Kansas City Southern's Management Presents at Citi US and European Industrials Conference (Transcript)

| About: Kansas City (KSU)

Kansas City Southern (NYSE:KSU)

Citi US and European Industrials Conference

September 18, 2013 9:30 a.m. ET


Michael Upchurch - EVP and CFO

Bill Galligan - VP, IR

Brian Steadman - IR


Chris Wetherbee – Citigroup

Michael Upchurch

Well, good morning everyone. Wanted to introduce real quickly two of my colleagues, Bill Galligan who is our vice president of investor relations and Brian Steadman who’s just recently joined the IR team at Kansas City Southern.

I am going to go through just a few slides and give you a current update on our business and leave the majority of the time for questions from Chris or from the audience. I hate to cover the safe harbor statement but we may be making some comments here that are forward looking and I would encourage everyone to take a look at our website for the detailed statement.

There may be a few investors here that don't know about Kansas City Southern. So I am going to take just a minute and summarize at a high level. Our network operation runs in the Midwest, we do run north-south and down into Mexico. Roughly half of our revenues are generated in Mexico. So we’re unique from that perspective with all the manufacturing renaissance that’s taking place there. We operate about 6300 network miles in the US and in Mexico. That's roughly a 50:50 split, and we do own a very short railroad in Panama, maybe the shortest railroad around at 47 miles but quite a profitable operation for us. Our revenues a year ago were $2.2 billion and as we’ll talk about here in a few slides, we believe we’re one of the best positioned growth stories in the rail sector.

So let me transition just to a quick update on our business, and obviously we report carload volumes each week through the AAR. So there is a fair bit of visibility for investors but I wanted to give you some insight into some of the trends that we are currently seeing. So on this slide, you can see at the top our revenue growth for the first and second quarter and where we are trending through mid-September. So the good news is we are obviously seeing an accelerating revenue trend and I will talk a little bit more about why that may be.

From a volume perspective, while we have 3% on this chart, we’re trending right around at 3.5% quarter to date. So certainly a better performance than where we were in the second quarter. Specifically let me address a few of the commodity segments with respect to our ag business, it's no surprise that we’ve had some pressure there over the last two to three quarters that really relates directly to the drought a year ago in the Midwest and a corn crop that was significantly below historical averages. The good news is at this stage the latest USDA projection calls for 13.8 billion bushel corn crop, which is up from 10.8 billion a year ago and does represent the best corn crop in many, many years. So we do expect our corn volumes – specifically the grain volumes to begin accelerating and in fact, in September we’ve lapsed those negative comparisons that you've seen for the last few quarters where we were down roughly 25%. September we’re actually now showing some year-over-year growth and would expect the fourth quarter to be quite strong.

We also are seeing a continued strength, actually volume improvements in the frac sand business, that’s both used for drawing the oil and natural gas opportunities, and for those of you familiar with our service territories, we’re pretty well-positioned to be able to participate in that market. So we are seeing a nice acceleration in that particular line of business.

Coal volumes have been down slightly 5% to 6% this quarter. We heard the prior speaker talk about really the same issue. It was a relatively mild summer until just recently in the last three or four weeks. We think that’s the primary contributor to volumes being slightly down. We do have some interesting challenges going into the fourth quarter with our coal business and many investors are aware of a particular customer that we serve in the Texas market, they have announced that they want to shut down some of their units, similar to what they have done each of the past two years. But at this stage we believe based on best available information that certainly doesn't have any impact on the guidance that we’ve shared with investors to date.

Our cross-border intermodal volumes continued to be quite strong in the quarter. Overall intermodal volumes are up in the high single digit, led by our effort to convert truck traffic to rail between Mexico and the United States. And so we’re quite pleased with the volumes that we are seeing there.

Automotive volumes started off relatively slow in the quarter. Typically the summer months are months where you will see some shutdowns for maintenance, also retooling for new models. The good news is we, in September, are seeing an acceleration of auto volumes. And certainly there is fundamentally nothing wrong with our auto franchise. We serve nine plants in Mexico. There are an additional four plants that will be coming online. Three of those will be open by the end of the year, early next year. And for those of you tracking auto sales, the month of August, auto sales were at the highest level since December of 2007. So there is nothing fundamentally wrong with our auto business, and we have a quite positive outlook going forward.

