Description

Note: All estimates above are CIQ Consensus estimates as of time of publishing.

KSU was written up by fellow VIC member ‘lars’ on 6/11/15. lars did a nice job then, so why revisit the name? Three reasons:

1. We really tried to sharpen our pencils to the best of our ability and dig in on the Mexico piece of the business (eg ~50 interviews, site-by-site analysis, ~10 large scale data sets, etc) which is core to KSU’s growth and has higher margins than the other (ie US) half of the .

2. -25% share price declines (stock was ~95/shr and is ~70 now) really do change the discussion parameters in investing and lars’ write-up is now the better part of a year old. Consensus has certainly changed in the meanwhile:

    

           3. We felt an opportunity was missed to include train puns, which we have tried to liberally intersperse below.

After briefly reviewing the thesis, we’ll discuss the business and our thesis at greater length and then specifically address our findings vis a vis Mexico and other summary notes.

Thesis

Long KSU, a high-quality Tier 1 railroad with a unique advantage: a fully-owned, cross-border US-Mexico network of routes that services many of Mexico’s high-importance commercial locations and should disproportionately benefit from growing cross-border trade over time. After genuine headwinds and some disappointing quarters, KSU’s stock is down >40% from its highs and no longer reflects its underlying business quality, its growth prospects (Mexico and the US Gulf in particular) or its deserved takeout premium. At these levels, the stock is cheap relative to historical assigned valuations but, more importantly, is cheap on an absolute basis given the baked-in valuation today relative to the growth we can comfortably underwrite. Getting back to historical growth or multiples levels provides incremental upside.

We believe that the worst of the damage from these headwinds has been done and focus has shifted away from KSU’s long-term prospects. As the headwinds pass and the comps lap, KSU’s business strengths will become more evident again and it will likely rerate to a more appropriate multiple. For a long-term holder looking for a high-quality business with a big moat, this is a terrific option.

Anyway, with our thesis on the table please mind the GAAP and prepare yourself for train puns but, like KSU itself, we'll try to make them more than just one-liners……

Discussion

KSU is a really attractive long. It is a wonderful, durable franchise that is on-track to grow substantially both from a top-line and margin perspective - we see the prospect for a multi-year double-digit EPS CAGR over the medium-term - yet it is only trading at ~15.5x lowered FY16 consensus EPS.

Let's examine each of the thesis elements but first, a quick intro for those not familiar: KSU is the smallest of the remaining Class I railroads. It operates a largely contiguous network of ~6500 route miles with track roughly equally distributed between the US and Mexico. The US portion of the network serves a ten-state region in the Midwest and Southeast. The Mexican component of the network is the crucial differentiator as KSU is the only Class 1 rail to solely own or operate track in both the US and Mexico and it will enjoy this position via a government concession that will last through at least 2047 . Revenue is roughly equally split between the US and Mexico but Mexico is higher margin. Revenues are split widely across many different cargo types, but intermodal and automotive have been the most important growth engines and that looks to continue.

Durable Franchise

In an age of modern zoning laws and labor costs, we probably don’t need to defend railroads as durable franchises. They are admittedly macro-sensitive (although the industry grew rev per ton-mile even in 2008) but are also the low-cost provider in a wide range of transportation scenarios among other advantages so we believe that they should at least grow with GDP but will more likely be share gainers over time. KSU in particular is especially defensible because of its long-term Mexican concession and large number of dedicated industrial customers on both sides of the border.

The key question, then, isn't so much the business quality as whether the business results can drive an attractive return. In the interest of chugging along, I'll leave it to the comments section if we need to discuss defensibility further but suffice to say that, while we love that this is an ultra-high-quality franchise, what makes this especially attractive is that KSU has multiple visible levers to grow earnings both from topline and through margins but we don’t appear to be paying for them.

Growing Top-Line (Pricing and Volume)

Taking top-line first, KSU has opportunities in both volumes and pricing.

Volumes: KSU is, of course, exposed to general US and Mexican GDP. But, on top of that, KSU is exposed to northern Mexico's dramatic growth as a world-class manufacturing power. This is a surprise to many, but did you know that Mexico is now the world's fourth-largest car exporter by some measures? And that Nuevo Leon, a northern Mexican state, is at South Korean levels of economic productivity? Or that Mexicans work the most hours per week of any OECD country and have more free trade agreements than any other country in the world?

These facts all signal a profound change in Mexico and what that has translated into is cross-border revenue for KSU roughly doubling since 3Q10, now representing ~25% of total revenue.

Looking forward, there are a wide range of new industrial projects in Mexico that are either committed to or highly likely to use KSU for their transportation needs but we'll highlight two crucial ones.

- The Port of Lazaro Cardenas, already Mexico's biggest port and in the process of expanding by >250% over the next 5 years. KSU has the sole concession to serve it. Lazaro is already 4% of KSU's revenue by itself and looks to be the platform for driving topline by +150-200bps/yr over the next 5 years all by itself and without any improvement in pricing or mix.

