cfa institute research challenge · ( 4(cfa institute research challenge 30 jan 2014 mexican...

CFA Institute Research Challenge

hosted by CFA Society Kansas City

University of Missouri – Kansas City

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Closing Price Target Price Current Price

Date: 30/01/2014 Ticker w NYSE: KSU Sector/Industry wIndustrials/Rail Current Price w $99.49 Target Price w $105 Recommendation w HOLD

Highlights wWe are upgrading our recommendation of KSU from SELL to HOLD. The recent earnings miss and subsequent price reduction brings KSU more in line with assumed growth. wGrowth Drivers: Management has identified crude oil, frac sand, Port of Lazaro Cardenas, cross-border intermodal, and automotive as strategic growth drivers in the years ahead. Collectively these 5 growth markets grew 22% year over year and accounted for 19% of total KCS freight revenue in 2013. w Financial Position: With recent debt restructuring and efforts to replace high-cost debt with lower-cost issues, KSU will continue to improve its overall financial strength. w Risks: Peso/USD exchange rate, crude price fluctuation and a global economic slow down headline the risks for KSU.

Market Profile 52 Week Price

Range 91.89 -‐ 125.96

Average Daily Volume 670,273

Sharpe Ratio (3 Years) 1.74

Dividend Yield 0.88%

Shares Outstanding 110.21M

Market Capitalization (Billion)

$11.10

ROE 2013 10.91

Debt to Equity 2013 0.50

P/BV 3.35

P/E 33.82

% Annual Returns -‐ 12/31/13 1yr. 49.48 3yr. 38.10 5yr. 45.93

This report is published for educational purposes only by students competing in The CFA Institute Research Challenge.

Important Disclosures appear at the back of this report

KSU Daily Stock Price (USD)

Revenue Sensitivity: Annual Percent Changes From

Forecasted Revenue

Valuation Methods

DCF EBITDA Multiple

EPS Multiple

Price Target

-‐25% $78 $79 $71 $76 -‐10% $94 $98 $88 $93 -‐5% $100 $104 $94 $99 0% $105 $111 $100 $105

5% $110 $116 $105 $110 10% $116 $123 $111 $117 25% $132 $141 $128 $134

**All other inputs remain consistent as a percent of revenue Source: Team Estimate

**Average annualized returns Source: Value Line

Source: Bloomberg, Team Est.

Valuation

Est. Price Weight

DCF 105.70 (1/3) P/E 99.51 (1/3)

EV/EBITDA 111.03 (1/3) Target Price 105.41

Kansas City Southern

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Source: Bloomberg

Source: Company Data

Business Description Kansas City Southern (KSU) is a transportation holding company with railroad investments in the U.S., Mexico, and Panama. It was founded in 1887 as a North-South rail line connecting Kansas City to Port Arthur, TX. KSU is one of the smallest class I railroads, but has grown its rail network to roughly 6,600 miles of track. The 2005 acquisition of Grupo Transportacion Ferroviaria Mexicana, S.A. de C.V. (TFM), Mexico’s largest railroad, completed the company’s goal of creating a NAFTA railway, linking the commercial and industrial centers of the U.S., Canada, and Mexico. During 2012, 54% of KSU’s total revenue came from their US operations, with the remaining 46% coming out of Mexico. Kansas City Southern’s U.S. operations are controlled by its subsidiary, Kansas City Southern Railway (KCSR). KCSR’s rail network consists of approximately 3,500 miles of main branch lines and 400 miles of other track. KCSR has the shortest north / south rail route between Kansas City and several key ports along the Gulf of Mexico in Louisiana, Mississippi and Texas. KSCR’s rail route also serves the Meridian Speedway, a 320 mile track between Meridian, Mississippi and Shreveport, Louisiana, and the east / west route linking Kansas City with St. Louis. In 2005, Kansas City Southern acquired control of Transportación Ferroviaria Mexicana (TFM), which operates under a concession from the Mexican government running through June 2047. TFM’s rail network runs through several major manufacturing zones and connect both Pacific and Gulf coast ports with Mexico City and Laredo, Texas. KSU subsequently renamed the subsidiary Kansas City Southern de Mexico (KCSM). In 2005, KSU assumed control of the Texas-Mexican Railway (Tex-Mex), which operates a 157-mile rail line extending from Laredo to the port city of Corpus Christi, Texas. This rail network connects the U.S. operations of KSU and KCSM. KCSM operates over 3,100 miles and has an additional 700 miles through trackage rights. Furthermore, KSU has a 50% stake in the Panama Canal Railway Company. This railway operates coast-to-coast container and passenger services on the 47 miles of track adjacent to the Panama Canal. Institutional ownership accounts for nearly 92% of shares outstanding. Taking shareholder structure one-step further, we observe that ~60% of KSU’s institutional shareholders are growth-oriented. This number is up from ~25% in 2006. However, KSU’s significant price multiple premium to other class I railroads suggest that further upside will need to be driven by earnings growth not price multiple expansion. KSU primarily generates revenue from six different divisions. Figure 2 provides insight into KSU’s 2013 revenue mix. While their revenue mix is diversified, there is significant exposure to industries highly correlated with GDP. Industrial and consumer products, chemicals, petroleum, and agriculture will tend to expand and contract with the overall economy. In order to provide an accurate forecast of these industries one must have a good feel of the U.S. and Mexican economies. Fortunately for KSU, automotive, intermodal and energy offer growth in excess of GDP.

Source: Seeking Alpha

CFA Institute Research Challenge 30 JAN 2014

GARP Growth

Value Index

Hedge Fund

Figure 1: Shareholder Structure by Style

2012 2013

Figure 2: Market Segment Revenue Comparison

Figure 3: KSU Track Positioning

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Corporate Strategy KSU believes that common control of its three railroads, KCSR, Tex-Mex, and KCSM, will provide shippers in the NAFTA corridor an excellent transportation option. Since the tracks are already physically linked in an end-to-end configuration, KSU can competitively challenge for market share in goods shipped between the U.S., Canada, and Mexico. Management has stated their primary use of excess cash will be utilized to capture growth opportunities. Furthermore, we were informed that an incremental dividend increase is likely, while a large-scale dividend increase or share repurchase program is not. Industry Overview and Competitive Positioning

According to the U.S. Department of Transportation, railroads have been gaining an increasing share of U.S. freight shipments over the last few decades. In 1980, railroads accounted for roughly 27% of ton-miles transported in the United States. The percentage of ton-miles attributable to railroads has increased to over 39% as of 2009 data. Over the last number of years, the largest individual commodity transported has been coal. However, the total amount of coal transported has dropped significantly from 2007 to 2009. As a percentage of total tons originated, coal accounted for 44% in 2007, and only 40% in 2009. This 4% drop equates to roughly 128 million tons less shipped during those years. The primary driver of that has been the significant decrease in demand for coal. The abundance of natural gas has caused its price to plummet over recent years. Substituting as a cheaper alternative to coal, the demand for natural gas has been gaining ground. The continued decrease in the demand for coal will further erode total revenues for the railroad industry. This erosion stems from the fact that natural gas is not transported by rail, causing a piece of the railroad industry’s revenue pie to disappear. Despite the decline in a key transported commodity, coal, there are some safety cushions the railroad industry can rely on. Railroads play a pivotal role in overall U.S. freight shipments because certain items transport most effectively by rail. According to the American Railroads (AAR), 70% of domestically produced automobiles and 35% of all U.S. grain harvest move by rail. This industry revenue moat lessens the sting companies have felt from the dip in coal commodity transport over the last few years. Strategic Track Location KSU's original objective was to provide the most efficient route from Kansas City to the Gulf of Mexico. With 3,226 track miles in a 10 state region of the United States, they have accomplished that goal. With access to major hubs in Shreveport, New Orleans, Dallas and Kansas City, their track creates a strategic advantage in the United States. A subsidiary of KSU, Kansas City Southern De Mexico, operates 2,645 track miles serving 17 states in the northeast and central Mexico regions. Most importantly this track serves the port city of Lazaro Cardenas, a key growth driver for KSU. However, the strongest competitive advantage for KSU is they are the only U.S. railroad with a fully owned Mexican subsidiary. With cross-border trade between U.S. and Mexico totaling nearly $400 Billion annually, Mexico is now the third-ranked commercial partner of the U.S. and second largest market for U.S. exports.

