Bankruptcy and Corporate ReorganizationAlfio Shkreta2 June 2013
Case summary CSX has put forth a two-tier merger agreement to acquire Conrail The front-end offer for 40% of the shares is $92.50 The back end offer is an exchange offer with a ratio of 1.85619 shares of CSX for 1 share of Conrail Conrail is also a potential a target of Norfolk Southern Both CSX and Norfolk are mature firms whom operate mostly in the railroad industry and intend to grow through acquaints as the market is amature one The Pennsylvania antitakeover law makes the bidding process difficult due to the several provisions incorporated in it The multiples valuation gives a range of $90.48 - $126.98 The DCF valuation gives a range of $93.24 - $93.54
Background information Formed from the remains of six bankrupt Northeastern railroads in 1973 Earned its first profit in 1981 - $39.2 million on revenues of $4.2 billion. Privatized through an IPO in 1987 Major player in the Northeastern cities and their connection with major Midwestern hubs In 1995 it had 23,510 employees, operated 10,701 miles of track and controlled 29.4% of the Eastern rail freight market Main financial indicators as of 1995 Operating revenues - $3.686 billion Operating ratio – 79.9% Revenues per employee - $156,784 P/E ratio – 12.9ConrailCSX A Virginia-based diversified transportation company (intermodal services, ocean-container shipping, barging, contract servicesand railroad services) Major player in the Southeastern and Midwestern States and the Canadian Province of Ontario In 1995 it had 29,537 employees, operated 18,645 miles of track and controlled 38.5% of the Eastern rail freight market Main financial indicators as of 1995 Operating revenues - $4.819 billion Operating ratio – 76.7% Revenues per employee - $163,151 P/E ratio – 11.6
Question 1Why is CSX interested in acquiring Consolidated Rail Corporation (Conrail)? Describe thearguments for the offer being motivated by synergies, as well as arguments for themotivation to pre-empt a bid by Norfolk.
Strategic choice CSX-Conrail The combined entity would result in more than $8.5 billion in revenues and nearly 70% of the Eastern market CSX-Conrail would be able to control the “rail-way” between the Southern ports (CSX), the Northeast (Conrail) and the Midwest (both). By havinga full access to these markets they new company would be able to offer services to its clients for a lower price (economies of scale). This newcombination would restrict the access the presence of Norfolk Southern in these markets, deviating “business” towards the new company The Midwest market, where both firms are heavily present, would become a center of operations and the result would be a reduction of costs Faster load and unload of goods More line tracks available for transportation Higher co-operation and greater manpower Exchange of market knowledge and client base Potential to capitalize on the opportunity of being the first railroad company to connect the East to the West Geographically well placed Network already existing Financial capacity present The railroad industry is a mature market. The only optionto grow is through acquisitions CSX-Conrail would consolidate overlapping transactions CSX-Conrail would increase revenue through service improvements Cost synergies of $370 million by the year 200 Additional operating income of $180 millions Revenues would come from taking industryand taking business over from Norfolk Southern
Pre-Empt Bid from Norfolk Southern Norfolk Southern is the most efficient and best-managed railroad company in the United States Operating ratio – 73.5% Revenue per employee – $193,690 Return on sales – 15.3% Made and unsuccessful bid of $1.6 billion for Conrail in the mid ‘80s. Clearly very interested in acquiring the firm for strategic reasons It has access in the Southeastern and Midwestern States and the Canadian Province of Ontario butit lacks the presence in the Northeastern states which are considered the industry’s prize possessors Financially Norfolk is healthier than CSX Leverage ratio is 33.6%. It can assume more debt than CSX can (40.1%) Current ratio of Norfolk 111.4% vs. CSX’s 64.7% EPS of Norfolk are $5.44. CSX is at $2.94Norfolk Southern has all the “cards” to make a bid that is betterthan the CSX one. It can sustain more liabilities in its balance sheetand it will benefit from synergies if it potentially merges withConrail. Therefore the sooner CSX closes the deal the better it isotherwise it faces a major risk. Both bidders are strategic biddersand therefore the war can result in high valuations for Conrail whichwould lower the realizable profits
Question 2Describe the offer made by CSX. How much is CSX effectively offering per Conrail share?
