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Old 01-30-2008, 09:28 AM
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Default China to Kansas via Mexico?


This is an old Forbes article, but there are some new implications that may not be so evident!

Quote:
You take a bumpy ride on a potholed gravel road through a fishing village to a grassy riverbank to get to the most important new shipping terminal in North America. There's nothing here yet, except birds and the blue Pacific. One mile to the south you can see the old terminal, where three cranes idly wait for a few cargo ships to pull in. It's so quiet you can hear the tilapia jumping out of the water.

But when Michael Haverty stands here, at the port of Lázaro Cárdenas in the Mexican state of Michoacán, he hears the whistle of a dozen freight trains and the throaty chorus of oceangoing container ships. He sees wharves and gantry cranes dotting 11 miles of undeveloped waterfront, and thousands of acres given over to railcars and trucks stacked high with goods from Asia.

Haverty, head of the Kansas City Southern railway, has dreamed for four years of turning the dusty town of Lázaro Cárdenas (pop. 80,000) into one of the busiest shipping terminals on the U.S. West Coast. He has spent $1.5 billion of KCS money to buy up control of a 2,600-mile artery linking the tiny port to 400 million North American consumers.

Now the dream is taking shape. In one month Hutchison Whampoa (other-otc: HUWHY.PK - news - people ), the giant port operator controlled by Hong Kong billionaire Li Ka-shing, will break ground on a $200 million terminal that will eventually handle 2.5 million containers per year, more than the ports of Oakland or Seattle.

Haverty bore the brunt of industry scorn for his Mexican investment. It trashed KCS' balance sheet and subjected the company to four years in the byzantine Mexican legal system. The Mexican government still owns the land under KCS' rails south of the border and can revoke its concession at any time. "There were times when I had doubts, and I spent many sleepless nights," he says. "However, we are determined and we persevere."

It's likely that little Lázaro Cárdenas will reshape trade in the Pacific, and KCS has the monopoly on rail freight in and out of it. The trip to Houston is 400 miles shorter than the trip from the congested port of Long Beach, California; the trips from Lázaro Cárdenas to Chicago and Kansas City are only 200 miles longer than from Los Angeles but likely a day or so quicker. Lázaro, blessed by nature with a deepwater channel, will be able to unload the world's largest container ships at 30% of the cost of California dock operations.

Haverty's Mexico bet has made what was once a second-tier railway a valuable acquisition morsel for Burlington Northern and Union Pacific (nyse: UNP - news - people ). Its revenue ($1.5 billion) and profit ($100 million) are one-tenth those of the bigger railroads, but KCS sports a higher multiple on its earnings.

Imports from Asia are growing 18% a year, and Los Angeles and Long Beach, which handle 80% of the trade, are maxed out. Ships can spend as many as eight days in San Pedro Bay waiting to unload. Each day delayed costs retailers importing goods from Asia an extra half-percent of a product's costs, estimates Boston Consulting Group's George Stalk Jr.

"The light is finally coming to Lázaro Cárdenas," says Gonzalo Ortiz, general manager of Hutchison's Lázaro Cárdenas operation. "We can't screw this up."

The port project would have impressed Arthur Stilwell, who founded KCS in 1887 as a belt rail around Kansas City. He often spoke of taking the line all the way to the Pacific Ocean in Mexico. But his vision didn't begin to become a reality until Haverty took over as chief executive in 1995.

Haverty, 62, grew up in Atchison, Kansas, dreaming of running a railroad. Both his father and grandfather were conductors on the Missouri Pacific, and Haverty started there working summers as a brakeman after high school, climbing the ranks at the Missouri. In 1970 he went to work for the Atchison, Topeka & Santa Fe, rising as high as president. When he was later offered the chief executive job at the smaller KCS, he took it.

Haverty arrived eager to play the massive southward shift in manufacturing activity. Mexico privatized its rail lines in 1997. Haverty jumped at the chance to bid for one of the three major concessions. He spent $300 million for 36% of the equity in a rail line running south from Laredo, Texas to Lázaro Cárdenas. His partner, a Mexican logistics company called Grupo TMM, put up $300 million for 38% of the equity. The Mexican government owned the rest. The port was an afterthought.

