies. The financial synergies of the deal would lead to improved economies of scale in financing. The size of the merged firm would increase the debt capacity and tax debt shield, therefore dilute financing costs. Although the management of both CSS and Conrail were convinced in the success Of this merger, individually the companies were the least efficient (higher operating ratio) among the three leading railroad companies in the East. This potential weakness could result in a concern about the management synergies of the deal. Following the merger announcement of $8. Ban of CSS-Conrail in 1996, the third largest railroad company in the Eastern region, Norfolk proposed a hostile offer of $9. Bin for Conrail. The concerns of a potential merger between CSS and Conrail would have significant implications for the transportation system and for the shipping public, which would pose a serious threat to Norfolk market share. Although the operating synergies for Norfolk-Conrail would be of a similar nature, I. E. Horizontal merger resulting in higher market share, expanded rail network, increased revenues and cost reduction, the bidder could offer stronger management synergies. Norfolk was recognized by the industry specialist as the most efficient (lowest operating ratio) and best managed railroad in the united States. In addition, Norfolk would have used cash as a payment method, which suggests that the company would borrow money, therefore benefit from higher Tax Shield. The case states that the bidder was backed by a consortium of banks, ready to fund the acquisition. This suggests that Norfolk has good access to the capital markets. Given the presence of the two competitors, CSS and Norfolk, the merger with Conrail resulted in bidding wars and legal battles. To close a good deal, the created value from the merger should exceed the costs, premium paid and transfer to other parties (source Lecture Notes FEMME): AAA + AP + C The bidding war would inflate the share price of the target, therefore would increase significantly the premium paid AP. From 14 October 1996 to 16 January 1997, the blended value of the CSS offer per share increased by 15% from $89. 07 to SSL 02. 16. On the other hand, Norfolk bid also increased by to $115. 00 per share in cash. In addition, the legal battles against the CSS-Conrail mergers increased the cost associated with organizing the deal C. The length of the price wars also resulted in decreased stock prices of the bidders and an increase of the targets stock price. Question 2 Deals Not Chosen: Santa Fee pacific (Jinn pacific) and Kansas City Southern are not taken because these offers did not go through. Therefore, the accepted value of the target companies was not determined, hence very biased: Potential synergies were probably rather biased since these bids were not accepted by the target Fundamental value of the target was probably undervalued since these bids were rejected Control premium was probably not correctly captured in the bid price Deals Chosen: Santa Fee Pacific (Burlington Northern), Chicago and North Westerner, Southern Pacific are chosen because: They are completed deals Both the targets and acquirers are from same industry of Conrail, and I would assume that they have the same risk exposure to the economy and industry The deal dates are within recent past Company sizes are closer to the target company in term of total asset value However, please note that the % operating synergy of chosen deals are significantly higher than that of either CSS or Norfolk Southern s deals, the derived equity price for Contrails deal is likely to be significantly lower due to lower synergy effects. Since we do not have any deals with similar synergy effects as Conrail, would chose these three deals to value Conrail. Multiples Not Chosen: Offer price per PEPS and Book Value as a Multiple of offer price are not used because of the following reasons: Both PEPS and book value are highly affected by accounting decision and standards (GAPS vs.. FIRS) adopted by companies, which make the multiples on these very hard to be compared across companies Both PEPS and book value can sometimes be negative if negative earnings are sustained over long period of time PEPS is affected by capital structure, which IS vastly different across firms. This characteristic makes the offer price multiple on this item not very useful to identify value of there firms Both PEPS and book value can be manipulated by the company management Book Value does not reflect the intangible side of the business such as employee skills, brand name etc. Book Value reflects the assets on historical basis, making it very hard to compare across companies with different asset ages due to high inflation and many major technological advances over time PEPS is not stable since it is affected by the business cycle, and/or one-off events (asset sale, debt write-offs etc.. The offer price and book value are not consistent with each other since the price is net cost of bet, however, book value includes debt Enterprise value/Sale multiple is not used because of the following reasons: Sale is quite distant from the bottom line of the business since it does not capture cost structure of the business, compared to EBITDA or Free