The Not-So-Little Railroad That Could: Increased manufacturing in Mexico, rising demand for internodal transport, and the use of railcars to carry oil are boosting Kansas City Southern


The Not-So-Little Railroad That Could


Increased manufacturing in Mexico, rising demand for internodal transport, and the use of railcars to carry oil are boosting Kansas City Southern. Takeover target down the line?

The railroad, which has cut overhead and downtime, reaches deep into Mexico, where more companies are building products that must be shipped to the U.S.


Oh, what a sweet roll railroads have been on since Warren Buffett jumped aboard Burlington Northern Santa Fe in 2009. Kansas City Southern (ticker: KSU), the group’s best performer, is up 344% since the Oracle took to the rails. KCS remains the smallest of the seven major railroads, at $12 billion in stock-market value and with 6,300 miles of track. But location is everything. Unlike its big rivals, KCS reaches deep into Mexico, where manufacturing has surged, particularly for automobiles.

At the same time, KCS has become a more efficient operator. Its trains are moving faster and spending less time stuck at terminals. Since 2007, annual earnings have soared 145%, to $377 million, or $3.34 a share. Industry profits are up just 30% over the same period. This year, earnings per share could jump 23%, to $4.10, and continue to climb at a spiffy double-digit clip over the next several years.The stock, recently at $107, is on track to reach $130 in a year, fueled by better-than-expected profits, according to some bulls. KCS is a good long-term play on Mexico, but investors also are underestimating the upside from crude-oil transport, which is becoming a major source of revenue and earnings for the railroads.

“Investors are looking for a long-term growth story, and Kansas City Southern provides that for them,” says CEO David L. Starling, explaining the run-up in KCS stock.

KCS’s rail network stretches from Kansas City south to New Orleans, Texas, and the Mexican ports of Veracruz and Lazaro Cardenas. Some 46% of the line’s revenue comes from our trading partner to the south. Mexican railcar traffic is up 9.2% in 2013, versus a 1.6% decline in the U.S., according to the Association of American Railroads. Kansas City Southern has also benefited from the ongoing shift to intermodal transport, in which ships, trains, and trucks are used to move goods or commodities, often in containers that can be carried by any of them.

Admittedly, investors are paying up for KCS’s above-average growth and Mexican connection. The company trades for more than 21 times 2014 EPS estimates, a nifty premium to the 15 times average for the group, including industry giant Union Pacific(UNP). But there is vague speculation that bigger rivals such as BNSF, Union Pacific, orCanadian Pacific Railway (CP) would love to get their hands on Kansas City Southern’s unique rail networks. Officials of those companies weren’t available to comment, but Starling, in an interview with Barron’s,suggests his company has no need to be acquired. “We can continue to create shareholder value by running the franchise as we are today,” the CEO says, adding that the railroad hasn’t been contacted by any potential buyer.

THE COMPANY’S COMPELLING long-term growth drivers, such as the cross-border intermodal business, could justify an even higher multiple than Kansas City Southern shares now boast, suggests Andrew Davis of T. Rowe Price, which jumped aboard the KCS express two years ago and is now the biggest institutional holder, with more than 10 million shares, or 9% of the outstanding stock. “Kansas City is a high-quality company, but [a takeover] is not a legitimate aspect of our thesis,” says Davis. “You are paying for a company that can grow earnings in excess of 15% annually for a long time, given manufacturing moving into south Texas and Mexico.”

Auto makers and their suppliers are moving production to Mexico and using rail to move vehicles and parts north. In addition, rising growth in trade with Mexico is likely to drive Kansas City Southern’s cross-border intermodal business, especially as other manufacturers, including appliance makers, move south to take advantage of lower labor costs.

And then there’s the rapid emergence of the rails as a key means of transporting crude oil, to supplement the flow through pipelines, which increasingly face political opposition as they try to expand. The Association of American Railroads reports that the number of crude-filled cars soared to 97,000 in the first quarter, 166% above the year-earlier total. KCS has indicated that it plans to announce an agreement in a “few weeks” with a yet-to-be-named partner to develop an unloading and storage facility in Port Arthur, Texas, which is close to refineries and which could become a key terminal for northern crude. Credit Suisse analyst Allison Landry says crude revenue could reasonably help drive earnings to $7.20 a share by 2015. That’s 21% above the current consensus estimate.

Meanwhile, Starling & Co. are increasingly running their trains more efficiently, with less downtime and lower overhead.

A top-performing railroad’s operating ratio—a key performance metric that divides expenses into revenue—should have a percentage in the low 60s. Kansas City Southern had its best year ever in 2012, with a 68% reading. Bulls such as Euan Sanderson, senior vice president of Standard Life Investments, think the railroad can lower the percentage to the mid-60s over the next three years, closer to the industry’s gold standard, Canadian National Railway’s 63%.

Improving margins should help push the shares to $130 in a year—21% above the recent quote—argues Jason Benowitz, portfolio manager with Roosevelt Investment Group in New York. “We expect earnings to more than double over the next three years, as the company leverages its network and uses its excess cash flow to retire debt,” says Benowitz. “At current levels, KCS shares are either not giving [the company] credit for the growth drivers, or else assuming a stalled U.S. economy.”

The Bottom Line

Although Kansas City Southern stock has soared over the past three years, revenue and profit have jumped, too. Bulls see the stock rising at least another 20% in the next 12 months.

Benowitz doesn’t see the economy stalling, and Kansas City Southern, with its pricing power and opportunities for growth in areas such as vehicle transportation, should continue to boost volume and revenue faster than U.S. gross domestic product expands.

Kansas City Southern hauls a diverse mix of freight. Last year, industrial and consumer goods generated the most revenue, 25%, followed by agriculture and minerals at 18%, and chemical and petroleum, also at 18%. Among the fastest-growing segments, intermodal, at 14% of revenue, climbed 17% in the recently reported first quarter, while automotive, at 8% of 2012 revenue, jumped 31%. Oil transport accounted for close to 1% of revenue last year.

Like other railroads, Kansas City Southern is suffering weakness in the coal and grain businesses. Coal volume has been weak as utilities turn to cheaper, cleaner natural gas, and grain suffered from last year’s drought in the Midwest. But an expected better 2013 harvest should help the company achieve “mid single digit” volume growth in grains.

This year, overall revenue is likely to climb nearly 7%, to $2.38 billion, while total carload volume (how much freight the railroad hauls) should rise 3.8%, says BMO Capital Markets.

In Mexico, four new plants from the likes of Nissan, Honda, and Mazda are expected to boost auto production 35% in the next three to five years. Credit Suisse notes that Kansas City Southern will get about half of the cars rolling off the new production lines. As those cars roll north, so should KCS shares.

Worth the Price

Although Kansas City Southern trades at a higher valuation than its peers, its strong prospects and Mexican connection appear to justify the premium.

Company/Ticker Recent 
Value (bil)
EPS Growth
Canadian National/CNI $97.33 16.6% $41 14.7 13%
Canadian Pacific/CP 120.74 70.3 21 16.2 24
CSX/CSX 23.46 7.4 24 11.6 13
Kansas City So/KSU 107.68 61.6 12 21.3 23
Norfolk Southern/NSC 73.49 5.3 23 11.5 14
Union Pacific/UNP 155.34 35.3 72 14.3 14
Source: Thomson Reuters

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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