Canadian Pacific's Bid for Norfolk Southern Formed in 1982 out of railroads that had been in existence for 100 years, Norfolk Southern Corporation (NS) had a proud history as one of the largest and most efficient railroads in the United States Despite this legacy, both revenues and profits began falling in 2015 as shipments of coal (20 of revenues) and other commodities declined and cost reduction efforts stalled As a result, the company's stock price had fallen by almost 40 from a high of $117 in late 2014 to a low of $72 in August 2015 Rumors that Canadian Pacific Railway Limited (CP) wanted to acquire Norfolk Southern began circulating in the market in early November 2015 Canadian Pacific did, in fact, make an offer to acquire NS on November 17, which the company acknowledged in a press release later that day (note all amounts in this case refer to U S dollars) Norfolk Southern Corporation ( the Company ) today confirmed that it has received an unsolicited, low premium, non binding, highly conditional indication of interest from Canadian Pacific to acquire the Company for $46 72 in cash and a fixed exchange ratio of 0 348 Canadian Pacific shares per Norfolk Southern share, representing a premium of less than 10 based on closing prices today Notably, any consolidation among Class I railroads in North America would face significant regulatory hurdles Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating After a comprehensive review the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders We believe that Canadian Pacific's short term, cut to the bone strategy could cause Norfolk Southern to lose substantial revenues from our Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating After a comprehensive review the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders We believe that Canadian Pacific's short term, cut to the bone strategy could cause Norfolk Southern to lose substantial revenues from our service sensitive customer base We also believe the proposed transaction risks harm to vital transportation infrastructure and the communities we serve In addition to rejecting CP's offer, James Squires, Norfolk Southern's CEO, announced a new strategic plan designed to improve the company's long term performance by reducing its operating ratio (defined as operating expenses divided by operating revenues it was an industry measure of cost efficiency) Squires argued that Norfolk Southern could, on a stand alone basis, reduce its operating ratio from over 70 to below 65 by 2020 through aggressive cost reduction and, in doing so, generate double digit earnings per share (EPS) growth 4 Within days of the rejection, Canadian Pacific announced a revised offer and proposed a novel deal structure that would allow operational improvements at Norfolk Southern to be implemented even before the merger received regulatory approval To further sweeten the deal, CP added a new security known as a Contingent Value Right (CVR) several days later This security, which CP described as a long term insurance policy, 5 was designed to protect investors if the share price of the combined entity fell below a certain level for any reason before the regulators approved the merger By including the CVR in the deal, CP was demonstrating confidence in its ability to achieve the projected merger benefits Before Squires and the NS board could respond to CP's sweetened offer, however, they had to review the offer with their financial and legal advisors, understand how the merger would affect the firm's operations and impact its shareholders, and prepare a response justifying their decision That response would not only determine the firm's prospects for many years to come, but could affect Squires's professional reputation and career prospects, as well The U S Railroad Industry The U S railroad industry had a long history of regulation starting with the establishment of the Interstate Commerce Commission (ICC) in 1887 6 ICC mandates and other federal regulation limited what railroads could charge on interstate routes, where they could construct new infrastructure, and whether they could divest rail lines After growing for years, total rail mileage peaked in 1916 as the federal government began subsidizing highway construction As trucking became an increasingly important form of competition, the share of intercity freight carried by trains fell steadily through the 1950s and 1960s The 1970s was an especially difficult decade for railroads as inflation caused costs to rise (e g , fuel, labor, and equipment), yet regulations prevented railroads from raising rates commensurately The end result was falling returns the average return on investment (ROI) during the 1970s was 2 and bankruptcies Penn Central, a Class I railroad, declared bankruptcy in 1970, the largest U S corporate bankruptcy at that time 10 The Staggers Rail Act of 1980 provided much needed relief to U S railroads, giving them the flexibility to set their own rates, abandon low density routes, and make acquisitions with limited scrutiny 1 In the following years, a flurry of mergers intended to improve service, efficiency, and safety reduced the number of Class I railroads from 56 to 7 12 In this new consolidated environment, railroads regained financial stability as they streamlined operations and cut costs For example, employment at Class I railroads fell from 458,000 people in 1980 to 178,000 people in 1998 and the industry's average operating ratio fell from 93 to 85 13 With higher profitability, the average ROI grew to 7 in the 1990s and then to 9 4 by mid 2015 4 (Exhibit 1 provides operating and financial statistics for the major railroads operating in the U S and Canada as of 2015 ) 15 Two important changes occurred in the 1990s First, the Surface Transportation Board (STB) replaced the ICC as the primary regulator in 1996, and gained the ability to regulate all mergers and acquisitions 5 Second, the rapid consolidation of Class I railroads continued Burlington Northern acquired Santa Fe Pacific in 1995 after an intense bidding war with Union Pacific 6 Union Pacific then acquired Southern Pacific in 1995 17 CSX acquired Conrail in 1996 and agreed to split the railroad with Norfolk Southern as a solution to an escalating bidding war 18 and finally, Canadian National acquired Illinois Central in 1998 19 (Exhibit 2 shows data on railroad acquisitions from 1995 2014 ) Rather than enhancing service and improving efficiency as promised, these mergers often disrupted service, increased costs (and prices), and reduced safety, at least in the short term, which prompted heightened regulatory scrutiny 20 For example, after BNSF and Canadian National agreed to merge in December 1999, the STB blocked the merger and froze all major rail mergers for 16 months, beginning in March 2000 21 According to the STB, the shipping public has not yet fully recovered from the service interruptions associated with the previous round of mergers from 1995 to 1998 22 The next year, the STB established rules forbidding all railroad mergers unless they were in the public interest, as it tried to create a stable, balanced, and reliable rail transportation system 23 Under the new rules, companies had to demonstrate that merging with another railroad would boost competition and maintain service quality 24 An STB spokesman said, Although our new rules and policy statement do not, as the Class I railroads argue, reflect an anti merger bias, we do plan to take a more skeptical 'show me' attitude toward claims of merger benefits and toward claims that no transitional problems would occur 25 At the time, the prevailing view was that another round of consolidation could leave the continent with just two Class I railroads 26 Norfolk Southern Corporation Norfolk Southern Corporation (NS or NSC) was formed in 1982 by the merger of two railways Norfolk Western and Southern Railway 27 As the fourth largest Class I railroad operating in North America, NS had 30,456 employees, controlled 20,000 miles of track in 22 eastern states, and served all of the major East Coast ports 28 The company generated $2 0 billion of income on operating revenues of $11 6 billion in 2014 29 (Exhibits 3 and 4 show NS's income statements and balance sheets, respectively ) By early 2015, revenues and profits were falling and the firm's relative cost position was deteriorating After being in the middle of the pack of Class I railroads in terms of its operating ratio, NS was at the high end of the group as of 2015 30 (Exhibit 5 shows operating ratios over time for Class I railroads) Analysts, however, expected the firm's performance would improve in the coming years (Exhibit 6 shows financial projections for NS on a stand alone basis according to equity analysts at UBS in October 2015 ) Squires became CEO of NS on June 1, 2015, at the age of 53 31 When former CEO Charles Wick Moorman announced his successor, he said, I am confident that the company is poised for continued growth, success, and shareholder value creation 32 Squires had joined the company in 1992, as a newly minted graduate of the University of Chicago Law School He rose through the ranks of the legal division before being named senior vice president of financial planning in 2006, CFO in 2007, and then president in 2013 33 Canadian Pacific Railway Limited Canadian Pacific Railway Ltd was founded in the late 19th century to connect the major cities in eastern Canada with the less populous western territories By 1986, CP had become Canada's second largest company 34 Headquartered in Calgary, Alberta, CP had 13,700 employees and operated 12,500 miles of track in Canada as well as the midwestern and northeastern parts of the United States 35 CP's main competitors were Canadian National Railway Company (Canadian National) in Canada and BNSF Railway in the U S Midwest 36 With revenues of $5 7 billion and net income of $1 3 billion in 2014, CP was considerably smaller than NS 37 (Exhibits 7 and 8 show CP's income statements and balance sheets, respectively ) 1pc In 2011, hedge fund manager and activist investor William Bill Ackman (HBS 1992) acquired a 12 stake in CP through his firm Pershing Square Capital Management 38 Ackman was known in the financial world for his overwhelming confidence and his willingness to place enormous bets based on his convictions 39 For example, he told one author I don't care what other people think I invest based on what I believe the opportunity for profit is compared with my estimate of the potential for loss 40 Ackman subsequently forced CP's CEO to resign, ousted the company's board of directors, and installed Hunter Harrison as chief executive after a proxy fight 41 Harrison, a long term railroad executive, had retired as the CEO of Canadian National (CN) in 2009 42 During his time at CN, Harrison had won various awards, including Canadian CEO of the Year43 and Railroader of the Year 44 Harrison believed consolidation was a good way to add critical rail capacity and simultaneously improve efficiency Toward that end, he had unsuccessfully approached CSX Corp , another Class I railroad located in the eastern United States, in 2014 about a possible merger, arguing, A pro competition, customer friendly, safety focused railway combination is one such solution that could not be ignored on its merits by regulators 45 Yet NS's then CEO Moorman said in 2014 that major railroad mergers would be highly problematic from both a regulatory and a service perspective 46 Absent mergers, careful cost control could also improve efficiency In fact, under Harrison's leadership, CP's operating ratio had fallen from 81 in 2011 to close to 60 in 2015 47 In response, the firm's share price during his tenure had soared from less than $68 at the end of 2011 to almost $215 in October 2014, yet had fallen back down to $135 as of early November 2015 48 (CP was traded on both the Toronto and New York stock exchanges ) Bidding for Norfolk Southern Despite market rumors of a possible bid for NS by CP, CP denied the rumors in a press release on November 9, claiming T here is no material news pending at this time CP does not comment on market rumor and speculation 4 Nevertheless, NS's stock price increased 11 0 (from $79 87 to $88 62) and CP's price increased 5 9 (from $134 31 to $142 18) on a day the market was down 1 0 Eight days later, after the market closed on November 17, 2015, CP did, in fact, make an offer for NS Canadian Pacific (CP) has sent an offer letter to Norfolk Southern Corp (NS) proposing a business combination The proposal, which includes a sizable premium in cash and stock offered to NS shareholders, would result in a company with the potential for faster earnings growth than either CP or NS could achieve on their own, all the while maintaining a strong investment grade credit rating 50 NS confirmed that it had received an offer from CP to acquire the firm's shares for $46 72 in cash and a fixed exchange ratio of 0 348 CP shares for each NS share 51 Based on closing stock prices that day, reporters estimated the offer was worth $94 95 per NS share ( $46 72 in cash 0 348 $138 58), which represented an acquisition