- Mexican automotive: as mentioned, Mexico is already an automotive powerhouse and it's still picking up steam. Mexican auto production is slated to grow >40% through 2020 just on the basis of currently scheduled projects. KSU is likely to disproportionately benefit, as the number of plants it has access to is slated to almost double between YE13 and YE19. These new plants - across a wide range of OEMS - could readily drive another 100bps/yr of topline growth for KSU for 5+ years.

Other drivers include new and scheduled US Gulf energy infrastructure (such as at Port Arthur), Mexican natural gas and, of course, further share gains against trucks in intermodal. But we highlight the Lazaro and Mexican auto because it is a scheduled set of growth drivers over time.

Pricing: Meanwhile, on the pricing side, the story is pretty simple, KSU has consistently been able to raise 'same-store' prices at an LSD/MSD rate quarter after quarter since 2005. It even took healthy price increases during 08/09 and was able to get a 4.1% price increase in the most recent quarter despite all of the gloom. While business mix will impact how much this flows directly through to revenue (eg higher volume lines of business with lower per unit pricing will mute the impact of good pricing on legacy contracts), it speaks to KSU being a crucial piece of their customers’ transportation solutions.

We don't see this pricing story losing steam in the foreseeable future but we count on very little of it.

Putting it all together, it's easy to see many years of HSD sustainable top-line growth xFX and fuel and this is just from modest GDP and pricing, small intermodal gains and currently contracted growth once they work through this current headwind.

Now, we are dubious of many adjustments out there but some do provide context for the business. We think some of KSU’s are in the relevant category, specifically their notes are FX and fuel. Because of KSU’s Mexico business, topline and optical per unit revenue is particularly sensitive to the Mexican peso. Additionally, fuel is effectively a passthrough for many transportation companies and KSU is no different, when the price of fuel declined, KSU’s contract pricing and resulting GAAP revenue declined in turn. As a result, we are not trying to make predictions about the peso or oil but you can see the impact on revenues here:

Margin

What about margins? Here again, KSU appears to be on the right track. KSU has been getting better operationally but rails are also network businesses and so incremental volumes tend to come at very high margins. To that end, EBIT margins between FY10 and FY14 improved ~600bps from 26.8% to 32.9%.

Management has confidently predicted further improvement and, given that KSU perpetually follows its larger peers down the operational curve on a lag, that seems quite reasonable. Several larger peers are ~800bps better today and see substantial room to improve. For KSU, just continuing to lag behind implies a ~15-20% EBIT margin improvement.

Other

There are several other attractive elements beyond the core earnings power of the business.

Buyback: KSU just recently authorized a $500mm buyback (its first in many years). Management commentary suggests that they may continue substantially beyond that amount, especially with the stock at this price. We don't bake much beyond the current buyback in our assumption but it's a nice free ride you're exposed to.

M&A Premium: As the smallest of the Class 1 rails, KSU is among the last credible acquisition candidates in the industry. This, along with its superior growth profile, is why it has historically traded at a much wider premium than it does today (~40% vs ~15% today). At these valuations, it's not inconceivable that KSU might receive an offer (especially one where the US and Mexico pieces were sold separately) and the Norfolk Southern bid suggests that it is on the mind of some of the bigger players.

Summary

So that was a quick whistle stop tour of the thesis but why are we getting this for so cheap? Put simply, the answer is tunnel vision around near-term macro. Recent headwinds from fuel and FX have weighed on revenues and other service and commodity-specific issues have hurt volumes. Similar issues are what have brought down multiples across the sector. KSU has been uniquely hurt by the peso's weakness relative to peers but most of these issues are cyclical and not secular. KSU will begin lapping these tough fuel and peso comps over the next couple of quarters and most of the service issues appear to be resolving themselves, with operating metrics sharply improving. Longer-term, none of these issues is likely to derail the growth story as Mexican industrial expansion alone will likely continue on an express track (see Mexico discussion below).

We are fully prepared to believe that coal will be the exception to these positive trends but KSU was only weighted at 50% the rail average in coal going into FY15 and now coal only represents <7-8% of revenues (from ~9-10%). That remaining coal business is now overwhelmingly regulated utility coal, meaning there's very little further it can fall from here in the foreseeable future absent large scale switching of fuel sources.

Bottom Line: We have KSU able to do >$6.50/shr in EPS by FY18 with several opportunities for further upside. You can pick your own multiple but the stock averaged a >21x FWD P/E over the 5 years and was previously higher than that. If we simply use 18x, this is a ~$120 stock by YE17 versus ~$71 today. Multiple expansion, premium expansion, the buyback and/or better results could readily take the stock to over $150/shr.

Ultimately, if you anticipate the global economy to be an absolute trainwreck in the intermediate-term then this name may not carry much freight with you but, over the longer-term, we think this idea is just the ticket.

Mexico Appendix

Mexico Context

Some Key Findings From Our Work

• Mexico has gone from 10% of NAFTA Automotive Production in 2003 to ~20% in 2014. Looks to get to 26% by 2020E based on factory newbuilds and currently scheduled capacity expansions.

• Within automotive and intermodal KCSM (KSU in Mexico) is likely to grow at HSD CAGRs or better from 2016-2020. The vast majority of this growth will be from the market.

