HARVARD I BUSINEssiscHOOL 9-298-006 REV: JULY 20, 2005 BENJAMIN C. ESTY The Acquisition of Consolidated Rail Corporation (A) After eight days of intense negotiations in a New York City hotel room, executives from CSX Corporation (CSX) and Consolidated Rail Corporation (Conrail), the first- and third-largest railroads in the Eastern United States, announced an $8.3 billion merger.1 This combination would create the second largest rail system in the United States and by far the largest rail system east of the Mississippi River. John W. Snow, CSX’s chief executive officer, announced the merger on October 15, 1996, proclaiming, “This merger of equals represents a strategic combination that will provide excellent value for our customers and our shareholders, and is consistent with sound public policy. This is the right merger at the right time between the right companies.”2 David M. LeVan, Conrail’s chief executive officer, concurred. “We are delighted to be merging with our ideal partner. Our companies share an uncompromising commitment to safety, operating excellence, and superior service and have compatible cultures that will expedite realization of the benefits of the merger.”3 Railroading Background4 Although its roots go back to the early 1800s, American railroading did not reach its heyday until the mid-1800s. Yet after two decades of explosive growth, the industry experienced a period of dramatic consolidation in the 1870s as railroads began acquiring other railroads in an attempt to lower costs. Despite the high cost of building and maintaining lines, expansion through acquisition proved to be very profitable because it reduced marginal costs significantly. As costs fell, however, railroads began to compete on price, causing many of them to fail. Recognizing the inherent danger in this form of competition, many of the surviving railroads formed cartels to allocate traffic and revenues. To prevent monopolistic pricing in a market without substitutes for long-haul transportation, the federal government intervened and established regulations on interstate rates. In the following years, the government extended its regulatory reach to include control of railroad mergers, infrastructure construction, and divestiture of rail lines. By the turn of the century, railroading had recovered and the industry once again entered an expansionary period. Railroads dominated the freight transportation business until trucking emerged as a powerful competitor in the 1940s. The rise of trucking resulted from not only innovations in motor and tire technologies, but also enormous investment in highway infrastructure by the federal government. Unlike railroads, which were responsible for constructing their own rail lines, trucking ________________________________________________________________________________________________________________ Professor Professor Benjamin C. Esty and Research Associate Mathew Mateo Millett prepared this case. Lori Flees (MBA ‘97) prepared an earlier version of the case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 1998 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 55 298-006 The Acquisition of Consolidated Rail Corporation (A) firms were not responsible for building roads. As a result, trucks could provide cheaper, and more flexible, transportation, especially over short distances. Railroads responded to declining profitability during the 1950s and early 1960s by trying to abandon unprofitable routes, merge with other railroads, and lower costs. But they faced significant regulatory impediments on all three fronts. The problems became worse in the early 1970s as inflation raised operating expenses. With rising costs, yet fixed prices, railroads were unable to generate profits. By 1972, the six largest Northeastern railroads had filed for bankruptcy. Critics argued that without some form of deregulation, the industry might collapse. In response to the failures, Congress passed the Stagger’s Rail Act of 1980, a deregulatory act that gave railroads the ability to set prices in competitive markets, abandon unprofitable lines, and pursue mergers and acquisitions. This Act caused the structure of the railroad industry to change dramatically. Consolidation reduced the number of Class I railroads (a classification based on revenue) from 40 to nine over the next 15 years. It also changed the way that railroads did business. Between 1980 and 1995, the number of railroad employees fell from 458,000 to 188,000 as railroads slashed crew sizes and computerized dispatching systems.5 As employment fell, measures of labor productivity, such as carloads per employee, increased commensurately. At the same time, railroads took advantage of their new ability to close unprofitable lines and shut more than one-third of their route-miles.6 These changes had their intended effect as industry profitability improved. The industry operating ratio (defined as the ratio of operating expenses to operating revenues—railroad analysts’ key profitability measure) fell from 93.3% in 1980 to 80.0% in 1995.7 With lower costs, railroads began to recapture market share from the trucking industry for the first time in years. By 1995, railroads carried 41% of the U.S. freight, up from 36% in 1985.8 Another round of consolidation began in the mid 1990s as railroads saw an opportunity to further reduce costs through economies of scale. In late 1995, Burlington Northern acquired Santa Fe Pacific in a deal valued at $4.0 billion, but only after an intense bidding war with Union Pacific.9 Burlington Northern Santa Fe (BNSF), the resulting entity, estimated the merger would result in $560 million of synergies annually. In fact, BNSF began to show improvement within a year—operating expenses fell by 1% while revenues increased by 3%.10 The following year, Union Pacific acquired Southern Pacific for $5.4 billion. Again the companies projected large synergies. In this instance, the estimate was $660 million of synergies annually within five years.11 Although these deals involved only western railroads, analysts saw them as two more steps down the path towards a time when the country would have only two major transcontinental railroads. Nevertheless, the Surface Transportation Board (STB), the federal regulator of railroads, approved both deals with little interference. Whereas these mergers focused primarily on consolidating domestic rail traffic, several US railroads were also seeking to capitalize on the possibility of increased North-South rail traffic following the passage of the North American Free Trade Agreement (NAFTA) in 1994. Union Pacific, Kansas City Southern, and Illinois Central all formed joint ventures with Mexican railroads hoping to create seamless rail service between Mexico, the United States, and Canada. What was lacking, however, was full East-West connections, as well as solid ties into and across Canada. Consolidated Rail Corporation (Conrail) In 1973, Congress passed the Regional Rail Reorganization Act, which created Philadelphia-based Conrail out of the remains of the six bankrupt, Northeastern railroads. Despite an infusion of more than $3.3 billion of federal funds, Conrail continued to lose money through 1980. Like other railroads, things 2 56 The Acquisition of Consolidated Rail Corporation (A) 298-006 began to change for Conrail with the passage of the Staggers Act in 1980. It earned its first profit—$39.2 million on revenues of $4.2 billion—in 1981. Within three years, Conrail’s net income jumped to $500 million on revenues of $3.4 billion as it reduced headcount and closed unprofitable routes. Based on Conrail’s financial strength, Congress began to consider ways of privatizing it. At the time, both Norfolk Southern and CSX had indicated an interest in acquiring Conrail. While CSX argued that the railroad should be split between the two, Norfolk Southern bid $1.6 billion for the entire company. Instead of selling Conrail to either one, Congress decided to sell it in 1987 using an initial public offering (IPO), the largest IPO in U.S. history at that time. By 1995, Conrail had 23,510 employees, operated 10,701 miles of track, and controlled 29.4% of the Eastern rail freight market. Exhibit 1 provides comparative operating and financial statistics for selected railroads while Exhibits 2 and 3 provide balance sheet and income statement information for Conrail. Its routes connected the major Northeastern cities, such as Philadelphia, Baltimore, Boston, and New York, with major Midwestern hubs, such as Chicago, St. Louis, and Detroit. Although Conrail had near monopoly control over the lucrative Northeast rail market, a market many considered to be one of the industry’s prize possessions, it was the least efficient railroad in the