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Fitch Raises Outlook on Kansas City Southern (KSU) to Positive

September 12, 2014 2:58 PM EDT

Fitch Ratings has affirmed the ratings for Kansas City Southern (KCS) (NYSE: KSU) and its primary operating subsidiaries, Kansas City Southern Railway Co. (KCSR), and Kansas City Southern de Mexico S.A. de C.V. (KCSM) at 'BBB-'. The Rating Outlook has been revised to Positive from Stable. Short-term ratings for KCSR and KCSM have been affirmed at 'F3'. A full list of ratings follows at the end of this release.

KSU's investment grade ratings are supported by the company's solid operating margins, steadily increasing revenues, and moderate leverage. The Positive Outlook reflects Fitch's view that KSU's credit profile will continue to improve in the coming years propelled by growth opportunities in Mexico, a healthy operating environment in in the U.S., and further operating margin expansion driven in part by the company's efforts to buy equipment off of operating leases.

Fitch expects leverage metrics to improve incrementally in the near-term due to decreased rental expenses, and growing EBITDA. Debt may also decrease if the company chooses to pay down some of its outstanding CP in the U.S., possibly using repatriated funds from Mexico to do so. Fitch calculates KSU's total adjusted debt/EBITDAR at 2.6x as of June 30, 2014. Near-term concerns include uncertainty around potential legislative changes in Mexico, newly proposed rail safety rules from the DOT, and pressured free cash flow from heavy capital spending.

KEY RATING DRIVERS

Revenue Growth Prospects Remain Healthy

Fitch expects KSU to generate top line growth in the mid-single digits in 2014, primarily driven by the company's five main focus areas: automotive, cross-border intermodal, frac sand, the Port of Lazaro Cardenas, and crude oil. KSU's cross-border business continues to benefit from a growing manufacturing sector in Mexico, a healthy automotive market in the United States, and from further conversion of cargo volumes from truck to rail. Fitch anticipates U.S. light vehicle sales to reach 16 million units in 2014, up from 15.5 million in 2013. Cross-border automotive volumes will be bolstered by a series of new auto manufacturing plants in Mexico that are in the process of coming on-line. Importantly, rising automotive sales also help to drive other industrial and consumer cargo volumes, which make up a much larger portion of KCS total revenue than automotive segment alone.

KCS' intermodal business also continues to show significant positive trends. Intermodal volumes are benefiting from the ongoing shift of cargo volumes coming across the border from Mexico away from trucks and onto the rails. KCS estimates that cross-border cargo is still largely dominated by truck traffic, leaving a significant opportunity for continued growth in intermodal. Domestic intermodal traffic also continues to be a positive for the rail industry as tight trucking supply, high fuel prices, aging highway infrastructure, and increasing rail efficiency makes moving cargo by rail more attractive to shippers. Through the first half of 2014 total revenue in the intermodal segment was up by 12% driven by a 5% increase in total carloads and an 7% increase in revenue/unit.

Energy segment (consisting of coal, crude oil, and frac sand) revenues dropped in the first half of 2014. However, Fitch believes that that this segment represents a growth opportunity over the longer term. Revenue in the first half was hit by a sharp drop in the volume of crude oil, which was impacted by a drop in the amount of crude moving to the Gulf via train due to new pipeline capacity coming on-line. Utility coal was also weak in the first half, partially due to network congestion caused by severe weather.

Crude volumes could see some improvements in the second half when new terminals for Canadian heavy crude begin operating. Longer-term, KSU's crude business should also benefit from the planned Port Arthur Crude Terminal (PACT). KSU signed a deal with Global Partners where Global will construct the facility on land owned by KSU. The unit train terminal is expected to handle two unit trains per day once completed (estimated at the first quarter of 2017). While crude volumes may fluctuate over the longer-term due to pipeline capacity and spread dynamics, demand for frac sand, one of the segments' main growth drivers, is expected to be steadily positive going forward.

In the LTM period ended June 30, 2014 KCS' consolidated revenue grew by 9.5% driven by expansion in cross-border, intermodal and agricultural related volumes. Growth will likely slow in the second half of the year as comps in the agricultural segment become more difficult. Grain volumes were particularly weak in the first half of 2013 due to a severe drought the previous summer.

Mexican Energy Reform

In August of this year, Mexican President Enrique Pena Nieto signed a series of energy reforms into law which will open oil and gas exploration to outside investors. The expected increase in foreign direct investment will allow Mexico to tap its harder to access oil stores along with opening up shale formations for fracking. As has been the case in the US, the increase in drilling activity should have positive longer-term implications for rail companies as demand for things like drill cuttings and frac sand increases. The Mexican economy also stands to benefit more broadly from lower energy prices stemming from the break-up of the current monopoly system covering Mexico's energy generation and distribution.

Strong Operating Margins

Kansas City Southern's operating margins have increased every year since 2006, and Fitch believes that the company has opportunities to incrementally expand margins further. The company is reducing its equipment costs by purchasing a significant amount of equipment off of operating leases. Through the first six months of the year KSU spent $294 million to purchase equipment off of lease. KSU is also managing its compensation costs (the company's largest single expense).

Compensation was up 4% through the first six months of the year compared to a 5% increase in carloads hauled. KCS' EBITDA margin in the LTM period ended June 30, 2014 was 42%, up from 40% for the comparable period a year ago reflecting healthy revenue growth and ongoing efforts to improve operating efficiency. KCS' adjusted operating ratio, which is a key metric observed in the rail industry, was 67% in the second quarter of 2014, which is comparable to or better than some of KSU's larger competitors.

