Not all happy rails: failed deal between Mexican transport company, Kansas City Southern paints merger prospects black.

Just like many a Hollywood marriage, the relationship between Kansas City Southern (KCS), a U.S. railway company, and Transportes Maritimos Mexicanos (TMM), a Mexican transport company, has been short and not so sweet, serving as a cautionary tale for firms who get hitched without cleaning the skeletons out of their closets.

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The matrimony started happily enough with the birth of their baby, Transportacion Ferroviaria Mexicana (TFM), a Mexican railway company which they jointly bought from the Mexican government in 1997. Sadly, Cupid's arrow has become dislodged and our lovebirds are no longer on convivial terms. Theirs is a story of woe and complexity that has brought grief to all parties involved.

BLUE-COLLAR MONEYMAKER

Before getting into the nitty-gritty of this failed romance let us set the scene. The rail freight sector may not be the coolest cat on the block. But it has certain tortoise qualities that allow it to remain as attractive as the hares, especially during recent economically torrid times. Shifting goods by rail is often cheaper, safer and faster than other overland alternatives. As a result, the Mexican domestic haulage market is currently worth about US$2 billion per year and has been growing at a respectable 4% annually.

"The rail network was underrepresented when it was first privatized," explained John Price, the logistics practice director for InfoAmericas, a Latin American focused market consultancy firm. "It was mainly focused on coal and minerals. Since then it has opened up new lines of business--moving chemicals, cars and auto-parts and steel products."

By far the biggest growth opportunity has been cross-border haulage. The Mexican rail network was originally built for the extraction of minerals mined in Mexico and sent north of the border. The Nafta trade agreement has given this infrastructure a new lease of life.

Although, thanks to the Chinese, cross-border trade has failed to grow in line with the U.S. economic recovery, growth in recent years has been in the double digits. This is partly due to the political debacle over cross-border trucking, which has made road haulage far more inefficient and costly than it should be.

Thus sparked a tale of railway romance and heartbreak so convoluted that it makes Gabriel Garcia Marquez' "One Hundred Years of Solitude" read like a nursery rhyme. Our two protagonists, KCS and TMM, first found love in December 1996, when they won the first concession in the Mexican government's rail privatization program.

The moment was strategically important for both companies. For TMM, the deal meant it could add an essential ingredient to its multi-modal transportation portfolio. For KCS, it formed part of its grand plan to create a transnational network linking Mexico City to Illinois and creating a seamless service that would give the firm a competitive edge.

VALUE IN PRIVATIZATION

Although, as a private entity, TFM's prospects looked much brighter, its new owners soon realized that, while it remained an independent company, they were still not able to extract the best possible returns from their acquisition.

"We've never been able to truly capture the strategic value of the company," Michael Haverty, CEO of KCS, said in a recent interview with the Kansas City Star newspaper. "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."

Their idea was to bring the family unit even closer together by absorbing TFM into KCS with the new company to be called Nafta Rail. After 14 months of arduous talks, a formal agreement was reached in April: In return for handing over its stake to KCS, TMM would receive US$200 million cash and 18 million shares of stock. That would give TMM a 20% interest in Nafta Rail.

Just as it seemed that our lovebirds were about to roll off into the sunset together, three skeletons have jumped out of their closets that have essentially destroyed their partnership.

The first is TMM's debt burden. In May, it failed make a US$178 million first-tranche payment of a US$378 million bond. Although TMM is technically in default, its bondholders have not yet called in the liquidators.

"It's a Mexican standoff," Rick Paterson, analyst with UBS Warburg, said in a report. "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."

INTRUSIVE GOVERNMENT

At this point, one might wonder why then TMM is not keener than ever to sell its stake and get the cash it needs to satisfy its creditors. Enter the Mexican government, co-owner of the other two skeletons.

The first regards tax. With the privatization, TFM's owners had banked on a deal sweetner they believed to have been offered by the government in the form of a rebate of the value-added tax (IVA) they paid upon purchase. Analysts believe that this is now potentially worth between US$800 million and US$1 billion--enough to cheer up any balance sheet.

Yet, fiscally challenged Mexican authorities are fighting the rebate in court. But it appears the decision is likely to not go its way, as in early November a federal court rejected its case. Of course, the taxman will take as long as possible before he signs the check.

The second government skeleton surrounds its remaining 20% share of TFM, which it wants to sell. According to the terms of the privatization, the government possesses a put option that gives it the right to force TMM and KCS to buy the stock for nearly half a billion dollars. TMM does not have the cash to make the purchase and is contesting the option in the courts on the grounds that the government failed to meet sufficiently its commitment to look for buyers on the open market before calling in the put.

Last month KCS told the Mexican government it would be more than happy to buy TMM's share. This may not be the gentlemanly act it appears.

Lurking deep in the fine print of the contractual agreements between KCS, TMM and the government is one clause that is haunting TMM. It says that if the tax issue is resolved before the put option dilemma is resolved, the IVA windfall will be split equally between TMM and KCS. If, however, the reverse happens, all the cash will go KCS' way. A quick resolution on the option case would therefore turn out to be a nice little earner for KCS.

"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," said Marco Provencio, a spokesperson for TMM.

As a result, a TMM shareholder meeting in August voted to pull the plug on the agreed sale of its TFM stake. According to Provencio, they are perfectly entitled to do this because the agreement was signed by their CEO and not the board that has final say over the matter. KCS disagrees, and as BUSINESS MEXICO went to press the arbitrators were being selected for the case to be heard in the United States.

Meanwhile, TMM is frantically trying to buy time. "We were trying to extend the put obligation, and that would give us time to collect the VAT," TMM president Javier Segoiva said at the company's third-quarter meeting with analysts.

Sadly, the couple's differences appear irreconcilable and a bitter custody battle is expected with both sides wanting control of TFM. And all that remains of a match made in Nafta heaven is fodder for the divorce lawyers.

Rawdon Messenger is a Mexico City-based freelance writer and columnist for the Evening Standard of London.