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Kansas City Southern (NYSE:KSU)

Morgan Stanley Industrials & Autos Conference

September 17, 2013 02:30 PM ET

Executives

Bill Galligan - VP, IR

Analysts

Bill Greene - Morgan Stanley

Bill Greene

All right, thank you everyone for joining us. This is the Kansas City Southern fireside chat. This is Bill Galligan who is the Vice President of Investor Relations, and we're going to have a little bit of a chat on what's going on at Kansas City Southern.

My name is Bill Greene. I cover the cover the freight transports for Morgan Stanley, and what we'll do is we'll leave a little bit of time at the end for some Q&A if you have any. I've got plenty of questions, if you're shy, but maybe we can kind of just start a little bit -- if we can start out with a little bit of commentary on just the economy and the current trends. Rails report traffic every week, so we kind of know what's going on there. But maybe you could talk a little bit about some of the reads from an economic perspective.

Bill Galligan

Sure Bill. Thanks, pleasure to be here. Interesting that you should ask that, because I was just kind of looking at our daily numbers this morning in preparation for today, and I kind of looked at it in a different way than I have been. Normally, we all look at quarter over quarter kind of numbers and they are fine, but I wondered, I started at looking at where we were compared sequentially. And there is a danger of doing that because cyclicality and all that, but I was just taking a look and I was astounded Bill, of the how many areas where we're volumes are growing double digits and I think what we kind of are seeing, it's probably too early to make any grand pronouncements, but on or around labor day, end of August, early September, we saw real uptick in various things. So, to the point where our chemical volumes, are trending nicely, scrap, and pulp paper are growing. Metals and one of the reasons I was looking at this is I was looking at some of the numbers where people might say, well it’s less exciting, like quarter-over-quarter our automotive franchises, volume wise kind of flat. But if you look at it sequentially, it's up very solid double digits and so I think there is reason to be cautiously optimistic that we're kind of seeing some growth in the economy.

Bill Greene

Okay, all right, fair. So can we -- maybe let`s talk about some of the key segments there. We'll start maybe with automotive because you’ve often talked about 2013 being a bit of a bridge here to where there will be a lot of new production facilities opening up in Mexico. Maybe you can talk a little bit about how you think about both the kind of near term sort of outlook but also even the longer term outlook. What is bridge here sort of mean and how do we think about kind of what that portends for '14 or beyond.

Bill Galligan

Good question. Yes, right now we at the remainder of this year. We had a very good second half to 2012 and so I would imagine that our growth will be somewhat muted in our carload standpoint in automotive for the rest of the year. Should be positive, but not anywhere near the double digit that we've been used to. Really though the first half of 2014, you'll see three new plans coming online. Nissan, Honda and Mazda and not all the allocations are in yet, but a lot are and we certainly have gotten our fair share of the new business. In addition then, after that you will see Audi come in line probably more in 2015, probably 2016 event. The other big German company plans to have an announcement, maybe later this year or where they are going to build and I don't know if you noticed, but a couple of weeks ago, the head of Toyota in North America said that, it's time they have to build a plant in Mexico. So long term, it looks very good. In the shorter term, 2014, we haven't given our estimates yet but you'll see some growth kind of comparable to what we've had in past few years, but those prices will be ramping up. So, it will be very solid in 2014; probably even better in 2015 as the plants all come in line.

Bill Greene

And there is a spill on effect at intermodal as well I think from some of the auto parts and what not but maybe you can talk a little bit about intermodal in a broader sense. We know you have some access to container ports in Mexico as well. There are some arguments for bridge traffic. On the other hand, 2014 the Panama Canal opens up. So how do you think about kind of weighing the pros and cons intermodal?

Bill Galligan

First of all, our cross border intermodal which is the key area in the intermodal that Kansas City Southern is interested. If you watched us, we've been growing at 75% to 90% volume quarter after quarter. Frankly even though the base is getting larger, those numbers continue to be in effect and there are some indication, we may start seeing a ramp up in some of the business as we add new lanes and as our service gets even better. So the core of our business, that's the longest high intermodal we have right now. It's very, very strong.