CFA Institute Research Challenge 30 JAN 2014 Chem

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Figure 4: US Rail Carload by Industry

Figure 5: Mexico Rail Carload by Industry

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Figure 6: Mexico Carload by Industry

Source: American Railroad Assoc.

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CFA Institute Research Challenge 30 JAN 2014 Mexican Concession KCSM has been granted a concession by the Mexican government to operate freight transport services over rail for a 50-year contract beginning in 1997 and running through 2047. The SCT may revoke the concession if KCSM fails to uphold its end of the bargain in either of two distinct areas. The first requires KCSM to maintain capital investments as stated in its five-year business plan filed with the SCT. The second requires KCSM to maintain obligations, compliance bond and insurance coverage specified in the Mexican railroad services laws and regulations.. At the current time, there are no known supportable sanctions or compliance issues with the SCT and KCSM. The concession will expire in 2047 unless renewed for another term of 50 years. Lazaro Cardenas In 2012 Lazaro Cardenas was the 2nd fastest growing container port in North America handling 1.24 million TEU’s (Twenty-Foot Equivalent Units). AP Maersk has recently invested $900 Million to build an additional container terminal, which would bring total annual capacity to 3.4 Million TEU’s. Rail Service to Lazaro is provided exclusively by Kansas City Southern de Mexico, making this an important element to KSU’s growth. Mexico Oil Legislation In December 2013 Mexican president Enrique Pena Nieto signed into law a bill allowing private sector investment in the world's ninth-largest oil producer. The bill ends the monopoly of state-owned Petroleos Mexicanos (PeMex) and hopes to jumpstart a stagnant industry. While the process of implementing the law is effective immediately, we estimate it will take 1-2 years before KSU experiences an increased demand for crude by rail services. While deep water and shale gas exploration will receive the first bidding, we feel KSU will benefit by moving steel and frac sand to develop the infrastructure. Eventually, when the drilling moves inland we expect there will be significant opportunity to move crude oil by rail. Port Arthur 6 of the 50 largest refineries are located on KSU’s line in the Port Arthur, Texas area. Those refineries are currently demanding over 1 million barrels of crude oil per day, largely supplied by heavy crude oil from western Canada. KSU is strategically positioned to receive this crude from the Canadian rail companies in Kansas City and deliver it to Port Arthur. KSU is also currently obtaining permits to finalize negotiations with a third party who is interested in building a crude facility on KSU’s land in the area. The new crude facility is expected to increase volumes in the area from 1-2 trains per week to 1 train per day. Volumes are expected to ramp up over the course of the next 1-3 years. Automotive Asian auto manufacturers have candidly admitted they are not able to profit on their small vehicles manufactured in Asia. Therefore, several companies are near shoring their operations to Mexico. Mazda, Honda and Nissan are scheduled to come online in 2014 while talks with other companies are in the works (Mercedes, Toyota). The other noteworthy competitive advantage regarding the automotive industry is the type of train cars currently being utilized by KSU. While a bi-level car can move 10 vehicles and a tri-level 15, the car KSU uses, the AutoMax car, can transport 26-28 vehicles. This unique advantage is helping KSU gain market share in the industry. Cross Border Intermodal More than 3 million trucks cross the US – Mexico border every year. With recent improvements to intermodal facilities, KSU is gaining market share quickly. With strategic track through the Laredo gateway, KSU provides a unique logistic opportunity. With only a ~3% current market share, KSU expects to continue to see exponential growth from this segment of their business. Management is optimistic that as this market matures KSU will grab close to 30% market share..

Source: portofportarthur.com

Figure 8: Rail Access to Port Arthur

Figure 9: AutoMax Rail Cars

Source: trainweb.com/funnelfan/automax

Figure 7: Originated Carloads of Crude Oil on US Class I Railroads

Source: Association of American Railroads

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CFA Institute Research Investment Summary Fairly Valued We are issuing an upgrade from SELL to HOLD for Kansas City Southern with a target price of $105. This is fairly consistent with the current market price ($99.49 as of 1/24). KSU has historically traded at a premium compared to other Class I railroads due to their growth prospects. When looking at current trading multiples of EV/EBITDA, EV/EBIT and P/E compared to its peers KSU is trading at premiums of 38%, 38% and 70%, respectively. This is in-line with historical trading premiums. KSU has seen its most important year-over-year growth metrics decrease. Recently, revenue and income growth year-over-year have been decreasing while the share price increased. If revenue and income growth disappoint, there will be further correction downward in the market price. Large Cap Growth Company KSU expects growth to be derived from five distinct segments; automotive, cross-border intermodal, crude oil, frac sand, and traffic out of Port Lazaro Cardenas. Due to increased labor costs in China, automotive manufacturing in Mexico has become increasingly favorable for companies. Three automotive plants are scheduled to come on line in Mexico in 2014. Our team expects this to increase automotive revenue by at least 20%. The firm is positioned to profit from increased intermodal transit with 3 million truckloads crossing the border every year. The International Energy Agency predicted the US could be the largest producer of oil by 2020. This translates into increased demand for transporting crude oil. Revenue Diversification KSU is well insulated against changes in commodity demand shocks, rising fuel prices and foreign exchange rate fluctuations. KSU has a well-diversified mix of revenue that span a vast array of different commodities. KSU’s transportation of industrial products encompasses the largest revenue portion at 31%, with the smallest exposure coming in the form of coal at only 11%. KSU’s relatively limited exposure to coal compared to competitors, is an added bonus as railroad companies continue to see erosion in coal revenues. While total fuel expense was $389 million, the firm essentially recaptured 82% of fuel cost through fuel surcharges. Interestingly, due to the structure of the fuel surcharge the firm will recapture 100% of its fuel cost if fuel prices reach $5 per gallon. See appendix 18 for a detailed explanation of the FSC. Financial Stability Management has taken steps to improve operating efficiency and profit margins. EBITDA, EBIT and Net Income margins have all seen improvements in recent years. We believe that this trend will continue, and have modeled our forecast accordingly. KSU has increased revenues while keeping headcount consistent. Kansas City Southern has implemented many cost saving initiatives in recent quarters, one being the refinancing of higher rate debt. On March 8, 2013 KSU became credit rated BBB- according to S&P. This gives KSU investment grade credit ratings by Fitch, Moody’s and S&P credit rating agencies, allowing the firm to refinance its debt at more favorable rates. Although the company will incur initial refinancing costs, these are completely outweighed by the improvement in long-term financial strength. KSU has seen its average cost of debt decrease from 8% in 2010 to 4.5% in 2013. In turn this has reduced interest expense in 2013 by $20 million and increased the interest coverage substantially. After all higher interest rate debt has been refinanced, we expect the average cost of long-term debt will settle around the 4% mark.

Figure 10: Year Over Year Growth

Figure 11: Margins - % of Sales

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CFA Institute Research Challenge 30 JAN 2014 High barriers to entry provide stability Rail transit moves more freight in ton/miles than truck, domestic boat or plane, accounting for 47% of total freight transported in the US. Trains carry freight with nearly ten times the energy efficiency of trucks per ton/mile. Being funded primarily by private sources, railway infrastructure costs pose significant barriers to entry while providing security for players already in the game. Investing legend Warren Buffett bought BNSF railroad for $35 Billion in 2009. Why else would he buy a railroad? Suffice to say, Kansas City Southern will be in existence for the long term and will provide decent profits for investors.

Valuation

Source: Bloomberg We calculated a target price of $105.41. Our valuation was modeled to accommodate management's guidance of converting operating leases to capital leases over the coming years. We based our projected trajectory of lease conversion on management's guidance of moving toward a 50/50 split between capital and operating leases. After modeling for this adjustment, we used a Discounted Cash Flow (DCF) approach and a comparable company multiplier method to generate a target price.