And then maybe just a final comment on our volumes in the third quarter, we do see some nice -- typically nice seasonal lift in volumes and we certainly are continuing to see that. So third quarter being a fair bit better than the second quarter results.

Want to transition over to crude volumes and just to remind everyone this is still a relatively small part of our overall business at 1.5% of our revenues but understand that there have been a lot of questions about what’s happening to the crude by rail story. And certainly what we have seen in our business is a very elastic relationship here with spreads. And I did catch the very end of the prior speaker, we have some similar issues there. From a negative perspective, we've seen some impact in not only West Texas but also the Bakken. Our story may be a little bit different because most of the movements that we have out of the Bakken are on spot basis and not on a contract basis. So as spreads contracted, we definitely saw an impact of volumes ramping off.

We do currently expect our third-quarter volumes to be down somewhere in the 20% to 25% range on a sequential basis. But if there's a good news part of our story here on the crude side is that the Canadian volumes have continued to hold up quite well. That’s a situation where there are pipeline options today, the refineries that we serve in the Gulf region typically prefer the heavy crude and we've been certainly telling investors for the last year or so that, that’s what we expect the future to be for us to be participating in that market going forward.

So what I wanted to share with you were just some trends and bear with me, this chart I’ll move a little bit slower here just to make sure people understand. But what we've done here is in the blue line charted the WTI Brent spread, and that's probably the most important spread to be looking at when we look at our crude shipments, although as we talk about Canada, we typically look at the WCS to Maya spread, which has stayed relatively wide at $20. And you can see our carload volumes by week and the impact that we saw beginning in week 31 where essentially our Bakken shipments [ceased] [ph]. And again, because that’s on a spot basis, may be different than some of other carriers who have committed contract volumes.

Then out of West Texas, you can see a similar impact and while the volumes weren’t nearly as material they were roughly 20% of our overall crude shipments. Those have also been negatively impacted by spreads. But the positive story is in Canada, we continue to see quite strong carload volumes. And so I thought this chart would be illustrative of really what’s happened in our business. And again because we believe that the refineries that we serve in the Gulf region typically prefer the heavy crude that our Canadian crude volume should stay relatively strong. And while we didn't put the Maya to WCS spread on here they’re relatively strong at $20. And then this just represents all of the regions that we are participating in on [one slide].

Wanted also shift and make a couple of comments around the overall economy. We’ve provided three charts here, the top two represent economic indicators in Mexico and correlations to our carload volumes in Mexico. So in the top left we have the producer price index. On the far right basket index which is a index of food and gas and utilities, consumer-related spend in Mexico. And you can see in both of those cases, based on the latest data points, it would tend to support on a six to nine months leading indicator here that carload volume should remain relatively healthy, if not strengthened in Mexico.

The first half of the year has been a little bit soft in Mexico with GDP results being below expectation. I am not sure that's a big surprise to us given that roughly two-thirds of what’s manufactured in Mexico still ends up in the United States. And our economy has certainly been slow growth the first half of the year.

And then on the bottom, what we’ve indicated here are new orders from the durable goods metric. Likewise certainly the most recent data points around PMI new orders were very, very strong in the 60s. So I think we’re seeing some positive signs and when we look at a few of the manufacturing-related commodities in our business, things like chemicals, metals, pulp paper product, those are all showing some sequential pickup and would certainly seem to indicate again the next three to six to nine months period, we would expect that these correlations hold true which -- by the way they are all above 80%. So highly correlated to our carload volumes would certainly seem to imply a good volume outlook for our business.

Transitioning -- wanted to spend a little bit of time on our capital structure. I think most investors understand what we've been through. We early in the year received an upgrade to, or our final upgrade to investment-grade. We took that opportunity then in April to refinance the vast majority of our debt, specifically about $1.2 billion and at extremely attractive coupons, as our chairman said, certainly a good foresight on our part to get that refinancing done but also perhaps a little bit of divine intervention there.

