Kansas City Southern: A Railroad in Decline?

Like a number of railroads; the Kansas City Southern (NYSE: KSU) is having a real struggle with falling revenue right now. Recent revenue drops at the railway even have investors wondering if this company is still a value investment.

Until December 2014, Kansas City Southern’s revenues had displayed impressive growth; rising from $2.368 billion in December 2013 to $2.577 billion in December 2014. This trend began to reverse itself in March 2015 when revenues fell to $2.573 billion and they kept falling throughout 2015, eventually landing at $2.378 billion in March 2015. Over the past year, Kansas City Southern saw its revenues fall by $195 million or by almost 10%.

Despite that the railroad paid off quite well for investors, delivering a dividend yield of 1.49% and a return on equity of 12.63% on March 31, 2016. Its performance was also fairly good; with a diluted earnings per share figure of 4.481, a net income of $490.5 million and a profit margin of 19.16%.

Those figures alone have a lot of value investors looking at the Kansas City Southern. Another attraction is its position as the only major US railroad with a lot of track in Mexico. This includes a direct rail connection between America’s industrial heartland and a Pacific Coast port Lazaro Cardenas.

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The thinking here is that the major US Pacific Coast ports; Los Angeles, Long Beach, San Pedro and Oakland, are congested and plagued by labor troubles. Although Lazaro Cardenas has problems of its own; in November 2013, drug violence got so bad the Mexican Army had to occupy the city to restore order.

Does Kansas City Southern Make Money?

Not surprisingly news like that will scare a lot of value investors away. Others will be worried about the US political situation; particularly the success of anti-trade candidates; like US Senator Bernie Sanders (D-Vermont) and Donald Trump, in the presidential elections.

Many of these people will be asking: does Kansas City Southern make enough money to justify the risks the railroad is taking. After all; the drug violence is far from over in Mexico, and there’s an outside possibility that a candidate hostile to free trade could land in the White House.

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The situation is made worse by the decline in commodities prices and the collapse of the coal industry. Around 40% of the coal-fired power plants in the United States shut down as of July 2015. More closures are expected because of stringent environmental regulations.

With this backdrop we need to ask the all-important question: how much money is Kansas City Southern making? The answer is not enough to be considered a classic value investment.

Limited Cash

On March 31, 2016, the Kansas City Southern or KSC reported a free cash flow of just $33.6 million and a net income of $490.5 million. It also reported making $907 million in cash from operations. That number was a slight drop from March 2015, when the railroad reported making $925.2 million in cash from operations.

Even more worrying was cash and short-term investments which fell dramatically in 2015. Kansas City Southern had just $39.2 million in the bank on March 31, 2016; that number was down slightly from $38.4 million in March 2015; but dramatically lower than March 2014 when the bank account contained $167.5 million.

Kansas City Southern has very little float, which is dangerous for a company in such a capital intensive infrastructure sector. The numbers indicate that it might not have the financial resources to operate its system.

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This would indicate a railroad that might have to join with a larger organization; such as Berkshire Hathaway (NYSE: BRK.B) or Union Pacific (NYSE: UNP), just to survive. A merger with UP or Berkshire’s Burlington Northern-Santa Fe might be in the cards because of the limited cash flow here.

All this makes Kansas City Southern a poor investment right now because it is overpriced. There is simply no way that this railroad is worth the $88.77 a share it was trading at on May 16, 2016. To make matters worse, neither the $9.5858 billion market cap nor the $12.15 billion enterprise value, reported on that day seem very realistic.

My prediction is that this railroad is heading for a major drop in share value in the near future. Investors should stay away for now because the Kansas City Southern could be trading at a much lower price soon.

The situation at Kansas City Southern should make investors reconsider the notion that railroads are a value investment. Changing economic conditions are calling that value theory into question. Political conditions and the potential of major technological disruption; in the form of innovations like Hyperloop, make railroads a far riskier investment than they once were.