premium of 9 over NS's closing price of $86 97 52 The next day, after the market incorporated the news of the proposed acquisition, NS's share price increased 6 3 to $92 49, while CP's price increased 5 4 to $146 65 53 NS responded by saying that in addition to facing significant regulatory hurdles, the offer was deficient, with a premium of less than 10 over the previous day's closing share price of $86 97 54 CP responded by noting that there had been a significant run up in NS's share price due to market rumors of the impending bid, and that its offer should be compared to an unaffected share price that did not include the effect of the potential merger In addition, CP argued that the merger would result in significant improvements in operating performance and synergies that should explicitly be recognized when valuing the offer 55 On December 4, 2015, the NS board of directors rejected the CP offer, stating that it was grossly inadequate 56 CEO Squires said There is a high probability that, after years of disruption and expense, the proposed combination would be rejected by the Surface Transportation Board Even if the proposed combination were ultimately to be cleared, it would be subject to a wide range of onerous conditions that would reduce the value of the stock consideration that has been proposed 57 Canadian Pacific quickly revised its offer to $32 86 in cash and 0 451 CP shares for each NS share (i e , less cash and more stock) on December 8 58 During a conference call that day, Harrison and Ackman gave formal presentations about the proposed merger and took questions from analysts regarding the merits of the proposed combination A vocal advocate for the merger, Ackman dismissed the NS board's resistance to the deal as similar to the resistance that followed his efforts to install Harrison as CEO of CP in 2012 I've seen this movie before, he said 59 Following the second conference call about the deal on December 16, NS and CP closed at $89 79 and $128 56, respectively (Exhibits 9a and 9b show stock prices for CP and NS from October 1 through December 18 ) The Merger Rationale According to CP, the merger provided an opportunity to create a 21st century railroad for a 21st century economy 60 Although additional rail capacity was desperately needed to meet the demands try economy Althou additional rall capacity was desperately needed to meet the demands of a growing economy, it was becoming increasingly difficult to add rail infrastructure in urban areas where most customers were located and railroads exchanged freight with trucks CP argued that industry consolidation offered the best opportunity to improve efficiency and add incremental capacity without requiring additional infrastructure 6 Importantly, consolidation would also improve service for shippers Nowhere was the need for additional infrastructure more crucial than in Chicago, Illinois In 2014, close to 25 of U S rail traffic passed through Chicago, and the volume of traffic was expected to double over the next 10 years 62 Despite various attempts to add infrastructure, the problem was only getting worse CP argued that the CP NS merger offered the best opportunity to increase capacity in the critical Chicago train yards Consolidation enables far better utilization of existing infrastructure For example, trains interchanged in Chicago today must be broken apart and rebuilt in yards within the city and then delivered to receiving carriers The process involves multiple interchanges between multiple carriers in multiple yards A merger would allow these activities to be performed elsewhere so that trains moving through Chicago can move smoothly through the city without exiting the mainline A merger would allow CP NS to provide end to end service to customers, without hand offs and interchanges Reducing these disruptive activities can significantly improve velocity, lower costs, and enable the combined company to move goods more quickly without increasing rates 63 In addition to improving efficiency, CP argued that a CP NS merger would not reduce competition because the two networks met end to end rather than serving overlapping geographies 64 (Exhibit 10 shows the combined CP NS rail network ) However, to address potential regulatory concerns, CP proposed that the new company would give shippers the choice of where they could connect with another railroad along its network, ending the industry practice of bottleneck pricing (i e , monopoly pricing on routes served by a single railroad) and would allow competing railroads to access its railway if the new company was not providing appropriate service or competitive rates in a particular location Finally, CP also identified significant opportunities to improve operating efficiencies on the NS system, thereby creating additional value 65 According to the plan, CP anticipated that the transaction would close by the end of April 2016, and the STB would render a decision to approve (or not) the merger by December 2017 From May 2016 to December 2017, CP and NS would be merged into a voting trust holding company that would allow the two companies to operate independently Newly created shares in this holding company (CP NS shares) would begin trading immediately Notably, however, CP proposed that Harrison would immediately resign from CP severing all ties, including his pension and any stock holdings and would become CEO of NS This meant that Harrison could immediately start implementing the planned operational improvements at NS, independent of the STB's ultimate decision If the STB ultimately rejected the merger, then the improved Norfolk Southern would be spun off, leaving the companies to operate independently On the other hand, if the STB ultimately approved the merger, then the combined entity would start realizing CP's projected post merger combination synergies CP argued that this novel structure was vital to the transaction, as 72 of its projected operational efficiencies were from pre merger operational improvements 66 Table A Projected Merger Benefits ($ millions) 2016 17 $214 0 2018 2019 2020 Pre Merger Operational Improvements Phase in ( ) 67 92 100 Increase in EBIT $844 $1,159 $1,260 Post Merger Combination Synergies Phase in ( ) 25 50 75 Increase in EBIT $0 $0 $124 $248 $371 $495 Projected Total Increase in CP NS EBIT $214 $529 $968 $1,407 $1,631 $1,755 Source Canadian Pacific Presentation, CP Value Proposition, December 8, 2015, p 8 Note The projections were on a pre tax basis and were net of merger related costs and other restructuring expenses In total, CP anticipated that the CP NS merger would generate almost $1 8 billion of annual incremental pre tax operating profit (earnings before interest and taxes EBIT ) by 2021 67 Table A provides CP's projected pre merger operational improvements and post merger combination 2017 42 $529 0 2021 100 $1,260 100 synergies resulting from the merger The cash flows were on a pre tax basis and were net of merger related costs and restructuring expenses The $1 26 billion of pre merger operational improvements included improvements in fuel efficiency ($100 million), train productivity ($610 million), and labor productivity ($550 million) The $495 million of post merger combination synergies included both revenue and cost synergies ($225 million and $270 million, respectively) CP assumed a tax rate of 36 for income earned by NS 68 CP argued that its assumed tax rate was conservative because, if the STB approved the merger, the overall tax rate of the combined entity could be somewhat lower These tax savings expected to be approximately $200 million annually starting in 2018 were not included in the projections of pre merger operating improvements and post merger combination synergies shown in Table A Finally, CP's CFO Mark Erceg stated that the combined company would initially have a BBB Baa credit rating (Standard Poor's Moody's) 69 However, because of the combined company's strong ability to generate cash flow, he anticipated that its credit rating would rise to BBB Baa by 2017, and its debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio would fall from 4 0x in 2016 to 1 6x in 2020 70 The temporary increase in the combined firm's debt to EBITDA ratio and the decline in its credit rating were due to the fact that CP would borrow funds to pay for the entire cash portion of the merger consideration CP's Sweetened Offer On December 16, CP sweetened its revised offer to include 0 451 units of a CVR in addition to the $32 86 in cash and 0 451 CP shares for each NS share it had offered on December 8 The CVR would expire in October 2017 (18 months after the transaction closed at the end of April 2016 and approximately two months before it expected to receive the final regulatory decision), and would be listed on a major exchange (e g , the NYSE) At maturity, each CVR would receive a cash payment equal to $175 minus the CP NS share price at maturity up to a maximum cash payment of $25 71,72 To determine the value of the CVR, CP used data on current market interest rates (see Exhibit 11), assumed annual stock price volatility for the combined entity of 25 , and assumed that no dividends would be paid between the closing of the transaction and the expiration of the CVR 73,74 Because the CVR would be highly liquid, NS shareholders could choose to hold the security to maturity or sell it T hink about this as a long life insurance policy on the trading price It protects you on a downside case CP believes that the market will value this (combined) company the way it's run by Hunter at a meaningfully higher price and that the CVR ultimately will require no payout by CP So it's the way you put your money where your mouth is Canadian Pacific is basically saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond Before he could respond, however, he and his advisors had to determine how much the sweetened offer was worth particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal Time was short and he had a lot to do T hink about this as a long life insurance policy on the trading price It protects you on a downside case CP believes that the market will value this (combined) company the way it's run by Hunter at a meaningfully higher price and that the CVR ultimately will require no payout by CP So it's the way you put your money where your mouth is Canadian Pacific is basically saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond Before he could respond, however, he and his advisors had to determine how much the sweetened offer was worth particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal Time was short and he had a lot to do Select at least 1 post response from the following case Read the following case This is an INDIVIDUAL case study (does not require any simulation meeting with a partner) See a review copy of the case posted here Canadian Pacific's Bid A printable copy of the case should be purchased at Harvard Case Website Cases made available through HBR are copyright protected for individual usage In light of the case and materials covered in the course, answer the following questions 1 Why is the NS management team so adamantly opposed to the deal Are there any benefits of the projected merger for NS Discuss and explain 2 Discuss with examples, some arguments for and against the proposed merger 3 Describe the value of the sweetened offer Should NS shareholders accept the sweetened offer from Dec 16th Why Why not 4 What makes the economic rationale for mergers deals complex (for the purpose of negotiation) What is your top two merger related advice for an acquiring company determining the reservation and aspiration values With reference to the assigned case, explain why doing due diligence (preparation pre negotiation valuation) is important to completing a merger deal 5 What will it take to build mutual trust and a long term relationship between CP and NS for a smooth post merger integration Discuss your top two recommendations Select at least 1 post response from the following questions Managerial Action Reflection Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience the importance of personality, motivation, and power differences when it comes to negotiation deals conducted by women (vis a vis men) Managerial Action Reflection Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways from the Leary et al article assigned for this module Managerial Action Reflection Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways about remaining ethical in conducting a negotiation deal Canadian Pacific's Bid for Norfolk Southern Formed in 1982 out of railroads that had been in existence for 100 years, Norfolk Southern Corporation (NS) had a proud history as one of the largest and most efficient railroads in the United States Despite this legacy, both revenues and profits began falling in 2015 as shipments of coal (20 of revenues) and other commodities declined and cost reduction efforts stalled As a result, the company's stock price had fallen by almost 40 from a high of $117 in late 2014 to a low of $72 in August 2015 Rumors that Canadian Pacific Railway Limited (CP) wanted to