July 29, 2009

A Eureka Moment For Kansas City Southern (KSU)

Cyclical Short Term, Secular Mid Term, a Eureka Moment in the Long Term.

The mantra of efficient market proponents is that all known information regarding a corporation becomes quickly priced into a stock price.

Such disciples suggest one cannot consistently outperform, based upon information that the market already knows, except by luck.

I believe that there are two basic flaws in the efficient markets premise. The first issues lies in the fact that statistical analysis and forecasting cannot ably handle uncertainty.  Accordingly, analysts prioritize or triage information, largely based on short term valuation models.  A minor development in the near term carries infinitely greater weight for most analysts, as compared to a longer term development.  Secondly, efficient markets theorists tend to focus quite narrowly upon company specific information.  Unintended benefits or consequences from external sources, even if already in the public domain, generally fail to be taken into account.  Until such developments are conclusively linked to a specific company, external news will have virtually NO impact on statistical investment modelling.

However, on occasion, some investors correctly determine the impact of external developments on a corporation and its competitors. This flash of insight, completely overlooked by analysts and the investing public at large, is sometimes referred to as a "Eureka Moment".  It is my opinion; that the highly prized, greatly sought after, yet seldom found "10 bagger", arises from a Eureka Moment.

I believe that for Kansas City Southern Railroads (KSU-NYSE, $17.50); a Eureka Moment occurred in August 2008.

In a nutshell, a series of little known and relatively unreported tax changes, imposed by the government of California in 2008, may eventually result in wholesale change to the flow of imports throughout western and central United States.

In the long term, California's actions could result in some very detrimental unintended consequences for Burlington Northern (BNI-NYSE, $74.55) and Union Pacific Railroads (UNP-NYSE, $56.54).  My prediction is that the single greatest unintended beneficiary of the change in trade flows will be Kansas City Southern. A secular windfall could accrue in the longer term, for new shareholders of KSU.

Who is Kansas City Southern Railroads?

KSU is the smallest of the 7 class one railroads now operating in the North America.  Roughly 1/10 the size of Burlington Northern, Kansas City Southern is sometimes referred to as the free trade railroad.  Most of the major class one railroads operate a continental operation, traversing east to west. KSU, in contrast, runs their tracks from Mexico into the mid continental United States.

The company has been investing heavily to increase its Mexican-US freight business.

Capital expenditures of more than $1.26 billion have been made in the past 3 years.  As a percentage of revenues, this is almost 2X that of larger peers.

The average age of KSU's locomotive fleet is just 10.9 years, and is considered to be the most modern in the industry.  At year end 2008, KSU owned 5584 pieces of rolling stock, up by 86.5% since 2004. The rolling stock has been modernized, and is now among the youngest among railroads.

Total liabilities have risen sharply since 2004.  However, based upon all important ratios, it seems clear that Kansas City Southern has invested this capital to improve the long term competitiveness of the business.  KSU continues to grow its inventory of owned equipment, vs. leased. 

Other rails have had to allocate major capital to address chronically under funded pensions.  In contrast, KSU reports just a $28 million healthcare/pension shortfall, at year end 2008.

A major capital project is now turning to sales.

The Rosenberg line is now operational.  Completed for an estimated capital cost of $170+ million, the refurbished 70 mile line eliminates the need for KSU to use 160 km of heavily congested track owned by Union Pacific.  An estimated $18 million per annum in right of way charges and fuel savings will be generated.  Shippers will benefit from reduced transit times, which management anticipates will lead to increased business.  Full utilization of the line should reduce total annual operating expenses by about 1.2%. (Source)

A second major capital expense will be completed by 2010.

70% owned by Kansas City Southern, the 320 mile Meridian Speedway line is now in the latter stages of a $300 million refurbishment and expansion. The expansion capital is being fully funded by Norfolk Southern Railroad (NYSE-NSC, $36.54), in exchange for a 30% interest in the line.

By 2010, the Meridian line should be able to accommodate 45 trains per day, almost double the present amount.  Transit times by shippers throughout the south-central US will be reduced by about 7 hours.      KSU will not only save millions in operating expenses on their trains, it is possible that other class one rails will increase their use of the Meridian line, creating substantial right of way fees.

Completion of the major projects should reduce KSU's future annual capex by more than half.

After a four year period (2005-2009) where KSU invested an average of $350 million per year in capex, management now anticipates about $150 million per annum to sustain the business.  Any incremental spending in the future could be considered as potentially accretive for the top and bottom lines.

The recession cast aside certain views that railroads were positioned to manage the swings of the economic cycle.

