To pull off the unprecedented, CP's Harrison fashions proposal to think like his shippers

If E. Hunter Harrison, CEO of Canadian Pacific Railway, wants to steer his unprecedented $28.4 billion transcontinental merger proposal with Norfolk Southern Corp. through a phalanx of hostile shippers, skeptical U.S. and Canadian regulators, fellow railroaders who view him with a mix of awe and concern, and a chilly Norfolk Southern board, he will have to step into the shoes of the shippers. That, it appears, is what Harrison plans to do.

As part of the unsolicited stock-and-cash offer, made public Tuesday evening after more than a week of speculation, Calgary, Alberta-based CP has proposed that, should the combined company fail to provide adequate service or offer competitive rates, it would allow another railroad to operate from a point of connection over the combined company's tracks and into its terminals. In addition, shippers of the combined company, which would constitute the continent's largest rail network, could decide where their freight could interline with another railroad along that carrier's network. CP also said it would end a practice in the U.S. under which an origin railroad dictates where it interchanges a customer's freight with another carrier, even if other interchange points are more advantageous to the shipper. The practice is illegal in Canada.

The combined two-part proposal is a "new approach" to track and terminal access "that will change the status quo in U.S. rail transportation," CP said in a statement last night. The first part "provides an unprecedented alternative" to shippers, who've long complained about the inability to access another railroad if they felt their primary carrier offered inferior service, was gouging them on rates, or a combination of the two.

It is also, on the face of it, an attempt to win over aggrieved shippers and to mollify regulators on both sides of the border that must approve the deal. U.S. regulators have watched the country's rail industry shrink to four east-west "Class I" carriers since it was deregulated in 1980. The Surface Transportation Board (STB), the U.S. agency that oversees the remnants of rail regulation, has shown little appetite to approve any further consolidation. A proposed 1999 combination of Montreal-based Canadian National Railway Co. and Fort Worth, Texas-based BNSF Railway Co. was scrapped the following year after a federal appeals court upheld the STB's authority to impose strict merger guidelines after a decade of subpar rail service. There has not been a merger proposal of Class I carriers since. (In a sad historical irony, Linda J. Morgan, who headed the STB during that time and who later sat on CP's board, died Nov. 7 at 63 after a long battle with cancer.)

Shippers, for their part, have groused for more than a decade about the railroads using their geographic leverage to drive up rates, deliver inconsistent service, and block the use of any alternatives. Many shippers, because of their location, commodity type, or both, are "captive" to the railroads, and in a lot of cases, to just one.

LOOKS FAMILIAR?

Shrewdly, CP crafted the proposal to resemble what the National Industrial Transportation League, a group of industrial shippers that are heavy rail users, has sought since it first proposed to the STB "reciprocal switching" rules in July 2011. Under reciprocal switching, a railroad, for a fee, moves a car between its interchange tracks and a customer's private or assigned siding on another railroad for loading and unloading freight. The NIT League proposal allows a captive shipper or receiver to gain access to a second rail carrier if the customer's facility is located within a 30-mile radius of an interchange where regular switching occurs. Only true captive customers could qualify, and the switch would not occur if the affected railroad proved the practice would be unsafe or if it were unfeasible or harmful to existing rail service, under the group's proposal. The proposal would provide badly needed relief to captive shippers and save customers between $900 million and $1.2 billion a year in freight costs, the group said. The entire rail industry opposes the measure, claiming it would raise costs and herald a new era of reregulation.

The proposal has languished at the agency for nearly four and a half years, with only a docket number (Ex Parte 711) assigned to it as any indication of regulatory movement. Bruce J. Carlton, the League's president, was at the group's annual meeting in New Orleans and unavailable for immediate comment.

Anthony B. Hatch, a long-time rail consultant who runs his own firm, called the CP competitive-access proposal a "whopper," especially since shippers are not known to be Harrison's most fervent supporters. In fashioning the proposal, Harrison also effectively thumbed his nose at the rail industry, something that hardly surprised Hatch since Harrison, who was coaxed out of retirement in 2012 to turn around a then-struggling CP, has achieved almost mythical status and is at a point in his life where he doesn't care what his peers think of him, his strategy, or his tactics. In a note issued last night, Hatch wondered if Harrison was "trading shipper favor for railroad enmity."

Still, Hatch, who opposes further industry consolidation because the costs and service distractions outweigh any benefits, said the access proposal doesn't really address the core issues confronting the rails in general, and Norfolk-based NS in particular. In fact, during the late-2013-to-mid-2014 time period, when rail service suffered greatly under the brunt of severe winter storms and a tough rebound, additional access "would have been, to say the least, counterproductive" because more assets potentially in play in a congested region would ultimately lead to more service problems, he said.

Hatch questioned the need to layer even more complexity on an increasingly service-intensive business that has finally gotten back on its feet. He added that it might be difficult to sort out just who, or what mechanism, would be used to determine how bad service would have to get, or how high rates would have to rise, before a customer of the combined entity could opt for another carrier. (A CP spokesman said it's too early in the process to have settled on a formula). Hatch also doubted that the access language would solve NS' problems, such as a secular and dramatic decline in coal demand that has hurt its revenues as well as those of its eastern rail counterpart, CSX Corp.

LONG ODDS

John G. Larkin, transport analyst for investment firm Stifel, forecast a one-to-three chance that the merger will be consummated. Despite CP's "innovative solution" to try to win over regulators, a still-fragile economy and the fresh memories of service dysfunction will make the STB reluctant to approve such a large-scale transaction. Larkin added that a successful merger would trigger a new and rapid consolidation cycle in the U.S. and Canada that would winnow the number of Class I rails from six to three. "Three megamergers would be more likely to disrupt service than the one proposed by CP," Larkin wrote.

Despite the long odds, it may be unwise to underestimate Harrison. In October 2014, following CP's decision to terminate merger talks with CSX after just three or four meetings, Harrison continued to push for further consolidation as the only logical way to sustainably resolve congestion problems that will only worsen as demand grows. Harrison told analysts that CP looked at CSX and NS, adding that there was little difference between the two. He claimed to be "not obsessed with some transcontinental merger," nor focused on his ego or his legacy. A merger with CSX would have combined two great complimentary systems, and would have eased the pressure at Chicago because of CSX's interest in a connecting railroad that would have allowed CP to bypass the city, Harrison said at the time. Left unsaid were his thoughts about NS.

NS' board has, for all intents and purposes, rejected the proposal, although it officially said it would evaluate it. NS stock closed today at $92.49 a share, up $5.52 a share from its Nov. 17 closing price. While a nice one-day pop, the increase was relatively modest given the deal's enormity, and indicates that CP may need to up the ante. However, if NS opposes a higher bid, it's hard to believe that Harrison, having gone this far and with so much at stake, won't go directly to NS' shareholders in a hostile move. In his corner—presumably—will be William A. Ackman, the activist investor instrumental in removing CP's then-CEO and six board members in 2012 and bringing in Harrison to run the railroad. Ackman's company, New York-based Pershing Square Capital Management L.P., is CP's largest shareholder.

Harrison may claim that ego and legacy are not involved. But at 71, he has the chance to create the continent's first transcontinental rail merger and offer shippers the potential to have their goods moved from Florida's northern tip to Canada's westernmost reaches, all on a single line. Even if the world is stacked against him, it would be hard to imagine him walking away from the opportunity to make history.