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Could a Teacher's Strike in Mexico Derail This Railroad's Quarter?

Lou Whiteman, The Motley Fool

In recent years Kansas City Southern (NYSE: KSU) has battled obstacles ranging from trade wars to network congestion, factors that have made the company the worst-performing North American railroad stock over the last five years. Its current quarter risks being spoiled by a teacher's strike.

Speaking at a Feb. 20 investor conference, Kansas City Southern CEO Patrick Ottensmeyer warned that a nearly month-long strike in the state of Michoacán, Mexico, would be a $0.05 drag on first-quarter earnings per share. During the strike, union members blocked railroad tracks, temporarily limiting railroad access to Toluca outside of Mexico City and the key Pacific Ocean port of Lázaro Cárdenas.

Two Kansas City Southern locomotives pass each other.

Image source: Kansas City Southern.

The tracks were cleared by Feb. 11, the day the strike was resolved, and operations have returned to normal.

The financial damage to KSU was limited because nearly half of the lost volume was intermodal, which tends to be lower revenue and lower margin than other shipments, though the company did fall behind on shipments of higher-margin heavy fuel oil from inland Mexican refineries.

The lost volume also helped reduce congestion elsewhere on Kansas City Southern's network, temporarily relieving a long-running problem for the railroad.

Mexico, for better and worse

Kansas City Southern is the smallest of the major North American railroads, and unique because of its streamlined footprint, running from the U.S. Midwest down the spine of Mexico to the Pacific Coast.

The company was a huge beneficiary of the 1990s-era North American Free Trade Agreement, moving goods and cargo between the two countries and establishing Lázaro Cárdenas, with its easy access to the U.S. heartland, as an alternative to crowded U.S. Pacific Coast ports. In recent years upward of one-third of the railroad's total traffic involved cross-border trade.

KSU network map

Kansas City Southern's network map. Image source: Kansas City Southern.

But Kansas City Southern's association with Mexico has grown more complicated in recent years. The Trump Administration has targeted autos and other imports from Mexico as part of the White House's push to return jobs to the U.S. Despite the rhetoric, cross-border volumes have held up well, but the uncertainty has put pressure on KSU shares.

Ottensmeyer in his remarks highlighted the importance of Mexico to Kansas City Southern's fortunes, noting the company recently held a board meeting in Mexico City so directors could learn more about the policy priorities of new Mexican president Andres Manuel Lopez Obrador. The CEO also said he plans to spend a considerable time in Washington in the coming months, lobbying Congress to approve the NAFTA replacement negotiated by the U.S., Mexico, and Canada last year.

He also said he could not completely rule out another work action disrupting operations south of the border. "We feel pretty good that for the foreseeable future all of the major issues have been resolved," Ottensmeyer said. "But it's really difficult to say with complete confidence it isn't going to happen again."

Full year still on track

Despite the strike, Kansas City Southern is not reducing its 2019 guidance, which includes projections that volume will recover to grow 3% to 4% for the year and revenue will be up 5% to 7%.

The railroad is in the early stages of adopting precision scheduled railroading, an operating philosophy designed to make railroads more efficient that was pioneered in Canada and is now making its way to U.S. companies, and has already stored 50 locomotives and nearly 2,000 freight cars without decreasing volume.

"You can do more with less if you are running a smoother, more fluid network," Ottensmeyer said.

Initially Kansas City Southern's PSR efforts will focus on relieving network congestion. The railroad believes that by redesigning its intermodal product between Kansas City and St. Louis it can eliminate eight crew starts per week over the corridor while still serving customers. Similarly, it hopes to cut as many as 28 trains per week over a delay-prone section of track north of Mexico City by rationalizing the network.

The company hopes to drop its operating ratio, a measure of operating expenses divided by operating revenue, from 64.3% for 2018 to between 60% and 61% by 2021.

Don't rush in

Trading at 10.6 times earnings and 2.3 times book value, Kansas City Southern is the least expensive North American major railroad stock. The two biggest factors holding the company back have been Mexico-related worries and the railroad's higher-than-average costs.

KSU Total Return Price Chart

North American Railroad Total Return Price data by YCharts

The PSR initiative, if successful, should help on the cost front. Mexico remains much more of a wild card. Given the company's discounted valuation and the strength of its cross-border assets, this is a stock worth watching, but I'd like to see a few quarters of 2019 results before I'd consider buying to see how the transformation is progressing and allow time for lawmakers to ratify the new trade deal.

Kansas City Southern is moving in the right direction, but there's no reason to hop aboard just yet.

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Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.