By Antoine Gara / www.forbes.com / November 18th, 2015
There’s a good chance Norfolk Southern NSC +6.52% may wind up becoming the Burger King of railroads. And to make the analogy sound less crazy, the Norfolk, Va.-based company’s suitor, Canadian Pacific, would be the Tim Hortons of tracks, terminals and railyards.
How so? A prospective of Norfolk Southern by Calgary-based Canadian Pacific could generate the kinds of tax savings for the combined company that the merger of Burger King and Ontario-based Tim Hortons yielded when it closed in late 2014. On Tuesday evening Canadian Pacific telegraphed a bid for Norfolk Southern and this morning it laid out the full offer.
Canadian Pacific is offering a little over $97 for Norfolk Southern in a bid that consists of $46.72 in cash and 0.348 shares in the combined company, which would be listed on the New York and Toronto Stock Exchanges, similar to Restaurant Brands International , the parent of Burger King and Tim Hortons.
Norfolk Southern operates rail lines almost exclusively in the southeast, northeast, Appalachia and the rust belt of the United States, including rail yards in Chicago, Cleveland, Detroitm Newark, St. Louis, Newark, among others. Canadian Pacific, by contrast, in one the biggest railroad operators in Canada, with track that connects the country’s port city Vancouver with western oil economies in Calgary and Edmondton and eastern cities such as Toronto and Montreal. The company does have track in the U.S., which access major cities in the Midwest, in addition to New York City.
Canadian Pacific said a combination would allow for increased competition in rates and change status quo in U.S. rail transport by way of its transcontinental reach. It also is offering a new way of looking at terminal access where operators would have to provide competitive rates its tracks or else risk losing connections to a superior operator. The combined company would also give shippers the choice of where they can connect with another railroad along its network, ending a practice of “bottleneck pricing,” thus enhancing competition.
Canadian Pacific also said its strategy would help alleviate congestion issues in Chicago by channeling cargo to other cities. Wednesday morning, it quantified just what this strategy might entail for investors, projecting a whopping $1.8 billion in annual operating synergies, in addition to up to 45% pro-forma earnings per share accretion when including those run rate synergies.
Given the cash and stock nature of the bid, Canadian Pacific expects to have pro-forma debt of four times EBITDA, with the ability to delever to 2.5x within two years. But there is one aspect that Canadian Pacific didn’t quantify, which could play a major piece of the deal.
By acquiring a U.S.-based railroad and tucking it into a Canadian operator, Canadian Pacific could realize billions of dollars in tax savings. In 2014, Canadian Pacific paid an effective tax rate of 27.5% on its $1.4 billion in profit, while Norfolk Southern paid an effective tax rate of 36% on its $3.1 billion in profit.
The merged company could adopt Canadian Pacific’s tax rate, potentially saving upwards of $1 billion a year if synergy targets are met. About potential tax savings, Canadian Pacific says a merger would yield “substantial tax savings in addition to operating synergies.”
Robert Willens, an independent tax expert, says that anytime a U.S. company becomes a subsidiary of a foreign corporation there is the ability to shift income ordinarily taxed at U.S. rates to a lower foreign rate. Through intercompany debt, earnings normally taxed in the U.S. can be shipped to Canada’s lower rate. “Such income shifting reduces the newly created group’s effective tax rate below the “expected” tax rate resulting from simply combining the two corporation’s current tax rate,” says Willens by email.
Perhaps, at a time when lawmaker in Washington are focusing on corporate income tax rates, some will find objection to Canadian Pacific’s deal.
Rail industries in Canada and the United States are also both highly regulated and face substantial antitrust issues given how the industry has consolidated over the past 20-years. Some analysts believe a deal could take upwards of two years to approve, and on Wednesday morning Norfolk Southern rejected the offer citing regulatory risks.
Burger King and Tim Hortons found itself the subject of a Senate subcommittee hearing this year into tax-focused M&A activity. The company, controlled by Brazilian PE giant 3G Capital, counts Warren Buffett and Bill Ackman as major investors. And the merger, structured as an inversion, moved Burger King’s headquarters to Canada, generating some flack for Buffett. Canadian Pacific’s deal is simply a straight takeover, with no inversion calculus, thus making it hard to block a deal on tax grounds. But the tax saving are similar.
One final point.
Could Canadian Pacific’s bid for Nortfolk Southern prod a recent spat between Ackman and Berkshire Hathaway, which culminated last week with the hedge fund activist’s criticism of Buffett’s holding of Coca-Cola at a 50th anniversary celebration of his conglomerate. It appears the orbits of both investors are, again, tethered together.
Canadian Pacific, under CEO Hunter Harrison, appears emboldened to try and disrupt the North American rail industry. Rail is one of Buffett’s biggest investments after Berkshire’s acquisition of Burlington Northern in 2010, and Wednesday’s merger bid comes with classic signs of Ackman’s involvement.
He’s a board member of Canadian Pacific after winning a proxy battle and hiring Harrison as CEO, one of his best-ever investments, even after a turn in the company’s shares in recent months. The company’s takeover proposal for Norfolk Southern tries to peg a future value on the combined company’s shares, putting out a fair value of $270.68 a share. That makes the future value of shares received in the merger bid worth $94.16. This is undoubtedly Ackman’s kind of math.
It underscores the ambition of Canadian Pacific as it seeks to capitalize on a souring of the rail market as investors question whether oil, coal and metals shipments are poised to drop amid collapsing commodities markets.
Canadian Pacific shares were gaining over 5% in early trading, while Norfolk Southern shares were gaining by over 7%.
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