Railroad companies were once part of a prominent growth industry in the United States. However, today there remains just a handful of railroad stocks for investors to choose between if they are interested in investing in the space. Decades of advancements in other forms of transportation – air and trucking – has greatly diminished the role of railroad companies in the economy and for investors. However, the group has been taking advantage in recent years of strong, sustained economic growth in the US and as a result, revenue and earnings growth has been robust, and dividend payments have been raised. For some investors, then, railroads can offer potential growth and yields that are attractive against the broader market.
Why Kansas City Southern Offers Investors Strong Fugrndamentals
One such stock that offers investors a bright outlook is Kansas City Southern (KSU). The company was founded in 1887 in Kansas City as a small beltway rail operation. Through organic growth and acquisitions that have occurred along the way, the past ~130 years have seen Kansas City Southern grown into a regional player with strong access to rail lines, transfer facilities and ports from Chicago to Mexico City. The company also enjoys a broad and deep customer base, helping it to diversify its exposure to various sectors of the economy. Kansas City Southern serves customers in the energy, industrial, automotive, and agriculture sectors, among others, providing diversification of revenue streams.
Business Overview and Growth Prospects
Kansas City Southern’s business has taken shape in recent years to not only foster growth, but to shift revenue mix in order to smooth out the company’s growth. In addition, continued economic expansion in the United States has afforded Kansas City Southern meaningful development. We see that progress continuing for the foreseeable future as analysts predict 10%+ earnings growth moving forward.
The company should benefit from underlying demand for rail services from economic growth in addition to more company-specific factors. Trucking capacity in the United States has been tight for some time as demand continues to exceed supply. This has led not only to short capacity, but higher prices for truck freight as well. This bodes well for Kansans City Southern as its services become relatively more attractive against its primary competitor.
In addition, it continues to add new customers and as an example, is boosting its customer base of automotive factories by four by the end of next year. The company’s strong operating history and its relative attractiveness against truck freight has set it up well for the coming years. Kansas City Southern is seeing strong volumes from its Chemicals business as well as it chases growth areas to fuel the next leg of expansion. In total, the growth outlook is quite favorable.
The company’s most recent earnings report was released on 7/20/18 and results were good. Revenue rose 4% on a 1% gain in volume with the balance coming from better pricing. Kansas City Southern continues to take advantage of the factors discussed above to grow the top line at a respectable pace. Unfortunately, the company’s operating ratio – a metric that defines how much of its revenue was consumed by operating expenses – rose 50bps to 64% in Q2, driven by higher fuel costs. That crimped operating margins but even so, a lower tax rate helped propel earnings-per-share 16% higher on an adjusted basis against the comparable quarter last year. Guidance for volume was revised down slightly for the rest of the year, but overall, the picture is still bullish.
This slide from the company’s Q2 investor presentation shows where Kansas City Southern is gaining and losing ground from a volume and pricing perspective. We can see low single digit growth for the industrial & consumer, agriculture/minerals and intermodal businesses. However, chemicals and automotive have seen double-digit surges in revenue year-over-year while energy offsets some of that growth. Kansas City Southern’s revenue diversification is a sizable asset given that there is so much weakness in the energy space, but that it can more than make up for it with growth in other areas. Fuel prices will continue to be a problem in the near term, so we expect some temporary headwinds to margins, but overall, Kansas City Southern’s outlook is robust as it continues to present an attractive alternative to trucking.
In addition, to its fundamentals, Kansas City Southern operates in a virtual monopoly. The railroad operators left in the United States have very little overlap in their routes and that is true of Kansas City Southern. With critical manufacturing, industrial and energy routes in the company’s North-South corridor, it stands poised to reap the benefits for many years to come.
We see the stock as reasonably priced at 18 times this year’s earnings, but wouldn’t classify Kansas City Southern as a value stock. As a result, most of the company’s expected shareholder returns will come from earnings growth and the relatively modest dividend, which currently pays 1.3%. The company has been increasing its dividend at meaningful rates and it may be an income stock in the future. Today, however, Kansas City Southern’s appeal is in its strong market position and robust growth prospects.
Kansas City Southern has underperformed the S&P 500 lately given strong price growth in the broader market amid generally rising valuations. The railroads have not enjoyed that same valuation expansion, but we do see strong growth prospects for Kansas City Southern. Therefore, we rate the stock a buy given projected double-digit earnings growth, a reasonable valuation and strong competitive position. Apart from weakness in the energy complex, Kansas City Southern’s diversified customer base is seeing continued volume growth, while rising truck freight costs support better pricing and margins for the railroads. Kansas City Southern’s low double-digit expected return makes the stock attractive for investors interested in the railroad sector.