Is the Kansas City Southern a Value Investment?

Many value investors are obviously wondering if it is time to buy Kansas City Southern (NYSE: KSU).

The railway’s share price has dropped dramatically in recent weeks because of lower revenue numbers. Kansas City Southern was trading at $74.67 a share on December 31, 2015. Yet it had been going for $91.63 a share as recently as December 1, 2015.

Value investors are interested in Kansas City Southern because it is still a good company that makes money even though its price is low. Kansas City Southern reported a dividend yield of 1.77%, a return on equity of 12.79% and a profit margin of 20.83% on September 30, 2015.

The railroad’s biggest weakness is its revenue, which has fallen slightly over the past year. In September 2014 Kansas City Southern reported a TTM revenue of $2.55 billion that fell to $2.463 billion in third quarter 2014. Revenues were off because of declining commodities prices and shipments.

Does Kansas City Southern Make Money?

The Kansas City Southern is still making money despite the revenue losses. On September 30, 2015, it reported:

• A net income of $485.2 million.

• A free cash flow of $29.4 million.

 

• Cash and short-term investments of $116.6 million.

 

• $895.4 million in cash from operations.

 

The cash flow and cash in the bank are low because, like all railways, the Kansas City Southern has high operating costs, although the operating costs are offset by the railroad’s assets. The Kansas City Southern reported assets of $8.322 billion on September 30, which actually exceeded its market capitalization of $8.149 billion. The assets also exceeded the railroad’s liabilities of $4.448 billion by a healthy margin.

More importantly, from an investors’ standpoint, the Kansas City Southern is underpriced. Its enterprise value was reported at $10.69 billion on December 31.

The numbers certainly make the Kansas City seem like a value investment, but what are its prospects for the future? To assess those prospects, we will now conduct a brief SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis of the Kansas City Southern.

Kansas City Southern SWOT Analysis

Strengths:

• Only major railroad with a direct connection to a Pacific coast port, Lazaro Cardenas, Mexico, that has significant room for expansion. Other major Pacific ports like Oakland and Los Angeles are facing growing gridlock as freight volumes increase.

• Direct rail connection between Mexico’s industrial heartland and Lazaro Cardenas

 

• Direct rail connection between Lazaro Cardenas and America’s Midwest

 

• Direct rail connection between America’s heartland and Mexico’s growing industry

 

• Connections with other U.S. railroads, such as the Union Pacific, BNSF and Norfolk Southern, that provide connections to U.S. population centers in Southern California, the Midwest and Northeast and Atlantic ports

 

• Direct rail access to Mexican gulf ports, including Tampico and Veracruz

 

• Direct rail connections between Mexican industry and gulf ports

 

Weaknesses

• Dependence upon exports and imports, particularly cyclical automobile exports from Mexico, for revenue

 

• Possible overreliance upon trade with China leaves railroad vulnerable to economic conditions in that country.

 

• Dependence upon commodities, including oil for revenue. Commodity prices have fallen dramatically in recent years.

 

• Aging rail infrastructure requires costly maintenance and could necessitate replacement at some point.

• Use of diesel burning locomotives makes Kansas City Southern vulnerable to rising fuel prices.

 

• Limited rail capacity could limit future expansion of the system.

 

Opportunities

• Congestion and labor strife at U.S. West Coast ports, including Oakland, Los Angeles, San Pedro and Long Beach, could drive shippers to seek alternatives, such as Lazaro Cardenas.

 

• Growth of ecommerce increases the volume of freight shipped and the demand for logistics infrastructure.

• New technologies could lead to increased efficiencies and lower operating costs.

 

• Growing exports to Asia, particularly of food

 

• Growing importation of manufactured goods from China

 

• Growing auto production in Mexico will lead to increased shipments of vehicles and of raw materials. Production of light trucks in Mexico in September 2015 was 4% higher than in the same month in 2014, The Wall Street Journal reported. Auto exports to the U.S. from Mexico increased by 8% in 2015. Mexico now exports more vehicles to the U.S. than Japan does.

 

• Growing congestion on U.S. highways could increase demand for rail transport.

 

• Kansas City Southern’s routes and railyards could be utilized by next generation transportation systems such as Hyperloop.

 

• Lower oil prices mean cheaper diesel fuel and lower operating costs.

 

• Beginning of U.S. oil exports could lead to increased commodities shipments, particularly through Lazaro Cardenas.

 

• Mexico’s growing economy

 

Threats

• Drug violence and crime in Mexico, particularly in the state of Michoacán, where Lazaro Cardenas is located, could interfere with operations. In November 2013 violence got so bad that the Mexican military had to occupy Lazaro Cardenas to restore order and protect the port, CNN reported.

• Drug cartels and other Mexican criminals could target the Southern’s lines and rolling stock for attacks or sabotage.

 

• Sudden increases in fuel prices could lead to increases in operating costs, particularly if oil prices rise.

 

• Environmental regulation in the United States could force the costly electrification of Kansas City Southern’s lines. Among other things, this would require replacement of all of the railroad’s locomotives and the building of powerlines and plants.

 

• Economic downturns in Canada and Latin America could cause auto exports to drop. Exports to those areas fell in the last year by around 1%, according to The Wall Street Journal.

 

• The U.S. or Mexican governments could seize some of the Kansas City Southern’s routes for use as high-speed rail corridors.

 

• Next generation transportation technologies such as Hyperloop or self-driving trucks could provide faster and lower-cost alternatives to rail shipment.

• Limited U.S. rail capacity could lead to gridlock on the rails.

 

• Aging U.S. rail infrastructure could lead to costly accidents and breakdowns and necessitate expensive maintenance or replacements.

 

• The possibility of a long-term economic slowdown in China could lead to greatly reduced freight volumes.

 

• Dramatic changes in the international political situation, such as war or bad relations, could shut down international trade or greatly reduce it.

 

As you can see, the Kansas City Southern is a riskier investment than other U.S. railroads because of its exposure to Mexico. Yet it is still a good value because of its low cost, profits and position as a trade corridor between the United States and our neighbor to the south.