After a roller-coaster year in 2020, Kansas City Southern (KSU, Financial) is forecasting banner years in 2021 and 2022. It listed the following guidance in its fourth-quarter and full-year earnings release on Jan. 22:
- Revenue: Double-digit growth this year.
- Operating ratio: 57.5% in 2021, down from 62.6% in 2020, and between 56% and 57% in 2022 (the lower the ratio, the better).
- Earnings per share: $9.00 or more in 2021, up from $6.96 in 2020 (an increase of nearly 30%), and another increase to $10.50 or more in 2022.
What is Kansas City Southern?
Based in Kansas City, Missori, Kansas City Southern is a transportation holding company with railroad investments in the U.S., Mexico and Panama. It is the smallest of the U.S. Class 1 railways (the seven railroads with the greatest revenue in the country).
Its American operations serve the central and south-central areas of the country. In addition, it has strategic alliances with other North American rail partners.
Mexican operations serve northeastern and central Mexico, and it holds a 50% stake in the Panama Canal Railway Company. The latter provides ocean-to-ocean freight and passenger service along the Panama Canal.
The operating ratio is a key metric for railways. In the recent past, a ratio of 80% or less was considered very good. As we saw above, Kansas City Southern plans to drive it down to the mid-50s this year and next. The ratio shows operating expenses as a percentage of revenue, and is used to compare the efficiency of railroads. This is how it compares with the three biggest Class 1 railroads:
- BNSF (owned by Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway ((BRK.A, Financial)(BRK.B, Financial): In its third-quarter earnings release, it reported a record low ratio of 59.7%.
- Union Pacific (UNP, Financial): It, too, reported a record low of 58.7% in the third quarter.
- CSX (CSX, Financial): Reported a ratio of 56.9% for the third quarter.
Behind much of the improvement in operating ratios is the adoption of Precision Railroading, or Precision Scheduled Railroading (PSR), among the Class 1 lines. Pioneered by E. Hunter Harrison at Illinois Central, the idea revolutionized the ways in which trains are put together and scheduled.
Kansas City Southern's president and CEO, Patrick J. Ottensmeyer, said in the earnings release:
"As we turn our focus to 2021, our primary objective will be the implementation of PSR Phase 3, which combines improved operational performance with an intense focus on customer service and revenue growth, Phase 3 of PSR will help us capitalize on the unique growth opportunities available across our franchise."
Competition
The Kansas City Southern railroads in all three countries face competition from other railways and the trucking industry. In the U.S., competition from BSNF and Union Pacific are significant, because they have both competing routes and substantially more resources.
In Mexico, its lines face competition from two railroads controlled by Grupo Mexico S.A.B. de C.V. Ferromex.
To some extent, competition from truckers has been blunted by the development of intermodal operations.
Fundamentals
Behind the company's middling rating for financial strength is the issue of high debt. Yet, we need some context here. The amount of capital expenditure railways need to make is high. Locomotives and rail cars are expensive to buy and must be maintained, and there are significant costs to maintaining tracks and line infrastructure.
With an interest coverage ratio of 7.19, Kansas City Southern is in relatively good shape compared to its peers. The Piotroski F-Score and Altman Z-Score are adequate for a financially stable company. Additionally, the return on invested capital (ROIC) is greater than the weighted average cost of capital (WACC).
While Kansas City Southern posts robust margins, investors should keep an eye on them. In theory, they should improve with the application of Precision Railroading, but they still deserve scrutiny:
Turning to the growth lines at the bottom of the table, we see reasonable revenue and Ebitda rates, while earnings per share are not keeping up. When earnings are growing more slowly than revenue and Ebitda, there will be questions about efficiency and/or accounting procedures.
Dividend and share buybacks
The dividend yield is small, less than half of the S&P 500 average, and it is not likely to grow much given the annual increase is just under 4%. The five-year yield-on-cost comes in below 1%.
Investors have seen some additional value per share, thanks to share buybacks or repurchases over the past few years:
Valuation
Kansas City Southern is currently on the Undervalued Predictable screener list at GuruFocus. That means its share price is estimated to be lower than its intrinsic value based on the screener's criteria, and that it has consistently grown its revenue and Ebitda per share.
The business predictability rating is 4 out of 5 stars, which not only reflects well on its past performance, but also suggests that over the next 10 years it should outperform stocks with lower ratings and investors will be less likely to lose money on it.
However, the metrics to support undervaluation are mixed. The GuruFocus Value Chart shows it being anything but undervalued:
The price-earnings ratio also indicates overvaluation. At 35.96, it is expensive compared to the transportation industry's 10-year median of 19.13 and its own 10-year historical median of 22.88.
The PEG ratio, which incorporates Ebitda growth over the past five years, is also high at 4.62.
The basis for the undervaluation in the Undervalued Predictable screener is the discounted cash flow (DCF) calculation. Using the below settings, including a growth rate of 20% (reflecting the average 10-year earnings growth rate of 20.4%), leads to a negative or overvalued result, but by increasing the growth-stage growth rate to 24%, we get a small margin of safety:
Is a 24% growth rate justified? It seems a stretch in my opinion, but that or a higher rate has gone into the DCF calculator to put Kansas City Southern onto the Undervalued Predictable list.
Overall, I think it seems hard to justify the undervalued rating when the price-earnings ratio, the PEG ratio and the GuruFocus Value chart point the other way. One final argument supporting the overvaluation assessment comes from the 10-year price chart:
As the chart indicates, there has been no pullback of any significance recently, so there is no reason to think it is undervalued. Keep in mind that the transportation industry, including railways, is cyclical, and far-sighted investors buy during the dips.
Total annual returns
This GuruFocus table shows Kansas City Southern's total returns over the past 10 years:
The two comparison stocks are Westinghouse Air Brake Technologies Corporation (WAB, Financial), which makes locomotive parts, and Trinity Industries Inc (TRN, Financial), which is mainly in the railcar leasing and management business.
Gurus
In the second and third quarters of 2020, gurus bought more shares than they sold of the stock:
Of the nine gurus who held positions in Kansas City Southern at the end of the third quarter, these are the three with the biggest stakes:
- Pioneer Investments (Trades, Portfolio) owned 689,013 shares, good for a 0.74% stake in the company and representing 0.13% of its total assets.
- Ken Fisher (Trades, Portfolio) of Fisher Asset Management owned 430,123 shares on Sept. 30, after reducing his count by 14.88%.
- Steven Cohen (Trades, Portfolio) of Point72 Asset Management bought 378,084 shares in the quarter, establishing a new holding.
Conclusion
This cyclical stock is enjoying the returns of a recovering economy. Even if the economy falters, we might expect some improvement in the key metrics because of progress on its Precision Scheduled Railroading. At the same time, Kansas City Southern also generates revenue and earnings from its operations in Mexico and Panama.
Even though it makes the Undervalued Predictable list, all the other metrics suggest the company is overvalued. Growth investors may wish to take a closer look at Kansas City Southern, given its predictable top and bottom-line growth. Value investors will need to look hard to find a value proposition, and then there is the matter of debt. Income investors will find nothing attractive here.
Disclosure: I do not own shares in any of the companies named in this article and do expect to buy any in the next 72 hours.
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