We used a DCF model because we thought it was an appropriate method to capture the growth potential of Kansas City Southern. With the unique growth potential that KSU has, our DCF model enabled our team to accurately value the cash flows while considering the timing of when they will take place. Our multiplier methodology, using P/E and EV/EBITDA, allowed us to take a deeper look at the historical and current market valuation of KSU. Our multiplier method was determined by selecting a specific group of industry competitors based on both quantitative and qualitative characteristics such as size, location, revenue mix, growth potential, and management skill.

Our DCF and Multiplier methods were most sensitive to our internal estimates of revenue, capital expenditures, dividend policy, discount rate, and the estimated perpetuity growth rate.

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Figure 14: KSU EBITDA

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Figure 13: KSU Market Price vs. Historical Premium

Source: Thompson One

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CFA Institute Research Challenge 30 JAN 2014 Optimistic growth assumptions appear priced into current valuation Our revenue forecast for Kansas City Southern was derived by estimating values within each industry segment. The industries estimated were chemical and petroleum, industrial and consumer products, agriculture and minerals, energy, intermodal, and automotive. We then broke down each industry by total carloads and yield growth rate. By estimating the total carloads and yield growth rate for each industry we were able to arrive at a total revenue estimate for the year. Our optimistic CAGR% in total revenue from 2013 – 2017 was 13.6%. The largest drivers in this above average revenue growth stemmed from the automotive, intermodal, and energy industries. Growth opportunities will drive CAPEX With the large growth prospects in Mexico and the southern portion of the United States, we believe future capital expenditures for Kansas City Southern will be significant. However, company reports and management estimates have stated that as a percent of revenue, CAPEX will decrease over the coming years. This supports lowering our estimates of capital expenditures as a percent of revenue slowly over the forecasted time period. Focus on growth will limit dividend expansion KSU currently pays a relatively low dividend indicative of its high growth potential. The 2012 dividend payout ratio stood at 23%. With managements guidance we included a slight increase in overall dividend payout over the forecasted years. However, we found it important to make sure that the dividend payout ratio stayed below the industry average. Doing so enables our forecasts to stay consistent with the overall growth driven agenda of Kansas City Southern. Upgraded debt rating impacts WACC The after tax cost of debt was calculated by using the most recent effective interest rate on debt of 4.37%, and the 2013 marginal tax rate of 35.95%. To calculate the cost of equity we used the CAPM model. The risk-free rate was determined by using the current rate on a 10 year US government bond of 2.87%. In an effort to remove the effects of leverage from KSU’s risk factor we unlevered their stated beta. We decided not to re-lever this beta using the industry average debt to equity ratio. This decision was based on the assumption that KSU is currently satisfied with their capital structure. The stated beta of 1.34 was adjusted to 1.22. To attain our market risk premium we took the current Bloomberg estimated MRP of 7.58 and added a 1.55% country premium for Mexico. We then identified the appropriate capital structure to use based off of 2013 financial statements, as well as our own internal estimates of moving toward a selected peer group average. We calculated a weighted average cost of capital for Kansas City Southern of 9.49%. United States and Mexican GDP drive perpetuity growth rate The GDP growth potential and expectations of Mexico and the United States were pivotal in determining the perpetuity growth rate we used. Our higher than average perpetuity growth rate of 4.5% is primarily driven by the growth potential specific to Mexico. The growth potential in Mexico comes from the country’s low labor costs, high labor pool, improved exchange rate between the peso and the dollar, as well as lower transportation costs for goods. With rising fuel costs, and increasing wages in China, many manufacturing companies are choosing to relocate closer to the U.S. All of these factors bode well for Kansas City Southern, and contributed to our above average perpetuity growth rate. KSU likely to continue trading at premium to peers Historically, KSU has traded at a significant premium to the industry in terms of P/E, 65%, and EV/EBITDA, 33%. Since KSU's growth potential is such a vital component to this valuation, we felt it fair to maintain these premiums in our valuation model.

Figure 15: Components of WACC Risk Free Rate 2.87% Beta 1.22 Market Risk Premium 7.58% Country Risk Premium 1.55% Cost of Debt 4.37%

Source: Team Estimates, Bloomberg

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Figure 17: Estimated EPS


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CFA Institute Research Challenge 19 Dec 2013

Financial Analysis Continued Operating Ratio Improvement Kansas City Southern has been able to decrease their operating ratio drastically over the last 4 years. From its recent peak in 2009 at 84%, it has been lowered to 68% as of 2013-year end. Increasing volumes while maintaining a disciplined cost structure will continue to drive margin improvement. Furthermore, we believe that the business operations in Mexico will play a vital role in continued margin improvement as well. Operating costs in Mexico are significantly less than the United States. While spending will be needed to fund future growth, we believe management when they claim further reductions in the operating ratio lie ahead. Ability to Generate Cash Flow In the analyzed historical period (2009-2013) KSU presented positive CFO and negative CFI due to the high level of CAPEX. We predict this trend will continue in the forecasted years ahead. In years 2009- 2013 KSU experienced negative CFF mainly from high debt payment. We expect this debt payment to level out over the forecasted period. Largely based on KSU’s ability to generate the necessary cash to cover their growth initiatives. We also think debt structure has been solidified, which in turn has decreased KSU’s weighted average coupon. KSU’s liquidity ratios have been strong over the analyzed period (Current ratio 2011: 1.47 2012: 1.23). We also expect the forecasted period to display above average liquidity ratios (Current ratio 2014E: 1.16 Current ratio 2017E: 2.03). For more financial ratios please see appendix #4. CAPEX is currently running greater than 2.5 times depreciation. While we don’t expect this to change during the forecasted period it is worth noting. A company maintaining this level of expenditure will be expected to grow. Much of KSU’s valuation will depend on their capitalization of their growth opportunities. DuPont Analysis – Drivers of Profitability In the analyzed period, KSU exhibited steady return on equity (2011 ROE 10.9% 2012 ROE 11.2). Our forecast period indicates an improvement to ROE (2014E ROE 15.9 2017E ROE 29.2) primarily driven by expanded net income margin and an increased asset turnover.

Financial leverage, measured by the ratio of asset over equity, is a primary determinant of future profitability. While we don’t forecast a large increase in liabilities over the forecast period, we do anticipate a marginal uptick in this source of profitability. Asset turnover, an indicator of a company’s ability to efficiently deploy resources (increase in sales due to increasing volume will be larger than the asset based) will prove another driver of profitability for KSU.

Debt Structure In March of 2013 Standard & Poor’s upgraded its rating on Kansas City Southern to investment grade, BBB-. S&P noted the company’s improving operating ratio, debt reduction, and decreasing interest expense. This upgrade allowed KSU to begin refinancing some of its high coupon debt for lower cost issues. In May of 2013 KSU was able to issue $900MM of 30 year paper at a coupon rate of 4.3%. As you can see in Figure 22 their interest coverage ratio has steadily improved since 2010, these refinancing issues aided that position. While $250MM of principle is due in 2016 the majority of principle repayment is greater than 8 years away. This allows KSU to focus it’s capital on growing earnings and provides the flexibility to deploy cash when necessary. Appendix 12 provides detail on current debt outstanding.

