Profit From the Auto Industry's Expansion Into Mexico

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It's no secret that the auto industry is booming. Sales jumped 14% in July, according to research by Autodata. The industry invested $3.7 billion in Mexico between 2010 and 2012, and plans to spend more this year. To keep up with demand, automakers are increasingly looking to Mexico as a solution. This is causing a trend in transportation that favors cross-border rail. 

A growing trend down south...

Ford’s (NYSE: F) three-shift assembly plant in Hermosillo, Mexico is capable of producing around 300,000 Fusions a year, which are produced at the Mexican plant and then shipped by rail to Michigan for inspection. This plant, and the rail transportation it uses, are crucial for maintaining normal inventory levels of one of the company’s best-selling vehicles, which sold a total of 241,263 units in 2012.

But why is Mexico really important to Ford? While the company's still increasing its labor force in the States to boost capacity, Mexico is becoming more attractive for its growing workforce. Strong population growth in Mexico is putting downward pressure on wages, which is part of the reason why labor for assembly workers, for instance, can be six to seven times cheaper in Mexico than in the U.S.

Hourly wages are now about a fifth lower in Mexico than in China as well, according to research by Bank of America Merrill Lynch. A shrinking Chinese workforce is leading to higher labor costs in China, and according to forecasts by the International Labor Organization, China's economically-active population will grow by only 2.9% from 2010 to 2012. This compares to nearly 20% growth in Mexico over the same period.

Now that population trends have led to a paradigm shift in "cheap labor" in the auto industry, creating more jobs in Mexico, shipping time is becoming a factor as well. Items traveling from Mexico to the U.S. by rail can get here as quickly as two to three days. Compare this to the 20-day delivery time typical of China, and it becomes clear why rail is increasingly getting cross-border business from the auto-industry.

Transportation by rail from a plant in Mexico can also be cheaper than transportation from China. Gabriel Lopez, CEO of Ford's Mexican unit, explained that his company “maximized the use of the railroad because it has important cost advantages... At this plant [Hermosillo], 85% of capacity is for export, and everything that goes to the U.S., Canada, and the ports goes by railroad.”

Rail is reaping in the rewards...

So who are the primary railroad beneficiaries of this trend? Kansas City Southern (NYSE: KSU) now gets close to half of its revenues from Mexico, and expects to see double-digit growth in its unit that ships cars. The company's most recent quarter saw a 20% year-over-year growth in automotive revenue, which accounted for around 8% of total sales.

K.C.S. also owns Kansas City Southern de Mexico, which operates in a duopoly down South along with Ferromex and Ferrosur (subsidiaries of Grupo Mexico). This gives KCS a lucrative cross-border business, positioned to profit from the $1 billion of goods exchanged between the two countries each day. 

Ferromex CEO Rogelio Velez said that “All the automakers have been reinforcing their presence in Mexico, and rail access is one of the ‘musts’ for the auto industry.” 

Not to be left out, Union Pacific (NYSE: UNP), like KCS, is also profiting from this trend. Mexico is responsible for over 50% of U.P.'s overall automotive revenues.

U.P.'s CFO Robert said, "if you focus just on Mexico automotive traffic, we currently handle roughly 90% of the rail market share in and out of Mexico. In fact, around half of our automotive business is cross-border traffic with Mexico.” 

That's pretty powerful. U.P. is likely able to achieve such a feat because it's the only American railroad with access to all six of the rail entry points into Mexico. In addition, it owns 26% of the country's largest railroad, Ferromex. 

Picking and choosing...

Rail is one of the best long-term investments you will find to gain exposure to the car-induced boom occurring in Mexico. Kansas City Southern and Union Pacific are the two publicly traded American rail companies you can choose from. But which company deserves your hard-earned money the most? 

In relation to earnings, Union Pacific is much cheaper than Kansas City Southern. U.P. trades at 18 times trailing earnings and only 14.5 times forward earnings. This compares to K.C.S's costly P/E ratio of over 38, and a forward P/E of over 20.

U.P. also offers the superior dividend, with shares yielding almost 2%, as opposed to K.C.S.'s dividend yielding less than 1%. Union Pacific also carries less debt than Kansas City Southern, which means that it should have more room to invest in itself for future growth.

Considering everything outlined above, Union Pacific looks like your best bet. The company is clearly the best positioned to profit from the auto industry's increasing investment in Mexico, as well as the increasing trade between Mexico and the U.S in general. Throw in its cheaper valuations and nice dividend, and you have a winner.

Joseph Harry owns shares of Ford. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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