East. It also faced tough competition from trucking, which had a dominant share of the total Northeast freight market. CSX Corporation (CSX) In contrast to Conrail and Norfolk Southern, whose major business was railroading, Richmond, Virginia-based CSX was a diversified transportation company providing intermodal service (transportation of truck-trailers and containers by rail-car), ocean-container shipping, barging, and contract logistics services in addition to railroad services. Its business units included Sea-Land Services, which operated 28 marine terminal facilities and a fleet of 105 container ships; American Commercial Lines, which operated 116 tugboats and 3,200 barges; CSX Intermodal, which provided intermodal services and facilities; CSX Transportation, which provided rail freight services; and several resort and real estate holdings. CSX’s railroad subsidiary was the result of the merger of three railroads: the Seaboard Coast Line, the Chesapeake and Ohio Railway, and the Baltimore and Ohio Railroad. By 1995, CSX had 29,537 employees, operated 18,645 miles of track, and controlled 38.5% of the Eastern rail freight market, the largest share of the three Eastern, Class 1 railroads (see Exhibit 1). Its routes connected 20 Southeastern and Midwestern States and the Canadian Province of Ontario. Exhibit 4 and 5 provide balance sheet and income statement information for CSX. Norfolk Southern Corporation (Norfolk Southern) Norfolk Southern, the third major Eastern railroad, had its headquarters in Norfolk, Virginia. Although the company owned several other businesses, including North American Van Lines (a motor carrier) and Pocahontas Land Corporation (a natural resources company that managed natural gas, coal, and timber resources), Norfolk Southern’s major business was railroading. It had 24,488 railroad employees, operated 14,415 miles of track, and controlled 32.1% of the Eastern rail freight market in 1995. Exhibits 4 and 5 present Norfolk Southern’s balance sheet and income statement information. Like CSX, its routes connected 20 Southeastern and Midwestern States and the Canadian Province of Ontario. 3 57 298-006 The Acquisition of Consolidated Rail Corporation (A) Industry observers widely regarded Norfolk Southern as the most efficient and best-managed railroad in the United States (see Exhibit 1). It also was an industry leader in technological innovation and safety. In fact, in 1995 the railroad received an unprecedented sixth consecutive E. H. Harriman Memorial Gold Medal Award for employee safety. The CSX-Conrail Merger The CSX-Conrail merger would create an entity with more than $8.5 billion in rail revenue and almost 70% of the Eastern market. According to the merger plan, CSX-Conrail would locate the combined company’s headquarters in Philadelphia, implement a succession plan allowing Conrail’s LeVan to replace CSX’s Snow as chief executive officer within two years, and increase LeVan’s annual compensation by about $2 million so that it was commensurate with Snow’s compensation.12 Both companies hired investment banks to advise them on the deal and to provide fairness opinions. Conrail retained Lazard Frères and Morgan Stanley as financial advisors. Their fees totaled 0.17% and 0.13% of the deal value, respectively, and both had payments tied to specific deal milestones. For example, Conrail would pay Lazard Frères a total of $14 million divided into three payments: $2.75 million at the time of the merger announcement, $3.75 million once Conrail shareholders approved the merger, and the remainder once the deal was completed. On the other side of the transaction, CSX retained Wasserstein Perella and agreed to pay them $19 million, also divided over three milestones. The Structure of the CSX-Conrail Deal CSX offered to acquire Conrail in a two-tiered deal worth $8.3 billion at announcement. On the day they announced the merger, Conrail’s stock price jumped from $71.00 to $85.13, while CSX’s stock price fell from $49.50 to $46.75. Conrail had been trading around $71.00, plus or minus a few dollars, for most of the past year. Although two-tiered offers were relatively common in the 1980s, they were used far less frequently in the 1990s. Under the agreement, CSX would purchase 90.5 million Conrail shares (“acquisition shares”) to complete the acquisition. This sum included common shares currently outstanding, preferred shares convertible to common shares, and employee incentive stock options exercisable in the event of an acquisition. CSX would pay $92.50 per share in cash for the first 40% of Conrail’s acquisition shares (the front-end offer) and would exchange shares in the ratio of 1.85619:1.0 (CSX:Conrail) for the remaining 60% (the back-end offer). Based on CSX’s stock price of $46.75, the offer had a blended value of $89.07 per share CSX planned to execute the front-end offer in two stages. The first stage, a cash tender offer for 17.86 million shares at $92.50 per share, began the day after the merger announcement. These shares represented 19.7% of Conrail’s acquisition shares. The second stage, another cash tender offer for an additional 20.3% of Conrail’s acquisition shares at the same price, could proceed only after Conrail shareholders approved the deal as required under Pennsylvania law. Pennsylvania’s Business Corporation Law, one of the toughest antitakeover statutes in the country, regulated acquisitions of Pennsylvania companies. Several of its many provisions were relevant to this transaction. First, the law required bidders holding 20% or more of a company’s stock to offer all shareholders the same price unless target shareholders explicitly voted to nullify this provision (the “fair value” statute). The Pennsylvania state government passed this provision after T. Boone Pickens Jr. made an unsolicited, two-tiered offer for Pittsburgh-based Gulf Oil in 1984. Because 4 58 The Acquisition of Consolidated Rail Corporation (A) 298-006 CSX had proposed a two-tiered offer with different prices, Conrail shareholders would have to “optout” of the Pennsylvania statute before CSX could purchase more than 19.9% of the shares—this regulation was the reason for executing the front-end offer in two stages. Second, the statute limited a bidder’s voting rights to a maximum of 20% of total shares outstanding, regardless of the percentage actually owned, unless shareholders or management approved the right to vote all the shares (the “voting rights” statute). Because Conrail’s management had approved the merger, CSX satisfied this requirement. Finally, the law required management to consider and protect the interests of employees and the community where the target was located in addition to meeting their fiduciary responsibility to shareholders (the “constituency” statute). One of the most important constituents was Conrail’s unionized workforce. On the day of the announcement, the unions, which represented approximately 90% of Conrail’s employees, did not state a position in favor or against the merger.13 An opt-out vote, as required by the fair value statute, was scheduled for mid-November. At the time of the vote, CSX would own 17.86 million Conrail’s shares from the first-stage tender offer, Conrail management would own approximately 1.3 million shares, and employee trusts (which included an employee stock option program and a traditional benefits trust), which reportedly supported the merger, would own another 13.0 million shares. Thus, parties in support of the merger would control 35.5% of the acquisition shares and would need only another 14.6% of the acquisition shares to vote in favor of opting-out for it to pass. Following shareholder approval, and successful completion of the second cash tender offer, CSX would proceed with the back-end offer for the remaining 60% of Conrail’s shares. The back-end offer would not be completed until the STB approved the merger, which might not occur until late 1997. Besides the two-tiered structure, the merger agreement contained several other important provisions. For example, the agreement contained a “break-up” fee, which obligated Conrail to pay CSX $300 million if the transaction did not take place. Break-up fees, which were becoming more common in the 1990s, typically averaged 1-3% of the deal value.14 Second, Conrail granted CSX the option to purchase 15.96 million newly issued common shares at $92.50 per share. These options, known as “lock-up” options, typically allowed bidders to acquire between 10% to 20% of a target’s fully diluted shares.15 Third, Conrail suspended its “poison pill.” Poison pills, also known as shareholder-rights plans, permitted companies to issue discounted shares in the event an outside party achieved a certain ownership level or made an unsolicited