Figure 22: Debt Metrics

Legend 2013 2017E

ROE

10.6% 29.2%

ROA 5.7% 13.1%

Asset/Equity 188.9% 222.2%

NI/Sales 14.9% 24.5%

Sales/Assets 37.6% 53.7%


Figure 20: DuPont Analysis for 2013 & 2017E (Appendix 14)

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Figure 21: ROE Compared to Peer

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Figure 19: CAPEX / Depreciation

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Corporate Governance Favorable to Shareholders KCS corporate governance structure received a rating of 8.9 out of 10. Our team took into consideration eight pertinent aspects of KCS corporate governance including: selection of directors, selection of the director chair, independence, diversity, size, compensation committee, and the voting process within the board. A rating of 10 demonstrates perfect alignment between the interest of directors and stakeholders. A rating of 0 would prove incongruent to aligning director’s interest with stakeholders. In our opinion, the largest area of concern with the governing document is the Chairman of the Board selection. Even though the current Chairman of the Board is an independent director there were not any explicit documents prohibiting a current active officer to hold the position. Overall Kansas City Southern has stringent corporate governance, which aligns director interests with shareholder interests. Social Responsibility Environmentally and Socially Prudent Kansas City Southern is actively engaged in socially responsible initiatives. The Association of American Railroads has recognized KCS for maximizing its fuel efficiency. KCS has lowered the average age of their locomotive fleet to 10.9 from 17.2 years. KCS has also begun an initiative using ultra low sulfur diesel fuel in 2007. Studies show firms with a positive social responsibility image perform better in the stock market than firms with negative social responsibility. Overall, Kansas City Southern is engaged in several company-wide initiatives such as reducing greenhouse gases, programs promulgating safety around railroad crossings and charitable giving. Conditional Drivers of Additional Upside In 2012 KSU derived 46% of its revenue from Mexico. This is a compelling thesis and provides growth opportunities for KSU. While Mexico’s GDP has been strong over the long term it has consistently carried a premium to the U.S. Mexico’s highly skilled labor force is converging with that of China in terms of cost of labor. Aside from the country specific potential of Mexico, KSU has positioned itself for expansive growth in three divisions over the next five years. By 2017 Mexico’s auto production is expected to increase by 1MM units. KSU currently secures a 34% market share in this industry. Further regarding the potential growth in KSU’s ability to drive revenue from Mexico’s automotive industry, it is worthwhile to mention the opportunity at the Port of Veracruz. KSU was not originally granted access to the Port of Veracruz, an Eastern Mexico port. While the concession states KSU cannot build into another company’s track, it does not prohibit the port from building to KSU’s track. Estimates state that the Port of Veracruz has built track connecting it to KSU. With 750,000 cars exported from the Veracruz annually this creates another growth opportunity for KSU.

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Figure 23: Governance Rating

Source: Team Scoring

Truck 2012 Total U.S.-‐Mexican Border 5,103,923

Total Top 5 Gateways 4,097,483

Laredo, TX 1,789,546

Otay Mesa, CA 778,929 El Paso, TX 724,964

Hidalgo, TX 481,620

Calexico East, CA 322,424

Train Total U.S.-‐Mexican Border 8,957 Total Top 5 Gateways 8,490

Laredo, TX 3,492

Eagle Pass, TX 2,349

El Paso, TX 1,392 Nogales, AZ 657

Brownsville, TX 600 Source: Bureau of Transportation Statistics

Figure 24: US – Mexican Border Gateways: Number of Truck and Train Crossings

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Investment Risks ECONOMIC RISK: Peso/USD Exchange Rate Fluctuations With 46% of revenue coming from Mexico, there is significant exposure to the Peso – Dollar exchange rate. Furthermore, this exchange rate could also impact volumes and revenue per unit. ECONOMIC RISK: Global GDP Decline The revenue from industrial and consumer products, chemicals and petroleum, and agriculture tends to be highly correlated to the gross domestic product of the US and Mexico. Therefore, the overall economic activity of those countries greatly impacts KSU’s revenue. ECONOMIC RISK: Crude Price Fluctuations As can be seen in Figure 25 WTI Brent Crude appears to have an inverse relationship with KSU’s stock price. While fuel surcharges aid in curbing the impact of price fluctuations on revenue. Investors continue to perceive changes in WTI Brent Crude as relevant to KSU’s valuation. POLITICAL RISK: Drug trafficking near Port Lazaro Cardenas The Mexican navy, army, federal police and Attorney General’s office are now in control of the city and port of Lazaro Cardenas. Increased drug trafficking and violence between local gangs could have a negative impact on KSU’s expected growth out of this port. POLITICAL RISK: Widening of Panama Canal The Panama Canal expansion program is expected to double the capacity of the Panama Canal by 2015. At the completion of this project many ships coming from Asia will now have an all-water method to transport goods to the east coast. On the cusp of such a huge industry change, the impact to KSU is still largely uncertain. The most likely affected growth market is the Port of Lazaro Cardenas. POLITICAL RISK: Increased industry regulations In a response to two recent derailments, the U.S. announced new rules aimed at improving rail safety standards. Last July, a runaway train carrying Bakken oil derailed and exploded in Quebec, killing 47 people. The new rule requires more frequent track inspections and prompt repairs aimed at lowering the risk of derailment. Increased regulation on this industry will provide a service and timing obstacle for KSU. SOCIAL RISK: Decrease in demand for American made goods A decrease in demand for American made goods is a cultural/sociological factor that may decrease demand for KSU’s transportation services. With the decreased demand for American goods, demand for items in all stages of production (raw materials, WIP, finished goods) would decline. TECHNOLOGY RISK: Failure to implement train control technology In mature industries, effectively implementing technology can differentiate a company from competitors. KSU will need to stay ahead of the curve in order to sustain their current levels of profitability. One particular innovation has been tentatively titled, MultiRail. MultiRail technology allows railroad companies to weigh train cars without coming to a stop, and at a much higher speed than ever before. It can be inserted as rail track, and has scanners that detect the weight of the container, as well as faulty wheels, as it passes over the designated area. Systems like MultiRail eliminate the need for expensive weigh stations, increase the accuracy of the weighing process, improve safety through early detection of faulty parts, as well as decrease dwell time.

50

60

70

80

90

100

110

120

130

WTI Brent Crude KSU

11

13

15

Figure 25: WTI Brent Crude impact on KSU

Figure 26: USD / MXN Exchange Rate

Figure 27: Panama Canal Expansion


Source: Bloomberg

Source: www.oil-electric.com

11


Appendix #1: Pro Forma Balance Sheet 2011 2012 2013E 2014E 2015E 2016E 2017E Current Assets:

Cash and Cash Equivalents $72 $73 $44 $195 $307 $529 $811 Accounts Receivable $166 $184 $191 $222 $253 $293 $329 Materials and supplies $110 $126 $133 $147 $168 $183 $195 Other $295 $141 $60

Total Current Assets $643 $522 $429 $564 $728 $1,005 $1,335 Investments $50 $52 $52 $53 $53 $54 $55 Property and Equipment $5,322 $5,685 $5,685 $5,685 $5,684 $5,684 $5,684 Lease Asset $0 $0 $0 $99 $99 $70 $70 Other Assets $131 $137 $137 $149 $160 $181 $197

Total Assets $6,145 $6,396 $6,302 $6,549 $6,725 $6,994 $7,341

Current Liabilities: Debt due within one year $36 $60 $55 $45 $50 $53 $61

Accounts Payable and accrued liabilities $401 $365 $396 $442 $495 $549 $596 Total Current liabilities $437 $425 $451 $487 $545 $602 $657

Long term debt $1,603 $1,548 $1,498 $1,647 $1,847 $2,077 $2,427 Deferred income taxes $861 $894 $908 $880 $860 $854 $850 Other noncurrent liabilities and deferred

credits $185 $129 $108 $105 $104 $104 $103 Total Liabilities $3,086 $2,995 $2,965 $3,119 $3,356 $3,637 $4,037

Stockholders' Equity

Preferred Stock $6 $6 $6 $6 $6 $6 $6 Common Stock $1 $1 $1 $1 $1 $1 $1 Paid in Capital $884 $925 $930 $935 $940 $955 $960 Retained Earnings $1,875 $2,167 $2,092 $2,170 $2,099 $2,067 $2,004 Acumulated other Comprehensive loss ($2) ($2) ($2) ($2) ($2) ($2) ($2)

Total Stockholders' Equity $2,765 $3,097 $3,027 $3,111 $3,044 $3,028 $2,969 Noncontrolling Interest Total equity $294 $304 $310 $320 $325 $330 $335

Total Equity $3,059 $3,401 $3,337 $3,431 $3,369 $3,358 $3,304 Total Liabilities and Equity $6,145 $6,396 $6,302 $6,549 $6,725 $6,994 $7,340

12


Appendix #2: Pro Forma Income Statement 2011 2012 2013 2014E 2015E 2016E 2017E Sales $2,098 $2,239 $2,369 $2,701 $3,030 $3,448 $3,940

