A Rail Stock for the Long Haul

Even though they may be platitudinous, analogies are sometimes hard to resist. On February 5, Kansas City Southern reported fourth-quarter earnings that blew past what Wall Street analysts had been expecting. On a day during which the Dow Jones industrial average fell 370 points, and despite an analyst's downgrade of KCS's railroad-industry competitors, shares in Kansas City Southern gained nearly 2%. Look at that performance as kind of like, well, a locomotive hauling heavy cargo up a slippery mountainside.

The stock gave up those gains and then some on February 6, falling 2.7% as the broader market waffled.

Make no mistake -- railroad stocks face plenty of challenges when the economy is slowing, as investors are convinced it now is. And Kansas City Southern (symbol KSU) has other challenges, too. But for investors in for the long haul, this rail stock is definitely worth a look.

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Kansas City Southern has more than 6,000 miles of track serving ten central and southern states as well as Mexico. The company, headquartered in Kansas City, Mo., is actually a holding company for three separate businesses.

Kansas City Southern Railway in the U.S. and Kansas City Southern de Mexico are roughly equal in terms of miles of track and total revenues. They haul grain, petroleum, chemicals, paper and forest products, as well as a growing number of containers. Miniscule by comparison is the company's third line, a 50% stake in the Panama Canal Railway Co., which provides freight and passenger service along the Panama Canal.

The fourth-quarter results showed that KSC's multi-year effort to ratchet up efficiency while growing revenues is mostly (ahem) on track. The company reported earnings of 56 cents a share (54 cents after adjusting for some one-time Mexican tax changes), up nearly 40% from 41 cents a share in the same quarter a year ago. For the year, the company reported record revenues of $1.74 billion, and earnings of $1.57 a share, up 45% from $1.08 a share in 2006.

"We think we are the fastest growing railroad in North America," says chief executive Michael Haverty "Even though the economy is slow, we have a lot of new growth opportunities."

Chief among them is the company's recently acquired operation at the Port of Lazaro Cardenas, in Mexico. The site, still being developed, could become a huge gateway for container ships, from Asia and elsewhere, that are trying to avoid the congested port at Los Angeles/Long Beach.

The first ocean liner was unloaded in November, and there are now five carriers calling on the port. KCS is making test runs from one of the carriers from Mexico into Texas.

Kansas City's rail lines are particularly well-situated to take advantage of industrial development. "They're in areas in the mid-south that have low wages, a well-educated workforce, decent tax situations," says Morgan Keegan Art Hatfield. "Businesses are relocating there, building assembly and manufacturing operations."

Another plus: Along KCS's Mexican network, five auto plants are scheduled to open over the next 18 months.

For now, though, KCS's outsized earnings gains have more to do with efficiency gains and cost controls, which leverage any gains in revenues. The yardstick railroads use to measure efficiency is known as the operating ratio, or operating expenses as a percentage of revenue. A ratio of 80 or below indicates things are humming along nicely. Not too long ago, KCS had one of the worst ratios in the industry.

Not any more. KCS shaved 3.7 percentage points off the operating ratio last year, bringing it down to 76.4% in the fourth quarter and to just below 80% for the full year.

Much of the improvement is coming from a program to bring 210 new locomotives on line, while removing 325 to 350 old ones, reducing the fleet's average age to nine years from 22.

The company's goal: shave one to two percentage points off the operating ratio each year through 2011. A one-point improvement in the operating ratio translates into 10% growth in earnings per share, says UBS analyst Rick Paterson.

The company has other challenges, however. Huge debt levels and a lot of preferred stock on which KCS pays healthy dividends doesn't leave all that much for reinvestment in a business that requires massive capital expenditures just to maintain the status quo, although refinancing a chunk of the debt this year should help.

And the stock, at the February 6 close of $36.45, is among the most expensive in its peer group, selling at a bit more than 18 times estimated '08 earnings of $1.98 a share. Railroads as a group trade at closer to 15 times earnings.

In light of its faster growth rate, KCS's higher price-earnings ratio seems defensible. Zacks Equity Research analyst Ann Heffron calls the stock "fairly valued" but concedes it could do better than she expects if analysts continue to underestimate earnings. She rates it a "hold."

Not even the bulls will call the stock a screaming bargain. "We love the long-term story but are increasingly conscious of valuation as the stock approaches $40," says UBS analyst Rick Paterson, who rates the stock a buy.

The biggest question mark facing Kansas City Southern is how far the economy will turn down, and for how long. "A recession will impact the business, but it's not the end of the world," says Morgan Keegan's Hatfield. "There's a lot of growth built in that's not wholly dependent on the economy."

A fairly mild recession could push the stock to bargain levels without doing much damage to the company's long-term prospects. In other words, if economic woes push this locomotive further down the mountain, you might want to think about hopping on board.