CONRAIL CASE-A

Submitted by : Amit Goyal

Rakshit Bansal

Siddhant Khemka

1. Why does CSX want to buy Conrail? How much should CSX be willing to pay for
it?

CSX want to buy Conrail as it can generate $8.5 billion in rail revenues and capture
almost 70% the Eastern market share. This deal might result in creating more value to
customers as this deal would increase company’s ability to consolidate overlapping
operations and increase revenues further through service improvements. This combined
rail network can provide long-haul, contiguous and therefore low-cost service between the
southern ports, the northeast and the Midwest. Through this merger they can create more
value in terms of cost to the customers by cost reductions and consolidations if they can
connect East and west parts. It is Estimated that cost reduction due to consolidation and
service improvements would yield $370 million in annual operating income by year 2000
and Projected revenue increase would additional yield $180 million in annual operating
income.
To move ahead in the competition, CSX’s decision to Conrail’s acquisition is the
best strategy to leap forward and gain as CSX is already operating in Southern parts but
not much in other parts. This merger would give CSX the opportunity to enter North-
eastern and Midwestern parts. As railways is a mature industry, cost reductions and
increasing revenues/profits is possible only through acquisitions. Norfolk, its competitor,
which is the most efficient railroad company when compared with CSX, has a better
operating ratio, less workforce, better profits and a healthier balance sheet compared to
CSX, which means Norfolk is very well capable of bidding for Conrail, a successful
acquisition would result in trouble in very existence of CSX. CSX has made a two-tier
offer to acquire Conrail, 40% of shares in the first phase at $92.50 acquiring 19.7% in the
first split phase and the remaining 20.3% in the second split phase.
 In the second phase CSX will exchange the Conrail shares with that of theirs with
the ratio of 1.85691:1, which means the Conrail’s shareholders will be receiving 1.85691
shares of CSX for each share of Conrail, which amounts up to 36.2 million shares * $92.5
= $3.348 billion and 100.8 million shares * $46.75 = $4.712 billion
Thus, summing both figures, the proceeds from the cash tender offer and the
expected value of shares once they are converted, we get a total value of $8.06 billion.

($8.06 billion)/ (90.5 million shares) = $89.06 per share

Hence price = $89.07

This is the Price at which CSX is offering the deal to Conrail’s shareholders.
Assessing Conrail’s worth to CSX

To assess how much CX should pay for Conrail we must look at the value of the CSX-
Conrail merger.

Cost of Equity Risk free rate + Beta* Risk Premium

Risk free rate = 6.83%

Beta of Conrail = 1.3

Let u assume the risk premium as 7%

Cost of equity = 6.83 + (1.3*7) = 15.93%

Using this we can see how much a share would worth after the merger. The price can be
named in such a way that the quote is around this figure.

TV(assuming
constant
Parameters 1997 1998 1999 2000 2001
growth of
4%)
Gain in Operating Income 0.00 188.00 396.00 550.00 567.00 4752.72
Tax @ 35% 65.80 138.60 192.50 198.45 1663.45
After Tax Income 0.00 122.20 257.40 357.50 368.55 3089.27
Present Value 0.00 90.92 165.20 197.92 176.00 1475.29
NPV of gain (in millions) 2105.34 - - - - -
# Shares 90500000 - - - - -
Incremental value per share 23.26 - - - - -
Old Share Price 71.00 - - - - -
New Possible Share Value $94.26 - - - - -

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 Thus, the quoted price should not exceed if CSX wishes to maximize the gain.

2. Analyze the structure of CSX’ structure for Conrail:

a) Why did CSX make a two-tiered offer? What effect does the structure have on the
transaction?

Whenever a two-tiered offer is made, the acquirer offers to buy a certain percentage
of shares at a higher price followed by second offer at a considerable lower price. The
initial offer is to gain control of the target company and then further increase the stake at a
lower price. CSX followed the same strategy by offering to buy 40% of acquisition shares
at $92.50 and then remaining 60% of acquisition shares at an exchange ratio of
1.85619:1.0, resulting in a price of $86.77. Thus, it would result in a value of $89.07 per
share. Benefits of doing this for CSX were Cost as The overall cost of acquiring the target
company, i.e. Conrail would be reduced substantially by making a two-tiered offer and
secondly Timing as Conrail shareholders were more likely to tender their shares in the first
tier to avoid being caught at a lower price in the second tier of the transaction.

So, as soon as the announcement of the merger was done, two things happened The
price of CSX fell from $49.50 to $46.75 and The price of Conrail jumped from $71.00 to
$85.13 which was clear indicative that the market thought Conrail has got a good bargain
for themselves. It would also have proved beneficial for CSX as well, as their share price
has fallen by almost $2.75 from the pre-announcement price, thus reducing the actual
amount they would have to shell out.

