02/24/14 Covered Call Pick: Kansas City Southern (NYSE:KSU)
Kansas City Southern (KSU) owns and operates domestic and international railroad networks throughout the United States, Mexico, and Panama through a number of subsidiaries. Engaging in the freight rail transportation business, Kansas City Southern has railroads through important cities such as Kansas City, Missouri, and important shipping ports all along the Gulf Coast. Kansas City Southern is the only Class 1 railroad that owns track both inside and outside of Mexico's boundaries.
Kansas City Southern has a market capitalization of $10.53 billion with 110.2 million outstanding shares.
KSU currently pays a $0.215 quarterly dividend for a current yield of 1.2%.
With a beta of 1.74, KSU currently trades with approximately 75% more volatility than the current market.
You normally don't see names as volatile as KSU on our humble little blog when Monday morning comes around. If you looked at the stock chart's last couple years, you wouldn't see anything too rambunctious until you come to this past January. That is when a bill in the Mexican lower house was passed that threatens a concession that grants exclusive right-of-freight operations to KSU for 13 more years, with an option to renew for an additional 50 years. This concession led to 46% of the company's 2013 revenue, and with such uncertainty on the table, the stock gaped downwards by over 20%. Technically, the chart looks pretty horrible, with increased volatility in the wake of the bill and the stock's 50-day moving average dropping below the 200-day moving average (affectionately called the "Death Cross"). The stock bounced off the $90 level, but is still showing higher than average volume and uncertainty.
That said, we still think that in the long term the stock and the company provide a great investment, and this recent drop in price can offer a great entry point.
How competitive a railroad is, is directly related to the location of its assets - in other words, its rails. While most Class 1 railroads have routes spanning continents, KSU operates a smaller north-south route, but one that is no less important. Its central U.S. franchise consists of track owned in the Midwestern United States running from Kansas City to New Orleans, and then around the Gulf down to Mexico City. This route is placed to take advantage of Nafta trade, Mexican automobile and appliance production, Mexico's port traffic, and U.S. intermodal volume. KSU's compact size and strategic placement also make it the only Class 1 railroad that is a potential target for takeover without regulatory opposition. The company has had a history of lagging profits, but recently turned free cash flow positive with greatly improved margins including a 2013 operating ratio of 68.8%. The company also holds a wide economic moat according to Morningstar's research, due to their cost advantages and efficient scale. Quoting Morningstar's analysis on KSU:
"While barges, ships, aircraft, and trucks also haul freight, railroads are the low-cost option by far where no waterway connects the origin and the destination, especially for freight with low value per unit weight. Moreover, railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight, and thanks to greater railcar capacity and train length make more effective use of manpower despite the need for train yard personnel."
Namely, railroads still provide the best way to ship large amounts of freight over land. In addition, they're nearly impossible to replicate. Another company can not just decide to start-up a railroad and lay thousands of miles of track across continents. The barrier to entry is high, which creates an amount of safety in KSU, despite the possible threat to the Mexico concession.
Despite the uncertainty surrounding the Mexico concession, 2014 and 2015 earnings growth estimates are at 16% and 17% respectively, and is now trading below Morningstar's fair value estimate of $100. Because of the technical instability of the stock in the near-term, we are recommending a longer-term Covered Call strategy on the stock in order to remove near-term price fluctuations. That is why we are recommending buying KSU and selling the September 2014 $100 Call.
- Buy 100 shares of KSU @ $95.31 = $9,531 + Commission ($12.95) = $9,543.95
- Write 1 KSU September 2014 $100 Call @ $570 - Commission ($8.70) = $561.30
Note: Prices may vary from the time of post. Actual commissions paid will vary returns.
Static Return (Not Called):
(Call + Dividend)/Stock Price X (Days/Year)/Days to Expiration
(5.61 + (3*0.215))/95.44 X (365)/208
= 11.50% Static Return
(Call + Dividend + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration
(5.61 + (3*0.215) + 100 - 95.44)/95.44 X (365)/208
= 19.89% If-Called Return
Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual's personal investment goals and risk tolerance.
Disclosure: I am long KSU.
Additional disclosure: As active managers we may add to or sell positions in KSU.