CSX VS. THE HEDGE FUND: The company is at odds about what's best for it, consumers and investors.

By Timothy J. Gibbons
Published by Florida Times-Union on August 12, 2007.

Snehal Amin has big plans for CSX Corp.

Over the next few years, he'd like the Jacksonville-based railroad to increase its debt load, buy back more shares and increase the rates it charges shippers, all with an eye toward boosting investor returns.

One sizable hurdle stands in the way of putting those plans into action, though: TCI Fund Management LLP, the British hedge fund Amin helps run, appears to own only about 4 percent of the company - and CSX management is adamantly opposed to the hedge fund's plans, saying they threaten future growth, imperil the company's financial reputation and raise safety concerns.

"The question is, does it make sense for all stakeholders," Michael Ward, chief executive officer of CSX, said about the suggestions made by his company's fourth-largest shareholder. As well as the other investors, "there are other stakeholders in the 23 states we operate in."

The argument over what direction this company with roots in the 19th century should take in the 21st sets up a fight that, at heart, is over how the railroad should be run, what it should do with its money and what's best for shareholders. More broadly, at least according to the company, the argument goes beyond investors to have an impact on things like public safety and how efficiently consumers get their goods.

Success attracts aggressive investors

The tension between activist investors and the company that has seen its stock price almost triple in the past three years comes at a period of unprecedented financial strength for modern railroads.

Since the railroad rally started, profits are up, stock prices have risen throughout the industry, competitive pressures have enabled railroads to charge their customers more, and rising gas prices have led shippers to come back from the trucks they abandoned railroads for in the 1950s.

The Russell 1000 Railroad Industry Index - which tracks all the large American railroad companies - is up 34 percent from a year ago, part of a steady climb that saw the index hit its to-date peak in July.

More importantly, observers say, all of that financial growth points to a fundamental change in the railroad industry: It has gone from a cyclical one, in which income fluctuates in time with some other economic activity, to a secular industry, one that avoids short-term ups and downs.

CSX's last quarter was an example of this change, analysts said: "This was the second quarter of negative demand," said Jason Seidl, a transportation industry analyst with Credit Suisse. "We're in a freight recession, but pricing power is as strong as it's ever been."

Those sort of results have attracted to the industry the attention of a new class of investors, different from the large shareholders like mutual funds and the smaller individual traders who typically bought in the past. These are proactive investors, like TCI, which owns stock in three railroads and during an industry conference pushed them, particularly CSX, to take more steps to distribute money to shareholders.

Hedge funds spar with management

That change in the investor mix is an important one because it points to different goals and methods: Hedge funds invest because they think an industry is undervalued or they think there's a way to make change that will unlock more value for shareholders, said Jay Ritter, a professor of finance at the University of Florida who has studied the industry.

"Activist hedge funds are different from mutual funds: Mutual funds are typically quite passive," he said. "Normally they don't talk to management and try to force a change in policy."

Hedge funds are an investment vehicle that has gained more popularity - and notoriety. The funds are designed to generate high returns based on the idea of investing in an array of industries and through a variety of investment tools with the goal of making money no matter which way the market turns.

Such funds have become increasingly popular and, flush with cash, have turned to a range of industries where fund managers believe they can unlock hidden value. Taking a page from deep-pocketed private equity investors, they often look to break up companies they own and sell the pieces, cashing out as the profits from the sale are distributed to shareholders. Another strategy: pressuring management to take cash a company had been planning to use for other purposes and instead distributing it to shareholders through stock buy-backs (which tend to increase the share price) and dividends.

These strategies can lead to showdowns with management.

For example, TCI, the company that has been tussling with CSX, helped oust the chairman of the German stock exchange in a fight over what the exchange should do with $774 million in cash it had on hand: Management wanted to buy the London Stock Exchange, while TCI thought the money should be distributed to investors. In another high-profile case, TCI pressure led to the breakup and sale of Dutch bank ABN Amro Holding NV (the fallout of which, incidentally, led to 550 financial service workers in Jacksonville being laid off).

Much of that pressure is done out of the public eye, with hedge funds not now subject to the SEC oversight received by, say, mutual funds.

Hedge funds also tend to avoid talking to the media: In this case, TCI did not return repeated messages left at its London office. After an unlisted phone number for 3G, another big hedge fund investor in CSX, was tracked down through an Internet forum devoted to Brazilian railroad acquisitions, the man who answered the phone refused to give his name and directed inquires to a PR contact who answered "no comment" to a series of questions.