For Conrail shareholders, it was a double-edged sword. On one hand they were
offered higher price for tendering shares in tier-1 phase of the deal, on the other hand they
would be subjected to assume equity risk arising out of exchange of shares that too at a
lower value. CSX had also structured the tier-1 phase into two parts, to get around the
Pennsylvania’s tough business corporation laws which required that bidders holding 20%
or more of a company’s stock to offer all shareholders the same price unless shareholders
explicitly voted to nullify this provision.

The reason for the two-tier structure was due to the legal requirement of the local
Pennsylvania law. According to the Pennsylvania’ Business Corporation Law,

 Bidders holding 20 percent of more of a company’ stock were required to offer all
the shareholders the same price unless the target shareholders explicitly voted to
nullify this provision (the fair value statute).
 The bidder’s voting right was limited to a maximum of 2 of total share outstanding,
regardless of percentage owned unless the shareholders approved the right to vote
all the shares (the voting right statute).

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  The management must make sure to protect the interests of the employees and the
community where the company was located in addition to meeting their fiduciary
responsibility to shareholders (the constituency statute).
b) What are the economic rationale for and the takeover implications of the various
provision in the merger agreement?

The various provisions that were part of the merger agreement between CSX and Conrail
are:

 Break-up Fee: This fee protected the acquirer incase the target company chose not
to honor the agreement and backs out of the deal. It typically averaged around 1-
3% of the deal value. Conrail was supposed to pay $300 million in case the
transaction failed to happen.
 Lock Up Option: These options allowed bidders to purchase up to 10-20% of a
target’s fully diluted shares. It was a mechanism by which the initial bidder was
protected from any hostile takeover bids other bidders. Conrail had granted CSX
the option to purchase up to 15.96 million newly issued shares at price of $92.5 per
share.
 Poison Pill/ Shareholder Rights Plans: This provision permitted the companies
to issue discounted shares incase an outside party achieved a certain level of
ownership or made an unsolicited takeover offer. Conrail permitted its shareholders
to purchase additional shares at a discount of 50% to the current market price incase
an outsider purchased more 10% or more of Conrail shares.
 No talk Clause: The target company, here, Conrail was not supposed to pursue any
merger discussions with other parties for a predefined period. In this case the time
fixed was 6 months. The no talk clause forbade Conrail from soliciting other bids.
The economic rationale behind having these provisions is to protect the interests of
shareholders of both the companies if the other company tries to act funny anytime
during the duration of the deal. These measures ensure that the acquirer and target
stay within their commitments and not jump out of the deal at the first given
opportunity.

3. As a Conrail shareholder would you tender your share to CSX at $92.5 in the first
stage offer?
Before the merger announcement, Conrail’s stock was trading at $71 and CSX at $49.50.
But soon after the merger, the prices changed to $85.13 Conrail and $46.75 CSX
respectively. In the back-end offer, one stock of Conrail will be traded for 1.85619 share
of CSX. Assuming the price of the share will remain at $46.75, that amounts to $86.78 per
share for the back-end offer. To the untrained eye, this value seems lesser than the first-
end offer which may trigger the success of the execution of the cash tender offer.

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However, the value of the Conrail stock may be much higher. Let us look at the multiples
that were offered during similar recent railroad acquisitions to assess the potential of the
stock.

Offer Price per Share as a Multiple of

Target Acquirer P/E P/BV EV/Sales EV/EBITDA
Santa Fe Pacific Burlington Northern 21.4 4.5 2.6 13.1
Kansas City Southern Illinois Central 14.6 1.7 3.6 9.9
Santa Fe Pacific Union Pacific 13.4 2.8 1.8 9.2
Chicago and North Western Union Pacific 18.3 5.5 2.4 8.5
Southern Pacific Union Pacific 18.4 3.7 1.7 12.2
Average 17.22 3.64 2.42 10.58

In the case of Conrail’s acquisition by CSX, if we use the above Price multiples to compare:

Parameters Estimated
# of fully
Conrail Multiples of Conrail Value
Debt(in diluted
value for Comparable Value(in of one
millions) acquisition
1996(in Acquisitions millions) share
shares
Parameters millions
Earnings 444.36 17.22 7651.79 90500000 84.55
Book Value 2937.63 3.64 10692.97 90500000 118.15
sales 3722.00 2.42 9007.24 2094 90500000 76.39
EBITDA 1017.00 10.58 10759.86 2094 90500000 95.76

Thus, according to Offer Price multiple comparison of similar acquisition bid, we can see
that the price per share ranges from $84.55 to $118.15.

The merger is also expected to bring many synergies such as revenue gains ($180
million) and cost savings ($370 million). This will definitely increase the value of the
combined entity leading to better gains if the shareholders decide to go with the share
exchange (in the back-end offer. Accounting for the time value of money, back-end
shareholders will only get around $9 per share less than the front-end shareholders. The
reward for holding onto the hare may be higher. But of course, there is a risk of the deal
getting called off if the tender offer during the front-end offer fails.

Thus, as a shareholder of Conrail, it would be wiser to hold on to the share and get the
benefit of the merger through the share exchange during the back-end offer.

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