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Rail News Home Union Pacific Railroad

February 2008



Rail News: Union Pacific Railroad

Who's buying shares in North America's freight railroads — why it matters



Entrepreneurs who take their companies public know it’s a double-edged sword. An initial public offering (IPO) brings in capital that’s used to expand and build a business. But IPOs also allow anyone to purchase a piece, however large or small, of a company — and that gives those shareholders a say in how the company is managed.

Shareholders can put forth proposals that fellow shareholders vote on at annual meetings. They also can speak publicly to executives and other shareholders at the meeting, asking questions and voicing their opinions on whatever topics they choose. And the more shares an investor owns, the more influence they have.

Some institutional investors — mutual funds, hedge funds and pension funds — have millions of dollars to invest, so they’re more likely to have management’s ear than the small, individual investor. Investors can nominate directors to a company’s board — often against a company’s wishes, and typically with the goal of forcing management to change its strategy, sell pieces or all of the company or take the firm private.

Shareholders haven’t been afraid to flex their muscles in recent years. They’ve helped oust chief executives at Fortune 500 companies, forced companies to add board directors who don’t have personal or business relationships with a company’s executives, and used their sway to separate the titles of chairman and CEO, dividing power between two people that was once held by a single exec.

And shareholders are beginning to do a bit of that flexing in North American railroad board rooms.

“The rail industry is sexy now,” says Longbow Research analyst Lee Klaskow. “[Warren] Buffett is in, activist shareholders are in them now. Buffett sees what he sees in other stocks, which is companies that are well developed and disciplined, have been around forever and move products that people use every day.”

Railroad executives want to attract investors who share their goals and visions, and who are buying the stocks for the long term, says independent railroad analyst Tony Hatch. Rail strategists are making decisions about how to spend capital on projects that have life spans of 30 to 50 years.

“So they’d love to have shareholders who can see through a cycle and can understand railroading, which is why they are often employees or retirees or family members,” Hatch says.

What happens when shareholders who aren’t employees, retirees or family members — i.e., those who aren’t railroaders (or aren’t perceived to be railroaders) — start to buy in? If they’re well-known investors, like Buffett, the fact that they’re buying in at all can trigger interest in a particular railroad from shareholders of all shapes and sizes.

And what happens if these new-breed shareholders not only begin to buy in, but weigh in (as owners) on a range of weighty railroad matters — from corporate governance to capital spending to operational strategies?

Ultimately, when so-called activists believe they have a better strategy than the management team does, they can use the rules of the public-company game to influence the direction of the company.

Who’s buying in?
Railroad executives are seeing both types of investors — the well known and activists — interested in their stocks these days. The railroads made headlines in the first half of last year when it was clear through Securities and Exchange Commission (SEC) filings that Buffett had stakes in Burlington Northern Santa Fe Corp., Norfolk Southern Corp. and Union Pacific Corp.

Buffett’s name, however, also attracted both big and small investors who monitor his every move, buying stocks he buys and selling those that he dumps. In the hopes of riding Buffett’s coattails and making a profit, investors quickly scrambled to mimic his moves, snapping up shares of the three railroads. Although Buffett since has reduced his holdings in NS and UP, he continues to purchase shares of BNSF. His most recent purchases in mid-January pushed his BNSF stake to nearly 18 percent of the railroad’s outstanding shares.

Buffett isn’t the only big-name investor who has attracted the attention of other buyers. Activist shareholders Carl Icahn and The Children’s Investment Fund Management L.L.P. (TCI) also have money in the sector. Activist shareholders typically have stakes large enough in a public company (either outright or through alliances with other shareholders) that they try to pressure executives to make operational or structural changes. The goal? Boost a company’s stock price.

If that strategy fails, some activist shareholders will nominate their own slate of individuals to a company’s board with the hope of having directors pressure executives or, in some cases, replace current management.

And then there’s Icahn, who made a name for himself as a corporate raider in the 1980s, buying shares of companies and then forcing management to issue special dividends, repurchase shares of stock and sell parts, if not all, of a given company. He was instrumental in the break-up of RJR Nabisco and took on what was then Time Warner in 2005. Icahn has worked to soften his image in the past 20-plus years, touting himself as a friend of shareholders. He has been American Railcar Industries Inc.’s principal shareholder, chairman and director since 1994. He purchased additional shares of the company in mid-November, pushing his stake in the railcar manufacturer to nearly 54 percent. It was the first time Icahn purchased shares of the company since its January 2006 IPO.

