Takeover bids are always great news for investors who own shares in the target company. These offers drive the share price higher and put the company in play. That can flush out other bids and/or force the would-be acquirer to sweeten the pot.
That's the situation shareholders of Norfolk Southern (NSC, Financial) find themselves in right now. Canadian Pacific (TSX:CP, Financial) (CP, Financial) is attempting to open negotiations for a merger with the Virginia-based U.S. rail giant, offering cash of $46.72 (figures in U.S. dollars) plus 0.348 of a Canadian Pacific share for each share of Norfolk Southern stock. Total value of the bid is $28.4 billion.
Based on Canadian Pacific's trading price of $149.24 at the time of writing, that works out to an offer of $98.66 per share. Of course, that valuation will fluctuate with Canadian Pacific's market price.
The bid couldn't have come at a better time for Norfolk Southern shareholders. The entire railroad sector has been in retreat this year. Norfolk Southern shares were trading between $115 and $120 a year ago. They fell as low as $72.10 in August and were at about $80 when the news of the Canadian Pacific offer broke.
Norfolk Southern stock was originally recommended in this newsletter by retired contributing editor Tom Slee in December 2009 at $52.22. It was last updated as a Hold in June at $91.70 and finished last week at $97.56.
In a letter dated Nov. 9, Canadian Pacific CEO Hunter Harrison and chairman Andrew Reardon told Norfolk Southern CEO James Squires that, if the deal goes ahead, a new company would be created that would own the assets of both railroads. They said that in the light of the "substantial synergies" of an estimated $1.8 billion that would be created by a merger. They believe the fair value of the new company would be $270.68 a share at the time the deal closes, which is targeted as Dec. 31, 2017.
"Moreover, as our combined network creates more comprehensive end-to-end shipment solutions for our customers while reducing congestion in key corridors such as Chicago, network capacity will expand allowing us to improve service and lower costs –Â which is both pro-shipper and pro-competition," they wrote. "A combined network will also lead to faster growth for the new entity versus what either of us would be able to achieve on our own and, importantly, would create a larger, more diversified book of business less dependent on volatile commodities such as crude oil or thermal coal."
The immediate reaction from Norfolk Southern was cool. In a press release, the company described the offer as an "unsolicited, low-premium, nonbinding and highly conditional indication of interest." But it did not reject the offer outright, saying its board would evaluate it "in the context of Norfolk Southern's strategic plans and its ongoing review of opportunities to enhance stockholder value through strategic, financial and operational measures and pursue the best interests of the company and its stockholders."
The Norfolk Southern statement also noted that such a merger "would face significant regulatory hurdles." That's a reference to tighter regulations introduced in 2001 to discourage more mergers in a railroad sector that is down to seven major players. The Canadian Pacific proposal would have to be approved by the U.S. Surface Transportation Board and the company would need to submit what The Wall Street Journal describes as "a tower of paperwork," including a Service Assurance Plan, in an effort to satisfy regulators that the merger was in the best interests of the industry and the country.
Those bureaucratic hurdles are one of the reasons for the long time frame proposed by CP for concluding a deal –Â more than two years from now. Even if Norfolk Southern buys in to the plan, a lot will have to happen before it can be brought to fruition. The uncertainty will add significant volatility to Norfolk Southern's share price. If the proposal dies, the share price could retreat to the $80 to $85 level in a hurry.
Investors who don't want to take that risk may wish to take advantage of the current price bump to sell their positions. Based on Friday's closing price of $97.56, we have a gain of 87% over the original recommended price.
However, anyone selling now could leave a lot of money on the table if the deal goes ahead. Canadian Pacific management estimates that Norfolk Southern shareholders will receive the $46.72 in cash plus $94.16 a share in market value when and if the merger happens, for a total value of $140.88 per share. That's 44% more than the current price. And Harrison has already said that Canadian Pacific might be willing to pay even more than the initial offer.
So do you take the bird in the hand or hope for two in the bush? My inclination is to maintain existing positions and monitor the situation. The Canadian Pacific offer has created a new dynamic in the rail sector. Even if this deal fails, investor perception of Norfolk Southern's value will be enhanced going forward, to the benefit of the share price.