THE GREAT CONRAIL SWEEPSTAKES The prize is a once moribund railroad that the federal government nursed back to profitability. Three bidders are eager to take the line off the government's hands for $1.2 billion. But taxpayers would be better off if Conrail were sold in a public stock offering.
By Kenneth Labich RESEARCH ASSOCIATE Brett Duval Fromsom

(FORTUNE Magazine) – CONGRESS IS about to begin debating how to dispose of the Consolidated Rail Corp., the amalgam of six bankrupt freight lines that the government took over in 1976. Three avid bidders want to buy Consolidated Rail, better known as Conrail, while the railroad's management wants to sell it through a public stock offering. As corporate acquisitions go nowadays, the Conrail sale looks minor league; the likely selling price is less than $1.5 billion. But the stakes are large. The government has spent more than $7 billion to restore the railroad to profitability, and Congress doesn't want to see it slide back into insolvency in the hands of an undercapitalized or incompetent owner. Taxpayers wouldn't like that either. Congress decided years ago that Conrail's 13,500 miles of track in the Northeast and Midwest are a vital national asset. If Conrail failed, the government would leap right back in the freight business, scattering more and more tax dollars along the roadbed. Hundreds of coal, steel, and automotive companies that use Conrail to move their goods also have a mighty interest in who gets it. They want Conrail to stay reliable and efficient--and competitive. Conrail competes with the Norfolk Southern and CSX, the two other big Eastern lines, on many routes. The competition has pushed freight rates down, on average, since deregulation gave railroads some pricing flexibility in 1981. Many of Conrail's customers believe rates would jump back up if Conrail were acquired by one of the other major railroads or sold off in pieces. Congress will take up the Conrail sale as soon as Transportation Secretary Elizabeth Hanford Dole decides who she thinks the buyer should be. Dole, wife of Senate Majority Leader Robert Dole, is another player with a lot on the line. She is frequently mentioned as a potential 1988 Republican vice presidential nominee, and disposing of Conrail is likely to be her most visible and politically delicate act in the next few years. More than anyone else in Washington, she will get the blame if Conrail goes to the buyer she chooses and then winds up on the dole again. She also has to worry about alienating the shippers, the rail unions, and Republican politicians in the 15 states where Conrail operates. A public offering looks like the best way to set Conrail free, but Dole rejects that option. She says the way to ensure that Conrail remains sound --and to get the highest price for taxpayers--is to sell the railroad to one of three finalists she selected from 15 bidders that submitted offers to the Transportation Department last year. The finalists are Norfolk Southern, Alleghany Corp., and an investment syndicate headed by hotel magnate J. Willard Marriott Jr.

All three are offering $1.2 billion for the 85% of Conrail owned by the government. (Conrail employees own the remaining 15%.) In late January Dole was rumored to have settled on Norfolk Southern, pending clearance from the Justice Department's antitrust division. She insisted that she hadn't made a choice. ''We are reaching a conclusion,'' she told FORTUNE, ''but parts of it are still not in place.'' Conrail Chairman L. Stanley Crane, the crusty 69-year-old who is widely credited with salvaging the railroad, thinks Dole's plan is dead wrong. Working with the New York investment banking house of Morgan Stanley, Crane has put together a proposal for a public stock offering that would keep Conrail independent and leave his hand on the throttle. Crane has been talking up his proposal with members of the congressional committees that will weigh Dole's recommendation. He has distributed bumper stickers reading LET CONRAIL BE CONRAIL, and he hired a high-octane public relations firm headed by former Reagan aide Lyn Nofziger to argue his case. Dole, needless to say, hasn't taken kindly to such behavior by someone who supposedly works for her. She hasn't been able to silence Crane, but she did persuade the Conrail board to drop Nofziger. Crane's efforts assure that Congress will look hard at a public offering before buying Dole's recommendation. Conrail's 16 labor unions also have the ear of Congress, a fact that hasn't escaped the bidders. Brian M. Freeman, 37, a lawyer and former Treasury Department official who is financial adviser to the unions, has extracted large concessions from the Transportation Department's finalists. Alleghany and the Marriott group have promised to give the unions more than 15% of Conrail's stock, raising their holdings to over 30%, and to boost wages to the rates paid by other railroads. Conrail employees have been working for about 12% less than the industry standard since 1981. Freeman was still negotiating with Norfolk Southern in late January, but had persuaded the railroad to pay at least $350 million for the Conrail stock owned by the employees. That's 65% more per share than Norfolk Southern would pay the government for its stock. At first glance, it seems that the government ought to get considerably more than $1.2 billion for its Conrail shares. The railroad earned $500 million last year and has $845 million in cash on its books. But those figures are misleading. Railroads need large cash reserves because their revenues are highly cyclical. Conrail, according to most estimates, will have to keep at least $500 million on hand. And Conrail's earnings are inflated by various tax and cost advantages that a private owner won't have. If the railroad had been in private hands last year, it would have earned