INTRO: Kansas City Southern has moved from a 2750 km regional carrier to a 16000 km international network, ideally placed to tap the expanding opportunities generated by the North American Free Trade Agreement

BYLINE: Michael R Haverty

President & Chief Executive OfficerKansas City Southern Railway

SIGNING OF the North American Free Trade Agreement between the United States, Canada and Mexico on October 7 1992 transformed at a stroke the continent’s railway landscape. Both in Canada and the USA, the biggest rail flows have been east - west, linking the industrial hubs along the Atlantic seaboard with the burgeoning cities of the Pacific Rim.

But Nafta changed all that. Suddenly the new axis of economic growth was aligned north-south. The east-west railroads scrambled for opportunities to create corridors linking Mexico with Canada. In the heart of the continent, one railway was already well placed to take advantage of the trend.

The Kansas City Southern Railway was originally conceived as a link between the US heartland and the Gulf of Mexico, way back in 1897. The founder Arthur E Stilwell envisaged a railway running south from the geographic centre of the United States to a port on the Gulf. From here commodities could be shipped to the east and west coasts, Europe, Asia and South America.

Stilwell was unconcerned that his concept ran counter to conventional wisdom, when the 19th century railroad barons were rushing to build east-west routes. He anticipated considerable opportunities for growth along his corridor - and far less competition!

Backed by foreign investors (KCS was not a land-grant railroad), Stilwell succeeded in building a line from Kansas City, Missouri, to Port Arthur, Texas (named after Stilwell). Later he planned another line across the border into Mexico, heading towards the Pacific Ocean, known as the Kansas City, Mexico & Orient. What eventually came to be the famed Chihuahua Pacific Railway was not completed until over 50 years after Stilwell’s death.

Over several decades KCS earned the reputation of being profitable, efficient and compact. Its diverse commodity mix generated enough revenue for classification as a US Class I carrier, but its route structure and operating philosophy was more regional in nature.

Deregulation spurs change

Were it not for two important developments, KCS might have remained a regional carrier. The first was the partial deregulation of the US rail industry following the Staggers Act of 1980, which unleashed a huge potential for change and growth. Deregulation led directly to consolidation; whereas there had been over 40 ’major’ US railroads prior to Staggers, by the late 1990s the number was less than 10 and falling.

For the most part the mergers strengthened the industry, enhanced customer service and promoted greater competition. But they profoundly changed our marketplace. While KCS was able to hold its own against slightly larger competitors, the long-term prospects surrounded by a few giants were not as sanguine. Three mergers in particular: Union Pacific + Chicago & North Western (1994), Burlington Northern + Santa Fe (1995), and Union Pacific + Southern Pacific (1996), effectively redrew the rail map of the western United States. And KCS was all but erased.

The other major development that helped reshape the company’s destiny was the passage of the North American Free Trade Agreement. Essentially, Nafta recognised that economic growth in the continent has shifted from east-west to north-south. The southern tier of the country - running from Georgia and Florida to Texas and on to the southwest - experienced enormous population growth and economic expansion.

At the same time, Mexico was undergoing significant change. International companies with substantial manufacturing requirements were locating in Mexico, especially in the Monterrey area. Nearby Saltillo became one of the world’s largest automobile and truck assembly locations. The corridor between Mexico City and Monterrey became one of the fastest-growing manufacturing areas in the world.

All of a sudden, the north-south KCS network was no longer contrary to the economic trend. An opportunity had opened up where there was none before. That opportunity enabled us to rethink our operations and take advantage of growing Nafta-related trade.

But this opportunity raised a series of more complex questions. Should KCS hunker down in the middle of a market place dominated by giants? Or should it use the prevailing economic growth patterns to expand its own markets and become a viable alternative to some of its larger competitors? Should KCS remain strong, and do what it could to remain profitable until it was inevitably swallowed up by one of the large Class I’s? Or should it attempt to grow and put together a network strong enough to compete into the 21st century?

Friends South of the Border

Around the same time that KCS reached this crossroads, Transportaciónes Maritima Mexicana was also evaluating how it could best expand its operations in North America. As Latin America’s largest transport company, TMM is predominantly an ocean shipping line, linking 41 ports in 23 countries around the world. It also has a trucking subsidiary providing intermodal services in Mexico in connection with its port operations.

