The Acquisition of Conrail Corporation

The Acquisition of Conrail Corporation

1. Bankruptcy and Corporate ReorganizationAlfio Shkreta2 June 2013
2. Case summary CSX has put forth a two-tier merger agreement to acquire
Conrail The front-end offer for 40% of the shares is $92.50 The back end offer is an
exchange offer with a ratio of 1.85619 shares of CSX for 1 share of Conrail Conrail
is also a potential a target of Norfolk Southern Both CSX and Norfolk are mature
firms whom operate mostly in the railroad industry and intend to grow through
acquaints as the market is amature one The Pennsylvania antitakeover law makes
the bidding process difficult due to the several provisions incorporated in it The
multiples valuation gives a range of $90.48 - $126.98 The DCF valuation gives a
range of $93.24 - $93.54
3. Background information Formed from the remains of six bankrupt Northeastern
railroads in 1973 Earned its first profit in 1981 - $39.2 million on revenues of $4.2
billion. Privatized through an IPO in 1987 Major player in the Northeastern cities
and their connection with major Midwestern hubs In 1995 it had 23,510 employees,
operated 10,701 miles of track and controlled 29.4% of the Eastern rail freight
market Main financial indicators as of 1995 Operating revenues - $3.686 billion
Operating ratio 79.9% Revenues per employee - $156,784 P/E ratio
12.9ConrailCSX A Virginia-based diversified transportation company (intermodal
services, ocean-container shipping, barging, contract servicesand railroad services)
Major player in the Southeastern and Midwestern States and the Canadian Province
of Ontario In 1995 it had 29,537 employees, operated 18,645 miles of track and
controlled 38.5% of the Eastern rail freight market Main financial indicators as of
1995 Operating revenues - $4.819 billion Operating ratio 76.7% Revenues per
employee - $163,151 P/E ratio 11.6
4. Question 1Why is CSX interested in acquiring Consolidated Rail Corporation
(Conrail)? Describe thearguments for the offer being motivated by synergies, as well
as arguments for themotivation to pre-empt a bid by Norfolk.
5. Strategic choice CSX-Conrail The combined entity would result in more than $8.5
billion in revenues and nearly 70% of the Eastern market CSX-Conrail would be able
to control the rail-way between the Southern ports (CSX), the Northeast (Conrail)
and the Midwest (both). By havinga full access to these markets they new company
would be able to offer services to its clients for a lower price (economies of scale).
This newcombination would restrict the access the presence of Norfolk Southern in
these markets, deviating business towards the new company The Midwest
market, where both firms are heavily present, would become a center of operations
and the result would be a reduction of costs Faster load and unload of goods More
line tracks available for transportation Higher co-operation and greater manpower
Exchange of market knowledge and client base Potential to capitalize on the
opportunity of being the first railroad company to connect the East to the West
Geographically well placed Network already existing Financial capacity present
The railroad industry is a mature market. The only optionto grow is through
acquisitions CSX-Conrail would consolidate overlapping transactions CSX-Conrail
would increase revenue through service improvements Cost synergies of $370
million by the year 200 Additional operating income of $180 millions Revenues
would come from taking industryand taking business over from Norfolk Southern
6. Pre-Empt Bid from Norfolk Southern Norfolk Southern is the most efficient and
best-managed railroad company in the United States Operating ratio 73.5%
Revenue per employee $193,690 Return on sales 15.3% Made and
unsuccessful bid of $1.6 billion for Conrail in the mid 80s. Clearly very interested in
acquiring the firm for strategic reasons It has access in the Southeastern and

Midwestern States and the Canadian Province of Ontario butit lacks the presence in
the Northeastern states which are considered the industrys prize possessors
Financially Norfolk is healthier than CSX Leverage ratio is 33.6%. It can assume
more debt than CSX can (40.1%) Current ratio of Norfolk 111.4% vs. CSXs 64.7%
EPS of Norfolk are $5.44. CSX is at $2.94Norfolk Southern has all the cards to make
a bid that is betterthan the CSX one. It can sustain more liabilities in its balance
sheetand it will benefit from synergies if it potentially merges withConrail. Therefore
the sooner CSX closes the deal the better it isotherwise it faces a major risk. Both
bidders are strategic biddersand therefore the war can result in high valuations for
Conrail whichwould lower the realizable profits
7. Question 2Describe the offer made by CSX. How much is CSX effectively offering
per Conrail share?