But if you look at our credit metrics, you can see we paid off roughly $400 million of debt since the end of ‘09 and a dramatic improvement in all of our credit metrics. Our weighted average coupon now on our debt portfolio is at 3.7% and certainly the April refinancing at extremely attractive rates before the run-up in treasuries contributes to that. But there is another part of our capital structure that I wanted to spend a few minutes on that we think is a good opportunity for us. And this relates to our assets that we have under lease. Historically our balance sheet hasn’t necessarily supported going out and buying and financing all of our equipment needs. So the company five years, 10 years ago ended up leasing a lot of the equipment, and when you look at our portfolio we have about 25% of our assets that are owned, 75% that are leased. And that compares unfavorably to the rest of the industry that has roughly two-thirds of their assets owned.

And so the negative impact that, that creates for us is much higher lease expense in our P&L. Specifically at the end of 2012, our lease expense as a percent of revenue was 5.3%. And that compares to the rest of the industry at 1.6%. So over the last two years we have tried to acquire some of this equipment, mainly locomotives, off of lease, used a combination of cash and a leverage to acquire those assets, put them on the balance sheet and you replaced the lease expense with depreciation expense. And certainly to the extent that you finance that equipment, there would be some incremental interest expense below operating income.

However when we look at this opportunity, we think there could be as much as 200 to 250 basis point improvement in our operating ratio. And we are spending a lot of time on this, evaluating all of our leases, discussing opportunities with lessors, determining what the purchase price might be and given this extremely attractive interest rate environment, assess whether or not we would have a good opportunity to try to really change that mix that you see in the pie chart on the left. And we will continue to update investors on a quarterly basis as we continue to make progress. But this opportunity is certainly one that won’t be achieved overnight. This will be something that will take us a few years to accomplish.

Wanted to give just a quick update on our strategic growth areas. For those of you who follow us, this is a pretty familiar chart where we identify five segments in our business that we believe have better than average growth opportunities. And I have indicated here in the second quarter, this represents roughly 20% of our business, that grew at 28% on a year-over-year basis. And what we try to illustrate while the bubbles and the percentages are from the second quarter, which direction these businesses are moving in the third quarter. So we haven’t given you the exact revenue growth rates but as an example, the crude oil business that grew at 193% in the second quarter based on my prior comments, obviously that growth rate is coming down, but offsetting that are nice improvements that we’re seeing in the frac sand business. Lázaro has rebounded a bit from a volume standpoint and it’s showing a sequential growth.

Our cross-border intermodal franchise, which is roughly 4% of our revenues now grew at 78% in the second quarter and is at or slightly above that number quarter to date here in the third quarter. So we are continuing to see very strong performance there. And then the auto sector, as I mentioned earlier, given some plant maintenance shutdowns and retooling for new models, is certainly trending to a number less than the 20% growth rate that we saw in the second quarter.

I did want to spend just a couple of minutes talking about one additional opportunity that we haven’t spent a lot of time but many of you, I'm sure, are aware of that in Mexico there are substantial shale reserves, both natural gas and oil. The government is going through a process right now to try to open those energy markets. It will in all likelihood be done outside of PEMEX. The details behind how they will attract foreign investment haven't been determined but we do expect that they'll come to some agreement on that by the end of the year and beginning in 2014 and beyond we may begin to see some level of investment in Mexico take place to really drill for both the natural gas and the oil deposits.

And so we've demonstrated here in the map where those shale areas are, where our network is and you can see we’re very well-positioned to participate in the buildout of those platforms, delivery of frac sand and then ultimately the end product. Mexico, interestingly enough, has doubled the shale reserves that Texas does, comes in slightly below the overall shale deposits in the US but sixth globally. So this is a big opportunity. It’s one that certainly isn't going to show up in our P&L in the fourth quarter or a significant amount in 2014 but one of those longer-term opportunities where I think we’re quite well-positioned.

So in conclusion, I won’t cover these points but leave those up here as we transition into Q&A. And hopefully I did a good enough job to keep plenty of opportunity for questions.

Question-and-Answer Session

Chris Wetherbee – Citigroup

I think that was great. We have about 20 minutes left. So we appreciate that. Thanks Mike. So let’s talk a little bit, I guess, about bigger picture, where you stand right now relative to what you’ve talked about as far as full year guidance. It sounds like based from your comments that you guys are still comfortable with the full year top line guidance that you gave out. Maybe give us a little bit of commentary around that as we have seen kind of a lull from a volume perspective. It sounds like grain is going to be an incremental driver of growth as we move into the fourth quarter. But what else should we be thinking about?

