MBAD 517

Canadian Pacific & Norfolk Southern AnalysisJennifer Baker, Mary Johnson, Stephen Page

Table of Contents:

1. Executive Summary1.1 Industry1.2 Company Analysis & Backgrounds1.3 Merger of Norfolk Southern & Canadian Pacific1.4 Recommendation

2. Industry Analysis2.1 Future Growth Potential2.2 Industry Life Cycle2.3 Barriers to Entry2.4 Concentration2.5 Changes in Capacity2.6 Stability2.7 Investing in Technology2.8 Government & Regulations

3. Company Backgrounds3.1 Canadian Pacific

3.1.A Background3.1.B Equipment3.1.C Competition3.1.D Past Financial Performance3.1.E Future Growth: ProFormas: SGR - Industry - Time-Trend

3.2 Norfolk Southern3.2.A Background3.2.B Competition3.2.C Past Financial Performance3.2.D Future Growth: ProFormas: SGR - Industry - Time-Trend

4. Financial Ratio Analysis4.1 Canadian Pacific4.2 Norfolk Southern

5. WACC5.1 Canadian Pacific

5.1.A Cost of Debt & Equity5.1.B Weight of Debt & Equity5.1.C WACC

5.2 Norfolk Southern5.2.A Cost of Debt & Equity5.2.B Weight of Debt & Equity5.3.C WACC

6. Firm Valuation6.1 P/E Ratios6.2 EV/EBITDA Ratios6.3 Free Cash Flows6.4 Summary of Valuation Methods

7. Merger Recommendation & ProFormas7.1 Overview7.2 Recommendation & ProFormas

2

Executive Summary

1.1 IndustryTaking multiple variables into account, such as population increase, oil price predictions, the US Railroad industry is expected to grow at 2.9%, up to $87.5 billion by the year 2021. Currently, the US Railroad industry is in a “Growth” phase, growing at a faster pace than the US Economy. This is due to private investments ($525 billion since 1980) and a mix of cost-efficiencies, fuel-efficiencies, and convenience. The barriers for entrance into this industry are very high with the top 4 competitors making up 87.4% of the market share. On top of these market share barriers, the US government places strict regulations on the railroad industry; making it that much harder to succeed.

1.2 Company Analysis & Background

Operating out of the United States and a little in Canada, Norfolk Southern operates on 36,000 miles of track with 4,353 locomotives. NS’s main form of rail business comes from bulk, intermodal, and merchandise freight. The growth rate of 2.9% was used in projecting future financials, raising revenue in 2015 of $10.5 billion to

3

$11.45 billion by 2018. Using financials, WACC was calculated to be 6.10% and 10.68%. Again, using the 2.9% industry growth rate published by IBIS, the share price was calculated to be $151.06.

Canadian Pacific, operating in US but mainly Canada, operates on 12,500 miles of track. CP’s main form of revenue comes from bulk. Intermodal, and merchandise freight. It was decided to focus on the time-trend growth rate of 6.76% from 2011 to 2015. Given this growth rate, there will be a surplus of funds over the coming years. These funds were used to repurchase shares of stock, increase dividend payouts and reduce long-term debt. In accordance with the 6.76% time-trend growth, WACC was calculated at 3.42% and 3.16%. Again, using the 6.76% time-trend growth, CP’s stock valuation was calculated to be roughly $202.57 per share.

1.3 Merger of Norfolk Southern & Canadian Pacific

If the merger of both Norfolk Southern & Canadian Pacific were to become a reality, it would create a true transcontinental railroad system from the gulf of mexico and the way up to the west edges of Canada; the first of its kind. With the merger comes an increased value of $1.8 billion. The improvements that come along with the merger are increased fuel-efficiencies, velocity improvements, and better asset utilization. The synergies created from this merger will the extend reach that was previously mentioned, increase in market shares, and interline efficiencies. This merger would increase combined revenues of $15.74 billion in 2015 up to a combined $19.74 billion in 2020. This takes into account a starting 2.5% growth increase in 2015 up to 6% in 2020; giving CP & NS ample time to combine cultures and reach full potential.

1.4 Recommendation

Given the potential future financials of a successful merger, Canadian Pacific is advised to continue pushing for a merger deal with Norfolk Southern. CP must show NS the true benefits of a transcontinental railroad. Should they use these given financials below, CP will be able to add power to their merger argument. Outside of attempts with Norfolk Southern, Canadian Pacific must convince the Surface Transportation Board as well as antitrust agencies that the merger will not only benefit themselves, but the economy as a whole.

