(The following story by Randolph Heaster appeared on the Kansas City Star website on November 13.)
KANSAS CITY, Mo. — The deal to create Nafta Rail, a 7,000-mile railroad that would stretch from Illinois to Mexico City, was conceived nearly two years ago at a meeting in New York.
For Mike Haverty, Kansas City Southern’s chairman and chief executive officer, it was a vision that really formed when he joined the railroad in 1995.
Haverty’s dream appeared to be on the verge of becoming reality this year. In April, Grupo TMM, Kansas City Southern’s Mexican partner, agreed to sell its controlling interest in Mexico’s Northeast railroad, Grupo TFM, which runs from Mexico City to the border town of Laredo, Texas. The sale also included Kansas City Southern gaining control of the Texas Mexican Railway, which runs from Laredo to Corpus Christi, Texas..
Four months after agreeing to the sale, TMM derailed the deal. That has led to a bitter dispute between Kansas City Southern and its Mexican partner that soon will be heard by a binding arbitration panel in New York. Kansas City Southern has obtained a court order saying the status quo at both companies must be maintained until the arbitration is settled.
From Kansas City Southern’s perspective, TMM simply reneged on a deal agreed upon by both parties after 14 months of negotiation. TMM, on the other hand, has contended that Kansas City Southern contacted Mexican authorities unilaterally after the agreement in an effort to dilute the deal’s value for TMM shareholders.
The two companies now are far apart after working together for six years to build TFM, Mexico’s biggest railroad. For Kansas City Southern, the investment in TFM has helped it keep its stand-alone status.
“We were pursuing, quite frankly, a survival strategy,” Haverty recalled in a recent interview.
In the mid-1990s, the domestic rail industry was in the midst of a consolidation that led to the formation of six megacarriers. Industry analysts, meanwhile, wondered what would become of Kansas City Southern, a relatively small independent railroad whose north-south route structure through the central United States did not appear to fit with the other carriers.
“Kansas City Southern was a vulnerable company, because we were so much smaller than the competition,” Haverty said. “We needed to expand, or we needed to shrink and sell the company.”
Haverty and Kansas City Southern chose the former and teamed with TMM, a transportation company based in Mexico City, to buy that country’s biggest railroad in 1997. It was auctioned by the Mexican government, and analysts at the time thought the $1.2 billion bid by TMM and Kansas City Southern was excessive. But with trade among the United States, Mexico and Canada growing because of the North American Free Trade Agreement, the investment turned out to be very fruitful for Kansas City Southern.
Under the arrangement, Kansas City Southern owned 39 percent of TFM while TMM held a 41 percent interest. The Mexican government maintained a 20 percent ownership in the railroad that was to be sold at a later time.
After Kansas City Southern and TMM made capital investments to TFM and improved its operations, TFM turned into a very profitable unit. While domestic rail traffic grew about 3 percent annually in the late 1990s, rail shipments between Mexico and the United States expanded at a 12 percent annual clip.
The growth of U.S.-Mexico rail traffic has slowed considerably the last two years because of a sluggish economy and the rise of the manufacturing sector in China. The Mexican market has remained the key to the future growth of Kansas City Southern.
Despite Kansas City Southern’s earnings gains through its Mexican investment, Haverty thought shareholders at both Kansas City Southern and TMM could realize greater value if all three rail properties ? Kansas City Southern Railway, TFM and the Texas Mexican Railway ? were all under common control.
“We’ve never able to truly capture the strategic value of the company,” Haverty said. “There was recognition on both sides that a combined company would be more valuable than three separate parts. That was originally the concept when we entered into the partnership.”
As separate parts, synergies were lacking, Haverty said. For example, 85 percent of all Mexican freight that TFM transfers to the United States goes to the Union Pacific Corp., which has a more direct route to Laredo than does Kansas City Southern.
“The traffic from TFM to the Tex Mex to KCS didn’t materialize the way we envisioned it in 1995,” Haverty said.
In January 2002, TMM Chairman Jose Serrano met with Haverty in New York.
“He said it’s time to put the three units together,” Haverty recalled. “That’s when we began to talk about how we might do that.”
After 14 months of arduous talks, a deal was struck. The agreement called for Kansas City Southern to acquire TMM’s interest in TFM and the Tex Mex, with the new company to be called Nafta Rail. In return, TMM would receive $200 million cash from Kansas City Southern and 18 million shares of stock. That would give TMM a 20 percent interest in Nafta Rail.
In addition, TMM could receive $100 million to $180 million as part of a value-added tax refund, known as VAT, that TFM could receive from the government. The total value of the VAT remains unknown, but both companies have estimated that it could exceed $800 million.
