Retired NS chairman, CEO gives behind-the-scenes look at railroad merger

[NS Newsfeed]

Norfolk Southern will fend off Canadian Pacific's unwanted merger overtures, survive an expected proxy battle, and prosper despite the severe decline in coal traffic, former NS CEO Wick Moorman says.

Moorman — whose retirement as Norfolk Southern's executive chairman became effective on Dec. 31 — spoke with Trains NewsWire in a wide-ranging telephone interview last week while he was traveling aboard Amtrak's Acela Express. He was critical of CP's proposed hostile takeover and its plans to install E. Hunter Harrison as CEO in Norfolk. And he said it's highly unlikely that NS would pursue a white knight or swallow a poison pill to avoid being acquired by CP.

"It's not a merger partner that makes any sense whatsoever from a strategic standpoint," Moorman says.

The NS board has unanimously rejected all three of CP's merger offers, setting the stage for a potential proxy battle that would play out before or during the NS annual shareholder meeting in the spring. CP Director Bill Ackman, the activist investor who waged the successful proxy fight that ousted CP CEO Fred Green and several CP board members in 2012, is using the same playbook against NS: Attack the railroad's management, criticize its operating and financial metrics, and tout Harrison as the handyman CEO who can fix everything.

CP's shareholders loved that message. Faced with an overwhelming defeat, seven CP directors and Green resigned the day before the railway's annual shareholder meeting. Based on the way NS has responded to CP — particularly by saying the CP operating plan wouldn't work on the NS network — Ackman has said he's "seen this movie before."

So how can NS CEO Jim Squires and the railroad's board avoid a similar fate?

"You only expect a similar outcome if the circumstances are similar," Moorman says. "It's not the same fight. It's not anything like the same fight."

For starters, NS is not an underperforming railroad, Moorman contends. "It's not like things are broken. Yes, we have to change. But this is not a CP situation where the operating ratio was 80 and everyone else was at 70," he says, noting that CP was a laggard for years.

"CP stuck out like a sore thumb. That's not the case here," Moorman says.

Instead, Moorman says Norfolk Southern's problem is primarily coal, which traditionally has been the railroad's most important and highest-margin traffic segment. NS has lost $1.5 billion worth of coal business in the past four years. Despite that, the railroad's operating ratio — or operating expenses as a percentage of revenue — has remained steady as overall revenue has hovered around $11 billion.

Those results are a testament to NS's management, Moorman says. "We have a good management team, a respected management team," he says.

Second, Ackman is comparing CP and NS despite the fact that they are very different railroads that operate in vastly different territories. "We operate in a different part of the world. There just aren't a lot of similarities between our franchises," Moorman says. "CP is primarily a Western Canada, commodities-based railroad. We have to scramble to make money due to our short hauls."

When Ackman was battling for control of CP, he showed how CP trailed Canadian National in every meaningful financial and operating statistic while noting how similar their systems are. A better comparison this time around would be between NS and CSX, Moorman says. NS and CSX financial and operating metrics are similar and both railroads are reducing costs in their hard-hit Appalachian coal networks.

Third, Moorman points out that the regulatory risks of a CP-NS merger were not a part of the CP proxy battle of 2012.

"My very strong belief is that the odds of this thing making it through the regulatory process at all are limited," Moorman says. "If it does get through, you'd have to give up too much" in the form of onerous conditions, ranging from open access to mitigating the concerns of trackside communities.

And he says it's highly unlikely that the Surface Transportation Board would approve CP's plan of putting itself in trust while the merger is under review. Under this scenario, Harrison would sever his ties with CP and take the helm in Norfolk immediately.

"That flies in the face of the concept of a voting trust, which is there to ensure that the acquiring carrier can't exercise any form of control over the acquiree," Moorman says. "CP has also categorically refused to go to the STB and seek a declaratory order that in fact such an arrangement would be approved, something that is well within their right and power to do."

Lining Up Support
NS has had "many conversations" with its major shareholders to educate them about the risks of a merger and the benefits of the railroad's standalone plan. "Shareholders want to see NS improve," Moorman says. "They have differing opinions about this."

Nonetheless, Moorman questioned how shareholders could support an alternative slate of board candidates. "What's their agenda? Is the agenda that we'll have a conversation with CP and see if we can come to an agreement? Shareholders will look at that and say it's a highly uncertain outcome," Moorman says.

But what if it appeared that CP was likely to win a proxy contest. Would NS look for alternatives?

Norfolk Southern's natural merger partners — BNSF Railway and Union Pacific — would only seek merger if another railroad made a first move. "They won't set the dominoes in motion themselves," Moorman says.

What about making a purchase of its own, like Kansas City Southern? It would make NS too big for CP to acquire. And it wouldn't qualify as a major transaction that would trigger the more stringent merger review rules the STB introduced in 2001.

"We're fine with the status quo," Moorman says. "That would be a dicey and expensive poison pill, and who knows how the STB would react."

So for now, NS is relying on a circle-the-wagons strategy that involves lobbying lawmakers on Capitol Hill and in state capitals, as well as talking with shippers. Those efforts have borne fruit. Lawmakers, labor unions, and shipper groups — including the automakers' trade association — have all written the STB to oppose a CP-NS combination. Executives from three other U.S. Class Is have also lined up against a CP-NS merger.

The growing political opposition to the merger has prompted CP to review its strategy for the acquisition and likely will delay CP's timeline, Harrison said yesterday.