Cash How Sale does follow business cy cle, which make it hard to compare across business Multiples Chosen: Enterprise Value/Belted multiple is chosen because: Consistent between numerator and denominator since both of them are pre- debt measures. EBITDA is earnings before interest, tax, depreciation and amortization, whereas Enterprise value includes both debt and equity This ultimate is not affected by differences in capital structure across firms EBITDA is the least affected items in the financial statement by the accounting standards EBITDA is closest item to Free Cash Flow, which can be used to indicate quality of earnings EBITDA is usually positive as well, especially in the railway case where depreciation tends to be high due to asset intensive Since the question does not state the timing of the takeover, I would assume that the takeover time is SQ 1996 As offs 1996, the long term debt is $2094 million (Exhibit 6), and the cash amount is $33 million. Therefore net debt mount as of SQ 1996 32061 million The EBITDA (last SQ) is 1017 (Exhibit 6) The number of fully diluted shares outstanding is 90,500,000 at acquisition Below is the summary of the valuation by multiples: The multiple valuation method gives a range of Contrails value between $73 and S 124, with the average value of $104 per share Question 3 Part a) Valuation of Conrail Growth Rate: In response to the failures, Congress passed the Staffers Rail Act of 1 980, a deregulatory act that gave railroads the ability to set prices in competitive markets, abandon profitable lines and pursue merger and acquisition. This has had major impacts on the market between 1980 and 1995, where companies significantly restructured their businesses with better dispatching system, cutting cost program, and abandoning unprofitable lines. Since the Act came into force in 1980, I would assume that the impact Of the program was not as extensive in 1 sass, and the Contrails growth was a sustainable one rather than event-driven growth post 1995. In addition, since the market is already rather mature, I would assume that inflation is to be used for projecting future sustainable growth of Conrail, which is 3% Appendix 6) Risk Free Rate: since the cash flow of Conrail is ongoing concern with indefinite cash flow horizon, hence the duration of cash flow will be rather high. Using Asset Liability duration matching, I would assume that 30 year bond is the one that have the most similar duration profile as Contrails cash flow. Therefore the risk free rate I would use to value Conrail in this case is 6. 3% Timing: since the timing is not indicated in question I would assume that the timing of the valuation exercise as of SQ 1 996 and no takeover activities or announcements have happened Marginal Tax Rate: 35% is assumed (Exhibit b) Market Return: 14. 1 % is the average annual return for S index (Source: Bloomberg) Cost of equity: I would assume that the current leverage ratio will remain the same going forward The current Conrail beta will remain the same as 1. 30. Assuming the market is the efficient and satisfying all the CAMP assumptions, I use CAMP to derive the cost of equity. Re=6. 83% + 1. 30 (14. 1% 6. 83%) = 16. 28% Equity Market Capitalization: is the price pre-bid (as Of 14/10/1996) (assuming the remaining the same due to no activity) multiplied by the number of shares in the market (77,628,000) (Exhibit 2). Equity market capitalization is $5,51 1 Leverage Ratio as of SQ 201 6: assuming the leverage ratio is constant going forward and the leverage ratio is net debt / (Equity market capitalization) = 206115511. 588 = 37. 3% Debt beta: since the debt leverage ratio is rather low, I would assume that debt beta equals O UN- levering Contrails Beta: Unlearned beta levered beta / (1+ ratio) 1. 3 / (1 + 0. 65 * 0. 373) = 1. 046 Identifying interest rate of the debt: assume that the debt rating can be identified using the interest coverage ratio. Below is the table from ONLY Stern (http://pages. Stern. You. Due/-?dammar/New_Home_page/ dateable/ratings. HTML) Assuming that rating of the debt is determined using the last year (1996) for rating going forward. The credit rating of Conrail Bond is A, hence its interest rate is 7. 71 % Assumption about the credit rating of Contrails Debt: the future merger between Conrail and either of CSS and Norfolk Southern likely to improve the Coverage Ratio, hence likely to improve the credit rating of the debt. However, since the success of the merger really depends on Surface Transportation Board decision of competitive access to certain key markets. Hence, from the perspective of the bank, it is highly risky and the bank is not likely to upgrade the debt rating. Also, since after the merger, both acquirer and acquirer become one company, the bank is likely to kick at both to decide the debt rating. Since this involves lots of assumptions, would assume that no financial synergy is achieved by the merger with either acquirer. Standalone Equity Value of Conrail: assuming that the market is efficient, and the market price of Conrail fully reflects the fundamental of business. Equity Value of Conrail in this case is then $71 , which is on 14th October 1 996 the day prior to CSS-Conrail announcement. A CSS Merger Growth Rate: assuming the synergy cash flow grows at the inflation rate of 3% beyond year 2000 (as explained above) Discount Rate for the merger CSS: I would assume that there is no debt attached to the synergy. Also, since I do not have the information CSS share volume, the unlearned beta of CSS cannot be calculated. Therefore, I would assume the unlearned beta is the same for both CSS and Conrail. Hence, I would use the Contrails cost of unlearned equity to value the merger as below: = 6. 