4

Railroad Industry Analysis

2.1 - Future Growth Potential

According to the IBIS report on the US Rail Industry, the industry is expected to grow at an average annual rate of 2.9%, up to $87.5 billion by 2021. These figures take into account US population growth projections of approximately 337 million people by the year 2021. With an increase in the population, the demand for goods increases, leading to increased demand for transporting those goods, and therefore aiding in the growth of the rail industry. Furthermore, oil prices are projected to increase, potentially leading to a shift away from trucks, creating more business for firms in the rail industry (Exhibit 1). By 2021, the US rail industry is projected to hit 599 operators, a 1.2% increase from 2015. With the increase of operators and overall growth, the industry is expected to expand the number of jobs to 178,054 by the year 2021.

5

6

World Bank Crude Oil Projections

2.2 - Industry Life CycleCurrently, the US railroad industry is in a “Growth” phase of its life cycle, growing even faster than the US Economy. The annual Industry Value Added (IVA) to the overall economy is expected to grow at 2.7% until 2021. The US railroad system is a mix of cost-efficiencies, fuel-efficiencies, and convenience. These components play a major role in the growth of the industry due to society’s desire to be more environmentally conscious. Another important factor in the life-cycle of the industry is that it is privately funded, rather than depending on US government spending budgets. Since 1980, US rail has reinvested roughly $525 billion back into growth, improvements, and maintenance of the rail systems across the country. This reinvestment of operational revenues is roughly $.40 for every incoming dollar.

Trends & Industry Drivers

7

2.3 - Barriers to EntryDeveloping and creating new rail lines requires a high cost of capital, and extensive operations connecting large consumer markets. These needs make it difficult for new companies to enter the industry. Additionally, since railroads are owned and funded by private investors, new entrants must acquire specific industry knowledge to be successful at raising capital. Regional and local rail companies also have strong barriers to entry because of their reliance on Class 1 firms. However, as demand for rail services increases over time, more companies are expected to enter the industry due to the appealing increase revenues associated with higher demand.

2.4 - ConcentrationIn the United States there are 564 railroad operations, not including sightseeing rail lines, street or commuter rail lines, or rapid transit. The top four competitors account for 87.4% of revenue so far in 2016, leaving 560 other competitors (mostly regional and local) to compete for 12.6% of the remaining market share.

In addition to the four major players (Exhibit), there are three other large companies that make up the seven Class 1 operators. These companies include: Grand Trunk Corporation, Soo Line Railroad Company, and Kansas City Southern. In order to be a Class 1 operator, a company’s operating revenue must be at least $433 million. These seven firms make up the largest freight rail organizations, while the National Railroad Passenger Corporation (better known as Amtrak) is widely

8

recognized as the largest, government-owned passenger rail operation. The concentration of railroad companies is expected to increase marginally until 2021.

2.5 - Changes in CapacityAccording to the U.S. Department of Transportation, demand for shipments by rail will increase by 88% over the 2002 levels by 2035, in terms of tonnage. This is due to the fact that as the U.S. population grows, there will be greater demand for imported products. However, as demand for rail services expands over time, the capacity to ship the influx of goods will be limited. In order to meet the anticipated demand, operators have started to invest in new equipment and infrastructure, enhancing overall productivity, performance, and profitability.

Import & Export VolumesThe U.S. rail industry is sensitive to import and export trade volumes. When volumes rise, demand for rail transportation increases, leading to a rise in revenue. Some export goods that are transported using U.S. railways include: coal, minerals, agricultural goods, and chemicals. International demand for these items is driven by economic growth in developing nations, global supply of goods, exchange rates, and global commodity prices. Total trade volumes are expected to rise in 2016.

2.6 - Stability The three key external drivers that affect industry stability include: the price of diesel fuel, global price of coal, and demand from the chemical manufacturing industry.

Fuel PricesMaintaining the cost of fuel is the most critical driver for maintaining profits. Rail

9

operators impose surcharges onto their customers in order to mollify fuel price fluctuations. If the price of fuel increases, rail transit becomes more competitive because lower fuel surcharges are offered relative to other modes of transportation. However, if the price of fuel decreases, trucking is often preferred over rail for it’s flexibility and customization. In 2015 oil prices dropped and have continued

to stay stagnant at these price levels into 2016.

Coal PricesCoal produces the greatest amount of revenue for freight rail. However, as other energy options become more and more popular (namely solar, wind, and hydropower), the price of coal has increased relative to these alternatives. This has pushed the global price of coal into a decline in 2016, leading operators to move away from concentrating their efforts on coal.