TMM was acutely aware of the growth under way in Mexico. It also perceived that the country’s deteriorating rail network could prove a drag on prospects for sustained economic activity. Foreign investment had kick-started the nation’s economy, but its deficient transport infrastructure posed a serious threat to long-term prospects.

Despite the poor state of the national road network, trucking had become the dominant force in Mexican freight transport. The state-owned railways were deteriorating rapidly from lack of investment. As the quality of rail services worsened, shippers were increasingly switching to road, cutting revenue and accelerating the spiral of decline. In the 1980s and early 1990s, rail’s share of the total Mexican freight market fell from 20% to barely 12%, compared to a figure of 35 to 40% for the US market. Conditions had reached the point where only those with no alternative used the Mexican railways.

TMM added its weight to an increasingly strident lobby calling for the Mexican government to privatise the railways. It saw two major benefits. First, in general terms, private enterprise could provide the investment and incentive for upgrading the network to handle increased freight volumes. Second, rail privatisation might give TMM the opportunity it was seeking to expand its activities both within Mexico and across the border into the United States.

As the privatisation movement gathered momentum during the 1990s, TMM made its first strategic rail acquisition, buying the Texas - Mexican Railway. Tex-Mex operates the 240 km route from Laredo to Corpus Christi, Texas, and also owns the northern half of the International Bridge at Laredo, the busiest rail connection between Mexico and the USA. Ownership of the US portion of the bridge means Tex-Mex benefits directly from any increase in cross-border trade. And the purchase gave TMM the entry it wanted into the North American rail market.

The Nafta partnership

TMM then began to seek actively a US Class I partner with which it could pursue more aggressively participation in the Mexican rail privatisation. Besides the rail expertise that such a carrier would offer, TMM also wanted a partner that would benefit directly from increased traffic to and from Mexico.

Despite readily-available projections of extraordinary trade growth as a result of Nafta, TMM did not get a particularly enthusiastic reception from the US railroads that they contacted. Most saw Mexico as a high-risk venture, largely unknown to those railroads expanding along an established east-west axis. They found it difficult, if not impossible, to factor in Mexico as a central element in their business plans.

But it was a different story when TMM approached Kansas City Southern. With its historical north-south focus, KCS immediately saw the potential of the Mexican rail network, particularly the 4000 km Ferrocarril del Noreste running from Mexico City through Monterrey to the Texas border. In-depth discussions led to a partnership agreement, and the concept of a ’Nafta Railway’ was officially born.

The partnership was cemented in 1995 when KCS became 49% owner of Tex-Mex. Then the two companies began what we feel was probably the most detailed, thorough and sophisticated due-diligence investigation ever performed on a railroad.

Central to our analysis was a market survey of Mexico’s 160 largest shippers, which brought out two important findings. Firstly, the Noreste was by far the crown jewel of the Mexican railways. Secondly, there was huge demand for a high quality rail service along this corridor. From the data collected during this survey, as well as a close investigation of the infrastructure of the entire Mexican network, KCS and TMM drafted marketing and operating plans for the Noreste. After comparing projected revenues with estimates of operations-related expenses, the partners were in a position to bid for the 50-year operating concession.

Conventional wisdom held that the consortium including Union Pacific would win the Noreste. After all, UP had been the primary US operator doing business in Mexico for decades, and its power and influence within the industry was second to none. This was evident in the acquisition of the Southern Pacific in 1996 despite widespread concern among shippers, the government and elected officials. Most observers thought the Mexican jewel would surely end up in UP’s crown.

But TMM and KCS had done their homework. The partnership had a more sophisticated knowledge of the market and the existing infrastructure than any of the other prospective bidders. TMM’s knowledge of the Mexican markets and strong relationship with government officials was coupled with KCS experience of rail operations in a highly competitive alliance. On November 29 1996 the partnership entered a sealed bid of US$1·4bn for the Noreste, under the aegis of a joint venture company known as Transportación Ferroviaria Mexicana. A week later, on December 5, TFM was awarded the concession.