8. CSXs offer deal structure1. CSX has advanced an offer to the shareholders of
Conrail. It is a two-tier offerworth an estimated total value of $8.3 billion. An offer is
generally structured inthis way as to gain effective control of the corporation the
first stage andthen acquire the remaining shares at a more favorable price2. CSX will
offer to the front-end shareholders $92.50 in cash for their shares. Thisoffer is
extended to 40% of the shareholders. Once the first stage is completedthe remaining
shareholders of Conrail will have the opportunity to convert oneshare of Conrail for
1.85619 shares of CSX. Based on CSXs stock price of$46.75 that is equal to $86.78.
Counting for the time value of money it meansthat the back-end shareholders will
get around $9 per share less than the front-end shareholders making it an unequal
offer3. Due to regulatory requirements of the State of Pennsylvania, the obligation
tobid for all shares at the same price once a 20% ownership is reached, the front-end
offer is divided in two stages. First CSX will put forth a tender offer for19.7% of
Conrails shares. After that is completed and the shareholders havevoted for the
nullification of the fair value statue, a statute that explicitlyrequires a bidder to
offer to all shareholders the same price unless targetshareholders dismiss this
provision, CSX will proceed to tender the remaining20.3% of the shares4. The CEO of
Conrail will eventually take over the new company after two years.He will get a
salary increase of $2 million. The reason is the fact that Act 36grants exclusivity to
the board to turn down an offer regardless of the priceoffered making a co-operation
with the board and its CEO crucialTwo-tieroffer60% inshares20.3%19.7%40%
at$92.50123 The deal contained several other important provisions1 Break-up fee
of $300 million CSX was granted the right to purchase 15.96 million newly issued
common shares of Conrail ay $92.50 Conrail suspended its poison pill, triggered at
10% ownership level A no-talk clause was included, forbidding Conrail from
pursuing merger discussions with third parties1- The provisions will be discussed in
detail in question 6The deal is not well constructed. Theshareholders will not accept
knowing they canget more out of the bid war. Also the CEOturnover may never
happen because there is nocontract that can uphold forever. Most probablythe first
vote will not succeed
9. CSXs offer effective price Conrail shareholders will have the option to tender
40% of the shares at aprice of $92.50 per share. Even though the process is split in
two phases it willbe consummated within a very short period of time, one month and
thereforethe value of money received is equal for both sub-groups of the front end
offer 36.2 million shares x $92.5 = $3.348 billion Conrails remaining shareholders
will not have the option to get cash for theirshares but will be part of the exchange
programme. They will get 1.85619shares of CSX for one share of Conrail, resulting in
a total 107,791,117 shares.The price of CSX dropped to $46.75. Because the shares
will be converted atsome point in the future I assume that it is fair to calculate the
value with thisprice 100.8 million shares x $46.75 = $4.712 billion Thus summing
both figures, the proceeds from the cash tender offer and theexpected value of
shares once they are converted, I get a total value of $8.06billion ($8.06 billion)/

(90.5 million shares) = $89.06 per share The effective/blended price paid for the
transaction is equal to $89.06 Exhibit 6 presents a summary of recent railroad
acquisitions. Out of 5 merger offers only 3 were anchored successfully. That shows
that there ispresent risk of the CSX-Conrail merger not being concluded and that
would harm the firms reputation and the share prices would suffer leadingto value
destruction for the shareholders In exhibit 1 the stock price of both firms shows
that Conrail is trading currently at its 52-week high and the changes of the price skyrocking arelimited as shown by its past. Conrail is not far from its 52-week high share
price either. This information can serve as an indicator that the shareprice movement
in the upper direction seems to be fairly limited. The synergies will not crystalize in
any time soon therefore the portion ofshareholders whom are being converted as
part of the merger agreement face a big chance of ending with a low value# of
shares Cash Exchanged sharesConrails 40% 36,200,000 $3.348 billionConrails 60%
54,300,000 100,791,117 The information in the case notes the opportunity ofthe
merger being closed by the end of 1997.Assuming that the 60% shareholders whom
have nottendered and are not able to sell in the meantimeand calculating the time
value of money with r beingequal to the cost of equity 16.45% they could end upwith
$74.50Price consideration
10. Question 3Using Multiples valuation, what is the value of Conrail to CSX?
Incorporate the estimatedsynergies in the value. Describe clearly which multiples
you use and why, and describewhich comparison firms you use and why. How does
this value compare to the offer madeby CSX?
