Santa Fe Southern Hopes to Get Back on Track : Scrambles to Salvage Merger of 2 Railroads

John Schmidt’s spirits were high as he sat in a crowded Interstate Commerce Commission hearing room July 24 waiting for the green light to merge his company’s two railroads, the Southern Pacific and the Santa Fe.

The chairman and chief executive of Santa Fe Southern Pacific was confident, as were most observers, that the commission would ultimately approve the combination after wrestling with objections from competitors and others.

After all, the railroads’ parent companies had merged in 1983 and the Reagan Administration line seemed to be that mergers were all right, although some conditions might be required to soften the blow to competition.

As he waited for the hearing to begin, Schmidt chatted about the combined railroad’s new red-and-yellow color scheme, which already graced more than 500 locomotives. He doodled on a piece of paper, showing a financial analyst how the railroads’ routes would mesh.

But after little more than 10 minutes of discussion in a meeting that was scheduled to last the entire day, the ICC rejected by a 4-1 vote the proposed merger of Southern Pacific Railroad and the Atchison, Topeka & Santa Fe Railway, calling it “anti-competitive.”

Barely hiding his anger during a hastily called news conference, Schmidt branded the decision “a horrible mistake based on a lack of understanding of the evidence” that would harm shippers in the Western and Southwestern United States. Schmidt declined to be interviewed for this article, although he agreed to supply written answers to a few questions submitted by The Times.

When the smoke clears, Santa Fe Southern Pacific may become known as the big engine that couldn’t. The ICC’s rejection could mean the dismemberment of the two archrival railroads, which were critical to the development of California and the West.

Santa Fe Southern officials had warned in earlier testimony before the ICC that the Southern Pacific, which has had to be operated independently under a voting trust, could face bankruptcy if the merger were not approved. And the Santa Fe was not in much better shape, they said.

The Chicago company has until Dec. 9 to submit a petition asking the ICC to reopen the case. It is racing to negotiate costly settlements with competitors that oppose the merger to grant them various concessions, such as the use of certain Southern Pacific and Santa Fe track, in order to defuse the opposition.

Victim of Changes

If the ICC does not allow the two railroads to merge, Santa Fe Southern has said it will have to sell one or both of them, leaving the company with its considerable real estate, oil and gas and leasing businesses.

How did these two once-mighty railroads get into this fix?

These were the railroads that built the West, but they fell victim to economic changes in the territories they helped carve from empty deserts. The rise of the trucking industry after World War II cost the railroads dearly, and mega-mergers forced weak competitors to combine or die.

For San Francisco-based Southern Pacific, nicknamed the Espee, it all began in 1856 when civil engineer Theodore D. Judah built the 23-mile Sacramento Valley Railroad, the first steam railroad in the Far West. Judah gained the backing of four Sacramento merchants in his search for a route over the Sierra Nevada toward the first transcontinental railroad.

Those merchants became known as the Big Four--but back then Leland Stanford was a grocer, Charles Crocker owned a dry goods store, and Mark Hopkins and Collis P. Huntington were partners in a hardware business.

With a new name, Central Pacific, the railroad broke ground for the western end of the transcontinental line in January, 1863. It hooked up with the Union Pacific on May 10, 1869, with the driving of the famous golden spike at Promontory, Utah.

Central Pacific--and its successor, Southern Pacific--promoted its territory heavily to attract residents and businesses. It also started Sunset magazine in 1898 for that purpose, but sold it in 1914.

The 1982 book “Everybody’s Business,” edited by Milton Moskowitz, Michael Katz and Robert Levering, called the Espee “one of the 19th Century’s most avaricious monopolies,” adding that the Big Four “turned their railroad into the prototypical American monopoly through the time-honored techniques of graft, bribery, fraud and outright mendacity.”

But railroad historian Don L. Hofsommer contends that the company’s power, although substantial, has probably been exaggerated over time.