takeover offer. In this case, each Conrail shareholder had the right to purchase an additional share at a 50% discount to the current market price for each share owned if an outsider purchased 10% or more of Conrail.16 Finally, the merger agreement included a clause forbidding Conrail from pursuing merger discussions with any other party for a period of six months (the “no talk” clause). The no-talk clause essentially forbid Conrail from soliciting other bids. Yet if another offer did emerge, the Conrail board could consider the bid and possibly terminate its merger agreement with CSX under a number of conditions. First, Conrail’s board could consider another offer if, by not considering it, the board would be in violation of its fiduciary duty. But Conrail’s board would have significant leeway in defining fiduciary duty under the constituency statute of Pennsylvania’s antitakeover law. And because Conrail had a “classified board”, which meant that only one-third of the directors were elected each year, the board could uphold this statute for several years to come even if one-third of the directors were replaced at the next annual meeting. Alternatively, the board could terminate the merger agreement if another offer made it unlikely that CSX could complete the merger or win the upcoming opt-out vote. 5 59 298-006 The Acquisition of Consolidated Rail Corporation (A) Conrail Acquisition Economics Over the previous few years, there had been several large mergers in the railroad industry. Exhibit 6 provides data on the five largest announced railroad acquisitions in recent years. Besides these transactions, there were no other transactions in the past five years in which the total consideration paid was more than $400 million. Like the previous deals, value creation for the CSX-Conrail deal would result from the merged company’s ability to consolidate overlapping operations and to increase revenue through service improvements. CSX and Conrail estimated that cost reduction would yield an additional $370 million in annual operating income by the year 2000, net of merger costs.17 Over the same period, they projected that revenue increases would yield an additional $180 million in annual operating income.18 Most of the revenue gains would come at Norfolk Southern’s expense, though a significant fraction would also come from the trucking industry. CSX and Conrail were careful to note that the $180 million figure included the expected revenue loss due to providing Norfolk Southern with greater access to markets currently served exclusively by CSX.19 Exhibits 7 and 8 present the projected gains in operating income and selected financial market data, respectively. This merger would improve CSX-Conrail’s competitive position in two ways. First, the combined rail networks would facilitate long-haul, contiguous, and, therefore, low-cost service between the Southern ports, the Northeast, and the Midwest. Because Norfolk Southern lacked access to the Northeast market, it would be less able to service long-haul routes from either the South or Midwest. Exhibit 9 provides a comparison of the pro forma CSX-Conrail and Norfolk Southern rail networks. Second, even in the shorter-haul routes between the Midwest and the South, CSX-Conrail would become more competitive through cost reduction. Exhibit 10 presents the results of a model of industry economics and efficiency. Using current cost and revenue data combined with estimates of merger synergies and historical trends, the model projects operating ratios for a combined CSX-Conrail and for Norfolk Southern. If CSX-Conrail were to achieve its projected revenue gains and cost savings, it would become more efficient than Norfolk Southern, at least according to this aggregate measure. Publicly, CSX claimed the merger was “. . . about growth and the future of the rail industry that sets the second act for a U.S. rail renaissance.”20 Yet one analyst gave a more cynical interpretation. He said that CSX’s motives were primarily driven by the “. . . fear that someone else was going to do it first. CSX-Conrail smacks of a preemptive strike. CSX doesn’t want Norfolk Southern to get Conrail.”21 The Conrail Shareholder Decision On October 16, 1996, the day after CSX and Conrail announced the merger, CSX commenced the first stage of its cash tender offer at $92.50 per share. Sometime before November 15th, the day on which CSX’s offer expired, Conrail shareholders would have to decide whether to tender their shares. Given the ownership structure at the time (non-taxable institutions, tax-paying institutions, individuals, and insiders owned 48%, 34%, 17%, and 1% of Conrail’s acquisition shares, respectively), it was not clear who would tender shares or how many.22 If shareholders tendered more than 19.7% of the shares, then CSX would buy the shares on a pro rata basis; if shareholders tendered less than 19.7%, CSX could either buy them all or withdraw its offer. 6 60 The Acquisition of Consolidated Rail Corporation (A) Exhibit 1 298-006 Selected Railroad Statistics (1995) BNSFa Conrail CSX Norfolk Southern Union Pacific Railroad Operations Results ($ millions) Operating Revenues Operating Expenses Operating Income Operating Ratio (%)b $8,150 6,617 1,533 81.2% $3,686 3,230 456 79.9% $4,819 3,951 868 76.7% $4,012 2,950 1,062 73.5% $6,602 5,207 1,395 78.9% Railroad Operations Data Railroad Employees Miles of Track Operated Total Carloads Originated (thousands) Tons Originated (thousands) 45,656 31,326 5,967 388,423 23,510 10,701 2,531 134,651 29,537 18,645 4,402 320,419 24,488 14,415 3,435 223,000 35,001 22,785 4,010 257,483 $178,509 260,167 1,366 20.98 $156,784 344,454 1,456 27.37 $163,151 258,461 1,095 15.04 $193,690 278,321 1,168 17.99 $188,623 289,752 1,646 25.64 9.0% 14.6 84.0 53.3 11.7 11.4% 9.0 59.5 108.9 12.9 6.9% 15.5 40.1 64.7 11.6 15.3% 15.0 33.6 111.4 12.8 12.6% 16.5 110.7 88.4 19.5 $83.88 47.50 78.00 $73.88 51.00 70.00 $45.63 35.13 45.63 $81.25 60.63 79.38 $47.09 31.59 44.48 Railroad Productivity Data ($) Revenue per Employee Revenue per Mile of Track Operated Revenue per Carload Originated Revenue per Ton Originated Financial Ratios (%) Return on Sales Return on Average Equity Leverage (Debt/Equity at book value) Current Ratio P/E Ratio Stock Price ($ per share) High Low Year-end Sources: Union Pacific, Conrail, CSX, and Norfolk Southern 1995 Annual Reports; Datastream; Bloomberg; Association of American Railroads, Railroad Facts, 1996; Value Line Investment Survey, September 20, 1996; Morgan Stanley Dean Witter, U.S. and the Americas Investment Research Report, “Investment Case for Railroads,” November 1997; and casewriter’s estimates. aBurlington Northern merged with Santa Fe Pacific on September 22, 1995, to form Burlington Northern Santa Fe (BNSF). The data provided are either pro forma results, or estimates thereof, for 1995. bThe operating ratio measures a company’s operating efficiency. In this case, it is defined as the ratio of operating expenses to operating revenues, excluding one-time charges. In 1995, CSX incurred a $257 million charge and Conrail incurred a $285 million charge. 7 61 298-006 The Acquisition of Consolidated Rail Corporation (A) Exhibit 2 Conrail Consolidated Balance Sheet ($ millions) 1992 1993 1994 1995 3Q 1996a ASSETS Cash Accounts receivable Deferred income taxes Materials and supplies Other current assets Total current assets $ Property and equipment Other assets Total assets 40 592 0 121 37 790 $ 38 644 227 132 21 1,062 $ 43 646 249 164 23 1,125 $ 73 614 333 158 28 1,206 $ 33 655 337 144 30 1,199 6,013 512 6,313 573 6,498 699 6,408 810 6,495 693 $7,315 $7,948 $8,322 $8,424 $8,387 $ $ 62 146 79 788 1,075 $ 119 130 112 840 1,201 $ 113 181 89 787 1,170 $ 158 138 65 889 1,250 1,577 644 1,067 1,959 1,081 1,049 1,940 1,203 1,053 1,911 1,393 973 1,891 1,420 888 $4,567 $5,164 $5,397 $5,447 $5,449 2,748 2,784 2,925 2,977 2,938 $7,315 $7,948 $8,322 $8,424 $8,387 LIABILITIES AND EQUITY Accounts payable Current portion of long-term debt Short-term debt Other current liabilities Total current liabilities Long-term debt Deferred income taxes Other long-term liabilities Total liabilities Total stockholders’ equity Total Liabilities and Equity 63 207 127 882 1,279 Sources: Conrail 1993 and 1995 Annual Reports, and Conrail Form 10-Q, November 14, 1996. aNine months ended September 30, 1996. 