Michael Upchurch

Yes, well, hopefully the summary I gave by business unit gives you a little bit of insight into that. I think the one soft area going into the fourth quarter and a bit of an unknown to us is coal. I would remind investors that’s roughly 8%, 9% of our revenues, so not nearly the exposure that maybe some of the other rails have. But with the situation that I described with the customer in Texas, that continues to be uncertain as to what will happen with volumes there. But again, we lived through this each of the last two years -- last two years where they shut down partial operations and whether that will be a similar shutdown or potentially a larger impact to us is unknown at this point in time.

Intermodal continues to be relatively strong. I heard some of the discussion around peak season and I guess I would echo those comments. I don’t know that we’re seeing any signs right now of a tremendously strong peak season, but this is the timeframe over the next four week, six week period where if we’re going to see some lift, we would certainly see that. The rest of the business, again, those commodities that seem to be a driver behind manufacturing activity as I mentioned are showing some slight improvement, which is a good sign and you couple that with strong PMIs and new orders we certainly are hopeful that the fourth quarter can be a really good quarter. Then obviously the grain is a very easy comp for us that certainly will produce strong results. And you roll all those factors together, we’re comfortable with the guidance that we have provided.

Chris Wetherbee – Citigroup

So when you think about grain specifically, I think you've added – I wouldn’t necessarily say added -- customers that may be added, facilities that should help funnel the grain into the KCS network a little bit more effectively this year versus last year. I just want to get some rough perspective, we kind of have the forecast on the crop, assuming that's right and we get that level of volume, should we be going back and looking at fourth quarter ’11 to get a sense of kind of what the baseline is, and do you do better than that, do you do worse than that, I guess I am just trying to get a rough sense of magnitude of what grain should look like in the fourth quarter?

Michael Upchurch

Sure. That’s a good question. And Chris, you’re right. We have two new grain originations on our network between St. Louis and Kansas City. The first one is open now in Jacksonville, Illinois, it’s owned by our largest grain customer Bartlett, which is based in Kansas City. They move a lot of grain into Mexico for food processing. And whether this ultimately becomes an incremental opportunity remains to be seen. It is certainly incremental in terms of new facilities that we serve on our network, but they certainly have to be successful in acquiring grain.

I think the other facility that you are mentioning is owned by Ray-Carroll, that’s over in Corder, Missouri, just east of Kansas City. So another good opportunity, that’s officially scheduled to be open here in the next week or two, just in time for the new corn harvest. So as you go back to 2011, I think it's safe to say at least given the projections that we’re seeing right now out of the USDA that it's stacking up to be a better year than what we saw back in 2011. Whether that ultimately leads to stronger carload growth for us than we saw in 2011, we’ll have to see how successful our customers are in acquiring the grain and allowing us to carry that but certainly we’re optimistic that they may end up happening. I think if you go back to 2011 and look at the potential increase, if you just go back to 2011 volume, you’d see a mid-teens increase in our grain business in the fourth quarter over 2012 levels.

Chris Wetherbee – Citigroup

Sure, that makes sense. And from a mix standpoint, I think you’ve mentioned this point before but first half of the year export grain to Mexico, which is a longer haul move, probably a relatively high revenue per carload move was down 20 plus percent if you average out the two quarters. Third quarter seemingly flattish and hopefully we start to see some growth in the fourth quarter.

Michael Upchurch

We’re actually now beginning to see a nice growth on the export side here in the month of September. So that’s certainly a good sign, and you're right, the length of haul is very strong for us and we see almost double the revenue per carload that we see in our overall grain business. And our overall grain business is roughly doubled what our average consolidated revenue per carload is. So if you go back to the slide I showed that, that were up roughly 3.5% in volume here in the third quarter but trending to 8 plus percent revenue growth in the third quarter. You're beginning to see the impact of some favorable mix there.

Chris Wetherbee – Citigroup

Yes, that makes sense. I'd like to touch a little bit on the coal and I know it’s only the high single digit percentage of your business. I am not going to dwell on that. I guess I just want to make sure I understand what the Texas customer is doing. Does it feel like there is a bigger shutdown than we had before, because if I am not mistaken, I don’t know if everything has gone offline in the previous year? I guess I am just curious, kind of how we should be thinking about that?