Chemical ManufacturingThe chemical manufacturing industry is the second largest producer of revenue for freight rail. This industry is expected to increase in 2016, leading to increased demand for the rail industry.

2.7 - Investing in TechnologyTechnology will help increase revenue and drive growth for the US rail industry. More fuel efficient and strong locomotive engines are beginning to take over the industry as older engines are being phased out. With anticipated freight volumes to

10

raise above 88% of the 2002 number by 2035, operators must begin investing in more infrastructure to be able to accommodate such large numbers. Again, this will be done through investments in tracks, engines, and railcars.

2.8 - Government & RegulationsThere are several governmental institutions, as well as environmental agencies, that regulate the rail industry. The Federal Railroad Administration (FRA) regulates railroad safety and equipment standards, ranging from rail track maintenance, handling of hazardous shipments, locomotive and rail car inspection and repair requirements, operating practices, and crew qualifications. Freight railroads are also prohibited, by antitrust laws, from forming agreements among one another to set rates, allocate markets, or unreasonably restrain trade in other ways. An agency within the US Department of Transportation, the Surface Transportation Board, is charged with economically regulating the railroads. They have jurisdiction over market entry and exit, mergers and acquisitions, rail service, and other conduct including rate structures.

Company Backgrounds

3.1 Canadian Pacific - BackgroundIncorporated in June 2001, Canadian Pacific (CP) operates a transcontinental railway system in the United States and Canada. Their rail services include bulk commodities, merchandise freight, and intermodal transportation. CP has access to 12,500 miles of rail across Canada and the United States stretching from the Northeastern United States, through the Midwest, all the way to Vancouver. Of the

11

12,500 miles of rail, CP owns 9,000 miles and either leases or jointly owns the remaining 3,500 miles. Approximately 7,600 miles are located in Canada and 4,900 miles are located in the United States. Note: all of the financials referring to CP in this report are in Canadian dollars unless otherwise noted.

Exhibit 1: Geographic extension of CP’s rail network.Source: Canadian Pacific. Investor Fact Book 2015 Supplement.

Exhibit 2: Revenue breakdown of CP’s services from 2013-2015Source: Canadian Pacific. Investor Fact Book 2015 Supplement.

3.1.B EquipmentCanadian Pacific owns a fleet of high-adhesion alternating current locomotives that, relative to standard direct current locomotives, have enhanced fuel-efficiencies and hauling capabilities. As of December 2015, CP had 600 locomotives in storage and does not intend to purchase or acquire new locomotives for several years.

12

Exhibit 4: Number of Locomotives Owned and Leased by Canadian Pacific.Source: Canadian Pacific. CP Works Annual Report 2015.

3.1.C CompetitionCanadian Pacific faces competition from alternative transportation services such as other railroad companies, trucks and vehicles, ships, air, and pipelines. Customers choose the cheapest transportation service, so the price of fuel often determines the type of transportation service they will use. When fuel prices drop, CP risks losing customers to lower cost providers, such as trucking fleets. When fuel prices rise, CP is often able to provide cheaper transportation services. Within the railroad industry, CP’s primary competitors are Canadian National

Railway Company and Burlington Northern Santa Fe. Other rail companies also run through CP’s network and exert pressure on transportation prices and customer service.

Exhibit 8. The extension of the

freight rail network across the

United States. The seven Class 1 Railroad companies are listed at right.

13

3.1.D - Past Financial PerformanceIn 2015, CP was able to produce an operating ratio of 61%, the lowest in the company’s history. Additionally, they produced a record free cash flow of $1.16 billion, a $430 million increase over 2014. This is result of trains making fewer trips and pulling more weight, requiring fewer assets overall. Capital expenditures in 2015 were $1.5 billion. This investment back into the company helped update rail infrastructure, with the goal of creating opportunities for future expansion and reducing capital expenditures in 2016. Below are Canadian Pacific’s past financial statements and key performance measures.

Exhibit 9: Canadian Pacific Key Performance Measures, 2011-2015.Source: Canadian Pacific. CP Works Annual Report 2015.

14

3.1.E Future Growth

Sustainable Growth RateCanadian Pacific’s sustainable growth rate is 24.23%. This rate seems to be an aggressive growth forecast, and CP will be unlikely to obtain this rate of growth within the next three years. The external funding needed is (in millions) $2,821.98, $3,363.62, and $4,036.51 in 2016, 2017, and 2018 respectively. In order to grow at this rate, long-term debt was increased each year by the EFN in the pro forma balance sheet. Considering CP has several locomotives sitting idle in storage, and infrastructure updates were performed in 2015 to maximize efficiency, it is very unlikely that CP will need this amount of funding. If they decide to start a new project(s), they may then need to raise capital to support their growth.

