Conrail Case Study

1. Why does CSX want to buy Conrail? Why can CSX justify paying a
premium to acquire Conrail?
The Staggers Rail Act of 1980 has created a deregulated environment in
which acquisitions are used to improve the competitive positioning of existing
companies within the railroad industry. CSX is interested in Conrail for a couple of
reasons. Primarily, CSX-Conrail merger would result in more than $8.5 billion in
revenues and nearly 70% of the Eastern market. The combined entity would be
able to control the railroads between the Southern ports (CSX), the Northeast
(Conrail) and the Midwest (both). By having a full access to these markets the new
company would be able to offer services to its clients for a lower price (economies
of scale). Additionally, CSXs acquisition of Conrail would prevent the companys
main competitor Norfolk Southern from gaining access to routes in the
Northeastern United States. The Midwest market, where both firms were heavily
present, would become a center of operations and the result would be a reduction
of marginal costs. The new business would be able to faster load and unload goods
with more line tracks available for transportation, higher co-operation and greater
manpower, not to mention benefits from exchange of market knowledge and client
base.
Beside this there were potential to capitalize on the opportunity of being the
first railroad company to connect the East to the West.
Geographically well placed
Network already existing
Financial capacity present
Also its worth to mention that the railroad industry was a mature market and
the only option to grow was through acquisitions.
2. Why would the Surface Transportation Board (STB) likely approve the
merger (i.e., why might the STB not be too concerned about the impact the
merger will have on competition in the northeast)?
It`s very unlikely that the Surface Transportation Board would block the
merger. Firstly, STB earlier approved two mega-mergers (Burlington Northern and
Union Pacific), so it would be irrational to interfere in consolidation of CSX and
Conrail, and thus preventing CSX to stay competitive with its western rivals.
Secondly, one of the goals of the Staggers Act was to give railroads the ability to
pursue mergers and acquisitions and ultimately lower costs.

3. How much should CSX be willing to pay for Conrail? Value Conrail using
the multiples of competitors as well comparable transactions methods. For
calculations, show your work (dont just write the final number).
CSX should pay somewhere between $94.92 and $110.86 for Conrail. This
range is based on a Discounted Cash Flow approach of incremental cash flow
including the revenue gained from rival Norfolk Southern (See the exhibit for
details).
Conrail Valuation
CSX Valuation 1

Required
return

Re

Rf

Beta

Mkt Risk
Prem

15.93%

6.83%

1.3

7.00%

1997

1998

1999

2000

2001

188

396

550

567

358
198

4943
3581
1710

Gain in Operating
Income
TV w. const growth
model at
After tax
PV
NPV
Shares
NPV per share
Pre-merger
Total

4%
35%

257
165

$23.92
$71.00
$94.92

Required
return

Gain
Gain in Operating
Income
TV w. const growth
model at
After tax

122
91

2164.35107
7
90.5

Conrail Valuation
CSX Valuation 2

0
0

4%
35%

Re

Rf

Beta

Mkt Risk
Prem

15.93%

6.83%

1.3

7.00%

1997

1998

1999

2000

2001

240

521

730

752

475

6556
4750

156

339

PV
NPV
Shares
NPV per share

116

217

263

2268

1997

1998

1999

2000

2001

-66

-123

-189

-196

-123
-68

-1709
-1238
-591

2864.457
90.5
$ 31.65

Opportunity Cost
Loss if rival gets
target
TV w. const growth
model at
After tax
PV
NPV
Shares

4%
35%

0
0

-43
-32

-80
-51

-742.462
90.5

NPV per share

$ (8.20)

