Should You Buy Kansas City Southern?

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The rail transport industry has been one of the better investments during the 21st century. These stocks collectively have gained several hundred percentage points. There are a couple of reasons for this:

  • These companies function as a de facto oligopoly. There are only a handful of these companies, and there is a very high barrier to entry given the capital and time required to construct thousands of miles of track.
  • Over the past several years, labor costs have increased. Not only have wages gone up, but the cost of hiring somebody has increased due to a more complicated regulatory environment. Rail transport requires fewer employees than truck transport, and so this added burden inherently hits the rail transport oligopoly’s primary competitor.
  • Not only have labor costs increased, but fuel costs have increased. Rail transport is more energy efficient than truck transport, and so this has given rail transport companies an additional advantage.
  • Rail transport companies are transporting things that they haven’t in the past, such as oil. They are also developing what is called “intermodal” transport, which is basically railroads transporting cargo that is easily moved from a truck to a ship to a train without loading or unloading the cargo.

Investors looking at rail transport companies can choose between a handful that operate across North America. The largest companies are slow and steady growers, and trade at around 15 to 18 times earnings. Investors who are looking for some more growth, but also more risk, might want to consider a smaller player: Kansas City Southern (NYSE:KSU).

While Kansas City Southern is smaller than its peer,s it has been the best performer during the 21st century — it has gained more than 1,400 percent. The company operates primarily in the southern part of the United States, as well as in Mexico. Given the company’s exposure to Mexico it only has one major competitor: Union Pacific (NYSE:UNP). Furthermore, Kansas City Southern has unique exposure to economic growth in Mexico, which has been faster than economic growth in the United States.

Furthermore, Kansas City Southern has been able to benefit from the aforementioned cost benefits, as the company applies to trade between Mexico and the United States. The company’s fastest-growing segment is intermodal transport across borders.  It is benefitting from the fact that Mexico and the United States are regular and friendly trade partners. A lot of America’s oil imports come from Mexico; the same can be said about America’s food imports.

Since labor is cheaper in Mexico than it is in the United States, a lot of companies reason that it is cheaper to produce components of goods in Mexico, ship them to the United States, and assemble them here, than to carry out the entire process in United States. With this being the case, it is interesting to note that a minimum wage hike in the United States would make the decision to do this easier for a lot of American companies, and Kansas City Southern would benefit.

The company has been growing its sales and its profits at a faster rate than many of its peers. Rail transport companies that have seen relatively flat revenue growth and profit growth only on an earnings per share basis due to share buybacks, such as CSX Corp. (NYSE:CSX), trade at 16 times earnings. Union Pacific has higher growth — about 13 percent profit growth — but it trades at 20 times earnings.

Kansas City Southern grew its profits by more than 20 percent from the fourth quarter of 2012 to the fourth quarter of 2013. This sort of growth has been normal for the company in the past few years. Even with net profits down last year due to a non-cash write-down, profits have nearly doubled in three years.

Unfortunately, this growth is slowing. This became very clear when the company released its fourth-quarter earnings and the stock collapsed over a period of a few weeks. It fell from $124 per share at the end of 2013 to below $90 per share in mid-February. The stock has since bounced back and trades at $104 per share now. It seems that a new uptrend is in place.

Excluding the non-cash write-down (which comes to about $1.08 per share, or about 68 cents per share if we assume that the company would have paid taxes on the income it lost), the stock trades at about 27-times earnings. However, it trades at just 22.4 times 2014 earnings estimates.

Thus, investors need to decide whether the company will be able to continue its rapid growth. If so, the stock is a buy. Otherwise, there are lower-risk stocks in the space — risk-averse investors should stick to these.

Disclosure: Ben Kramer-Miller is long CSX Corp.

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