Perhaps this would have been true during a soft landing, but the US economy recently experienced the largest economic dislocation since the recession of 1980.

All railroads were impacted.  Kansas City Southern was the hardest hit of all.  Investors who purchased KSU late in the last cycle suffered from a serious bout of unbridled enthusiasm.  Analysts placed far too much emphasis on the long term the free trade story, and ignored competitive forces in the transport sector.  It appears that they completely forgot about the cyclical nature of the business.

With greater financial leverage than larger peers, and a major capital works program in mid stream, KSU fell from a $5.5 billion market cap, all the way down to a small cap, within the past 52 weeks. The market cap reduction of more than $3.7 billion seems to have removed all but the most intrepid of shareholders.  Large cap mutual funds were forced to divest the shares based upon cap weight restrictions.  Mid cap funds were going through massive redemptions and could not add the stock to their portfolio lists.  Retail investors were largely overwrought.

Analysts have belatedly remembered the cyclical issues, and now appear to have discounted KSU as a cyclical recovery pick.

Just 15 months ago, KSU management was anticipating as much as $2.8 billion of annualized revenues in 2012.    EBITDA was anticipated to be as high as $1.17 billion in that year.  EBITDA margins were forecast to grow to almost 42%, up from the 30% level achieved in 2008. (Source)

Intermodal growth was forecast to be the main driver of revenue.  With the expansion of a key container port (Lazaro Cardenas) scheduled for the end of 2010, KSU was anticipating intermodal revenues to grow by almost $500 million through 2012.

Now, in the tail end of the current recession, KSU is now looking to generate possibly just $1.4 billion of revenues for 2009.  EBITDA might fall to as little as $400 million.

While existing KSU shareholders remain in shock, new investors may have a remarkable opportunity.

Business has fallen off by less than 25% since 2008.  EBITDA seems to have fallen off by about 30%.  By way of contrast, Kansas City Southern share values have declined by more than 68% from their 52 week high. The share price decline appears excessive.

With 90.75 million shares currently outstanding, KSU has a market cap of $1.58 billion.  Add to this the estimated total liabilities (less short term cash) of $3.1 billion, $216 million of preferred shares and the result is a current enterprise value of roughly $4.9 billion.

Kansas City Southern now has a "Made in California" secular benefit, to add to the cyclical recovery story.

1.  A sea change in the international shipping industry occurred in August 2008.

Little known to the general investing public, the State of California passed a series of levies and taxes.  The intended victims are Asian producers and shippers of consumer goods to the United States.  A series of new fees are now applied against international shippers.  Port charges again these shippers have gone up by 160% in California.

State port taxes and levies now add an extra $160 per TEU, to the basic container handling charge in California.

Until recently, Asian exporters had few cost effective alternatives to getting goods into the United States.  Consequently, California is earning taxation revenues that would be classified as confiscatory, and possibly illegal, by trading partners in other countries.  Expressed as a percentage of the cargo values, port fees, dwell fees and taxes at California ports now exceed 5%, a global high.

Domestic shippers and outbound freight are largely exempted from the new tariffs and fees, and have remained very quiet about the tax changes.  In the eyes of the legislative assemblies, this robbery appears to be a victimless crime.

2.  To add insult to injury, the Longshoreman's union is doing to the west coast port industry, what the automotive unions did to the domestic auto business.

Average cash wages for the typical West Coast longshoreman exceeded $138,000 in 2008.  This is the highest paying blue collar job in the world.  Over and above the exorbitant wages, benefits are second to none.  The union boasts full health care coverage without deductible, fully paid by the employer.  In total, the average wage and benefits package per full time longshoreman exceeded $179,000 in 2008. (Source 1, Source 2)

In order to pay such ridiculous sums, a total of 9000 containers per employee, per annum, must be processed. With net margins on container handling at ports average about 20% globally, it appears that the most recent longshoreman's contract will push the two ports into the red, when container volumes drop below 15 million TEU.

Based upon the extraordinarily high cost of labour at California ports, it appears that insufficient funds will remain for future modernization and expansion of Long Beach and Los Angeles.

The failure to reign in longshoremen's wages coupled with sharply increased shipping charges; has effectively priced California out of the international container business.

Unlike ports, vessels are mobile.  The great shipping conglomerates of Asia can and will change where they will ultimately unload freight, as soon as an alternative port becomes available.  Most of the Asian ships heading to the US come with fully loaded containers, and leave with empty containers.  They are no ties to keep the shipments flowing through the US west coast, if a viable alternative may be found.

All that shippers require is a deepwater facility with direct access to roads and rails, and California will stand to lose every bit of container freight that can't be directly consumed within the state.  More than 65% of total container volumes are at long term risk of displacement.

