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South of the Border

Mexico’s impressive economic growth should continue to outpace that of the U.S. and even some other emerging nations. Indeed, Latin America’s second-biggest economy grew 3.9% last year, compared with 1.0% in Brazil, and 2.2% in the United States. Political and social issues (most notoriously, drug violence), have done little to deter advancements in many different industries. Though growth should slow somewhat, consensus estimates suggest that Mexico’s economy will rise between 3.0% and 3.5% in 2013.
This emerging nation is experiencing ample investment from international shippers and manufacturers, as companies look to stem rising labor and transportation costs, and capitalize on Mexico’s close proximity to the United States. Also, the North American Free Trade Agreement (NAFTA) appears to be paying dividends, as evidenced by burgeoning trade activity among all involved partners. The grain market has benefited the most from this alliance. Furthermore, we believe the grain market will remain strong, due to the favorable supply/demand dynamics (supply- constrained and demand- high) in the Mexican market.

Similarly, NAFTA has helped increase volumes for industrial products, intermodal, and automotive. In fact, Mexico’s auto production for export is expected to increase 40% over last year’s levels by 2015, to three million units. Intermodal expansion is projected to range in the mid-single digits this year, outpacing both GDP and truckload growth. Additionally, the transportation of petroleum products, chemicals, and consumer goods ought to remain healthy in the coming years. We believe the country’s lower labor costs, and rising global fuel prices, will continue to lure international manufacturers to the Latin American nation.

Railroad Opportunity

Railroad operators are positioned well to capitalize on these favorable economic dynamics. Currently, railroads have a strong presence in and around the border. In fact, U.S. exports by rail to Mexico rose 38.6% year over year, while imports from Mexico increased 23.5%. Kansas City Southern (KSU) and Union Pacific (UNP) are the only two with direct exposure in Mexico’s market. Kansas City Southern operates roughly 2,645 miles of track in the country’s central and eastern regions. Union Pacific operates at all six border terminal stations and owns 26% of “Ferromex” (the largest railroad operator in that country). These two railroads work with Canadian National Railway (CNI), Norfolk Southern (NSC), and CSX (CSX) as well as various trucking companies to better serve the manufacturing and industrial supply chain in North America.

Kansas City Southern generates 46% of its annual sales from Mexico. The company owns a rail bridge in Laredo, Texas, which serves as a critical intermediary for cross-border trade. The railroad also has the only concession to service the Port of Lazaro Cardenas on Mexico’s west coast (more on this below). The company has partnerships with nine automotive plants, various steel facilities, and numerous alliances with the likes of DuPont (DD) and Tyson Foods (TSN) to name a few.

The growth drivers are compelling for Kansas City Southern. Four new car plants (Honda, Mazda, Nissan, and Audi) are expected to come on line by next year and two additional facilities by 2015. The company believes it will be able to capture at least 50% of additional automotive capacity. In addition, five new steel plants are coming into service over the next two years, largely due to the aforementioned cost advantages. The hauling of grain to Mexico is also set to expand, as one of its Midwestern customers just received the fourth largest grain contract in U.S. history.

However, the greatest potential for KSU is the continued development of the Port of Lazaro Cardenas. The port should begin to challenge the West Coast docks in the U.S. for imports and exports from Asia. Many of the world’s biggest shippers, including Maersk, plan to invest billions of dollars to develop and operate loading terminals. Capacity is expected to increase five- to six-fold over the next decade with consumer goods, intermodal, and automotive accounting for a large share of the goods.

Union Pacific does a decent amount of business in Mexico, as well. Union Pacific has direct access to all six gateways between the two countries and has a 26% stake in Ferromex. The company’s Mexican business ships mostly grain, intermodal, and automotive, which make up roughly 9%-10% of its annual revenues. The automotive market should be a nice catalyst going forward, as management believes the company has a 70%-75% market share working with industry giants General Motors (GM) and Ford (F). Finally, the intermodal business should start seeing cost savings and capacity gains, due to the completion of several capital spending projects in the southern portion of the United States.

We expect trade between the NAFTA nations to ramp up over the next decade. Mexico will most likely outpace its partners, due to its low labor costs and proximity to the world’s largest economy. A recovering U.S. housing market and favorable natural gas prices could further boost opportunities for railroads. As such, we believe Mexico’s economy will help drive stronger top- and bottom-line growth for railroad operators in the coming years.

For a more detailed evaluation of the companies mentioned here, and the particular investment merits of the stocks, subscribers are encouraged to view our full-page reports in The Value Line Investment Survey.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.