EUR 850.00 For Business Accounts Only

Morningstar | Kansas City Southern Positioned to Improve Its Operating Ratio on Par With Larger Class 1 Railroads

Kansas City Southern, after years of lagging profitability, is free cash flow positive and producing margins on par with the large Class I railroads. As recently as 2009, KCS' operating expenses exceeded 80% of sales, but in its annual results for 2018, the company attained an impressive 63.7% operating ratio. Such performance puts it in the company of Class I railroads with top lines several times larger than KCS', and we expect the improvement to continue. After years of being cash flow negative, the firm initiated a dividend on its common shares in early 2012 and received investment-grade credit ratings in early 2013. This is a highly profitable railroad reaping the fruit of heavy investment for over a decade.A railroad's competitive advantage is inseparable from the location of its assets, and KCS is no exception. Other rails span half a continent, but KCS is different. It operates a unique, smaller north-south route in its central U.S. franchise and derives half of its revenue from its Mexican operations. KCS' system consists of track owned in the Midwestern United States (running from Kansas City to New Orleans) and track operated by concession running down to Mexico City and to the east and west coasts of Mexico. We believe this route is well placed to exploit Nafta trade, Mexican automobile and appliance production, Mexico's port traffic, and U.S. intermodal volume on the strategically placed east-west Meridian Speedway. In our opinion, Kansas City Southern affords both strong volume growth potential through its high exposure to Mexico and a takeout option, since we believe it's the only Class I that could be acquired by another railroad without insurmountable regulatory opposition. KCS has gained control of its operating ratio, refinanced its balance sheet, and is expanding freight volume. This smaller railroad has a wider range of possible outcomes than investments in the larger Class I railroads, but we believe KCS holds significant potential for revenue growth and margin enhancement. We also consider the firm to have a wide economic moat guarding its profits from competitors' incursions, thanks to its cost advantages and efficient scale.