Description

Kansas City Southern (ticker: KSU)

Conclusion:

KSU is one the high quality businesses who has seen its share price depressed in recent months due to the impact of lower energy prices.  KSU’s share price and coal carloads are down the most YTD out of all the Class 1 rails.  However, KSU has the smallest energy exposure out of all the class 1 rails, and the YTD decline in coal carloads is a result of their only unregulated thermal coal customer going to zero.  KSU’s remaining coal exposure is all regulated utilities; they now have no unregulated thermal or export met coal exposure.  As we comp this issue (as well as some other smaller headwinds; some service issues, steel demand for drill rigs, etc.) I believe that the company’s volumes will accelerate into ’16 on the back of several strong growth drivers.

Business Description:

KSU is a class 1 rail with a unique U.S.-Mexico cross-border network and the most profitable rail franchise in Mexico.  The company’s U.S. holding, the Kansas City Southern Railway Company, has network coverage in the central and south central U.S.  The company’s main international holding is Kansas City Southern de Mexico S.A. de C.V. which serves northeastern and central Mexico and the port cities of Lazaro Cardenas, Tampico and Veracruz.  The company has the only U.S.-Mexico rail crossing, and the sole concession to Mexico’s largest port, Lazaro Cardenas.  In short, the company is uniquely positioned to capitalize on one of the fastest growing industrial trends in North America; the flow of goods between Mexico and the U.S., which is largely underpinned by massive auto industry FDI in Mexico, as well as capacity problems at L.A.’s port of Long Beach.  The company is headquartered in Kansas City, Missouri.

Why KSU is Cheap / Misunderstood:

KSU shares have reacted negatively to the lowering and then retraction of 2015 guidance as a result of energy pressures (declines in coal, frac sand, steel) as well as some service issues.  I believe that energy exposure in generally less than people think, and that a large part of the recent negative impact is from temporary factors.  I also believe that this situation is causing the market to overly discount risks to the company’s secular growth, as well as underestimate its potential to improve its operating ratio (OR).

The variance between results and guidance has been due mainly to worse results both the energy and intermodal segments of the business.  The revenue variance has also been magnified by surcharges (due to declining diesel prices) and FX (due to the declining Mexican Peso).  Before focusing on energy, let’s discuss the other factors.  Given the massive growth in the port of Lazaro Cardenas (discussed in more detail later), a solid U.S. economy, and structural pressures on North American trucking (driver shortages, road congestion, etc.), the outlook for KSU’s intermodal segment is very bright.  Results have disappointed YTD, however this has been mainly due to temporary service issues, mainly work in their Southwest quarter, including work on the international bridge in Laredo, TX, as well as crew availability in Mexico.  This service impact is not reflective of demand, and when it subsides the intermodal business will resume a strong growth trajectory.  The last two factors, fuel and FX, are pass-through / hedged.  Fuel surcharges are a pass-through, and the company’s peso revenue and cost base are nearly perfectly hedged.  Therefore, as fuel and FX impact the top-line, the company’s OR falls commensurately.  However, this last dynamic was clouded in the quarter as the company did not pare variable costs fast enough to compensate for lower volumes from the service issues.

The weakness in energy is partly a real structural issue, however the structural piece is played out and is what I believe the primary cause of the attractive opportunity in KSU shares, since the company has lost the majority of its premium multiple as a result of the recent fundamental weakness, despite the fact that their structural growth drivers remain firmly intact.  What has been the main driver of KSU’s weakness has been the loss of their one unregulated thermal coal customer (this is the structural issue, as a result of an era of low natural gas prices).  With this customer now at zero, KSU not only has the smallest exposure to coal among the class 1 rails, but no more unregulated thermal coal exposure and no export met coal exposure.  Other pockets of energy weakness for KSU are smaller (frac sand and steel for drill rigs) and I believe are reflecting more cyclical than structural weakness (you still need to drill, even in an era of low natural gas prices).  The company’s crude by rail growth has also slowed, but as discussed at greater length below, I believe this remains a growth opportunity for the company.

Earnings Power:

The first main driver of earnings power at KSU is the substantial volume growth they should experience over the coming years.  The main drivers of this volume growth should be from the auto industry, the port of Lazaro Cardenas, cross-border intermodal volume, and crude by rail.  These segments in aggregate make up nearly 20% of KSU’s business, and are all expected to grow approximately in the double-digit range on an annual basis.  Taken together, those segments should make up nearly the entire mid single digit volume growth that the market is expecting from KSU over the next few years.

Auto is currently ~10% of KSU’s business, and growing double digits when adjusted for FX (much of their auto business is in pesos, but as mentioned before so is much of their cost base).  3^rd party data provider Autocast estimates that Mexican auto production will rise approximately 40% from 3.2m units in 2014 to 4.5m units in 2019.  KSU could see even faster growth based on its current and future plant connections.  Prior to 2014 KSU was connected to 9 auto plants.  3 opened last year but operated only at half capacity and continue to ramp.  5 more plants have been announced for 2016-2019 openings, and GM still has $3.5b to spend on the $5b expansion plan they announced several years ago.  It is also worth noting that due to the continuation of these announcements, Autocast has revised up their numbers in the past, and that KSU is in ongoing discussions with automakers about additional plant investment in Mexico.

Lazaro Cardenas is currently ~4% of KSU’s business and growing double digits.  Lazaro Cardenas is Mexico’s largest port and taking share from L.A.’s port of Long Beach, which continues to struggle with current capacity.  KSU has the sole concession for rail access to Lazaro Cardenas.  Lazaro Cardenas port capacity is growing rapidly.  Currently there is only one terminal operated by Hutchinson Port Holdings.  This terminal’s existing capacity is 1.8m TEUs, but is being expanded to approximately 2.5m TEUs. , A second terminal is also being built by APM, a subsidiary of Maersk.  This second terminal will open in 2016, is being built in phases, and should have capacity of approximately 4m TEUs.  In short, capacity at Lazaro Cardenas will increase by over 250% over the next five years, and KSU has the only rail concession to that port.

