With market speculation rife that railroad Kansas City Southern (KSU) is generating intense buyout interest, the stock price was always likely to be volatile around its earnings report. However, instead of speculating on a bid, or even a rebid, let's focus on what makes the stock attractive to potential investors. There's a lot to like about the company, and the recent third-quarter earnings help to highlight that.

Key takeaways from Kansas City Southern earnings report

There are three things that investors need to focus on, and there was good news on all fronts in the report.

  • Railroad revenue tends to correlate with the industrial economy at large, and there's clear evidence of improvement in many of Kansas City Southern's end markets;
  • The company's precision scheduled railroading (PSR) initiatives continue to bear fruit and enhance the company's long-term earnings potential; and
  • The company-specific growth drivers, such as exposure to cross-border trade with Mexico and winning market share from trucking, appear to be on track.

End markets improving

The company's revenue declined 12% on a year-over-year basis in the quarter as carload volumes fell 4%. However, under the circumstances it's actually a pretty decent result. To put it into context, management disclosed that carload volumes ended the third quarter some 60% up from the trough in early May. Moreover, there was a whopping negative-10% impact to revenue from unfavorable foreign exchange movements in the quarter.

A freight train.

Image source: Getty Images.

As you can see below, only chemical and petroleum products (led by strong growth in refined products) and intermodal (led by e-commerce) grew carload volume over the third quarter of 2019, but all of the business groupings grew carloads over the second quarter of 2020.

In particular, automotive and intermodal carload volumes had strong sequential growth as automotive production plants reopened, and e-commerce volume remains in strong growth mode.

Kansas City Southern carload volumes.

Data source: Kansas City Southern presentations.

Precision scheduled railroading

All the listed Class 1 railroads are adopting PSR initiatives in order to try and improve their operating ratios (OR) -- meaning the ratio of operating expenses to revenue, with a lower number being better.

In a nutshell, PSR is a set of management techniques designed to improve the productivity of a railroad by running trains between points within the network on a fixed schedule rather than the traditional hub-and-spoke model.

Despite the headwinds created by the COVID-19 pandemic, Kansas City Southern continues to make good progress on reducing its OR. Following the horror show of the second quarter, management managed to significantly reduce OR in the third quarter on a year-over-year and sequential basis. Moreover, management updated full-year guidance for the OR to be at the low end of the 60%-61% range originally given in January.

Kansas City Southern operating ratio.

Data source: Kansas City Southern presentations.

Company-specific growth drivers

During the earnings call, Chief Marketing Officer Mike Naatz highlighted the strength of the railroad's cross-border business, saying: " cross-border franchise volumes were up 10%, demonstrating the unique role that we play in facilitating trade between the U.S. and Mexico. The Mexico energy-related business rebounded with revenues rising 17% and a 34% increase in volumes."

U.S. and Mexico flags together.

Kansas City Southern benefits from growing U.S./Mexico trade. Image source: Getty Images.

In addition, Kansas City Southern runs refined products into Mexico from the U.S., and in that business, "[y]ear-over-year, third quarter revenues were up an impressive 55%, and a 61% increase in carloads."

Moreover, cross-border automotive, grain, intermodal and manufacturing product carloads are expected to improve in line with the economy. Kansas City Southern also has a long-term opportunity to grow if reshoring accelerates in line with Trump administration's aims.

Looking ahead

All told, the railroad's end markets appear to be improving, and management continues to reduce its OR as a consequence of its PSR initiatives. Management expects $550 million in free cash flow for 2020, a figure more than 3.6 times its dividend payout of around $150 million or $1.60 per share.

As such, the stock remains a useful, if slightly pricey, option for investors looking for a relatively safe long-term stream of dividends.