acquire Norfolk Southern began circulating in the market in early November 2015 Canadian Pacific did, in fact, make an offer to acquire NS on November 17, which the company acknowledged in a press release later that day (note all amounts in this case refer to U S dollars) Norfolk Southern Corporation ( the Company ) today confirmed that it has received an unsolicited, low premium, non binding, highly conditional indication of interest from Canadian Pacific to acquire the Company for $46 72 in cash and a fixed exchange ratio of 0 348 Canadian Pacific shares per Norfolk Southern share, representing a premium of less than 10 based on closing prices today Notably, any consolidation among Class I railroads in North America would face significant regulatory hurdles Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating After a comprehensive review the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders We believe that Canadian Pacific's short term, cut to the bone strategy could cause Norfolk Southern to lose substantial revenues from our Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating After a comprehensive review the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders We believe that Canadian Pacific's short term, cut to the bone strategy could cause Norfolk Southern to lose substantial revenues from our service sensitive customer base We also believe the proposed transaction risks harm to vital transportation infrastructure and the communities we serve In addition to rejecting CP's offer, James Squires, Norfolk Southern's CEO, announced a new strategic plan designed to improve the company's long term performance by reducing its operating ratio (defined as operating expenses divided by operating revenues it was an industry measure of cost efficiency) Squires argued that Norfolk Southern could, on a stand alone basis, reduce its operating ratio from over 70 to below 65 by 2020 through aggressive cost reduction and, in doing so, generate double digit earnings per share (EPS) growth 4 Within days of the rejection, Canadian Pacific announced a revised offer and proposed a novel deal structure that would allow operational improvements at Norfolk Southern to be implemented even before the merger received regulatory approval To further sweeten the deal, CP added a new security known as a Contingent Value Right (CVR) several days later This security, which CP described as a long term insurance policy, 5 was designed to protect investors if the share price of the combined entity fell below a certain level for any reason before the regulators approved the merger By including the CVR in the deal, CP was demonstrating confidence in its ability to achieve the projected merger benefits Before Squires and the NS board could respond to CP's sweetened offer, however, they had to review the offer with their financial and legal advisors, understand how the merger would affect the firm's operations and impact its shareholders, and prepare a response justifying their decision That response would not only determine the firm's prospects for many years to come, but could affect Squires's professional reputation and career prospects, as well The U S Railroad Industry The U S railroad industry had a long history of regulation starting with the establishment of the Interstate Commerce Commission (ICC) in 1887 6 ICC mandates and other federal regulation limited what railroads could charge on interstate routes, where they could construct new infrastructure, and whether they could divest rail lines After growing for years, total rail mileage peaked in 1916 as the federal government began subsidizing highway construction As trucking became an increasingly important form of competition, the share of intercity freight carried by trains fell steadily through the 1950s and 1960s The 1970s was an especially difficult decade for railroads as inflation caused costs to rise (e g , fuel, labor, and equipment), yet regulations prevented railroads from raising rates commensurately The end result was falling returns the average return on investment (ROI) during the 1970s was 2 and bankruptcies Penn Central, a Class I railroad, declared bankruptcy in 1970, the largest U S corporate bankruptcy at that time 10 The Staggers Rail Act of 1980 provided much needed relief to U S railroads, giving them the flexibility to set their own rates, abandon low density routes, and make acquisitions with limited scrutiny 1 In the following years, a flurry of mergers intended to improve service, efficiency, and safety reduced the number of Class I railroads from 56 to 7 12 In this new consolidated environment, railroads regained financial stability as they streamlined operations and cut costs For example, employment at Class I railroads fell from 458,000 people in 1980 to 178,000 people in 1998 and the industry's average operating ratio fell from 93 to 85 13 With higher profitability, the average ROI grew to 7 in the 1990s and then to 9 4 by mid 2015 4 (Exhibit 1 provides operating and financial statistics for the major railroads operating in the U S and Canada as of 2015 ) 15 Two important changes occurred in the 1990s First, the Surface Transportation Board (STB) replaced the ICC as the primary regulator in 1996, and gained the ability to regulate all mergers and acquisitions 5 Second, the rapid consolidation of Class I railroads continued Burlington Northern acquired Santa Fe Pacific in 1995 after an intense bidding war with Union Pacific 6 Union Pacific then acquired Southern Pacific in 1995 17 CSX acquired Conrail in 1996 and agreed to split the railroad with Norfolk Southern as a solution to an escalating bidding war 18 and finally, Canadian National acquired Illinois Central in 1998 19 (Exhibit 2 shows data on railroad acquisitions from 1995 2014 ) Rather than enhancing service and improving efficiency as promised, these mergers often disrupted service, increased costs (and prices), and reduced safety, at least in the short term, which prompted heightened regulatory scrutiny 20 For example, after BNSF and Canadian National agreed to merge in December 1999, the STB blocked the merger and froze all major rail mergers for 16 months, beginning in March 2000 21 According to the STB, the shipping public has not yet fully recovered from the service interruptions associated with the previous round of mergers from 1995 to 1998 22 The next year, the STB established rules forbidding all railroad mergers unless they were in the public interest, as it tried to create a stable, balanced, and reliable rail transportation system 23 Under the new rules, companies had to demonstrate that merging with another railroad would boost competition and maintain service quality 24 An STB spokesman said, Although our new rules and policy statement do not, as the Class I railroads argue, reflect an anti merger bias, we do plan to take a more skeptical 'show me' attitude toward claims of merger benefits and toward claims that no transitional problems would occur 25 At the time, the prevailing view was that another round of consolidation could leave the continent with just two Class I railroads 26 Norfolk Southern Corporation Norfolk Southern Corporation (NS or NSC) was formed in 1982 by the merger of two railways Norfolk Western and Southern Railway 27 As the fourth largest Class I railroad operating in North America, NS had 30,456 employees, controlled 20,000 miles of track in 22 eastern states, and served all of the major East Coast ports 28 The company generated $2 0 billion of income on operating revenues of $11 6 billion in 2014 29 (Exhibits 3 and 4 show NS's income statements and balance sheets, respectively ) By early 2015, revenues and profits were falling and the firm's relative cost position was deteriorating After being in the middle of the pack of Class I railroads in terms of its operating ratio, NS was at the high end of the group as of 2015 30 (Exhibit 5 shows operating ratios over time for Class I railroads) Analysts, however, expected the firm's performance would improve in the coming years (Exhibit 6 shows financial projections for NS on a stand alone basis according to equity analysts at UBS in October 2015 ) Squires became CEO of NS on June 1, 2015, at the age of 53 31 When former CEO Charles Wick Moorman announced his successor, he said, I am confident that the company is poised for continued growth, success, and shareholder value creation 32 Squires had joined the company in 1992, as a newly minted graduate of the University of Chicago Law School He rose through the ranks of the legal division before being named senior vice president of financial planning in 2006, CFO in 2007, and then president in 2013 33 Canadian Pacific Railway Limited Canadian Pacific Railway Ltd was founded in the late 19th century to connect the major cities in eastern Canada with the less populous western territories By 1986, CP had become Canada's second largest company 34 Headquartered in Calgary, Alberta, CP had 13,700 employees and operated 12,500 miles of track in Canada as well as the midwestern and northeastern parts of the United States 35 CP's main competitors were Canadian National Railway Company (Canadian National) in Canada and BNSF Railway in the U S Midwest 36 With revenues of $5 7 billion and net income of $1 3 billion in 2014, CP was considerably smaller than NS 37 (Exhibits 7 and 8 show CP's income statements and balance sheets, respectively ) 1pc In 2011, hedge fund manager and activist investor William Bill Ackman (HBS 1992) acquired a 12 stake in CP through his firm Pershing Square Capital Management 38 Ackman was known in the financial world for his overwhelming confidence and his willingness to place enormous bets based on his convictions 39 For example, he told one author I don't care what other people think I invest based on what I believe the opportunity for profit is compared with my estimate of the potential for loss 40 Ackman subsequently forced CP's CEO to resign, ousted the company's board of directors, and installed Hunter Harrison as chief executive after a proxy fight 41 Harrison, a long term railroad executive, had retired as the CEO of Canadian National (CN) in 2009 42 During his time at CN, Harrison had won various awards, including Canadian CEO of the Year43 and Railroader of the Year 44 Harrison believed consolidation was a good way to add critical rail capacity and simultaneously improve efficiency Toward that end, he had unsuccessfully approached CSX Corp , another Class I railroad located in the eastern United States, in 2014 about a possible merger, arguing, A pro competition, customer friendly, safety focused railway combination is one such solution that could not be ignored on its merits by regulators 45 Yet NS's then CEO Moorman said in 2014 that major railroad mergers would be highly problematic from both a regulatory and a service perspective 46 Absent mergers, careful cost control could also improve efficiency In fact, under Harrison's leadership, CP's operating ratio had fallen from 81 in 2011 to close to 60 in 2015 47 In response, the firm's share price during his tenure had soared from less than $68 at the end of 2011 to almost $215 in October 2014, yet had fallen back down to $135 as of early November 2015 48 (CP was traded on both the Toronto and New York stock exchanges ) Bidding for Norfolk Southern Despite market rumors of a possible bid for NS by CP, CP denied the rumors in a press release on November 9, claiming T here is no material news pending at this time CP does not comment on market rumor and speculation 4 Nevertheless, NS's stock price increased 11 0 (from $79 87 to $88 62) and CP's price increased 5 9 (from $134 31 to $142 18) on a day the market was down 1 0 Eight days later, after the market closed on November 17, 2015, CP did, in fact, make an offer for NS Canadian Pacific (CP) has sent an offer letter to Norfolk Southern Corp (NS) proposing a business combination The proposal, which includes a sizable premium in cash and stock offered to NS shareholders, would result in a company with the potential for faster earnings growth than either CP or NS could achieve on their own, all the while maintaining a strong investment grade credit rating 50 NS confirmed that it had received an offer from CP to acquire the firm's shares for $46 72 in cash and a fixed exchange ratio of 0 348 CP shares for each NS share 51 Based on closing stock prices that day, reporters estimated the offer was worth $94 95 per NS share ( $46 72 in cash 0 348 $138 58), which represented an acquisition premium of 9 over NS's closing price of $86 97 52 The next day, after the market incorporated the news of the proposed acquisition, NS's share price increased 6 3 to $92 49, while CP's price increased 5 4 to $146 65 53 NS responded by saying that in addition to facing significant regulatory hurdles, the offer was deficient, with a premium of less than 10 over the previous day's closing share price of $86 97 54 CP responded by noting that there had been a significant run up in NS's share price due to market rumors of the impending bid, and that its offer should be compared to an unaffected share