Ask The Experts: August 14, 2019

Tony Hatch
Independent Transportation Analyst and Consultant

Q: What are your thoughts on the Q2/19 performance of Kansas City Southern (KCS)?
A:
Kansas City Southern – beats expectations on an adjusted basis, and reassures the markets but (slightly) disappointed me. In addition, they fell victim once again to the “It’s Always Somethin’” Syndrome (in this case the OR dilutive but income neutral Mexican fuel excise tax elimination) and had a complex quarter. Cutting through all that, their EPS grew (adjusted/diluted) by 6% and their OR fell by 30bps to 63.7% . They too followed the Q2/19 rail pattern of reiterating near term revenue growth and intermediate term OR targets while capitulating to the inevitable on volumes, with more than 6 months traffic booked (now “flat to slightly down” for 2019). Pricing obviously is strong. Q2/19 carloads were flat, but 4/6 commodity categories were down, one flat – and chemicals/petroleum up 18% - led by refined product shipments to Mexico (“Mexican Energy Reform” volumes grew 125%, revenues 136%). Their outlook is split 60% positive, however, 20% neutral, and 20% negative. That latter category includes energy (coal, CBR and sand) which makes sense, - and Intermodal, both in Mexico (hurt by the unequal fuel tax) and US domestic (truck overcapacity). I do not like the sound of that….nor the phrase from CEO Pat Ottensmeyer (RailTrends 2019 Railroad Innovator of the Year) that “with the exception of intermodal, things look good….” And, in fact, in Q2/19 cross-border intermodal volumes grew 10% and even Lazaro Cardenas volumes grew (by 2%). So what happened to “Service Begets Growth”, their (excellent) mantra from April? Yes, Pat said it in the Q&A, but this felt like a more standard USA PSR story unfolding, rather than the exceptional one I saw in April. Time will tell….

  • Operations were sort of mixed – operating expense increased 4% on that flat growth level; headcount was flat. But, early stage PSR is working for them too – dwell improved 11%, velocity 12.55, cars on line down by 17%. Their active loco fleet is down 12% form YE18, and system car fleet by 7%. There’s more to come (and another related charge) in H2/19. In fact, they have more than doubled their own targeted 2019 PSR benefit level, (to $40mm from $16mm; on an annualized basis from $25mm to $55mm). making up for some of the volume headwinds.

  • KSU cut planned 2019 Capex to “below $600mm” from their earlier range of $640-660mm; reiterated that the YOY increase was due to the now completed $140mm loco plan. Capex will still be at ~18% of revenues for 2020-21, but this still feels like a sop to the short term. Yes, volumes are weaker or at least more uncertain – now. Yes, PSR has reduced the asset base (rolling stock etc) and what’s left is newer. But what is the outlook five years from now? What are you implying? We know that rails are awful at precisely matching supply with demand – so why try? Come one guys – be best!

  • AMLO keeps trying to reduce Mexican dependence on US refined products, KCS’ shining star, but the markets aren’t buying the Pemex reform plans – at all….

Q: Genesee & Wyoming Railroad (GWR) is to be acquired by Brookfield Infrastructure Partners (BIP). What were the reasons behind this deal, and what does it mean for GWR’s future?
A:
Thanks in part to an unprecedented amount of deal info leaking (kudos to Bloomberg), this was no real surprise. In addition, as far back as their last Investor Conference in November 2017, GWR had itself said that North American deal making was getting harder as asset inflation accelerated (due in part to the differing return requirements between public, strategic, private equity and infrastructure investors) – but the upside was that they realized their own portfolio was under-valued. Interestingly, the short line community thought this was a done-deal for some time; the investment community was a tad more cautious, an interesting role reversal. Meanwhile, as an aside, the timing of Canada Day for a Canadian-led deal (and BIP is widely followed up North) wasn’t too bad, given recent major rail calls on Yom Kippur, etc. But what does it mean – to GWR, to the rail industry, for other deals?

Why did GWR do this? Well, the deal represented a 40% premium to the share price before the leaks began (for the 4% short – oops!), and at 13.3X 2019E EBITDA and 26X ‘19E EPS, that’s a healthy haul! The sellers market bonanza, as described above and noted by GWR repeatedly for the last 18+ months, for one reason. In addition, GWR can be viewed in part as a victim of their own success – by creating a 114-railway behemoth in North America, they made it harder on themselves to continue to make deals “that move the needle”. A $10mm revenue deal that would be coveted by some SLHCs would require the same effort in due diligence and “go teams” and yet be barely noticeable to their investors. It could be inferred (even though denied) that this problem could cause GWR management to take bigger risks and do deals in other regions (the UK, perhaps, if not Australia). A combined deal/operating company might not be best suited for quarterly results.... 

What does this mean for GWR? They can recommit to the small, fill-in deals, for one – and at the same time have a parent with deep, deep pockets for larger ones, should they arise. But the deal leads to some questions. Will the current management stay? They say they will. Did BIP see this as a pure infrastructure investment (stable, say mid-single digit returns/hands off style), or will they view this more as a private equity investment (investing with an aim to provide something – capital/expertise/directional change- to improve results and achieve double-digit returns)? The deal press release states that BIP et all “fully supports the G&W business plan”, but some sources say that isn’t entirely accurate, citing some issues of operational efficiency, and growth potential....In addition, a Canadian source close to BIP said that the ownership & fund structure was complicated – with some seeing themselves as lifetime investors and others with a 10-year (still “long term”, to be sure) horizon. The source suggests perhaps 1/3 of the ownership confederation would be in that more opportunistic (PE) category....That could be interesting – an internal “activist” in the mix? 

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Alison Babcock