CSX’s offer deal structure1. CSX has advanced an offer to the shareholders of Conrail. It is a two-tier offerworth an estimated total value of $8.3 billion. An offer is generally structured inthis way as to gain “effective control” of the corporation the first stage andthen acquire the remaining shares at a more favorable price2. CSX will offer to the front-end shareholders $92.50 in cash for their shares. Thisoffer is extended to 40% of the shareholders. Once the first stage is completedthe remaining shareholders of Conrail will have the opportunity to convert oneshare of Conrail for 1.85619 shares of CSX. Based on CSX’s stock price of$46.75 that is equal to $86.78. Counting for the time value of money it meansthat the back-end shareholders will get around $9 per share less than the front-end shareholders making it an unequal offer3. Due to regulatory requirements of the State of Pennsylvania, the obligation tobid for all shares at the same price once a 20% ownership is reached, the front-end offer is divided in two stages. First CSX will put forth a tender offer for19.7% of Conrail’s shares. After that is completed and the shareholders havevoted for the nullification of the “fair value” statue, a statute that explicitlyrequires a bidder to offer to all shareholders the same price unless targetshareholders dismiss this provision, CSX will proceed to tender the remaining20.3% of the shares4. The CEO of Conrail will eventually take over the new company after two year’s.He will get a salary increase of $2 million. The reason is the fact that Act 36grants exclusivity to the board to turn down an offer regardless of the priceoffered making a co-operation with the board and its CEO crucialTwo-tieroffer60% inshares20.3%19.7%40% at$92.50123 The deal contained several other important provisions1 Break-up fee of $300 million CSX was granted the right to purchase 15.96 million newly issued common shares of Conrail ay $92.50 Conrail suspended its poison pill, triggered at 10% ownership level A “no-talk” clause was included, forbidding Conrail from pursuing merger discussions with third parties1- The provisions will be discussed in detail in question 6The deal is not well constructed. Theshareholders will not accept knowing they canget more out of the bid war. Also the CEOturnover may never happen because there is nocontract that can uphold forever. Most probablythe first vote will not succeed
CSX’s offer effective price Conrail shareholders will have the option to tender 40% of the shares at aprice of $92.50 per share. Even though the process is split in two phases it willbe consummated within a very short period of time, one month and thereforethe value of money received is equal for both sub-groups of the front end offer 36.2 million shares x $92.5 = $3.348 billion Conrail’s remaining shareholders will not have the option to get cash for theirshares but will be part of the exchange programme. They will get 1.85619shares of CSX for one share of Conrail, resulting in a total 107,791,117 shares.The price of CSX dropped to $46.75. Because the shares will be converted atsome point in the future I assume that it is fair to calculate the value with thisprice 100.8 million shares x $46.75 = $4.712 billion Thus summing both figures, the proceeds from the cash tender offer and theexpected value of shares once they are converted, I get a total value of $8.06billion ($8.06 billion)/(90.5 million shares) = $89.06 per share The effective/blended price paid for the transaction is equal to $89.06 Exhibit 6 presents a summary of recent railroad acquisitions. Out of 5 merger offers only 3 were anchored successfully. That shows that there ispresent risk of the CSX-Conrail merger not being concluded and that would harm the firms reputation and the share prices would suffer leadingto value destruction for the shareholders In exhibit 1 the stock price of both firms shows that Conrail is trading currently at its 52-week high and the changes of the price sky-rocking arelimited as shown by its past. Conrail is not far from its 52-week high share price either. This information can serve as an indicator that the shareprice movement in the upper direction seems to be fairly limited. The synergies will not crystalize in any time soon therefore the portion ofshareholders whom are being converted as part of the merger agreement face a big chance of ending with a low value# of shares Cash Exchanged sharesConrails 40% 36,200,000 $3.348 billionConrails 60% 54,300,000 100,791,117 The information in the case notes the opportunity ofthe merger being closed by the end of 1997.Assuming that the 60% shareholders whom have nottendered and are not able to sell in the meantimeand calculating the time value of money with r beingequal to the cost of equity 16.45% they could end upwith $74.50Price consideration
Question 3Using Multiples valuation, what is the value of Conrail to CSX? Incorporate the estimatedsynergies in the value. Describe clearly which multiples you use and why, and describewhich comparison firms you use and why. How does this value compare to the offer madeby CSX?
