As I have predicted numerous times, railroads have been outperforming broader indices. In this article, I will run you through a DCF model on Kansas City Southern (KSU) and then triangulate the result against a review of the fundamentals of CSX and Union Pacific (UNP). I find that Kansas City is slightly undervalued but that CSX and Union Pacific are substantially undervalued.
First, let's begin with an assumption about the top-line. Kansas City finished FY2011 with $2.1B in revenue, which represented a 15.6% gain off of the preceding year. I model a 15.4% per annum growth rate over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold hovering around 34% of revenue versus 20.5% for SG&A, and 20% - 17% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 0.1% of revenue over the explicitly project time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% suggests that the stock is fairly valued. However, a WACC of 9% suggests that the stock has just north of 20% upside at an intrinsic value of $84.40.
All of this falls within the context of strong operating performance:
[O]bviously we're very pleased with the results KC has posted. First quarter revenues, carloads and operating income are record. A few things that stand out as important contributors to these results, first, our Cross Border revenues increased 28% in the first quarter over a year ago. A 26% increase in Cross Border grain revenues and an 87% increase in Cross Border Intermodal were key contributors…
But as it's turning out, we're seeing good growth in 2012 due to increased auto production. The latest forecast calls for 2012 North American auto production to be around 14.8 million vehicles, which would be up 13% from 2011. Still below the 16.3 million in 2006, but definitely moving in the right direction.
With that said, the company is more expensive than peers on a multiples basis. It trades at a respective 22.7x and 16.7x past and forward earnings versus 12.3x and 10.4x for CSX and 15.6 and 12.1x for Union Pacific.
Consensus estimates forecast CSX's EPS growing by 9% to $1.82 in 2012 and then by 13.7% and 14% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $2.04, the stock would hit $28.56 for 32.8% upside. According to NASDAQ, the stock is rated near a "strong buy". It also is led by top management and has seen strong momentum.
Consensus estimates forecast Union Pacific's EPS growing by 21% to $8.13 in 2012 and then by 14.1% and 13.6% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $9.24, the stock would hit $147.84 for 31.5% upside. According to NASDAQ, the stock is rated a "strong buy". Union Pacific merits a premium due to the fact that it is the largest operating railroad with a leading brand. Momentum has been excellent and the railroads are well positioned to exploit key export markets.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.