about $262 million (see table). On that basis, the bids don't seem outlandishly low. Dole points out that some 100 companies looked at Conrail and none offered more than the three finalists. The only ones talking about a higher price are Crane and Morgan Stanley, who say that the government could get at least $200 million more in a public offering. All three bidders have painted themselves up for Dole, Congress, and the unions, though each still has blemishes. Neither Alleghany nor the Marriott group is a railroader now, but both have agreed to retain Conrail's management, which has proved competent. In addition, both have accepted several conditions laid down by the Department of Transportation, most of which would run for five years. These conditions require the buyer to keep at least $500 million in cash reserves, spend at least $350 million a year on capital improvements, and sell no more than half the shares to other investors. The Marriott group plans to borrow more of the purchase price than Alleghany ($700 million vs. $500 million), but both appear to have enough financial muscle to weather anything short of a cataclysmic drop in Conrail's earnings. Alleghany and Marriott say they want to get into railroading to stay, a commitment of great importance to Dole and many Congressmen. Like the shippers, they fear that competition would decline and freight rates rise if Conrail were sold off in pieces to Norfolk Southern, CSX, and smaller Eastern railroads. Conrail's buyer could have plenty of reasons to break it up. While the system performed respectably last year, its long-term prospects are questionable. Conrail has said earnings will drop 30% to 40% if the economy goes into recession in the next two years, and many of its biggest customers are in shrinking industries. ''It's a rust bowl railroad,'' says John J. Burns, the chief executive of Alleghany. But the government has spent dearly to endow Conrail with excellent track, rolling stock, repair yards, and the like. Many observers believe that liquidating those assets could bring a much higher price than any of the current bidders are offering. Bill Marriott says he wants a railroad in order to diversify his holdings. But some Congressmen question Marriott's motives. Their suspicions have been piqued by the presence of the Bass brothers of Texas in his investment group. The folks in Washington regard the Basses as short-term financial speculators and find it hard to believe that they really want to own a railroad. Alleghany, a New York-based holding company, has a more compelling reason to want Conrail. The company sold its largest business, Investors Diversified Services, to American Express last year for a large block of stock. Alleghany's only other asset is a relatively small manufacturing business, and the Securities and Exchange Commission has ordered it to register as an investment firm subject to securities regulations unless it acquires a sizable operating company. Alleghany doesn't want to do that. The company was supposed to register by January 12, but the SEC gave it an extension until the Conrail sale is decided. Alleghany Chairman Fred M. Kirby, 65, has long had an affinity for railroads. Alleghany was the largest shareholder in the New York Central before that line merged with the Pennsylvania Railroad to form the Penn Central. But Kirby's past could work against him in Congress. He was a director of the Penn Central, whose 1970 bankruptcy led to Conrail's formation and the government takeover of rail freight in the Northeast. No one questions Norfolk Southern's commitment to railroading. Nor are there serious doubts about the carrier's management depth or financial strength. Last year the Virginia-based company, which serves the Southeast and portions of the Midwest, earned $482 million on revenues of $3.5 billion. The addition of Conrail to its system would make Norfolk Southern an extremely formidable entity, with tentacles reaching into nearly every state east of the Mississippi. ''We are not concerned with Conrail's liquidation value,'' says Norfolk Chairman Robert B. Claytor, 62. ''We are in for the long haul.'' If the government's only concern were to find a financially secure, long-term haven for Conrail, the choice of Norfolk Southern would be unassailable. But that choice would outrage all sides--labor, Congress, shippers, and other railroads. Claytor has tried to defuse opposition by vowing to keep Conrail's headquarters in Philadelphia--of some concern to Pennsylvania pols--and estimating that only 1,800 jobs would be eliminated. He also plans to retain Conrail's management, with the exception of Crane, who has passed Norfolk Southern's mandatory retirement age. That's not enough to win the endorsement of the Brotherhood of Railroad and Airline Clerks, whose members hold most of the jobs Claytor plans to abolish. Some other unions are likely to oppose Norfolk Southern because they fear that their jobs will disappear in the future. Senators and Representatives from the Northeast are raising questions about the antitrust implications of a Norfolk Southern acquisition. ''I have a completely open mind,'' says Representative James Florio, the New Jersey Democrat who chairs a House transportation subcommittee. ''But I am greatly concerned about competition.'' SHIPPERS have only recently entered the debate over who should get Conrail, and while no clear consensus has formed, most seem to oppose the Norfolk Southern bid because it would limit their choice of carriers. ''There is a clear and present danger of creating a monopolistic railroad if Norfolk Southern gets Conrail,'' says James Scahill, director of the Pennsylvania Coal Mining Association. Coal represents more than 16% of Conrail's traffic and is the largest commodity the railroad carries. Claytor has been talking to several small Eastern