15

Exhibit 14: Pro Forma Income Statement, Sustainable Growth Rate, 2015-2018.

16

Exhibit 15: Pro Forma Balance Sheet, Sustainable Growth Rate, 2015-2018.

Industry Growth Rate

The predicted industry growth rate is 2.9%. With this amount of growth, CP will have a surplus of funds and therefore will not need any external funding. In 2016, CP intends to repurchase up to 6,910,000 common shares (out of 153,059,426 total shares outstanding), but will not acquire more than 116,562 shares in one trading day. Given this information, 116,562 shares were repurchased, reflected in the 2016 pro forma statements, at the price of $129.13 (close on 5/20/26), equaling $15.05 million in share repurchases. Only one day’s worth of shares were repurchased in

17

the pro forma statements because CP announced that the share repurchase was not definite, so a moderate amount of repurchased shares were assumed. The remaining $669.97 million surplus funds were then used to reduce total long-term debt. For 2017, the extra funds were used to increase the dividend payout ratio from 14.06% to 15.5%. This new ratio was chosen based on recent payout ratios in 2014 and 2015. The remaining funds were then used to reduce long-term debt. Lastly, in 2018, the dividend payout ratio was again increased by the same rate as the last year (a 10.95% increase). The new ratio for 2018 is 17.31%. The remaining funds were then used to reduce long-term debt.

Exhibit 16: Pro Forma Income Statement, Industry Growth Rate, 2015-2018.

18

Exhibit 17: Pro Forma Balance Sheet, Industry Growth Rate, 2015-2018.

Time-trend Growth Rate

The time-trend growth rate from 2011-2015 is 6.76%. With this growth rate CP will have surplus of funds and will not need any external funding. Given the information about CP’s intentions to repurchase common stock, 116,562 shares were repurchased, which is reflected in the 2016 pro forma statements, at the price of $129.13 (close on 5/20/26), equaling $15.05 million in share repurchases. The remaining $35.85 million was then used to reduce long-term debt to $8,855.30. The same actions were taken in 2017 and 2018 as in the industry growth rate pro

19

formas. The biggest difference is that there are more surplus funds with the industry growth rate, resulting in more long-term debt being retired. Of the three growth rates analyzed, the time-trend growth is what we expect to see in the next three years. The sustainable growth rate seems very ambitious for any company in the highly competitive and relatively mature railroad industry, and given CP’s past financial performance, we predict CP will surpass the expected industry growth rate.

Exhibit 18: Pro Forma Income Statement, Time-trend Growth Rate, 2015-2018.

20

Exhibit 19: Pro Forma Balance Sheet, Time-trend Growth Rate, 2015-2018.

21

3.2 Norfolk Southern - Background

Founded in 1982 in Norfolk, Virginia, Norfolk Southern is a Class 1 railroad firm. Norfolk Southern operates in 22 different states and is directly responsible for over 36,000 miles of railroad track. In addition to the 22 states, the firm has track located in the District of Columbia as well Canadian routes connecting Albany & Montreal and Buffalo & Toronto. Norfolk Southern’s main form of income is from the transportation of coal up and down the east coast as well as through the plain states. In addition to coal, Norfolk Southern is the largest intermodal freight transporter on the eastern seaboard. The firm is currently publically traded on the NYSE with a stock value of roughly $34.5 billion, as of October 2014.

Exhibit 20: Norfolk Southern Rail MapSource: Wikipedia, Norfolk Southern Railway, web, 2016

Exhibit 20, 21: Plant and Equipment, Operating Revenue SourcesSource: Norfolk Southern Corp website, Corporate Profile

3.2.B Competition

Norfolk Southern Corporation faces competition from several different subdivisions of the transportation industry. First and foremost, Norfolk Southern faces competition from other railroad companies; including Canadian Pacific, Union

22

Pacific, and CSX. Depending on conditions in the oil industry, Norfolk Southern could face competition from the truck industry as well as independent parcel services, like FedEx and UPS. Norfolk Southern is also susceptible to the Cargo Ship industry, which can freely operate around the world.