price that did not include the effect of the potential merger In addition, CP argued that the merger would result in significant improvements in operating performance and synergies that should explicitly be recognized when valuing the offer 55 On December 4, 2015, the NS board of directors rejected the CP offer, stating that it was grossly inadequate 56 CEO Squires said There is a high probability that, after years of disruption and expense, the proposed combination would be rejected by the Surface Transportation Board Even if the proposed combination were ultimately to be cleared, it would be subject to a wide range of onerous conditions that would reduce the value of the stock consideration that has been proposed 57 Canadian Pacific quickly revised its offer to $32 86 in cash and 0 451 CP shares for each NS share (i e , less cash and more stock) on December 8 58 During a conference call that day, Harrison and Ackman gave formal presentations about the proposed merger and took questions from analysts regarding the merits of the proposed combination A vocal advocate for the merger, Ackman dismissed the NS board's resistance to the deal as similar to the resistance that followed his efforts to install Harrison as CEO of CP in 2012 I've seen this movie before, he said 59 Following the second conference call about the deal on December 16, NS and CP closed at $89 79 and $128 56, respectively (Exhibits 9a and 9b show stock prices for CP and NS from October 1 through December 18 ) The Merger Rationale According to CP, the merger provided an opportunity to create a 21st century railroad for a 21st century economy 60 Although additional rail capacity was desperately needed to meet the demands try economy Althou additional rall capacity was desperately needed to meet the demands of a growing economy, it was becoming increasingly difficult to add rail infrastructure in urban areas where most customers were located and railroads exchanged freight with trucks CP argued that industry consolidation offered the best opportunity to improve efficiency and add incremental capacity without requiring additional infrastructure 6 Importantly, consolidation would also improve service for shippers Nowhere was the need for additional infrastructure more crucial than in Chicago, Illinois In 2014, close to 25 of U S rail traffic passed through Chicago, and the volume of traffic was expected to double over the next 10 years 62 Despite various attempts to add infrastructure, the problem was only getting worse CP argued that the CP NS merger offered the best opportunity to increase capacity in the critical Chicago train yards Consolidation enables far better utilization of existing infrastructure For example, trains interchanged in Chicago today must be broken apart and rebuilt in yards within the city and then delivered to receiving carriers The process involves multiple interchanges between multiple carriers in multiple yards A merger would allow these activities to be performed elsewhere so that trains moving through Chicago can move smoothly through the city without exiting the mainline A merger would allow CP NS to provide end to end service to customers, without hand offs and interchanges Reducing these disruptive activities can significantly improve velocity, lower costs, and enable the combined company to move goods more quickly without increasing rates 63 In addition to improving efficiency, CP argued that a CP NS merger would not reduce competition because the two networks met end to end rather than serving overlapping geographies 64 (Exhibit 10 shows the combined CP NS rail network ) However, to address potential regulatory concerns, CP proposed that the new company would give shippers the choice of where they could connect with another railroad along its network, ending the industry practice of bottleneck pricing (i e , monopoly pricing on routes served by a single railroad) and would allow competing railroads to access its railway if the new company was not providing appropriate service or competitive rates in a particular location Finally, CP also identified significant opportunities to improve operating efficiencies on the NS system, thereby creating additional value 65 According to the plan, CP anticipated that the transaction would close by the end of April 2016, and the STB would render a decision to approve (or not) the merger by December 2017 From May 2016 to December 2017, CP and NS would be merged into a voting trust holding company that would allow the two companies to operate independently Newly created shares in this holding company (CP NS shares) would begin trading immediately Notably, however, CP proposed that Harrison would immediately resign from CP severing all ties, including his pension and any stock holdings and would become CEO of NS This meant that Harrison could immediately start implementing the planned operational improvements at NS, independent of the STB's ultimate decision If the STB ultimately rejected the merger, then the improved Norfolk Southern would be spun off, leaving the companies to operate independently On the other hand, if the STB ultimately approved the merger, then the combined entity would start realizing CP's projected post merger combination synergies CP argued that this novel structure was vital to the transaction, as 72 of its projected operational efficiencies were from pre merger operational improvements 66 Table A Projected Merger Benefits ($ millions) 2016 17 $214 0 2018 2019 2020 Pre Merger Operational Improvements Phase in ( ) 67 92 100 Increase in EBIT $844 $1,159 $1,260 Post Merger Combination Synergies Phase in ( ) 25 50 75 Increase in EBIT $0 $0 $124 $248 $371 $495 Projected Total Increase in CP NS EBIT $214 $529 $968 $1,407 $1,631 $1,755 Source Canadian Pacific Presentation, CP Value Proposition, December 8, 2015, p 8 Note The projections were on a pre tax basis and were net of merger related costs and other restructuring expenses In total, CP anticipated that the CP NS merger would generate almost $1 8 billion of annual incremental pre tax operating profit (earnings before interest and taxes EBIT ) by 2021 67 Table A provides CP's projected pre merger operational improvements and post merger combination 2017 42 $529 0 2021 100 $1,260 100 synergies resulting from the merger The cash flows were on a pre tax basis and were net of merger related costs and restructuring expenses The $1 26 billion of pre merger operational improvements included improvements in fuel efficiency ($100 million), train productivity ($610 million), and labor productivity ($550 million) The $495 million of post merger combination synergies included both revenue and cost synergies ($225 million and $270 million, respectively) CP assumed a tax rate of 36 for income earned by NS 68 CP argued that its assumed tax rate was conservative because, if the STB approved the merger, the overall tax rate of the combined entity could be somewhat lower These tax savings expected to be approximately $200 million annually starting in 2018 were not included in the projections of pre merger operating improvements and post merger combination synergies shown in Table A Finally, CP's CFO Mark Erceg stated that the combined company would initially have a BBB Baa credit rating (Standard Poor's Moody's) 69 However, because of the combined company's strong ability to generate cash flow, he anticipated that its credit rating would rise to BBB Baa by 2017, and its debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio would fall from 4 0x in 2016 to 1 6x in 2020 70 The temporary increase in the combined firm's debt to EBITDA ratio and the decline in its credit rating were due to the fact that CP would borrow funds to pay for the entire cash portion of the merger consideration CP's Sweetened Offer On December 16, CP sweetened its revised offer to include 0 451 units of a CVR in addition to the $32 86 in cash and 0 451 CP shares for each NS share it had offered on December 8 The CVR would expire in October 2017 (18 months after the transaction closed at the end of April 2016 and approximately two months before it expected to receive the final regulatory decision), and would be listed on a major exchange (e g , the NYSE) At maturity, each CVR would receive a cash payment equal to $175 minus the CP NS share price at maturity up to a maximum cash payment of $25 71,72 To determine the value of the CVR, CP used data on current market interest rates (see Exhibit 11), assumed annual stock price volatility for the combined entity of 25 , and assumed that no dividends would be paid between the closing of the transaction and the expiration of the CVR 73,74 Because the CVR would be highly liquid, NS shareholders could choose to hold the security to maturity or sell it T hink about this as a long life insurance policy on the trading price It protects you on a downside case CP believes that the market will value this (combined) company the way it's run by Hunter at a meaningfully higher price and that the CVR ultimately will require no payout by CP So it's the way you put your money where your mouth is Canadian Pacific is basically saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond Before he could respond, however, he and his advisors had to determine how much the sweetened offer was worth particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal Time was short and he had a lot to do T hink about this as a long life insurance policy on the trading price It protects you on a downside case CP believes that the market will value this (combined) company the way it's run by Hunter at a meaningfully higher price and that the CVR ultimately will require no payout by CP So it's the way you put your money where your mouth is Canadian Pacific is basically saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond Before he could respond, however, he and his advisors had to determine how much the sweetened offer was worth particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal Time was short and he had a lot to do Select at least 1 post response from the following case Read the following case This is an INDIVIDUAL case study (does not require any simulation meeting with a partner) See a review copy of the case posted here Canadian Pacific's Bid A printable copy of the case should be purchased at Harvard Case Website Cases made available through HBR are copyright protected for individual usage In light of the case and materials covered in the course, answer the following questions 1 Why is the NS management team so adamantly opposed to the deal Are there any benefits of the projected merger for NS Discuss and explain 2 Discuss with examples, some arguments for and against the proposed merger 3 Describe the value of the sweetened offer Should NS shareholders accept the sweetened offer from Dec 16th Why Why not 4 What makes the economic rationale for mergers deals complex (for the purpose of negotiation) What is your top two merger related advice for an acquiring company determining the reservation and aspiration values With reference to the assigned case, explain why doing due diligence (preparation pre negotiation valuation) is important to completing a merger deal 5 What will it take to build mutual trust and a long term relationship between CP and NS for a smooth post merger integration Discuss your top two recommendations Select at least 1 post response from the following questions Managerial Action Reflection Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience the importance of personality, motivation, and power differences when it comes to negotiation deals conducted by women (vis a vis men) Managerial Action Reflection Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways from the Leary et al article assigned for this module Managerial Action Reflection Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways about remaining ethical in conducting a negotiation deal

Question