Cross-border intermodal is currently ~3% of KSU’s business and has been growing double digits until recently when growth has been temporarily interrupted due to aforementioned service issues.  Growth in this segment is driven by general economic activity, as well as share gains from other modes of transportation.  Mexico has been the beneficiary of significant FDI in recent years ($39.2b in 2013, an increase of 120% over 2012) and much of that has been in manufacturing segments and in states where KSU has access.  Additionally, KSU estimates that it has only 3% share of its available market.  Furthermore, the trucking industry continues to be pressured by driver shortages, regulation, and road congestion.  With the only U.S.-Mexico cross-border rail access, KSU is well positioned to continue to gain market share and growth this business by double digits for years to come.

Crude by rail is only 1% of the company’s business and has been growing nearly 100%.  This growth will undoubtedly slow, and has slowed recently with the decline in crude prices and narrowing in light-heavy spread, but still has significant opportunity ahead.  First of all, it’s important to note that KSU moves nearly all heavy Canadian crude.  This is important because heavy crude is important to Gulf Coast refiners who have the coking capacity to economically process this crude.  There are four expanded or new facilities that are available to KSU in 2015: Sunoco Logistics, Jefferson Rail Terminal, Genesis Energy and Hunt Refining.  The capacity of those plants is such that they can handle 100-110 trains a month, vs the 3.5 trains per week that KSU was doing at the end of 2014, so this is a 6x in market opportunity for KSU over the next several years.  Importantly, three new origin points for loading crude into trains are becoming operational in the first half of 2015.  In addition, the company has a large opportunity with the Port Arthur Crude Terminal that is being built by Global Logistics and should begin operation in 2017.  Whereas investors in rail stocks have generally been concerned about crude by rail in recent months, it should be an enormous opportunity for KSU over the next several years.  Lastly, on the energy-related front, there is a substantial energy-related growth opportunity in the amount of ethane cracker plants under construction along the U.S. Gulf Coast.  There is currently 16m tons of production either under construction or in the planning phase, and KSU is engaged in discussions with these companies regarding the possibility of shipping plastic pellets within the U.S., as well as to Mexico, and also South America and Asia via the port of Lazaro Cardenas.

In addition to top-line growth, KSU has meaningful opportunity to improve its OR.  The three main drivers of this will be price, the transition to more owned equipment, and the rolling off of some legacy maintenance agreements.  Before I cover these three drivers, I think it’s also worth mentioning that the fuel surcharge and FX-related top line pressures seem to be clouding the OR picture for some investors.  On their Q4 call KSU gave guidance for a “low 60s” OR by the end of 2017.  Management has also said that the reason that they gave guidance that is by definition a little vague, is because non-operational factors like fuel surcharges and FX can shift the OR “artificially”.  I believe this has in fact happened, but given the top-line pressures and high OR in Q1, many are still modeling a ~63% OR by the end of 2017 versus what should now be more like a 60% OR.  Now on to the operational / fundamental drivers of the expected OR increase.

The first driver is price.  Because of the fact that KSU has the sole rail concession to Lazaro Cardenas, the only U.S.-Mexico rail border crossing, as well as other factors like increased FDI in Mexico, a strong U.S. economy and pressures on over-the-road transportation, KSU has consistently gotten approximately 4% price in recent years.  Recently management has said they feel even stronger about re-pricing contracts that are rolling off, so underwriting a continued 4% price increase seems secure.

The next driver is the transition from leased to owned equipment.  As recently as 2013 KSU was roughly 25% owned equipment vs industry-average/standard of ~70%.  At the time they outlined 100-200bps margin advantage, net of D&A, from moving towards industry-average/standard.  They are roughly halfway there now with just over 50% owned.  I think it’s worth noting, especially since they’ve spent roughly half the capital already, that the cash impact is greater since the D&A impact on the P&L is roughly equal to the net OR benefit.

The last major driver is the rolling off of some legacy maintenance contracts that are expiring over the next several years.  The company has characterized these contracts as multi-year (10-20) with price escalators and they’ve gotten to the point where they are above market.

With the above fundamental backdrop, I expect KSU to rebound strongly in 2016 from this year’s pause in EPS growth.  I expect revenues to reaccelerate to the high single digits, OR to drop to ~60% (excluding any further change in fuel prices and the peso), share repurchases to become a more material part of the company’s capital allocation plans (capital intensity is currently peaking), and EPS growth to reaccelerate to back to the high teens.

Valuation:

I expect an investment in KSU equity to realize an IRR in the teens or low 20s over the following 3-5yrs.  The teens would imply no multiple expansion, but I believe it is possible that KSU’s multiple expands back towards its historical low 20s from the current mid to high teens as revenue, earnings and ROIC accelerate.

Balance Sheet & Liquidity:

• Conservatively / appropriately levered at ~2x EBITDA

• Capital intensity peaking this year as they are buying a significant number of locomotives and their leased-to-owned equipment strategy is peaking in capital needs

• Just initiated first share repurchase in response to attractive share price, availability of capital, and accelerating free cash flow over the next few years

Catalysts:

• Improving results over the next several quarters as the company laps the current volume comps and service issues improve

Risks:

• Economy: KSU is a cyclical company that would feel the negative impact by any North American economic recession

• Service: KSU has the lowest % of freight origination out of the class 1 rails and therefore depends more on others for level of service in order to keep its efficiency high

Catalyst

Improving results over the next several quarters as the company laps the current volume comps and service issues improve