With management having reported rejected a buyout bid worth $208/share, the pressure is on Kansas City Southern (KSU) management to show that they can drive even more value for shareholders staying independent. The third quarter was a step in the right direction, as the company benefited from a significant sequential improvement in volumes, including a strong recovery in cross-border traffic, as well as ongoing efficiency efforts tied to precision-scheduled railroading (or PSR).
I’m bullish on KSU’s above-average growth potential from its Mexican rail network and cross-border traffic, and I’m likewise bullish on the potential of higher margins from those PSR efforts. That said, I think the reported $208/share bid was a pretty fair offer and it’s tough for me to get a near-term (12-month) fair value much beyond $215 without a materially better near-term outlook for the U.S. and Mexican economies.
Good Performance In A Recovery Quarter
Kansas City Southern’s performance in the third quarter wasn’t significantly better than analysts expected, but between rail traffic data repots and several management presentations during the quarter, analysts had multiple opportunities to dial in their expectations. Moreover, the nearly 2% beat on operating income (a nearly one-point margin beat) was still a good result in a quarter where some transport/freight companies may well have struggled to manage the quick turnaround in volumes (J.B. Hunt (JBHT) in intermodal/dedicated trucking comes to mind).
Revenue declined 12% in the quarter, a small miss relative to the Street, with freight revenue down 12% on a 4% decline in carloads and a 9% decline in average realized prices. Revenue per carload was down across every category, ranging from a 3% drop for ag/minerals to a 13% drop for intermodal. Carload volumes were driven by intermodal, up 2% and nearly 46% of carload volume, while chemical/petrochem was the only other category to show year-over-year growth (up 5%).
Revenue from U.S. operations was down 11% and Mexico was down a similar 12%, but cross-border business improved throughout the quarter, ending up 3% higher than the year-ago period on 10% higher volumes (with intermodal volumes up 19%).
Helped by its PSR-based efficiency efforts, operating income fell 4%, with operating margin improving almost two points.
PSR Continues To Push Efficiency Higher
Since adopting PSR practices in 2018, KSU has seen the operating ratio (the ratio of operating expenses to sales) fall from around 64% to below 60%, and management believes that the mid-50%’s are still a credible target over the next three to five years.
The third quarter offered plenty of challenges as the economy got moving again after COVID-19 shutdowns, but there was nevertheless progress on multiple fronts. System velocity improved 4% and fuel efficiency improved 3%. KSU had 15% fewer locomotives in use and 23% lower crew starts. Terminal dwell time worsened by 13%, with car miles down 5%, and these were among the few reversals relative to management goals.
All told, these efforts helped drive 70% incremental margins on a 60% improvement in volumes from the second quarter trough. The next year should be more conducive to further PSR implementation, and management guided to PSR savings “in excess” of $150 million versus around $100 million in 2020.
Above-Average Growth Potential Versus The Certainty Of A Buyout
KSU shares shot up back in August on word that Blackstone and Global Infrastructure Partners was preparing a bid for the company. After reportedly rejecting an initial bid, KSU then turned down a sweetened $208 bid. Management hasn’t formally commented on any of this, but the company did recently execute an accelerated share repurchase program with JPMorgan (JPM) and Goldman Sachs (GS) that would seem to suggest the company is not actively engaged in any discussions on another bid.
At $208, KSU would have been accepting a price in line with the last major deal in the rail space – Canadian Pacific’s (CP) acquisition of Fortress Transportation and Infrastructure Investors’ (FTAI) Central Maine & Quebec Railway (14.3x EBITDA). Given the superior growth potential of KSU’s business footprint, as well as ongoing margin improvement opportunities, I can understand the rejection. Still, I’d probably be more supportive of management “betting on itself” if it had more skin in the game.
KSU has benefited significantly from increased cross-border trade between the U.S. and Mexico, with 13% annualized volume growth through Laredo since 2009 and more growth likely as companies near-shore away from China and into Mexico. KSU was recently granted permission to build a second bridge in Laredo, and the company’s assets and access to Monterrey, San Luis Potosi, and Lazaro Cardenas can all drive meaningful volume growth over the next five to 10 years.
KSU isn’t just leveraged to bringing Mexican-made goods across the border and into the U.S.. Mexico is a meaningful importer of petrochemical products, metal, grain, and various industrial and consumer goods.
I can understand why KSU management would have rejected the go-private bid, but that doesn’t mean that the shares are worth substantially more than that bid in the near term.
I expect high single-digit growth over the next three years as the U.S. and Mexico recover from their respective economic troubles, with growth slowing toward the low end of the mid-single-digits afterwards. Factoring in the benefits of increased efficiency gains, I expect high single-digit long-term FCF growth. Although I usually favor a required rate of return approach to discount rates (instead of WACC), it’s not hard to get to a WACC of 6%, supporting a fair value around $200 on discounted cash flow, but I can’t get much past $210.
Looking at other valuation approaches leads me to similar conclusions. Given where other rails trade on 2021 EBITDA (particular Canadian National (CN), CP, and Union Pacific (UNP), a 14.5x forward EBITDA multiple is reasonable, driving a $210 fair value (I could argue for 14.75x/$215 on the basis of margins and growth, but that’s not a significant difference). I would likewise note that at today’s price, KSU shares already trade at 22x ’21 EPS, or about two standard deviations above its long-term average forward PE.
The Bottom Line
Given the above-average growth and margin improvement potential, I like KSU into the $200’s. A weaker Mexican economy is a threat, but a manageable one, and counterbalanced by longer-term growth opportunities like the second Laredo bridge and increased manufacturing activity in Mexico over the next five years. I also see some risk from KSU driving better asset efficiency, but progress with PSR efforts should help there. All told, while the rejection of that reported bid may be creating some overhang, these shares have some appeal here even after year-to-date sector outperformance.
Disclosure: I am/we are long JPM. 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.