Operating Expenses $1,487 $1,523 $1,631 $1,807 $1,965 $2,154 $2,421

Op. Exp. % Rev 71% 68% 69% 67% 65% 62% 61%

Operating Income (EBIT) $612 $716 $739 $894 $1,066 $1,294 $1,519

EBITDA $798 $915 $962 $1,160 $1,370 $1,619 $1,909

EBITDA Margin 38% 41% 41% 43% 45% 47% 48%

Depreciation and Amortization $186 $199 $223 $266 $304 $325 $390

CAPEX % 24% 24% 25% 23% 21% 19% 17%

Financial Expense ($159) ($99) ($186) ($60) ($62) ($44) ($41)

Financial Income $2 ($1) ($1) $1 $5 $2 ($1)

EBT $455 $616 $552 $836 $1,008 $1,253 $1,477

Income Tax Expense $123 $237 $198 $290 $350 $435 $513

Net Income $332 $379 $353 $546 $658 $818 $965

Net income (loss) to NC interests $2 $2 ($2) $0 $0 $0 $0

Net Income to KSU and Subsidiary. $330 $377 $355 $546 $658 $818 $965

Dividends $3 $89 $90 $120 $140 $170 $200

NI to Common Shareholders $327 $288 $265 $426 $518 $648 $765

13


Appendix #3: Statement of Cash Flows 2013E 2014E 2015E 2016E 2017E Operating Activities:

Net Income $353 $546 $658 $818 $965

Depreciation and Amortization $223 $266 $304 $325 $390

Changes in Working Capital $0 ($14) ($15) ($17) ($9)

Other $140 $175 $180 $185 $190

Net cash provided by operating activities $697 $955 $1,102 $1,290 $1,514

Investing Activities: Capital Expenditures ($600) ($619) ($636) ($655) ($670)

Other Investments ($13) ($15) ($14) ($13) ($12)

Net cash used for investing activities ($613) ($634) ($650) ($668) ($682)

Financing Acitivities: Proceeds from debt borrowings $300 $250 $250 $220 $150

Debt payment ($250) ($300) ($450) ($450) ($500)

Share repurchases $0 $0 $0 $0 $0

Share Issues $0 $0 $0 $0 $0

Other $0 $0 $0 $0 $0

Dividends paid ($90) ($120) ($140) ($170) ($200)

Net cash used for financing activities ($40) ($170) ($340) ($400) ($550)

Net increase (decrease) during each period $44 $150 $112 $222 $282

At beginning of year $73 $117 $267 $379 $601

At end of Year $44 195 307 529 811

14


Appendix #4: Ratio Analysis 2011 2012 2013 2014E 2015E 2016E 2017E Profitability ratios ROE 10.85% 11.16% 10.59% 15.91% 19.54% 24.36% 29.20% ROA 5.40% 5.93% 5.61% 8.33% 9.79% 11.69% 13.14% ROIC 73.77% 63.33% 48.73% 72.90% 74.50% 76.66% 77.08% Gross margin 29.15% 31.98% 31.17% 33.11% 35.16% 37.54% 38.56% Operating margin 70.85% 68.02% 68.83% 66.89% 64.84% 62.46% 61.44% EBITDA margin 38.02% 40.86% 40.60% 42.95% 45.20% 46.95% 48.45% Net Income Margin 15.82% 16.95% 14.91% 20.21% 21.73% 23.72% 24.49% NOPAT margin 21.25% 20.48% 22.80% 21.62% 22.96% 24.51% 25.18% Liquidity Current Ratio 1.47 1.23 0.95 1.16 1.34 1.67 2.03 Quick Ratio 1.22 0.93 0.65 0.86 1.03 1.36 1.74 Cash ratio 0.17 0.17 0.10 0.40 0.56 0.88 1.23 Efficiency Total Asset Turnover 0.34 0.35 0.38 0.41 0.45 0.49 0.54 Net Long Term Asset Turnover 0.38 0.38 0.40 0.45 0.51 0.58 0.66 Operating Working Capital 1.30 1.06 0.85 0.76 0.77 0.79 0.80 Net Long Term Asset Turnover 0.47 0.46 0.49 0.54 0.60 0.69 0.78 Accounts Payable Turnover 3.71 4.18 4.11 4.08 3.97 3.92 4.06 Accounts Receivable Turnover 12.64 12.19 12.41 12.17 11.97 11.77 11.97 Inventory Turnover 13.56 12.12 12.22 12.25 11.68 11.77 12.43 Days Receivable 28.88 29.94 29.40 30.00 30.50 31.00 30.50 Days Payable 98.47 87.40 88.71 89.36 91.95 93.04 89.87 Days Inventory 26.91 30.11 29.88 29.79 31.26 31.01 29.36 Cash Conversion Cycle 96.51 87.57 89.19 89.15 92.71 93.06 88.73 Solvency Debt ratio 0.50 0.47 0.47 0.48 0.50 0.52 0.55 Debt to Equity 0.54 0.47 0.47 0.49 0.56 0.63 0.75 Net Debt to Equity 0.51 0.45 0.45 0.44 0.47 0.48 0.51 Debt to EBITDA 2.05 1.76 1.61 1.46 1.38 1.32 1.30 EBITDA/Int 6.18 9.11 11.93 15.68 20.75 26.11 31.82 Financial Leverage 2.01 1.88 1.89 1.91 2.00 2.08 2.22 Internal CAPEX Financing (CFO/CAPEX) 1.29 1.25 1.21 1.55 1.70 1.95 2.25

15


Appendix #5: KSU Summary Model 2011 2012 2013 2014E 2015E 2016E 2017E Income Statement (US$ Millions, except per share data)

Revenues 2,098 2,239 2,369 2,701 3,030 3,448 3,940 Growth y/y % 15.6% 6.7% 5.8% 14.0% 12.2% 13.8% 14.3%

Comp & Benefits (424) (431) (442) (500) (530) (569) (611) Purchased Services (205) (220) (217) (204) (229) (261) (298) Fuel (347) (360) (390) (406) (440) (483) (531) Equipment Costs (167) (167) (161) (203) (228) (259) (296) Depreciation (186) (199) (223) (216) (255) (290) (355) Materials & Others (184) (190) (198) (230) (235) (259) (296) Total Operating Costs (1,512) (1,566) (1,631) (1,760) (1,917) (2,121) (2,387)

EBITDA 798 915 962 1,110 1,320 1,584 1,874 Growth y/y % 15.0% 14.6% 5.2% 20.6% 18.1% 18.2% 17.9% EBIT 612 716 739 894 1,066 1,294 1,519 Growth y/y % 20.5% 17.0% 3.2% 21.0% 19.2% 21.4% 17.4%

Net Income 332 379 353 546 658 818 965 Growth y/y % 75.2% 14.2% -‐6.8% 54.5% 20.5% 24.3% 18.0%

Diluted EPS 3.00 3.43 3.18 4.95 5.95 7.40 8.72 Growth y/y % 14.33% -‐7.29% 55.66% 20.20% 24.37% 17.84%

Key Assumptions

Revenue/Carload % y/y 8.3% 4.9% 3.2% 9.8% 9.4% 10.5% 10.8%

Carloads Growth % y/y 6.8% 1.7% 2.8% 3.8% 2.6% 3.0% 3.1% Operating Ratio 72.3% 69.2% 67.8% 66.9% 64.8% 62.5% 60.3%

Balance Sheet

Cash 72 73 !! 195 307 529 811

Other Current Assets 846 766 384 365 415 471 521 Total Assets 6,145 6,396 6,396 6,549 6,725 6,994 7,341 Debt (Short + Long Term) 1,639 1,608 1,553 1,692 1,897 2,130 2,488 Total Liabilities 3,086 2,995 2,965 3,119 3,356 3,637 4,037 Shareholders' Equity 3,059 3,401 3,337 3,431 3,369 3,358 3,304

