The Acquisition Acquisition of Conrail Corporation Corporation The Acquisition of Conrail Corporation 1. Bankruptcy and Corporate ReorganizationAlo ReorganizationAlo Shkreta2 une 2!1" 2 . Case su##ary♣ CS$ has put forth a t%o&tier #erger agree#ent to acquire Conrailθ The front&end o'er for (!) of the shares is *+2.,!θ The -ack end o'er is an echange o'er %ith a ratio of 1./,01+ shares of CS$ for 1 share of Conrail ♣ Conrail is also a potential a target of orfolk Southern♣ Both CS$ and orfolk are #ature r#s %ho# operate #ostly in the railroad industry and intend to gro% through acquaints as the #arket is a#ature one♣ The ennsyl3ania antitakeo3er la% #akes the -idding process di4cult due to the se3eral pro3isions incorporated incorporated in it ♣ The #ultiples 3aluation gi3es a range of *+!.(/ & *120.+/♣ The 5C6 3aluation gi3es a range of *+".2( & *+".,( Background Backgroun d infor#ation♣ 6or#ed fro# the re#ains of si -ankrupt ortheastern 3 . railroads in 1+7"♣ 8arned its rst prot in 1+/1 & *"+.2 #illion on re3enues of *(.2 -illion. ri3atized through an 9: in 1+/7 ♣ ;a 7+.+)θ Re3enues per e#ployee & *1,0=7/(θ ?8 ratio > 12.+ConrailCS$♣ A @irgin @irginia&-ased ia&-ased di3ersied transportation co#pany inter#odal ser3ices= ocean&container shipping= -arging= contract ser3icesand railroad ser3ices ♣ ;a 70.7)θ Re3enues per e#ployee & *10"=1,1θ ?8 ratio > 11.0 4 . uestion 1Dhy is CS$ interested in acquiring Consolidated Rail Corporation ConrailE 5escri-e theargu#ents for the o'er -eing #oti3ated -y synergies= as %ell as argu#ents for the#oti3ation to pre&e#pt a -id -y orfolk. Strategic choice CS$& CS$&Conrail Conrail♣ The co#-ined entity %ould result in #ore than */., 5 . -illion in re3enues and nearly 7!) of the 8astern #arket♣ CS$&Conrail %ould -e a-le to control the Frail&%ayG -et%een the Southern ports CS$= the ortheast Conrail and the ;id%est -oth. By ha3inga full access to these #arkets they ne% co#pany %ould -e a-le to o'er ser3ices to its clients for a lo%er price econo#ies of scale. This ne%co#-ination %ould restrict restrict the access the presence presence of orfolk Southern in these #arkets= de3iating F-usinessG to%ards the ne% co#pany♣ The ;id%est #arket= %here -oth r#s are hea3ily present= %ould -eco#e a center of operations and the result %ould -e a reduction of costsθ 6aster load and unload of goods θ ;ore line tracks a3aila-le for transportationθ Higher co&operation and greater #anpo%erθ 8change of #arket kno%ledge and client -ase♣ otential to capitalize on the opportunity of -eing the rst railroad co#pany to connect the 8ast to the Destθ Ieographically %ell placedθ et%ork already eistingθ 6inancial capacity present♣ The railroad industry industry is a #ature #arket. #arket. The only optionto gro% is through through acquisitions♣ CS$&Conrail %ould consolidate o3erlapping transactions♣ CS$&Conrail %ould increase re3enue through ser3ice i#pro3e#entsθ Cost synergies of *"7! #illion -y the year 2!!θ Additional operating inco#e of *1/! #illions ¬ Re3enues %ould co#e fro# taking industryand taking -usiness o3er fro# orfolk Southern re&8#pt Bid fro# orfolk Southern ♣ orfolk Southern is the #ost e4cient and 6 . -est&#anaged railroad co#pany co#pany in the Jnited Statesθ :perating ratio > 7".,)θ Re3enue per e#ployee > *1+"=0+! θ Return on sales > 1,.") ♣ ;ade and unsuccessful -id of *1.0 -illion for Conrail in the #id K/!s. Clearly 3ery interested in acquiring the r# for strategic reasonsθ 9t has access in the Southeastern and
;id%estern States and the Canadian ro3ince of :ntario -utit lacks the presence in the ortheastern states %hich are considered the industryLs prize possessors♣ 6inancially orfolk is healthier than CS$θ Me3erage ratio is "".0). 9t can assu#e #ore de-t than CS$ can (!.1) θ Current ratio of orfolk 111.() 3s. CS$Ls 0(.7)θ 8S of orfolk are *,.((. CS$ is at *2.+(orfolk Southern has all the FcardsG to #ake a -id that is -etterthan the CS$ one. 9t can sustain #ore lia-ilities in its -alance sheetand it %ill -enet fro# synergies if it potentially #erges %ithConrail. Therefore the sooner CS$ closes the deal the -etter it isother%ise it faces a #a