• 70% of that growth comes from automotive and we believe that that growth has fairly low risk given that much of this usage is non-optional for auto-related purposes.

• Within intermodal, assuming only modest rail share gains vs truck, our work again supports HSD or better CAGRS through 2020 within the Northbound Cross-Border, the Southbound Cross-Border and the Maritime markets

• Petrochemicals also a likely growth opportunity for KCSM given low US feedstock prices, the opening of the Mexican market away from Pemex, planned capacity expansions in the US Gulf and port capacity constraints at Houston.

• KCSM has gained ~11pts of share vs Ferromex since 2011, 60% of which has been explained because KCSM has a base of faster growing customers.

• Notable Mexican Newbuild Auto Plant Construction: Toyota/Guanajuato, Hyundai/Monterrey, COMPAS/Aguascalientes, VW/San Jose Chiapa, BMW/San Luis Potosi

• Notable Mexican Auto Plant Capacity Expansions: VW/Puebla, GM/San Luis Potosi, GM/Ramos Arizpe #2, Honda/Celaya, Nissan/Aguascalientes

* ~50% of projected capacity growth in Mexico will come from new plants, the majority of these plants are either contracted with KCSM already or are likely to given rail locations upon plant completion

• KCSM moves ~1mn autos/yr today. It is likely to gain ~300k new units of auto per year by 2020 from just three new plants: Toyota/Guanajuato, Hyundai/Monterrey, BMW/San Luis Potosi. It will gain another <300k units just from 3 expanding plants: GM/San Luis Potosi, Ford/Cuautitan, Fiat-Chrysler Toluca. These 6 plants alone will drive 80% of KCSM auto revenue.

• KSU has highlighted plant retooling (at GM/Ramos Arizpe, GM/San Luis Potosi and FCA/Toluca) as a driver for flat auto performance in 2016, our independent checks bear that out and it looks like these plants would be likely candidates to do ever more business with KCSM after the retooling.

• Auto volumes tend to be the key drivers for KCSM’s Chemical & Petroleum and Industrial volumes as well as these tend to represent parts and materials that go into auto manufacturing. Intermodal is a key recipient of this interlinked business as well (autoparts tend to be shipped this way).

• On cross-border intermodal, KCSM has ~80% share in Mexico.

• In addition to auto parts, other manufactured goods would be logical candidates for intermodal share gains over time (eg refrigerators, TVs & monitors, furniture). These are areas where KCSM has already been a material share-gaine, esp in the northbound trade.

• As compared to trucking, intermodal has gained share vs trucking (~8.2% in 2015 vs 5.5% in 2010)

• KCSM is seen as doing a better job on security of goods than Ferromex (theft is a real problem)

Bottom Line: What is exciting about Mexico as a growth story is that most of the volume growth we anticipate is a function of capacity expansions that are already planned, permitted and in-process.

Variant Perception

• Conviction on Mexican growth opportunity.

•Industry Improvement is More Secular Than Cyclical – There is some concern that KSU simply enjoyed a bullish rails cycle that is now reversing. We do not share that concern and believe that rails are likely to be share gainers and , most especially KSU.

•Longer Time Horizon – While we see the near-term headwinds and are not optimistic about a substantial rebound in coal volumes or global trade (for example), we are willing to look out towards the long-term opportunity set.

•Better Holder – We do not require a near-term catalyst and are correspondingly less concerned about near-term volatility. We are also less likely to panic in response to negative macro or coal/other energy headlines which are driving much of the pressure on the transportation sector in general.  

Why Does the Opportunity Exist?

•Generalized Sector Sell-off(s) - KSU has been hit by linked pressure on coal-linked names and transportation names. We are able to take advantage of such generalized selling when the proverbial baby has been thrown out with the bathwater.

•Time Horizon Arbitrage -  we are willing and able to hold this security for a longer period of time than most marginal buyers and sellers (which explains the general absence of hedge funds in KSU).

•Behavioral Advantage -  we do not have a particularly differentiated take on KSU’s longer-term prospects but are much better suited temperamentally to own a name with murky near-term prospects and the likelihood of further volatility.

Risks

•KSU is sensitive to what happens in the North American auto industry - a moderate decline in SAAR would not be great but hardly a disaster. A big decline would hurt a fair bit in the interim, especially if Mexican plants were idled over US/Canadian plants (although we consider that unlikely).

•A weak macro environment, especially around commodities, could pressure KSU’s volumes – China could be a logical catalyst for this.

•Specific issues (political or macro) that are detrimental to US-Mexico trade.

•An unwind in operating ratios driven by overbuilding or potentially even just poor execution.

•Continued labor and service problems in Mexico put pressure on growth.

•In an outright bad outcome, if the rails cycle really has turned against KSU (because of a deteriorating pricing environment, an overall decline in goods moved or simply an erosion of the structural advantages enjoyed by rails) we could see sustained negative volumes and margins are certain to follow.

•Changing Mexican political environment could put pressure on rates there.

Catalyst

Lapping challenging comps

Positive (or at least neutral) commodity datapoints

Management commentary that credibly suggests an improvement

Expansion of buyback or other piece of coporate news (eg M&A)