Wednesday, April 23, 2008 CSX Stands Ground Against Activists

Cross-posted from my article from today:

In the face of a gloomy economy where consumer spending is tepid, some of the smartest minds in the investment world have recently made big bets on the sleepy railway transporters. First it was Warren Buffett buying a big stake in Burlington Northern(BNI - Cramer's Take - Stockpickr). Bill Gates' investment vehicle also has a large stake in CN Railway. Both have been winning bets, appreciating 27% and 6% respectively in the last year.

But both of these transporters' gains have been eclipsed by Jacksonville-based CSX(CSX - Cramer's Take - Stockpickr), which has racked up a 45% increase in its share price in the last 52 weeks -- mostly coming in the last three months.

While Buffett and Gates have been passive investors in Burlington Northern and CN Rail, CSX has generated this performance while battling a group of activist investors led by Christopher Hohn of London-based The Children's Investment Fund (or TCI).

You might remember Hohn teamed up with Atticus Capital in 2005 to battle the German stock exchange Deutsche Borse. The two firms adamantly protested the German stock exchange's plans to merge with the London Stock Exchange(LSE - Cramer's Take - Stockpickr). When other investors sided with this view, Werner Seifert, the CEO of Deutsche Borse at the time, quit. It was reported that Hohn had told Seifert that his investor group was so powerful that they could nominate Mickey Mouse and Donald Duck to Deutsche Borse's supervisory board (board of directors) and have them approved by other investors. Seifert later titled his memoirs Invasion of the Locusts, referring to Hohn and the others he battled against.

Hohn had an equally high-profile and successful battle with ABN Amro(ABN - Cramer's Take - Stockpickr) in 2007. He bought up a 1% stake in the Dutch bank and began to call for its sale. After ABN lined up a deal with Barclays, TCI agitated for a better price. RBS(RBS - Cramer's Take - Stockpickr) finally swooped in to buy the bank and helped deliver a 70% return for TCI for a few months of work.

With these and other successes, TCI has delivered a 41.98% three-year annualized return, making it the ninth best performing hedge fund in the world, according to Barron's. The EuroHedge Awards crowned TCI the "Fund of the Year" in 2004 and 2005. Assets swelled from $3 billion in 2004 to over $15 billion today.

But the CSX investment has also proved a challenge for Hohn. TCI went public with its criticisms of CSX last October, with a long list of complaints that were mostly governance-related. They wanted the Chairman and CEO roles split, new directors to replace those with tenures of over a decade, and asked that shareholders be able to call special meetings. They also criticized that the company wasn't managing its costs well and had under-performed its peers of late. This was true for the 12 months prior to TCI's complaints, but CSX had significantly out-performed its peers if you went back further back in time.

CSX shot back at TCI in November, rejecting its demands. Most damning to TCI in the response was that CSX brought some previously private demands TCI had made over the previous 10 months to light. According to CSX, TCI had asked CSX to do a leveraged buyout, to lever up the company with "junk" debt to fund a massive share buyback, to commit to doubling its prices to customers over the next decade and to "freeze capital spending for growth until Congress determines the outcome of an issue that has been the subject of its policy debate for more than 20 years."

But CSX didn't stop there. The company proceeded to sue TCI for improperly disclosing its actual CSX ownership that was held in SWAPs. They also successfully managed to paint TCI as an ominous foreign threat to U.S. national interests, getting local politicians to question the "aggressive" actions of Hohn and TCI.

For his part, Hohn fought fire with fire and has, in turn, counter-sued CSX and accused the board of insider trading. TCI has announced its own slate of directors to be elected to the board, and a proxy battle appears set for June.

It's not clear whether Hohn will win the support of other institutional investors.

Although CSX's stock is up 29% since TCI first announced its complaints, investors need to weigh who will do the best job of overseeing CSX's activities beyond the annual meeting. Will other shareholders see TCI as a short-term opportunist or a long-term steward of CSX's best interests? CSX has effectively portrayed TCI as having inconsistent and poor ideas for how the company should be managed.

The battle is reminiscent of the first proxy battle Carl Icahn ran against Motorola(MOT - Cramer's Take - Stockpickr) last year. The handset maker was able to convince shareholders to trust them over Icahn due to the activist initially calling for increasing its debt-load and doing a buyback just as the company was about to see its sales fall sharply, causing it to need every dollar on its balance sheet.

Hohn's been successful with a "rough edges" and aggressive style of activism. For his 2006 Christmas card, his family trumpeted to friends that "Chris has had an exceptionally exciting year overthrowing German CEOs and expanding his investment conquests to China and Brazil."
CEOs have long bristled at TCI's demands for change and recently some investors have too. Yale's pension fund, which was one of the original investors in TCI when it started in 2004, pulled its $500 investment in 2006 after TCI retroactively raised its fees to existing investors presumably because of the hedge fund's success.

Hohn's initial successes as an investor were all event-driven. He became the loudest voice of shareholders in favor of or against a merger or buyout happening. When he started to broaden his approach to go after targets in an activist way (with a long-term time horizon for improving a company absent any specific "event"), he's run into problems. CSX has stiff-armed him to date in the U.S. and he's hit another brick wall in Japan with his investment in the utility J-Power.
Chris Hohn and TCI are still very successful, as their Barron's hedge fund ranking shows.

However, they've made several mistakes in the CSX battle which they -- and other activist investors -- should learn from for future campaigns:

- A battering ram approach that is publicly critical of targets can be very successful in an event-driven context but does not always work in activist situations. Negotiation, diplomacy, cajoling, humor and tact are just as important when meeting with an activist target as the threat of "going negative" in a public battle. TCI's successes in the activist realm will increase as they demonstrate their abilities in these softer skills.

- Avoid inconsistencies. This applies to politicians and activist investors alike. Your words can be easily used against you by your opponents in a debate, so don't give them any ammunition. Activist investing requires a lot of up-front work in selecting targets and the kinds of actions you think would create value if implemented. If you advocate changes that come across as potentially weakening the company in the long-term (such as taking on significant debt), expect a tough time convincing your fellow institutional and pension fund investors to go along with your prescriptions.

- CSX didn't exploit this, but TCI initially disclosed in October that it held "shares in other US railroads but has not had to launch similar campaigns there because managements have been more co-operative." If I was a CSX shareholder without holdings in CSX's competitors, this would be a red-flag. It says to me that the company has mixed motives -- even if it doesn't. Activist investors need to avoid any perceived conflict of interest and should therefore avoid investing in competitors.

I would bet that CSX will likely prevail in the June proxy battle for the same reason that Motorola's investors refused to embrace Carl Icahn in his first attempt at a board seat last year. On top of that, CSX's relative performance to its peers and the market has been good in recent years. It's tougher to rally the troops in opposition to management when that investment is one of your better performers.

If his proxy fight fails at CSX, Chris Hohn will then have to decide whether to stay on as an investor and look to fight another day or cash in his winnings and move on. Activist investing is still a place which allows the "loser" to walk away with a 30% gain. That should help nurse TCI's wounds.

At the time of publication, Jackson was long MOT.

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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