Canadian Pacific's Bid for Norfolk Southern Formed in 1982 out of railroads that had been in existence for 100 years, Norfolk Southern Corporation (NS) had a proud history as one of the largest and most efficient railroads in the United States  Despite this legacy, both revenues and profits began falling in 2015 as shipments of coal (20  of revenues) and other commodities declined and cost reduction efforts stalled  As a result, the company's stock price had fallen by almost 40  from a high of $117 in late 2014 to a low of $72 in August 2015  Rumors that Canadian Pacific Railway Limited (CP) wanted to acquire Norfolk Southern began circulating in the market in early November 2015  Canadian Pacific did, in fact, make an offer to acquire NS on November 17, which the company acknowledged in a press release later that day (note  all amounts in this case refer to U S  dollars)  Norfolk Southern Corporation ( the Company ) today confirmed that it has received an unsolicited, low premium, non binding, highly conditional indication of interest from Canadian Pacific to acquire the Company for $46 72 in cash and a fixed exchange ratio of 0 348 Canadian Pacific shares per Norfolk Southern share, representing a premium of less than 10  based on closing prices today      Notably, any consolidation among Class I railroads in North America would face significant regulatory hurdles  Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating  After a comprehensive review     the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders        We believe that Canadian Pacific's short term, cut to  the bone strategy could cause Norfolk Southern to lose substantial revenues from our Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating  After a comprehensive review     the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders        We believe that Canadian Pacific's short term, cut to  the bone strategy could cause Norfolk Southern to lose substantial revenues from our service sensitive customer base  We also believe the proposed transaction risks harm to vital transportation infrastructure and the communities we serve  In addition to rejecting CP's offer, James Squires, Norfolk Southern's CEO, announced a new strategic plan designed to improve the company's long term performance by reducing its operating ratio (defined as operating expenses divided by operating revenues it was an industry measure of cost efficiency)  Squires argued that Norfolk Southern could, on a stand alone basis, reduce its operating ratio from over 70  to below 65  by 2020 through aggressive cost reduction and, in doing so, generate double digit earnings per share (EPS) growth 4 Within days of the rejection, Canadian Pacific announced a revised offer and proposed a novel deal structure that would allow operational improvements at Norfolk Southern to be implemented even before the merger received regulatory approval  To further sweeten the deal, CP added a new security known as a Contingent Value Right (CVR) several days later  This security, which CP described as a  long term insurance policy, 5 was designed to protect investors if the share price of the combined entity fell below a certain level for any reason before the regulators approved the merger  By including the CVR in the deal, CP was demonstrating confidence in its ability to achieve the projected merger benefits  Before Squires and the NS board could respond to CP's  sweetened  offer, however, they had to review the offer with their financial and legal advisors, understand how the merger would affect the firm's operations and impact its shareholders, and prepare a response justifying their decision  That response would not only determine the firm's prospects for many years to come, but could affect Squires's professional reputation and career prospects, as well  The U S  Railroad Industry The U S  railroad industry had a long history of regulation starting with the establishment of the Interstate Commerce Commission (ICC) in 1887 6 ICC mandates and other federal regulation limited what railroads could charge on interstate routes, where they could construct new infrastructure, and whether they could divest rail lines  After growing for years, total rail mileage peaked in 1916 as the federal government began subsidizing highway construction  As trucking became an increasingly important form of competition, the share of intercity freight carried by trains fell steadily through the 1950s and 1960s  The 1970s was an especially difficult decade for railroads as inflation caused costs to rise (e g , fuel, labor, and equipment), yet regulations prevented railroads from raising rates commensurately  The end result was falling returns   the average return on investment (ROI) during the 1970s was 2 and bankruptcies  Penn Central, a Class I railroad, declared bankruptcy in 1970, the largest U S  corporate bankruptcy at that time 10 The Staggers Rail Act of 1980 provided much needed relief to U S  railroads, giving them the flexibility to set their own rates, abandon low density routes, and make acquisitions with limited scrutiny 1 In the following years, a flurry of mergers intended to improve service, efficiency, and safety reduced the number of Class I railroads from 56 to 7 12 In this new consolidated environment, railroads regained financial stability as they streamlined operations and cut costs  For example, employment at Class I railroads fell from 458,000 people in 1980 to 178,000 people in 1998  and the industry's average operating ratio fell from 93  to 85  13 With higher profitability, the average ROI grew to 7  in the 1990s and then to 9 4  by mid 2015 4 (Exhibit 1 provides operating and financial statistics for the major railroads operating in the U S  and Canada as of 2015 ) 15 Two important changes occurred in the 1990s  First, the Surface Transportation Board (STB) replaced the ICC as the primary regulator in 1996, and gained the ability to regulate all mergers and acquisitions  5 Second, the rapid consolidation of Class I railroads continued  Burlington Northern acquired Santa Fe Pacific in 1995 after an intense bidding war with Union Pacific 6 Union Pacific then acquired Southern Pacific in 1995 17 CSX acquired Conrail in 1996 and agreed to split the railroad with Norfolk Southern as a solution to an escalating bidding war 18 and finally, Canadian National acquired Illinois Central in 1998 19 (Exhibit 2 shows data on railroad acquisitions from 1995 2014 ) Rather than enhancing service and improving efficiency as promised, these mergers often disrupted service, increased costs (and prices), and reduced safety, at least in the short term, which prompted heightened regulatory scrutiny 20 For example, after BNSF and Canadian National agreed to merge in December 1999, the STB blocked the merger and froze all major rail mergers for 16 months, beginning in March 2000 21 According to the STB,  the shipping public has not yet fully recovered from the service interruptions associated with the previous round of mergers  from 1995 to 1998   22 The next year, the STB established rules forbidding all railroad mergers unless they were in the public interest, as it tried to create  a stable, balanced, and reliable rail transportation system  23 Under the new rules, companies had to demonstrate that merging with another railroad would boost competition and maintain service quality 24 An STB spokesman said,  Although our new rules and policy statement do not, as the Class I railroads argue, reflect an anti merger bias, we do plan to take a more skeptical 'show me' attitude toward claims of merger benefits and toward claims that no transitional problems would occur  25 At the time, the prevailing view was that another round of consolidation could leave the continent with just two Class I railroads 26 Norfolk Southern Corporation Norfolk Southern Corporation (NS or NSC) was formed in 1982 by the merger of two railways  Norfolk   Western and Southern Railway 27 As the fourth largest Class I railroad operating in North America, NS had 30,456 employees, controlled 20,000 miles of track in 22 eastern states, and served all of the major East Coast ports 28 The company generated $2 0 billion of income on operating revenues of $11 6 billion in 2014 29 (Exhibits 3 and 4 show NS's income statements and balance sheets, respectively ) By early 2015, revenues and profits were falling and the firm's relative cost position was deteriorating  After being in the middle of the pack of Class I railroads in terms of its operating ratio, NS was at the high end of the group as of 2015 30 (Exhibit 5 shows operating ratios over time for Class I railroads)  Analysts, however, expected the firm's performance would improve in the coming years  (Exhibit 6 shows financial projections for NS on a stand alone basis according to equity analysts at UBS in October 2015 ) Squires became CEO of NS on June 1, 2015, at the age of 53 31 When former CEO Charles  Wick  Moorman announced his successor, he said,  I am confident that the company is poised for continued growth, success, and shareholder value creation  32 Squires had joined the company in 1992, as a newly minted graduate of the University of Chicago Law School  He rose through the ranks of the legal division before being named senior vice president of financial planning in 2006, CFO in 2007, and then president in 2013 33 Canadian Pacific Railway Limited Canadian Pacific Railway Ltd  was founded in the late 19th century to connect the major cities in eastern Canada with the less populous western territories  By 1986, CP had become Canada's second  largest company 34 Headquartered in Calgary, Alberta, CP had 13,700 employees and operated 12,500 miles of track in Canada as well as the midwestern and northeastern parts of the United States 35 CP's main competitors were Canadian National Railway Company (Canadian National) in Canada and BNSF Railway in the U S  Midwest 36 With revenues of $5 7 billion and net income of $1 3 billion in 2014, CP was considerably smaller than NS 37 (Exhibits 7 and 8 show CP's income statements and balance sheets, respectively ) 1pc In 2011, hedge fund manager and activist investor William  Bill  Ackman (HBS 1992) acquired a 12  stake in CP through his firm Pershing Square Capital Management 38 Ackman was known in the financial world for his overwhelming confidence and his willingness to place enormous bets based on his convictions 39 For example, he told one author   I don't care what other people think  I invest based on what I believe the opportunity for profit is compared with my estimate of the potential for loss  40 Ackman subsequently forced CP's CEO to resign, ousted the company's board of directors, and installed Hunter Harrison as chief executive after a proxy fight 41 Harrison, a long term railroad executive, had retired as the CEO of Canadian National (CN) in 2009 42 During his time at CN, Harrison had won various awards, including Canadian CEO of the Year43 and Railroader of the Year 44 Harrison believed consolidation was a good way to add critical rail capacity and simultaneously improve efficiency  Toward that end, he had unsuccessfully approached CSX Corp , another Class I railroad located in the eastern United States, in 2014 about a possible merger, arguing,  A pro  competition, customer friendly, safety focused railway combination is one such solution that could not be ignored on its merits by regulators  45 Yet NS's then CEO Moorman said in 2014 that major railroad mergers would be  highly problematic  from both a regulatory and a service perspective 46 Absent mergers, careful cost control could also improve efficiency  In fact, under Harrison's leadership, CP's operating ratio had fallen from 81  in 2011 to close to 60  in 2015 47 In response, the firm's share price during his tenure had soared from less than $68 at the end of 2011 to almost $215 in October 2014, yet had fallen back down to $135 as of early November 2015 48 (CP was traded on both the Toronto and New York stock exchanges ) Bidding for Norfolk Southern Despite market rumors of a possible bid for NS by CP, CP denied the rumors in a press release on November 9, claiming   T here is no material news pending at this time  CP does not comment on market rumor and speculation  4 Nevertheless, NS's stock price increased 11 0  (from $79 87 to $88 62) and CP's price increased 5 9  (from $134 31 to $142 18) on a day the market was down 1 0   Eight days later, after the market closed on November 17, 2015, CP did, in fact, make an offer for NS  Canadian Pacific (CP)    has sent an offer letter to Norfolk Southern Corp  (NS) proposing a business combination      The proposal, which includes a sizable premium in cash and stock offered to NS shareholders, would result in a company with the potential for faster earnings growth than either CP or NS could achieve on their own, all the while maintaining a strong investment grade credit rating 50 NS confirmed that it had received an offer from CP to acquire the firm's shares for $46 72 in cash and a fixed exchange ratio of 0 348 CP shares for each NS share 51 Based on closing stock prices that day, reporters estimated the offer was worth $94 95 per NS share (  $46 72 in cash  0 348   $138 58), which represented an acquisition premium of 9  over NS's closing price of $86 97 52 The next day, after the market incorporated the news of the proposed acquisition, NS's share price increased 6 3  to $92 49, while CP's price increased 5 4  to $146 65 53 NS responded by saying that in addition to facing  significant regulatory hurdles,  the offer was deficient, with a premium of less than 10  over the previous day's closing share price of $86 97 54 CP responded by noting that there had been a significant run up in NS's share price due to market rumors of the impending bid, and that its offer should be compared to an  unaffected  share price that did not include the effect of the potential merger  In addition, CP argued that the merger would result in significant improvements in operating performance and synergies that should explicitly be recognized when valuing the offer 55 On December 4, 2015, the NS board of directors rejected the CP offer, stating that it was  grossly inadequate  56 CEO Squires said  There is a high probability that, after years of disruption and expense, the