8 62 The Acquisition of Consolidated Rail Corporation (A) Exhibit 3 298-006 Conrail Consolidated Income Statement ($ millions, except earnings per share) 1992 1993 1994 1995 3Q 1996a $3,345 $3,453 $3,733 $3,686 $2,771 $465 692 348 1,306 -- $492 703 384 1,283 -- $499 815 350 1,379 84 $485 766 370 1,324 285 $364 614 252 1,048 135 Total Expenses $2,811 $2,862 $3,127 $3,230 $2,413 Income from Operations $534 $591 $606 $456 $358 (172) 98 -- (185) 114 (80) (192) 118 -- (194) 130 -- (137) 83 -- $460 $440 $532 $392 $304 178 -- 206 (74) 208 -- 128 -- 109 -- $282 $160 $324 $264 $195 79,742 79,575 78,620 78,837 77,443 Operating Revenues Operating Expenses Way and structures Equipment General and administrative Transportation Special charges Interest expense Other income Loss on disposition of subsidiaryb Income before taxes Income taxes Changes in accounting principles Net Income Average number of primary shares outstanding (thousands) Total number of fully diluted (Acquisition) shares outstanding (thousands)c Fully Diluted Earnings Per Share before effect of chargesd,e 90,500 $2.97 $3.00 $4.08 $4.69 $3.01 Sources: Conrail 1993 and 1995 Annual Reports; Conrail Form 10-Q, November 14, 1996; CSX Schedule 14D-1, October 16, 1996, and casewriter estimates. aNine months ended September 30, 1996. bIn September 1993, Conrail recorded a loss for the disposition of its investment in Concord Resources Group, Inc. cThe number of fully diluted shares assumes conversion of the preferred stock and exercise of all outstanding options (except CSX’s lock-up options). It is measured as of the announcement date and equals the total number of shares CSX would have to purchase to acquire Conrail. dBased on net income adjusted for the effects of preferred dividends, net of income tax benefits. eAdjusted for extraordinary charges, loss on disposition of subsidiary, and changes in accounting principles. 9 63 298-006 The Acquisition of Consolidated Rail Corporation (A) Exhibit 4 CSX and Norfolk Southern Consolidated Balance Sheets ($ millions) CSXa 1995 3Q 1996b 660 832 148 220 75 1,935 $ Norfolk Southern 1995 3Q 1996c ASSETS Cash Accounts receivable Deferred income taxes Materials and supplies Other current assets Total current assets Property and equipment Other assets Total assets $ 515 928 151 217 108 1919 $ 68 704 145 62 365 1,344 $ 188 776 152 58 284 1,458 11,297 1,050 11,720 1,002 9,259 303 9,460 345 $14,282 $14,641 $10,905 $11,263 $ 1,121 486 148 1,236 2,991 $1,073 201 276 1,149 2,699 $ $ 2,222 2,560 2,267 2,288 2,657 2,182 1,553 2,299 1,018 1,811 2,351 1,037 $10,040 $ 9,826 $ 6,076 $ 6,408 4,242 4,815 4,829 4,855 $14,282 $14,641 $10,905 $11,263 LIABILITIES AND EQUITY Accounts payable Current portion of long-term debt Short-term debt Other current liabilities Total current liabilities Long-term debt Deferred income taxes Other long-term liabilities Total liabilities Total stockholders’ equity Total Liabilities and Equity 733 86 45 342 1,206 747 79 45 338 1,209 Sources: CSX and Norfolk Southern 1995 Annual Reports; CSX Form 10-Q, October 31, 1996; and Norfolk Southern Form 10-Q, November 13, 1996. aIncludes all CSX operations, rail and non-rail. bNine months ended September 27, 1996. cNine months ended September 30, 1996. 10 64 CSX and Norfolk Southern Consolidated Income Statement ($ millions, except earnings per share) $266 $4,313 3,456 699 $8,468 $4,434 -3,148 1,152 $8,734 1992 (298) 18 633 (274) -- $913 $3,643 4,291 93 $8,027 $4,380 -3,246 1,314 $8,940 1993 $652 (281) 55 1,006 (354) -- $1,232 $3,696 4,680 $8,376 $4,625 -3,492 1,491 $9,608 1994 210,270 $618 (270) 72 974 (356) -- $1,172 $3,951 5,124 257 $9,332 $4,819 -4,008 1,677 $10,504 1995 $2.83 212,567 $602 (188) 19 927 (325) -- $1,096 $2,836 3,901 $6,737 $3,661 -2,977 1,245 $7,833 3Q 1996a $3.94 $3.94 141,624 $558 (109) 98 875 (318) -- $887 $2,851 869 $3,720 $3,777 830 --$4,607 1992 $5.54 $3.94 139,350 $772 (98) 137 899 (350) 223 $860 $2,831 769 $3,600 $3,746 714 --$4,460 1993 $4.90 $4.90 136,367 $668 (102) 85 1,049 (381) -- $1,065 $2,875 641 $3,516 $3,918 663 --$4,581 1994 $5.44 $5.44 131,067 $713 (113) 142 1,115 (402) -- $1,086 $2,950 632 $3,582 $4,012 656 --$4,668 1995 $4.49 $4.49 126,912 $570 (68) 68 887 (317) -- $887 $2,213 490 $2,703 $3,075 515 --$3,590 3Q 1996b -11- (276) 3 (7) 27 -- $359 209,303 $3.73 $2.83 298-006 Operating Revenues Railway Motor carrier Container shipping Other Total Revenues $20 207,830 $3.12 $2.94 Exhibit 5 Operating Expenses Railway Other Special charges Total Expenses 205,814 $2.02 $3.12 Norfolk Southern Income from Operations $2.31 $1.73 CSX Earnings Per Share before effect of changes $0.08 Average shares outstanding (thousands) Net Income Interest expense Other income Income before taxes Income taxes Accounting adjustments Earnings Per Sharec Sources: CSX and Norfolk Southern 1993 and 1995 Annual Reports; CSX Form 10-Q, October 31, 1996; Norfolk Southern Form 10-Q, November 13, 1996; and casewriter estimates. aNine months ended September 27, 1996. bNine months ended September 30, 1996. cAdjusted for special charges and accounting adjustments. Note: CSX stock split 2 for 1 in December 1995. Prior years have been restated. 65 Exhibit 6 Deal Attitude Offer Status $5,941 1,399 5,941 2,203 4,359 Assets ($ millions) Recent Railroad Acquisitions and Conrail Financial Data Announcement Date Completed Withdrawn Withdrawn Completed Completed 298-006 Target Financial Data Revenues Debt/Equity ($ millions) (at book) Projected Synergies as a Percent of the Target’s Operating Expenses 0.96 1.42 0.96 3.86 1.38 Projected Merger Synergies ($ millions) $2,795 $495 2,795 1,116 3,159 Four-Week Acquisition Premium (%) Acquirer Friendly Friendly Hostile Friendly Friendly EBITDAd 22.3% n/a n/a 27.7 24.5 Target 29-Jun-94 19-Jul-94 5-Oct-94 10-Mar-95 2-Aug-95 Sales $560 n/a n/a $250 $660 Burlington Northern Illinois Central Union Pacific Union Pacifica Union Pacific Book Value 73% n/ae 52 34 54 Santa Fe Pacific Kansas City Southern Santa Fe Pacific Chicago and North Western Southern Pacific EPSd 13.1X 9.9 9.2 8.5 12.2 Total Enterprise Valueb,c as a Multiple of Acquirer 2.6X 3.6 1.8 2.4 1.7 Offer Price per Shareb as a Multiple of Target 4.5X 1.7 2.8 5.5 3.7 Number of Acquisition Shares 90.5 million 0.71 (at book value) 21.4X 14.6 13.4 18.3 18.4 Conrail Financial Data $ per Fully Diluted Share $4.84 4.91 5.69 32.46 Debt/Equity Burlington Northern Illinois Central Union Pacific Union Pacific Union Pacific $ in Millions $8,387 2,094 3,722 1,017 EPS (last 4Q) EPS (1996 est.) EPS (1997 est.) Book Value (3Q 1996) Santa Fe Pacific Kansas City Southern Santa Fe Pacific Chicago and North Western Southern Pacific Assets (3Q 1996) Debt (3Q 1996) Sales (last 4Q) EBITDA (last 4Q) -12- Sources: Securities Data Company, Inc.; Conrail Forms 10-Q, November 11, 1995, May 13, 1996, August 5, 1996, and November 18, 1996, and 1995 Annual Report; CSX Schedule 14D-1, October 16, 1996; Chicago and North Western Form 10-K, March, 22, 1995; Natwest Analyst Reports; Value Line Investment Survey, September 20, 1996; and casewriter's estimates. aUnion Pacific purchased the 72.5% of Chicago and North Western that it did not already own. bAll multiples are based on the fully diluted number of shares outstanding at announcement. cTotal Enterprise Value = common equity (at market) + preferred equity + cost to retire in-the-money options + debt (at book) - cash and marketable securities. dBased on current year earnings estimates, before extraordinary items. eBecause Kansas City Southern Railroad was a division of a conglomerate, it did not have traded equity. 66 The Acquisition of Consolidated Rail Corporation (A) Exhibit 7 298-006 Projected Gains in Operating Income from a CSX-Conrail Merger ($ millions) 1997E 1998E 1999E 2000E 2001Ea $0 $111 $259 $370 $381 $0 $ 50 $ 89 $117 $121 Gain in Operating Income from Cost Reductionb Gain in Operating Income from Revenue Increase Gain coming from Norfolk Southern 0 27 48 63 65 Total Gain from Revenue Increase Gain coming from other sources $0 $77 $137 $180 $185 Total Gain in Operating Incomec $0 $188 $396 $550 $567 Sources: Casewriter’s estimates based on data from 1996 Natwest Analyst Reports. aGrows at the rate of inflation (3%) after the year 2000. bNet of merger costs. cPre-tax gain; the applicable federal income tax rate was 35%. 13 67 298-006 The Acquisition of Consolidated Rail Corporation (A) Exhibit 8 Selected Financial Market Data Week Ending October 18, 1996 Yields on U.S. Treasury Bills, Notes, and Bonds 3-month 6-month 1-year 2-year 5-year 10-year 30-year 5.11% 5.40 5.55 5.91 6.28 6.54 6.83 Yields on Long-term Corporate Bonds Aaa Aa A Baa 7.40 7.59 7.71 8.08 Interest Rates Federal Funds 3-month Commercial Paper 3-month Certificate of Deposit Prime Rate 5.22 5.42 5.40 8.25 Value Line Equity Betas Conrail CSX Norfolk Southern 1.30 1.35 1.15 Sources: Federal Reserve Bulletin, January 1997; and Value Line Investment Survey, October 11, 1997. 