The long term economic risk to California cannot be understated.  1 million California jobs are directly and indirectly tied to the international shipping industry.

Highly efficient, cheap and modern port competition is now being built, due south of California.

Located on the Pacific coast of Mexico, Lazaro Cardenas is well positioned to become a key competitor to west coast container ports. The facility is managed by Hong Kong based Hutchison Port Holdings.  Hutchison has strong ties to both the shipping industry in general and Chinese exporters specifically.  Both moral suasion as well as preferred customer discounts can be applied, should Hutchison choose to divert freight from Los Angeles to their facility.

TEU charges are estimated to be $235 US at Lazaro.  This compares very favourably to the $901 per TEU total charge levied at Long Beach.

The average longshoreman at Lazaro Cardenas earns less than 1/10th the total pay and benefits package, as the typical California longshoreman.

In total, the total estimated costs to move freight from Lazaro to Chicago appear to be exactly 50% of the current charges being levied just by the ports in California.  Fees assessed by BNI and UNP to transport containers to end markets, widen the differential.  In the world of logistics, shippers will move business to generate a 1 or 2% net saving.  A 50% net saving represents an irresistible pull. (Source)

Lazaro's expanded operation will be highly automated.  It will also be considerably more efficient than any US West coast port.  Dwell times are now almost non existent at Cardenas, while ships may wait 3-6 days at Long Beach to unload freight.

Over and above the compelling cost advantage, Cardenas also offers many strategic advantages over Los Angeles.  At 60 feet of depth, Lazaro Cardenas is the deepest port on the Pacific Ocean.  Being 7 feet deeper than the port of Los Angeles, this Mexican port is better able to handle the newest generation of container vessels.  (Source)

Cardenas is ideally situated to capture Asian goods destined for the US Midwest and south, such as Chicago, Kansas City and Houston. 

The port is quite new, and just in the first stages of start-up. In 2005, the port handled just 150,000 TEU.  Current volumes are running at 220,000 TEU per annum.

The first expansion will allow for a total of 2.2 million TEU per annum to be processed.  At full capacity over 4 million TEU annually may be handled. (Source 1, Source 2, Source 3)

California risks becoming an "also ran" in international trade.

While confronted with incontrovertible and irrefutable logic supporting large scale shipment diversions out of California, US detractors of Lazaro Cardenas remain dismissive.  They note that Lazaro Cardenas has been operating for a few years now, and hasn't pulled much freight away.  In reality, Lazaro was simply constrained by size.  The limitations will be removed in late 2010.

Status quo arguers further fail to acknowledge the economics of dropping containers into California have deteriorated, on a more or less permanent basis.  West coast ports have been unable to wrestle down longshoreman costs, which have now spiralled out of control.  Refusing to acknowledge the economic rationale for shippers changing ports won't stop it from happening.

And what makes things worse, is that a cash strapped government is no longer working to preserve the strong monopoly position of Long Beach/Los Angeles.  The state has actually put into action, a series of taxes that will ensure an increase in competition.  Everyone with a vested interest in preserving the ports appear to be working towards their demise.

Asian shippers are pragmatic.  Rather than complain to deaf ears, they will simply work to bypass California completely.  When Lazaro Cardenas and Punta Colonet (another proposed Mexican port) are fully operational, international shipping companies will save billions of dollars annually.

Lazaro Cardenas will benefit, as will all of Mexico.  So too, will Kansas City Southern Railway.

I have gently probed industry sources for several months, and have determined that the investment industry is completely apathetic to California's actions.

Not a single analyst has publicly questioned Kansas City Southern management since August 2008, regarding the change in California port charges.  Also, to my knowledge, after having listened to the many conference calls held by BNI and UNP since that time, it appears that not a single buy or sell side analyst has queried the competition about the development.

I have also spent some time diligently assessing the average retail railroad investor for their opinions, and found that they were:

a. Uniformly unaware of the tax changes.
b. Largely disinterested as to the long term ramifications.

Perhaps the largest potential driver of future revenue growth at KSU appears to be virtually unknown, and largely scoffed at, by those who should be highly attuned to the industry.  As a long term investor, I couldn't be more excited by the collective inattention.

If Kansas City Southern can increase its intermodal revenues from the Mexican port, revenues and EBITDA could soar.

In 2008, a whopping $2.5 billion, or 14% of 2008 Burlington Northern's total revenues, came from international container freight transport.  When combined with domestic container movements, BNI generated almost 34% of total revenues from container and auto hauling in 2008.

