Fitch Ratings has affirmed the ratings for Kansas City Southern (KCS)
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 is Positive. The short-term ratings for KCSR
and KCSM have been affirmed at 'F3'. A full list of ratings follows at
the end of this release.
KCS's investment grade rating is supported by the company's solid
operating margins, moderate leverage and ample financial flexibility.
Fitch considers KCS to be an improving credit story based on the
prospects of higher margin generation, continued growth out of Mexico
and improving free cash flow (FCF). Fitch may upgrade the ratings to
'BBB' as KCS makes progress towards its goal of reaching a low 60% range
operating ratio, as freight volumes rebound from weakness experienced
this year, and as prospects for FCF improve.
KEY RATING DRIVERS
Near-term Revenue Weakness but Long-term Growth Prospects Remain Healthy:
Fitch expects total revenues for 2015 to be down in the low to
mid-single digits after declining by 5.4% through the first half of the
year. F/X and lower fuel surcharges are the primary driver, but volumes
have also been weak, led by declining utility coal and metals shipments.
Low natural gas prices are pressuring demand from coal fired power
plants while crude oil prices have led to lower demand for steel
utilized in fracking and for frac sand.
Beyond 2015, revenue is expected to trend positive as longer-term growth
trends prevail (cross-border intermodal, port of Lazaro Cardenas,
automotive). Concerns over top line weakness are partially offset by the
company's continued strong margin generation. Also note that nearly the
entire revenue decline is based on weaker fuel surcharges related to
lower oil prices and by the impacts of a weak Mexican Peso. Lower
surcharges are offset by lower fuel costs, and the weak peso is offset
by lower peso denominated costs. Both impacts are largely margin neutral.
Debt Funding for Share Repurchases Contributing to Marginally Higher
than Anticipated Leverage:
Fitch expects incremental debt raised to fund share repurchases to
increase debt/EBITDAR by around 0.2x-0.3x by year end (YE) to roughly
2.6x. In our previous review, Fitch had forecast that leverage would
decline slightly to around 2.4x by YE 2015 and decline incrementally
thereafter. Fitch still considers leverage at this level to be
appropriate for the current rating. Though the debt funded repurchases
are a consideration in delaying a potential ratings upgrade to 'BBB'.
The company announced the $500 million repurchase program in May. KCS
then issued $500 million in unsecured notes in July, around $290 million
of which was used to pay off outstanding commercial paper with the
remainder available for general corporate purposes and share repurchases.
Fitch expects that KCS will be able to fund the bulk of its repurchases
in 2016-2017 with internally generated cash, but incremental borrowing
remains a possibility. Should leverage rise and be sustained in the
2.75x-3.0x range as a result of shareholder friendly actions it could
put pressure on the ratings. However, KCS has publicly stated that it is
committed to maintaining its investment grade ratings and Fitch expects
the company to manage its share repurchases accordingly.
Strong Operating Margins:
Despite recent revenue pressures, KCS's operating margins continue to
improve. Kansas City Southern's operating margins have increased every
year since 2006, and Fitch believes that the company has opportunities
incrementally expand margins further. KCS has recently laid out a target
to reduce its operating ratio to the low 60% range by 2017, which would
represent several hundred basis points of improvement from current
levels. Fitch views this target as achievable given the company's track
record in recent years.
The company is benefiting from its ongoing program of purchasing
equipment off of operating leases. Through the first six months of the
year, KCS spent $61.3 million to purchase equipment off of lease.
Margins also benefit from investments in rail infrastructure and from
managing headcount. KCS's EBITDA margin in the latest 12 months (LTM)
period ended June 30, 2015 was 43.9%, up slightly from 42.2% for the
comparable period a year ago. KCS's adjusted operating ratio, which is a
key metric observed in the rail industry, was 68.1% in the first quarter
of 2015, which is comparable to or better than some of KCS's larger
competitors.
Solid Financial Flexibility but Limited FCF:
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. Total liquidity was $409 million at the end of
the second quarter. Cash on hand totaled $50.9 million plus $158 million
in availability under KCSR's $450 million commercial paper (CP) program
and the full $200 million available under KCSM's CP program. All of the
outstanding CP at June 30 was paid down with the proceeds from the
recent $500 million unsecured issuance. Upcoming debt maturities are
manageable. The company has no significant maturities until KCSM's $250
million floating rate notes mature in October of 2016.
KSU consistently generates significant cash flow from operations but
Fitch expects FCF to be limited in the intermediate term due to
relatively heavy capital spending, increasing cash taxes and the
potential for future increases to the dividend. KSU's capital spending
through the LTM ended June 30, 2015 totaled $830 million or 33% of the
company's LTM revenue, which represents a capital intensity ratio that
is notably higher than most other rail companies. Excluding KSU's
purchase of equipment off of operating leases capex totaled 29% of LTM
revenue, which is still higher than the industry average.
Continued growth opportunities will likely keep total capital spending
relatively high in the intermediate term. Examples include the company's
recent agreement with the chemicals company Sasol to build a new rail
yard to support a new ethane cracker facility. KSU will spend around $50
million-$75 million a year for the next two to three years constructing
the facility which it will then operate under a long-term lease. Other
growth capex will be focused on things like capacity expansion and
additional sidings that will allow for more trains and more efficient
operations on KSU's network. The company has indicated that total
capital spending for 2015 (excluding purchases of leased equipment) is
expected to equal $650 million-$670 million or roughly 27% of revenue.
Over the longer term, capital spending as a percent of revenue may
decline into the low 20% range, at which point Fitch would expect KSU to
be solidly FCF positive. Sustained positive FCF, in the low single
digits or higher as a percentage of revenue, could contribute to a
positive ratings action.
Stable Credit Metrics:
Fitch expects KSU's total adjusted debt/EBITDAR to remain around 2.5x
over the next one to two years. Fitch considers leverage at this level
to be solid for the current rating and could consider a ratings upgrade
if leverage were to be sustained below the 2.5x level (among other
factors). KSU's leverage is down from as high as 5.2x at YE 2009.
Coverage ratios have also improved in recent years. As of June 30, 2015,
funds from operations (FFO) fixed charge coverage stood at 7.0x and FFO
interest coverage was more than 13x both of which are supportive of the
ratings.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Kansas City Southern
include:
--Continued moderate economic growth in the U.S. and Mexico;
--Low-to-mid-single digit revenue decline in 2015 followed by modest
growth thereafter;
--Operating margins expanding incrementally over the intermediate term;
--Adjusted debt levels remaining roughly flat through the forecast
period;
--Modest annual increases in the dividend.
RATING SENSITIVITIES
Future actions that may individually or collectively cause Fitch to take
a positive rating action include:
--Total adjusted debt/EBITDAR sustained below 2.5x;
--Sustained FCF margin in the low to mid-single digits;
--Execution on KSU's goal of reaching a low 60% range operating ratio.
A negative rating action is not expected at this time. However, a
downgrade could be precipitated by more aggressive, debt funded share
repurchases causing debt/EBITDAR to be sustained above the 2.75x-3.0x
range. Ratings pressure could also be caused by a severe drop off in
demand for cargo flowing between the U.S. and Mexico. EBITDAR margins
falling towards or below the 40% range, and sustained negative free cash
flows could also lead to a negative ratings action.
FULL LIST OF RATING ACTIONS
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 is Positive
Additional information is available on www.fitchratings.com.
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent
and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=990720
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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