Michael Upchurch

It’s a very fluid situation. We don't know exactly what this customer will end up doing. They do have some challenges and just for background, they are not a regulated utility. So they have to compete with natural gas providers and with natural gas below $4 which is generally the point that they believe they need to be at to be competitive and burning coal and selling into the grid. And we’re at, I think yesterday maybe $3.70 range. So it's relatively close and that could always change between now and the time they plan to shut down. But what they have indicated to us is that they have two facilities, one that they've closed down two of their three units each of the last two years. It would appear that they are looking to do the same thing this year. So that should be essentially a net neutral look at it year-over-year, but they also have a second facility and they have indicated that they have plans to shut down one of those units. So it could incrementally be a little bit worse than what we've seen in the past. But again, we’re very comfortable with the guidance that we’ve given for the rest of the year. So we don’t really see it as having that big of an impact to our business.

Chris Wetherbee – Citigroup

And then Port Arthur, it’s a question that I get all the time, so just kind of curious the update there. I know we’re – it sounds like it’s more of a permitting issue than anything else but just want to make I kind of understand the progress there, whether or not there has been lower levels of interest, similar level of interest that we have seen at 100 plus dollar oil that there would be, I think, meaningful interest in getting that done?

Michael Upchurch

Sure. Well we obviously didn’t announce anything today. So we are still work in progress. I would characterize it as largely a permitting environmental review process that the party we’re working with would like to have completed before they make any commitments to us. And I think that's understandable, because aside to the facility that they are discussing is a significant financial commitment on their part. Admittedly that process has gone slower than what we thought. We’re not aware of any kind of deal-breaker and they certainly have not backed off at all in terms of their interest in working with us to develop this facility. I wish we could give you a specific date when we will have an agreement, we can't do that here today. But it is still on track and really subject to governmental reviews both at the federal and state levels and hopefully we will have all those issues worked out and an agreement signed, and then as we've communicated it's roughly a 12 to 18 month cycle to build out those facilities.

Now we do have some interesting opportunities with them that could put us in the market much earlier and again they are largely interested in bringing crude from Canada, the heavy crude. And we specifically have a couple of opportunities, one, we own a facility adjacent to the land that they want to build on that we operate a facility called Pabtex and we export petroleum coke out of that particular facility. There is an existing dock there. It would need to be certainly reconfigured to be able to handle crude because pet coke is like a pulverized coal, but that’s an option for us to potentially be in the market earlier with them. We also have announced that we signed a purchase agreement to acquire land on the other side of that property that has an existing dock facility, that could get us working with them a little bit quicker in terms of unit train type volumes.

And then lastly, the port at Belmont has recently completed a loop track facility and unloading stations to be able to pull unit trains in, unload into barge and given some of the spreads there’s not as much crude moving in there right now. They also have some limitations around the heavy crude because they need steaming facilities, but that investment will be made sometime in 2014. So that would also represent a good opportunity to work with them to bring Canadian crude into that region.

Chris Wetherbee – Citigroup

Okay. So that’s the opportunity prior to the build-out of the Port Arthur, correct? Okay. I want to make sure the audience has an opportunity to ask questions and certainly if anybody has any, feel free to jump in. I think down in the side here. We can repeat it if the microphone doesn’t work.

Unidentified Analyst

(Question Inaudible)

Michael Upchurch

That’s a great question. We have not publicly given the number on what the implicit rate is in those leases. But suffice it to say there is a substantial spread there that makes it a good economic decision for us. We’d love to give a little more guidance on that but I am sure you can appreciate with the 100 plus leases it becomes an individual negotiation with the lessor to determine essentially a business case that you do for every lease, [air the interest that well]. We start with, do we have some long-term use for that equipment, if we do, are they willing to sell it to us, at what price and then it becomes a lease versus buy analysis for us. And the spread at current rate is still substantial for us to generate a nice return there.

Chris Wetherbee – Citigroup

Can I switch gears to auto for a second, want to get a rough sense, so I think you mentioned and based on the schedule we’ve seen before, the three out of the four new auto plants are opening up in, call it, the next quarter and a half or two, I guess. I think back around the middle of the year you were suggesting that maybe the wins were coming in slightly ahead of 50% for you, these are dual-serve facilities as far as I understand. So how should we think about that? Have you guys gotten your share, maybe better than your share of market share coming from the production?