14 68 Exhibit 9 Chicago Canada Cleveland Pittsburgh Buffalo Binghamton New York/New Jersey Philadelphia Morehead City Norfolk/Hampton Roads Baltimore Harrisburg Altoona Charleston Jacksonville Savannah Charleston Charlotte Roanoke Macon Atlanta Cincinnati Indianapolis Ft. Wayne Detroit Norfolk Southern Rail Network and CSX-Conrail Rail Network Kansas City St. Louis Chattanooga Mobile Birmingham Memphis New Orleans Miami Norfolk Southern Rail Network Des Moines Kansas City Cincinnati Canada Roanoke Charlotte Greensboro Greenville Knoxville Louisville Montreal Wilmington Morehead City Raleigh Orlando Jacksonville Brunswick Norfolk Albany Boston Buffalo Lansing Hartford Detroit Newark New York City Toledo Chicago Cleveland Harrisburg Trenton Philadelphia Ft. Wayne Pittsburgh Columbus Peoria Dover Hagerstown Indianapolis Baltimore Washington D.C. Charleston Richmond St. Louis Nashville Chattanooga Memphis Tallahassee Savannah Columbia Atlanta Charleston Macon Augusta Montgomery Birmingham Meridan Mobile New Orleans Tampa St. Petersburg Miami Pro Forma CSX-Conrail Rail Network 298-006 -15- 69 298-006 The Acquisition of Consolidated Rail Corporation (A) Exhibit 10 Projected Impact of a CSX-Conrail Merger on Operating Ratios 100.0% Conrail Actual CSX Actual Norfolk Southern Actual CSX-Conrail Projected Operating Ratio (%) 90.0% Norfolk Southern Projected if CSX Acquired Conrail 80.0% - -. . . .. . - ... 70.0% ------- . . . 60.0% 1990 1991 1992 1993 1994 1995 1996E 1997E 1998E 1999E 2000E 2001E 2002E Sources: Actual operating ratios are based on data from: CSX, Norfolk Southern, and Conrail 1993 and 1995, and 1996 Annual Reports; and Morgan Stanley Dean Witter, U.S. and the Americas Investment Research Report, “Investment Case for Railroads,” November 1997. Projections are casewriter’s estimates based on these sources and additional data from 1996 Natwest Analyst Reports. Note: The operating ratio measures a company’s operating efficiency. In this case, it is defined as the ratio of operating expenses to operating revenues, excluding one-time charges. 16 70 The Acquisition of Consolidated Rail Corporation (A) 298-006 Endnotes 1 Charles Slack, Rail Giants Flew Stealth to Merger,” Richmond Times-Dispatch, October 20, 1996, p. A1. 2 “CSX and Conrail to Combine in Pro-Competitive, Strategic Merger,” CSX Press Release, October 15, 1996. 3 Ibid. 4 This section draws to a limited extent on “Note on Railroad and Trucking Deregulation,” HBS No. 793-041. 5 Association of American Railroads, Railroad Facts, September 1996, p. 55. 6 Ibid., p. 44, and casewriter’s calculations. 7 Ibid., pp. 12 and 14, Andras R. Petery, “Investment Case for Railroads: Opportunities After the Correction,” Morgan Stanley Dean Witter, November 1997, p. 19, and casewriter’s calculations. 8 “How Conrail Became a Hot Ticket,” The New York Times National Edition, November 1, 1996, p. C1. 9 Richard A. Oppel Jr., “Burlington Northern Wins Bid, But At What Cost?” The Dallas Morning News, February 1, 1995, p. 1D. 10 Wayne C. Nef, Value Line Investment Survey, September 20, 1996, p. 285. 11 Ibid., p. 292. 12 Conrail 1996 Notice of Annual Meeting of Shareholders, April 3, 1996, and CSX Schedule 14-D, December 6, 1996. 13 Rip Watson, “Conrail, CSX to Sit Down With Union Chiefs: Goal is to Outline Merger Plan, Gain Support for $8.4 Billion Deal,” The Journal of Commerce, November 15, 1996, p.1A. 14 William G. Lawlor, “The Mounting Risks in Buying Public Targets,” Mergers & Acquisitions, July/August 1996, pp. 27–32. 15 Ibid. 16 CSX Schedule 14-D, October 16, 1996. 17 Anthony Hatch and Jeff Julkowski, “CSX and CRR Strengthen Their Marriage,” NatWest Securities, November 7, 1996, p. 1, and casewriter’s estimates. 18 Ibid. 19 Ibid. 20 Suzanne Wooton, “CSX to Buy Conrail for $8.4 Billion,” Baltimore Sun, October 16, 1996, p. 1A. 21 Christopher Dinsmore, “Merger Could Leave Norfolk Southern in a Competitive Hole,” Virginian-Pilot, October 20, 1996, p. D1. 22 Based on analysis of 13f filings provided by the Carson Group, Conrail 1996 Notice of Annual Meeting of Shareholders, April 3, 1996, and casewriter’s estimates. I would like to thank Jay Light for helping classify investors by type. 17 71 Harvard Business School 9-298-095 Rev. May 20, 2001 The Acquisition of Consolidated Rail Corporation (B) After making it through the 1980s without the vicious public takeover 1 fights that tore through other industries, railroading has its battle royal. On October 15, 1996, Richmond-based CSX Corporation (CSX) and Philadelphia-based Consolidated Rail Corporation (Conrail) surprised the railroad world by announcing an $8.3 billion merger. Just hours after the announcement, Norfolk Southern Corporation (Norfolk Southern), the second largest railroad in the East and one of the premier railroads in the United States, issued the following statement: Norfolk Southern recognizes that the proposed merger of Conrail and CSX, if consummated, would have very significant implications for the nation's transportation system and for the shipping public. This combination raises serious concerns. Norfolk Southern will act responsibly and aggressively; … we do not rule 2 out any options. Eight days later, Norfolk Southern countered CSX’s bid with a hostile $9.1 billion offer for Conrail. When describing the offer, David R. Goode, Norfolk Southern’s chief executive officer, said: People always talk about our war chest … but there comes a time to use it. A CSXConrail combination posed a serious threat to Norfolk Southern. [We made the offer because…] I was concerned about being excluded from important markets in the 3 Northeast. An industry analyst concurred: “Takeover competitions are very intense when the target is a 4 scarce jewel in a rapidly evolving industry that is populated by relatively few firms.” Indeed, the bidding war escalated over the next several months, culminating on January 17, 1997 in a critical vote for Conrail shareholders on whether to permit the CSX-Conrail merger to proceed. Research Associate Mathew Mateo Millett prepared this case under the supervision of Professor Benjamin C. Esty as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Lori Flees (MBA ‘97) prepared an earlier version of the case. Copyright © 1998 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1 73 298-095 The Acquisition of Consolidated Rail Corporation (B) Conrail as a “Scarce Jewel” Conrail was the sole Class I railroad (a designation based on revenue) serving the lucrative Northeast market, considered by many to be one of the industry’s prize possessions. Its routes connected the major Northeastern cities such as Philadelphia, Boston, and New York with major Midwestern cities such as Chicago, St. Louis, and Detroit, and Southern cities such as Atlanta and New Orleans. In 1996, Conrail had 21,280 employees, controlled 29.2% of the rail freight market east of the Mississippi, and operated 10,543 miles of track. Conrail's revenue per mile of track operated, per carload originated, and per ton originated were the highest by far of the three major Eastern railroads (Conrail, CSX, and Norfolk Southern). Yet it was the least profitable railroad due to its high cost position. For example, Conrail had 30% more employees per mile of track operated than either CSX or Norfolk Southern. As a result, its operating ratio, the standard industry measure of efficiency, was significantly higher. Exhibits 1 and 2 provide Conrail's balance sheet and income statement information, respectively. CSX’s Friendly Offer A CSX-Conrail merger would create an entity with $8.6 billion in revenues and 68% of the Eastern market. CSX planned to buy Conrail in a friendly, two-tiered transaction. To complete the deal, CSX would have to purchase 90.5 million Conrail shares ("acquisition shares") including approximately 1.3 million common shares owned by management and directors. According to the merger agreement, CSX would pay $92.50 per share in cash for 40% of Conrail's acquisition shares (the front-end offer). The front-end offer would be completed in two stages for regulatory reasons. CSX would acquire 19.7% of the shares in the first stage and 20.3% of the shares in the second stage. Following the cash tender offers, CSX would then exchange shares in the ratio of 1.85619:1.0 (CSX:Conrail) for the remaining 60% of Conrail’s shares (the back-end offer). Based on closing prices on the day Norfolk Southern announced its bid, the blended value of CSX’s offer was $87.67 per share, which represented a 23.5% premium over Conrail’s pre-announcement stock price of $71.00 per share. Conrail had traded around $71.00 for most of the previous year. Norfolk Southern's Hostile Offer A Norfolk Southern-Conrail combination would have rail revenues of $7.8 billion and 61% of the Eastern market. The combined rail network would appear quite similar to the CSX-Conrail network with contiguous rail service between the Northeastern, Midwestern, and Southeastern markets, but with slightly fewer total rail miles—24,843 versus 