The Buffetts and Icahns of the world clearly influence what some investors do. Having Buffett’s Berkshire Hathaway purchase shares in a company is akin to a product getting a Good Housekeeping stamp of approval, and while few executives will say it publicly, most are pleased when Berkshire takes a stake in their company.

Not everyone, however, makes investment decisions or recommendations based on the actions of well-known investors.

“If [Buffett] didn’t buy Burlington Northern, it wouldn’t be so expensive, so his ownership has had a material impact,” UBS analyst Rick Paterson says. “Are we more bullish on our estimate because Buffett is in Burlington Northern? No. The ownership is irrelevant to our forecast and we really don’t have any enhanced conviction. In fact, it’s a negative because [the stock] is more expensive than it otherwise would be.”

Activism in the house
Activist shareholders can make their ownership presence felt in a variety of ways. For the past several months, TCI has been tussling with CSX management, arguing that Chairman, President and CEO Michael Ward and other execs are failing to deliver the types of returns to shareholders that TCI claims are possible.

Stating it had tried unsuccessfully for the past year to “engage in constructive dialogue” with CSX management to share its concerns, TCI on Oct. 16 sent the CSX board a letter urging “immediate action” to improve corporate governance and business performance — specifically, TCI urged the board to separate the positions of chairman and chief executive, and provide shareholders a plan to improve operations. TCI also took its concerns public, issuing a press release and launching a Web site featuring CSX performance measures, links to selected news articles about the Class I and a “TCI Fridays” blog.

CSX responded in mid-November, saying that after considering TCI’s proposals, it plans to continue with the strategy that has led to a tripling in CSX’s stock price since the current management came on board in 2004. CSX also noted that TCI’s past suggestions included a leveraged buyout of the railroad and doubling customer pricing during the next decade.

On Dec. 19, TCI and private investment fund 3G Capital Partners Ltd. launched what amounts to a proxy battle with the railroad when the pair nominated five individuals to CSX’s board of directors. The pair said in their filings with the SEC that their nominees would help CSX’s board by adding independent directors who have a broad range of railroad experience and who are committed to improving the railroad’s operating performance and corporate governance.

CSX, however, took issue with the nominee rationale, contending that its current directors have a broad range of experience and are “well qualified to further advance the interests of the company’s shareholders, as well as its employees, customers and communities.”

Regardless of how the CSX/TCI tussle plays out, activist shareholders are likely to hold stakes in the rail industry for some time. Depending on one’s point of view, activist shareholders’ presence can be a blessing or a curse. On the one hand, their ownership in a stock can help its valuation rise as other investors also purchase shares. Also, they can force executives to consider new strategies that could help improve a company’s profits or raise its share price.

In some financial circles, the term “hedge fund” suggests an entity that shorts a stock, expecting to make money on it when it declines in price. But the term is broad; they aren’t all alike, analyst Hatch says. The hedge funds investing in railroads these days appear to see in the companies a lot of what Buffett sees in them, he adds.

“We’re seeing a bunch of investors who see that railroads have tough barriers to entry, terrific growth prospects given globalization and congested highways, and who believe in the ‘Rail Renaissance,’” Hatch says.

Whether they’re hedge funds or other investment vehicles, activist shareholders can cause headaches if they opt to sell their stakes because that can lead to a quick and steep decline in the stock price as other investors follow suit.

Also, actions by activist shareholders can be problematic if those actions lead to a large scale management turnover or lead executives to make decisions that help the company in the short term but are harmful over the longer term. TCI’s push for CSX to raise rates more aggressively is one example. And although CSX arguably would have a tough time aggressively hiking prices at a time when the North American economy appears to be heading south, doing so could garner unwanted attention from Congress and possibly lead to more industry regulation, some Wall Street observers believe.

