Neutral on Kansas City Southern - Analyst Blog

We reiterate our long-term Neutral recommendation for Kansas City Southern (KSU), which implies the stock will perform mostly in line with the broader market. The company's third quarter 2010 net earnings soar, easily beating the Zacks Consensus Estimate.Improvement in business volumes, effective cost control measures, and solid pricing environment are the primary reasons for this excellent result.

During the third quarter of 2010, Kansas City Southern achieved several operating milestones. Quarterly operating ratio was 73.5% compared to 78.3% in the prior-year quarter. Total business volume in the reported quarter was 459,400, up 9% year over year. Operating income in the same quarter was $116 million, up 38.3% year over year.

All these results were achieved in spite of facing a devastating Hurricane Alex in the Mexican cost that resulted in the third quarter revenue loss of $33 million and negatively affected earning by 14 cents per share.

An improving U.S. economy, surge in automotive shipments, and a rebound in many of the company's end-markets will help in sustaining its businesses in the long run. Mexico has become a huge growth engine for the company.

Management is expecting the revival of the Mexican economy will generated low double-digit top-line growth in 2011. Furthermore, labor cost in Mexico is much cheaper than the U.S. which will also boost the company's bottom line.

Nevertheless, railroads are subject to the ratification of laws by Congress that could increase regulation of the industry. A recent report presented by the U.S. Senate Commerce Committee stated that the discretionary pricing power enjoyed by the Class I freight rail transport companies are putting excessive pressure on freight customers.

The committee has decided that the railroads have become financially stable and a higher transportation rate is actually impacting household budgets. It remains to be seen how the railroad industry maintains growth if any adverse changes occur related to its discretionary pricing policy.

At the same time, the stock price has moved up by nearly 71% in the last year. According to our assessment, current valuation is fairly reflecting all the positives leaving little room for above market gain. Kansas City Southern competes with other freight railroad operators in the U.S. like Union Pacific Corp. (UNP), CSX Corp. (CSX), and Norfolk Southern Corp. (NSC).

 
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