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Kansas City Southern Neutral

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Kansas City Southern (KSU - Free Report) is one of the oldest and foremost freight rail transportation companies. It functions in a seller’s market, enjoying pricing power since 1980 when the U.S. government formulated the Staggers Rail Act.  The company has been able to increase prices on average by nearly 4%–5% per annum thereby, subsequently maintaining a substantial profit margin.

Additionally, improving cross-border traffic between the U.S. and Mexico and emerging business opportunities in the Mexican market supported by its cheap labor costs, favorable currency environment and lower transportation cost to the U.S. markets are expected to bode well for the company’s top and bottom-line growth.

Kansas City Southern looks forward to a mid-single digit growth in volumes and core pricing in 2012. In terms of the Energy segment, management projects a double-digit growth this year based on a rising demand for natural gas and crude oil supplies. In addition, increase in frac sand shipments due to enhanced drilling activities in petroleum products and existing low cost natural gas will drive higher shipments in this segment.

Auto production is expected to rise in Mexico, with upcoming plants set up by Honda, Mazda, Nissan and Audi. These facilities will facilitate greater automotive shipments. Based on these proposed expansion plans, finished vehicle production is expected to reach 3.5 million units in 2015; about 40% higher than the 2011 production levels and over a 30% increase from current levels.

However, the current state of a volatile U.S. and world economy may keep Kansas City Southern’s top-line growth under pressure in the near future. Moreover, near-term growth for the company is expected to be tempered by lower coal production forecasts by the U.S. Energy Information Administration. Besides, lower natural gas prices and a weak utility coal market have raised serious concerns and limited overall coal shipments despite strong exports to the Asian countries.

Additionally, the company foresees a decline in its grain shipments, given higher U.S. grain prices. Going forward, the company expects fuel prices for the remainder of the year to decline by around 10% in the U.S. and 2% in Mexico. Although lower fuel prices should benefit operating expenses, we believe it will also adversely impact fuel surcharge revenues of the company. Going forward, exchange rate fluctuation also remains a critical factor for the company‘s earnings, as a substantial part of the business arises from cross-border markets. Given these near-term headwinds, the company lowered its revenue estimates for this year to a mid-single digit range from a low-double digit range.

Further, stiff competition from railroads like Canadian Pacific Railway Limited (CP - Free Report) , increased railroad regulation, highly unionized labor may limit the upside potential of the company.

Consequently, we maintain our long-term Neutral recommendation on the stock.  For the short term, Kansas City Southern holds a Zacks #3 Rank (Hold).

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