Lázaro Cárdenas of course since 2007 has been pretty much the fastest growing container port in North America. Don't think that will be the case in 2013. The numbers, again sequentially I notice that they were up double digits, but year-over-year, they are not. It's been pretty sluggish. Today it’s a combination build, some global trade issues and maybe some concession issues against of KCF. I think [indiscernible] has been very competitive this year. I think that it will pick up again in 2014 which very exciting though is APM ME Risk are really planning to have their concession up and running certainly by 2015. They are very interested not only in trade and moving into Mexico but also using Lázaro as a key jumping point into the United States. This is more than just speculation. This is something that they are really talking about a great deal. So I think over time, Lázaro will get back to the kind of high single or double digit growth in volumes. Maybe not in the fourth quarter but I think it will ramp up again in the next 18 months.

Panama Canal, we are fortunate that our CEO Dave Starling, was the Head of the Panama Canal railroad for nine years. So he knows that very well. The canal has some positive impact on our slow railroad down there, the Panama Canal Railway in so far as it will probably take more cargo off some of the big ships and move it across border. Frankly Lázaro will never be competitive to Baltimore or New York or Charleston. At the same time don't think the Canal is going to be competitive to Houston, to compete against any cross border traffic we do. So long and short of it, we really don't see there will be much of an impact on Kansas City Southern.

Bill Greene

Do you have any early views on the peak, so we talked for long, long time, which always used to be the peak season coming in the fourth quarter or even late third quarter, haven't really had one since '06, do you have any sort of thoughts on that restocking?

Bill Galligan

You know Bill it doesn't seem to be [indiscernible]. We are really not expecting it to -- the volumes are steady but we don't see this kind of surge.

Bill Greene

Okay. Maybe we can turn a little bit some of the bulk. Coal and grain have been tough. Any update there that's worth noting?

Bill Galligan

Let`s see do I start with the good or the bad? Let`s start with the bad for a second, our coal volumes are down a few percent this quarter. I think in some ways, we had a good third quarter last year and I think we ramped up a little bit faster in the second quarter in terms of stock piles than we had anticipated. That's a fact with us.

The bigger issue [indiscernible] put out a press release on Friday. Now [indiscernible] operates two of the nine plants we serve. They serve a plant both near Dallas, one Monticello, one Martin Lake. They have announced that they are shutting down two of the three units at Monticello beginning of October. We suspected that was going to happened or we expected sometime in the fourth quarter there to shut down. I think we probably thought it might have been closer to November or December but we had kind of thought that would happen. Similar to pricing, they also announced that they are closing or shutting down one of the units at Martin Lake in December and they will be closed or they have the right to keep those close until June of next year. They can open them up sooner after they want to. The issue here is and I don't know if any of you will file [indiscernible], they have had some problems because their whole structure is based on natural gas prices never fallen below $7 and so really they need to have natural gas at least at 4 and it drop below that. So in terms of the impact on the company, it's not major because they were closed, a lot of the units were closed last year, so the year-over-year comps won't be that bad, a little disappointing though. So that's kind of negative. Coal really isn't a growth area, at KCS. Fortunately it's not our coal franchise is not like some of the other rails, its less than 10% now in terms of revenues.

The real good news is the grain. The harvest -- we knew two or three weeks ago that no matter what happened at this point, no matter what numbers came out USDA, the crops in our area were there and it's going to be servicing. Because of the wet spring, the crops are going to get about two or three late which means that you're really going to start seeing the numbers jump at the beginning of October. Now already we've lapsed the bad comps. We're actually slightly positive in terms of grain movements in the third quarter. I think if you want to get some reading of where we'll be, you'll have to go back to the fourth quarter of 2011 and the first quarter of 2012 and use those as a kind of a base. If we did nothing more than match our 2011 numbers, it would be an 18% volume gain for us in the fourth quarter. We're hoping maybe for some better than that actually.

Bill Greene

Okay, the last question on volume we have to ask is just crude by rail. So, we got a little excited in the spring, not quite so excited, some investors tell me that we're never going to move crude by rail again. But, maybe you can just touch a little bit on the topic, particularly speak a little bit to the [indiscernible], investments because I don't think folks quite understand how to put that in context.

