Rail shippers are one of the few industries benefiting from higher energy prices. That's because rising crude and gasoline prices have caused many companies to switch from trucking to more cost-effective rail services to ship their goods.
That fundamental shift in the shipping landscape has been a big boost for the entire rail shipping industry during the past three years, with leading rail shippers like Union Pacific Corp. (NYSE: UNP) and Norfolk Southern Corp. (NYSE: NSC) both trading at all-time highs on record earnings.
But there is one company that has and will continue to benefit more than its peers. Both sales and earnings of this little-known rail shipper have exploded in the past three years, lifting its share price more than 220% during that time.
Kansas City Southern (NYSE: KSU) is a rare mid-cap rail shipper valued at $8 billion in an industry that is dominated by giants like Canadian National Railway Co. (NYSE: CNI) and CSX Corp. (NYSE: CSX), which are valued at $39 billion and $24 billion, respectively.
Even though Kansas City Southern has seen sharp gains in the past few years, the company and its stock price should continue to benefit from the long-term trend in rail shipping, its key trade routes, unique size and a compelling valuation.
The bull case for KSU
One of the most compelling aspects of Kansas City Southern's business is its key shipping routes in Central America and the Gulf of Mexico. Kansas City Southern operates rail routes between Kansas City, Mo., and a number of ports along the Gulf of Mexico in Alabama, Louisiana, Mississippi and Texas. It also operates direct rail passages between Mexico City and Laredo, Texas, servicing a string of Mexico's industrial cities and three seaports. Finally, the company has a license to operate a 47-mile railroad that is adjacent to the Panama Canal.
The geography of Kansas City Southern's rail network is important because it enables the company to take advantage of growing trade volumes between Central and South America. And that definitely includes Mexico, Latin America's second largest economy and a key trading partner for the United States. Looking forward, as global trade between developing and emerging economies grows, Kansas City Southern will be uniquely positioned to benefit.
Kansas City Southern is also unique because of its relatively small size as a mid-cap in an industry dominated by companies with market caps north of $30 billion. Industry consolidation has been driven by scales of economy, where larger shipping networks enable companies to reduce expenses. That makes Kansas City Southern a very attractive takeover target for a larger rail shipper looking to cash in on its key routes in the Gulf of Mexico and Central America.
That trend of bigger companies scooping up smaller players was on display in July when micro-cap RailAmerica (NYSE: RA) fielded a buyout offer from Genesee & Wyoming (NYSE: GWR) at a 27% premium to its closing price on the day the offer was announced in July.
Furthermore, Kansas City Southern operates in an industry with very high barriers to entry. This is the exact reason that Warren Buffett sunk $34 billion into Burlington Northern in 2009 in what he called a "100-year investment." The cost and high barriers to entrance should help keep Kansas City Southern protected from new competition.
In spite of industry and company strength, Kansas City Southern still trades at a discount to historical levels with a forward price-to-earnings (P/E) ratio of 21 times, below its 10-year average of 24. And although that is higher than the industry average of 16, it's still a great deal for a mid-cap growth stock that is a potential takeover target.
Risks to Consider: One area of weakness in rail shippers has been with coal volumes. As one of the country's leading sources of energy and electricity, coal has traditionally accounted for a large portion of shipping volumes for rail shippers. But as power plants increasingly shift to natural gas and other alternative sources of energy, coal volumes have slumped. Although Kansas City Southern still beat second-quarter expectations, lower coal volumes will be a headwind.
Action to Take --> Kansas City Southern is a rare mid-cap in a field of mega-caps. The company has rail networks into key Gulf of Mexico routes that offer access to Central American markets, is a potential takeover target, and trades with a compelling valuation. Using Rail America's 27% premium as a benchmark, shares of KSU could easily jump more than 20% on news of a takeover bid from a larger competitor.