83% + 1. 046 * (14. 10% 6. 83%) = 14. 43% Valuation Without opportunity cost of losing the bid Terminal Value as of 1 996 = [488. 80 * 1. 03 / (0. 1443 factor of year 5 = $2,245 million Opportunity cost of losing the bid Terminal value as of 1 996 [127. 4 * 1. 03 / (0. 1458 factor of year 5 = -585. 14 million Value of equity value/share of Conrail from the point of view of CSS: Pre-merger: $71 synergy: (871. 02 + 2245) / 90. 5 = $34. 4 Opportunity Cost: (222. 7 + 585. 14)/90. 5 = $8. 92 Total Offer Price: SSL 14. 6 B Norfolk Southern Merger not have the information Norfolk Southern share volume, the unlearned beta of Norfolk Southern cannot be calculated. Therefore, I would assume the unlearned beta is the same for both Norfolk Southern and Conrail. Hence, would use the Contrails cost of unlearned equity to value the merger as below: = 6. 83% 1. 046 * (14. 10% 6. 83%) = 14. 43% Terminal Value as of 1 996 = [442 * 1. 03 / (0. 1443 0. 03)]*Discount factor of year 5 52030 Opportunity cost Of losing the bid Terminal Value as of 1 996 = [-208 * 1. 03 / (0. 1443 0. 03)]*Discount factor of year 5 = -$955. 33 Value of equity value/share of Conrail from the point of view of CSS: Pre-merger: $71 Synergy: (776. 6+2030) / 90. 5 $31 opportunity cost: (387. 95 + 955. 33)/90. = $14. 84 Total Offer Price: SSL 16. 84 Please note: the equity values of Conrail calculated above are absolute maximum value that both CSS and Norfolk Southern will pay for Conrail since the gain in revenue from competitor is highly risky, subject to the decision of SST B. Technically, the discount rate should be higher and probability should be applied on this portion of incremental synergy. Part b) Contrails Market Capitalization as a standalone value Pros Since Conrail is rather large company, I would assume that it is w ell covered by analysts and practitioners in the financial market. Hence, it can be safely assumed the market is efficient and the price of Conrail is fundamentally reflected in its price Easy and quick way to determine the value of Conrail Cons The market is highly fluctuated dependent on Stage Of the market Ignore the control premium since the stock price does not assume the control power of the stock owner There might be information available to the acquirers but the market is not aware of. Therefore the market price does not reflect the information Question 4 The stand-alone bidders, CSS and Norfolk would value the target, Conrail, based on its fundamentals, however if both bidders are present they would enter price wars and legal battles, therefore this would inflate the offered price for the target. In particular the acquirers have to take into account of the opportunity cost of losing the bidding war (I. E. Losing significant proportion of their revenue going forward). According to our analysis, the value Of opportunity cost of losing the bid war can be as high as 13% of total offer price (calculated in SQ). In this case, although the synergy impact between Norfolk and Conrail is lower compared to that with CSS, the value of opportunity cost of Norfolk losing the bid is significantly higher, which brings Norfolk potential offer price higher than that of CSS (116. 84 vs.. 114. 36) calculated in SQ. If they were stand-alone bidders, Coxs potential offer price is significantly lower (105. 44), and Norfolk offer price is c. 02. However, since CSS, Conrail and Norfolk are in mature market with high concentration of market power, I believe the bidding war is naturally the product of this market structure. Question 5 CSS Friendly Offer: Two-tiered transaction of the purchase 90. 5 Mil lion Conrail Shares (acquisition shares) Inc. Apron. 1. 3 million common shares owned by management and directors. 1 CSS to pay USED 92. 5 per share on cash for 0% of Contrails acquisition shares (Front-end offer) to be completed in 2 stages (regulatory reasons) a Stage 1: CSS to acquire 19. 7% of the shares (17. 86 million shares at USED 92. 5 per share) b stage 2: CSS to acquire 20. % of the shares (after shareholders approved the deal) The reason why the front-end offer was split as such is given Pennsylvania Business Corporation Law in which Conrail Shareholders would be required to opt-out of the Pennsylvania Statue before CSS could purchase more than 19. 9% of the shares. For the opt-out vote, CSS had 17. 86 million shares from the first-stage tender offer, management had 1. Million shares and employees trust had 13 million shares. Since management was in favor of the merger, parties in support had 35. 5% of the acquisitions shares and would require another 14. 6% to vote in f avor of theopt-out for it to pass. Following shareholders approval it would be possible to complete the second cash tender offer. 2 Following cash tender offers, CSS would exchange shares in ratio of 1. 