11. Transaction multiples value range $90.48 - $126.98 The peer group that I chose
are the transactions that have been completed That is for the simple reason that
because this are transaction multiples, the bid offerencompasses the potential
synergies . As such when the deal is not concluded the numberis biased and it will
give an unrealistic number. Plus the synergies value for the two omittedfirms are
missing (one being Santa Fe Pacific whom I cannot twice) When a bidder puts forth
an offer he will include a premium as a result of gaining controlfor the enterprise.
Thus including deals whom are not concluded would lead to biasednumbers Santa
Fe Pacific, Chicago and North Western and Southern Pacific The best peer group
would be selected on the following criteria Business risk all of the peer members
are part of the same industry and face on averagethe same risks. There may be
some risk differentiation due to some firms operating in theWest vs. Midwest vs. East
but that does not deteriorate the quality of the peer group Growth expectations
the railroad market is a mature one. The growth is to be expectedthrough
acquisitions and no technological breakthrough is expected Profitability on
average Conrail is more profitable than the peer group in terms of netincome and it
depends very much on how efficient assets are used Leverage structure the peer
group is more levered than Conrail Considering the multiples presented below, CSX
is offering less than the counterparts in the otherdeals. An important difference that
are the synergies (as a % of targets operating expenses) to berealized which are
estimated to be lower for Conrail and that would certainly affect the price to
beoffered as there is less to get from the targetConsiderationsEPS Book Value Sales
EBITDASanta Fe Specific 21.4x 4.5x 2.6x 13.1xChicago and North 18.3x 5.5x 2.4x
8.5xSouthern Pacific 18.4x 3.7x 1.7x 12.2xAverage 19.4x 4.6x 2.2x 11.3xConrail
18.4x 2.19x 1.72x 4.26xOffer Price Per Share as a Multiple ofTotal Enterprise Value as
amultiple ofProjected synergies22.30%27.70%24.50%24.83%17%Inputs As the
offer price I use the $89.06 The EV is calculated as the # offully diluted shares
outstandingtimes the pre-bid price $6.425 billion The EPS that I use is the 1996
oneas to be as close as possible tothe bid time and not the forwardEPS For book
value I use the bookvalue of equity When calculating the EBITDA andSales multiple
I subtract the debtof ConrailValuation range The transaction multiplesvaluation
gives a range $90.48 - $151.00 The EPS multiple and the Salesmultiple are close

to the industryaverage giving a range value veryclose to the offer price $90.48 $93.90 Yet the EPS and Book Value arevery much affected from theleverage
structure and thus arenot a true representation undermultiple valuation EBITDA
$126.98
12. Valuation multiples explanationSanta Fe Pacific Deals not completed are
notconsidered due to possible biasKansas City Southern Chicago & North Western
Southern Pacific CommentsStatusSynergies11- As a percent of the targets operating
expensesBusinessRiskGrowthExpectationProfitabilityLeverage+ + + Synergies
are very important asthey affect the bid price. If theyare n/a I discard the deal22.3%
n/a 27.7% 24.5% Companies operate in therailroad industry which is cyclical.They
generate most revenuesfrom this streamline+ + + + Due to maturity the growth
willcome from mergers andincreasing efficiency of assets+ + + + Operating ratio
differs a bit, yetin terms of net income Conraildoes slightly better+/- +/- +/- +/- The
D/E ratio is very different. Itleads to huge variation in termsof value. Under this
hypothesisthe best multiples would be theSales and EBITDA which are lessaffected
from the leverage. Theindustry is quite capital intensiveso debt is important.
Followingon this logic the value rangewould be $90.48 - $126.98 Peer
Group Yes Yes YesNo
13. Question 4Using DCF valuation, what is the value of Conrail to CSX? (You should
use the pre-announcement share value of Conrail as the stand alone value and then
value theestimated synergies with the DCF method). Describe clearly what cash
flows and discountrate you use and what are these based on. How does this value
compare to the offermade by CSX?