Key Ratios

Debt/EBITDA 2.05 1.76 1.61 1.46 1.38 1.32 1.30

EBITDA/Interest 6.18 9.11 11.93 15.68 20.75 26.11 31.82 ROIC 73.8% 62.1% 54.6% 72.9% 74.5% 76.7% 77.1% ROE 10.9% 11.2% 10.6% 15.9% 24.4% 29.2% 29.2% ROA 5.4% 5.9% 5.6% 8.3% 9.8% 11.7%% 13.1%

Cash Flow Items

Cash From Operations 638 673 697 955 1,102 1,290 1,514

CAPEX (445) (540) (600) (619) (636) (655) (670) Dividends (3) (86) (90) (120) (140) (170) (200) Free Cash Flow 190 47 7 216 326 465 644

16


Appendix #6: DCF Analysis

2013 2014E 2015E 2016E 2017E

Risk Free Rate 2.87% 2.87% 2.87% 2.87% 2.87%

Equity Risk Premium 7.58% 7.58% 7.58% 7.58% 7.58% Country Risk Premium 1.55% 1.55% 1.55% 1.55% 1.55% Beta 1.22 1.22 1.22 1.22 1.22

Cost of Equity 13.67% 13.67% 13.67% 13.67% 13.67% Cost of Debt 4.37% 4.37% 4.37% 4.37% 4.37% Marginal Tax Rate 35.95% 35.95% 35.95% 35.95% 35.95%

After-‐Tax Cost of Debt 1.57% 1.57% 1.57% 1.57% 1.57%

Weight of Equity 61.54% 61.54% 61.54% 61.54% 61.54%

Weight of Debt 38.46% 38.46% 38.46% 38.46% 38.46%

WACC 9.49% 9.49% 9.49% 9.49% 9.49%

2013 2014E 2015E 2016E 2017E

NOPAT 540 584 696 845 992

D&A 223 266 304 325 390 Change in NWC 0.3 (13.8) (15.4) (17.1) (9.5) CAPEX (600) (619) (636) (655) (670)

FCFF 245 291 414 560 762

Terminal Growth Rate 4.50%

Perpetuity WACC 9.49% Terminal Value 15,968 PV of Terminal Value 11,111 PV of Free Cash Flow 2,075 Enterprise Value 13,186 Net Debt (1,508) Value of Equity 11,678 Number of Shares 110.478 Price Per Share $105.70

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Appendix #7: Market Multiple Valuation

Price/Earnings 2008 2009 2010 2011 2012 2013

CSX 9.3 16.6 15.3 12.1 10.8 14.9 CP 10.2 15.6 16.8 20.6 36.3 25.7 NSC 10.0 18.7 15.0 12.6 11.1 15.6 UNP 10.3 17.0 16.4 15.4 15.0 17.4

Average P/E 10.0 17.0 15.9 15.2 18.3 18.4 KSU P/E 9.5 47.1 27.3 22.6 24.4 31.4 Historical Premium (+)/Discount (-‐) -‐4.8% 177.5% 71.7% 49.1% 33.2% 70.8%

Average KSU Trading Premium: (2008-‐2013) 66.3%

EV/EBITDA 2008 2009 2010 2011 2012 2013

CSX 5.4 8.2 7.7 7.0 6.5 7.9 CP 7.0 9.6 9.3 11.3 11.9 14.0 NSC 6.0 9.2 8.2 7.6 6.8 8.5 UNP 5.8 8.3 8.2 8.0 7.9 9.1

Average EV/EBITDA 6.1 8.8 8.4 8.4 8.3 9.9 KSU EV/EBITDA 7.0 12.0 10.1 12.1 12.7 13.6 Historical Premium (+)/Discount (-‐) 15.3% 36.4% 20.3% 43.2% 53.3% 38.0%

Average KSU Trading Premium: (2008-‐2013) 34.4%

2014E 2014E Target P/E Multiple 22.0 Target EV/EBITDA Multiple 12.0 PV of 2014E EPS 4.52 PV of 2014E EBITDA 1,060

Enterprise Value 13,774

Net Debt (1,508)

Equity Value ($/Mln) 12,266

Price from P/E $99.51 Price from EV/EBITDA $111.03

Price from P/E Valuation $99.51

Weight of P/E Valuation (1/3) Price from EV/ EBITDA Valuation $111.03 Weight of EV/EBITDA (1/3) Price from DCF Valuation $105.70 Weight of DCF (1/3) Target Price Per Share $105.41 5.95% Upside Potential

Current Price Per Share (1/24/2014) 99.49

18


Appendix #8: Stock Price Sensitivity

Perpetuity Growth Method

EBITDA Multiple Method

P / E Multiple Method

Weighted average cost of capital

8.74% 8.99% 9.24% 9.49% 9.74% 9.99% 10.24%

3.50% $100.12 $95.75 $91.77 $88.11 $84.74 $81.63 $78.75

Terminal 3.75% $105.11 $100.30 $95.93 $91.93 $88.27 $84.89 $81.77 growth 4.00% $110.63 $105.31 $100.49 $96.10 $92.10 $88.42 $85.04 rate 4.25% $116.77 $110.84 $105.50 $100.67 $96.28 $92.27 $88.58

4.50% $123.62 $116.99 $111.05 $105.70 $100.86 $96.46 $92.43

4.75% $131.34 $123.86 $117.21 $111.26 $105.90 $101.05 $96.63

5.00% $140.09 $131.60 $124.10 $117.44 $111.47 $106.10 $101.23

5.25% $150.10 $140.37 $131.86 $124.34 $117.66 $111.68 $106.30

5.50% $161.65 $150.40 $140.65 $132.12 $124.58 $117.89 $111.89


9.04% 9.19% 9.34% 9.49% 9.64% 9.79% 9.94%

10.00x $92.28 $92.13 $91.99 $91.85 $91.70 $91.56 $91.41

10.50x $97.10 $96.94 $96.79 $96.64 $96.49 $96.34 $96.19

11.00x $101.91 $101.75 $101.59 $101.44 $101.28 $101.12 $100.96

Terminal 11.50x $106.73 $106.56 $106.40 $106.23 $106.07 $105.90 $105.74 multiple 12.00x $111.54 $111.37 $111.20 $111.03 $110.86 $110.69 $110.52

12.50x $116.36 $116.18 $116.00 $115.82 $115.64 $115.47 $115.29

13.00x $121.17 $120.99 $120.80 $120.62 $120.43 $120.25 $120.07

13.50x $125.99 $125.79 $125.60 $125.41 $125.22 $125.03 $124.84

14.00x $130.80 $130.60 $130.41 $130.21 $130.01 $129.81 $129.62


9.04% 9.19% 9.34% 9.49% 9.64% 9.79% 9.94%

14.00x $63.59 $63.50 $63.41 $63.32 $63.24 $63.15 $63.07

16.00x $72.67 $72.57 $72.47 $72.37 $72.27 $72.17 $72.07

18.00x $81.75 $81.64 $81.53 $81.42 $81.31 $81.20 $81.08

P/E 20.00x $90.84 $90.71 $90.59 $90.46 $90.34 $90.22 $90.09 Multiple 22.00x $99.92 $99.78 $99.65 $99.51 $99.37 $99.24 $99.10

24.00x $109.00 $108.86 $108.71 $108.56 $108.41 $108.26 $108.11

26.00x $118.09 $117.93 $117.76 $117.60 $117.44 $117.28 $117.12

28.00x $127.17 $127.00 $126.82 $126.65 $126.48 $126.30 $126.13

30.00x $136.26 $136.07 $135.88 $135.70 $135.51 $135.33 $135.14

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Appendix #9: Precedent Transaction Analysis Two precedent transactions were identified as viable transactions to analyze. However, due to the transactions being immaterial in number and irrelevant in occurrence, our team decided to exclude them from our main report. The precedent transaction model identifies past mergers or acquisitions of comparable companies in which transaction multiples can be calculated similar to current market multiples. Those transaction multiples are then applied to financial metrics of Kansas City Southern. The results are shown below. Based on the precedent transaction model an intrinsic share price of $98.5 was reached. This valuation confirms that KSU is valued fairly when compared to the market price (1/24).

