Can Railroads Make Money at Kansas City Southern?

The financial numbers at Kansas City Southern (NSE: KSU) cast serious doubts upon the future of America’s railroads.

The railroad’s revenues shrank from $660.48 million in 4th Quarter 2017 to $638.60 million in 1st Quarter 2018. Revenues were not the only number that shrank at the Kansas City Southern these figures indicate:

  • A gross profit that fell from $430.80 million to $414.40 million.

 

  • An operating income that fell from $237.80 million to $218.70 million.

 

  • A net income that fell from $551.70 million to $144.50 million.

  • An operating cash flow that fell from $294.70 million to $140.60 million.

 

  • A free cash flow that fell from $158.40 million to $20.80 million.

 

  • Cash and short-term investments that dropped from $134.10 million to $47 million.

 

These numbers from Stockrow indicate that 2018 is not shaping up to a very good year for the Kansas City Southern (KSC). The railroad is making less money from its 6,400 miles of track which connect the American Midwest with Mexico’s heartland.

Reasons for the drop in earnings are unclear, but a few potential causes appear to be more likely.

The most probable cause is the rising costs of operations, driven by higher labor and fuel expenses. Another variable that can have a huge effect on railroads is the falling demands for fossil fuels such as coal and oil. Coal, which has to be moved by train, is being replaced by natural gas which has to be moved through pipelines in North America’s power plants.

Lower oil prices have an effect too because they make trucks, which are more flexible than rail, more competitive with trains. Operating costs make electric-powered trucks like the Tesla Semi a huge threat to railroads because electricity is cheaper than diesel fuel, and more readily available.

Something to remember is that trucks do not have to be cheaper than trains to operate to be competitive. Since the truck can drive right to a customer, simply cutting its cost of operations by 25% or 30% can take a lot of rail’s market share.

How the Auto Industry Threatens Kansas Southern City Southern

A looming menace at Kansas City Southern is declining auto sales because Mexico and the U.S. Midwest are major producers of both vehicles and car parts. Hauling of vehicles from factories to ports and dealers is one of the railroads’ major profit centers.

U.S. vehicle sales are up slightly from last year, they rose to $17.53 million in April 2018, up from 17.38 million in April 2017, Ycharts data indicates. American vehicle sales are still down dramatically from an all-time of $18.93 million in September 2017.

Something to watch for will be a spike in American auto sales in September 2018. There is also a strong possibility of a huge glut of unsold vehicles on the market in late 2018 if carmakers ramp up production in anticipation of a repeat of last years’ sales bonanza.

Trump is no Threat to Kansas City Southern’s Future

Trade troubles between the US and Mexico are an existential threat. Any fall in trade is a potential threat because the KSC’s main role is hauling freight between the two nations.

Despite President Donald J. Trump’s (R-New York) bombast, there is no popular appetite for a trade war with Mexico. Any attempt by Trump to impose tariffs or NAFTA can be easily overridden by the U.S. Congress.

Such an override would more likely if Democrats win control of one or more houses of Congress next year.  Blocking Trump trade actions would be a quick way for Democrats to score points with left-wing voters who hate Trump and business interests that want free trade at all costs. A more likely scenario is that Trump will redirect his vitriol at less politically risky targets such as Iran, Muslims, and Honduran immigrants.

Nor is anti-trade populism a long-term threat to the Kansas City Southern. The Baby Boomer voters (roughly persons between 53 and 73 years of age) who strongly care about trade and back Trump are starting to die off. Pew Research and the US Census Bureau are forecast that the number of Boomers will fall by one million from 73 to 72 million in 2019. That means politicians like Trump are likely to pay less attention to trade in the future.

Most Americans support free trade and that number is growing. The Pew Research Center reported that 56% of Americans believe free trade agreements are a “good thing” for the USA. Only 30% of Americans called the free trade a bad thing. In 2016 around 52% of Americans called free trade a “good thing.” The only danger to Kansas City Southern would be a well-financed and well-organized but politically potent minority promoting protectionism that seems unlikely.

What Does Kansas City Southern tell us about Hyperloop?

The Kansas City Southern’s financial numbers cast doubt on the viability of next-generation ground-transportation systems like the Hyperloop.

The low margins at the KSC indicate that a system like Hyperloop would need a lot of taxpayer support-just like highways and mass transit. That is problematic in the United States, where the federal government has historically been reluctant to finance transportation.

Government transportation policy in the United States tends to swing in extremes. For example, we went from massive spending on Interstate Highways and airports in the 1950s, 1960s, and 70s, to benign neglect in recent decades. This a repeat of a historical pattern, the US government went from financing transcontinental railroads in the 1860s and 1870s to demonizing railway executives in the early 1900s.

Hyperloop promoters will either need to find some other revenue stream such as moving packages for Amazon (NASDAQ: AMZN) to finance construction or hire a lot of very good lobbyists. An obvious alternative is public-private partnerships which be a tough sale to corporation hating Democrats on the left and fiscal conservatives on the right.

Despite that Hyperloop presents an opportunity for railroads like Kansas City Southern because their existing track will provide perfect routes for the tubes. A working Hyperloop; which would run on electricity, and have lower labor costs would theoretically be far cheaper to operate than a railroad.

The Hyperloop would be faster (moving at speeds of 300 to 600 miles per hour), and more efficient. Greater volumes of freight could be moved in a lot less time which can generate far more money.

How Would Railroads Pay for the Hyperloop?

A Hyperloop would also give railroads access to new sources of revenue. Those sources include passengers, and vast volumes of goods now moved by air freight.

Another intriguing source of revenue would be moving vehicles for private individuals at speeds that are faster than highways. Instead of driving, a person moving from Los Angeles to New York might load his car on the Hyperloop for the trip. A Chicago family vacationing in Mexico might load their car on the Kansas City Southern Hyperloop for shipment to that country.

Two other revenue streams Hyperloop offers would come from data and electricity. Fiber optic cables for high-speed internet can be built into the Hyperloop tube. The tube might also be built in such a way as to transmit electricity across the country.

The challenge railroads will face is finding the financing for the new Hyperloop infrastructure. That will be daunting but today’s financial markets will surely an answer perhaps in the form of “infrastructure bonds” backed by the US treasury.

Floating such issues will be difficult because of all the hysteria about the national debt in the Republican Party. One reason why former Trump advisor Steve Bannon was hounded out of the White House was his; surprisingly reasonable, suggestion that the federal government issue a large amount of debt to rebuild and modernize America’s crumbling infrastructure.

Despite such challenges and declining revenues, railroads like the Kansas City Southern are in an enviable position. They control the routes next-generation infrastructure will require when that infrastructure gets built railways will make a lot of money from it.

Railways, like the Kansas City Southern, are still a value investment and shall remain so for a long time to come. New technologies like Hyperloop will increase the value of that investment.