Transaction multiples value range $90.48 - $126.98 The peer group that I chose are the transactions that have been completed That is for the simple reason that because this are transaction multiples, the bid offerencompasses the potential synergies . As such when the deal is not concluded the numberis biased and it will give an unrealistic number. Plus the synergies value for the two omittedfirms are missing (one being Santa Fe Pacific whom I cannot twice) When a bidder puts forth an offer he will include a premium as a result of gaining controlfor the enterprise. Thus including deals whom are not concluded would lead to biasednumbers Santa Fe Pacific, Chicago and North Western and Southern Pacific The best peer group would be selected on the following criteria Business risk – all of the peer members are part of the same industry and face on averagethe same risks. There may be some risk differentiation due to some firms operating in theWest vs. Midwest vs. East but that does not deteriorate the quality of the peer group Growth expectations – the railroad market is a mature one. The growth is to be expectedthrough acquisitions and no technological breakthrough is expected Profitability – on average Conrail is more profitable than the peer group in terms of netincome and it depends very much on how efficient assets are used Leverage structure – the peer group is more levered than Conrail Considering the multiples presented below, CSX is offering less than the counterparts in the otherdeals. An important difference that are the synergies (as a % of target’s operating expenses) to berealized which are estimated to be lower for Conrail and that would certainly affect the price to beoffered as there is less to get from the targetConsiderationsEPS Book Value Sales EBITDASanta Fe Specific 21.4x 4.5x 2.6x 13.1xChicago and North 18.3x 5.5x 2.4x 8.5xSouthern Pacific 18.4x 3.7x 1.7x 12.2xAverage 19.4x 4.6x 2.2x 11.3xConrail 18.4x 2.19x 1.72x 4.26xOffer Price Per Share as a Multiple ofTotal Enterprise Value as amultiple ofProjected synergies22.30%27.70%24.50%24.83%17%Inputs As the offer price I use the $89.06 The EV is calculated as the # offully diluted shares outstandingtimes the pre-bid price $6.425 billion The EPS that I use is the 1996 oneas to be as close as possible tothe bid time and not the forwardEPS For book value I use the bookvalue of equity When calculating the EBITDA andSales multiple I subtract the debtof ConrailValuation range The transaction multiplesvaluation gives a range $90.48 - $151.00 The EPS multiple and the Salesmultiple are close to the industryaverage giving a range value veryclose to the offer price $90.48 - $93.90 Yet the EPS and Book Value arevery much affected from theleverage structure and thus arenot a true representation undermultiple valuation EBITDA $126.98
Valuation multiples explanationSanta Fe Pacific Deals not completed are notconsidered due to possible biasKansas City Southern Chicago & North Western Southern Pacific CommentsStatusSynergies11- As a percent of the targets operating expensesBusinessRiskGrowthExpectationProfitabilityLeverage+ × + + Synergies are very important asthey affect the bid price. If theyare n/a I discard the deal22.3% n/a 27.7% 24.5% Companies operate in therailroad industry which is cyclical.They generate most revenuesfrom this streamline+ + + + Due to maturity the growth willcome from mergers andincreasing efficiency of assets+ + + + Operating ratio differs a bit, yetin terms of net income Conraildoes slightly better+/- +/- +/- +/- The D/E ratio is very different. Itleads to huge variation in termsof value. Under this hypothesisthe best multiples would be theSales and EBITDA which are lessaffected from the leverage. Theindustry is quite capital intensiveso debt is important. Followingon this logic the value rangewould be $90.48 - $126.98× × × ×Peer Group Yes Yes YesNo
Question 4Using DCF valuation, what is the value of Conrail to CSX? (You should use the pre-announcement share value of Conrail as the stand alone value and then value theestimated synergies with the DCF method). Describe clearly what cash flows and discountrate you use and what are these based on. How does this value compare to the offermade by CSX?
