BREAKINGVIEWS-Rail deal puts America first and shareholders last

By Jeffrey Goldfarb

NEW YORK, July 29 (Reuters Breakingviews) - Stakeholder capitalism has gone off the rails. In unveiling its plan to buy smaller rival Norfolk Southern NSC.N for $85 billion, Union Pacific UNP.N gave pride of place to ostensible benefits for U.S. manufacturing and national security. Shareholders, by comparison, are riding in the caboose on this proposed coast-to-coast freight line.

The respective CEOs of Union Pacific and Norfolk Southern, Jim Vena and Mark George, started a presentation on Tuesday by invoking Abraham Lincoln and touting how a transcontinental railway would make the United States stronger. They also promised no union jobs would be lost and more dependable service for customers. The emphasis caters to the U.S. Surface Transportation Board, which conducts notoriously rigorous reviews of rail mergers, but also nods to the White House occupant whose thumbprint is evident on deals ranging from United States Steel to Paramount Global.

There’s little doubt that time and money would be saved by eliminating switches between lines now required to get cargo across the country. The combined company would also be a more formidable competitor against truckers. Union Pacific and Norfolk Southern even pitched this as a boon for drivers and taxpayers, saying that it could reduce traffic and the cost of road repairs.

For shareholders, the rewards are fuzzier, despite Union Pacific avoiding some risks. It eschewed a trust structure, commonly used in railroad tie-ups, that requires funding an acquisition ahead of a two-year regulatory probe. A $2.5 billion breakup fee payable to Norfolk Southern if the merger collapses represents just 2.9% of the purchase price, a lower proportion than for many recent mega-deals, including Kellanova’s agreed sale to Mars. Caution looks shrewd: although a lengthy timeline will be partly to blame, share-price movements imply that investors put the odds of success at only 36%.

Vena expects to extract $2.75 billion of annual synergies, roughly two-thirds of which come from boosting revenue. They’ll cost $2 billion to achieve. Combined with Norfolk Southern’s $4.8 billion in projected 2026 operating profit and then taxed, it would lead to a return of 6.7%, Breakingviews calculates, compared to a 7.9% cost of capital estimated by Morningstar analysts.

It’s possible Vena is underselling the financial uplift, which already bakes in concessions to railway trustbusters. A few years ago, Canadian Pacific factored in revenue synergies worth 8% of its combined top line with Kansas City Southern while Union Pacific is only estimating about 5%. And yet the reason why consolidation largely ground to a halt 25 years ago is because of the terrible outcomes for all involved, regardless of their position in the stakeholder hierarchy.

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CONTEXT NEWS

Union Pacific said on July 29 that it had agreed to buy smaller rival Norfolk Southern for $85 billion, including debt, in a deal that would create the first transcontinental U.S. railroad.

Under the terms of the transaction, Union Pacific will pay $88.82 in cash and one of its shares for each Norfolk Southern share, for a total implied value of $320, representing a 23% premium based on both companies’ unaffected stock prices on July 16, prior to media reports of a potential deal. Norfolk Southern shareholders are in line to own about 27% of the combined company.

Union Pacific said it expects to generate about $2.75 billion of annualized synergies, estimating that they are worth about $30 billion. In addition, Union Pacific agreed to pay Norfolk Southern a $2.5 billion reverse termination fee if the deal fails to be completed.

Morgan Stanley and Wells Fargo are advising Union Pacific while BofA is advising Norfolk Southern.