Pre-merger
Gain
Opp cost
Total

$71.00
$ 31.65
$ 8.20
$110.86

4. Analyze the structure of CSXs offer for Conrail.

(a) Why did CSX make a two-tiered offer?
A two tiered deal was made by CSX because of the heavy regulation
Pennsylvania has for mergers and to provide financial considerations for Conrails
shareholders. Pennsylvanias Business Corporation Law makes it difficult to
perform a first tier tender offer this is why CSX choose to split the offer into two
stages. The first stage cash offer of $92.50 per share enables CSX to gain control
of Conrails stock as shareholders should be willing to trade their ownership for
such a significant payout. The remaining shareholders who decide not to give up
their shares will only be paid $86.78, calculated from taking the initial stock price
of $46.75 multiplied by the exchange ratio of 1.85619. This creates an incentive for
shareholders to initially take CSXs offer to speed up the deal process.
This type of two-tier structure has an effect on the transaction. To start, the
first tier offer receives only 19.3% which avoids the Pennsylvania one-price-deal
and instead allows the process to become a vote. Eventually 35.6% will be owned

including the shares owned by management and therefore only 14% more is
required to have an opt out approval for the second tier. Finally, by utilizing the
second tier offer shareholders are enticed to vote for the opt out provision which
ultimately gives the remaining 60% of shareholders a lower value for their share
price.
(b) Discuss the various anti-takeover measures included in the CSXConrail merger agreement (i.e., no-talk clause, poison pill, break-up fee, lockup options). What implications do these provisions have for the cost of
acquiring Conrail for other bidders (other than CSX)?
There were four important provisions in this CSX/Conrail Merger
Agreement:
1. Conrail had to suspend its Poison Pill clause a defense mechanism that
would have prevented the takeover. The Poison Pill would have allowed
shareholders to purchase shares discounted at 50% of value so shareholders could
maintain ownership interest if an attempt was made by an outside company to
acquire more than 10% of the overall shares. The economic rationale of getting rid
of the Poison Pill was to allow CSX to gain ownership of the Company while
working within the lines of the regulatory laws in Pennsylvania.
2. The No-talk clause was implemented which disabled Conrails ability to
have merger discussions for a 6-month period unless special conditions occurred,
such as the necessity for the Companys board of directors to consider another
offer that way they can act responsibly for their shareholders or if a better offer
comes into play which dominates CSXs bid and CSX is considered unlikely to
compete. This allows Conrail to pursue better deals while weakening CSXs
barriers of preventing another company to compete in the merger.
3. A break-up fee of $300 million charged to Conrail. This guarantees that
CSX will not lose the money they used to pay for the deals fees while
compensating the Company for their time spent and reputation involved with the
deal. This demotes Conrail to consider other bidders or to decline the merger in
such a late stage of the deal process. On the other hand, this could also benefit
Conrail because if another bidder emerges then that new bidder would be required
to pay at least $300 million extra to Conrail to cover the break-up fee.
4. CSX is given lock-up options which will allow them to buy 15.96 million
newly issued Conrail shares at a price of $92.50 per share. This sets that CSX will
keep ownership control of Conrail and also disallows Conrail from selling their
newly obtained shares to another buyer, therefore diminishing the risk of a bidding
war.

5. As a shareholder of Conrail, would you tender your shares to CSX at

$92.50 in the first-stage offer? Why?
If I were a shareholder of Conrail, I would tender my shares to CSX at
$92.50 in the first-stage offer. I think that in the complete absence of another
bidder and a foreseeable market for the acquisition of the company, it is in a
shareholders best interest to tender their shares during the first round offer
whether or not the deal succeeds ultimately. This is because the absolute value in
this circumstance is higher. Therefore, I would tender our share in the initial round.
Conrail shareholders will have the option to tender 40% of the shares at
aprice of $92.50 per share. Even though the process is split in two phases it will be
completed within a very short period of time, and thereforethe value of money
received is equal for both sub-groups of the front end offer => 36.2 million shares
x $92.5 = $3.348 billion. Conrails remaining shareholders will not have the option
to get cash for their shares but will be part of the exchange programme. They will
get 1.85619shares of CSX for one share of Conrail, resulting in a total 107,791,117
shares. The price of CSX dropped to $46.75. Because the shares will be converted
at some point in the future we can calculate the value with this price=> 100.8
million shares x $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, I get a total value of $8.06billlion ($8.06 billion)/(90.5 million shares) =
$89.06 per share. The effective price paid for the transaction is equal to $89.06.
In addition, Exhibit 6 of the case presents a summary of recent railroad
acquisitions. Out of 5 merger offers only 3 were successful. It can be implied that
there is a risk that the CSX-Conrail merger might not being concluded and that
would harm the firms reputation and the share prices would decrease leading to
value destruction for the shareholders.