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National Post: Scott Rostan in “Hunter Harrison is the key to Canadian Pacific Railway’s merger plan – and its potential flaw”

Kristine Owram, Financial Post

Canadian Pacific Railway Ltd.’s takeover bid for Norfolk Southern Corp. rests on the assumption that CEO Hunter Harrison is a railroading Midas who turns everything he touches into gold. But as the ancient myth moralizes, this blessing can quickly turn into a curse.

When Hunter Harrison retired as CEO of Canadian National Railway Co. in 2009, he planned to return to his estate in Connecticut and take it easy, focusing on charitable work, his horse-breeding business, and maybe writing a book. But some people just aren’t very good at taking it easy. Less than two years later, Mr. Harrison was tapped by activist investor Bill Ackman to lead CN’s chief competitor, Canadian Pacific Railway Ltd., and he gladly accepted.

All Harrison has to do, the theory goes, is take over the corner office at NS and the operating improvements will begin to show immediately. He’s done it before at CP, Canadian National Railway Co. and Illinois Central Corp. This is why CP wants to install the veteran railroader at NS before the merger even closes, putting chief operating officer Keith Creel, a long-time Harrison protégé, in charge of CP.

To do this without breaking the regulatory rule that one railroad can’t take control of another before a deal closes, CP would be held in trust until the merger receives a green light from the U.S. Surface Transportation Board (STB).

This would supposedly allow the companies to merge in a financial sense, but keep their management separate while giving shareholders of both companies the opportunity to realize significant upside even if the merger isn’t approved.

It sounds like the perfect solution, but some industry experts say the very linchpin of the deal – the golden touch of Harrison himself – could also be its undoing. That’s because the U.S. transport regulator could see too much coziness between a Harrison-run NS and the managers at CP.

“In my mind, this (voting trust) thing is frankly a sham and my sense is that the Surface Transportation Board is not going to approve it,” said one prominent U.S. rail lawyer with no connection to the deal who spoke on the condition of anonymity.

“It’s completely naïve to think that Mr. Harrison is going to NS for any reason other than that CP has acquired the stock and is looking to merge. It’s trying to be clever and elevate form over substance.”

The STB is independent from Congress, but it’s still a political body that might not love Harrison’s reputation of ruthless efficiency, said Tony Hatch, principal at New York-based railway consulting firm ABH Consulting.

“They’re a political body and he’s an outsized character, so somewhere in the back of their minds it’s not just a CEO but that CEO,” Hatch said.

CP’s largest shareholder, however, argues that it’s no different than if Harrison decided to quit and accept a new job elsewhere.

“Hunter is an American, he is a free agent, and if Hunter sold his stock in CP and gave up his pension at CP, any railroad in North America or frankly Australia could hire Hunter,” Bill Ackman, a director at CP and head of Pershing Square Holdings Ltd., said on a conference call this week.

CP has repeatedly pointed to CNs acquisition of Illinois Central in 1998 as setting the precedent for what it’s trying to do now. At the time, Harrison was CEO of Illinois Central and became chief operating officer at CN before the deal closed, while Illinois Central was held in a voting trust.

However, there are three distinct differences between that deal and what CP is proposing to do with NS, said Frank Wilner, former chief of staff at the STB and author of Railroad Mergers: History, Analysis, Insight.

First, CN’s acquisition of Illinois Central occurred before the STB implemented stringent new merger rules in 2001. Second, Illinois Central was a much smaller railroad than NS. And third, the target sent its CEO to the acquirer, not the other way around.

“Historically, the voting trust rules require independence, and there is nothing independent about the acquirer, CP, sending its CEO to the acquiree, Norfolk Southern,” Wilner said in an interview.

A move like that would be unprecedented, said Scott Rostan, a former investment banker who worked on Norfolk Southern’s hostile takeover of Conrail in the 1990s.

“I personally can’t think of another situation where the CEO of the acquirer came in as the CEO of the target under the trust structure,” said Rostan, who is now head of corporate training firm Training The Street.

“That does seem to raise eyebrows and a potential conflict of interest, but I’m sure (Harrison) has some very smart legal advisers who are researching that issue right now.”

CP is eager to install its miracle worker at NS as soon as possible because it believes more than 70 per cent of the US$1.8 billion in annual cost savings it has identified will come from his operational improvements.

The upshot of this is that Harrison can realize significant upside for shareholders of the combined company while it’s held in trust. Even if the merger is eventually rejected by the STB, the trust then has two years to spin off the railways back into two separate companies.

“If Hunter can go to Norfolk Southern, to hell with the merger, it doesn’t matter if it gets approved or doesn’t get approved,” said Wilner. “If they can get that stock price up, they have made a bundle of money and then they can peddle those shares at the higher price and reap their benefit.”

The downside is that the plan is almost entirely dependent on the work of one man.

If the company is relying on Harrison’s prowess to add value to NS, it can’t wait too long to put him in charge. Harrison is 71 years old and was forced to take time off earlier this year after surgery on his legs led to medical complications, including pneumonia.

Ackman insists Harrison’s “got a lot more fight in him.”

“That’s the big linchpin: if something happens to Hunter the day after this thing’s signed, there’s an issue there,” said Jeff Young, co-CEO and chief investment officer at NexGen Financial, which holds CP shares.

“So there’s a tremendous amount of key-man risk, full stop.”

But Wilner questioned whether Harrison is really the “indispensable man” his advocates make him out to be.

“That’s really what Ackman is trying to sell to shareholders: this is a ‘god from the machine’ and if we can only get this voting trust he’s going to turn Norfolk Southern into gold,” he said. “The whole case they’re making is contingent on one man.”

He added that Harrison undoubtedly proved himself during his time at Illinois Central, CN (where he eventually became CEO) and CP, but NS is a different beast with a much more complicated network and an intense focus on personal relationships that might result in a lot of push back from employees.

Harrison’s track record is undisputed. Since he took over CP in mid-2012, the company’s share price has more than doubled and he has lowered the railway’s operating ratio – a key measure of efficiency, where a lower number is better – from 83.3 per cent in 2012 to 59.9 per cent in the third quarter of this year. This mirrored his accomplishments at CN, and the two Canadian railways are now the unchallenged top performers in North America thanks to Harrison’s Midas touch.

“His legacy is tremendous – he’s a two-time hall-of-famer and making an effort to become an unprecedented three-time hall-of-famer,” said Hatch.

But his legacy is also controversial. Since he joined CP, the company has shed nearly 6,000 jobs and he’s not popular among shippers, some of whom feel that service has deteriorated under his leadership.

“To make an omelette you’ve got to break a few eggs, and there might be a few broken eggs out there who might be willing to weigh in on this,” Hatch said.

“There could be certain communities, certain labour groups, certain shippers groups … everybody gets a say, that’s the downside, that’s part of the risk.”