Drip Portfolio Report
Monday, September 22, 1997
by Randy Befumo (TMF [email protected])

ALEXANDRIA, VA (Sept. 22, 1997) -- Although this may prove somewhat confusing in the midst of Jeff's analysis of various healthcare companies under consideration, today, as promised, I wanted to begin looking at KANSAS CITY SOUTHERN (NYSE: KSU). Rather than duplicating each another's analysis, Jeff and I have decided instead to look at different companies initially, consult the other when done, and then make the final decision. It is this approach that we hope will give readers the best education in financial analysis -- our real goal here, along with beating the market.

For the Drip Portfolio, Kansas City Southern poses a number of interesting problems, including determining whether or not it is substantially undervalued, figuring out if it is if worth investing in before the separation of the railroad and financial asset management business, and finally comparing the opportunity afforded by Kansas City Southern with the many other companies that compete for our direct investment dollars. As the first company we have looked at that is considering a spin-off, navigating these treacherous waters together will hopefully help readers perform the same analysis for other companies in similar situations. Today we will focus on Kansas City Southern's railway operations, describing them in some detail and isolating key aspects of their financials.

Kansas City Southern is a holding company that owns the Kansas City Southern Railroad (KCSR) as well as having substantial Financial Asset Management operations. KCSR consists of 2,739 miles of main and branch track and 1,106 miles of "other" track in nine states, specifically Missouri, Kansas, Arkansas, Oklahoma, Mississippi, Alabama, Tennessee, Louisiana and Texas. The company also owns part of the Kansas City Terminal Railway Co. as well as more than 167 miles of other track where other railroads are the main partners. In addition to KCSR, the holding company also has other railroad operations, including 49% of Mexrail, a holding company that controls the Texas Mexican Railway Company; 49% of Transportacion Ferroviaria Mexicana, which is purchasing 80% of a concession that will allow it to run Mexico's Northeast Railway; and 100% of Gateway Western Railway Company, which runs between Kansas City and East St. Louis and Springfield, Illinois.

Although we will return to the problem of valuing the unconsolidated subsidiary railways when we deal with Kansas City Southern's miscellaneous grab-bag of businesses, right now we will only focus on the revenues and earnings that come from the consolidated railroads -- KCSR and the Kansas City Terminal Railway Company. We will need to get the revenues, the operating earnings, and the depreciation and amortization costs for the company in order to examine its current valuation on an absolute basis and to compare it against the valuation of other substantially similar railroads.

From the most recent 10-K for fiscal 1996: 

                                 1996
Revenues
 KCSR                      $ 492.5 million
Operating Income
 KCSR                      $  74.1 million

From the June 30, 1997 10-Q:
 
                              Six Months
                            Ended June 30,
                            1997      1996
Revenues:
 Transportation             $274.2    $260.6
Operating Income:
 Transportation             $ 28.1    $ 26.9

From these numbers, we can figure out the results for the last four quarters for KCSR. All we need to do is find out the difference between the revenues and earnings from the current six-month period and last year's equivalent six-month period and add this difference to the total for all of 1996. For revenues, we take $274.2 and subtract $260.6 million, getting $13.6 million. For income, we take $28.1 million and subtract $26.9 million, ending up with $1.2 million.

Now that we have the differences, we just add these to the 1996 numbers and come up with revenues of $506.1 million ($492.5 million plus $13.6 million) and operating income of $75.3 million ($74.1 million plus $1.2 million). From this, we know that KCSR has generating pre-tax, pre-interest operating margins of 14.9%. Now, all we need is depreciation and amortization costs for the railroad to figure out the earnings before interest, taxes, depreciation and amortization (EBITDA). This number, also know as cash flow, is how railroads get valued because of the rather high depreciation and amortization expenses.

From the 10-K, we find that depreciation and amortization for KCSR was $59.1 million. In the 10-Q for June 30, we find that for the six months, depreciation and amortization for KCSR was $27.3 million versus $29.5 million last year. By doing the same math described above, we get a difference of -$2.2 million (or a negative $2.2 million), meaning that we subtract this value from 1996's depreciation and amortization to find out that current trailing 12-month depreciation and amortization is $56.9 million. Adding this to the operating income (which is pre-interest and pre-tax), we now know we have EBITDA of $132.2 million for the trailing 12-month period.

Tomorrow, we will learn how to use EBITDA and revenues to value the railroad component.