We upgrade shares of Norfolk Southern and CSX to Buy as the likelihood of rail consolidation moves up considerably. A Union Pacific bid for NSC likely results in a BNSF bid for CSX. An announcement should be a catalyst for shares despite regulatory hurdles. We view the risk/reward as favorable for NSC, conservatively modeling rev/cost synergies to arrive at $323 PT. CSX may come with a lower premium if it’s the second offer; PT to $45.
Where We Stand
We believe UNP will likely make a bid for NSC, and we view the risk/reward to the upside given where NSC shares are currently trading ($276.66 as of close 7/18). Following the unsubstantiated WSJ report that UNP is in active discussions with the NSC board, we hosted a call with a former Class I rail executive on Friday.
It is our view that UNP 1) could have an inclination of 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); 2) may have a nod from Washington (we don’t think UNP would hire bankers if they didn’t get some form of acknowledgment from the Washington); 3) sees significant revenue and cost synergies (that we conservatively estimate), which should drive better service and growth, both of which are necessary to clear regulatory hurdles. We believe the downside risk to NSC may be closer to ~$250. While pre-Liberation Day price was closer to $238, we note that NSC shares were near current levels last fall (though M&A speculation has been circulating for some time). We see a potential bid announcement as a catalyst to shares despite subsequent regulatory hurdles being well understood. The notion of a politically favorable window with the prevailing administration is likely to become more entrenched in the narrative.
CEO Jim Vena has brought strong leadership to UNP, and that operational performance would be a significant asset for an Eastern carrier. On our call on Friday, our panelist did not rule out the possibility of a UNP-CSX combination ultimately prevailing given the fundamentals, but noted that other intangible factors such as cultural compatibility play a key role in any deal formation.
From Four to Two
We believe any transaction would result in the rail industry going from 4 U.S. Class I’s to 2 (with the acknowledgment of both Canadian players having significant U.S. exposure). If UNP makes a bid for NSC, then BNSF may wait to see how the process evolves (i.e., not make an offer immediately following UNP) before possibly making an offer for CSX. We believe an offer would eventually come, though may come at a smaller premium to UNP/NSC, given they would be the later draft pick. 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 carrier, in our view.
STB Hurdle: Large but Not Insurmountable
The regulatory hurdle would be the biggest challenge for a potential merger to be approved. We believe UNP should be able to show a merger would come with a higher quality service product and enhanced competition. Watershed routes should drive upside to revenue synergies that may increase labor, which could win over the unions. Additionally, UNP likely has a “sell the story” process to the White House, focusing on pro-America growth with something like a “slamming in the golden spike” finish (and a great potential photo-op even for President Trump).
That said, the 2001 merger rules go into detail on the downstream effects, including “the likely strategic responses to that transaction by non-applicant railroads.” They also discuss risks of a potential duopoly: “A significant number of shippers and smaller railroads stated that we need new rules to ensure that competition would not be curtailed by future mergers. Their concerns are heightened by the very real prospect that the rail industry is on the threshold of making another round of rail merger proposals that, if approved, could result in a transcontinental rail duopoly.”
We believe that UNP has a strong understanding of these rules and would be prepared to offer hefty concessions that could include reciprocal switching, which 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). How the STB interprets downstream implications of a duopoly threat is the biggest question, in our view.
Valuation & Synergies Assumptions
We estimate potential revenue and cost synergies for both a UNP-NSC and UNP-CSX combination. Applying conservative ranges using the CP-KCS deal as a comparable yardstick still yields significant upside to NSC and CSX shares as we illustrate in the sensitivity tables below that depict various valuation and revenue and cost synergy outcomes.
Revenue Synergies: Improved service on watershed routes and efficient routing underpin the strategic growth rationale for a transcontinental merger that should be expressed as revenue synergies. In the CPKC deal, which was a growth and revenue synergy focused merger, originally targeted synergies amounted to ~6% of the combined revenue base. We take a conservative view on revenue synergies as a percentage of the combined base given the much larger scale of the U.S. Class I’s, and assume 2% of the base (implying ~$785 million for NSC and $830 million for CSX). We assume revenue synergies come in at favorable incremental margins given the rails operate mature networks with large fixed-cost bases. Revenue synergies could see upside in our view given a single-line service alleviates some of the main bottlenecks preventing OTR conversion, allowing volumes to potentially outperform GDP (which the rails have not been able to achieve for decades).
Cost Synergies: Efficiencies and productivity savings on the combined cost base for a transcontinental railroad are expected to be relatively modest, per the former CSX executive we hosted last week, though he acknowledged upside potential. For a CP-KCS deal, we estimate originally targeted run-rate cost synergies amounted to ~2.5% of the combined cost base. We use a slightly lower 1% cost synergy factor for the two potential transcontinental combinations. While a more moderate synergy driver than top-line, cost takeout flows straight to the bottom line.
Valuation: We use a 12.5x EV/EBITDA multiple for NSC on synergy inclusive EBITDA using our estimates above. This implies ~14.1x EV/EBITDA ex synergies. For reference, CP acquired KCS for ~17x EV/EBITDA ex synergies (~12.8x including originally targeted synergies) in 2021 when freight and macro were in better shape. Using these multiples, PT moves up to $323, upgrade to Buy. We believe the first transcontinental pair to form should see a higher takeout multiple, but we acknowledge uncertainty on which pair would potentially strike a deal first. Our sensitivity table below offers investors different multiple and synergy ranges for reference. As the table shows, most scenarios represent healthy upside to shares.
Rail Shipper Survey
Recall our 2Q TD Cowen rail survey where we asked rail shippers if they would support a transcontinental merger; 47% answered that they would support it, a higher level of support than we would have expected. Of shippers that stated they would not support a merger (53%), 39% would support a merger if the railroads made concessions regarding service. This brings total support to ~two-thirds of surveyed shippers. We also asked shippers which concessions would be desirable; participants’ responses included full reciprocal switching, rate case reform and liquidated damages provisions based on service outcomes.