Michael Upchurch

Well, there are four new plants, Mazda, Nissan, Honda and then Audi will probably be late – well, I doubt they would open 2014, it’s probably early 2015. So some of those contracts haven't been awarded. I think we’re, given our network position we’re happy with the share that we seem to be getting on those contracts. Those percentages are obviously very fluid in terms of where the vehicles end up. If they stay in Mexico, typically truck is a more efficient mode of transportation. Depending on where they go in the US, we may or may not be well positioned to carry that traffic. So if there was a shift to the West Coast, as an example, there are a number of border-crossings west of Laredo, Texas that we serve that we wouldn't be well-positioned to be carrying that. But at this stage of the game we’re pretty pleased with the results and I'll probably leave it at that. Overall increase in annual vehicle production in Mexico out of those four plants is roughly 700,000 a year and that’s on the base of I believe 2.9 million trend this year.

Chris Wetherbee – Citigroup

And Veracruz, does that still present an opportunity for you towards the end of this year as they build out the ability for you to serve that export facility?

Michael Upchurch

Yes. It still represents an opportunity that, that’s more of a 2014 opportunity though. And what Chris is referring to is there is a port in Veracruz on the Gulf side of Mexico, we don't have direct access into that port. We serve the city of Veracruz, but the port operator is building their own rail connection to our rail line, and that essentially provides the opportunity for us to be in participating in some of the trade volumes there. And it’s one of the more significant auto export facilities in Mexico with roughly 500,000 units a year being exported out of that facility, so that, that may represent a nice opportunity for us going forward. But it’s really out of our control in terms of when that connection gets completed, but what we continue to hear is sometime in 2014.

Chris Wetherbee – Citigroup

Anything else from the audience? I have a few more if not. So just jumping back to the lease versus owned. I think in the second quarter maybe you got a little bit of progress there. Anything we should be thinking about for the third quarter as we are kind of in the home stretch here, as far as the impact of that? Or was this quarter kind of largely absent of any of those conversions?

Michael Upchurch

Well, to date we haven't acquired any new assets under lease in the third quarter. What you're referring to in the second quarter, we did acquire some locomotives for about $155 million. We indicated that would be about 30 basis point improvement to the operating ratio. But since then, we haven't accomplished any further transactions. That may very well change by the end of the year but we will continue to update investors on our quarterly calls.

Chris Wetherbee – Citigroup

And then – I am sorry, jumping back to auto here, just curious. I think that one of the GM plants, the Silverado plant had been closed for retooling as the new product was being configured. So I believe that was supposed to be post-Labor Day that we saw that kind of back up and running. Is that the right way to be thinking about it? I think you mentioned that you’ve seen a lull in the auto, but maybe that it was picking up a little bit. Is that kind of what you are talking about?

Michael Upchurch

Yes. That was certainly one impact, I believe though they were open [let’s say] second quarter before the end of the second quarter. So I don't think we've been impacted as much in terms of third quarter volumes by that particular situation.

Chris Wetherbee – Citigroup

I guess when we take a step back, I guess, maybe just thinking out into ‘14 and ‘15, you guys have highlighted the near term as being a little bit of the bridge to get you to some of these revenue and growth opportunities that are out there. How do you characterize that now? We’ve had some puts and takes, I’d say, on the timing of it. Has anything materially changed, or is it just timing or kind of how do you think about the bridge and the potential for revenue acceleration from some of these new projects, that kind of growth driver slide that you had up earlier?

Michael Upchurch

Yes, I don’t think anything to materially change. Obviously the crude business had some impact here in the third quarter with spread that if you look a longer term, certainly the forecast that we’ve looked at would suggest they are kind of widened back out, so we may see a pickup again in some of the volumes coming out of Texas and the Bakken region. That may be the only area that could be a little bit behind where we had anticipated. But again it's 1.5% of our revenues. So not a significant driver of that bridge concept that you discussed.

Chris Wetherbee – Citigroup

Okay. I think that’s all I have. So if there is no more from the audience, thank you very much, Mike, for your presentation. We appreciate it.

Michael Upchurch

Thanks Chris.

Chris Wetherbee – Citigroup

Brian and Bill, thank you too.

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