Premium Paid

Days Prior to Unaffected Announced Acquirer Target 1 7 30

11/3/2009 Berkshire Hathaway BNSF 25% 30% 31%

4/8/1997 NSF/CSX Conrail 8% 9% 9%

Mean 17% 20% 20%

2013 Average EV/EBIT 16.1 2013 EBIT 738.6 Implied Enterprise Value 11,907.8 Less STD, LTD, Minority, Pref Stock plus cash -‐2,071.5 Enterprise Value 9,836.3 Less acquisition premium -‐20.2% Plus historic trading premium 38.5% Implied Equity value 10,867.3 Shares Outstanding 110.3

Implied Price from EV/EBIT $98.5

Compare Market Price

Market price (1/24/14) $99.5 Implied share price $98.5

FAIRLY VALUED

_____________________________ *Last Twelve Months Source: Thomson One Investment Banking


Transaction Purchase Equity Enterprise EV / EV / EV / Announced Acquirer Target Type Consideration Value

(M) Value (M) Sales* EBITDA* EBIT*

11/3/2009 Berkshire Hathaway

Burlington Northern Sante

Fe (BNSF) Acquisition Cash/Stock

$35,369

$44,593 3.0x 8.4x 11.9x

4/8/1997 NSF/CSX Conrail Acquisition Cash/Stock

10,200

12,257 3.3x 11.5x 20.4x

Mean 3.1x 10.0x 16.1x

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Appendix #10: DCF Assumptions

1. Revenue: Our revenue forecast for Kansas City Southern was derived by estimating figures within each industry segment. These industries were chemical and petroleum, industrial and consumer products, agriculture and minerals, energy, intermodal, and automotive. Next we broke down each industry in sub components of total carloads and yield growth rate. By estimating the total carloads and yield growth rate for each industry we were able to arrive at a total revenue estimate for the year. The total revenue CAGR% from 2013 – 2017 is 13.6%. A more detailed description behind our assumptions for each industry is as follows:

uAutomotive: A growing automotive industry, specifically in Mexico, is a huge potential for future revenue growth for Kansas City Southern. With Nissan having just opened up a plant at the end of 2013, followed by Mazda and Honda opening new plants in 2014, KSU will see a surge in automobiles that need to be transported. Possible plant construction for other automobile companies such as Mercedes, and Toyota, in 2015 and beyond, could be additional growth drivers for KSU down the road. We do see some headwind in the automobile industry that could slow down the incredible ascent projected by management. With all of the new plants projections of supply stealing the spotlight, people seem to have forgotten about the other part of the equation, demand. Of the three new plants, Nissan, Mazda, and Honda, only Honda ranks in the top 5 U.S. automotive sales, coming in at the bottom 5th spot. Additionally, according to an industry analysis by the NADA, new vehicle sales for each of the companies mentioned previously (Nissan, Mazda, Honda, Mercedes, and Toyota) are growing at a slower rate than American companies such as GM, Chrysler, and Ford. We believe the trend of consumers pursuing American brand automobile companies will continue, and that the demand for the foreign competitors building out of Mexico, will not be the revelation anticipated. uEnergy: The energy business unit will benefit from the increased production and transportation coming from the growing southern United States. The primary growth drivers in this area lie in the Port Arthur market, as well as the new Beaumont facility. Port Arthur currently imports between 1.5 – 2 million barrels a day of crude by rail from the Bakken region and Western Canada. With KSU positioned well to serve, we see strong growth ahead in this area. In regards to the Port of Beaumont, the recent completion of the rail loop track now connects the new crude oil terminal with KSU’s mainline. Expectations are that capacity at this new facility will be at 2 million barrels by the end of 2014. This is a particular sweet spot due to the addition of steaming capabilities the new oil terminal will have. The steaming will allow the terminal to handle Bakken sweet crude, light crude, and the Canadian heavy crude. However, all is not well with the energy segment. Even with KSU having a lower industry average exposure to coal, the decreasing demand of this resource will continue to be a lag on revenues. With the seasonal shutdown of the Luminant plant happening again in 2014, we believe KSU will continue to see erosion in revenues attributable to the coal. u Intermodal: The rapidly growing intermodal division of KSU will be one of the largest revenue drivers over the coming years. KSU’s intermodal growth is primarily driven by truck-‐to-‐rail conversion in cross-‐border business. Since KSU barely occupies 3% market share on an estimated 3 million trucks crossing the U.S.-‐Mexico border, the potential for gains are huge. uAgriculture and Mineral: The agriculture and mineral segment will see strong growth over the next year, rebounding from the disastrous drought of 2012. The agriculture and mineral segment will then begin to taper back to normalcy and continue to be a consistent, albeit low growth driver of revenue. The risk with the agriculture and mineral division is that there is limited upside potential, but nearly unlimited downside potential. This predicament is a natural occurrence since KSU operates in an outdoor environment that leaves the company exposed to weather risks. u Industrial and Consumer Products: We estimate the industrial and consumer products division will be the lowest growth potential for Kansas City Southern. This is due to management’s guidance that the core business in industrial and consumer products is only expecting single digit growth, running into the head wind of a decreasing paper business. We fear that the effect of the decreasing paper trend will weigh down revenues in this area more than anticipated. uChemical and Petroleum: The chemical and petroleum business will be a moderate to low growth potential for KSU over the coming years. The main driver for a lower growth assumption stems from the continued shift away from fuel oil to hydroelectric and natural gas. We believe the continued low price of natural gas, and social trend of moving toward green energy will stymie any large growth opportunities.

21


Appendix #10: DCF Assumptions Cont.

2. Cost of Goods Sold: We forecasted cost of goods sold as a percent of revenue. With increased revenues over the coming years we foresee continued improvement in the operating ratio of KSU. Over the last few years KSU has seen a consistent 1-‐1.5% improvement in the operating ratio. We believe this trend will continue through volume improvement, Mexico operation benefits, and managements continued focus on headcount (the largest component of operating expenses).

Risk free rate 10 Year United States government bond 2.87%

Beta Based off a three-‐year regression starting in 2010 and going through 2012. 1.34

Beta (Adj.) The adjusted beta was calculated by un-‐levering KSU’s stated beta, in an effort to remove the effects of leverage.

1.22

Market risk premium Bloomberg calculation 7.58% Country Risk Premium Based on A. Damodaran's calculation 1.55%

Cost of Debt The cost of debt was calculated by using the most recent effective interest rate on debt. 4.37%

Tax Rate Based on the 2013 marginal tax rate. 35.95%

Capital Structure Based upon 2013 financial statements, and estimates of moving toward a peer group average.

Debt 32% Equity 68%

3. Weighted Cost of Capital:

Carloads Growth over Prior Year 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 2.0% 1.0% 1.0% 1.0% 0.0%

Industrial and Consumer Products 0.4% 1.0% 0.8% 0.8% 0.8%

Agriculture and Minerals (2.2%) 18.0% 4.0% 5.0% 6.0%

Energy 5.2% 9.0% 9.0% 9.5% 10.0%

Intermodal 7.0% 13.0% 14.0% 15.0% 15.0%

Automotive 7.0% 15.0% 20.0% 22.0% 21.0% Yield Growth over Prior Year 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 5.0% 5.0% 5.0% 6.0% 5.0%

Industrial and Consumer Products 4.6% 7.0% 6.5% 7.0% 7.0%

Agriculture and Minerals (1.2%) 7.0% 5.0% 6.0% 7.0%

Energy 5.8% 3.5% 4.0% 4.5% 5.0%

Intermodal 8.9% 7.0% 7.0% 7.0% 7.0%

Automotive 8.6% 6.0% 7.0% 7.5% 7.0% Percent of Total Revenue: 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 18% 17% 16% 15% 14%