3.2.C Past Financial Performance

Since 2011, Norfolk Southern’s revenues have been up and down the last five years; ranging from $10.5 billion just this past year up to $11.6 billion in 2014. The firm’s stock prices have also been very inconsistent over the last 5 years in terms of steady growth, as the stock price has ranged anywhere from the highest at $117.64 to a low of $56.05. The only upside to Norfolk Southern’s previous 5 year financial performance is the steady climb in both Gross Margin % and Dividends. Gross Margin % has climbed from 63.1% in 2011 to 65.2% in 2015 (Exhibit 22). Dividends have climbed from 1.66 in 2011 to 2.36 in 2015 (Exhibit 22).

Exhibit 22:

Norfolk Southern Corp. 2011-2015 Financial PerformanceSource: Morning Star, NSC Key Ratios, web, 2016

3.2.D Future Growth

23

Sustainable Growth Rate

Norfolk Southern’s sustainable growth rate pro forma statements was calculated to be at 8.2% via previous years financial statement postings. With this growth rate, Norfolk Southern’s operating revenues should increase from $10.511 billion in 2015 to $11.373 billion in 2016, $12.306 billion in 2017, and $13.316 billion in 2018. Using an average Dividend Payout of 35.74% from the previous 5 years, Norfolk Southern should see Retained Earnings increase as well. Retained earnings will hike up from $996 million in 2015 to $1.321 billion in 2018. (Exhibit 24). With the balance sheet uneven from 2016-2018,, it is advised to invest in technology and superior performing locomotives by taking on more long-term debt. This would increase the LTD account from $9.39 billion in 2015 to $14.3 billion by end of fiscal year 2018 (Exhibit 26). The Sustainable Growth rate of 8.2% is a bit too ambitious considering Norfolk Southern’s recent negative growth a railroad industry analysis estimate at

2.9%.Exhibit 24: Norfolk Southern SGR ProForma Income Statement 2015-2018

24

Exhibit 26: Norfolk Southern ProForma - B/S - 2015-2018

25

Industry Growth Rate

The US railroad industry is estimated to be an average of 2.9% until 2021, according to IBISWorld industry report (2.7% → 3.3%). If this estimation were to come to fruition, Norfolk Southern stands to increase their revenues from $10.5 billion in 2015 to $10.8 billion in 2016, $11.1 billion in 2017, and $11.45 billion in 2018 (Exhibit 27). By keeping the dividend payout ratio constant at 35.74% (5-year previous average), Norfolk Southern will see an increase in the firm’s retained earnings account. Retained Earnings will steadily grow from $996 million in 2015 to $1.1 billion by end of fiscal year 2018 (Exhibit 29). With a surplus of funds coming into the picture from 2016-2018, it is advised to try and payoff as much long-term debt that Norfolk Southern may have. The estimated industry growth rate of 2.9% seems to right on target, as Norfolk Southern’s Chief Financial Analyst, has been quoted as saying “Norfolk expects $2.5% annual volume growth”.

26

Exhibit 27: Norfolk Southern Industry Growth Pro Forma - Income Statement - 2015-2018

27

Exhibit 29: Norfolk Southern Industry Growth ProForma - B/S - Liab. and Equity - 2015-2018

28

Time-trend Growth Rate

Norfolk Southern’s previous 5-year growth has been calculated to an average of -1.38%. If this trend were to continue the company would see operating revenues decline from $10.5 billion in 2015 to $10.36 billion in 2016, $10.2 billion in 2017, and $10.08 billion by the end of fiscal year 2018 (Exhibit 30). By keeping the dividend growth at a previous 5-year average of 35.74%, Norfolk Southern would also see a decline in their Retained Earnings account. Retained Earnings would fall from $996 million in 2015 to $940 million by 2018 (Exhibit 30). Despite Norfolk Southern’s average negative growth rate of -1.38% over the previous 5 years, this would give the firm a surplus of funds. This can be handled in several different ways, such as repurchasing stock from holders or trying to payoff long-term debt. With the potential of Norfolk Southern to continue a downward slide it is advised to try and payoff as much debt as possible. This can be seen in Exhibit 32, where LTD can be lowered from $9.3 billion in 2015 to $5.23 billion by 2018. The continued negative growth rate is very pessimistic; Norfolk Southern should expect to see a turnaround in revenues via the 2.9% average annual growth IBISWorld has predicted.

Exhibit 30: Norfolk Southern Company Growth ProForma - Income Statement - 2015-2018

29

Exhibit 32: Norfolk Southern Company Growth ProForma - B/S - Liab & Equity - 2015-2018

30

Financial Ratio Analysis4.1 Canadian Pacific When Canadian Pacific’s growth is projected at the time-trend rate of 6.76%, a boost can be seen in their interest coverage ratio in a 3-year forecast, indicating that their debt expenses are less of a burden to the company. This is important for CP in the future, as potential investors will want to make sure that they are able to pay interest on future debts. This improving ratio will prevent CP from having to use their cash or borrow even more, which will allow them to better use their cash to invest in the capital assets that are so critical to this industry.

