Writing to shareholders on May 15, CSX Chairman, President & CEO Michael J Ward insisted that 'CSX is a great company. Its record and its guidance show that the company is progressing towards excellence in every category of operating and financial performance.'
Ward's letter was responding to an 'in-depth growth plan' issued on April 30 by two of its more outspoken investor groups who have been lobbying for months to change the way CSX does business, commercially, operationally and financially.
UK-based The Children's Investment Fund Management has teamed up with 3G Capital Partners to nominate five experienced transport industry executives (below) for election to the CSX board at the company's annual general meeting in New Orleans on June 25, challenging five incumbent directors who are up for re-election. The two funds believe that the current board does not have enough railway expertise to hold CSX management accountable for its performance.
TCI and 3G currently hold 8·7% of CSX shares and derivative securities equivalent to another 12·3%, reportedly through an equity swap arrangement with a group of banks led by Deutsche Bank. TCI has been arguing since last year that CSX management is under-performing by comparison with other Class I operators, and that the management and directors have not served the shareholders well. According to the growth plan, extensive research has identified 'numerous productivity opportunities' which TCI and 3G believe 'can add another $2·2bn to CSX's annual earnings power within five years'.
TCI Partner Snehal Amin, who has been leading the campaign to reform CSX, insists that 'the question shouldn't be “where has CSX come from?” but rather “where should CSX be?”.' He points out that the funds have invested more than $2bn in CSX, and are looking at the longer term rather than simply making a short-term profit and getting out. At a hearing of the House Transportation Committee in Congress on March 5, Amin told committee chairman James Oberstar that the funds were not seeking to control CSX or to cut investment in safety or maintenance. CSX is currently investing heavily in infrastructure renewals, to address a backlog in spending during the 1980s and 1990s which led to a blitz of safety inspections by the Federal Railroad Administration.
However, Amin said he would like CSX to suspend any future investment in capacity expansion until current legislative proposals to tighten regulation of the US rail sector are settled. But he is a strong believer in technical improvements, reportedly suggesting that all the Class Is should move as quickly as possible to ECP braking, which he says could boost capacity by around 20% without additional infrastructure.
The hedge funds are critical of the fact that Ward currently holds three senior positions, and would like him to step down as Chairman so that the board can be led by an outside director, separating the board and management roles. They would also like to restructure the remuneration of senior management, alleging that recent share grants were not justified, and that Ward's package, in particular, is out of line with his contemporaries.
In their growth plan, TCI and 3G point to the rapid improvement in performance and profitability at Canadian National in its first decade after privatisation as an example of what might be achieved at CSX.
In his letter to shareholders, Ward claims that the growth plan actually contains 'a concerning mix of bad maths, flawed assumptions and half truths', and that the group's suggestions threaten 'to reduce CSX's investment-grade debt rating to “junk” status'. He dismisses the comparison with CN as 'flawed and misleading', pointing out that CSX's operating ratio has improved steadily over the past four years; in Q1 of 2008, CSX reported an operating ratio of 77% against 73% for CN.
Ward also rejects suggestions that CSX is under-charging shippers compared to its local Class I competitor Norfolk Southern, insisting that after adjustments the two sets of rates are 'at parity'.
Although CSX has repeatedly rejected the TCI and 3G proposals, it announced in March a financial restructuring much along the lines envisaged by its investors. The company will increase its borrowings in order to buy back 15% of its share capital at a cost of around $3bn. Dividend payments have been increased by 20%, and in its latest guidance note to investors CSX upped its forecast annual earnings growth until 2010 from 15% to around 20%.
Cost of capital
Although shipper groups have become increasingly vocal in claiming that the major railroads are exploiting their position unfairly, there have also been suggestions that the railway industry has not been earning enough to cover its cost of capital.
On May 6 the Surface Transportation Board announced its annual determination of revenue adequacy for the seven Class Is, finding that only BNSF, Norfolk Southern and CP subsidiary Soo Line Railroad met the requirements. The Association of American Railroads wants the rules changed so that they would 'conform to modern day financial practice', suggesting that replacement costs should be used instead of the depreciated book value of assets. It contends that the current method underestimates revenue needs, noting that the change would 'give railroads the ability to better compete for capital in today's financial markets'. AAR CEO Ed Hamberger points out that STB already uses replacement costs as the standard in rate case analysis.
The two sides in the CSX dispute may still be a long way apart, but a compromise may not be out of the question. TCI and 3G have endorsed a proposal by the company to nominate for election to the board the former President of Florida East Coast, John McPherson - a hands-on railwayman who was once Vice-President of Operations at Illinois Central. Some other institutional investors may side with TCI and 3G, but even if the five challengers are all elected, they would still be a minority on the board. Amin says the funds want to work with the company and not against it, but the recent animosity suggests it would be unlikely that he and Ward could work together.
According to TCI and 3G, 'our goal is a strong CSX that can provide the returns shareholders deserve, the service communities can count on, and a working environment employees can be proud of'. The current management would undoubtedly say the same; it's just the best way to get there that seems to be in doubt.
TCI nominees for election to CSX board
Chris Hohn, Managing Partner, TCI
Alex Behring, Managing Director, 3G; formerly COO of ALL Argentina
Gil Lamphere, Former director of CN and IC
Tim O'Toole, Managing Director, London Underground; formerly CEO of Conrail
Gary Wilson, Former Chairman, Northwest Airlines