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Can This Railroad Run Any Faster?

A British hedge fund tries to shake up an eastern rail giant.

Sometimes you just can't win. That's probably how CSX chairman Michael Ward feels. In 2007, his railroad beat profit forecasts, boosted its dividend by 25% and accelerated its stock-buyback program. CSX shares rose 28% in the first ten and a half months of the year, easily beating the market. And for his troubles Ward earned É a swift kick in the you-know-what from CSX's second-biggest shareholder.

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In a blistering letter to CSX directors, the London-based Children's Investment fund indicts Ward's five-year tenure. The hedge fund, also known as TCI, says Ward and his minions do not "fully understand the economics of the business" and are "cavalier" about potential risks, "undisciplined" about spending, "unrealistic" about the future and "complacent" about operations.

The irony is that CSX may have been all of those things five years ago. Under former chairman John Snow, the 21,000-mile eastern railroad was an underachiever with erratic operations, deteriorating infrastructure and a revolving roster of executives. When Snow left in early 2003 to become secretary of the Treasury, CSX lifer Ward stepped up. Under Ward, the share price has gone from $13 to $43 (giving CSX a market value of $18 billion), and the dividend has tripled. Since 2004, the personal-injury rate for employees is down 44%, the accident rate has dropped 43%, and on-time arrivals of CSX freight trains are up 71%.

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So Ward clearly is not clueless. But neither is TCI your garden-variety hedge fund. In 2005, it forced Deutsche Bourse to abandon what TCI called an ill-considered attempt to buy the London Stock Exchange, prompting the departure of Bourse's chief executive. Bourse's stock subsequently soared. Recently, TCI attacked a lagging Dutch bank, ABN AMRO, leading to its sale for a big premium to the preexisting price.

On one level, the fight is over spending. CSX plans to invest $5 billion over the next three years in capital improvements, and TCI wants to know why. Capital spending jumped 50%, it notes, after directors rewrote the executive-pay formula in 2005 to focus on a lower operating ratio (expenses as a percentage of revenues) rather than on higher free cash flow. TCI says the operating ratio can be gamed by capitalizing what would otherwise be expenses -- for example, buying new locomotives (capital spending) rather than leasing them (operating expense). It also says the change made Ward, who reaped $36 million the past two years, the industry's most highly compensated executive.

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CSX directors aren't buying these arguments. In a reply to TCI on November 16, they stood behind Ward and essentially told the hedge fund to get lost.

Thick-skinned. A sign on Ward's desk at CSX headquarters in Jacksonville, Fla., reads "No Whining," and he isn't. The son of a Baltimore pool-hall manager, Ward is known for his thick skin and appears intent on waiting TCI out.

If so, good luck. A source close to TCI, which owns 4.1% of CSX shares, says it will steadily escalate the pressure. All 12 CSX directors are elected annually, and the railroad's annual meeting in May could turn into a proxy fight for control of the company. Meanwhile, Ward has told Wall Street that CSX should generate annual earnings growth of 15% to 17% through 2010. (Analysts see earnings of $2.54 per share in 2007 and $2.92 in '08.) The question is whether, in the revitalized rail industry, that's good enough to satisfy most shareholders. No matter what, this seems a win-win deal for CSX investors.

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