14. DCF value range $93.24 - $93.54 I start with the synergies as presented in
Exhibit 7 I calculate the Cost of Equity based on the inputs given in the case. In
order to address the differentbetas for Conrail I make three calculations. One with
Conrails beta, one with CSXs beta and onefor the average of both the Conrail and
CSX betas. The range of the cost of equity is 16.45 16.82%. That leads to very
similar synergy per share price (see Appendix). The beta of NorfolkSouthern is 1.15.
This entity is very efficient and because the new CSX-Conrail company will belevered
even more I did not choose a beta close to Norfolk Southern as it would be not a very
goodrepresentative Afterwards I calculated the Terminal Value using a growth rate
of 3%. Due to a mature market theinflation rate is a reasonable number. According to
an Analyst report of UBS for the railroadindustry a growth rate of 1-3% is very
adequate and ensures good financial returns Then I discount the value with the
cost of equity, for the three scenarios. I add the number and findthe total value of
the synergies. Dividing it by the total # of shares I get the value of the synergy
pershare The stand alone value is $71.00. I add the value of the synergies per
share and find the value pershare of Conrail with the synergies included that
provides a roof value for the bid form CSX Synergies are assumed to be interest
free. If they are not it would be essential to know the type ofdebt being assumed and
the repayment attached to it, to value the PV of synergiesConsiderations Inputs The
risk free rate is the US T-billof 30-years equal to 6.83% The market premium is the
yieldon Long-term Corporate BondsAAA because both Conrail andCSX are Class I
railroads and it isequal to 7.40% The growth rate, due to a maturemarket is equal
to 3% (inflationrate) The beta of Conrail and CSX arevery similar. The effect on
thevalue is very littleValuation range The DCF valuation gives a range $93.24 $93.54 That is very close to the offer forthe front-end offer. It differs with$4 for the
back-end offer The cost of equity calculated forthe beta of Conrail, CSX and
bothdifferentiates is small amountsleading to a narrow range of thepresent value of
synergies. I usethe cost of equity as it goes to theequity (firm) and it is not used
fordebt paymentsSynergies DCF Valuation ($ millions except per share prices)1997E
1998E 1999E 2000E 2001E T.ValueTotail Gain in Operating income 188 396 550 567

4342.08Tax (35%) 65.8 138.6 192.5 198.45 1519.73FCFE 122.2 257.4 357.5 368.55
2822.35Cost of equtiy 16.45% 16.45% 16.45% 16.45% 16.45%PV of FCFE 104.94
189.81 226.39 200.42 1318.00Sum 2,039.56 Rf 6.83%# of shares 90.5 M. Premium
7.40%Synergies per share 22.54 Conrail 1.3Pre-bid Price $71.00 Grow th rate
3%Share price $93.54 C. Equity 16.45%
15. Question 5Why did CSX make a two-tiered offer? For the shareholders of Conrail,
does this make adifference relative to an all cash offer?
16. Two-tiered offer CSX will first acquire 19.7% at $92.50 of the common shares
outstanding of Conrail because it has two sideline two major issues: The law
explicitly requires bidders holding 20% or more of a companys stock to offer to all
shareholders the same price. In order not toextend the offer to all stockholders CSX
has agreed with Conrails management to nullify this provision Under Act 36 any
entity who brings its voting power above the levels of 20%, 33% and 50% possesses
the so-called control shares. If theentity manages through market operations to get
this share percentage but without the approval of the board losses its voting
rights.Regardless of the amount of shares that the bidder gets he will be bound to
only voting rights of 20%. That would mean a hugeeconomical expense, a possible
majority share ownership to whom there is a limited voting right opportunity After
the board agrees to get rid off the above mentioned issues CSX will proceed with a
cash offer to acquire the remaining 20.3% of theshares at the same price. That
would put CSX share ownership at 40%. Looking at the ownership structure before
CSX does acquire any sharesthere are 4 groups of stock holders, thus there is
concentrated ownership structure requiring a big chunk of shares to achieve entity
control Non-taxable institutions 48% CSX 40% Tax-paying institutions 34%
Non-taxable institutions 28.8% Individuals 17% Tax- paying institutions
20.4% Insiders 1% Individuals 10.2%Insiders - .6% Assuming that the merger
is not blocked in the first instance and that due to the more favorable economic
conditions and taking economicrationality at par, everyone would try to tender so at
to get $92.50. That would result is a new ownership structure granting effective
control toCSX and making it the largest shareholder, able to influence company
decision-making The two-tier structure helps to mitigate the free-rider problem
The tendering shareholders get the higher price The non-tendering shareholders are
hurt P0 - $71.00 PT - $92.50 PE - $86.78 PB - $89.06Successful FailsTender
$92.50 $71Not tender $86.78 $71
17. Why not an all cash offer? A two-tier offer is per se constructed in this way as to
pay less to the non-tendering stockholders. In this deal $3.348 billion are paid in
cash The remaining shareowners face major risks. The stock price can go up, but at
the current levels it is nearly around its 1-year peek. The chancesof going down are
much higher and that would result in a big loss to them and unequal payment for
