KCS 3Q2020 ‘Demonstrates Resiliency’ (UPDATED)

Kansas City Southern, the first Class I railroad out of the earnings report gate, took a revenue hit based on a carloadings drop, yet managed to post a 58.8% quarterly operating ratio. KCS also will initiate a $500 million share repurchase program on Oct. 16.

KCS reported revenues of $659.6 million, a decrease of 12% from third quarter 2019. Overall, carload volumes were down 4% compared to prior year, “driven by a decline in demand due to COVID-19 and lower commodity prices, lower fuel surcharge, and unfavorable foreign currency impacts.”

Third-quarter operating expenses were $388.1 million. Operating income was $271.5 million and the reported operating ratio was 58.8%. Third-quarter net income was $190.2 million, or $2.01 per diluted share. Adjusted third-quarter operating income, net income and diluted earnings per share were as follows:

“As KCS’s outlook improves, the Company has updated and improved elements of its 2020 guidance,” KCS noted. “The Company now expects adjusted diluted EPS to be slightly higher on a year-over-year basis, and the full-year 2020 adjusted OR to be on the low end of the 60% to 61% range. Additionally, previously provided 2020 capital expenditure guidance remains $425.0 million or below. Guidance for 2021 and 2022 capital expenditures remains at ~17% of revenue. Finally, the Company expects free cash flow to be approximately $550 million in 2020, and intends to enter into accelerated share repurchase agreements on or around Oct. 16, 2020 for the repurchase of approximately $500 million of its outstanding shares of common stock. This will be executed under the Company’s $2 billion share repurchase program announced on Nov. 12, 2019.”

“Kansas City Southern’s strong third-quarter results demonstrate the Company’s resiliency and the tremendous discipline and focus of our workforce,” stated President and Chief Executive Officer Patrick J. Ottensmeyer, Railway Age’s 2020 Railroader of the Year. “Our service was tested this quarter with an unprecedented volume recovery and two hurricanes that struck the heart of our network [on the Gulf Coast]. KCS responded by steadfastly executing the lessons learned in its Precision Scheduled Railroading (PSR) implementation, which included aligning resources with rapidly increasing demand while maintaining a keen focus on preserving efficiencies created from PSR principles.

“Our performance this year has been remarkable given the challenges we have faced. This strong and sustainable operational performance has given us confidence to reintroduce elements of our guidance. Our outlook has improved for adjusted operating ratio, free cash flow and adjusted diluted earnings per share, and the Company is positioned to deliver superior growth and customer service.

“It is from this position of solid financial performance, confidence in the sustainability of our operations, outlook for our business and our outstanding liquidity and financial position that we announce our intent to enter into a new $500 million accelerated share repurchase.”

KCS Statement Regarding Non-GAAP Financial Measures

In addition to disclosing financial results in accordance with U.S. GAAP, KCS’s 3Q2020 earnings statement contains non-GAAP financial measures. KCS management said it “believes that certain non-GAAP financial measures used to review and in certain cases manage the Company’s business fall within the meaning of Regulation G (Disclosure of non-GAAP financial measures) and may provide its users of the financial information with additional meaningful comparison when reviewing the Company’s results. KCS management uses non-GAAP information in its planning and forecasting processes and to further analyze its own financial trends and operational performance, as well as making financial comparisons to prior periods presented on a similar basis. Management believes investors and users of the Company’s financial information should consider all of the above factors when evaluating KCS’s results. These non-GAAP measures should be viewed as a supplement and not considered a substitute for GAAP measures. Some of KCS’s non-GAAP measures may differ from similar measures used by other companies, even if similar terms are used to identify such measures.”

THE COWEN INSIGHT

“The positive volume turnaround is occurring at a fast pace, which should lead to higher operating leverage once the company works past some service disruptions caused by a confluence of an active hurricane season, an abrupt traffic improvement, and a hard-to-predict macro environment,” said Cowen and Company analysts Jason Seidl (Managing Director and Railway Age Wall Street Contributing Editor), Matt Elkott and Adam Kramer.

Among their key takeaways:

• “KSU [Kansas City Southern] reported adjusted EPS of $1.96, just above our $1.95 estimate and ahead of consensus of $1.89. Operating income decreased 7% y/y to $272MM and was below our $280.5MM estimate but above the Street forecast of $264.4MM. Revenue declined 12% to $659.6MM, below our $676.9MM estimate but largely in line with consensus. Despite the revenue decline, the operating ratio (OR) improved ~190bps y/y to 58.8%, just 20bps worse than our projection but 110bps better than the Street.

• “The volume decline decelerated significantly in the quarter, with traffic coming in 3.6% below last year, following a 21.4% y/y decrease in 2Q20. Importantly, volume trends improved progressively throughout 3Q20; and our model projects continued improvement followed by 7% growth next year. The likely growth drivers include cross-border traffic, such as intermodal and autos; grain; and refined products.

• “In the third quarter, the volume recovery did not occur without service hiccups that were caused by a very busy Gulf Coast hurricane season and a hard-to-predict macro environment. While train velocity improved 4% y/y, it deteriorated 15% sequentially. Dwell time deteriorated 13% sequentially and y/y. Once we move away from the violent swings in demand to a more normalized growth environment, we would expect to see solid gains in service measures at KSU.

• “We adjust our 2020 and 2021 EPS estimates to $7.05 and $8.50 from $7.00 and $8.40, respectively, the result of the slight 2Q EPS beat, improved volume outlook, and other model fine-tunings. We are also introducing our 2022 EPS estimate of $9.65, which represents 14% growth. Our price target rises from $193 to $203 as we move to valuing the stock based on our 2022 EPS estimate (previously 2021) while lowering the multiple to 21x, from 23x. KSU continues to be our top rail pick, the result of the remaining cost reduction initiatives and numerous growth opportunities in Mexico and the Gulf Coast area. We should note that our recommendation of KSU does not include a potential take out scenario. While we cannot predict if a potential PE take out would occur as was previously reported by major news outlets, we still believe it could be possible.”