In 2008, roughly $1.3 billion, or 7% of UNP's total revenues came from international container freight transport.  When combined with domestic movements, Union Pacific generated 18% of revenues from container transport.  A further 8% of UNP revenues were earned through automotive transport.

In sharp contrast, Kansas City Southern generated just 9% of 2008 revenues from container transport.  Automotive transport accounted for just 6% of 2008 revenues. In 2008, container and auto intermodal revenues at KSU totalled $266.2 million

Should my long term thesis prove to be correct, roughly $2.5 billion of BNI and UNP's international container freight volumes could be displaced, in the next decade.  This is more than 25X KSU's current international container revenues. Kansas City Southern may not get all of my forecast revenue displacement, but they should certainly obtain some.

The woes of the auto industry also may have some unintended benefits for KSU.

In the near term, auto hauling is down sharply throughout North America.  This is due to declining sales.  I consider this purely temporary. At some point, sales should recover.

A long term windfall may accrue for railroads that specialize in moving imports. An estimated 1900 auto dealer franchises will be cut loose by the big 3 domestic producers.  GM, Ford and Chrysler "hope" these dealers will simply close up shop.  I consider this to be a naive assumption.  If the domestic big 3 thought that cutting loose a highly sophisticated network of dealers was a good thing, they will be sadly mistaken. 

A likelier event; at least half or more of these dealers will simply switch nameplates.  Penske Auto Group for example, has purchased 350 dealers to maintain the Saturn brand.  Penske now wants to add a foreign product (products) to build out the Saturn name. China has been looking for entry to the United States with their many car brands.

In years to come, I predict that the big 3 will dearly regret the decision to simply pull franchises, rather than buy them out and close them down.  The most logical outcome of the planned dealership reductions is that a host of inexpensive foreign products will be unleashed on North American shores soon.  The Chinese needed a distribution network, and many are now available.  North American dealers are used to a great deal of service revenue, so they will have no problem selling cars with perceived low initial vehicle quality.

Chinese autos will be low cost, so the shipping costs need to remain low.  Los Angeles and Long beach has priced themselves out of the Chinese market with their recent moves.  Mexico, with port charges just 26% that charged by the US west coast, seems to be the only logical choice.

Anecdotal evidence of the foreign car growth potential is already in the markets.  KSU has just announced a new venture with Nissan.  The goal is to beef up the flow of imports to the US. (Source)

My belief is that we are now in the nascent stage of a new economic cycle.

Market opinions are divided, as they should be. When investors are uniformly bullish or bearish, this is a sure sign of trouble. Currently, many consider the stabilization of a deteriorating US economy to be just a double dip.  Alternatively, some consider the stimulus packages to be the priming of the pump.

According to my data, the economic downturn was exacerbated by machinations of financial service firms, and would have conceivably been quite an ordinary recession at best...perhaps even a soft landing.  Therefore, the upside in the mid term could be pretty impressive, should consumers regain confidence.

I am not a market timer, and always run the risk of overpaying in the short run.

In the earliest part of a new economic upswing, deeper cyclicals tend to produce their absolute worst fiscal results.  Accordingly, these companies often look historically expensive, and therefore miss the numerous value screens now in use by retail investors.  The second quarter now ended could be the trough for rails, which will make the entire industry look more expensive than at any time in the last 5 years.  However, when compared to the last economic bottom, I consider this entry point to be cheap.

It is my intention is to increase Kansas City Southern to a core weight holding in RMG#1

While the balance sheet of KSU is the most leveraged among class one railways, liabilities have gone towards went towards building a better railroad, not paying out legacy retiree benefits.  The benefits of aggressive capital spending will be enjoyed in the next up cycle. With one of the newest engine and rolling stock fleets in the industry, and cost savings starting now on completed capex, KSU would potentially generate more than $650 million of EBITDA in 2012.  If the markets eventually value KSU at a 10X EV/EBITDA multiple in that year, shareholders could potentially double their money from here. 

A three year potential double, based upon a cyclical recovery in North America would be adequate compensation for my time.  If the secular trend does start to play out as planned, potential revenue and EBITDA growth could be far more dramatic.

By 2015, KSU could certainly generate the $2.8 billion of revenues originally forecast by management for the 2012 period.  If, by 2015, EBITDA surpasses $1.17 billion, a 9X EV to EBITDA multiple could value the shares at $75.

RMG#1 is a predominantly large cap, globally themed portfolio seeking to benefit from global secular trends.  A very small initial position was started in KSU a few months ago, while I began assessing the potential impact of the Californian tax decisions.  After considerable reflection, I will be comfortable increasing the holding to a 3%-5% market weight position.  I also own shares of Kansas City Southern personally.

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