“That doesn’t say that the Southern Pacific was without power,” said Hofsommer, who recently published a book on Southern Pacific in the 20th Century. “But if the Southern Pacific was that powerful, how do these people explain that the Santa Fe got to the Bay Area?” the heart of SP country.

Santa Fe Railway was founded in 1859 by Cyrus K. Holliday as the Atchison & Topeka. The Civil War and other problems delayed things and the railroad laid no track for nine years, by which time it had added Santa Fe to its title. Holliday’s ambition was to build a railroad that followed the old Santa Fe Trail, which guided many a wagon train from Missouri to the West.

The Santa Fe evokes images of the Old West, of trains chugging out of Dodge City with the lights off so that rowdy cowboys wouldn’t shoot them out, of Judy Garland singing the praises of riding “On the Atchison, Topeka and the Santa Fe” in the 1946 movie “The Harvey Girls,” a romantic comedy celebrating the women who worked the first railroad restaurants that served palatable food.

Became Fierce Enemies

The two railroads became fierce enemies in the 1880s as Santa Fe tried to build a route to the West Coast, only to be repeatedly checkmated by the Southern Pacific, which would build to meet its rival at various points. Men working the two railroads reportedly faced off with rifles more than once.

Santa Fe finally reached the California coast by building first to Mexico’s Pacific coast. It then used the threat of transcontinental competition to coerce the Southern Pacific into leasing it some Southern California track that eventually was swapped for Santa Fe’s Mexico operations. Santa Fe resumed building, and finally completed its first through route from the Midwest to San Diego in 1885.

The romantic history of both lines is highlighted by passenger travel on such famous trains as Santa Fe’s Super Chief and El Capitan and the SP’s Sunset Limited and City of San Francisco.

But competition from airlines and private automobiles did in the railroads’ passenger business and, in 1971, they turned it over to Amtrak, the federally subsidized passenger rail service. Meanwhile, growing competition from trucks after World War II put a quite a dent in the railroads’ freight business.

Railroads excel at carrying large amounts of heavy commodities over long distances while trucks have grabbed more and more of the other business. Smaller loads of lighter products with a shorter way to travel became the territory of trucks, aided by a 42,500-mile government subsidized interstate highway system.

“Trucks? Well, nobody took them very seriously,” said Schmidt in an October, 1985, speech at Chicago’s DePaul University--his alma mater. “They were OK to haul things around the city--but between cities? Forget it.”

Freight Business Declined

In 1944, railroads carried nearly 69% of all intercity freight traffic in the United States, compared to 5.4% carried by trucks, according to the Assn. of American Railroads. By last year, the railroads’ share had shrunk to a little more than 37% while trucking’s portion had jumped to an estimated 24.8%.

Railroads were slow to respond to the threat from the trucking industry. And though they repeatedly called for deregulation to allow them to compete more effectively, they were ill-prepared when it arrived in 1980, Hofsommer said.

What’s more, the economies of the very territories that Santa Fe and Southern Pacific helped develop changed course in ways that the railroads could not follow. Auto plants, lumber mills and steel mills in the West have closed in recent years and the service and high-technology businesses that have opened do not have much use for the railroads.

“We have to remind ourselves that we don’t haul GNP (gross national product), we haul freight,” Schmidt said at DePaul. “The service and high-tech industries are making up a larger portion of the GNP, and the railroad industry just doesn’t get much business from car washes, hamburger stands or microchip manufacturers.”

The problems facing railroads have caused many companies to merge, continuing a consolidation trend that has been going on since the industry was founded. There are about 400 railroads today--23 of them major companies--compared to 6,000 in the 19th Century, according to the Assn. of American Railroads. By the early 1980s, Southern Pacific and Santa Fe found themselves facing some gigantic competitors who had made good marriages.

The Burlington Northern, for example, took over the St. Louis-San Francisco Railway in 1980 and added the Colorado & Southern, Fort Worth & Denver and Walla Walla Valley railroads two years later. In 1982, the Southern and Norfolk & Western combined to form Norfolk Southern Corp. That same year, the Union Pacific, Missouri Pacific and Western Pacific merged into Union Pacific Corp.

