Stoking the Fires at CSX

Shades of Jim Fisk and Jay Gould! Like those 19th century robber barons, hedge funds and buyout firms have been swarming around railroads in 2007.

Railroads are targets because their profits are rising sharply thanks to their newfound ability to raise rates in a tight transportation market. One small pike, Florida East Coast Railway, was taken private this year, but North America's Big Seven all resisted buyout inquiries.

Now a hedge fund with a reputation for getting its way is confronting the weakest of the large railroads, CSX Corp., in a manner that suggests a proxy fight over policies and maybe even control of the board of directors is only months away.

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The irony is that five years ago, CSX was ripe for an aggressive investor. Under former chairman John Snow, the 21,000-mile eastern railroad was an underachiever with erratic operations, deteriorating infrastrcture and revolving-door senior management.

When Snow left in January 2003 to become Secretary of the Treasury, CSX lifer Michael J. Ward stepped up, and what a change. Under Ward, 56, the split-adjusted share price soared from $14 to a close of $43.67 November 2, the dividend tripled, injuries and accidents plummeted and on-time arrivals of CSX freight trains improved more than 70%. Although Ward won't admit that CSX has deferrred track maintenance, rail and tie replacements are up sharply, too. By almost any reckoning, these are impressive achievements.

But they're not nearly good enough, according to London-based Children's Investment Fund (so named because the wife of founder Chris Hohn runs a charity that gets some of the fund's profits). The fund, better known as TCI, is now the second-largest holder of CSX stock (symbol CSX), with 4.1% of shares.

On October 16, it launched an aggressive campaign against the railroad's management. In a scathing 14-page letter to CSX directors, made public on a new Web site (www.strongercsx.com), the hedge fund minced no words.

Hohn and partner Snehal Amin call Ward and his minions deficient on the economics of railroading, cavalier about potential risks, undisciplined in spending, overly optimistic about future prospects and complacent about underperformance. Oh yeah -- they're also adversarial toward labor, shippers and shareholders.

Although harsh, the rhetoric is standard fare when activist shareholders stir the pot. And it sometimes works. TCI in 2005 forced Deutsche Borse to abandon what it called an ill-considered bid to buy the London Stock Exchange, and the German firm's stock has since soared. More recently, TCI attacked a lagging Dutch bank, ABN AMRO, leading to its pending sale to a consortium of banks at a premium of more than 50% to the preexisting price.

Will TCI be as successful in making CSX management sing its tune or in replacing it if it doesn't? Among the things the hedge fund's letter demands are new, railroad-savvy independent directors, a new method of paying top management, a plan to improve operations and justification of the railroad's capital-spending plans.

Interviewed in his Jacksonville office, Ward doesn't seem concerned that his job could be on the line. "Wolves are not at the door," he says. "We are running a fine company and producing great results. I'll stand on our record." The son of a pool-hall manager (and a whiz at pool himself), Ward is known for his thick skin and seems prepared to withstand a TCI onslaught. A sign on his desk reads, "No Whining."

Ward contends that TCI wants to harvest all the benefits of the railroad renaissance in the short term, at the cost of CSX's long-term viability. "First, they proposed a leveraged buyout," he says, referring to earlier exchanges between CSX and the hedge fund. "The board looked at it, and the idea didn't make sense."

"Then they came up with another idea: to put extreme leverage on the company in order to buy back 20% of our stock year after year," Ward says. "Their theory was that money was readily available and we shouldn't worry about debt ratings. That didn't add up, either."

It's unclear from the letter just how the Children's Investment Fund would cause the CSX share price to increase, other than by cutting back on capital spending and using the cash for share buybacks.

CSX plans $5.1 billion in capital outlays between 2008 and 2010 to repair its physical plant and to add capacity. TCI claims CSX already enjoys 23% excess capacity, but the reasoning behind that claim is fuzzy. The fund suggests that expansion money not be spent until it is known whether a rail re-regulation bill becomes law. TCI's Hohn and Amin did not respond to a request for an interview.

If CSX doesn't cave, matters may come to a head at the railroad's annual shareholder meeting early next May. Of the 12 directors, all but Ward are outsiders, and all stand for election annually.

TCI, along with two other activist investors, Atticus Capital and Icahn Enterprises, own roughly 8% of CSX shares -- a stout launching pad should the three join forces, which they have not publicly done. They could introduce resolutions instructing directors to enact TCI's agenda or seek to replace the directors.

For other CSX investors, "It's hard to see a down side," rail analyst Rick Paterson of UBS tells clients. Ward's guidance to Wall Street is to expect earnings per share to rise 15% to 17% per year through 2010 -- not bad for a company that was foundering a few years ago.

Concludes Paterson: "While we remain confident CSX will get where it needs to be, operationally and financially, if activists light a fire under management that causes them to work harder and get there faster, we'll take it."