29,047. Exhibit 3 shows the pro forma route maps for both combinations. Exhibit 4 and 5 provide CSX and Norfolk Southern’s historical balance sheet and income statement information. Norfolk Southern’s $100 per share cash tender offer, totaling $9.1 billion, represented a 40.8% premium over Conrail's pre-merger announcement stock price and a 14.1% premium over CSX’s blended offer. However, Norfolk Southern’s offer included a number of important conditions that had to be met before it would proceed with the offer. For instance, Conrail had to terminate its merger agreement with CSX and suspend its poison pill; shareholders had to tender a majority of the acquisition shares; and Norfolk Southern had to arrange sufficient financing to complete the acquisition. Norfolk Southern retained J.P. Morgan and Merrill Lynch to advise them on the deal and agreed to pay them each 0.125% of the total deal value upon consummation of the merger. The Competitive Impacts of the Proposed Mergers Over the previous few years, there had been several large railroad mergers as firms tried to reduce costs through scale. Like the previous deals, both CSX and Norfolk Southern projected large 2 74 The Acquisition of Consolidated Rail Corporation (B) 298-095 merger synergies from acquiring Conrail. On one side, CSX and Conrail projected gains in operating income of $565 million per year from cost reductions and $165 million per year from revenue 5 enhancements by the year 2000. Over the same period, Norfolk Southern projected gains in 6 operating income of $515 million from cost reductions and $145 million from revenue increases. These amounts were net of merger costs and the effects of granting competitive access to certain markets currently served only by the acquirer. Exhibits 6a and 6b present projections of gains and losses in operating income from the two proposed mergers. The cost savings would be driven by consolidation of overlapping operations and lower costs on longer-haul contiguous routes (see the route maps in Exhibit 3). For this reason, CSX was projecting greater cost savings than Norfolk Southern even though it was less efficient (had a higher operating ratio). The revenue increases would come from trucking and from the remaining Eastern railroad competitor. In other words, CSX-Conrail would steal revenue from Norfolk Southern or, alternatively, Norfolk Southern-Conrail would steal revenue from CSX. Exhibits 7a and 7b present the results of a model of industry economics and efficiency. Using current cost and revenue data combined with estimates of merger synergies and historical trends, the model projects operating ratios under the various merger scenarios. According to the model, the winning combination would suffer a short transition period of reduced operating efficiency due to Conrail’s high-cost position. Over time, as it achieved the cost reductions and revenue enhancements, operating efficiency would improve. Assuming it was able to achieve the projected merger synergies, the winning combination would become more efficient than the standalone railroad. However, if the Surface Transportation Board (STB), the federal railroad regulators, required the winning combination to provide competitive access to certain key markets, then the value of acquiring Conrail would significantly less. Both CSX and Norfolk Southern hoped to cede as little access as possible. Commenting on the importance of the deal, one analyst said, “Both [CSX and Norfolk 7 Southern] are in a position where they cannot be willing to lose.” Another said, “The winner [will] obtain an overwhelming dominance of the Eastern and Midwestern rail freight markets. The loser 8 [will] not only lose the instant battle, but, perhaps, its very existence.” The Bidding War and Legal Battles Within hours of Norfolk Southern’s bid, CSX dismissed it as a “non-bid.” Norfolk Southern's highly conditional non-bid would inevitably face serious delay and could not in any event be consummated without the approval of the Conrail board. The provisions of the CSX-Conrail merger agreement effectively preclude the Conrail board of directors' approval of any competing offers prior to mid-April 1997. The certain delays involved in the Norfolk Southern non-bid severely and negatively impact the present value of its proposal. Using a customary discount rate of two percent per month, the Norfolk Southern non-bid is worth less than $90.00 per Conrail share, far less than Norfolk Southern would have Conrail shareholders 9 believe. In response, Norfolk Southern sued to stop the deal and force Conrail’s board to consider its offer. Norfolk Southern contended that CSX’s two-tiered offer was "… a strategy to subvert the intent 10 of the state law and coerce Conrail shareholders into accepting an inadequate offer for their shares." Pennsylvania’s antitakeover law required bidders holding 20% or more of a company’s stock to offer all shareholders the same price unless target shareholders explicitly voted to nullify this provision (the "fair value" statute). As a result, Conrail shareholders had to “opt-out” of the Pennsylvania 3 75 298-095 The Acquisition of Consolidated Rail Corporation (B) statute before CSX could purchase more than 19.9% of the firm. This fair value statute was the reason why CSX was forced to execute its front-end tender offer in two stages. The suit also alleged that Conrail’s board had violated its fiduciary duty by accepting CSX’s offer. Specifically, Norfolk Southern said that Conrail's board had "… agreed to take a six-month leave of absence during the 11 most critical six months in Conrail's history” when it agreed to the no-talk clause. The combination of Conrail’s poison pill and the no-talk clause forced Norfolk Southern to make a hostile offer. Yet Pennsylvania’s voting rights statute made such an offer especially difficult to execute successfully. Unless Conrail's board terminated its merger agreement with CSX and approved a Norfolk Southern-Conrail merger, the statute would preclude Norfolk Southern from acquiring Conrail. Thus even a hostile takeover would not work unless it was coupled with a proxy contest through which Norfolk Southern replaced Conrail’s directors with directors in favor of the Norfolk Southern deal. Because Conrail directors were elected on a staggered basis—one-third every year—it would take at least one and one-half years from January 1997 before Norfolk Southern could replace a majority of the directors. Then, it would probably take at least another six months before Norfolk Southern could gain regulatory approval and complete a deal. In total, it might take as long as two years to consummate a Norfolk Southern-Conrail merger. John W. Snow, CSX’s chief executive officer, dismissed the lawsuit by saying, “A company ought to have a right to choose to fulfill a strategic vision with a partner without throwing itself open 12 to an auction.” Conrail management agreed. "The [Conrail] Board had already carefully considered the relative merits of a merger with Norfolk Southern rather than CSX and had unanimously 13 determined that a merger with CSX was in the best interests of Conrail and its constituencies." Although management was in favor of the deal, one of the most important constituents, the labor unions, had not yet taken a position on the specific merger proposals. Nevertheless, the AFL-CIO did issue a press release in which they said they were analyzing the deals and would determine the best 14 course for their members. Two weeks later, on November 6, CSX amended its tender offer. The new merger agreement increased the front-end cash offer to $110 per share, extended the no-talk period by three months until July 12, 1997, and postponed the Conrail shareholder opt-out vote until December 23, 1996. Conrail delayed the vote so that CSX could complete the first stage of the cash tender offer under the new terms. Two days later, Norfolk Southern increased its own bid to $110 cash per share. Exhibit 8 provides a bidding chronology and stock returns for each company. The US District Court in Pennsylvania dismissed Norfolk Southern’s lawsuit on November 19, 1996. The judge ruled that although Norfolk Southern’s bid “… is fine for the shareholders, whose only interest is that of short-term financial investment to maximize their profits, it completely ignores 15 the economic utility and value of corporations as a form of business enterprise.” This ruling backed Conrail’s assertion that its board had a fiduciary duty to all of the company’s constituents, not just shareholders, and that it was justified in agreeing to the no-talk clause. Moreover, it was justified in using a “just say no” defense, meaning that it could reject Norfolk’s offer without explicit justification. The judge