+!., #illion shares N */+.!0 per share♣ The e'ecti3e?-lended price paid for the transaction is equal to */+.!0 ♣ 8hi-it 0 presents a su##ary of recent railroad acquisitions. :ut of , #erger o'ers only " %ere anchored successfully. That sho%s that there ispresent risk of the CS$&Conrail #erger not -eing concluded and that %ould har# the r#s reputation and the share prices %ould su'er leadingto 3alue destruction for the shareholders♣ 9n ehi-it 1 the stock price of -oth r#s sho%s that Conrail is trading currently at its ,2&%eek high and the changes of the price sky& rocking areli#ited as sho%n -y its past. Conrail is not far fro# its ,2&%eek high share price either. This infor#ation can ser3e as an indicator that the shareprice #o3e#ent in the upper direction see#s to -e fairly li#ited. The synergies %ill not crystalize in any ti#e soon therefore the portion ofshareholders %ho# are -eing con3erted as part of the #erger agree#ent face a -ig chance of ending %ith a lo% 3alueO of shares Cash 8changed sharesConrails (!) "0=2!!=!!! *"."(/ -illionConrails 0!) ,(="!!=!!! 1!!=7+1=117♣ The infor#ation in the case notes the opportunity ofthe #erger -eing closed -y the end of 1++7.Assu#ing that the 0!) shareholders %ho# ha3e nottendered and are not a-le to sell in the #eanti#eand calculating the ti#e 3alue of #oney %ith r -eingequal to the cost of equity 10.(,) they could end up%ith *7(.,!rice consideration uestion "Jsing ;ultiples 3aluation= %hat is the 3alue of Conrail to CS$E 1 0 . 9ncorporate the esti#atedsynergies in the 3alue. 5escri-e clearly %hich #ultiples you use and %hy= and descri-e%hich co#parison r#s you use and %hy. Ho% does this 3alue co#pare to the o'er #ade-y CS$E 1 1 . Transaction #ultiples 3alue range *+!.(/ & *120.+/♣ The peer group that 9 chose are the transactions that ha3e -een co#pleted θ That is for the si#ple reason that -ecause this are transaction #ultiples= the -id o'erenco#passes the potential synergies . As such %hen the deal is not concluded the nu#-eris -iased and it %ill gi3e an unrealistic nu#-er. lus the synergies 3alue for the t%o o#ittedr#s are #issing one -eing Santa 6e acic %ho# 9 cannot t%iceθ Dhen a -idder puts forth an o'er he %ill include a pre#iu# as a result of gaining controlfor the enterprise. Thus including deals %ho# are not concluded %ould lead to -iasednu#-ersθ Santa 6e acic= Chicago and orth Destern and Southern acic♣ The -est peer group %ould -e selected on the follo%ing criteriaθ Business risk > all of the peer #e#-ers are part of the sa#e industry and face on a3eragethe sa#e risks. There #ay -e so#e risk di'erentiation due to so#e r#s operating in theDest 3s. ;id%est 3s. 8ast -ut that does not deteriorate the quality of the peer groupθ Iro%th epectations > the railroad #arket is a #ature one. The gro%th is to -e epectedthrough acquisitions and no technological -reakthrough is epected θ rota-ility > on a3erage Conrail is #ore prota-le than the peer group in ter#s of netinco#e and it depends 3ery #uch on ho% e4cient assets are usedθ Me3erage structure > the peer group is #ore le3ered than Conrail ♣ Considering the #ultiples presented -elo%= CS$ is o'ering less than the counterparts in the otherdeals. An i#portant di'erence that are the synergies as a ) of targetLs operating epenses to -erealized %hich are esti#ated to -e lo%er for Conrail and that %ould certainly a'ect the price to -eo'ered as there is less to get fro# the targetConsiderations8S Book @alue Sales 8B9T5ASanta 6e Specic 21.( (., 2.0 1".1Chicago and orth 1/." ,., 2.( /.,Southern acic 1/.( ".7 1.7 12.2A3erage 1+.( (.0 2.2 11."Conrail 1/.( 2.1+ 1.72 (.20:'er rice er Share as a ;ultiple ofTotal 8nterprise @alue as a#ultiple ofro