As part of the deals Haverty got an additional 157-mile line from Laredo to Corpus Christi, Texas and the rail bridge at the Mexican border that carries 60% of trains crossing between Mexico and the U.S. His company could now collect $11 per loaded car. Haverty helped secure use of 400 miles of Union Pacific's track, giving the company a straight shot from Lázaro Cárdenas to Kansas City. Today KCS runs 2,300 carloads a day in Mexico of everything from steel to beer. In 2005 those goods accounted for more than $540 million in revenue.

But when it first bought the company, most of the track in Mexico was outdated and in bad shape, despite heavily staffed repair crews; trains were featherbedded with manned cabooses. KCS and TMM replaced the cabooses with wayside detectors to spot overheated trains and began increasing spending on Mexican tracks from $45 million a year to a projected $100 million this year, doing things like relaying ties and mending cracked rail. KCS struggled to trim the bloated payroll. The first time Haverty went down with his chief operating officer, Arthur Shoener, to meet with national union boss Victor Flores (usually referred to as Don Victor), Flores did not take kindly to their straight-talking ways. KCS fell victim to union grumbling and a work slowdown.

After many long meals Haverty and Shoener won the unions to their side. KCS was able to cut workers per train from eight to three. But it was labor unrest in the U.S.--a walk-off in 2002 by West Coast longshoremen--that reshaped KCS' plans. Shortly before that dock strike Hutchison Port Holdings had bought the Lázaro Cárdenas concession. Haverty had worked with Hutchison in Panama, where KCS co-owns a rail line that runs along the canal. Haverty figured he could work with Hutchison to pitch shippers on an American-run, unbroken rail line from Lázaro Cárdenas to the U.S.

But first Haverty had to gain full control of the railroad. And that meant dealing with a country emerging from decades of corrupt leftist politics. When KCS won the original rail concession in the 1997 privatization, it was expected the Mexican government would refund $200 million in value-added taxes paid. After several requests for the refund were denied, the government said, You know, we never meant to give that back. So KCS sued the finance ministry in Mexican fiscal court in 1997 and won five years later--but the government appealed the decision.

After two years of negotiations KCS reached an agreement in 2004 with TMM to buy out the joint venture for $200 million in cash and $305 million in KCS stock (22% of its float). A few months later TMM mysteriously tried to back out; it was suspected they were shopping for a better deal. Haverty took TMM to arbitration in New York and was able to force it back to the table.

But the Mexican government, which still owned part of the joint venture, continued to hold out on that tax credit, with accrued interest now valued at $1 billion. Last September the parties settled the suit, with the government handing over to KCS its 20% of shares of the railroad in lieu of the tax credit. Haverty finally had total control of the railroad.

But Haverty was edging his balance to the limit. Capital spending went from $117 million in 2004 to $276 million in 2005, and debt to total capital rose from 40% to 57% during that period. Then KCS missed the March 2006 filing deadline for its 10K, because of problems with 2002 deferred taxes in Mexico that were found by KCS' auditors.

A $40 million one-time charge for personal injury claims pushed the company over the edge and caused KCS to miss its May 15 dividend payment. S&P declared the move a default and downgraded its rating on KCS' preferred stock to a D. The rating agency may downgrade the rest of the company's credit. Amazingly, the company's stock has remained strong. KCS is trading at $26.25, 38% above its 52-week low of $19. Rick Paterson, an analyst at UBS, says the worst of the merger costs are over and further consolidation of the Mexican and American halves will wring out more efficiencies.

Haverty has gotten smarter about doing business in Mexico, especially the need to schmooze often. He was one of five U.S. businessmen to meet in March with Presidents Bush and Vicente Fox of Mexico and Stephen Harper, prime minister of Canada, at their Cancún summit. KCS recently named as its highest-ranking Mexican executive a former federal antitrust attorney who breakfasts often with Don Victor. And Haverty has been courting Michoacán Governor Lázaro Cárdenas Batel, the grandson of the former Mexican president (and port's namesake), to help him develop a 450-acre rail yard and secured customs zone near the new port.

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