For all the talk about trade wars, you certainly wouldn't know it from U.S.-Mexico border railroad Kansas City Southern's (NYSE:KSU) most recent earnings results. The company posted a 19% year-over-year increase in cross-border volumes to post a record revenue rate for the second quarter. According to management, it appears that these trends will continue for some time based on the investments both it and other companies are making on both the U.S. and Mexican side of the border.
Here's a brief look at Kansas City Southern's most recent results and whether future tariffs or other trade-related issues could take a bite out of its business in the future.
By the numbers
|Metric||Q2 2018||Q1 2018||Q2 2017|
|Revenue||$682 million||$638 million||$656 million|
|Operating income||$245.8 million||$218.7 million||$239.3 million|
|Free cash flow||$25.2 million||$16.4 million||$112.3 million|
Overall, Kansas City Southern's revenue grew by 4% compared to the prior year. By railroad standards, that is considered OK but not good. It certainly doesn't merit a celebration of booming cross-border trade -- that's for sure. However, the gains in revenue came almost exclusively from cross-border traffic sectors while the declines came from lower coal shipments and fracking sand that remained in the country, which fell 39% and 25%, respectively. The closure of a Texas coal power plant and an increasing amount of fracking sand coming from local suppliers have drastically cut demand for these particular services.
The driving forces behind the company's revenue increases came from its chemicals and petroleum and automotive segments, both of which gained 14% and 17%, respectively. Energy and petrochemical consumptions are two segments that are likely to remain robust as crude oil and natural gas production in the U.S. continue to surge and exports of refined products to Mexico go up. The one question mark will be whether these automotive gains will hold if the Trump administration decides to enact the proposed tariffs on autos and car parts.
On the operational side of the business, increasing fuel and material prices were the big factors driving up costs and increasing the company's operating ratio to 65%. For the most part, fuel costs will get passed on to the customer, but management is also looking to lower these expenses by investing heavily in updating its locomotive fleet and capacity. In 2019, management intends to purchase 50 new locomotives to retire 30 in its existing fleet and reduce the number of locomotives in its fleet that are on lease. These new locomotives are more fuel efficient than their predecessors and should help to at least mitigate increasing fuel costs.
It should also be noted that there was a $35 million foreign exchange impact on earnings compared to this time last year. Adjusting for these foreign currency effects and some early debt retirement costs, earnings per share were $1.54.
What management had to say
In the press release, CEO Patrick Ottensmeyer's outlook for the company was as optimistic as the 19% volume increase this past quarter.
We persevered through volume headwinds from utility coal and a challenging FX [foreign exchange] environment impacting Mexico international intermodal business, to deliver topline growth from five of six business units, record franchise cross-border revenue and record adjusted diluted earnings per share. As we move into the second half of 2018 and 2019, we expect volume growth to accelerate, benefiting from a strong economy, network capacity investments and commercial opportunities that are unique to the KCS franchise.
Lots to disrupt before tariffs and trade can impact the bottom line
Any investment that involves the words "international" and "trade" prominently are going to carry a bit of a stigma with them as long as there is constant news about tariffs and trade wars with countries that we didn't really think were imaginable just a few years ago. However, if you follow the money of investments in cross-border trade with Mexico, it's pretty clear that it will be incredibly hard to upend the trends working in Kansas City Southern's favor. Customers have invested directly in more than 20 new railroad spurs on both sides of the border to grow in the booming trade for energy and other industries that have integrated operations on either side of the Rio Grande.
It's not out of the question that automotive tariffs could have a substantial impact on Kansas City Southern's business, but it's hard to speculate exactly how much it could impact the bottom line. Considering that it is only one of the railroad's growing business segments, it's looking as though trade fears aren't a huge deterrent for this company. For investors, that could be a chance to take advantage of other's fears as Kansas City's stock currently trades at a reasonable enterprise value-to-EBITDA ratio of 11 times.