Solid Financial Flexibility

The company maintains solid financial flexibility through its cash on hand as well as availability under its two commercial paper programs which total $650 million. Liquidity at the end of the second quarter was sufficient for the rating. Cash on hand totaled $190 million plus $130 million in availability under KCSR's $450 million CP program and the full $200 million available under KCSMs CP program. Upcoming debt maturities are manageable. The company has no significant maturities until KCSM's $250 million floating rate notes mature in October of 2016.

FCF Pressures

KSU consistently generates significant cash flow from operations. While CFFO generation will continue to be strong, Fitch expects free cash flow in the intermediate term to be pressured by relatively heavy capital spending as KCS continues to grow its business, and by increasing in cash taxes and rising dividend payments.

Capital spending may total more than $1.0 billion in 2014, including around $300 million of equipment purchased off of operating leases. Excluding those purchases, which are more one-time in nature, capital spending is expected to total around 28% of KSU's annual revenue, which is notably higher than in previous years. High capex, (excluding lease conversion spending) driven by the company's growth and by some accelerated purchasing of locomotives, will keep FCF minimal or negative in 2014. Higher dividend payments will also impact FCF. The company announced a 30% dividend increase in the first quarter of the year, bringing its annual payout to roughly $120 million. However, Fitch expects FCF to improve in 2015 and remain positive thereafter as capex comes down and operating profit grows.

Credit Metrics Improving

Fitch anticipates that KSU's total adjusted debt/EBITDAR could decrease incrementally over the coming 1 - 2 years as equipment rental expenses decline and as margins expand. KSU's leverage ratio of 2.6x as of June 30, 2014 is down from as high as 5.2x at year end 2009. Coverage ratios have also improved in recent years. As of June 30, 2014 FFO fixed charge coverage stood at 5.7x and FFO interest coverage was more than 12x. KSU's coverage metrics are comparable to companies in Fitch's 'BBB' rated peer group, and are supportive of the positive outlook.

Concerns Around Mexican Rail Legislation

In February of this year, the lower house of the Mexican congress passed legislation that would impact KCSM's business if implemented. The bill calls for; 1) regulation, where necessary, of rates that the railroads are allowed to charge their customers, 2) freedom for competitors to use rail lines which are currently granted to KCSM and its competitor Ferromex under exclusive concessions, and 3) the requirement of smooth interchange between the KCSM and Ferromex networks.

The ability for competitors to utilize KCSM's network presents a risk in that competitors would likely focus on the company's most lucrative contracts, and harm KCSM's profitability. Although this legislation presents a risk, there are several mitigating factors. To date, the legislation has only been considered by the lower house of congress, and may not be passed by the upper house in its current form. Since the initial legislation was passed, both KCSM and Ferromex have made lobbying efforts voicing their concerns over the regulations.

Both companies have stated that new regulations could reduce future investments in Mexican infrastructure, and have threatened potential legal action to stop the bill from passing in its current form. If the rails were to gain an injunction, it could tie up the legislation in court for years. The Mexican legislature may also hesitate to enact a law that is seen as violating its 1997 agreements with the railroads as it may deter other outside investors.

Potential New Safety Regulations

A potential concern around the growth of KSU's crude oil business is the increased focus on safety following several incidents involving crude tanker cars over the past several years. Concerns regarding the safety of shipping crude by rail led the DOT to propose a possible new set of rules in July of this year. The DOT's proposal, which includes several different possible regulations, was made available for public comment in July of this year. The public comment period remains open. Potential regulations include the possibility that older tank cars may have to be retired within two years unless they are retrofitted to comply with updated safety standards. There are also several possible restrictions on speed limits for trains carrying flammable materials.

Regulatory concerns are partially offset by the fact that KSU does not own its tanker cars, which are instead owned by the oil companies. Thus the cost of retrofitting cars or purchasing new ones wouldn't be born directly by Kansas City Southern. The largest direct risk for the rails could come from newly imposed speed limits, as slower tanker trains could lead to increased congestion and reduced operational efficiency.

Kansas City Southern de Mexico

The ratings reflect KCSM's solid business position as a leading provider of railway transportation services in Mexico with a diversified revenue base. The ratings also factor in the company's consistent financial performance, which have resulted in stable low leverage, adequate liquidity, solid cash flow generation, and positive free cash flow. Also incorporated in the ratings is the strong credit linkage between KCSM and its parent company, Kansas City Southern (KCS). The ratings incorporate the high sensitivity of the company's credit profile to change in the macroeconomic environment, as its operational performance is highly related to the strength or weakness of the United States and Mexican economies.

RATING SENSITIVITIES

Fitch generally views KSU's credit profile as improving. A positive rating action could be triggered by a return to solid positive free cash flow, continued operating improvements, and the maintenance of leverage at or below current levels. Fitch would also look for clarification around proposed Mexican rail legislation and around new safety regulations currently being proposed by the DOT.

A negative rating action is not expected at this time. However a downgrade could be precipitated by a severe drop off in demand for cargo flowing between the U.S. and Mexico. Alternatively, a shift in management strategy emphasizing shareholder returns or growth that comes at the expense of a healthy balance sheet could also negatively impact the ratings.

Fitch has affirmed the following ratings:

Kansas City Southern
--Issuer Default Rating (IDR) at 'BBB-'.

Kansas City Southern Railway Co.
--IDR at 'BBB-';
--Short-term IDR at 'F3';
--CP at 'F3'
--Senior unsecured bank facility at 'BBB-';
--Senior unsecured notes at 'BBB-'.

Kansas City Southern de Mexico
--Foreign currency IDR at 'BBB-';
--Local currency IDR at 'BBB-';
--Short-term IDR at 'F3';
--CP at 'F3'
--Senior unsecured notes at 'BBB-'.

The Rating Outlook has been revised to Positive from Stable.



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