Canadian Pacific's Underwhelming Bid

[NS Newsfeed]

Canadian Pacific may want to rethink its definition of "sizable."



The $21 billion railroad operator said Tuesday that it had approached Norfolk Southern with an offer to buy the company for a "sizable premium" in cash and stock. Norfolk Southern shed some light on the terms a few hours later: $46.72 in cash and 0.348 of a Canadian Pacific share, or about $95 a share.



Sizable? The offer on the table -- which Norfolk Southern says it's evaluating -- works out to about a 20 percent premium to the stock's average price before Bloomberg News reported last week that Canadian Pacific was exploring a deal. The biggest North American railroad deals of the last decade have commanded an average premium of about 23 percent (admittedly, it's a small pool).



Norfolk Southern shareholders will probably want more -- not less -- than average. They're already signaling their discontent with the current terms. After Norfolk Southern's statement, shares of the $26 billion railroad erased much of an after-market gain that had amounted to as much as 12 percent.



The company may not be able to lay claims to its peak valuation of about $117 a share last year. It's on track for the biggest sales slide since the financial crisis as lower commodity prices reduce the loads of coal and crude oil carried by trains. But Canadian Pacific is probably going to have to come pretty darn close to that high.



Even if commodity prices don't recover next year, they will eventually. After 2015, analysts are projecting revenue gains at Norfolk Southern for the next four years. And when results improve, Norfolk Southern's stock should, too. As the relative dearth of deal activity this year among oil and gas explorers has shown, companies aren't usually willing to sell near the bottom.



If it pays for about half the deal in cash, Canadian Pacific could offer a 40 percent premium to the unaffected share price, or about $112, and still have a deal add to earnings before accounting for any synergies, according to data compiled by Bloomberg. Canadian Pacific will have to be mindful of maintaining a large stock component, though. Norfolk Southern's shareholders will want to ride along for the rebound in commodity prices.



Investors also have to be properly incentivized to go along with what is sure to be a lengthy regulatory review process. Approval of a merger with Canadian Pacific is anything but certain, as railroad CEOs have made abundantly clear. Even though Canadian Pacific and Norfolk Southern don't have much overlap, the industry is already pretty consolidated. Most operators have been reluctant to even attempt big deals amid the heavy scrutiny. Canadian Pacific thinks it can overcome the hurdles, but it's not going to be an easy process.



Canadian Pacific's approach -- which was disclosed in a "bear-hug'' letter -- is a sign that Norfolk Southern isn't interested in what Canadian Pacific has to offer (a position that CNBC reported earlier on Tuesday). By revealing its advance to the public, Canadian Pacific is hoping Norfolk Southern's shareholders will persuade their board to do more than evaluate what the latter has dubbed an "indication of interest."



Should Canadian Pacific convince Norfolk Southern to sell, one potential beneficiary is Bill Ackman. The activist investor is on the board of the railroad and the largest shareholder, with a 9.1 percent stake as of October. Ackman's Pershing Square's average buy-in price is C$56.95, according to data compiled by Bloomberg. That's well below Canadian Pacific's C$184.68 closing price on Tuesday.



Canadian Pacific's stock has gained about 3.4 percent since news first broke of a potential combination. They're likely to climb higher if Canadian Pacific can strike an accretive deal, allowing Pershing to mark up its holding at a time when its positions in Valeant Pharmaceuticals and Platform Specialty Products are underwater.



If Pershing is involved in financing the deal -- it's not yet clear if it is -- the Norfolk Southern pursuit would be the firm's second attempt at a hostile deal in the past two years. Last April, Pershing teamed up with Valeant in pursuit of Allergan, a deal which ultimately perished.



Waiting for the Train

Hostile deals don't fare well in the railroad industry. They're not often successful in any industry, actually.



Let's not forget, Ackman's not a fan of the word "hostile:" he believes it's more gentlemanly to describe them as unsolicited or even ... happy.



Happy definitely isn't the first word one would use to describe how Norfolk Southern's shareholders are likely to feel toward the current offer. It might take some negotiation, and a better bid, to turn their frowns upside down.