Meanwhile, a shareholder base also affects a company’s credit rating. When completing a railroad’s credit profile, Fitch Ratings analyst Steve Brown views activist shareholders as a potential negative if he sees those who have a history of pushing companies to engage in shareholder-friendly activities, such as large share repurchase programs, large increases in dividends or other actions that would add risk from a credit profile perspective.

“If it’s a shareholder who will allow the company to continue to operate well, it’s less of an issue,” Brown says. “Our concern is shareholders who put pressure on companies to increase the risk materially to the creditors.”

Bottom line: Buffett, Icahn and TCI each have a different motivation for getting into rail stocks, but the common thread among them appears to be a long-term view of industry, railroad consultant and author Tom Murray says.

“And even though TCI is newer on the investment scene than the other two, the fact that they are setting the stage for a proxy fight for directors indicates to me they’re in it for the long haul also,” Murray says. “[The three] aren’t in [the rails] just for trading purposes.”

With rail, you can’t be. “It’s important that the investor base for the rail industry understand that, and that they be willing to fund those long-term investments that are necessary for the industry to continue to grow,” Murray says.

The momentum slows
How much longer the railroads remain appealing to big-name investors remains to be seen. Last year, U.S. freight rail traffic was the second highest on record but down 2.5 percent, to just under 17 million carloads, from the record-setting year of 2006, according to the Association of American Railroads. Intermodal loadings clocked in at 12 million, a 2.1 percent decline from 2006.

This year’s early returns have been mixed. For the first four weeks of 2008, U.S. and Canadian carload volume increased 0.5 percent and intermodal volume fell 1.8 percent compared with the same 2007 period. The weak housing market continued to contribute to declines in lumber and wood-products carloads. Lingering softness in U.S. vehicle sales also continued to dampen motor vehicle and equipment carloads.

Although some on Wall Street would beg to differ, many investors view railroad stocks as cyclical, rising in value as the economy improves and going south when it sours. With the U.S. economy pointing to a slowdown, possibly even a recession, investors have put the brakes on railroad stocks.

“Investors’ perspective of rail stocks is heavily influenced by the state of the economy,” says BMO Capital Markets analyst Randy Cousins. “As concerns about economic growth increase, railroad stocks have come under a fair amount of pressure.”

Stocks of all six of the largest U.S. and Canadian railroads — BNSF, CSX, Canadian National Railway Co., Canadian Pacific Railway, NS and UP — had been increasing in price in recent weeks. In early January, they had been trading close to their 52-week lows.

“We continue to look at macro economic factors to see where they’re headed and nothing is positive right now,” Fitch Ratings analyst Brown says. “There’s pressure on the consumer and we think that will translate into a weak freight environment in 2008 in the U.S. Early on, there were some hopes for the second half of 2008, but now there is concern for all of 2008 and perhaps into 2009. There’s a lot of concern right now about the freight market and how that will affect financial performance of railroads and trucking.”

How long is long term?
Pricing is one of the few pieces of good news for the railroads. Despite sluggish volumes, the industry has been able to maintain strong pricing thanks to rails being more fuel efficient than trucks when it comes to moving heavy items, such as coal, having a limited amount of track space and limited competition among the rails.

“We expect pricing to hold up in 2008, even though volumes are declining,” Brown says. “I would expect to see some declines in pricing power in 2008, but not huge declines.”

Although railroads can’t control the direction of the economy, they can control another element that’s crucial to continued pricing power, and that’s customer service, consultant Murray says. Railroads must work to improve their service because their customers also do business with such customer-service-oriented companies as United Parcel Service and Federal Express.

“To me, there’s a crucial nexus between pricing power and service quality,” Murray says. “Railroads as a group, with the exception of Canadian National Railway, haven’t delivered on customer expectations for improved service. If the rails don’t continue to improve service, the pricing momentum is at risk.”

But if investors, whatever their profile, are truly in it for the long haul, they won’t be derailed by short-term blips in rail stocks, the overall stock market or the economy.

Desiree J. Hanford — who worked for Dow Jones & Co. the past 10 years covering the equities market, including transportation — is a Chicago-based free-lance writer.


Keywords

Browse articles on rail investment publicly traded railroads rail stocks Warren Buffett BNSF Norfolk Southern CSX Children's Investment Fund activist shareholder 3G Capital Partners

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