Kansas City Southern (KSU) is a holding company, operating railroads in the United States, Mexico, and Panama.  In the U.S., the railroad’s network extends 3,500 miles, encompassing a ten-state region in the Midwest and southeastern part of the country. The Mexican railroad operates primarily in the northeastern and central parts of that country, serving the major port cities of Lazaro Cardenas and Tampico.

The company is engaged in the haul of industrial products, energy-related material, automobiles, intermodal containers, and retail goods. The company partners with, but also competes, with truckers, logistic firms, ports, barge lines, and other railroads. Despite intense competition, we believe Kansas City Southern is well positioned to benefit from stronger global commerce and a developing Mexican economy. In fact, the railroader has a 50 year concession through 2047 from the Mexican government, along with FerroMex, to operate along key industrial and commercial corridors, including lanes between Mexico City and Laredo, Texas. What’s more, this corridor accounts for over half of all cross-border rail and truck traffic. The company derives roughly half its revenue from Mexico, which we believe will help it to grow profits at a healthier clip than its peers in the coming years

Kansas City Southern reports revenue under six divisions; industrial and consumer products (25% of 2013 revenue), chemical and petroleum (18%), agricultural and minerals (16%), intermodal (16%), energy (15%), and automotive (10%). Growth in the automotive, intermodal, and industrial and consumer units helped offset the weakness in utility coal and agricultural businesses in 2013. The bottom line rose 24% year over year, thanks to 6% top-line growth, along with operational improvements in the network.

The Freight

The industrial and consumer products division transports iron, steel, and copper, which are largely mined and consumed within Mexico. In addition, the sector also hauls household appliances and electronics. The company is currently benefitting from the relocation of asian manufacturers to Mexico. We believe cheaper labor costs and proximity to the United States will only accelerate this trend going forward. 

The agricultural and minerals division is primarily driven by the transportation of grain and other food products. The railroad hauls mostly corn, soybeans, and wheat from the U.S. to Mexico. We expect grain exports to remain healthy over the foreseeable future, largely due to a new client in the Midwest and stronger demand from a developing middle class in Mexico. 

The energy segment will probably provide an area of weakness for the railroad in 2014. The coal business continues to remain under pressure, as utilities switch to cheaper natural gas and deal with a tougher regulatory environment for coal. In addition, the crude-by-rail trend has softened somewhat, as WTI and Brent crude prices have narrowed. That said, the recent legislative energy reform in Mexico, coupled with the infrastructure buildout in the Gulf of Mexico, ought to provide a number of opportunities to transport frac sand, pipelines, and crude oil.

Endless Opportunities

The railroad has a number of growth drivers largely related to a developing Mexican economy. For one, cheap labor costs and proximity to the United States creates a favorable atmosphere for commerce. Auto manufacturers are locating south of the border for these reasons. Honda (HMC), Mazda, and Nissan (NSANY) are in the process of building and ramping production in the next year or two. Audi also plans on building a facility along KSU’s network by 2016. Kansas City Southern has approximately 30% to 35% of the auto market share in Mexico and these capacity gains ought to help the bottom line. What’s more, the increased production will fuel opportunities to transport auto parts, plastics, steel, and other ancillary products.

The Port of Lazaro Cardenas represents another promising opportunity. Kansas City Southern has exclusive access to Pacific Ocean port, which we believe will be able to take market share from the west coast in the United States. The port is in the process of increasing capacity, as APM Terminals and Hutchinson, are investing billions of dollars building out their operations. We expect the haul of autos and intermodal to expand significantly going forward, driven by increased trade among NAFTA partners and manufacturers looking for cheaper shipping costs.  

Finally, the intermodal business ought to provide a boost to growth. The company has invested heavily in its intermodal capabilities between Houston and Mexico City. We believe these investments were prudent, considering the transportation of domestic intermodal via rail. Too, trucking is getting more expensive due to higher fuel costs and tougher regulatory burdens, which we believe will only accelerate truck-to-rail conversions.

Recent Developments

Shares of Kansas City Southern dropped considerably following weaker-than-expected guidance for 2014. Management indicated that some of its projections in the automotive and crude businesses may take longer to materialize. The company also suggested that its bottom-line growth rate will probably fall from 20% to 15% over the next couple years. Additionally, the lower house of the Mexico’s Congress passed legislation calling for increased rail competition. According to the bill, businesses would be allowed to operate their own trains along Kansas City Southern’s tracks.    

Despite the recent developments, we still view these shares quite positively. The railroad legislation in Mexico is disconcerting, yet we believe that most businesses would probably find it quite burdensome and costly to build and maintain their own rail fleet. Secondly, the rail concession is enshrined in the constitution, potentially setting up a costly legal battle for both sides. Although profit growth should moderate, the company’s longer-term opportunities are very favorable compared to its transportation peers.

Due to some of the near-term concerns in the auto and crude oil businesses, we recently reduced our 2014 share-net outlook. Nonetheless, long-term growth prospects are encouraging, given the company’s exposure to Mexico’s economy, stronger intermodal and auto volumes, and rising trade between North America and Asia. Consequently, we believe the recent pullback in KSU’s stock price, provides a decent entry point for buy-and-hold investors.

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