added that “… the law of Pennsylvania leaves decisions such as what is best for the corporation to be that of the duly elected board of directors rather than second guessing by the 16 courts.” In addition, the court rejected Norfolk Southern’s argument that the CSX offer was coercive because, in the judge’s words, “… those [shareholders] who accept the lower valued back-end of the 17 bid and end up with stock in the merged company could see their stock value rise eventually.” When analysts questioned David M. LeVan, Conrail’s CEO, about the ruling, he remarked, “If you 18 don’t like the law, don’t buy the company’s stock.” Given this ruling, CSX proceeded with the first stage of its front-end tender offer. When one trader was asked whether he was going to tender, he responded, "How can I take the risk of not even getting a prorated share of the cash portion of the deal and being stuck with the stock the market will discount for both the delay in the exchange and the risk of adverse action by the Surface 19 Transportation Board?" CSX subsequently acquired 19.9% of Conrail’s shares (17.86 million shares) 4 76 The Acquisition of Consolidated Rail Corporation (B) 298-095 on November 21. Interestingly, the offer was highly oversubscribed with 84.7% of Conrail’s shares tendered. On December 19, 1996, four days before the scheduled opt-out vote, CSX once again amended its offer by adding $16 of new convertible preferred stock to the back-end offer. CSX hoped that by increasing the back-end offer, it would entice Conrail shareholders to vote in favor of optingout. At the same time, CSX postponed the opt-out vote until January 17, 1997, extended the no-talk period through December 1998, and agreed to execute the back-end stock-swap following the completion of the second stage tender offer instead of waiting for regulatory approval from the STB. Not wanting to be left out, Norfolk Southern raised its own bid to $115 cash per share within hours. A press release read, “… Norfolk Southern remains as determined as ever to acquire Conrail 20 and will use any and all appropriate financial means to accomplish that objective." In fact, a consortium of banks had already made loan commitments to the railroad totaling more than $13 21 billion and one banker indicated that, if necessary, the consortium would provide more financing. The Shareholder Vote As the decisive shareholder vote approached, Norfolk criticized the CSX-Conrail deal in a series of advertisements in the financial press, and encouraged Conrail shareholders to vote against opting-out. Conrail and CSX countered with their own advertisements that encouraged shareholders to vote in favor of opting-out (see Exhibits 9a and 9b). On January 13, 1997, four days before the scheduled vote, Norfolk Southern announced that it would unconditionally tender for 9.9% of Conrail's stock at $115 per share in cash if shareholders voted against opting-out—9.9% was the maximum percentage of shares it could own without triggering Conrail's poison pill. With the vote only one day away, the outcome was still uncertain. A vote in favor of optingout would allow CSX to execute the second stage of its cash tender offer for an additional 18.34 million shares, approximately 20.3% of the total, at $110 per share. Upon completion of the second stage tender offer and exercise of the lock-up options on 15.96 million shares, CSX would control 52.16 million shares. When combined with the 1.3 million shares held by Conrail managers directly or through incentive compensation contracts, parties in favor of the deal would control 53.46 million shares, approximately 50.2% of the 106.5 million shares that would be outstanding at that time. Of course this scenario assumed that a majority of the shareholders would vote in favor of opting-out. If they did not, it was unclear what would happen. In anticipation of the vote, investors were actively trading Conrail shares and options. Exhibit 10 provides capital market information as of January 16, 1997, the day before the shareholder vote. On that day, Conrail closed at $103.50. 5 77 298-095 The Acquisition of Consolidated Rail Corporation (B) Exhibit 1 Conrail Consolidated Balance Sheet ($ millions) 1992 1993 1994 1995 1996 ASSETS Cash Accounts receivable Deferred income taxes Materials and supplies Other current assets Total current assets $40 592 0 121 37 790 $38 644 227 132 21 1,062 $43 646 249 164 23 1,125 $73 614 333 158 28 1,206 $30 630 293 139 25 1,117 Property and equipment Other assets 6,013 512 6,313 573 6,498 699 6,408 810 6,590 695 $7,315 $7,948 $8,322 $8,424 $8,402 Accounts payable Current portion of long-term debt Short-term debt Other current liabilities Total current liabilities $63 207 127 882 1,279 $62 146 79 788 1,075 $119 130 112 840 1,201 $113 181 89 787 1,170 $135 130 99 728 1,092 Long-term debt Deferred income taxes Other long-term liabilities 1,577 644 1,067 1,959 1,081 1,049 1,940 1,203 1,053 1,911 1,393 973 1,876 1,478 849 $4,567 $5,164 $5,397 $5,447 $5,295 2,748 2,784 2,925 2,977 3,107 $7,315 $7,948 $8,322 $8,424 $8,402 Total Assets LIABILITIES AND EQUITY Total liabilities Total stockholders’ equity Total Liabilities and Equity Sources: Conrail 1993, 1995, and 1996 Annual Reports. 6 78 The Acquisition of Consolidated Rail Corporation (B) 298-095 Conrail Consolidated Income Statement ($ millions, except earnings per share) Exhibit 2 1992 1993 1994 1995 1996 $3,345 $3,453 $3,733 $3,686 $3,714 $465 692 348 1,306 - $492 703 384 1,283 - $499 815 350 1,379 84 $485 766 370 1,324 285 $462 803 328 1,385 135 Total Expenses $2,811 $2,862 $3,127 $3,230 $3,113 Income from Operations $534 $591 $606 $456 $601 (172) 98 - (185) 114 (80) (192) 118 - (194) 130 - (182) 112 - $460 $440 $532 $392 $531 208 - 128 - 189 - Operating Revenues Operating Expenses Way and structures Equipment General and administrative Transportation Special charges Interest expense Other income Loss on disposition of subsidiarya Income before taxes Income taxes Changes in accounting principles Net Income Average number of primary shares outstanding (thousands) 178 - 206 (74) $282 $160 $324 $264 $342 79,742 79,575 78,620 78,837 77,628 Total number of fully diluted (Acquisition) shares outstanding (thousands)b Fully Diluted Earnings Per Share before effect of chargesc,d Sources: 90,500 $2.97 $3.00 $4.08 $4.69 $4.59 Conrail 1993 and 1995 Annual Reports; Conrail Form 10-Q, November 14, 1996; and CSX Schedule 14D-1, October 16, 1996. aIn September 1993, Conrail recorded a loss for the disposition of its investment in Concord Resources Group, Inc. bThe number of fully diluted shares assumes conversion of the preferred stock and exercise of all outstanding options (except CSX’s lock-up options). It is measured as of the announcement date and equals the total number of shares CSX or Norfolk Southern would have to purchase to acquire Conrail. cBased on net income adjusted for the effects of preferred dividends, net of income tax benefits. dAdjusted for extraordinary charges, loss on disposition of subsidiary, and changes in accounting principles. 7 79 Exhibit 3 Canada Roanoke Charlotte Greensboro Greenville Knoxville Louisville Montreal Morehead City Wilmington Miami Orlando Jacksonville Raleigh Norfolk Richmond Albany Boston Buffalo Lansing Hartford Detroit Newark New York City Toledo Chicago Cleveland Harrisburg Trenton Philadelphia Ft. Wayne Pittsburgh Columbus Peoria Dover Hagerstown Indianapolis Baltimore Washington D.C. Charleston Cincinnati Proposed Post-Merger Route Networks Des Moines Kansas City St. Louis Nashville Chattanooga Memphis Savannah Tallahassee Brunswick Columbia Atlanta Charleston Macon Augusta Montgomery Birmingham Meridan Mobile New Orleans Tampa St. Petersburg CSX-Conrail Rail Network Des Moines Kansas City Cincinnati Canada Montreal Wilmington Morehead City Raleigh Roanoke Norfolk Greensboro Charlotte Greenville Columbia Jacksonville Brunswick Charleston Augusta Savannah Tallahassee Macon Atlanta Knoxville Louisville 298-095 Albany Boston Buffalo Lansing Hartford Detroit Newark New York City Toledo Chicago Cleveland Harrisburg Trenton Philadelphia Ft. Wayne Pittsburgh Columbus Peoria Dover Hagerstown Indianapolis Baltimore Washington D.C. Charleston Richmond St. Louis Nashville Chattanooga Memphis Montgomery Birmingham Meridan Mobile New Orleans Tampa Orlando St. Petersburg Miami Norfolk Southern-Conrail Rail Network -8- 80 The Acquisition of Consolidated Rail Corporation (B) Exhibit 4 298-095 CSX and Norfolk Southern Consolidated Balance Sheets ($ millions) CSXa 1995 1996 Norfolk Southern 1995 1996 ASSETS Cash Accounts receivable Deferred income taxes Materials and supplies Other current assets Total current assets $660 832 148 220 75 1,935 $682 894 139 229 128 2,072 $68 704 145 62 365 1,344 $209 704 159 63 321 1,456 Property and equipment Investment in Conrail Other assets 11,297 1,050 11,906 1,965 1,022 9,259 303 9,529 431 $14,282 $16,965 $10,905 $11,416 $1,121 486 148 1,236 2,991 $1,189 101 335 1,132 2,757 $733 86 45 342 1,206 $709 56 44 381 1,190 2,222 2,560 2,267 4,331 2,720 2,162 1,553 2,299 1,018 1,800 2,412 1,037 $10,040 $11,970 $6,076 $6,439 4,242 4,995 4,829 4,977 $14,282 $16,965 $10,905 $11,416 Total Assets LIABILITIES AND EQUITY Accounts payable Current portion of long-term debt Short-term debt Other current liabilities Total current liabilities Long-term debt Deferred income taxes Other long-term liabilities Total liabilities Total stockholders’ equity Total Liabilities and Equity Sources: CSX and Norfolk Southern 1995 and 1996 Annual Reports. aIncludes both CSX’s rail and non-rail operations. 