Warren Buffett and Berkshire Hathaway (NYSE: BRK-B) homed in on the railroad industry a few years back, admitting they were arriving a bit late to the party. In the words of Buffett's colleague Charlie Munger:
We should have done it two years ago, but we were too stupid. ... There's a German saying: Man is too soon old and too late smart. We were too late smart.
As they say, however, better late than never. That was in 2007, and since then the major railroads have turned in some impressive results. None has measured up to the stock performance of Kansas City Southern (NYSE: KSU), though. Let's take a look at the star performer of this sector to shed some light on its upcoming earnings announcement.
What's past is prologue
Although Berkshire acquired Burlington Northern Santa Fe as a value play in the railroad sector, Buffett overlooked the growth story that would emerge from smaller rival KSU. The regional carrier has generated massive returns for shareholders, outperforming its peers and the broader S&P 500 over the past decade.
Kansas City Southern Stock Chart by YCharts
The railroads depend heavily on the economy to dictate demand, and all of the stocks took a notable hit during the recession. Besides that brief pullback, however, the upward trajectory of the largest public rail carriers has rarely faltered. KSU leads the pack, posting a 456% return over the past decade, almost doubling the average of the other three carriers.
Buffett targeted the railroads because he believed a significant competitive advantage existed over other transportation methods. Through an effective system of fuel surcharges, the railroad industry has been able to avoid the margin squeeze that can weigh heavily on competitors in the trucking and airfreight industries.
How KSU measures up
The smallest of the Class I railroads, KSU maintains only 3,200 miles of track in the central and southern U.S. Competitors CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC) maintain approximately 21,000 miles primarily on the East Coast, and Union Pacific (NYSE: UNP) operates on 32,000 miles of track laid out on the West Coast. KSU pales in comparison to these larger players.
Despite its smaller network, KSU benefits from critical routes that connect Midwestern cities and extend all the way down through Mexico. The ability to deliver goods to and from both coasts of Mexico and tap into the major market of Mexico City positions KSU as an integral part of the NAFTA trade routes. Mexico offers significant cost advantages for manufacturing and possesses substantial natural resources, and thus will likely remain a key U.S. trading partner. Expect KSU's connections beyond the border to continue driving revenue and earnings growth.
What to expect going forward
Analysts' average prediction for revenue at KSU stands at $579 million for the quarter and $2.12 billion for the year. These figures represent potential top-line growth of 14.9% on a quarterly comparison and 16.7% on an annual basis. Over the past five years, KSU has outpaced its peers with revenue growth of 6.1% versus an average of 3.7% from the carriers noted above.
On the earnings side, the average analyst estimate calls for profit of $0.79 per share from KSU, an increase of 27.4% from quarterly earnings a year ago. For the full year, analysts are predicting earnings of $2.86 per share, which would imply year-over-year growth of 38%. For some perspective, KSU has topped analyst expectations by an average of 4.35% in each of the past four quarters.
In an age-old industry, such strong earnings growth would seem rare, but operators like KSU are at the top of their game. While KSU's top line grew more than 22%, the driving force behind earnings has been margin improvements made over the past few years. Forced to reduce overhead during the downturn, the railroads emerged leaner and were able to ramp up volume while adding only minimally to the cost structure. The result has been expanding profit margins and a boost in shareholder returns.
Foolish takeaway
Investors should stay tuned for earnings results from KSU and competitors CSX and Norfolk Southern early this week. In my opinion, all of these operators are poised to benefit from a steady U.S. economic recovery, and it's not too late for investors to hop on for the ride. Furthermore, investors should pay particular attention to the outlook provided by these railroads. Railroad demand forecasts serve as a leading indicator for the broader economy.
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