railroads, assuring them that he will continue the joint shipping arrangements they now enjoy with Conrail. Under such arrangements, one railroad pays a fee to use another railroad's track. But Claytor hasn't discussed such matters with CSX, and it wouldn't do him much good if he tried. Top officials at the Richmond-based railroad estimate that it would lose $400 million in annual revenues if Claytor acquires Conrail. CSX figures that a combined Norfolk/Conrail would take business away from it by offering direct shipments at lower prices between more cities. Says John Snow, a CSX executive vice president: ''We'd have no option but to oppose Norfolk Southern with all our resources, in every forum available.'' Snow says CSX considered bidding for Conrail itself, but came away from a meeting with Justice Department officials last year convinced that a merger with a large Eastern railroad would not be permitted. ''If something's changed now,'' he says, ''we want to know what that is.'' Many opponents of the Norfolk Southern bid have fixed on a public offering as an acceptable alternative. The plan developed by Morgan Stanley for Conrail management calls for selling $500 million of common stock and $600 million of preferred. In addition, Conrail would turn over $300 million of the cash in its treasury to the government, bringing the total proceeds to $1.4 billion. Thomas A. Saunders III, a Morgan Stanley managing director, says the common shares would be attractive because they would be priced at four to five times earnings and have a dividend yield of 7.5%. CSX and Norfolk Southern shares sell at seven to eight times earnings and yield about 4 1/2%. ''We already have institutional investors calling us for a piece of the action on Conrail,'' says Saunders. ''This thing is doable--it can be done in one day.'' Elizabeth Dole has been fighting the Morgan Stanley plan with ammunition supplied by Goldman Sachs, the investment banking firm she hired to advise her on Conrail. The experts at Goldman initially saw a public offering as an attractive option but changed their minds, and their arguments, when their client's preferences became clear. Dole's principal argument is that Conrail is too big for a public offering. Industrial companies have made only ten stock offerings in excess of $300 million over the past 30 years, and many of those were by blue chips such as General Motors, Exxon, and IBM. But the paucity of large offerings may simply reflect the reluctance of large companies to issue lots of new stock. Morgan Stanley's proposal does have drawbacks. Conrail would have to pay $72 million a year in dividends on the preferred stock. A few lean years could leave Conrail financially strangled by its dividend commitment. Morgan's plan - also would prohibit any shareholder from owning more than 10% of the stock for five years after the offering. That provision is intended to allay fears that a raider might take over the railroad and break it up. But it also would reduce the value of the stock by eliminating a source of potential gain for investors.

And why should Conrail be immune to a takeover? Liquidating the railroad would be profitable only if other carriers could use its assets more efficiently or if they would gain monopoly power. In the first case, freight rates probably would drop. And any scheme that lessened competition would run afoul of the antitrust laws. Dole may also object to a public offering because it's dangerous for her. The public might not be willing to pay as much as her three finalists, which would leave her with an odious choice: accepting less than the government could have raised in a direct sale or starting the bidding all over again. Says Dole: ''You've got an uncertain situation vs. a done deal. You have all the downside risks and virtually no upside.'' IN FACT, the risks Dole faces in a public offering are on the upside too. If the underwriters priced the shares too low and the stock shot up just after the offering, she could be accused of letting stock-market speculators profit at the expense of taxpayers. That's precisely what happened last year when the British government sold British Telecom, its telephone monopoly, in a public offering. The shares are now selling at more than double the December offering price. Morgan Stanley was the lead underwriter. Still, an offering that didn't have the drawbacks of the Morgan Stanley plan probably would represent the best deal for the public. The strongest argument against an offering is that as an independent railroad, Conrail might not have as much staying power as it would if it were owned by another corporation. But no owner, however deep its pockets, will keep a failing operation going forever. And while Conrail doesn't seem fraught with profit potential, it could become a bonanza for a shareholder willing to hold the stock awhile. Industry analysts predict that before long the three major Western railroads--the Santa Fe, Burlington Northern, and Union Pacific--will want to buy the big Eastern roads to form coast-to-coast systems. Santa Fe, in fact, considered bidding for Conrail in 1983 but dropped the idea when it decided to merge with the Southern Pacific. If one of the Western roads does eventually buy Conrail, who better deserves a chance to profit on the deal than the public who propped up Conrail for so long?

CHART: Conrail's reported 1984 earnings $500 million Minus extra costs a private owner would pay: Labor $80 million State and local taxes $32 million Federal income taxes $126 million Adjusted earnings $262 million Why Conrail's Earnings Are Unreal Special benefits that apply only to the federal government make Conrail's profit look better than they are. The rail-road's unions have granted wage concessions and Conrail is exempt from all taxes. A private owner wouldn't enjoy those savi gs.