DCF value range $93.24 - $93.54 I start with the synergies as presented in Exhibit 7 I calculate the Cost of Equity based on the inputs given in the case. In order to address the differentbetas for Conrail I make three calculations. One with Conrail’s beta, one with CSX’s beta and onefor the average of both the Conrail and CSX beta’s. The range of the cost of equity is 16.45 –16.82%. That leads to very similar synergy per share price (see Appendix). The beta of NorfolkSouthern is 1.15. This entity is very efficient and because the new CSX-Conrail company will belevered even more I did not choose a beta close to Norfolk Southern as it would be not a very goodrepresentative Afterwards I calculated the Terminal Value using a growth rate of 3%. Due to a mature market theinflation rate is a reasonable number. According to an Analyst report of UBS for the railroadindustry a growth rate of 1-3% is very adequate and ensures good financial returns Then I discount the value with the cost of equity, for the three scenarios. I add the number and findthe total value of the synergies. Dividing it by the total # of shares I get the value of the synergy pershare The stand alone value is $71.00. I add the value of the synergies per share and find the value pershare of Conrail with the synergies included that provides a “roof value” for the bid form CSX Synergies are assumed to be interest free. If they are not it would be essential to know the type ofdebt being assumed and the repayment attached to it, to value the PV of synergiesConsiderations Inputs The risk free rate is the US T-billof 30-years equal to 6.83% The market premium is the yieldon Long-term Corporate BondsAAA because both Conrail andCSX are Class I railroads and it isequal to 7.40% The growth rate, due to a maturemarket is equal to 3% (inflationrate) The beta of Conrail and CSX arevery similar. The effect on thevalue is very littleValuation range The DCF valuation gives a range $93.24 - $93.54 That is very close to the offer forthe front-end offer. It differs with$4 for the back-end offer The cost of equity calculated forthe beta of Conrail, CSX and bothdifferentiates is small amountsleading to a narrow range of thepresent value of synergies. I usethe cost of equity as it goes to theequity (firm) and it is not used fordebt paymentsSynergies DCF Valuation ($ millions except per share prices)1997E 1998E 1999E 2000E 2001E T.ValueTotail Gain in Operating income 188 396 550 567 4342.08Tax (35%) 65.8 138.6 192.5 198.45 1519.73FCFE 122.2 257.4 357.5 368.55 2822.35Cost of equtiy 16.45% 16.45% 16.45% 16.45% 16.45%PV of FCFE 104.94 189.81 226.39 200.42 1318.00Sum 2,039.56 Rf 6.83%# of shares 90.5 M. Premium 7.40%Synergies per share 22.54 β Conrail 1.3Pre-bid Price $71.00 Grow th rate 3%Share price $93.54 C. Equity 16.45%
Question 5Why did CSX make a two-tiered offer? For the shareholders of Conrail, does this make adifference relative to an all cash offer?
Two-tiered offer CSX will first acquire 19.7% at $92.50 of the common shares outstanding of Conrail because it has two sideline two major issues: The law explicitly requires bidders holding 20% or more of a company’s stock to offer to all shareholders the same price. In order not toextend the offer to all stockholders CSX has agreed with Conrail’s management to nullify this provision Under Act 36 any entity who brings its voting power above the levels of 20%, 33% and 50% possesses the so-called control shares. If theentity manages through market operations to get this share percentage but without the approval of the board losses its voting rights.Regardless of the amount of shares that the bidder gets he will be bound to only voting rights of 20%. That would mean a hugeeconomical expense, a possible majority share ownership to whom there is a limited voting right opportunity After the board agrees to get rid off the above mentioned “issues” CSX will proceed with a cash offer to acquire the remaining 20.3% of theshares at the same price. That would put CSX share ownership at 40%. Looking at the ownership structure before CSX does acquire any sharesthere are 4 groups of stock holders, thus there is concentrated ownership structure requiring a big chunk of shares to achieve entity control Non-taxable institutions – 48% CSX – 40% Tax-paying institutions – 34% Non-taxable institutions – 28.8% Individuals – 17% Tax- paying institutions – 20.4% Insiders – 1% Individuals – 10.2%Insiders - .6% Assuming that the merger is not blocked in the first instance and that due to the more favorable economic conditions and taking economicrationality at par, everyone would try to tender so at to get $92.50. That would result is a new ownership structure granting “effective control” toCSX and making it the largest shareholder, able to influence company decision-making The two-tier structure helps to mitigate the free-rider problem The tendering shareholders get the higher price The non-tendering shareholders are hurt P0 - $71.00 PT - $92.50 PE - $86.78 PB - $89.06Successful FailsTender $92.50 $71Not tender $86.78 $71