9 81 Operating Revenues Railway Motor carrier Container shipping Other Total Revenues (276) 3 (7) (27) - $266 $4,313 3,456 699 $8,468 $4,434 3,148 968 $8,550 1992 $359 (298) 18 633 274 - $913 $3,643 4,291 93 $8,027 $4,380 3,246 1,141 $8,767 1993 209,303 $652 (281) 105 1,006 354 - $1,182 $3,696 4,531 $8,227 $4,625 3,492 1,292 $9,409 CSX 1994 $3.73 210,270 $618 (270) 118 974 356 - $1,126 $3,951 4,970 257 $9,178 $4,819 4,008 1,477 $10,304 1995 $4.00 $4.00 213,633 $855 (249) 43 1,316 461 - $1,522 $3,782 5,232 $9,014 $4,909 4,051 1,576 $10,536 1996 $3.94 $3.94 141,624 $558 (109) 98 875 318 - $887 $2,851 869 $3,720 $3,777 830 $4,607 1992 $5.54 $3.94 139,350 $772 (98) 137 899 350 223 $860 $2,831 769 $3,600 $3,746 714 $4,460 1993 $4.90 $4.90 136,367 $668 (102) 85 1,049 381 - $1,065 $2,875 641 $3,516 $3,918 663 $4,581 Norfolk Southern 1994 $5.44 $5.44 131,067 $713 (113) 142 1,115 402 - $1,086 $2,950 632 $3,582 $4,012 656 $4,668 1995 $6.09 $6.09 126,437 $770 (116) 116 1,197 427 - $1,197 $2,936 637 $3,573 $4,101 669 $4,770 1996 298-095 Operating Expenses Railway Other Special Charges Total Expenses $20 103,915 $3.12 $2.94 CSX and Norfolk Southern Consolidated Income Statements ($ millions, except earnings per share data) Income from operations 102,907 $4.04 $3.12 Exhibit 5 Average shares outstanding (thousands) $4.61 $3.46 Net Income Interest expense Other income Income before taxes Income taxes Accounting adjustments Earnings Per Share before effect of changes $0.19 CSX and Norfolk Southern 1993, 1995 and 1996 Annual Reports, and casewriter’s estimates. Earnings Per Sharea Sources: aAdjusted for special charges and accounting adjustments. -10- 82 The Acquisition of Consolidated Rail Corporation (B) Exhibit 6a 298-095 Selected CSX Financial Projections ($ millions) CSX ACQUIRES CONRAIL Gain in Operating Income from Cost Reductionb Gain in Operating Income from Revenue Increase Gain coming from Norfolk Southern Gain coming from Other Sources Total Gain from Revenue Increase Total Gain in Operating Incomec Norfolk Southern’s Total Loss in Operating Incomed Exhibit 6b 1998E 1999E 2000E 2001Ea $0 $170 $396 $565 $582 $0 0 $46 25 $82 44 $107 58 $110 59 0 71 125 165 170 $0 $240 $521 $730 $752 ($0) ($130) ($232) ($308) ($320) Selected Norfolk Southern Financial Projections ($ millions) NORFOLK SOUTHERN ACQUIRES CONRAIL Gain in Operating Income from Cost Reductionb Gain in Operating Income from Revenue Increase Gain Coming from CSX Gain Coming from Other Sources Total Gain from Revenue Increase Total Gain in Operating Incomec CSX’s Total Loss in Operating Incomed Sources: 1997E 1997E 1998E 1999E 2000E 2001Ea $0 $180 $335 $515 $530 $0 0 $33 18 $61 33 $94 51 $97 52 0 51 94 145 149 $0 $231 $429 $660 $680 ($0) ($66) ($123) ($189) ($196) Casewriter’s estimates based on data from: 1996 NatWest Analyst Reports. aGrows at the rate of inflation (3%) after the year 2000. bNet of Merger Costs. cPre-tax gain; the applicable federal income tax rate was 35%. dThe amount of operating income a firm might lose if its competitor acquired Conrail. The model makes specific assumptions about the loser's operating ratio and cost structure. 11 83 298-095 The Acquisition of Consolidated Rail Corporation (B) Exhibit 7a Projected Impact of a CSX-Conrail Merger on Operating Ratios 100.0% C SX Actual N orfolk Southern A ctual C SX-C onrail P rojected N orfolk Southern P rojected if C SX Acquired C onrail 90.0% Operating Ratio (%) C onra il Ac tua l 80.0% - -' -------- - -. 70.0% ' ... - ...... -- 60.0% 1990 Exhibit 7b 1991 1992 1993 1994 1995 1996 1997E 1998E 1999E 2000E 2001E 2002E Projected Impact of a Norfolk Southern-Conrail Merger on Operating Ratios 10 0.0% C onra il A c tua l C S X A c tua l N orfo lk S ou the rn A ctu al N orfo lk S ou the rn-C on rail P rojected 90 .0 % Operating Ratio (%) C S X P ro je cte d if N o rfolk S ou the rn A c qu ire d C o nrail 80 .0 % --·---- ... 70 .0 % - - ... - - - 60 .0 % 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 E 19 98 E 19 99 E 20 00 E 20 01 E 20 02 E Sources: Actual operating ratios are based on data from: CSX, Norfolk Southern, and Conrail 1993 and 1995, and 1996 Annual Reports; and Morgan Stanley Dean Witter, U.S. and the Americas Investment Research Report, “Investment Case for Railroads,” November 1997. Projections are casewriter’s estimates based on these sources and additional data from 1996 and 1997 NatWest Analyst Reports. Note: The operating ratio measures a company’s operating efficiency. In this case, it is defined as the ratio of operating expenses to operating revenues, excluding one-time charges. 12 84 Exhibit 8 Bidding Chronology and Returns Stock Price CSX 3-day Returnc Event Length of No-Talk Clause Date Norfolk Southern Bid ($ per share) in Cash 6 months 9 months 24 months (6.8%) (5.9) (1.4) 2.3 (3.9) 1.7 6.3 Day prior to CSX-Conrail merger announcement. CSX and Conrail announce merger. Norfolk Southern announces hostile bid. CSX increases front-end offer. Norfolk Southern increases cash offer. CSX increases back-end offer. Norfolk Southern increases cash offer. Norfolk Southern offers to buy 9.9% of Conrail after shareholder vote. Eve of shareholder vote. CSX Bid ($ per share) Front-end Back-end Blended Offer Offera Valueb 92.04 110.00 115.00 $89.07 80.06 100.41d 115.00 $86.77 110.00 97.21 102.16d $92.50 110.00 99.53 $100.00 110.00 Datastream and The Wall Street Journal, and casewriter’s estimates. $49.50 46.75 45.50 43.13 43.13 43.75 44.38 45.00 14-Oct-96 15-Oct-96 23-Oct-96 6-Nov-96 8-Nov-96 19-Dec-96 13-Jan-97 16-Jan-97 Date 14-Oct-96 15-Oct-96 23-Oct-96 6-Nov-96 8-Nov-96 19-Dec-96 13-Jan-97 16-Jan-97 Sources: 1.6% (2.1) (4.1) 1.3 5.3 0.3 (1.1) Norfolk Southern Stock 3-day Price Returnc $92.00 95.00 94.13 87.13 86.63 88.38 89.00 88.13 aBack-end offer = 1.85619 * CSX share price. bBlended value = weighted average of front-end and back-end offers. cThe 3-day return is the return on the stock from the day before to the day after the event (except for 1/16/97 which is a two-day return). dThe blended value is adjusted to reflect the completion of CSX’s first stage tender offer. Stock Price 20.1% 10.0 (0.7) 3.1 1.8 2.6 1.1 Conrail 3-day Returnc $71.00 85.13 95.63 93.63 96.38 100.75 103.00 103.50 298-095 -13- S&P 500 3-day Returnc 0.5% (1.1) 3.0 1.0 3.1 1.9 1.0 85 298-095 Exhibit 9a The Acquisition of Consolidated Rail Corporation (B) Norfolk Southern Announcement TO CONRAIL SHA RE HOLDERS: It's bad enough: They want you to settle for inferior value. They want you to accept an oiler worth $I biftoo less than what Norfolk Southern is offering, approximoiely $15 par shore lass~ They want you to assume equity risks. They want you to receive much of CSX's remaining offer in~, bm of CSX stock, which hos already declined 13%• since the CSX offer for Conrail was announced. Its value will continue to be subject 1o· market risk. With Norfolk Southern's offer, you know exocllywhotyou will begetting: $115. All cash. No risk. Period. They want to take away your right to receive fair value. They want you to appro,o an amendment to the Conrail d,arter !hat will deprive you al the important pro1actian of the Pennsylvania Fair Value Statute, which requires that 1haRlhdders be abte to receive lmr valae, in cash, for their shores in takeover transactions such as the one CSX has proposed. And they wantyou to help them pull it off. Don't h~p '• Conroil Baard ,rom down CSX's inferior oll.r. Remind the Board that you advally own the company, that you eleded the Board in the fint plxe, and !hat you can ,epla08 them they ignoro your Into- Put a slop 1o the;, complete di""9Clrd al your shcnholder righ• and abdicaiion of their mpomibilty lo ,_..nt those rights. Tolo, bad«:onlrOI of your company. "-yai,r ......_Vole,_ AGANT Conlalll pnrposals ID •opt CIIII" of Pelinsylvanicn Fair Value Slalule and to adjaum lhe spadal ..-ing, rif VOI'E Conrail Shareholders P - the volu
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