Risk, Reward Balance Kansas City - Analyst Blog

By Zacks | December 28, 2012 AAA

Kansas City Southern (KSU) is one of the foremost freight rail transportation companies. It functions in a seller's market and has enjoyed pricing power since 1980 when the U.S. government formulated the Staggers Rail Act. The company has been able to increase prices on average by nearly 4-5% per annum, thereby maintaining a substantial profit margin. Additionally, improving cross-border traffic between the U.S. and Mexico and business opportunities in the Mexican market supported by its cheap labor costs, favorable currency environment and lower transportation cost to the U.S. markets are expected to bode well for the company's top and bottom-line growth.

Kansas City Southern looks forward to mid-single digit growth in volumes and core pricing. In terms of the Energy segment, management projects double-digit growth this year based on growing demand for natural gas and crude oil supplies. In addition, the increase in frac sand shipments on enhanced drilling activities in petroleum products and existing low cost natural gas will drive shipments in this segment.

Auto production is expected to rise in Mexico, with upcoming plants by Honda, Mazda, Nissan and Audi. These facilities will expedite automotive shipments. Based on these proposed expansion plans, finished vehicle production is expected to reach 3.5 million units in 2015; up about 40% from the 2011 production level and 30% from the current level.

However, the current volatility in the U.S. and world economy may keep Kansas City Southern's top-line growth under pressure in the near future. Moreover, near-term growth for the company is expected to be tempered by lower coal production forecasts. Besides, lower natural gas prices and a weak utility coal market have raised serious concerns and limited overall coal shipments despite strong exports to the Asian countries.

Additionally, the company foresees a decline in its grain shipments, given higher U.S. grain prices. Although lower fuel prices are a plus, it also means lower fuel surcharge revenue for the company. Going forward, exchange rate fluctuations also remain a critical factor for the company's earnings, as a substantial part of the business arises from cross-border markets. Given these near-term headwinds, the company lowered its revenue estimates for this year to a mid single-digit range from a low double-digit range.

Further, stiff competition from railroads like Canadian Pacific Railway Limited (CP), increased railroad regulation and highly unionized labor may limit the upside potential of the company.

Consequently, we maintain our long-term Neutral recommendation on the stock.  For the short term, Kansas City Southern holds a Zacks #3 Rank (Hold).

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