The Noreste is in many ways the railway that executives can only dream about. The corridor is dense in population and commercial activity - although accounting for only 19% of Mexico’s rail network, TFM handles over 40% of all rail freight. Its routes serve almost 70% of the population, including the primary industrial centers of Mexico City and Monterrey and the major ports of Lazaro Cardenas, Tampico and Veracruz, which are also served by TMM ocean-going vessels. It connects with US railroads at Laredo, the largest rail gateway between the two countries.

Since the actual handover of Noreste operations on June 23 1997, TFM has done nothing to disappoint the expectations of rail analysts or its owners TMM and KCS. For the first six months, TFM’s revenues were more than US$26m over plan. We forecast that revenues could surpass US$1bn a year by the middle of the next decade. If anything, the demand for a quality railway serving shippers along the corridor is even greater than the most optimistic estimates to date. With US-Mexican cross-border trade growing by around 17% a year, our target of lifting rail’s market share back over 20% looks set to be accomplished on schedule, if not before.

Of course, we need to recognise that TFM is still in its start-up phase. It is impossible to turn around completely in one year a system that had been allowed to deteriorate for decades. While the Mexican government maintained the tracks and key service buildings along this corridor, TFM inherited an under-maintained and seriously under-powered locomotive fleet. The rolling stock was also in bad repair, with a marked shortage of the kinds of cars needed to move most of the commodities now using rail.

Likewise the signalling and information technology necessary for operational efficiency and customer service in the 1990s were almost non-existent. Financial reporting and billing systems were also deficient. There was a very understaffed and inadequately trained marketing organisation. There were no standards for locomotive or car utilisation, and safety standards barely existed and were not enforced.

All that is changing. TFM is committed to being as efficient and well-managed as the best of the US Class I railways. Over US$700m will be invested during the first five years of the concession, of which US$200m is being spent in the first 12 months. Right-of-way improvements during the second half of 1997 accounted for US$36m. TFM is due to receive 75 new diesel locos from General Electric at the rate of five per month staring this month. They will be followed from January 1999 by 75 General Motors SD70MAC diesel locomotives to be assembled at Bombardier’s Concarril works near Mexico City, bringing the total investment in locos to US$300m by 2000.

In terms of operational quality, US railway managers with decades of experience in operations and marketing, working with highly skilled and dedicated Mexican employees, have made tremendous progress in less than a year. While there is still work to be done, there can be no doubt TFM will be a world-class operation within the next two or three years.

North to Canada

While the Mexican venture has been our biggest expansion so far, the Nafta corridor also stretches north to Canada. This too offers growth potential, and it is perhaps no coincidence that the other major north-south Midwest Class I, Illinois Central, has agreed to merge with Canadian National.

However, KCS had already started to look north. Within a few days of winning the TFM concession in December 1996, we had reached agreement to take over Gateway Western Railway - a mid-1980s spin-off from the then Illinois Central Gulf. Linking Kansas City with Springfield, Illinois, GWWR has haulage rights into Chicago, giving KCS access to the biggest hub of the US rail network. From here it is but a short step to the Canadian border. We also have a marketing agreement with the 1 840 km I&M Rail Link, allowing KCS to arrange service into the Upper Midwest and Canadian market. Operating in Iowa and Minnesota, I&M is owned 66% by the Washington Organisation (which also controls Montana Rail Link) and 34% by Canadian Pacific Railway.

In just a few years, KCS has transformed itself from a small regional carrier into an extensive international rail network. More importantly, this expansion has been developed within the context of the most powerful economic growth engine on the continent, ideally positioning us for the future.

The Nafta Railway is still a work in progress. KCS is planning for further expansion - both through marketing alliances with other railroads and through strategic acquisitions - to enlarge our market reach and strengthen the network. With a strategic vision based on powerful economic growth patterns, Kansas City Southern is looking forward to exciting growth opportunities in the years ahead. o

CAPTION: KCS forms the heart of a group of railways which connect Chicago to Mexico, accomplishing the original 1897 aim of creating a north - south corridor

CAPTION: The Nafta Railway combines KCS (including MidSouth and Gateway Western), TFM in Mexico and I&MRail Link providing the link to Canadian Pacific

CAPTION: Crossing the Rio Bravo is a TFM freight hauled by a ’Nafta’ liveried loco

The Noreste is in many ways the railway that executives can only dream about.

Michael R Haverty

Kansas City Southern Railway