Santa Fe and Southern Pacific “found themselves in a position like that of a baseball team trying to play major league ball with Triple-A facilities,” Schmidt said at DePaul. “We had become medium-sized railroads in a land of giants.” Part of that is the companies’ own fault, analysts say. The two companies had announced plans to merge in 1980 but called it off a few months later.

“How did they get to where they are?” asked Andras R. Petery, an analyst with the investment banking firm of Morgan Stanley. “Because they were slow, unimaginative, let events happen around them,” such as allowing the 1980 merger proposal to derail. The currently proposed merger, he added, “is a must-do thing.”

If the Southern Pacific and Santa Fe railroads ever merge, they will create the nation’s second-largest railroad in terms of track mileage. The Southern Pacific & Santa Fe Railway--the name would be the reverse of the parent company’s--would have 25,426 miles of track. Burlington Northern leads with 26,780 miles and CSX Corp. (Chessie Systems and Seaboard Coast Line) would be third with 23,945 miles. The merged railroad also would be second in revenue, based on 1985 totals. Southern Pacific and Santa Fe had combined revenues of $4.6 billion in 1985, compared to CSX’s $4.8 billion.

But by using other financial indicators, the health of Santa Fe and Southern Pacific can be described as bad and worse.

Southern Pacific & Santa Fe would have ranked last among major carriers in 1985 operating income, which would have been $160.1 million if the two companies had operated as one. That compares to $779 million for Burlington Northern and $695 million for Norfolk Southern, the railroads that led the industry last year.

Also, Southern Pacific & Santa Fe would have used 96.3 cents of every revenue dollar for its day-to-day operations in 1985. Industry leader Norfolk Southern used only 79.8 cents and Burlington Northern 80.7 cents.

Santa Fe Southern claims that the future of both its railroads is bleak without the merger.

“We can see no way that our two railroads, operating separately, can compete effectively in the long term with the giant railroads already created in the West, or with the aggressive trucking industry,” Schmidt wrote in the company’s 1986 annual report.

The merger would result in annual benefits of $287.4 million because of increased efficiency and traffic gains, the company has estimated. In addition, $522 million in capital expenditures would be avoided. The result would be a lower-cost, more-efficient railroad, the company said.

For the last several years, Southern Pacific has been using $100 million more in cash a year than its railroad operation is producing, Schmidt stated in response to a question from The Times. The company has made up the shortfall mainly through a $150-million cash infusion from the parent firm when the voting trust was set up and has used proceeds from the sale of real estate and attached tax benefits, he said.

“The subsidy from land sales cannot continue forever, however, and there is no question that (Southern Pacific’s) financial situation will deteriorate as this cash drain continues,” Schmidt said. “Eventually, there will be no more real estate to sell.”

Going against a recommendation from its staff that the merger be approved, the Interstate Commerce Commission rejected the marriage because it would be a “parallel” combination, with both railroads serving overlapping areas in the Southwest and California, rather than an “end-to-end” consolidation. A near-monopoly would be created in California and in a stretch from Southern California to the Gulf Coast, the commission said.

In its written decision, issued Oct. 10, the ICC also rejected Santa Fe Southern’s contention that its railroads are headed for failure, although the commission acknowledged that the roads are weak.

ICC Chairman Heather Gradison, the only commissioner to support the merger, sharply criticized the majority’s decision in a published dissent.

Many Santa Fe and Southern Pacific competitors and customers had opposed the merger unless concessions were granted to make it less damaging to competition. Union Pacific, for example, said the merger would cost it at least $165.6 million in lost revenue and requested the right to use some Santa Fe Southern tracks. The Transportation Department had supported the merger while the Justice Department opposed it.

Schmidt and the company took the stand that extensive conditions imposed on the merger would greatly reduce its value, although the company did offer some concessions and reached a settlement early on with Burlington Northern.