A 3-year forecast also shows CP’s debt/equity ratio dropping by about 45%, down to 1.677. While such a large decrease may suggest that CP’s current debt/equity mix is probably too high, the cost of their current debt financing is healthy, as it is reaping great enough earnings to still benefit their shareholders. Given that the rail industry is very capital-intensive, this is not uncommon for a firm like CP to have a seemingly high debt/equity ratio.

In terms of profitability, CP should be able to continue to leverage their cost advantages and scale efficiencies against competitors (ships, barges, aircraft, and trucks), in order to generate positive profits. Time-trend growth forecasts predict that CP’s profit margin will see a 8.9% increase by 2018. This may be accepted by some investors as somewhat of a conservative prediction, given that today railroads are claiming to quadruple the fuel efficiency of trucking per ton mile of freight, and they have economically greater railcar capacity, with minimal manpower required.

Next, a 9% increase in ROA over the three years is a useful teller of how efficient CP’s management is at using their assets to generate earnings. Although CP actually lost a significant amount of revenues in 2015, due to some of their major commodities delivering negative currency-adjusted revenue growth compared with years past, their operating metrics have consistently improved. When revenues from some categories declined by as much as 25%, (US grain, crude, metals,

31

minerals), CP compensated for the loss by improving their terminal dwell, network speed, and fuel efficiency, which they are believed to have improved by more than double the average annual improvement rate of the industry. In short, this rise in ROA shows investors how effective they are at converting money from invested capital into net income.4.2 Norfolk Southern

Norfolk Southern’s strength is in their financial stability over years past, as well as looking into the future, using the industry growth rate to predict their future financials. When investors are assessing the company’s short-term health in order to identify opportunities, Norfolk’s historical interest coverage ratio and their equally steady future projections provide a favorable view for a positive investment decision.

Norfolk’s network of assets is vastly dense across the country, with tracks expanding all across the US to capture about half of rail volume in many regions. This requires strict asset management and constant renewal, yielding historical annual capital investments averaging 15%-20%, with the majority being applied towards maintenance of capital expenditures and less than a quarter for driving growth and productivity. Given this information, although forecasts show Norfolk’s ROE as decreasing over the next several years, this should not be a major red flag, as comparing the ROE of companies in a capital-intensive sector can sometimes not be the most telling of profitability. Therefore, ROCE, return on capital employed, is a better and more useful indicator of financial performance, because unlike ROE, which only analyzes profitability related to a company’s common equity, ROCE considers debt and other liabilities as well. For investors, Norfolk’s stable ROCE over the years is a very favorable trend, especially when compared with companies whose returns on capital employed are volatile and inconsistent.

32

Company Weight Average Cost of Capital (WACC)5.1 Canadian Pacific WACC

5.1.A Cost of Debt & EquityCanadian Pacific’s beta was given as 1.07 on Morningstar, the risk-free rate is the current rate of three month t-bills, and the market risk premium of 6% was given. Using these numbers we were able to find a CAPM of 6.74%. The cost of debt was found using CP’s Components of Long-term Debt portion of their 10K. We matched the coupon rate and maturity rate of their outstanding bonds to bonds of similar companies in the industry (mainly CSX and Norfolk Southern). We then weighted each bond with the total amount of debt in order to come up with a cost of debt.

5.1.B Weight of Debt & Equity

CP’s total debt, equity, and assets were found using the SMF Function in Excel. We

33

weighted both debt and equity to Total Assets in order to come up with the weight of each.

5.1.C WACC

Using the weights of debt and equity, the CAPM, and the cost of debt, we were able to come up with a WACC of 3.42% (left). Using the DGM (right) we came up with a WACC of 3.16%.

5.2 Norfolk Southern WACC5.2.A

Cost of Debt & Equity

34

Norfolk Southern’s CAPM was computed the same way as CP, using a beta of 1.28 from Morningstar, a market risk premium of 6%, and the current yield on 3-month treasury bills. The cost of debt was found by calculating the weighted average YTM of the bonds listed for Norfolk Southern on Morningstar.

5.2.B Weight of Debt & Equity

Norfolk Southern’s total debt was calculated by a summing the amounts of each of their bonds. The value of equity is the market capitalization. Both amounts have been weighted according to their values relative to total assets.