Why not an all cash offer? A two-tier offer is per se constructed in this way as to pay less to the non-tendering stockholders. In this deal $3.348 billion are paid in cash The remaining shareowners face major risks. The stock price can go up, but at the current levels it is nearly around its 1-year peek. The chancesof going down are much higher and that would result in a big loss to them and unequal payment for holding the same security as did the frond-end tenderers If the price of the new entity goes up a lot then it is the bidder who loses because it granted shares to the target with a favorable ratio CSX financial position as of 1995 Total current assets - $1.935 billion Total current liabilities - $2.991 billion Long-term debt - $2.222 billion D/E – 40.1% CSX’s balance sheet is not at the greatest shape. With only $660 million in cash, and with large operations requiring day-to-day cash infusion itwill go to the capital market to raise financing for its merger plans. It can only allow up to a certain level of debt in its balance sheet, therefore itis not extending an all cash offer. More debt is unsustainable and that would shoot up the leverage ratio far from the current one making accessin the future at a higher cost of capital The operation will add another $3.348 billion of debt, most probably in the form of long-term liabilities (assumed). With revenues being onsteady level and the operating ratio being not the best in the industry, CSX would be extremely leveraged if it ought to extend an all cash offer.That would not guarantee a more efficient operating entity The DCF valuation gives a roof price of $93.54. That is assuming all synergies are realized and paying for all synergies. As a bidder that is notfinancially smart, to calculate the synergies entirely in your bid offer, therefore the two-tier offer allows for a part of the synergies to be retainedand not paid to the current shareholders of Conrail In the ownership structure of Conrail a large percentage, 48% is hold by non-taxable institutions. That is a very important indicator because theyare more incentivized to tender as they would not pay taxes if they cash out. The 40% front-end offer captures these feature as well because itallows for a majority of them to tender and keep the full economic remuneration. That is another reason why it is not a full cash offer
Question 6Describe the anti-takeover devices in the deal structure: 1) no-talk clause, 2) poison pill, 3)break-up fee, 4) lock up option. What are these devices and why would CSX or Conrailwant to have them included?
Defensive mechanisms (1) A no-talk clause is an agreement between the bidder (CSX) and the seller (Conrail) that bars the later from soliciting a purchaseproposal from a third party Yet in this case the board of Conrail has the opportunity to terminate the merger agreement under a # of conditions First it risks breaching its fiduciary duties towards the shareholders if it does not consider another put forth. Due to theleeway of the definition of violation of fiduciary duty under Pennsylvania law the board could uphold this statue forseveral year. Second the board had the right to terminate the merger agreement in case when a second offer would make it unlikelyfor CSX to close the deal or win the opt-out vote In the way the no-talk clause is structured it mirrors more a “window shop” provision in the sense that the board is not obligedto go and search for other potential bidders but it can value offers if they are presented to themNo-talkclausePoisonpill A poison pill (rights plan) is a security that gives holders the rights to purchase stock at a discount in the form of common stockdividends. It can be adopted without shareholder approval and its an exclusive mechanisms useable by the board of directors It wards-off potential hostile offers The poison pill provision imposes losses on the acquirer and dilutes his/her equity provision In the Conrail case the trigger level was at 10% and the discount factor was 50% of the current market price. The mechanism ishighly effective if the board does not “like” the bidder but due to the friendly nature of the