Kansas City Southern - A Prime Target For Takeover

| About: Kansas City (KSU)
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Summary

Kansas City Southern is the smallest of the major railroad operators in North America.

In addition to operating in a wide moat sector, the company is the only operator running seamlessly between Mexico and US.

This makes the company very attractive and a prime takeover target by the larger railroads.

The company has reinstated dividends since 2012 and dividend growth remains strong.

Kansas City Southern Inc (NYSE:KSU) is the smallest of the North American railroad companies operating approximately 6,500 miles of rail network, serving business centers in south central US and Mexico. KSU's peers include Union Pacific Corp. (NYSE:UNP), Canadian National Railway (NYSE:CNI), CSX Corp. (NYSE:CSX), Norfolk Southern (NYSE:NSC), and Canadian Pacific Railway (NYSE:CP).

KSU operates in one of the widest moat industries - railroads. The company has a diversified traffic volume including intermodal, agriculture & minerals, chemicals & petroleum, industrial & consumer products, automotive and other products.

(Source: KSU IR book)

Corporate Profile (from Yahoo Finance)

Kansas City Southern, through its subsidiaries, engages in the freight rail transportation business. It operates north/south rail route between Kansas City, Missouri, and various ports along the Gulf of Mexico in Alabama, Louisiana, Mississippi, and Texas in the midwest and southeast regions of the United States. The company also operates direct rail passageway between Mexico City and Laredo, Texas serving various Mexico’s industrial cities and three of its seaports; a 157-mile rail line extending from Laredo, Texas to the port city of Corpus Christi, Texas; and The Kansas City Southern Railway Company rail line between Meridian, Mississippi and Shreveport, Louisiana, as well as owns the northern half of the rail bridge at Laredo, Texas. Its coordinated rail network comprises approximately 6,500 route miles extending from the midwest and southeast portions of the United States south into Mexico and connects with other Class I railroads. The company serves customers conducting business in various industries, including electric-generating utilities, chemical and petroleum products, paper and forest products, agriculture and mineral products, automotive products, and intermodal transportation. Kansas City Southern was founded in 1962 and is headquartered in Kansas City, Missouri.

The Railroad Industry

Railroads are the pulse of the economy. Whether transporting crude, lumber, merchandise, agricultural or industrial products, railroads are what keep the economy moving. While the transportation for entities such as coal (which used to be the largest users of railroad services a few years ago) has fallen due to the fall in crude prices and rise of green energy alternatives, the transportation need for crude saw significant rise in the recent past. However, the recent turn of events with falling energy prices has put a damper on crude transportation via railroads. However, the bright spot for KSU includes the faster growing Mexican economy and the need to transport the products between Mexico and US.

The following table compares the railroad industry to show where KSU fits in compared to Union Pacific Corp., Canadian National, CSX Corp., Norfolk Southern, and Canadian Pacific.

(Source: Created by author. Data from Google Finance and FinViz)

I present a more detailed railroad sector overview in this post.

Kansas City Southern Subsidiaries

  • Kansas City Southern controls and owns all of the stock of The Kansas City Southern Railway Company ("KCSR"), a U.S. Class I railroad founded in 1887. KCSR serves a 10-state region in the midwest and southeast regions of the United States and has the shortest north/south rail route between Kansas City, Missouri and several key ports along the Gulf of Mexico in Alabama, Louisiana, Mississippi and Texas.
  • Kansas City Southern controls and owns all of the stock of Kansas City Southern de México, S.A. de C.V. ("KCSM"). Note that KSU has a 50-year concession from the Mexican government (the "Concession"), which could expire in 2047 unless extended - to operate the KCSM arm. The Company wholly owns Mexrail which, in turn, wholly owns The Texas Mexican Railway Company ("Tex-Mex"). Tex-Mex owns a 157-mile rail line extending from Laredo, Texas to the port city of Corpus Christi, Texas, which connects the operations of KCSR with KCSM.
  • Panama Canal Railway Company ("PCRC"), an unconsolidated joint venture company owned equally by KCS and MiJack Products, Inc. ("Mi-Jack"), was awarded a concession from the Republic of Panama to reconstruct and operate the Panama Canal Railway, a 47-mile railroad located adjacent to the Panama Canal that provides international container shipping companies with a railway transportation alternative to the Panama Canal. The Concession was awarded in 1998 for an initial term of 25 years with an automatic renewal for an additional 25 year term. The Panama Canal Railway is a north-south railroad traversing the Isthmus of Panama between the Atlantic and Pacific Oceans.
  • Meridian Speedway, LLC ("MSLLC"), a 70%-owned consolidated affiliate that owns the former KCSR rail line between Meridian, Mississippi and Shreveport, Louisiana. The other 30% is owned by Norfolk Southern.
  • KCSM Servicios, S.A. de C.V. ("KCSM Servicios"), a wholly-owned and consolidated affiliate that provides employee services to KCSM.
  • Southern Capital Corporation, LLC ("Southern Capital"), a 50%-owned unconsolidated affiliate that owned and leased locomotives and other equipment.
  • Ferrocarril y Terminal del Valle de México, S.A. de C.V. ("FTVM"), a 25%-owned unconsolidated affiliate that provides railroad services as well as ancillary services in the greater Mexico City area.
  • PTC-220, LLC ("PTC-220"), a 14%-owned unconsolidated affiliate that holds the licenses to large blocks of radio spectrum and other assets for the deployment of positive train control ("PTC").