The California Public Utilities Commission was very interested in the merger, providing evidence during hearings that shipping rates would rise as much as 55% in certain parts of the state if it were approved without conditions.

The merger “would result in higher prices and inferior service to our major shippers,” said Vincent MacKenzie, a PUC lawyer. On the other hand, “we saw some benefits emanating from the proposed merger, namely . . . it would be a more efficient and economically run railroad.”

While it compiles its petition to reopen the case, Santa Fe Southern is trying to reach agreements with Union Pacific and other competitors that would remove their objections to the merger. The company recently announced a settlement with the Denver & Rio Grande Western that gave the Denver company use of Santa Fe Southern tracks, providing it with its first access to Northern and Central California. The ICC’s rejection of the merger contained a political element, observers said.

“The ICC is fighting for its institutional existence” and has been less pro-railroad in recent months as some in Congress have discussed abolishing the agency, analyst Petery said. “This was probably the best example of suddenly a consumer-oriented ICC.”

And some of the blame lies with Santa Fe Southern itself because of its resistence to conditions on the merger. Most observers assume that the merger will eventually be approved by the ICC, although extensive conditions are expected to be attached to make it less anti-competitive.

The anticipated concessions will cost Santa Fe Southern, said Isabel Benham, president of Printon, Kane Research, a New York consulting firm. “The big worry from the standpoint of financial analysts is that the Santa Fe, in the effort to get the merger, would give away the store” by making too many concessions to competitors, she said. Santa Fe Southern is much more than a railroad company these days. While the railroads represented 72% of Santa Fe Southern’s revenue in 1985, they contributed only 20% of its income.

Santa Fe Southern figures that it is probably the largest publicly held real estate company in the country. It is California’s biggest public landholder.

For example, the company owns such properties as the Pacific Design Center in West Hollywood, a part interest in the New Orleans Hilton Hotel and the huge Mission Bay commercial and residential project proposed for downtown San Francisco. Among other things, it owns 22,000 acres of commercial and industrial properties, 160,000 acres of farmland in the San Joaquin Valley and 2.9 million acres of primarily grazing and desert land in the Southwest.

Santa Fe Southern owns the third-longest oil and gas products pipeline system in the nation. Its Santa Fe Energy Co. is one of the top five independent oil producers in the country.

It is also parent of San Mateo-based Bankers Leasing, which leases about 85,000 pieces of equipment--from rail cars to aircraft to computers--worth more than $600 million. Finally, the company owns SF Minerals Corp., a major Western U.S. coal firm.

But the history and the bulk of its employees--51,000 of 57,500--lie with the rails.

Yet some on Wall Street hope that Santa Fe Southern will finally lose its merger case and live profitably ever after on the strength of its non-rail operations--business cycles willing. The price of Santa Fe Southern’s stock plunged right after the ICC rejection to $27.50 a share from $34.375 three weeks before the July 24 hearing. But the stock has since recovered and is now trading at around $33.

“Today, railroads are being valued (by Wall Street) for the assets more than for their earning power,” consultant Benham said. If the Santa Fe Southern loses its merger case, “there are many many possibilities of buyers for Southern Pacific.”

At the end of last year, the two railroads valued their combined assets at $9 billion, including real estate. Money manager E. Magnus Oppenheim, who heads a New York investment firm bearing his name, said the rail assets alone are worth about $3.2 billion. However, it is hard to say how much they could be sold for because of the vagaries of the market.

Since the merger of the parent companies, Oppenheim noted, Santa Fe Southern has created a master limited partnership for part of its oil and gas reserves, has purchased nearly 30 million of its own shares in a 50-million-share buyback program and has announced plans to sell part of its forest products operation.

“The picture developing here is of an aggressive management that has taken a huge company, combined it, rationalized it, (but) has a long way to go still in rationalizing it,” Oppenheim said.

Whatever happens, Schmidt has said, don’t count the Santa Fe Southern out. “The company doesn’t stop just because of one disappointment,” Schmidt wrote in August in the company magazine. “We take a deep breath, tighten our belt and go forward.”