Kansas City Southern Is on the Right Track, But Is It a Buy?

Source: Thinkstock

Source: Thinkstock

Kansas City Southern (NYSE:KSU) is one of the smaller rail transport companies in North America, but it is probably the fastest growing. When the company reported its second-quarter earnings, it reaffirmed this growth. The company increased its revenues by 12 percent, and it increased its operating profits by 13 percent. As a result, the shares rose by nearly 3 percent.

Despite this strong performance and continued growth, shares of Kansas City Southern have largely underperformed the market year-to-date. The stock is down 6 percent for the year versus the S&P 500, which is up 7 percent, and the underperformance appears worse considering the outperformance of rail transport stocks.

The reason for this underperformance was a sharp correction toward the beginning of the year. The company’s fourth-quarter 2013 earnings figures were below analyst estimates, and they showed signs of slowing growth. This sent the shares down from about $125 each to about $90 each. With the shares back at $116/share, it appears as if the stock’s uptrend has resumed. But it it a good time to buy?

Clearly, the opportunity isn’t as compelling as it was back in February when the stock hit its 2014 low. Furthermore, the company’s shares trade at about 28-times trailing earnings and at 24 times this year’s full earnings estimates. This seems somewhat expensive, but we have to keep a few things in mind.

First, the rail transport business is a phenomenal one. These companies generate a lot of cash-flow and return capital to shareholders. They are experiencing a secular bull market as their competition in the trucking and airline segments are suffering from rising fuel prices. Trains are far more fuel-efficient than trains and planes, and as a result, these companies have been able to maintain their strong margins as the oil price has risen. These companies also have limited labor costs considering that a train requires just a single operator yet can carry hundreds of times more freight than a truck.

The industry is further benefiting at the expense of the trucking industry due to the rise of intermodal shipping. Intermodal shipping basically takes truck cargo and puts it on train cars. This benefits the entire transport complex in that these intermodal containers can easily be transferred from train to boat to truck, but the railroad companies benefit the most because they get business that would have otherwise gone to the trucking industry.

Second, Kansas City Southern is unique in the rail transport business in that it has a lot of exposure to Mexico. Mexico has one of the fastest growing economies in the world, and Kansas City Southern’s Mexican and cross-border revenues reflect this strength.

Third, the company has particular strength in a couple of segments — automotive transport and grain transport. The strong economy and relatively loose credit standards have been good for the automotive industry, and this has benefited companies that ship a lot of cars, including Kansas City Southern. The company’s grain shipping segment is benefiting from the strong grain production numbers in the U. S. and in Mexico. These two segments are growing at 25 percent and 33 percent, respectively.

Suddenly, Kansas City Southern shares don’t appear to be so expensive. But there are risks. First, Kansas City Southern may not be expensive, but it is certainly not cheap either. It was cheap back in February, but now I think a fair amount of the aforementioned positives are priced in. Second, rail transport companies are economically sensitive, and economic data in the U.S. has largely been mixed. The economy faces risks on numerous fronts including Fed tapering, poor demographics with an aging population, geopolitical risks, and excessive debt at the governmental and consumer levels.

If these risk factors come into play, then Kansas City Southern is probably the most vulnerable of the major rail transport companies. With this in mind, the stock is meant for more aggressive investors. Furthermore, this is a stock that is best purchased on weakness. Unfortunately, it seems to be too late to do so given that most of the stock’s January and February losses have been erased. Thus, I think the best strategy for now is to remain on the sidelines.

Disclosure: Ben Kramer-Miller has no position in Kansas City Southern.

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