"This is not an NS-coordinated set of discussions," Moorman claims. "We told customers what the facts were. They took it on themselves to write."

Dueling Operating Plans
In its standalone plan, NS aims to grow its general merchandise and intermodal traffic, raise prices, increase efficiency, and prune its network where required. "I think it's a good plan," Moorman says. "It...gets the company to the right place. It's ambitious but realistic."

The goal is to bring the NS operating ratio — which has been around 70 — to 65 percent by 2020.

CP says it would be able to bring NS's operating ratio to 60 or below. Harrison has said he would wring $1.2 billion in cost savings out of the NS system by implementing his precision scheduled railroading operating plan. This would drive improvements in fuel efficiency, train velocity, locomotive and railcar productivity, and yard and terminal operations.

But CP's plan is doomed to failure, Moorman says, citing Harrison's call to sideline at least a third of the 4,000-unit NS locomotive fleet.

"Conrail is living proof of what can go wrong quickly," Moorman said, noting how the NS-CSX breakup of Conrail almost immediately caused major service disruptions. "If Hunter puts out an order to park 700 locomotives, I don't even give it a week."

"The service would collapse. It's just that easy," Moorman says. "We worry about the size of our locomotive fleet."

The size of the fleet is determined using modeling that includes traffic levels and the velocity of the railroad, including the all-important metric of how many trains are held for power and for how long. As velocity goes up, NS stores locomotives. As velocity sinks, it pulls units out of storage.

Harrison doesn't have access to any of that information, Moorman says. "I don't know what he's thinking. I really don't. He has no idea what our network looks like, what our requirements are."

NS needs a large locomotive fleet to handle fragmented traffic moving over a spider web network. "We have a very complex network and a big merchandise network. We have twice as many origin-destination pairs that CP does. It's significantly more complexity," Moorman says.

NS has more than 32,000 origin-destination pairs.

"In order to handle that traffic you have to switch it," Moorman says. "You can't build huge trainloads of one, two blocks and move it across the railroad. We're always going to have to switch – a lot."

Yard Closures
In the past few years NS has shuttered humps at Buckeye Yard in Columbus, Ohio, and in Roanoke, Va. But it added a second hump and classification bowl to its already big yard in Bellevue, Ohio, because of its strategic location on the NS system.

Until Bellevue — renamed Moorman Yard last June — was fully operating according to plan and operational improvements boosted velocity systemwide, NS could not consider additional yard closures and consolidation, the retired CEO says. Now it can.

Moorman says that the improvement in CP's operating ratio after Harrison's arrival had more to do with revenue growth than his touted cost-cutting and efficiency measures. "NS has always been aggressive on pricing," Moorman says, so he contends that the only way that Harrison would be able to reduce the operating ratio at NS is through excessive and damaging cutbacks.

"Can you lower the operating ratio at NS? Yes. How do you do it? You cut maintenance spending on infrastructure and cars. It's that simple," he says. And that's bad news in light of the commodities NS hauls, some of which are highly hazardous, Moorman adds.

But these cutbacks would come at the expense of service-sensitive intermodal traffic. "You can drive the operating ratio to 60 but if you lose 20 percent of the revenue base you're worse off than when you started," he says.

"It's hard to maintain it too much," Moorman says. "You can slow the railroad down, cut the maintenance off. In three years time you'll be saying 'Oh my God, what did I do?' "

Harrison has called Norfolk Southern's infrastructure "gold plated" and said he would close terminals and sell off real estate in the metro New York City area.

"If NS closes hump yards or terminals, it's not like we're located on pot-of-gold real estate," Moorman says. "They are in places where you'd say, 'Oh, that'd make a nice cornfield.' "

Plus, most of the terminals NS relies on in New Jersey are fully utilized Conrail Shared Assets facilities jointly owned with CSX.

The Hunter Factor
Moorman expressed frustration with Wall Street analysts for not delving into some of the claims that CP's Harrison has made as the merger process has unfolded.

"I've known Hunter a long time and I like Hunter," Moorman says. "But Hunter just goes out and says things."

For example, Harrison told Wall Street analysts that he recalls stepping onto an NS office car at Augusta, Ga., in 2006. NS officials told him they were looking forward to having a quarterly operating ratio in the 60s. "That was 10 years ago and they are still trying to get to the point of starting with a 6," Harrison said last month.

The problem? Norfolk Southern's operating ratio dropped to 69.2 percent in 2014.

"What he said was right," Moorman says of the gist of the 2006 office car story. "What no one foresaw — no one — was what happened to our coal business."

Caught Off Guard
After stepping down as CEO, Moorman was serving as an NS board member and special advisor to Squires when CP came calling — and leaked stories began appearing in the financial media.

"We were very surprised," Moorman says. "It became clear instantly that this wasn't going to become a conversation about putting our two companies together successfully. It played out in a way that wasn't conducive to any real dialogue."

The NS board considered what was in the best interest of shareholders but could not get past CP's roughly $28 billion offer or the regulatory risk.

"All three of the offers that CP made were totally inadequate, and all were highly dependent on a very significant increase in CP's share price, which has plummeted in the last year," Moorman says. "This was the first and foremost reason that the NS board has rejected the CP overtures. Even if CP's offer was substantially increased, there has been no meaningful effort on CP's part to offset the very considerable risk to the NS shareholders that the merger might not be approved."