Haverty said the two companies celebrated with congratulatory calls between Haverty and Serrano.
“The system we were going to create would be headquartered in Kansas City,” he said. “The Nafta Rail system would become a much more viable and powerful competitor in the industry.”
Analysts agreed, saying Nafta Rail would easily be the fastest growing railroad in North America. Nafta Rail would also be a prime candidate for acquisition if further consolidation occurred in the rail industry, industry observers said.
Regulatory hurdles in both the United States and Mexico had to be cleared, and that was proceeding through the summer months. Shippers, who normally oppose further consolidation in the transportation industry, were not opposed to this particular move, Haverty said.
The National Industrial Transportation League, one of the biggest shipper associations in the country, supported the creation of Nafta Rail in an August filing with the federal Surface Transportation Board
The group said it and Kansas City Southern had negotiated protections that will keep rates and services the same with any railroad at the Laredo interchange.
“The agreement between KCS and the League contains provision, which should protect league members, and other rail shippers from anti-competitive effects, if any should arise as a result of this transaction,” the filing stated.
While shippers were amenable to the deal, other problems were arising. In May, a month after the announcement to create Nafta Rail, reports of financial problems at TMM began to surface. TMM defaulted on $377 million in May. But the bondholders have not forced TMM into bankruptcy because of the possibility it may have funds coming to it as part of the big VAT refund that TFM has been seeking for several years.
“It’s a Mexican standoff,” said Rick Paterson, analyst with UBS Warburg. “The bondholders can put TMM into bankruptcy, but TMM knows they are reluctant to risk two years in a Mexican bankruptcy court, particularly under new, and largely untested, bankruptcy procedures.”
Complicating matters is the fact that the Mexican government was supposed to sell its 20 percent interest in TFM, currently valued at $470 million, on Oct. 31. Because TMM does not have the cash to buy its portion of the shares, TFM has gone to court seeking to delay the government’s put option.
Paterson said TMM could lose its part of the VAT refund if the government’s put option is exercised before the refund is distributed. The VAT refund, which could be as much as $1 billion, could give TMM up to $180 million in cash even after paying for its portion of the government’s interest in the TFM railroad.
Kansas City Southern proceeded with getting regulatory approvals in both countries to create Nafta Rail. But in August, Serrano stunned Kansas City Southern executives by voting to reject the sale.
TMM accused Kansas City Southern of seeking to have the Mexican government exercise its option on Oct. 31, which would eventually mean that Kansas City Southern would receive the VAT refund.
“We were trying to extend the put obligation, and that would give us time to collect the VAT,” said Javier Segoiva, TMM president, at the company’s third-quarter meeting with analysts. “KCS essentially said it was going to honor the put on Oct. 31.”
Kansas City Southern was trying to get TMM’s portion of the tax refund, and that was a breach of contract in the sale of TFM, TMM spokesman Marco Provencio recently told The Wall Street Journal.
Haverty said his company simply told government officials that it would comply with the put agreement that was made in 1997. Backing out, he said, could jeopardize Kansas City Southern’s plans for the Nafta Rail deal.
“Our position was that we signed an agreement, and we intend to live up to it,” he said. “We always met with them (TMM) and let them know what we were doing. We weren’t trying to undermine them in any way.”
If Kansas City Southern has abided by the terms of the sale, as Haverty has insisted, why did TMM’s Serrano suddenly vote to reject the sale?
Paterson said the financially strapped TMM may now think TFM is worth more than what it agreed to sell it for back in April.
“The Mexican tax court decision on the VAT refund was favorable and was resolved more quickly than anyone expected,” Paterson said. “If TMM wins the arbitration with Kansas City Southern, it frees them up to sell TFM to someone else at a higher price. Perhaps they want a better deal.”
That doesn’t fly with Haverty, who is known as the executive who with a handshake cut a deal with J.B. Hunt to start intermodal rail service.
“I have a great sense of disappointment because when you sign an agreement, you have an obligation to go through with it,” he said. “We weren’t standing there with a gun to our partner’s head and saying you have to sign this contract.”
Haverty is confident Kansas City Southern will win its arbitration case and eventually create Nafta Rail, but what happens if TMM wins?
“If it doesn’t happen, we’re still a viable company,” he said. “A lot of people say this is a bet-your-company strategy, but I think that’s a stretch. If the deal is done, it does make us a major player in the future. But if not, does this company dry up and blow away? Absolutely not.”
The stakes in this dispute with TMM are high for Kansas City Southern.
“They’re swinging for the fences, because that’s where the future is for the franchise,” Paterson said. “They’re doing OK now, but a successful acquisition of TFM would change the game. TFM would accelerate the company’s growth rate, improve margins and returns on capital, and drive a higher stock price.”