to the industrya3erage gi3ing a range 3alue 3eryclose to the o'er priceθ *+!.(/ & *+".+!♣ Pet the 8S and Book @alue are3ery #uch a'ected fro# thele3erage structure and thus arenot a true representation under#ultiple 3aluationθ 8B9T5A *120.+/ 1 2 . @aluation #ultiples eplanationSanta 6e acic♣ 5eals not co#pleted are notconsidered due to possi-le -iasQansas City Southern Chicago orth Destern Southern acic Co##entsStatusSynergies11& As a percent of the targets operating epensesBusinessRiskIro%th8pectationrota-ilityMe3erage ♣ Synergies are 3ery i#portant asthey a'ect the -id price. 9f theyare n?a 9 discard the deal22.") n?a 27.7) 2(.,)♣ Co#panies operate in therailroad industry %hich is cyclical.They generate #ost re3enuesfro# this strea#line ♣ 5ue to #aturity the gro%th %illco#e fro# #ergers andincreasing e4ciency of assets ♣ :perating ratio di'ers a -it= yetin ter#s of net inco#e Conraildoes slightly -etter?& ?& ?& ?&♣ The 5?8 ratio is 3ery di'erent. 9tleads to huge 3ariation in ter#sof 3alue. Jnder this hypothesisthe -est #ultiples %ould -e theSales and 8B9T5A %hich are lessa'ected fro# the le3erage. Theindustry is quite capital intensi3eso de-t is i#portant. 6ollo%ingon this logic the 3alue range%ould -e♣ *+!.(/ & *120.+/ eer Iroup Pes Pes Peso 1 3 . uestion (Jsing 5C6 3aluation= %hat is the 3alue of Conrail to CS$E Pou should use the pre&announce#ent share 3alue of Conrail as the stand alone 3alue and then 3alue theesti#ated synergies %ith the 5C6 #ethod. 5escri-e clearly %hat cash Uo%s and discountrate you use and %hat are these -ased on. Ho% does this 3alue co#pare to the o'er#ade -y CS$E 1 4 . 5C6 3alue range *+".2( & *+".,( ♣ 9 start %ith the synergies as presented in 8hi-it 7♣ 9 calculate the Cost of 8quity -ased on the inputs gi3en in the case. 9n order to address the di'erent-etas for Conrail 9 #ake three calculations. :ne %ith ConrailLs -eta= one %ith CS$Ls -eta and onefor the a3erage of -oth the Conrail and CS$ -etaLs. The range of the cost of equity is 10.(, >10./2). That leads to 3ery si#ilar synergy per share price see Appendi. The -eta of orfolkSouthern is 1.1,. This entity is 3ery e4cient and -ecause the ne% CS$&Conrail co#pany %ill -ele3ered e3en #ore 9 did not choose a -eta close to orfolk Southern as it %ould -e not a 3ery goodrepresentati3e♣ After%ards 9 calculated the Ter#inal @alue using a gro%th rate of "). 5ue to a #ature #arket theinUation rate is a reasona-le nu#-er. According to an Analyst report of JBS for the railroadindustry a gro%th rate of 1&") is 3ery adequate and ensures good nancial returns ♣ Then 9 discount the 3alue %ith the cost of equity= for the three scenarios. 9 add the nu#-er and ndthe total 3alue of the synergies. 5i3iding it -y the total O of shares 9 get the 3alue of the synergy pershare ♣ The stand alone 3alue is *71.!!. 9 add the 3alue of the synergies per share and nd the 3alue pershare of Conrail %ith the synergies included that pro3ides a Froof 3alueG for the -id for# CS$♣ Synergies are assu#ed to -e interest free. 9f they are not it %ould -e essential to kno% the type ofde-t -eing assu#ed and the repay#ent attached to it= to 3alue the @ of synergiesConsiderations 9nputs♣ The risk free rate is the JS T&-illof "!&years equal to 0./")♣ The #arket pre#iu# is the yieldon Mong&ter# Corporate BondsAAA -ecause -oth Conrail andCS$ are Class 9 railroads and it isequal to 7.(!) ♣ The gro%th rate= due to a #ature#arket is equal to ") inUationrate♣ The -eta of Conrail and CS$ are3ery si#ilar. The e'ect on the3alue is 3ery little@aluation range♣ The 5C6 3aluation gi3es a rangeθ *+".2( & *+".,(♣ That is 3ery close to the o'er forthe front&end o'er. 9t di'ers %ith*( for the -ack&end o'er♣ The cost of equity calculated forthe -eta of Conrail= CS$ and -othdi'erentiates is s#all a#ountsleading to a narro% range of thepresent 3alue of synergies. 9 usethe cost of equity as it goes to theequity r# and it is not used forde-t pay#entsSynergies 5C6 @aluation * #illions ecept per share prices1++78 1++/8 1+++8 2!!!8 2!!18 T.@alueTotail Iain in :perating inco#e 1// "+0 ,,! ,07