Bill Galligan

Absolutely, first of all, let`s put the context of what we've said in the past about crude by rail. By nature of where our service territory is, it's really in the Port Arthur area where is the home of the largest really concentration of coca plants in the United States and years ago, the refineries made this bet that the rail will make money in the United States, that they will process to really heavy, heavy crude from Saudi Arabia, Peninsula, Mexico to an extent in the southern tier of the United States. This is the market that we're really trying to penetrate and obviously the heavy crude in North America is coming from Canada and so the spreads by the way between in that quarter, that -- the heavy crude are still in $20. So it's still very much in the money and really we haven't seen a drop off to speak off of our car loads of heavy crude working with the Canadian railroads. Where we've seen a significant drop off in our volumes is in the white crude coming out in the Bakken and the West Texas.

Essentially when you -- I think most railroads, certainly KCS needs about $8 spread for us to be competitive against pipelines, I think we're around 3.5 right now. So we've seen a precipitous drop in that business quite frankly. And I think long term, you probably should expect that our future is heavy and not really the light, that's because when the spreads get larger and we can play in that market, but I don't think we should count on it in our modeling. The Port Arthur Crude Terminal, I would -- if I were outside looking in like you folks, I would be suspicious of this thing as we backed off, has the spreads made us kind of turn us as our partner starting to think that this isn't quite a great opportunity, a fair understandable for a lot of the community to think that. The fact that its moving along just as fast as it was beforehand. It just didn’t make sense, definitely our partners felt this. If you're talking about a multi-multi-multi year lease agreement, to sign an agreement before you get through the due diligence and permitting process. And we understood that. So had nothing to do with spreads, but we decided to hold off with any kind of public announcement. I will say and we're working through the process, some of the things that we did might be difficult in the permitting process, some of its turned out to be a little bit easier than we had imagined back in the second quarter. So there is still hope in the not too distant future, we can announcement something.

Still the same plant to build what would be the largest crude terminating facility in the Gulf up to a capacity of three to five trains a day, that's not saying we'll do that, but to have that kind of capacity in the terminal. But to show that this partnership is still very strong, they are working with us marketing KCS bringing crude into the Port of Belmont which has opened a facility there. Belmont will not be able to handle heavy crude until 2014, but I think you should expect we'll be moving crude trains, heavy crude trains into the Port of Belmont in 2014. We're planning, we're looking very seriously in building a facility on our property in Port Arthur in [indiscernible] where we have a petroleum coke facility that could take a train a day. And so I think Bill you'll be seeing a continued growth in 2014, but let`s say, if we're fortunate enough to be able to kind of get to the permitting process by the end of this year, that the Port Arthur crude terminal is really end of 2015, 2016 e vent in terms of revenue.

Bill Greene

Okay. And the incident in Quebec, does that have any bearing on any of these plants?

Bill Galligan

It doesn’t. Quite frankly it made it easier, neither we nor our partner wanted to put on a press release about a crude terminal in couple weeks after that tragedy. But in terms of the regulatory atmosphere, in terms of business atmosphere, I know it hasn’t…

Bill Greene

If we can touch a little bit on pricing, so we sort of described the volume environment. Historically I think you’ve talked about kind of mid-single digits as a decent growth, at least for '13, ,maybe gets better beyond that depending on the macro. But how do we think about pricing? You’ve got some of your business obviously originating in Mexico which is a little bit of a different environment than it is for the US. So if you can walk folks through how you think about long term pricing.

Bill Galligan

Sure. We haven't given guidance yet. But, from where we're looking here in September, I would be surprised if we kind of backed off our guidance which is kind of in that mid-single digit really lower mid-single digit range given, the inflation has been so low in the United States. Slightly higher in Mexico, so inflation plus in Mexico is a little stronger. Basically, we and other, when you talk about car load business in the bulk business, we're not finding a great deal of push back. I think the rails are being sensible in their pricing and the customers are too. They see that their capacity issues out there and as long as they -- and there is also this reluctant, no matter what commodity you are handling to have inventory. So if rails can produce good service, provide good service, so you don't have to have big inventory, then the customer doesn’t mind paying a fair price. And so we're seeing that certainly in the Baltimore, the carload area. Intermodal of course that can be affected by truck prices, obviously.

We do have a bit of an advantage there and that is that so much of our business is in Mexico. Again, the pricing environmental is a little stronger there. I know our partners always say we have a great feeling of security when they walk through a container to go across border on our intermodal cars because they know they can't be touched, so that kind of security. So I think we are benefited somewhat in our pricing in intermodal for that reason too.