'A matter of degree'

Whether the pressure is applied in the public spotlight or not, railroads don't have the obvious inflection points that other hedge fund targets have displayed: After selling off businesses like its terminal operating arm in 2004, for example, CSX basically just runs trains. (The company does, it should be noted, have real estate holdings that could be sold, in total, for something like $1 billion, according to analysts, although the company has shown little interest in pursuing those sales.)

TCI's strategy for CSX, therefore, takes the distribution approach. As Amin laid out TCI's strategy at a Bear Stearns conference in New York, over the next 10 years the company should raise the rates it charges shippers by at least 7 percent a year and take out more debt in order to increase its dividend and buy back more shares.

Those ideas have merit, said Tony Hatch, an independent railroad analyst who has consulted with hedge funds, although they may go too far.

"It's a matter of degree," he said. "I want to make sure railroads have the ability to make capital expenditures."

CSX has been aggressive in distributing cash to investors, the analyst conceded, pointing to the company's announcement last quarter that it was increasing the amount it would spend on share buybacks this year to $3 billion and was bumping its dividend to 15 cent, announcements that came before Amin publicly laid out TCI's strategy.

"The debate between CSX and the others is should they be more aggressive," Hatch said.

But taking out more debt, particularly after years in which the company focused on getting its debt ratio down to 50 percent, would be foolish, Ward said. Doing so would push the company's bond rating below investment grade, turning its debt into junk bonds - a change which, Ward said, would make loans both more expensive and less available as the company looks to turn to the bond market to fund billions in track repair and expansion he feels will be necessary in years to come.

"We need access to the debt markets," which would become more costly with a junk rating, the CEO said. "If that's such a great thing, why hasn't everyone jumped on it?"

Ward reacts almost as strongly to the suggestion that the company commit to raising prices by 7 percent or 8 percent each year for the next 10 years, increases that would in effect double current prices over the decade. Although CSX, like the rest of the industry, has profited over the past few years from the ability to charge its customers more, governmental pressure to stem the rising rates and customer push-back means such increases will eventually have limits, limits that Ward said are hard to predict more than two or three years out.

"We have always priced to the market," Ward said, "but we have never and would never tell our customers that we plan to effectively double their prices over 10 years."

But activist investors, said Hatch, are right in saying that railroads do have a responsibility to "stop subsidizing customers": Historically, whenever railroads realized productivity gains, those savings were passed on to customers, with the cost of service in real dollars actually declining for 25 years. "This is a historically underpriced business," the analyst said. "There's now a greater demand for their product than a supply of their product."

At the same time, at least some of the extra dollars generated by those price increases do need to go into capital products that would increase safety and capacity, the analyst said.

"It's very good business sense to run a safe railroad," he said.

With some high-profile accidents early this year, it's important for CSX - whose safety record has seen the most improvement in the industry - to make sure its tracks are up to snuff, Ward said, as well as investing to make sure that the system is able to handle increased amounts of freight in coming years.

On top of the strategic concerns, there is a touch of a personal overtone to the disagreement. Being pressured to forgo investment in "a critical piece of the nation's infrastructure" by "Cayman Island hedge fund managers who answer to a handful of anonymous investors" personally bothers Ward. "It rankles me not as a CEO, but as a citizen of the United States," he said.

Defining the race

So what comes next?

Although the 17.8 million shares that TCI owns, according to SEC filings, add up to just over 4 percent of the company, that does make the British firm the railroad's fourth-largest shareholder. Perhaps more importantly, the hedge fund has shown itself able at getting things accomplished even without relatively large stakes, owning only 8 percent of the Deutsche Bourse shares and just 1 percent of ABN Amro. In addition, TCI has told CSX that it owns additional shares through different financial instruments that don't show up in a search of SEC filings.

And if push comes to shove, TCI probably wouldn't act alone. If a group of like-minded investors - say TCI, 3G and Ichan working together - pushed in the same direction, activist investors would control at least 10 percent of the voting power. Then, if such investors appear to be making headway, more traditional investors could also join their team, looking to back a winner.

"Mutual funds are very conservative in general when it comes to challenging management. They like to be on the winning side," said Ritter, the finance professor. "If they see an activist investor has a plan that make sense, suddenly, those passive investors can join hands and create the winning side."

But Ward said he will continue to fight plans that management doesn't think make sense: "We have a fiduciary responsibility to exercise our business judgment. We'll listen to opinions," he said, "but we'll make our own business judgment."

And that judgment says that sustainable value is created by investing in the business as well as distributing profits to shareholders, said the CEO.

"Investing in people and safety creates the money to do things. We're running more of a marathon than a sprint," he said. "We have to share in the short term, but we have to be looking long term, too."


This is a showcase of the work done by Timothy J. Gibbons during a journalism career now stretching back more than a decade.

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