("(2.!/Ta ",) 0,./ 1"/.0 1+2., 1+/.(, 1,1+.7"6C68 122.2 2,7.( ",7., "0/.,, 2/22.",Cost of equtiy 10.(,) 10.(,) 10.(,) 10.(,) 10.(,)@ of 6C68 1!(.+( 1/+./1 220."+ 2!!.(2 1"1/.!!Su# 2=!"+.,0 Rf 0./")O of shares +!., ;. re#iu# 7.(!)Synergies per share 22.,( V Conrail 1."re&-id rice *71.!! Iro% th rate ")Share price *+".,( C. 8quity 10.(,) 1 5 . uestion ,Dhy did CS$ #ake a t%o&tiered o'erE 6or the shareholders of Conrail= does this #ake adi'erence relati3e to an all cash o'erE 1 6 . T%o&tiered o'er♣ CS$ %ill rst acquire 1+.7) at *+2.,! of the co##on shares outstanding of Conrail -ecause it has t%o sideline t%o #a (/) CS$ > (!)♣ Ta&paying institutions > "() on&taa-le institutions > 2/./)♣ 9ndi3iduals > 17) Ta& paying institutions > 2!.()♣ 9nsiders > 1) 9ndi3iduals > 1!.2)9nsiders & .0)♣ Assu#ing that the #erger is not -locked in the rst instance and that due to the #ore fa3ora-le econo#ic conditions and taking econo#icrationality at par= e3eryone %ould try to tender so at to get *+2.,!. That %ould result is a ne% o%nership structure granting Fe'ecti3e controlG toCS$ and #aking it the largest shareholder= a-le to inUuence co#pany decision&#aking♣ The t%o&tier structure helps to #itigate the free&rider pro-le#θ The tendering shareholders get the higher priceθ The non&tendering shareholders are hurtθ ! & *71.!!θ T & *+2.,!θ 8 & */0.7/θ B & */+.!0Successful 6ailsTender *+2.,! *71ot tender */0.7/ *71 1 7 . Dhy not an all cash o'erE♣ A t%o&tier o'er is per se constructed in this %ay as to pay less to the non&tendering stockholders. 9n this deal *"."(/ -illion are paid in cash♣ The re#aining shareo%ners face #a (!.1)♣ CS$Ls -alance sheet is not at the greatest shape. Dith only *00! #illion in cash= and %ith large operations requiring day&to&day cash infusion it%ill go to the capital #arket to raise nancing for its #erger plans. 9t can only allo% up to a certain le3el of de-t in its -alance sheet= therefore itis not etending an all cash o'er. ;ore de-t is unsustaina-le and that %ould shoot up the le3erage ratio far fro# the current one #aking accessin the future at a higher cost of capital♣ The operation %ill add another *"."(/ -illion of de-t= #ost pro-a-ly in the for# of long& ter# lia-ilities assu#ed. Dith re3enues -eing onsteady le3el and the operating ratio -eing not the -est in the industry= CS$ %ould -e etre#ely le3eraged if it ought to etend an all cash o'er.That %ould not guarantee a #ore e4cient operating entity♣ The 5C6 3aluation gi3es a roof price of *+".,(. That is assu#ing all synergies
are realized and paying for all synergies. As a -idder that is notnancially s#art= to calculate the synergies entirely in your -id o'er= therefore the t%o&tier o'er allo%s for a part of the synergies to -e retainedand not paid to the current shareholders of Conrail♣ 9n the o%nership structure of Conrail a large percentage= (/) is hold -y non&taa-le institutions. That is a 3ery i#portant indicator -ecause theyare #ore incenti3ized to tender as they %ould not pay taes if they cash out. The (!) front& end o'er captures these feature as %ell -ecause itallo%s for a #a
policy. This #echanis# is usedto ensure that directors ha3e the right to run the -usiness as they -est -elie3e and to stop current shareholders fro# tendering theirshares to third parties such as T. Boone ickens r. ♣ Conrail has a classied -oard and that does gi3e signicant protection to the -oard #e#-ers and #akes it 3ery di4cult to control it♣ CS$ %ants to include the a-o3e #entioned pro3isions -reak&up fee= no&talk and lock&up as toWθ Reco3er the econo#ical epenses and reputational da#ages in case the deal goes -ust θ To ensure the eclusi3ity of the deal and to deteriorate other potential -iddersClassied-oard♣ A classied -oard is a structure %here directors ser3e for di'erent ti#e lengths♣ ConrailLs -oard #e#-er structure is such that only one&third of the# %e re elected each year #eaning that a -idder %ho%ould %ant to start a proy ght %as una-le to get a #a