A Closer Look

Kansas City Southern operates in a unique geographical location providing service in south central US and providing seamless railroad service to the US gulf coast and Mexico.

The Mexican economy has been growing well, and at a faster rate than the US and the growth is expected to continue (see chart below). Mexico has 10 free trade agreements involving 45 countries and foreign direct investment (FDI) has increased over the years, with 2014 FDI reaching $22.5B. Investors paying attention may have noticed the announcements from various industries from banks increasing their operations to telecom providers moving to form alliances, and manufacturers such as car makers moving to take advantage of good labor conditions, stable government and economy in Mexico. The proximity to US makes Mexico an excellent emerging market economy.

(Source: KSU IR book)

KSU has a great mix of rail traffic and is not dependent on one heavy source such as coal or petroleum. According to the 2014 revenue mix, the breakdown appears well diversified.

(Source: KSU IR book)

KSU provides seamless transportation between US and Mexico. The network is fairly small with just 6500 miles of network; and the company has to rely on intermodal traffic for shipping destinations reaching various other parts of North America. The company faces competition from Ferrocarril Mexico - which has operations in Mexico and has a strong presence in the western regions of Mexico. However, KCSM (Kansas City Southern de Mexico) serves most of Mexico's principal industrial cities and three of its major seaports.

The railroad industry is facing pressure due to collapse in traffic in coal and petroleum products. This has caused companies to entertain the thought of M&A. Canadian Pacific has just made a move to takeover Norfolk Southern in a hostile $28.4B deal, after a failed attempt of a merger with CSX Corp. Whether that deal will progress and complete as planned remains to be seen. KSU, however, remains uniquely positioned with a great rail network and access to the Mexican market. A smaller company with a market cap of under $10B, makes KSU a prime takeover target from any of the larger railroad operators.

Dividend Stock Analysis

Financials

Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations.

(Source: Created by author. Data from Morningstar)

(Source: Created by author. Data from Morningstar)

Actual: The railroad business has been profitable over the past decade, and the financials show a nice steady rise in revenue year over year except for the stumble in 2009. The earnings have also seen a steady rise over the years after the 2009 recession. KSU has a debt/equity of 0.61 and a current ratio of 1.20.

Dividends and Payout Ratios

Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future.

(Source: Created by author. Data from Morningstar)

Actual: KSU terminated their dividends for over a decade and reinstated in 2012. Since then, the dividends have grown well, but the growth record remains in nascent stage. The current yield is 1.5% and the payout ratio is 27%, with plenty of room for future increases.

Outstanding Shares

Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble.

(Source: Created by author. Data from Morningstar)

Actual: The number of shares rose during the financial crisis and recession, but have stabilized since 2011.

Book Value and Book Value Growth

Expected: Growing book value per share.

(Source: Created by author. Data from Morningstar)

Actual: The book value saw a drop in 2008 but recovered after - pretty early in the recession. The book value has continued to grow well over the years.

Operating Margins

Expected: A healthy operating margin of over 30%.

Actual: Operating margin for KSU, while not the best in sector, still is better than some of its bigger competitors. The company has an operating margin of 32.4%.

Valuation

To determine the valuation, I use the Graham Number, average price-to-earnings, average price-to-sales, and discounted cash flow. For details on the methodology, click here.

The Graham Number for KSU with a book value per share of $35.45 and TTM EPS of $4.39 is $59.17. Based on the last closing price, the stock is currently 49% overvalued.

KSU's 5-year average P/E is 30.16, and the 10-year average P/E is 32.69. Based on the analyst earnings estimate of $4.99, we get a fair value of $150.50 (based on 5-year average) and $163.12 (based on 10-year average).

The average 5-year P/S is 4.34 and average 10-year P/S is 3.02. Revenue estimates for next year stand at $23.18 per share, giving a fair value of $100.61 and $70.01 based on 5- and 10-year averages, respectively.

The consensus from analysts is that earnings will rise at 4.68% per year over the next five years. If we take a more conservative number at 4% and assume that KSU is growing its earnings by 6% thereafter, running the three-stage DCF analysis with a 10% discount rate (expected rate of return), we get a fair price of $71.68.

The following charts from F.A.S.T. Graphs provide a perspective on the valuation of KSU.

(Source: F.A.S.T. Graphs)

The chart above shows that KSU is slightly undervalued even though the stock currently trades at P/E ~20. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 3-year return could average ~10% annually.

(Source: F.A.S.T. Graphs)

Conclusion

Railroads are the pulse of the economy, and KSU operates an impressive 6500 miles of rail network serving Mexico and some parts of the US. The railroad industry is facing pressure to collapse in traffic in coal and petroleum products. This has caused companies to entertain the thought of M&A. KSU remains uniquely positioned with a great rail network and access to the Mexican market. A smaller company with a market cap of under $10B, makes KSU a great takeover target from any of the larger railroad operators. With a low starting yield of 1.5% and low payout ratio of 27%, there is plenty of room for those dividends to grow. If we give equal weight to all valuation metrics used above, we get a fair value of $108.48.

Full Disclosure: Long CNI. My full list of holdings is available here.

Disclosure: I am/we are long CNI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.