holding the same security as did the frond-end tenderers If the price of the new
entity goes up a lot then it is the bidder who loses because it granted shares to the
target with a favorable ratio CSX financial position as of 1995 Total current assets $1.935 billion Total current liabilities - $2.991 billion Long-term debt - $2.222
billion D/E 40.1% CSXs balance sheet is not at the greatest shape. With only
$660 million in cash, and with large operations requiring day-to-day cash infusion
itwill go to the capital market to raise financing for its merger plans. It can only allow
up to a certain level of debt in its balance sheet, therefore itis not extending an all
cash offer. More debt is unsustainable and that would shoot up the leverage ratio far
from the current one making accessin the future at a higher cost of capital The
operation will add another $3.348 billion of debt, most probably in the form of longterm liabilities (assumed). With revenues being onsteady level and the operating
ratio being not the best in the industry, CSX would be extremely leveraged if it ought
to extend an all cash offer.That would not guarantee a more efficient operating
entity The DCF valuation gives a roof price of $93.54. That is assuming all synergies

are realized and paying for all synergies. As a bidder that is notfinancially smart, to
calculate the synergies entirely in your bid offer, therefore the two-tier offer allows
for a part of the synergies to be retainedand not paid to the current shareholders of
Conrail In the ownership structure of Conrail a large percentage, 48% is hold by
non-taxable institutions. That is a very important indicator because theyare more
incentivized to tender as they would not pay taxes if they cash out. The 40% frontend offer captures these feature as well because itallows for a majority of them to
tender and keep the full economic remuneration. That is another reason why it is not
a full cash offer
18. Question 6Describe the anti-takeover devices in the deal structure: 1) no-talk
clause, 2) poison pill, 3)break-up fee, 4) lock up option. What are these devices and
why would CSX or Conrailwant to have them included?
19. Defensive mechanisms (1) A no-talk clause is an agreement between the bidder
(CSX) and the seller (Conrail) that bars the later from soliciting a purchaseproposal
from a third party Yet in this case the board of Conrail has the opportunity to
terminate the merger agreement under a # of conditions First it risks breaching its
fiduciary duties towards the shareholders if it does not consider another put forth.
Due to theleeway of the definition of violation of fiduciary duty under Pennsylvania
law the board could uphold this statue forseveral year. Second the board had the
right to terminate the merger agreement in case when a second offer would make it
unlikelyfor CSX to close the deal or win the opt-out vote In the way the no-talk
clause is structured it mirrors more a window shop provision in the sense that the
board is not obligedto go and search for other potential bidders but it can value
offers if they are presented to themNo-talkclausePoisonpill A poison pill (rights
plan) is a security that gives holders the rights to purchase stock at a discount in the
form of common stockdividends. It can be adopted without shareholder approval and
its an exclusive mechanisms useable by the board of directors It wards-off potential
hostile offers The poison pill provision imposes losses on the acquirer and dilutes
his/her equity provision In the Conrail case the trigger level was at 10% and the
discount factor was 50% of the current market price. The mechanism ishighly
effective if the board does not like the bidder but due to the friendly nature of the
merger and the fact that after twoyears the current CEO of Conrail would take over
the company the board decided not to use the pillBreak-up fee A break-up fee is a
common feature used in merger agreements and it serves two main purposes If the
seller decides to back-off from the deal it will serve as a compensation for the bidder
to cover costs (legalcounseling, financial advisors) and for the possible reputational
damages It can discourage other bidders as they would have to offer a counter-bid
that would cover the amount payable due tothe termination, thus increasing the
costs and making the offer less attractive The industry average is about 1-3%. In
the CSX-Conrail merger the amount is $300 million. That represents 3.6% of the
mergervalue. It is a bit higher than the average and I believe that is for two
purposes. First the value of the entire operation is very bigand therefore a deviation
is acceptable and second knowing the interest shown from Norfolk Southern, CSX
wants to make it ashard as possible for them to get a grip of Conrail
20. Defensive mechanisms (2) A lock-up stock option is the right/option to buy
authorized but unissued shares. It is a common mechanism to protectfriendly deals
Conrail granted to CSX the option to buy 15.96 million newly issued common shares
which would represent 14.99% of thecommon shares outstanding The purchase
price was $92.50 (equal to the offer price) The advantages of the lock-up stock
option are It allows the initial bidder to profit from a higher bid from a third party It
grants the bidder the option to influence the targets shareholder voteLockupoption Conrail had a poison pill already in place, before CSX presented it offer.