5.3.C WACC

To conclude, these measurements of debt and equity ultimately yield a WACC of 6.10%. However, a WACC of 10.68% is the result when using DGM.

Firm Valuation

6.1 P/E Ratios

Canadian Pacific Norfolk Southern

35

6.2 EV/EBITDA Ratios

Canadian Pacific Norfolk Southern

6.3 Free Cash Flows

Norfolk Southern

Using the free cash flows method, we calculated six different versions of Norfolk Southern’s estimated stock price (shown in

the table above on the right side). We calculated share prices using all three of the predicted growth rates that we found earlier, and also calculated the price using the two different WACCS (the WACC from CAPM and the WACC from DGM). Earlier, we decided to grow Norfolk Southern’s pro-formas at the Industry growth rate of 2.9%, so we selected the FCF stock price that corresponded to this rate, and used the WACC from CAPM, which seemed to be a more accurate cost of capital. The other

36

share prices were then disregarded, and using this method, the company would be valued at just under $45 billion.

Canadian Pacific

The same methodology was used to find the share price for Canadian Pacific, except we used the previously selected Time Trend growth rate or 6.76% for the company, since

it is believed that their growth will be higher than the industry overall, but certainly not as high as the calculated sustainable growth rate. This methodology values the firm at just over $30 billion.

6.4 Summary of Valuation Methods

(Today’s stock price: $135.49) (-7.27%)

37

(Today’s stock price: $85.19) (-10.01%)

To estimate what we feel is the most accurate valuation of both company’s stock price, we generated a weighted average, using all three of the methods we calculated, as well as incorporation of the Morningstar Analyst’s fair value estimate of the stock price. For both companies, we weighted the Morningstar Analyst’s estimate at only 10%. While we believe it is a fair and trustworthy estimation, it is likely an average of all of the different methods, so we do not want to unfairly account for one or the other as double in weight if it has already been accounted for.

Next, we weighted the P/E ratio and EV/EBITDA ratio prices as the strongest weights, as the prices that were found fairly represented the value of the stock. With Canadian Pacific, we believed that the stock price valuation from the FCF method was too high, likely driven by a potentially underestimated operating cash flow - due to an undervalued amount of asset depreciation. Because the amount of depreciation may have been slightly inaccurate (too small), this could have caused operating cash flows to appear smaller, and made the overall free cash flows also appear to be lower, thus affecting the stock price calculation. Because of the possibility, we weighted the FCF value as less important than P/E and EV/EBITDA so that it would not skew the average.

Similarly, with Norfolk Southern, the FCF is not as heavily weighted because a negative change in net working capital was found, which may have altered the overall cash flows (overvalued), and subsequently led to a misrepresentation in the

38

stock price. Using the uniquely weighted average method, Canadian Pacific would be valued at $22,245,954,684 and Norfolk Southern at $27,717,030,870.

Merger Recommendation & Pro Formas7.1 Overview

CP believes that merging the two companies will enhance competition, ease freight congestion in the Chicago area, improve service, support the growing economy by creating a transnational railway system, and generate significant shareholder value for both companies. However, on April 11, 2016 Canadian Pacific terminated its third effort to merge with Norfolk Southern because NS was not on board with the terms CP suggested. Under the proposal, CP CEO, Hunter Harrison, will cut all ties with CP and become the CEO of NS, all while the merger is being reviewed by the Service Transportation Board. Harrison wants to increase operating efficiency (similar to how he turned CP around in 2011), in order to create the largest, most productive Class 1 railroad company.

NS is also concerned about antitrust issues if they move forward with the merger. US politicians, other railroad companies, and shippers are all very concerned about the potential merger because they believe it will have a negative impact on competition. Additionally, the Service Transportation Board is solely responsible for mergers and acquisitions in the railroad industry. They will not approve any merger applications involving Class 1 railroads (which includes both CP and NS), unless the transaction is shown to be in the public interest. Therefore, CP must be able to

prove without a doubt that the merger of these two companies will serve the public and not decrease competition.