proposed combination would be rejected by the Surface Transportation Board     Even if the proposed combination were ultimately to be cleared, it would be subject to a wide range of onerous conditions that would reduce the value of the stock consideration that has been proposed 57 Canadian Pacific quickly revised its offer to $32 86 in cash and 0 451 CP shares for each NS share (i e , less cash and more stock) on December 8 58 During a conference call that day, Harrison and Ackman gave formal presentations about the proposed merger and took questions from analysts regarding the merits of the proposed combination  A vocal advocate for the merger, Ackman dismissed the NS board's resistance to the deal as similar to the resistance that followed his efforts to install Harrison as CEO of CP in 2012   I've seen this movie before,  he said 59 Following the second conference call about the deal on December 16, NS and CP closed at $89 79 and $128 56, respectively  (Exhibits 9a and 9b show stock prices for CP and NS from October 1 through December 18 ) The Merger Rationale According to CP, the merger provided an opportunity to create  a 21st century railroad for a 21st century economy  60 Although additional rail capacity was desperately needed to meet the demands try economy  Althou additional rall capacity was desperately needed to meet the demands of a growing economy, it was becoming increasingly difficult to add rail infrastructure in urban areas where most customers were located and railroads exchanged freight with trucks  CP argued that industry consolidation offered the best opportunity to improve efficiency and add incremental capacity without requiring additional infrastructure 6 Importantly, consolidation would also improve service for shippers  Nowhere was the need for additional infrastructure more crucial than in Chicago, Illinois  In 2014, close to 25  of U S  rail traffic passed through Chicago, and the volume of traffic was expected to double over the next 10 years 62 Despite various attempts to add infrastructure, the problem was only getting worse  CP argued that the CP NS merger offered the best opportunity to increase capacity in the critical Chicago train yards  Consolidation enables far better utilization of existing infrastructure  For example, trains interchanged in Chicago today must be broken apart and rebuilt in yards within the city and then delivered to receiving carriers  The process involves multiple interchanges between multiple carriers in multiple yards  A merger would allow these activities to be performed elsewhere so that trains moving through Chicago can move smoothly through the city without exiting the mainline      A merger would allow CP  NS to provide end to end service to customers, without hand offs and interchanges  Reducing these disruptive activities can significantly improve velocity, lower costs, and enable the combined company to move goods more quickly without increasing rates 63 In addition to improving efficiency, CP argued that a CP NS merger would not reduce competition because the two networks met end to end  rather than serving overlapping geographies 64 (Exhibit 10 shows the combined CP NS rail network ) However, to address potential regulatory concerns, CP proposed that the new company would give shippers the choice of where they could connect with another railroad along its network, ending the industry practice of  bottleneck pricing  (i e , monopoly pricing on routes served by a single railroad) and would allow competing railroads to access its railway if the new company was not providing appropriate service or competitive rates in a particular location  Finally, CP also identified significant opportunities to improve operating efficiencies on the NS system, thereby creating additional value 65 According to the plan, CP anticipated that the transaction would close by the end of April 2016, and the STB would render a decision to approve (or not) the merger by December 2017  From May 2016 to December 2017, CP and NS would be merged into a  voting trust  holding company that would allow the two companies to operate independently  Newly created shares in this holding company (CP NS shares) would begin trading immediately  Notably, however, CP proposed that Harrison would immediately resign from CP severing all ties, including his pension and any stock holdings and would become CEO of NS  This meant that Harrison could immediately start implementing the planned operational improvements at NS, independent of the STB's ultimate decision  If the STB ultimately rejected the merger, then the  improved  Norfolk Southern would be spun off, leaving the companies to operate independently  On the other hand, if the STB ultimately approved the merger, then the combined entity would start realizing CP's projected  post merger combination synergies   CP argued that this novel structure was vital to the transaction, as 72  of its projected operational efficiencies were from pre merger operational improvements 66 Table A Projected Merger Benefits ($ millions) 2016 17  $214 0  2018 2019 2020 Pre Merger Operational Improvements Phase in ( ) 67  92  100  Increase in EBIT $844 $1,159 $1,260 Post Merger Combination Synergies Phase in ( ) 25  50  75  Increase in EBIT $0 $0 $124 $248 $371 $495 Projected Total Increase in CP NS EBIT $214 $529 $968 $1,407 $1,631 $1,755 Source  Canadian Pacific Presentation,  CP Value Proposition,  December 8, 2015, p  8  Note  The projections were on a pre tax basis and were net of merger related costs and other restructuring expenses  In total, CP anticipated that the CP NS merger would generate almost $1 8 billion of annual incremental pre tax operating profit (earnings before interest and taxes  EBIT ) by 2021 67 Table A provides CP's projected pre merger operational improvements and post merger combination 2017 42  $529 0  2021 100  $1,260 100  synergies resulting from the merger  The cash flows were on a pre tax basis and were net of merger  related costs and restructuring expenses  The $1 26 billion of pre merger operational improvements included improvements in fuel efficiency ($100 million), train productivity ($610 million), and labor productivity ($550 million)  The $495 million of post merger combination synergies included both revenue and cost synergies ($225 million and $270 million, respectively)  CP assumed a tax rate of 36  for income earned by NS 68 CP argued that its assumed tax rate was conservative because, if the STB approved the merger, the overall tax rate of the combined entity could be somewhat lower  These tax savings expected to be approximately $200 million annually starting in 2018 were not included in the projections of pre merger operating improvements and post merger combination synergies shown in Table A  Finally, CP's CFO Mark Erceg stated that the combined company would initially have a BBB Baa credit rating (Standard   Poor's Moody's) 69 However, because of the combined company's strong ability to generate cash flow, he anticipated that its credit rating would rise to BBB  Baa  by 2017, and its debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio would fall from 4 0x in 2016 to 1 6x in 2020 70 The temporary increase in the combined firm's debt to EBITDA ratio and the decline in its credit rating were due to the fact that CP would borrow funds to pay for the entire cash portion of the merger consideration  CP's  Sweetened  Offer On December 16, CP sweetened its revised offer to include 0 451 units of a CVR in addition to the $32 86 in cash and 0 451 CP shares for each NS share it had offered on December 8  The CVR would expire in October 2017 (18 months after the transaction closed at the end of April 2016 and approximately two months before it expected to receive the final regulatory decision), and would be listed on a major exchange (e g , the NYSE)  At maturity, each CVR would receive a cash payment equal to $175 minus the CP NS share price at maturity up to a maximum cash payment of $25 71,72 To determine the value of the CVR, CP used data on current market interest rates (see Exhibit 11), assumed annual stock price volatility for the combined entity of 25 , and assumed that no dividends would be paid between the closing of the transaction and the expiration of the CVR 73,74 Because the CVR would be highly liquid, NS shareholders could choose to hold the security to maturity or sell it  T hink about this as a long life insurance policy on the trading price        It protects you on a downside case     CP believes that the market will value this (combined) company   the way it's run by Hunter   at a meaningfully higher price and that the CVR ultimately will require no payout by CP  So it's the way you put your money where your mouth is     Canadian Pacific is basically    saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond  Before he could respond, however, he and his advisors had to determine how much the  sweetened  offer was worth  particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer  If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection  If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not  Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal  Time was short and he had a lot to do   T hink about this as a long life insurance policy on the trading price        It protects you on a downside case     CP believes that the market will value this (combined) company   the way it's run by Hunter   at a meaningfully higher price and that the CVR ultimately will require no payout by CP  So it's the way you put your money where your mouth is     Canadian Pacific is basically    saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond  Before he could respond, however, he and his advisors had to determine how much the  sweetened  offer was worth  particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer  If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection  If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not  Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal  Time was short and he had a lot to do  Select at least 1 post response from the following case  Read the following case  This is an INDIVIDUAL case study (does not require any simulation meeting with a partner) See a review copy of the case posted here  Canadian Pacific's Bid A printable copy of the case should be purchased at Harvard Case Website  Cases made available through HBR are copyright protected for individual usage  In light of the case and materials covered in the course, answer the following questions  1  Why is the NS management team so adamantly opposed to the deal  Are there any benefits of the projected merger for NS  Discuss and explain  2  Discuss with examples, some arguments for and against the proposed merger  3  Describe the value of the  sweetened  offer  Should NS shareholders accept the  sweetened  offer from Dec 16th  Why  Why not  4  What makes the economic rationale for mergers deals complex (for the purpose of negotiation)  What is your top two merger related advice for an acquiring company determining the reservation and aspiration values  With reference to the assigned case, explain why doing due diligence (preparation pre negotiation valuation) is important to completing a merger deal  5  What will it take to build mutual trust and a long term relationship between CP and NS for a smooth post merger integration  Discuss your top two recommendations  Select at least 1 post response from the following questions  Managerial Action Reflection  Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience the importance of personality, motivation, and power differences when it comes to negotiation deals conducted by women (vis a vis men)  Managerial Action Reflection  Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways from the Leary et al article assigned for this module  Managerial Action Reflection  Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways about remaining ethical in conducting a negotiation deal  Canadian Pacific's Bid for Norfolk Southern Formed in 1982 out of railroads that had been in existence for 100 years, Norfolk Southern Corporation (NS) had a proud history as one of the largest and most efficient railroads in the United States  Despite this legacy, both revenues and profits began falling in 2015 as shipments of coal (20  of revenues) and other commodities declined and cost reduction efforts stalled  As a result, the company's stock price had fallen by almost 40  from a high of $117 in late 2014 to a low of $72 in August 2015  Rumors that Canadian Pacific Railway Limited (CP) wanted to acquire Norfolk Southern began circulating in the market in early November 2015  Canadian Pacific did, in fact, make an offer to acquire NS on November 17, which the company acknowledged in a press release later that day (note  all amounts in this case refer to U S  dollars)  Norfolk Southern Corporation ( the Company ) today confirmed that it has received an unsolicited, low premium, non binding, highly conditional indication of interest from Canadian Pacific to acquire the Company for $46 72 in cash and