Class I merger talk comes back to center stage as the Wall Street Journal reports Union Pacific is in early discussions with Norfolk Southern. We hosted a call with Littlejohn & Co. LLC Operating Advisor Farrukh Bezar, a former Class I rail executive.* Union Pacific has logical story to tell for both rails, voting trust unlikely, concessions highly likely. Bezar does not see an immediate response from BNSF; however, they would likely need an eastern partner if Union Pacific/Norfolk Southern were to go through.
Both Eastern Class I’s are good fits for Union Pacific, but Bezar sees Union Pacific/CSX as slightly better on fundamentals. Network alignment on the carload (bulk/merchandise) franchise between Union Pacific and CSX is notable, and a single-line network would enable service improvements. Additionally, Union Pacific’s strong leadership under CEO Jim Vena (whom Bezar praised) and operational performance would be a significant asset to a consolidated industry. Bezar did not rule out the possibility of a Union Pacific/CSX combination ultimately prevailing given the fundamentals but noted that other intangible factors such as cultural compatibility play a key role in deal formation.
The main synergy driver would be through service-driven growth and revenue opportunities, though early to quantify. Revenue synergies will be enabled by 1) interchange rationalization turning otherwise unattractive short-haul moves (watershed traffic) into financially favorable longer-haul moves and 2) more efficient routing for customers improving the service offering. These network changes would resolve key impediments to over-the-road conversions, per Bezar. We believe it is too early to quantify the revenue opportunity but see this as directionally positive.
Union Pacific having M&A discussions may indicate they know who will fill the fifth STB Board seat (currently a 2-2 split and the risk of moving forward with a merger in a split is too high, in our view). The risk of not moving fast is the perception that there may be a window open for the Administration, given the two-plus-year process. Vena seems to have stepped on the gas and has done an exceptional job at running Union Pacific, in our view. Union Pacific likely has a “sell the story” process to the White House, focusing on pro-America growth with a “slamming in the golden spike” finish.
Many stakeholders will likely raise their hand for concessions as an opportunity to get something. The unions will be a key in the process, but spinning this as a pro-growth merger could tell a story of increased labor, not downsizing. Short line rail partners would also likely embrace the opportunity to ask for concessions during this time. The elephant in the room will be what the shippers will say and what they ask for; competitive access or switching is on the table (it works in Canada though very different vs. Eastern U.S). The U.S. form of reciprocal switching was actually struck down by courts recently in the rail industry’s favor, thereby providing them the opportunity to offer it up again to get a deal done (although a more robust structure is likely needed).
Bezar does not believe a voting trust will be necessary; it could almost be a reverse merger in that Norfolk Southern may want to be owned by Union Pacific. A voting trust is a positive for Norfolk Southern (given you get paid to bear less risk) and less so for Union Pacific, given the flip side. Bezar sees an advantage to being the first buyer and first seller in a transaction; there would likely be less of a premium for CSX given they are the last option and where they are operationally.
Bezar thinks both BNSF and CSX may have been caught flat-footed and that it is unlikely BNSF will announce interest in the next week; they will likely observe and see how the process evolves. We don’t expect the Canadian rails to get involved given there are fewer synergies to extract and zero political will to have a Canadian carrier own an Eastern U.S. carrier.
The implications for intermodal carriers will likely create some confusion in the near- to medium term, but the long-term strategic issue for the Class I’s will be if they need the IMCs. Bezar believes that, yes, you will need the IMCs long term, given IMCs are much better at managing boxes on the street, among other reasons. The IM carriers will have to wait for contracts to end, but we believe this is net-positive for Hib Group given their exclusive partnership with Union Pacific and Norfolk Southern. J.B. Hunt is exclusive to BNSF on the West Coast but supports both Eastern carriers. Schneider is exclusively on Union Pacific and CSX, and Knight-Swift Transportation Holdings is on Union Pacific and Norfolk Southern. However, if BNSF were to ultimately go after and acquire CSX, there is a likelihood of J.B. Hunt’s evergreen contract continuing under the new railroad.
Cost synergies would be present and a notable source of value even if not in immediate focus. Bezar discussed modest G&A/efficiency gains while acknowledging that broader operational savings could be higher (and flow straight to the bottom line). We estimate that for the CP-KCS deal, which had less network overlap, targeted run-rate cost synergies amounted to ~2.5% of the combined U.S. dollar cost base. We acknowledge the possibility of post-merger congestion (particularly at Chicago) and integration complexity, but see robust leadership as a mitigant that should enable achievement of cost takeout on a full run-rate basis.
*Bezar was Senior Vice President and Chief Strategy Officer at CSX. Prior to joining CSX in May 2019, he founded and led Lynwood Partners, a transportation and logistics advisory firm. His previous experience includes senior leadership roles within the transportation and logistics functions at Clarendon, Booz Allen Hamilton, and A.T. Kearney. He also held sales and marketing positions at the Santa Fe and served as a financial analyst with Chase Manhattan Bank.
