Takeaway: The CP bid may have already created value for NSC by forcing NSC management to drive more efficient operations. Performance metrics have already improved notably, with NSC velocity higher than CP’s in December. While NSC shareholders should be very skeptical of both CP claims and bulge bracket analyst coverage, we also think that NSC management is giving an overconfident read on the regulatory hurdles. We plan to ignore the biased NSC shouting and instead focus on the potential for improved operating performance, consolidation, or both.
Since our September NSC Long Black Book, shares of NSC have outperformed in what is an increasingly obvious industrial contraction. The rail discussion has shifted from a bearish volume decline narrative to a bullish consolidation narrative. Improved operating performance at NSC is underway, and we suspect the valuation premium associated with merger potential is unlikely to fade near-term. While a long NSC position requires tolerance for tedious conference calls and headline driven volatility, we continue to expect the shares to perform well relative to a challenged sector. Sure, fourth quarter coal volumes are going to be weak – anyone who has gone outside in North America can put that together; weak coal is why the shares are in the 80s instead of in the triple digits. Market focus has already shifted to 2016 and beyond.
CP & Ackman Bias: While he gets some negative press, we think Bill Ackman’s participation in the rail industry of late is productive. He deserves credit for helping the consolidation narrative. We agree with CP that NSC is an attractive asset, particularly in the mid-70s to low 80s, with significant potential to improve performance. However, Ackman is also a smart and self-interested activist fund manager; NSC holders should view CP’s input with overwhelming skepticism. Ackman is correctly pushing his book since that is his obligation; he is long CP, on the CP Board, and wants NSC on the cheap. We can respect that. But do we care what CP or Ackman says about a potential BNSF bid for NSC? Nope. Are they about to bid for CSX? Probably not, and it wouldn’t necessarily be a negative for NSC long-term. Is the CP offer “highly attractive”? Obviously not. Do they present their bids with a misleading headline number? That is our take. Is EHH the only person who can fix NSC? No, and even he is pretty hot on his COO’s skill set. We’ll stick to just the number, however structured and presented; the number is still too low.
“I think the analyst community can be very helpful in what you say and what you write.” - Ackman 12/8/15
Careful Trusting Bulge Bracket Analysts, Too: Holders of NSC should also view traditional Street coverage with more skepticism than usual, as we see it. First, the Street typically loves the volume, volatility, attention, fees and deals generated by a circus atmosphere. Second, CP’s use of Street analysis in the deal valuation and suggestion that “the analyst community…weigh in” with the NSC Board (along with long calls that get analyst’s names in the transcript) could be viewed as a not-so-subtle effort to get the Street in line. We’d love to hear the off-line conversations/pressure.
“Let's look at analysts' estimates going again back to Citi, quote, based on our math, NS' target for a sub-65% OR in 2020 was largely priced into the valuation prior to CP's proposal …. So, if you want that plan, that's worth CAD 90 a share according to analysts' estimates. The stock is trading above that. You should sell your stock in NS.” – Ackman 12/8/15
HLF Contradiction: According to analyst estimates, HLF is worth $70 a share (12 month price target average). By the above logic, shorts should cover…and get long HLF. Also, we would point out that Street price targets for NSC were much higher last year, with the average at around $120. Street valuations follow share prices, not the other way around. We would be surprised if Mr. Ackman uses bulge bracket valuations for…well…pretty much anything in his fund’s investment decision-making.
“We estimate the total value of the stock and cash consideration to NSC shareholders to be worth $125 to $140 per share at the closing of the transaction in May 2016. The revised transaction offers a 37% to 53% premium to today's closing price of $91.52 and a 58% to 77% premium to the unaffected price of $79.14 per share.” – CP Press Release 12/8/15
Why NSC Rejected Bid, As We See It: We believe the NSC Board has rejected the bid because the price is too low. Efforts to obfuscate the bid by pitching the possible operating performance and synergies have not confused the market – CP is not bidding $125 + CVR or $140 + CVR. They are instead guessing at how the market will value the combined company; we aren’t sure where a regulator would come down on that framing, but we note its absence from the press release today. The addition of the CVR today adds a bit of value, but we think that it would take a bid in excess of, perhaps, $100 per share to get the NSC Board to take the risks of the proposed transaction with engagement. If NSC goes the sale route, they would have an obligation to seek full and fair value, and to explore the potential other suitors. No one knows how the regulatory process will play out; taking on additional regulatory scrutiny is not a good idea without a substantial reward.
What We Do See: NSC management also has an agenda (keeping their jobs) and is probably overstating the challenges to the deal. After all, no one really knows what the regulators will say – most likely including the regulators. Management should encourage a higher offer to maximize shareholder value, and not much else. But NSC management has one huge advantage – performance is dramatically improving. We don’t really care if Mr. Squires was a lawyer or a pole-dancer as long as he improves NSC’s performance. Speeds are soaring and dwell is plummeting – both are key to what Mr. Harrison is targeting for NSC. Perhaps the best part of the CP bid is that it has forced NSC management to set long-term targets and move toward hitting them to keep their jobs.
Upshot: The CP bid may have already created value for NSC by forcing NSC management to drive more efficient operations. Performance metrics have already improved notably, with NSC velocity higher than CP’s in December. While NSC shareholders should be very skeptical of both CP claims and bulge bracket analyst coverage, we also think that NSC management is giving an overconfident read on the regulatory hurdles. We plan to ignore the biased NSC shouting and instead focus on the potential for improved operating performance, consolidation, or both.