Kansas City Southern Kept Neutral


We remain encouraged by Kansas City Southern’s (KSU) favorable revenue trend on the back of continued momentum in pricing and shipments, particularly in Intermodal, Energy and Automotives.

New business opportunities in Mexico and other emerging international markets will also bode well for future growth. Moreover, the improvement in the company’s cost structure and estimated reduction in debt expenses look promising and suggest earnings going forward.

However, stiff competition, increased railroad regulation, highly unionized labor and uncertain market conditions for some products may limit the upside potential of the company.Consequently, we maintain our long-term Neutral recommendation on the stock. 

Kansas City Southern is one of the oldest freight rail transportation companies. It functions in a seller’s market, enjoying pricing power since 1980 when the U.S. government adopted the Staggers Rail Act.  The company has thereby been able to increase prices on average by nearly 4–5% per annum, subsequently maintaining a substantial profit margin.

Additionally, improving cross-border traffic between the U.S. and Mexico and emerging business opportunities in the Mexican market supported by its cheap labor costs, favorable currency environment and lower transportation cost to the U.S. markets are expected to bode well for the company’s top- and bottom-line growth.

The company remains optimistic about most of its product segments. In terms of the Coal business, which is now grouped under the Energy segment, the management expects double-digit growth this year. This is based on new business opportunities which are in the pipeline.

Coal exports will benefit from growing demand for coal shipments to the Asian market through the new facilities at Lazaro Cárdenas. Auto production is expected to rise in Mexico, with upcoming plants by Honda, Mazda, Nissan and Audi. Further, the company’s expanding business in crude oil and fracturing sand shipments will also aid long-term growth opportunities.

Given a capital-intensive operating environment, investments play a vital role in expanding network and terminal capacity, and enhancing safety, service and reliability for railroads customers. The company expects capital expenditure of approximately 18% of total revenues in this year.

Additionally, in February this year, the company got a loan worth $54.6 million from the U.S. Department of Transportation to buy 30 new locomotives. Kansas City Southern expects delivery by the end of this year and 20 each year through 2015.

However, Kansas City Southern faces intense competition from various transportation providers, including railroads like Union Pacific Railroad (UNP), and motor carriers, barges and ships that operate along similar routes across its service area.

Transportation providers such as motor carriers and barges utilize public rights-of-way that are built and maintained by governmental entities, while Kansas City Southern and other railroads must build and maintain rail networks using largely internal resources.

The current state of a volatile U.S. and world economy may keep Kansas City Southern’s top-line growth under pressure in the near future. Moreover, near-term growth for the company is expected to be tempered by lower coal production forecasts by the U.S. Energy Information Administration.

Lower natural gas prices and a weak utility coal market have raised significant concerns, limiting overall coal shipments despite strong exports to Asian countries.

Additionally, the company foresees declines in its grain shipments, given higher U.S. grain prices. Going forward, exchange rate fluctuation also remains crucial for the company‘s earnings, as a substantial part of the business arises from cross-border markets.

For the short-term, Kansas City Southern holds a Zacks #3 Rank (Hold).

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