Since I put out my cautious piece on Kansas City Southern (KSU) 116 days ago, the shares are up about 36% against a gain of 19% for the S&P 500. In this article I want to work out whether my earlier caution was justified or not. I’ll try to answer whether the shares currently represent good value by looking at the state of the business, by reviewing the financial statements and by looking at the stock as a thing distinct from the actual business. I should also update investors on the options trade that I recommended in my previous article.
As usual, I’ll express my thesis statement up front for those who missed the title of this article and who also skimmed past the bullet points above. If you don’t want me to spoil the surprise, dear reader, please skip this paragraph. I’m assuming that if you’re still reading, you can’t wait to reach the end of the article and you need to know my distilled thoughts now. I think Kansas City Southern is a terrible investment at current prices. I’ve come to this conclusion because the valuation is greater now than it was this time last year. It’s as if the market hasn’t heard that we’ve got this pandemic and resulting economic devastation happening at the moment. I’ll expand on this thesis below.
Like the other two railroads that I just looked at, Kansas City has seen a decline in traffic drop relative to the same period a year ago. This is obviously understandable. Interestingly (to me at least), the drop was of a different character than the other two. For instance, Kansas City Southern’s food business suffered much more heavily, while its fuel business held up rather well. This was the exact opposite of what happened over at both Union Pacific (NYSE:UNP) and CSX (NASDAQ:CSX). In addition, there were some segments of the business that performed very well, notably primary metals (up 118%) and “other” (up 38%). On balance, I’d say that Kansas City Southern did relatively better than the other two rails, with overall traffic down only about 8.3%. While this certainly isn’t “good,” it’s far less bad than I suspected it would be when I began this analysis.
I’ve written extensively about the long-term financial history here previously, so I won’t go over old ground. Instead, I’ll focus on the most recent period compared to the same time last year. In spite of a drop off in traffic of 8.28%, revenue was down only 7.8% from the prior period. This suggests to me that it was the lower value business that was lost recently, which is a positive. Also worth noting is the fact that in spite of the slowdown in traffic and sales, net income actually rose fairly dramatically. This requires some explanation.
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The silver lining to the dark cloud of reduced business is the fact that a host of variable costs also drop. Specifically, fuel expense was 33% lower, and equipment costs were 29.5% lower. The most significant cause of the shift in net income was as a result of a $102 million drop in restructuring charges. This obviously makes 2019 a much easier comparison year for the company.
Source: Company filings
As I’ve written previously, I consider the dividend quite safe here, especially in light of the fact that there are no significant debt maturities for years. I’m also impressed by the fact that revenue declined less than did carloads. I’m less impressed that net income rose, because most of the relative rise had to do with a drop in restructuring expenses. Still, it should be said that Kansas City Southern has so far managed the downturn better than the two peers I’ve reviewed so far. Given all of that, I’d be happy to buy more of the shares at the right price.
I think the more an investor pays for a stream of future cash flows, the lower will be their subsequent returns. Thus, I want to spend at least some time writing about whether the shares are cheap enough at the moment. The way I judge cheapness is by looking at how much an investor is willing to pay for $1 of future economic benefit. The more they’re willing to pay, the more risky the stock in my estimation. Also, a reasonable expectation in this case would be that the shares should be less optimistically priced than they were in the pre-Covid world. This is because traffic has obviously declined on the network and profitability will be impacted for an unknown period of time as a result of this pandemic. When we look at the chart of the history of the PE here, we note that the multiple has ballooned over the past year, and it’s as if the reality on the ground is irrelevant.
Given the combination of richer valuations and slowed traffic, I don’t think it makes sense to buy at current prices.
In case you’ve temporarily misplaced your “Patrick Doyle’s trades” notebook, dear reader, I’ll fill you in on my options history with this stock. This past November I shorted the March 2020 puts with a strike of $120. These lost most of their value until the shares cratered and then they became very valuable indeed. Three hundred shares were put to me earlier this year at a net price of ~$118.35. Some time later, I decided to sell three covered calls on the shares. Specifically, I sold the January 2021 calls with a strike of $140 for $17.70. I can assume that these options will be exercised and the shares will be taken from me. I’ll console myself with the 33% return on this capital and drive on. This episode reminds me of something my first boss on Bay Street (Canada’s Wall Street) told me years ago, “bulls make money, bears make money, pigs get slaughtered.” The point of that quip relates to the fact that if we’re only satisfied buying at the absolute bottom and selling at the peak, we’re bound to fail. I’m telling myself that’s sage investing wisdom in order to not feel bad about letting these go at a net price of $157.
This also prompts a discussion of whether or not there are reasonable puts to sell at this point. Unfortunately, since I consider the shares to be fairly overpriced, I don’t think any of the premia on offer at the moment compensates investors for taking on the risk associated with these shares at the moment. I think a reasonable price to pay for these shares is closer to $130, and the January 2022 (i.e. the put with 17 months of time value) at that strike price is bid at $1.70 at the moment. Thus, I’m afraid there are no short puts on this one at the moment, dear reader. Of course, I’ll update my thesis if the shares drop in price as I suspect they will.
I think this is a fine business, and I think the dividend is well-covered and there’s a chance that it’ll grow. I’m also impressed by the fact that the company has managed to slash variable costs to more than make up for the (lower margin) lost business. That said, investors buy stocks, they don’t buy companies. It’s embarrassingly tautological to state this, but given some of the comments from my previous articles, I feel the need to do so. An investor buying company X at $100 will have a much different return over time than another investor who buys that exact same company at $200. Price paid matters much more than whether this company is improving yard efficiency or building more double track or whatever. Given that the shares are being bid more highly than this time last year, and that the business is down and may not recover quickly, I can’t recommend buying at current prices. I think price and value can remain unmoored for some time, but will inevitably meet. I think investors would be wise to sell now before price drops to match value here.
Disclosure: I am/we are long KSU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’m the proud owner of 300 shares, but I strongly suspect that these will be taken away given the short calls described in this article.