Kansas City Southern (NYSE:KSU) is an odd duck in the railroad space. Although a Class 1 railroad, it's quite a bit smaller than the likes of Union Pacific (NYSE:UNP) or CSX (NYSE:CSX). Likewise, it often seems to be overlooked - more than a couple of analysts who cover the major rails don't cover Kansas City Southern. On the other hand, this company has uncommonly strong growth prospects, but a valuation to match.
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Q3 Results Better Than They Seem
Although Kansas City Southern delivered a miss relative to published analyst estimates, it wasn't a bad quarter. The company's revenue performance was solid and so was the improvement in operating efficiency; currency moves spiked the effective tax rate and largely fueled the technical miss.
Revenue rose 6% compared to the same quarter last year, with carload growth of more than 6% and yield (revenue per carload) down about 1% despite solid "core" pricing. Within the company's total revenue, intermodal revenue rose about 25% and climbed to more than 14% of revenue.
Operating income decreased 0.6% compared to the same quarter last year. Operating expenses rose about 9%, while average costs per employee were down almost 1%.
SEE: Understanding The Income Statement
Solid Volume Growth, but will it Stick?
KSU's carload growth of 6.6% definitely stands out against the declines reported by Union Pacific and CSX. Some of this is due to the relatively lesser proportion of coal traffic at KSU (about 15% of carloads), but it's also worth noting that KSU's coal traffic actually rose 3% this quarter, while rails including CSX, Union Pacific, and Norfolk Southern (NYSE:NSC) have been reporting double-digit declines. Elsewhere, auto traffic continues to grow nicely (up 31%), while intermodal traffic grew 17% and is closing in on half of the rail's carload traffic.
The $64,000 question is whether the company can maintain this growth.
KSU's coal business serves a pretty small number of plants and 25-30% of its coal traffic could be at risk due to EPA regulations and natural gas substitution. In fact, a single plant in Texas (KSU's largest customer) could be curtailing coal-fired generation and this will impacting volumes in the fourth quarter. Likewise, grain traffic could suffer from the impact of the drought on the corn crop.
On the brighter side, the grain traffic issue could be just a momentarily disruption to an otherwise strong business; KSU has added grain customers and volumes should recover in 2013. What's more, while Bakken-related traffic isn't a perfect offset to coal, KSU gets to double-dip as it takes frac sand into the region and brings crude back out.
Intermodal Can Be Even Bigger
While KSU does lag behind Union Pacific in terms of the percentage of revenue it gets from intermodal, this business is growing rapidly. Yields were up almost 7% this quarter, and the company is in the process of a major capacity expansion at Lazaro Cardenas. Although it's true that this business has very different pricing dynamics (about 20% of the pricing of auto traffic, for instance), it also has a different cost make-up, and it's still very much worth the company's time to expand this business.
The Bottom Line
Between the two smaller U.S. railroads (KSU and Genesee & Wyoming (NYSE:GWR)), KSU is the more conventional one and the company also has that intermodal growth kicker. In any case, it's not hard to be optimistic about the above-average growth prospects for Kansas City Southern.
On the other hand, even above-average growth has its price/value trade-off, and I'm not sure it's a favorable one for KSU at this point. KSU has historically enjoyed about a 25% premium to the industry-average EBITDA multiple of seven times, but the stock is presently well above that level. If you think KSU's above-average growth prospects merit an even larger premium, these shares could still hold appeal, but I'm a little reluctant to chase the stock today.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.