8561 9:1. (CSS:Conrail) for the remaining 60% of Contrails Shares (back-end- offer). The back end offer is calculated by multiplying the ratio with the Coxs closing price on the bid announcement day. A Based on closing price on the id announcement day, blended value of CSS was USED 86. 77 per share (23. 5% premium over Contrails pre-announcement stock price of USED 71. 00) b 06/11/1996 CSS increased front-end offer. In 19/1 2/1996 CSS increased back- end offer. 16/01/1 997 was the eve of shareholder vote The blended value in Exhibit 8 is calculated by weighted average affront-end and back-end offers: The blended value was adjusted in 19/12/1 996 and 16/01/1 997 to reflect the completion of Coxs first stage tender offer. Blended value idea is to have a single value of the combination of both the front-end and back-end offers given they were done with different set of eights (40% and 60% respectively). Its major limitation is that it calculates both Front-end and Back-end offers on the same day ignoring the time element. The time element is essential for a correct valuation given there are a set of events that need to happen in between the first cash tender offer from the front-end offer until the back-end offer and hence both would happen on a different set of dates. The back-end offer is sensitivity to the time because it is reliant on prices given its proposition to exchange of shares based on a ratio. Question 6 CSS intended to take control of Conrail through a combination of financial orientations, deals with management and limiting Contrails susceptibility to other acquisitions. By definition, the most important aspect of the aqua session was through the ownership of Conrail stock. However, in order to make the acquisition easier for CSS, CSS wanted to control access to Conrail. CSS tried to do this by placing barriers to prevent Conrail from back-tracking from the deal, such as: A breakup fee of $mm in the event Conrail chose not to proceed with the takeover. The breakup fee is a crude and obvious deterrent for Conrail, as well as for any new potential bidder. It would no longer make sense for Conrail to pull out of the agreement unless it discovered it would be more than $mm worse off if the deal went ahead -? which was highly unlikely. The deterrent for any new bidder is that they would now have to beat Coxs offer by $mm in order to become more attractive for Contrails management to choose their new bid. Offer of 15. Mm newly issued lock-up shares to CSS at the same price as the initial Front-End tender. This reduces many of the fees and complications associated with purchases on the stock exchange. It also means that this 20% of stock would not be subject to shareholder whims and s a certainty to CSS regarding how it will obtain 20% of the required shares. It made sense to exercise the option only if shareholders voted to opt-out of the fair value statute (described below), because if shareholders did not opt out of the fair value statute, common stock to the value of 20% of Conrail would have been needlessly created. If CSS purchased shares that were already outstanding, they could simply resell them on the open market, and Conrail would not have created these additional shares. Conrail suspends Poison Pill option to offer new shares at 50% discount in order to protect itself against an unsolicited takeover. This mitigates one of Contrails biggest threats against Coxs ownership. Should there be a change in management that is no longer willing to proceed with the takeover, the poison pill option will no longer be available to deploy. A no-talk clause, which prevents Conrail from entertaining other bids. This clause is valid unless it interferes with the boards fiduciary duty to shareholders (and if it seems unlikely that CSS would be able to complete the deal). Conrail board members, to an extent, had license to define Fiduciary Duty as they pleased, and since the board had already agreed to the CSS bid, Norfolk would have to replace board members in favor of the deal. This would be difficult, since Conrail had a classified board, which meant only a third were up for election each year so it could take years before the decision to go with CSS was overturned by which time the CSS deal would have been consummated. Further complications to the deal were Pennsylvania Business Laws. Coxs bid to take control of Conrail included a Front End offer to purchase at $11 0 per share with cash, 40% of the shares it needed to take control. The Back End offer was to exchange the remaining 60% of the shares it needed, or shares in the new company at the rate of 1. 85619:1. 0 plus a further $16 of new convertible preferred stock. This created a blended value to the Back End of $105. 07 per share. The difference in prices (SSL 10 vs. $105. 07) meant that the bid was subject to a Pennsylvania fair value statute, which stated that an acquirer must tender all shares at the same price. An acquirer cannot tender at different prices, unless shareholders explicitly vote to opt out of the fair value statute. CSS now had to persuade Conrail customers to vote to opt out of this statute. It attempted to do this by running adverts in financial newspapers hampering its proposed takeover.