a fixed exchange ratio of 0 348 Canadian Pacific shares per Norfolk Southern share, representing a premium of less than 10  based on closing prices today      Notably, any consolidation among Class I railroads in North America would face significant regulatory hurdles  Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating  After a comprehensive review     the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders        We believe that Canadian Pacific's short term, cut to  the bone strategy could cause Norfolk Southern to lose substantial revenues from our Two weeks later, Norfolk Southern's board of directors unanimously rejected the offer, stating  After a comprehensive review     the Norfolk Southern board concluded that the indication of interest is grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to overcome, and is not in the best interest of the Company and its shareholders        We believe that Canadian Pacific's short term, cut to  the bone strategy could cause Norfolk Southern to lose substantial revenues from our service sensitive customer base  We also believe the proposed transaction risks harm to vital transportation infrastructure and the communities we serve  In addition to rejecting CP's offer, James Squires, Norfolk Southern's CEO, announced a new strategic plan designed to improve the company's long term performance by reducing its operating ratio (defined as operating expenses divided by operating revenues it was an industry measure of cost efficiency)  Squires argued that Norfolk Southern could, on a stand alone basis, reduce its operating ratio from over 70  to below 65  by 2020 through aggressive cost reduction and, in doing so, generate double digit earnings per share (EPS) growth 4 Within days of the rejection, Canadian Pacific announced a revised offer and proposed a novel deal structure that would allow operational improvements at Norfolk Southern to be implemented even before the merger received regulatory approval  To further sweeten the deal, CP added a new security known as a Contingent Value Right (CVR) several days later  This security, which CP described as a  long term insurance policy, 5 was designed to protect investors if the share price of the combined entity fell below a certain level for any reason before the regulators approved the merger  By including the CVR in the deal, CP was demonstrating confidence in its ability to achieve the projected merger benefits  Before Squires and the NS board could respond to CP's  sweetened  offer, however, they had to review the offer with their financial and legal advisors, understand how the merger would affect the firm's operations and impact its shareholders, and prepare a response justifying their decision  That response would not only determine the firm's prospects for many years to come, but could affect Squires's professional reputation and career prospects, as well  The U S  Railroad Industry The U S  railroad industry had a long history of regulation starting with the establishment of the Interstate Commerce Commission (ICC) in 1887 6 ICC mandates and other federal regulation limited what railroads could charge on interstate routes, where they could construct new infrastructure, and whether they could divest rail lines  After growing for years, total rail mileage peaked in 1916 as the federal government began subsidizing highway construction  As trucking became an increasingly important form of competition, the share of intercity freight carried by trains fell steadily through the 1950s and 1960s  The 1970s was an especially difficult decade for railroads as inflation caused costs to rise (e g , fuel, labor, and equipment), yet regulations prevented railroads from raising rates commensurately  The end result was falling returns   the average return on investment (ROI) during the 1970s was 2 and bankruptcies  Penn Central, a Class I railroad, declared bankruptcy in 1970, the largest U S  corporate bankruptcy at that time 10 The Staggers Rail Act of 1980 provided much needed relief to U S  railroads, giving them the flexibility to set their own rates, abandon low density routes, and make acquisitions with limited scrutiny 1 In the following years, a flurry of mergers intended to improve service, efficiency, and safety reduced the number of Class I railroads from 56 to 7 12 In this new consolidated environment, railroads regained financial stability as they streamlined operations and cut costs  For example, employment at Class I railroads fell from 458,000 people in 1980 to 178,000 people in 1998  and the industry's average operating ratio fell from 93  to 85  13 With higher profitability, the average ROI grew to 7  in the 1990s and then to 9 4  by mid 2015 4 (Exhibit 1 provides operating and financial statistics for the major railroads operating in the U S  and Canada as of 2015 ) 15 Two important changes occurred in the 1990s  First, the Surface Transportation Board (STB) replaced the ICC as the primary regulator in 1996, and gained the ability to regulate all mergers and acquisitions  5 Second, the rapid consolidation of Class I railroads continued  Burlington Northern acquired Santa Fe Pacific in 1995 after an intense bidding war with Union Pacific 6 Union Pacific then acquired Southern Pacific in 1995 17 CSX acquired Conrail in 1996 and agreed to split the railroad with Norfolk Southern as a solution to an escalating bidding war 18 and finally, Canadian National acquired Illinois Central in 1998 19 (Exhibit 2 shows data on railroad acquisitions from 1995 2014 ) Rather than enhancing service and improving efficiency as promised, these mergers often disrupted service, increased costs (and prices), and reduced safety, at least in the short term, which prompted heightened regulatory scrutiny 20 For example, after BNSF and Canadian National agreed to merge in December 1999, the STB blocked the merger and froze all major rail mergers for 16 months, beginning in March 2000 21 According to the STB,  the shipping public has not yet fully recovered from the service interruptions associated with the previous round of mergers  from 1995 to 1998   22 The next year, the STB established rules forbidding all railroad mergers unless they were in the public interest, as it tried to create  a stable, balanced, and reliable rail transportation system  23 Under the new rules, companies had to demonstrate that merging with another railroad would boost competition and maintain service quality 24 An STB spokesman said,  Although our new rules and policy statement do not, as the Class I railroads argue, reflect an anti merger bias, we do plan to take a more skeptical 'show me' attitude toward claims of merger benefits and toward claims that no transitional problems would occur  25 At the time, the prevailing view was that another round of consolidation could leave the continent with just two Class I railroads 26 Norfolk Southern Corporation Norfolk Southern Corporation (NS or NSC) was formed in 1982 by the merger of two railways  Norfolk   Western and Southern Railway 27 As the fourth largest Class I railroad operating in North America, NS had 30,456 employees, controlled 20,000 miles of track in 22 eastern states, and served all of the major East Coast ports 28 The company generated $2 0 billion of income on operating revenues of $11 6 billion in 2014 29 (Exhibits 3 and 4 show NS's income statements and balance sheets, respectively ) By early 2015, revenues and profits were falling and the firm's relative cost position was deteriorating  After being in the middle of the pack of Class I railroads in terms of its operating ratio, NS was at the high end of the group as of 2015 30 (Exhibit 5 shows operating ratios over time for Class I railroads)  Analysts, however, expected the firm's performance would improve in the coming years  (Exhibit 6 shows financial projections for NS on a stand alone basis according to equity analysts at UBS in October 2015 ) Squires became CEO of NS on June 1, 2015, at the age of 53 31 When former CEO Charles  Wick  Moorman announced his successor, he said,  I am confident that the company is poised for continued growth, success, and shareholder value creation  32 Squires had joined the company in 1992, as a newly minted graduate of the University of Chicago Law School  He rose through the ranks of the legal division before being named senior vice president of financial planning in 2006, CFO in 2007, and then president in 2013 33 Canadian Pacific Railway Limited Canadian Pacific Railway Ltd  was founded in the late 19th century to connect the major cities in eastern Canada with the less populous western territories  By 1986, CP had become Canada's second  largest company 34 Headquartered in Calgary, Alberta, CP had 13,700 employees and operated 12,500 miles of track in Canada as well as the midwestern and northeastern parts of the United States 35 CP's main competitors were Canadian National Railway Company (Canadian National) in Canada and BNSF Railway in the U S  Midwest 36 With revenues of $5 7 billion and net income of $1 3 billion in 2014, CP was considerably smaller than NS 37 (Exhibits 7 and 8 show CP's income statements and balance sheets, respectively ) 1pc In 2011, hedge fund manager and activist investor William  Bill  Ackman (HBS 1992) acquired a 12  stake in CP through his firm Pershing Square Capital Management 38 Ackman was known in the financial world for his overwhelming confidence and his willingness to place enormous bets based on his convictions 39 For example, he told one author   I don't care what other people think  I invest based on what I believe the opportunity for profit is compared with my estimate of the potential for loss  40 Ackman subsequently forced CP's CEO to resign, ousted the company's board of directors, and installed Hunter Harrison as chief executive after a proxy fight 41 Harrison, a long term railroad executive, had retired as the CEO of Canadian National (CN) in 2009 42 During his time at CN, Harrison had won various awards, including Canadian CEO of the Year43 and Railroader of the Year 44 Harrison believed consolidation was a good way to add critical rail capacity and simultaneously improve efficiency  Toward that end, he had unsuccessfully approached CSX Corp , another Class I railroad located in the eastern United States, in 2014 about a possible merger, arguing,  A pro  competition, customer friendly, safety focused railway combination is one such solution that could not be ignored on its merits by regulators  45 Yet NS's then CEO Moorman said in 2014 that major railroad mergers would be  highly problematic  from both a regulatory and a service perspective 46 Absent mergers, careful cost control could also improve efficiency  In fact, under Harrison's leadership, CP's operating ratio had fallen from 81  in 2011 to close to 60  in 2015 47 In response, the firm's share price during his tenure had soared from less than $68 at the end of 2011 to almost $215 in October 2014, yet had fallen back down to $135 as of early November 2015 48 (CP was traded on both the Toronto and New York stock exchanges ) Bidding for Norfolk Southern Despite market rumors of a possible bid for NS by CP, CP denied the rumors in a press release on November 9, claiming   T here is no material news pending at this time  CP does not comment on market rumor and speculation  4 Nevertheless, NS's stock price increased 11 0  (from $79 87 to $88 62) and CP's price increased 5 9  (from $134 31 to $142 18) on a day the market was down 1 0   Eight days later, after the market closed on November 17, 2015, CP did, in fact, make an offer for NS  Canadian Pacific (CP)    has sent an offer letter to Norfolk Southern Corp  (NS) proposing a business combination      The proposal, which includes a sizable premium in cash and stock offered to NS shareholders, would result in a company with the potential for faster earnings growth than either CP or NS could achieve on their own, all the while maintaining a strong investment grade credit rating 50 NS confirmed that it had received an offer from CP to acquire the firm's shares for $46 72 in cash and a fixed exchange ratio of 0 348 CP shares for each NS share 51 Based on closing stock prices that day, reporters estimated the offer was worth $94 95 per NS share (  $46 72 in cash  0 348   $138 58), which represented an acquisition premium of 9  over NS's closing price of $86 97 52 The next day, after the market incorporated the news of the proposed acquisition, NS's share price increased 6 3  to $92 49, while CP's price increased 5 4  to $146 65 53 NS responded by saying that in addition to facing  significant regulatory hurdles,  the offer was deficient, with a premium of less than 10  over the previous day's closing share price of $86 97 54 CP responded by noting that there had been a significant run up in NS's share price due to market rumors of the impending bid, and that its offer should be compared to an  unaffected  share price that did not include the effect of the potential merger  In addition, CP argued that the merger would result in significant improvements in operating performance and synergies