Is there a bright spot in the Railroad Industry?

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The railroads have been going through a nightmare since the shale gas boom pulled down natural gas prices significantly.  Moreover, transportation stocks fail to attract investors in recessionary times, given that low economic activity leads to lesser transportation of goods. In this situation, 20% capital appreciation for Kansas City Southern (NYSE: KSU) in 2012 has been a sheer surprise for the analysts. The question is: Should  investors still buy KCS?

Investment Thesis

I believe that KCS is likely to sustain a strong pace of both revenue and EPS growth over the next several years, driven by both solid organic growth in its broader customer base and significant contributions from new manufacturing capacity in Mexico and new markets in the US.

The following chart shows different streams of revenues for KCS:

 

The company is expected to see a growth in its carloads for the following categories:

1)      Intermodal: The company believes that the potential addressable market for cross-border intermodal will be 2.6 million truckloads per year. This is a 58% rise from the current Southern states that KCS caters to.

2)      Automotives: There are 10 automotive assembly plants in Mexico, nine of which are being served by KCS and Ferromex. KCS currently owns 40% of the total carloads served between KCS and Ferromex. Till 2015, the auto production is expected to rise by 41% i.e. one million units in Mexico. Also, the current plants are expected to extend their existing operational capacity, which will also lead to a rise in carloads for KCS.

3)      Metals: 70%-75% of Mexico's steel production is transported through railcars. 2011 figures show that 18.1 million tons of steel was produced in Mexico. With the additional five new facilities, 3.5 million tons is expected to be added in the next 12 months.

4)      Crude oil: Bakken in North Dakota appears to be the greatest opportunity that KCS can avail, since this region lacks a pipeline infrastructure. Also, KCS owns the land where it can benefit by connecting to nearby Gulf pipelines by building the Port Arthur Crude Terminal, in partnership with Savage.

5)      Frac sand (Chemicals): KCS network is well positioned to haul frac sand from the Midwest states through Kansas City down to shale regions such as Permian and Eagle Ford.

Competitors Analysis

The following chart shows the different revenue streams for KCS’ competitors:

CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC) both face a similar set of problems. A high exposure to coal has significantly dented their revenues and profitability. Also, low demand for exports of met coal has increased the woes for both these railroads.

Union Pacific (NYSE: UNP) is another bright spot in the industry (after KCS). Most of the coal transported by this railroad comes from Powder River Basin (PRB). The PRB coal is competitive versus the natural gas price at around $3/Btu. However, I like KCS the most due to its ideal mix of exposure to different commodities.

Valuations

KCS is currently trading at a forward P/E multiple of 21. The strength of KCS’s EPS growth track record along with strong visibility to a pipeline of clear drivers of future EPS growth support a high end valuation for KCS compared to the overall transport group. The medium-term reward to risk is attractive and upside potential is significant.

Potential risk: A weaker US economy and a slowdown in US / Mexico trade are the primary sources of risk to the EPS estimates and bullish stance on KCS. 


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