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CSX CEO Hunter Harrison’s Pay Is No Great Train Robbery

Hunter Harrison’s pay deal shows the new railroad executive is in it for the long haul, not a quick heist.

Earlier this month, when Harrison took the job of CEO of the nation’s No. 3 railroad CSX(CSX) some critics said the exec, who has proven adept at turnarounds, was essentially holding up his new shareholders by demanding they make good on the $84 million payday he walked away from when he exited his old job. It seemed to be another example of CEO pay going off the rails.

But what many missed at the time is that the actual details of the compensation deal that Harrison signed puts shareholders in the conductor’s seat. Notably, it will require Harrison to not only keep the trains running at CSX, which is often the case with CEO pay, but to really improve the company’s profit schedule in order to cash in. The high performance bar of Harrison’s pay deal also makes this clear: No one thinks his reputation is better deserved, or has more faith that he can deliver on it once again, than Harrison himself.

Harrison got the CSX job after teaming up with activist hedge fund manager Paul Hilal, whose first priority for the railroad company has been to install the turnaround expert as CEO. In its March 6 press release, CSX stated that Harrison “will receive an award of incentive options to purchase nine million shares of CSX stock at its current trading price.” Half of the options vest over four years with no contingencies other than Harrison’s continued employment, and the other half are subject to performance goals that CSX hasn’t yet disclosed.

Stock options are often a bad deal for shareholders. In a conversation with this reporter around a decade ago, Warren Buffett criticized options as “a royalty on the passage of time.” His point: Most options are granted at today’s share price, and since the average company retains around half its earnings, stock prices are likely to rise simply because the CEO gets more and more cash to invest, even if returns on those retained earnings are nothing special. If the grants are big enough, CEOs get fabulously rich even if their companies underperform their rivals.

But the Harrison deal is refreshingly different.

Since his campaign became public on January 19, CSX shares jumped 35%, closing at $49.79 on March 6. That seven-week sprint lifted its market cap from $34 billion to $46.2 billion, or $12.2 billion. In an SEC filing issued on March 7, CSX disclosed that Harrison’s options carry a strike price of that’s day’s close, $49.79, the all-time record. Over the next three days, CSX shares dropped over 4% to $47.65. So Harrison started his tenure with options that are already “out of the money.”

What’s highly encouraging for both CSX’s existing shareholders, and those pondering whether to buy its shares, is that Harrison, whether or not he initially wanted a lower strike price, believes that he can substantially lift the stock from the current plateau that, after the recent selloff, is still almost 26% higher than it was just a little more than nine weeks ago. Simply maintaining the huge gains garnered from his popularity on Wall Street does nothing for his options. Hence, Harrison’s wager is the mark of a fierce competitor with unshakeable optimism, based on a proven belief in his own abilities.

But can Harrison deliver? The path to rich returns is a lot steeper than when he and Hilal, who runs hedge fund Mantle Ridge, began their onslaught. At that time, CSX had a dividend yield of 1.9% and a price-to-earnings multiple of 20. Today, the yield stands at 1.4%, and the P/E is a lofty 27.

Let’s assume investors want a 10% total annual return from these already elevated levels. Let’s further assume that the P/E falls from 27 to 20 over the next four years—the length of Harrison’s contract. (P/Es are generally high when investors are anticipating big earnings growth, and drop as that growth inevitably falls to more sustainable rates.) Under that scenario, CSX’s share price would rise from almost $50 to roughly $70, plus 8% capital gains, for a total annualized return of 10% (assuming dividends are reinvested). Harrison needs to raise earnings from $1.7 billion in 2016, to a run rate of $3.1 billion by early 2021. That’s annual growth of 16% a year.

Harrison has an excellent chance of achieving what sound like forbidding numbers. It’s well-known that he’s had spectacular success at Canadian Pacific (CP), and earlier at Canadian National (CNI) and Illinois Central, imposing a model known as “precision railroading.” The system boosts efficiency by putting the network on a tight, fixed schedule and keeping hoppers and gondolas on the rails more hours a day. What’s less appreciated is the result of those efficiencies: Big improvements on what matters most to stocks: Returns on capital.

A good yardstick for how efficiently companies deploy their capital stock is COROA, or cash operating return on assets, developed by Jack Ciesielski, author of the Analyst’s Accounting Observer newsletter. COROA eliminates the effects of leverage and taxes to get a pure measure of how well a competitor runs its operations. It adds interest and taxes to cash flow from operations to get a measure called “operating cash flow.” Operating cash flow is then divided by assets plus accumulated deprecation—i.e. all the money ever invested to make the cars or appliances, or, in this instance, run the railroad— to get COROA. So COROA tells us how much cash a company generates each year on every dollar in assets.

Especially revealing is the additional cash generated by adding new assets. From 2011, the year before Harrison arrived at CP, through 2015 (the last year for which full numbers are available), that railroad company’s average annual assets increased by a minuscule $68 million, but its operating cash flow jumped $774 million to $2.15 billion, a rise of 177%.

CSX is moving in the opposite direction. Not that, given the tough market, it’s doing badly. CSX has proven resilient considering a loss of $2 billion in lucrative coal business in the past several years. Its COROA is still a respectable 10.4%.

But that number has been dropping, as assets rise and cash flow stagnates, precisely reverse what has happened at CP. Since 2011, CSX has raised its assets from $35.7 billion to $45 billion, up 25%. Yet its operating cash flow waxed just $280 million over those four years, or 6%.

That record of rising capital and flat cash flows presents a fat opportunity for Harrison. At CP, he lowered the operating ratio, consisting of operating expenses to total revenues, from over 80% to a current 56%. The operating ratio at CSX has been in the high 60s. So, according to projections that BMO Capital made in January, if Harrison can get that down to 60%, the stock should be worth as much as $60. Get to CP-like levels, and the value of CSX shares should shoot up to near $70, delivering Harrison’s shareholders a 10% annual gain over his four year contract.

Let’s not overstate how much risk Harrison is actually taking.

Harrison and Hilal are demanding that CSX cover all of Harrison’s foregone benefits from CP, including CP’s agreement to make large tax payments on Harrison’s behalf. CSX’s position has been that if Harrison traded $84 million and big tax payments for a release from a non-compete, and Mantle Ridge provided a guarantee, that’s their business. Why should CSX shareholders pay?

The CSX board is shrewdly leaving the decision to shareholders. They will vote on the “make-whole” package at the next annual meeting, which the March 7 filing states will be held “no later than” June 15. But Harrison and Hilal are clever, too. The $84 million sounds like a lot of money, but it amounts to less than 10 cents a share. Keep in mind that Harrison has added more than $10 a share already. Nixing the $84 million would send Harrison packing and the share price tumbling. Chances are excellent he’ll get the cash.

How much more will Harrison pocket if he delivers a 10% return? At $70 a share, his nine million options would be ‘in-the-money” by $20. The by-then 76-year old would make $180 million. At the same time, shareholders would gain around $20 billion, on top of the $12 billion his vaunted reputation has already added.

Buffett’s right about most options. But because CSX shares already popped, this grant is a good one. Hunter Harrison wants nothing more in life than to transform this railroad, and judging from his pay package, is supremely confident that he’ll triumph once again.