The rationale to have such a defense mechanism is to: Ward-off unsolicited,
coercive, and preclusive offers that would lead to a change of control or corporate

policy. This mechanism is usedto ensure that directors have the right to run the
business as they best believe and to stop current shareholders from tendering
theirshares to third parties such as T. Boone Pickens Jr. Conrail has a classified
board and that does give significant protection to the board members and makes it
very difficult to control it CSX wants to include the above mentioned provisions
(break-up fee, no-talk and lock-up ) as to: Recover the economical expenses and
reputational damages in case the deal goes bust To ensure the exclusivity of the
deal and to deteriorate other potential biddersClassifiedboard A classified board is
a structure where directors serve for different time lengths Conrails board member
structure is such that only one-third of them were elected each year meaning that a
bidder whowould want to start a proxy fight was unable to get a majority of board
member within the first-year It would be difficult for CSX to get the merger
concluded if the board would be against it because they could upheld theprovisions
(poison pill, fair value) for a long period
21. AppendixSynergies DCF Valuation ($ millions except per share prices)1997E
1998E 1999E 2000E 2001E T.ValueTotail Gain in Operating income 188 396 550 567
4342.08Tax (35%) 65.8 138.6 192.5 198.45 1519.73FCFE 122.2 257.4 357.5 368.55
2822.35Cost of equtiy 16.82% 16.82% 16.82% 16.82% 16.82%PV of FCFE 104.61
188.61 224.25 197.89 1297.25Sum 2,012.61 Rf 6.83%# of shares 90.5 M. Premium
7.40%Synergies per share 22.24 CSX 1.35Pre-bid Price $71.00 Grow th rate
3%Share price $93.24 C. Equity 16.82%Synergies DCF Valuation ($ millions except
per share prices)1997E 1998E 1999E 2000E 2001E T.ValueTotail Gain in Operating
income 188 396 550 567 4342.08Tax (35%) 65.8 138.6 192.5 198.45 1519.73FCFE
122.2 257.4 357.5 368.55 2822.35Cost of equtiy 16.64% 16.64% 16.64% 16.64%
16.64%PV of FCFE 104.77 189.21 225.31 199.15 1307.58Sum 2,026.02 Rf 6.83%# of
shares 90.5 M. Premium 7.40%Synergies per share 22.39 Avg. 1.325Pre-bid Price
$71.00 Grow th rate 3%Share price $93.39 C. Equity 16.64%Inputs The risk free
rate is the US T-billof 30-years equal to 6.83% The market premium is the yieldon
Long-term Corporate BondsAAA because both Conrail andCSX are Class I railroads
and it isequal to 7.40% The growth rate, due to a maturemarket is equal to 3%
(inflationrate) The beta of Conrail and CSX arevery similar. The effect on thevalue is
very little For the first figure the beta of CSXis used. It leads to a Cost of
equityequal to 16.82% and a share priceof $93.24 For the second figure the
averagebeta of CSX and Conrail is used. Itleads to a Cost of equity equal to16.64%
and a share price of$93.39. Levering and Un-Leveringdoes not lead to
significantdifferences