merger and the fact that after twoyear’s the current CEO of Conrail would take over the company the board decided not to use the pillBreak-up fee A break-up fee is a common feature used in merger agreements and it serves two main purposes If the seller decides to back-off from the deal it will serve as a compensation for the bidder to cover costs (legalcounseling, financial advisors) and for the possible reputational damages It can discourage other bidders as they would have to offer a counter-bid that would cover the amount payable due tothe termination, thus increasing the costs and making the offer less attractive The industry average is about 1-3%. In the CSX-Conrail merger the amount is $300 million. That represents 3.6% of the mergervalue. It is a bit higher than the average and I believe that is for two purposes. First the value of the entire operation is very bigand therefore a deviation is acceptable and second knowing the interest shown from Norfolk Southern, CSX wants to make it ashard as possible for them to get a grip of Conrail
Defensive mechanisms (2) A lock-up stock option is the right/option to buy authorized but unissued shares. It is a common mechanism to protectfriendly deals Conrail granted to CSX the option to buy 15.96 million newly issued common shares which would represent 14.99% of thecommon shares outstanding The purchase price was $92.50 (equal to the offer price) The advantages of the lock-up stock option are It allows the initial bidder to profit from a higher bid from a third party It grants the bidder the option to influence the target’s shareholder voteLock-upoption Conrail had a poison pill already in place, before CSX presented it offer. The rationale to have such a defense mechanism is to: Ward-off unsolicited, coercive, and preclusive offers that would lead to a change of control or corporate policy. This mechanism is usedto ensure that directors have the right to run the business as they best believe and to stop current shareholders from tendering theirshares to third parties such as T. Boone Pickens Jr. Conrail has a classified board and that does give significant protection to the board members and makes it very difficult to control it CSX wants to include the above mentioned provisions (break-up fee, no-talk and lock-up ) as to: Recover the economical expenses and reputational damages in case the deal goes bust To ensure the exclusivity of the deal and to deteriorate other potential biddersClassifiedboard A classified board is a structure where directors serve for different time lengths Conrail’s board member structure is such that only one-third of them were elected each year meaning that a bidder whowould want to start a proxy fight was unable to get a majority of board member within the first-year It would be difficult for CSX to get the merger concluded if the board would be against it because they could upheld theprovisions (poison pill, fair value) for a long period
AppendixSynergies DCF Valuation ($ millions except per share prices)1997E 1998E 1999E 2000E 2001E T.ValueTotail Gain in Operating income 188 396 550 567 4342.08Tax (35%) 65.8 138.6 192.5 198.45 1519.73FCFE 122.2 257.4 357.5 368.55 2822.35Cost of equtiy 16.82% 16.82% 16.82% 16.82% 16.82%PV of FCFE 104.61 188.61 224.25 197.89 1297.25Sum 2,012.61 Rf 6.83%# of shares 90.5 M. Premium 7.40%Synergies per share 22.24 β CSX 1.35Pre-bid Price $71.00 Grow th rate 3%Share price $93.24 C. Equity 16.82%Synergies DCF Valuation ($ millions except per share prices)1997E 1998E 1999E 2000E 2001E T.ValueTotail Gain in Operating income 188 396 550 567 4342.08Tax (35%) 65.8 138.6 192.5 198.45 1519.73FCFE 122.2 257.4 357.5 368.55 2822.35Cost of equtiy 16.64% 16.64% 16.64% 16.64% 16.64%PV of FCFE 104.77 189.21 225.31 199.15 1307.58Sum 2,026.02 Rf 6.83%# of shares 90.5 M. Premium 7.40%Synergies per share 22.39 β Avg. 1.325Pre-bid Price $71.00 Grow th rate 3%Share price $93.39 C. Equity 16.64%Inputs The risk free rate is the US T-billof 30-years equal to 6.83% The market premium is the yieldon Long-term Corporate BondsAAA because both Conrail andCSX are Class I railroads and it isequal to 7.40% The growth rate, due to a maturemarket is equal to 3% (inflationrate) The beta of Conrail and CSX arevery similar. The effect on thevalue is very little For the first figure the beta of CSXis used. It leads to a Cost of equityequal to 16.82% and a share priceof $93.24 For the second figure the averagebeta of CSX and Conrail is used. Itleads to a Cost of equity equal to16.64% and a share price of$93.39. Levering and Un-Leveringdoes not lead to significantdifferences