39

Exhibit 31. Map of Rail Lines currently owned by CP & NS.Source: CPConsolidation.com7.2 Options Moving Forward

CP and NS have four options they should consider moving forward. These options include:

1. CP & NS can try to come to an agreement and apply to merge2. CP or NS can try to merge with another major railroad company3. CP & NS can acquire smaller, regional companies independently4. CP & NS can do nothing for the time being and use extra cash to increase

dividends or buy-back stock

Based off of the Pro Forma statements (Exhibit X) created for the merger between CP and NS, we think that CP should choose option 1 and continue to pursue merging with NS. The benefits of merging for CP include: creating the first transcontinental railway system owned by one entity, including full access from the Canadian West Coast to the US Gulf and Atlantic Coast, and their superior financial position relative to the rest of the industry makes merging with NS an affordable deal. The benefits for merging for NS include: eliminating $650 million in annual expenses, enhancing shareholder value, and the opportunity to reduce their operating ratio. In addition the synergies created by the merger, and the value saved, are described in Exhibit X.

40

Exhibit 32. The Synergies and Value Created from CP & NS Merging.Source: CPConsolidation.com

41

Exhibit 33. Combined Pro Forma Balance Sheet, CP & NS

42

Exhibit 34. Combined Pro Forma Income Statement, CP & NS.

Looking at the combined pro forma statements, it is easy to see that merging will likely benefit both companies in the long run. We believe that, because the two companies are in a mature industry and they have consistent, reliable clients, the growth rate in the first year after merging (whether that is later in 2016, or a few years down the road) will be about 2.5%. This is less than the projected industry average of 2.9% because it will take time for the companies to combine their strengths and weakness. The following year we think the companies will be able to grow at the industry growth rate, and in years 3-5 we think the synergies and increased operating efficiencies will allow the firms to grow at increasing rates each year. However, we do not anticipate that the company would grow faster than 6.76%, the growth rate CP is predicted to grow at in the next few years.

If the firms were to indeed follow through with the merger, they would see significant improvements in operating ratio, a major measure of profitability in the railroad industry, since such a large percentage of their revenues are used to maintain operations. Norfolk Southern really could use this reduction in OR, especially since many competitors are pushing 60% and NS is currently sitting at

43

71% as of the first quarter of 2016. Overall, Canadian Pacific would gain synergies from the combining of railway networks, shareholder value would increase, and Norfolk Southern would be able to receive some turnaround expertise from Canadian Pacific, especially with the influence of their CEO, Hunter Harrison, who is respected for his leadership in other recent turnaround projects.

In conclusion, we think that CP should continue to push NS to an agreement. By becoming the first transcontinental railroad in North America, CP will have an advantage as the economy grows, and imports and exports increase. CP must show NS how beneficial their operations system could be for NS’s current financial situation in order to get them on board. Additionally, CP must convince the Service Transportation Board that the merger is in the best interest of the public and that it will not decrease competition within the industry. In order to execute this plan well, CP should consider revising their offer to NS only after taking care of the antitrust issues. This means it may take CP a few years to perfect their offer to NS and convince them that merging is what is best for both companies.

44

Works CitedAssociation of American Railroads. North American Freight Rail Industry. Transportation Research Board. Washington, D.C. March 2014. <http://onlinepubs.trb.org/onlinepubs/railtransreg/Gray031414.pdf>.

Association of American Railroads. State of the Industry 2016 Report 1 Safety and Innovation. <https://www.aar.org/report/Documents/AAR%20State%20of%20the%20Industry%202016%20Full%20Report.pdf>.

Association of American Railroads. Total Annual Spending, 2013 Data. <https://www.aar.org/Fact%20Sheets/Safety/2013-AAR_spending-graphic-fact-sheet.pdf>.

Knoema.com. Crude Oil Price Forecast: Long Term 2016 to 2025. <https://knoema.com/yxptpab/crude-oil-price-forecast-long-term-2016-to-2025-data-and-charts>.

Matusitz, Jonathan. The impact of the railroad on American society: a communication perspective of technology. Pasos Online. Vol. 7. Pgs: 451-461. 2009. <http://www.pasosonline.org/Publicados/7309special/PS0309_9.pdf>.

Norfolk Southern. <http://www.nscorp.com/content/nscorp/en/investor-relations/stock-information.html>.

Pages, E., Lombardozzi, B., Woolsey, L. The Emerging U.S. Rail Industry: Opportunities to support American manufacturing and spur regional development. National Institute of Standards and Technology. <http://www.nist.gov/mep/upload/Rail-Report.pdf>.

Quandl. “Coal Prices and Charts” <https://www.quandl.com/collections/markets/coal>.

45

Rivera, Edward. IBISWorld Industry Report 48211: Rail Transportation in the US. IBISWorld. March 2016. Web.

U.S. Department of Transportation Federal Railroad Administration. <http://www.fra.dot.gov/Page/P0001>.

Yahoo! Finance. <http://finance.yahoo.com/q?s=CP>.

46