that should explicitly be recognized when valuing the offer 55 On December 4, 2015, the NS board of directors rejected the CP offer, stating that it was  grossly inadequate  56 CEO Squires said  There is a high probability that, after years of disruption and expense, the proposed combination would be rejected by the Surface Transportation Board     Even if the proposed combination were ultimately to be cleared, it would be subject to a wide range of onerous conditions that would reduce the value of the stock consideration that has been proposed 57 Canadian Pacific quickly revised its offer to $32 86 in cash and 0 451 CP shares for each NS share (i e , less cash and more stock) on December 8 58 During a conference call that day, Harrison and Ackman gave formal presentations about the proposed merger and took questions from analysts regarding the merits of the proposed combination  A vocal advocate for the merger, Ackman dismissed the NS board's resistance to the deal as similar to the resistance that followed his efforts to install Harrison as CEO of CP in 2012   I've seen this movie before,  he said 59 Following the second conference call about the deal on December 16, NS and CP closed at $89 79 and $128 56, respectively  (Exhibits 9a and 9b show stock prices for CP and NS from October 1 through December 18 ) The Merger Rationale According to CP, the merger provided an opportunity to create  a 21st century railroad for a 21st century economy  60 Although additional rail capacity was desperately needed to meet the demands try economy  Althou additional rall capacity was desperately needed to meet the demands of a growing economy, it was becoming increasingly difficult to add rail infrastructure in urban areas where most customers were located and railroads exchanged freight with trucks  CP argued that industry consolidation offered the best opportunity to improve efficiency and add incremental capacity without requiring additional infrastructure 6 Importantly, consolidation would also improve service for shippers  Nowhere was the need for additional infrastructure more crucial than in Chicago, Illinois  In 2014, close to 25  of U S  rail traffic passed through Chicago, and the volume of traffic was expected to double over the next 10 years 62 Despite various attempts to add infrastructure, the problem was only getting worse  CP argued that the CP NS merger offered the best opportunity to increase capacity in the critical Chicago train yards  Consolidation enables far better utilization of existing infrastructure  For example, trains interchanged in Chicago today must be broken apart and rebuilt in yards within the city and then delivered to receiving carriers  The process involves multiple interchanges between multiple carriers in multiple yards  A merger would allow these activities to be performed elsewhere so that trains moving through Chicago can move smoothly through the city without exiting the mainline      A merger would allow CP  NS to provide end to end service to customers, without hand offs and interchanges  Reducing these disruptive activities can significantly improve velocity, lower costs, and enable the combined company to move goods more quickly without increasing rates 63 In addition to improving efficiency, CP argued that a CP NS merger would not reduce competition because the two networks met end to end  rather than serving overlapping geographies 64 (Exhibit 10 shows the combined CP NS rail network ) However, to address potential regulatory concerns, CP proposed that the new company would give shippers the choice of where they could connect with another railroad along its network, ending the industry practice of  bottleneck pricing  (i e , monopoly pricing on routes served by a single railroad) and would allow competing railroads to access its railway if the new company was not providing appropriate service or competitive rates in a particular location  Finally, CP also identified significant opportunities to improve operating efficiencies on the NS system, thereby creating additional value 65 According to the plan, CP anticipated that the transaction would close by the end of April 2016, and the STB would render a decision to approve (or not) the merger by December 2017  From May 2016 to December 2017, CP and NS would be merged into a  voting trust  holding company that would allow the two companies to operate independently  Newly created shares in this holding company (CP NS shares) would begin trading immediately  Notably, however, CP proposed that Harrison would immediately resign from CP severing all ties, including his pension and any stock holdings and would become CEO of NS  This meant that Harrison could immediately start implementing the planned operational improvements at NS, independent of the STB's ultimate decision  If the STB ultimately rejected the merger, then the  improved  Norfolk Southern would be spun off, leaving the companies to operate independently  On the other hand, if the STB ultimately approved the merger, then the combined entity would start realizing CP's projected  post merger combination synergies   CP argued that this novel structure was vital to the transaction, as 72  of its projected operational efficiencies were from pre merger operational improvements 66 Table A Projected Merger Benefits ($ millions) 2016 17  $214 0  2018 2019 2020 Pre Merger Operational Improvements Phase in ( ) 67  92  100  Increase in EBIT $844 $1,159 $1,260 Post Merger Combination Synergies Phase in ( ) 25  50  75  Increase in EBIT $0 $0 $124 $248 $371 $495 Projected Total Increase in CP NS EBIT $214 $529 $968 $1,407 $1,631 $1,755 Source  Canadian Pacific Presentation,  CP Value Proposition,  December 8, 2015, p  8  Note  The projections were on a pre tax basis and were net of merger related costs and other restructuring expenses  In total, CP anticipated that the CP NS merger would generate almost $1 8 billion of annual incremental pre tax operating profit (earnings before interest and taxes  EBIT ) by 2021 67 Table A provides CP's projected pre merger operational improvements and post merger combination 2017 42  $529 0  2021 100  $1,260 100  synergies resulting from the merger  The cash flows were on a pre tax basis and were net of merger  related costs and restructuring expenses  The $1 26 billion of pre merger operational improvements included improvements in fuel efficiency ($100 million), train productivity ($610 million), and labor productivity ($550 million)  The $495 million of post merger combination synergies included both revenue and cost synergies ($225 million and $270 million, respectively)  CP assumed a tax rate of 36  for income earned by NS 68 CP argued that its assumed tax rate was conservative because, if the STB approved the merger, the overall tax rate of the combined entity could be somewhat lower  These tax savings expected to be approximately $200 million annually starting in 2018 were not included in the projections of pre merger operating improvements and post merger combination synergies shown in Table A  Finally, CP's CFO Mark Erceg stated that the combined company would initially have a BBB Baa credit rating (Standard   Poor's Moody's) 69 However, because of the combined company's strong ability to generate cash flow, he anticipated that its credit rating would rise to BBB  Baa  by 2017, and its debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio would fall from 4 0x in 2016 to 1 6x in 2020 70 The temporary increase in the combined firm's debt to EBITDA ratio and the decline in its credit rating were due to the fact that CP would borrow funds to pay for the entire cash portion of the merger consideration  CP's  Sweetened  Offer On December 16, CP sweetened its revised offer to include 0 451 units of a CVR in addition to the $32 86 in cash and 0 451 CP shares for each NS share it had offered on December 8  The CVR would expire in October 2017 (18 months after the transaction closed at the end of April 2016 and approximately two months before it expected to receive the final regulatory decision), and would be listed on a major exchange (e g , the NYSE)  At maturity, each CVR would receive a cash payment equal to $175 minus the CP NS share price at maturity up to a maximum cash payment of $25 71,72 To determine the value of the CVR, CP used data on current market interest rates (see Exhibit 11), assumed annual stock price volatility for the combined entity of 25 , and assumed that no dividends would be paid between the closing of the transaction and the expiration of the CVR 73,74 Because the CVR would be highly liquid, NS shareholders could choose to hold the security to maturity or sell it  T hink about this as a long life insurance policy on the trading price        It protects you on a downside case     CP believes that the market will value this (combined) company   the way it's run by Hunter   at a meaningfully higher price and that the CVR ultimately will require no payout by CP  So it's the way you put your money where your mouth is     Canadian Pacific is basically    saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond  Before he could respond, however, he and his advisors had to determine how much the  sweetened  offer was worth  particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer  If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection  If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not  Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal  Time was short and he had a lot to do   T hink about this as a long life insurance policy on the trading price        It protects you on a downside case     CP believes that the market will value this (combined) company   the way it's run by Hunter   at a meaningfully higher price and that the CVR ultimately will require no payout by CP  So it's the way you put your money where your mouth is     Canadian Pacific is basically    saying we're willing to bet $3 4 billion that this stock is above $175 a share (in 2017) 75 Conclusion With a live offer to acquire the firm on the table, Squires had to respond  Before he could respond, however, he and his advisors had to determine how much the  sweetened  offer was worth  particularly given the addition of the CVR and make a recommendation to the NS board members on whether to accept or reject the offer  If they were going to reject the offer, the board had to consider what NS might do next given how quickly it had responded to the prior rejection  If, on the other hand, they accepted the offer, they had to consider whether the merger would receive regulatory approval from the STB and what might happen if it did not  Squires needed to prepare answers to the full range of questions the board members were certain to ask concerning the offer, its value, and the ramifications of accepting the deal  Time was short and he had a lot to do  Select at least 1 post response from the following case  Read the following case  This is an INDIVIDUAL case study (does not require any simulation meeting with a partner) See a review copy of the case posted here  Canadian Pacific's Bid A printable copy of the case should be purchased at Harvard Case Website  Cases made available through HBR are copyright protected for individual usage  In light of the case and materials covered in the course, answer the following questions  1  Why is the NS management team so adamantly opposed to the deal  Are there any benefits of the projected merger for NS  Discuss and explain  2  Discuss with examples, some arguments for and against the proposed merger  3  Describe the value of the  sweetened  offer  Should NS shareholders accept the  sweetened  offer from Dec 16th  Why  Why not  4  What makes the economic rationale for mergers deals complex (for the purpose of negotiation)  What is your top two merger related advice for an acquiring company determining the reservation and aspiration values  With reference to the assigned case, explain why doing due diligence (preparation pre negotiation valuation) is important to completing a merger deal  5  What will it take to build mutual trust and a long term relationship between CP and NS for a smooth post merger integration  Discuss your top two recommendations  Select at least 1 post response from the following questions  Managerial Action Reflection  Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience the importance of personality, motivation, and power differences when it comes to negotiation deals conducted by women (vis a vis men)  Managerial Action Reflection  Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways from the Leary et al article assigned for this module  Managerial Action Reflection  Write a 150 word professional media post (imagine LinkedIn or Twitter), explaining to your audience 2 of your most important takeaways about remaining ethical in conducting a negotiation deal

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Canadian Pacific's Bid for Norfolk Southern Formed in 1982 out of railroads that had been in existence for 100 years, Norfolk Southern Corporation (NS) had

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