Bill Greene

Just one last question before we open it up to the audience to see if any out there, just some of the rails have put out some longer term margin targets, operating ratio targets. Can you talk about what you’ve said and how you think about the margin development from here?

Bill Galligan

Yes. We have not given any kind of single number of target like some rails do. We just don't care for the optics of doing that. Let`s put it this way. We are very -- as you know, we are positioned our self and have really proven this, we are growth rail roads, so we're going to have continued good volume gains, we've gone over the pricing, that's going to be strong. And one thing, we're pretty committed, we're very committed to keeping operating expense growth below the volume growth. And we feel very comfortable that we can do that over the long term. So if you put that together, and put together, as of the fact we have a good cost environment, expense environment in Mexico which is a fast growing area of us. There is no reason that we shouldn’t be one of the best in terms of margins in the industry over the next few years.

Bill Greene

Okay, are there any questions from the audience, anybody who wants to ask any questions.

Question-and-Answer Session

Unidentified Analyst

In past conference call you folks talked about the cross border opportunity you have 2 million trucks, we believe going country to country. My question is this, are you folks still in the early innings as the growth opportunities still present themselves? How do you feel about the potential?

Bill Galligan

Yes, as a big baseball fan, I say we are still in the batting practice really, pre-game almost, because I think it's really now 3 million truck loads a year ago across Laredo, in service territories that we can connect to. Even with this kind of 75% run rate that we've kind of been enjoying, I think we're a tad under 2%. Now we don't have this written in stone, at our headquarters, but if you take a mature market like LA to Chicago and that BN and UP have been growing for years, you have about 30%-35% penetration for that market and there is nothing structurally keeping us from that kind of number. So, while we don't do our planning based on the 30%-35%, we are doing our capacity planning based on considerable penetration in that market. And what is very interesting about this. We are growing at this rate and we're really not truck competitive at this point because most of our cross border intermodal trains are mix contest between intermodal and automotive. As we get more density and have dedicated streamlined business, even our service will get better which probably is going to even speed up our growth at some of the lanes. So we are very, very bullish on that and it’s very early in the game.

Bill Greene

Maybe we can touch a little bit on balance sheet cash flows. So you’ve talked about this tremendous growth in your early stages. Are we in the early stages of some significant CapEx as well? CapEx has been running higher than most of the other rails, so when is that kind of normalize or how do you think about that?

Bill Galligan

That's a good question Bill, I am not sure, first of all we haven't given guidance, so I shouldn’t talk too much about it and I don't even know the answer at the tip of my tongue. But look at it this way, we have fortunately with the crude by rail, we don't mostly investments in that are as we have to buy locomotives, but when you talk about that we're probably a couple of years from these ethylene and polyethylene plants coming online and some of them have the promise to be extraordinarily large potential for us. When you talk about that some people are thinking that Mexico in the shale and the frac drilling maybe the new Bakken and really, all that development, if it occurs and we think it will occur is in the area we serve and we go through it. That will take a certain amount of investment. If you look at just the intermodal growth, the carload growth, it is for 2013, we've guided the 25% of revenue dedicated for CapEx in the period of 16% to 18%. What I will say this, with the kind of growth horizon we have over the next five or 10 years, I'd imagine the next 3 will be elevated from the norm and the industry will gladly pay it if we have the growth that we expect.

Bill Greene

And then just as a follow on, how do you think about what that means for cash flows dividend, buybacks, how does that all play together?

Bill Galligan

Well obviously our first one was just based on what I said, the first use of cash will be for growth, but hopefully we expect there will be greater cash generation as we go forward. We get some of this new business. Our general plan is not to do a buyback at this point. We're still a growth company. We rather not, get into the buyback, don't have to get into the buyback. We would like to -- it's really a board decision. I think we're inclined to try to keep perhaps giving more back to our shareholders to common stock dividend. We'll always keep the percentage below what the average is for the industry again, growth company. But we want to show people that we, number one appreciate them as investors; number two that we are stable company at this point, not just a growth company, but a stable company.

Bill Greene

Great. Well with that, thank you for your time. Thank you for the insights, appreciate all of you showing up. Thank you.

Bill Galligan

Thank you.

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