Heading into 2018, Kansas City Southern (KSU) looked poised for a great year, as it posted record results thanks to increasing U.S.-Mexico border traffic and new tax rates that are very favorable to railroad companies. While the company continued to see increasing rail traffic in key segments like refined petroleum products, it hit a few cost snags that weighed on the bottom line.

One word that kept coming up in Kansas City Southern's earnings -- and other railroad companies' reports lately, too -- is "congestion." Is this just a one-time thing, or are there some underlying issues with rail companies right now? Let's take a look at Kansas City Southern's most recent earnings results and what trends investors should be watching for the rest of 2018.

rail switching station at sunset.

Image source: Getty Images.

By the numbers

Metric Q1 2018 Q4 2017 Q1 2017
Revenue $638 million $660 million $609 million
Operating income $218.7 million $422 million $210.7 million
EPS (diluted) $1.40 $5.33 $1.38
Free cash flow $16.4 million $157 million ($32.8 million)

Data source: Kansas City Southern earnings release. EPS = earnings per share.

Kansas City Southern's results were a bit of a mixed bag this past quarter. On the one hand, revenue was up compared to this time last year from higher volumes across its entire network. That, combined with the lower tax rates it now pays, resulted in a modest improvement in net income. 

(Don't even bother trying to make a comparison to the prior quarter -- there were too many one-time gains to make an apples-to-apples comparison.)

Looking at the breakdown of the company's various revenue segments, the two parts of the business that declined were agriculture and energy. More specifically, coal was the only commodity that posted a significant decline. While management expects coal shipments to keep falling in the foreseeable future, shipments of fracking sand and crude oil via rail should continue to pick up and offset coal's weakness.

KSU revenue by business segment for Q1 2017, Q4 2017, and Q1 2018. Shows modest gains with the exception of Agriculture and energy segments.

Data source: Kansas City Southern earnings release. Chart by author.

On the other side of the coin, Kansas City Southern's cost increases outpaced its revenue growth such that margins contracted slightly and net income actually declined. Higher fuel costs, depreciation, and higher compensation costs ate into the bottom line, along with some changes in foreign exchange rates. The company's operating ratio -- the all-important efficiency metric for the railroad industry -- ticked up to 65.8%.

Were it not for the lower tax rate and the 3.6 million shares management repurchased since this time last year, earnings per share would have been considerably lower. 

What management had to say

One of the other reasons that Kansas City Southern's results weren't as robust as some might have hoped is that there have been some signs of capacity constraints and congestion across the North American rail system. As part of his prepared remarks, CFO Mike Upchurch acknowledged that these congestion issues impacted the bottom line, but expects that situation to improve throughout the year: "The North American Rail network congestion did impact both revenues and operating expense during the quarter. Congestion affected primarily our cross-border business as cycle times slowed and we experienced some challenges positioning equipment in and out of Mexico."

Apparently, this congestion issue is a big enough deal that Chief Transportation Officer Jeff Songer also weighed in:

Resources are at sufficient levels with respect to both crews and locomotives. Congestion in South Texas and Houston has had the most impact to operating performance during the quarter, but are starting to show signs of improvement. We do expect some lingering effects in the second quarter as fluidity in this region returns to normal. Congestion in this region also caused some expense inefficiencies during the quarter driven primarily by elevated recrews over time and car hire expense related to multilevel cycle time.

KSU Chart

KSU data by YCharts.

Is the railroad industry switching tracks?

It's clear, based on these statements, that management is trying to ease investor concerns that demand for rail is outpacing network capacity. Kansas City Southern isn't the first company to report higher costs related to congestion and capacity constraints, either. So this seems to be a trend that investors should perhaps keep an eye on throughout 2018. There are already signs that transport capacity in the trucking industry is showing some strain, which could lead to even more traffic trying to catch a ride on the rails as well.

If we are at a point where network capacity is stretched, then further cost increases are likely to continue. It could also mean that railroad companies will need to up their capital spending to expand their respective networks. In fact, we have already seen both Canadian National Railway and Canadian Pacific Railway increase their capital spending to boost capacity.

Investing heavily in capacity expansion may not necessarily be a bad thing in the long run, but it could mean that the generous share repurchases and dividend hikes that rail investors have become accustomed to might start to dwindle. This may not come to pass, and it's entirely possible that these congestion issues will abate in the second quarter as management suggests, but it is a trend that investors in Kansas City Southern and other railroads should keep tabs on for the rest of the year.