The upcoming presidential election has dominated the 24-hour news cycle. However, the knock on effects of COVID-19 still linger, and the economy could face headwinds even after a vaccine emerges. That could be foreboding for cyclical names like Kansas City Southern (KSU). The company reported Q3 revenue of $659.6 million, non-GAAP EPS of $1.96 and GAAP EPS of $2.91. The company missed on revenue, but beat on earnings. KSU is down in the low single-digit percentage range post earnings.
It was an interesting Q3 as revenue fell 12% Y/Y, yet rose 20% sequentially. Rail traffic fell 4%, while average selling price (“ASP”) fell 9%.
Chemicals/Petroleum revenue fell 1% on a 5% increase in carloads and 6% decline n ASP. The segment has benefited from volume related to energy reform and plastics. If Mexico’s economy does not gain traction long term then it could jeopardize a major catalyst for the company. Chemicals/Petroleum represents 31% of total revenue, up from 27% in the year earlier period.
Agriculture/Mineral revenue fell 6% on a 3% decline in volume and 3% decline in ASP. Bad weather for iron ore and minerals weighed during the quarter. Intermodal revenue was off 11% on a 2% increase in volume and 13% decline in ASP. Sequentially, Intermodal rose 40%, for the month of September, Intermodal traffic spiked as retailers and others restocked inventories. This could remain a hot sector for railroads in Q4 as well.
Total carloads fell 4% Y/Y. Total industry rail traffic for the first 43 weeks of the year was down about 10%, which implies KSU’s Q3 rail traffic was better than the industry’s full-year performance.
Chemicals/Petroleum volume rose 5% on a recovery in refined fuel product shipments to Mexico. Energy volume fell 20% due lower shipments for frac sand amid weak oil prices. Automotive volume fell 18% due to lower automotive production, which was hurt by COVID-19. However, Automotive volume more than doubled sequentially, implying the segment could be heading for a rebound.
Last year KSU was known for its pricing power. In Q2 ASP fell in the high-single-digit percentage range.
ASP for Intermodal, Industrial/Consumer and Energy fell in the double-digit percentage range. Until the economy fully reopens, pricing power in certain product lines like Industrial/Consumer and Energy could remain depressed. If the company cannot hike prices then it could be difficult to keep future revenue from falling.
Management Makes Deep Cost Cuts
KSU reported total operating expenses of $388 million, down 17% Y/Y. Operating costs fell more rapidly than revenue, which led to margin expansion. Compensation and benefits expense was $117 million, down 13% Y/Y. Purchased services fell 11%, while fuel costs fell over 40%. Falling costs was a side benefit of a weak economy. The company’s voluntary separation program and asset utilization measures helped create efficiency gains:
The headline story for this quarter is clearly operating ratio, and more specifically our ability to hold the PSR driven efficiency improvements and cost savings generated over the prior year and a half, as our volumes and revenues experience a truly unprecedented roller coaster ride, with the steep decline in the second quarter and then the very sharp recovery in growth during the third quarter.
The fact that we were able to hold these operating efficiency and cost improvements and produce a meaningful reduction in operating ratio vs. last year and a 640 basis point reduction in operating ratio from the second quarter of this year is solid validation of the substantial and sustainable improvements to the way we run our network that have resulted from our PSR transformation.
KSU reported an operating ratio of 58%, a marked improvement over that of the prior year period. The company had been reporting operating ratios in the low-to-mid-60 percent range. While CSX (CSX) an Union Pacific (UNP) have delivered operating ratios sub-60%, I had not expected KSU to get there.
The fallout was that EBITDA of $361 million fell 5% Y/Y. EBITDA margin was 55%, up 400 basis points versus that of the year earlier period. Results for Q3 was a big achievement for KSU pursuant to efficiency. It now can be considered as best-in-class alongside the Canadian railroads. Cost take-outs and its shipments to Mexico could further differentiate KSU from U.S. competitors.
KSU Appears Overvalued
KSU has an enterprise value of $19.5 billion and trades at 13.9x EBITDA. The company was previously the subject of takeover rumors pursuant to Blackstone (BX) and Global Infrastructure Partners, yet KSU decided to go it alone. While KSU is proving itself to be one of the better railroads pursuant to earnings growth, the company will likely face headwinds until the economy reopens. Even before the pandemic, industry railroad traffic was slowing and global economic expansion appeared to be long in the tooth. If the global economy has seen its best days then railroads and KSU could find it difficult to deliver consistent growth. I do not believe the valuation reflects these challenges.
KSU is up over 15% Y/Y, despite the pandemic. Some of its rise could be due to optimism over a vaccine emerging or monetary stimulus from policymakers. Given potential headwinds, the stock remains a sell.
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