Kansas City Southern’s Mexico business sees growing pains as congestion rises

Railroad sees more appliance and brown paper freight moving off road transportation to rail.

Kansas City Southern (NYSE: KSU) pulled in its 2018 guidance as the railroad deals with a backlog of carloads at its northern Mexico terminals.

KCS reported third quarter revenue up 6% year-on-year to $699 million against volume growth of 4%. The growth stemmed largely from carloads going into Mexico with cross-border volume rising 20% and revenue growing 18% to $210 million.

Reported net income of $170 million was up 35% from a year ago. Excluding one-time effects of last year’s Hurricane Harvey, KCS’s adjusted earnings per share came in at $1.57, in-line with consensus expectations.

But performance measures deteriorated in the quarter with terminal dwell reaching a two-year high of 26.8 hours and train velocity hitting a two-year low of 25.9 miles per hour.

Adjusted operating ratio was 63.4%, a 100 basis points improvement over last year.

Speaking of the results, chief executive Patrick Ottensmeyer said “it’s hard to feel bad about our performance: it was record revenue for the quarter, an operating ratio improvement of one percent over last year, and earnings per share growth of 16% year over year.”

“But our performance did not meet our own expectations and the expectations that we articulated earlier in the year,” he added. The company now expects low single-digit volume growth for the year, down from an earlier guidance of 3% to 4% growth.

KCS says the service deterioration stemmed largely from congestion at two cross-border switching facilities, Monterrey and Sanchez. The congestion led to weekly cars online in Mexico rising as high as 32,000 in September, up from about 26,000 through the first half of 2018.

KCS chief operating officer Jeff Songer said Monterrey is a “high volume terminal with significant local daily switching demand.” KCS plans to deploy 30 additional locomotives and additional crew to reduce congestion.

Ottensmeyer says the congestion reflects the strong growth in KCS’s cross-border business. He was overall more positive on U.S.-Mexico trade now that the U.S.-Mexico-Canada Agreement lifted uncertainty from the business.

“The new USMCA still has some work to do, but It looks like a good agreement,” Ottensmeyer said.

Ottensmeyer says KCS is looking at implementing some elements of the precision scheduled railroading model that “can be helpful to getting us through the congestion issues we are experiencing now.”

With its largest intermodal partner Union Pacific (NYSE: UNP) moving to a precision scheduled railroading model, Ottensmeyer says KSC will “cooperate and follow their lead in changes in operating philosophy.”

Chemical and petroleum freight stood out for growth during the quarter with revenue up 17% to $160.6 million. Growth was strong thanks to the impact of Hurricane Harvey last year. But gasoline imports into Mexico, part of the country’s energy reforms, saw carload and revenue growth more than double from year earlier levels.

Industrial and consumer products saw flat results for the year. The business has benefited from forest products, brown paper and appliance freight moving to railcar and away from trucking. KCS expects more paper and appliance business to move to rail thanks to tight trucking capacity.

But metals freight saw shorter length-of-haul and lower volumes. Energy freight revenue declined 2% to $73.2 million as lower coal volumes due to a power plant outage and changes in frac sand sourcing offset rising volumes of crude-by-rail out of Canada.

Intermodal saw 8% revenue growth to $100 million against 7% carload growth thanks to ongoing truck conversion. Chief innovation officer Brian Hancock says U.S. domestic and cross-border intermodal saw “solid performance” thanks to truck conversions. But volumes out of the Lazaro Cardenas container terminal were down 9% due to competitive pressure from Mexico’s trucking capacity. But Hancock says containers might shift back to KCS thanks to the August start of hours of service regulations in Mexico.

“We are seeing early positive trends during peak season as additional truck regulations are implemented in Mexico,” Hancock said. KCS has also started a volume-based pricing strategy to bring containers back to rail.