Industrial and Consumer Products 25% 23% 22% 21% 20%

Agriculture and Minerals 16% 18% 17% 17% 17%

Energy 14% 14% 14% 14% 14%

Intermodal 15% 16% 17% 18% 20%

Automotive 9% 9% 10% 12% 13%

Other 4% 4% 4% 3% 3%

Total: 100% 100% 100% 100% 100%

22


-20%

-15%

-10%

-5%

0%

5%

10%

15%

-8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

-‐20%

-‐15%

-‐10%

-‐5%

0%

5%

10%

15%

-‐8% -‐6% -‐4% -‐2% 0% 2% 4% 6% 8% 10%

Appendix #11: WACC Analysis

COMPANY LEVERED BETA TAX RATE DEBT / EQUITY UNLEVERED BETA Kansas City Southern 1.615 34.72% 49.69% 1.220 Canadian Pacific 1.189 28.63% 79.10% 0.760 CSX Corporation 1.331 35.96% 91.72% 0.838 Norfolk Southern 1.190 35.56% 86.90% 0.763 Union Pacific 1.125 37.85% 45.51% 0.877

Industry Average 1.290 34.50% 70.60% 0.891

Source: Bloomberg

KSU stock price regressed against the S&P 500 Index. Source: Bloomberg

Market risk premium

6.08% 6.58% 7.08% 7.58% 8.08% 8.58% 9.08%

0.72 5.54% 5.76% 5.98% 6.20% 6.42% 6.65% 6.87%

0.82 5.91% 6.16% 6.42% 6.67% 6.92% 7.17% 7.43%

0.92 6.29% 6.57% 6.85% 7.14% 7.42% 7.70% 7.99%

1.02 6.66% 6.97% 7.29% 7.60% 7.92% 8.23% 8.54%

1.12 7.04% 7.38% 7.72% 8.07% 8.41% 8.76% 9.10%

Beta 1.22 7.41% 7.78% 8.16% 8.54% 8.91% 9.29% 9.66%

1.32 7.78% 8.19% 8.60% 9.00% 9.41% 9.81% 10.22%

1.42 8.16% 8.60% 9.03% 9.47% 9.91% 10.34% 10.78%

1.52 8.53% 9.00% 9.47% 9.94% 10.40% 10.87% 11.34%

1.62 8.91% 9.41% 9.90% 10.40% 10.90% 11.40% 11.90%

1.72 9.28% 9.81% 10.34% 10.87% 11.40% 11.93% 12.46%

23


Appendix #12: Debt Structure

-‐

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1,000,000

2016 2017 2018 2020 2022 2023 2025 2030 2043

Bonds Revolving Credit Term Loans

Bonds

Issuer Ticker Value (M) Coupon YTM Price

1/12/14 Maturity Rating Currency

Kansas City Southern De Mexico KSU 250,000 FLOAT 0.840% 100.827 10/28/16 BBB-‐ USD

Kansas City Southern De Mexico KSU 300,000 8.000% 5.876% 104.000 2/1/18 BBB-‐ USD


Southern Capital Corp KSU 167,616 5.700% 5.701% N.A. 6/30/22 BBB+ USD


The Kansas City Southern Railway Co KSU 200,000 3.850% 4.051% 98.379 11/15/23 BBB-‐ USD


Kansas City Southern KSU 100,000 7.000% 7.000% N.A. 12/15/25 NR USD



Weighted Average YTM 4.367%

Revolving Credit



Kansas City Southern De Mexico KSU 200,000

N.A 11/15/17 BBB-‐ USD

The Kansas City Southern Railway Co KSU 200,000 N.A 11/15/17 BBB-‐ USD

Project Financing



Texas Mexican Railway Co KSU 50,000 0.0429 4.290% N.A 7/13/30

USD

The Kansas City Railway Co KSU 266,000 0.0149 1.490% N.A 5/15/18 BBB-‐ USD

Kansas City Southern De Mexico KSU 72,750 0.05737 5.737% N.A 2/28/23 BBB-‐ USD

24

CFA Institute Research Challenge 30 JAN 2014 Appendix #13: Working Capital Calculation

Projected

2011 2012 2013 2014E 2015E 2016E 2017E

Sales $2,098.3 $2,238.6 $2,369.3 $2,701.1 $3,030.5 $3,448.3 $3,940.1

Cost of sales $1,328.3 $1,486.7 $1,522.7 $1,630.7 $1,806.6 $1,964.8 $2,153.9

Accounts receivable, net $166.0 $183.6 $190.8 $222.0 $253.2 $292.9 $329.2

% of Sales 7.91% 8.20% 8.05% 8.22% 8.36% 8.49% 8.36%

Inventories 109.6 125.6 133.5 147.4 168.3 183.0 194.7

% of Sales 5.22% 5.61% 5.63% 5.46% 5.55% 5.31% 4.94%

Other current assets 69.5 48.4 66.3 81.0 97.0 113.8 122.1

% of Sales

3.31% 2.16% 2.80% 3.00% 3.20% 3.30% 3.10%

Other Plug $61.80 $61.70 $60.00 $60.00 $60.00 $60.00 $60.00

Total non-‐cash current assets: $406.9 $419.3 $450.7 $510.5 $578.5 $649.7 $706.1

Accounts payable $401.1 $364.6 $396.3 $442.3 $495.0 $549.1 $596.0

% of Sales 30.20% 24.52% 26.03% 27.12% 27.40% 27.95% 27.67%

Total non-‐debt current liabilities $401.1 $364.6 $396.3 $442.3 $495.0 $549.1 $596.0

Net working capital / (deficit) $5.8 $54.7 $54.4 $68.2 $83.5 $100.6 $110.1

(Increase)/decrease in working capital ($43.0) ($48.9) $0.3 ($13.8) ($15.4) ($17.1) ($9.5)

Working Capital Assumptions Accounts receivable (days collection period) 28.9 29.9 29.4 30.0 30.5 31.0 30.5 Inventories (days outstanding)

30.1 30.8 32.0 33.0 34.0 34.0 33.0

Accounts payable (days outstanding)

110.2 89.5 95.0 99.0 100.0 102.0 101.0

Other current assets (as % of sales)

3.3% 2.2% 2.8% 3.0% 3.2% 3.3% 3.1%

Total non-‐debt current liabilities (as % of sales) 19.1% 16.3% 16.7% 16.4% 16.3% 15.9% 15.1%

25

CFA Institute Research Challenge 30 JAN 2014 Appendix #14: Monte Carlo Simulation

To supplement our sensitivity analysis we conducted a Monte Carlo simulation. The simulation would allow for us to see how overall changes in GDP growth rate, total carloads, and the price of oil, would effect our estimated target price. These three variables were selected because they had some of the highest degrees of impact relating to the outlook, revenue, and profitability of Kansas City Southern. Our Monte Carlo simulation was generated using 10,000 iterations. Our estimates from the simulation concluded that KSU’s stock price revolves around $106 per share, which supports our hold recommendation.

Monte Carlo Summary Statistics Mean $104 Lower Range $65 Upper Range $145 Hold Percentage 78% Sell Percentage 7% Buy Percentage 15%

0 200 400 600 800

1000 1200 1400 1600 1800 2000

$60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Freq

uency

Stock Price

Chart Title

Sell

Hold

Buy

26

CFA Institute Research Challenge 30 JAN 2014 Appendix #15: Regression Models

Auto-‐Regression (1 Period) and Linear Trend Model of Revenue: We conducted a simple linear model, as well as an AR (1) model on the revenue components of KSU. This was conducted to determine what the statistically predicted revenue streams would yield. Our regression analysis broke down the revenue components first by industry, followed by total carloads and yield growth rate. We used the previous 5 years annual historical data gathered from Kansas City Southern financial statements as our data set. For consistency between valuation methods we kept all other variables constant, or based off of a percent of total revenue. Upon reviewing our findings, the AR (1) model determined significantly lower revenue than our manual estimates, as did the linear trend model. The final target price using the linear model and the AR(1) were $101.62 and $95.02 respectively. With the growth potential that KSU has we were not surprised by the lower price due to the inherent nature of regression based forecasting (Predicting future values from historical data). However, we were surprised by the gravity with which the revenue shortfall amounted to in each model.

We used these regression models as a point of reference to see how KSU would perform if some of the expected growth did not materialize. These regressions allowed for us to see what valuation the market has built into the stock price, as well as how KSU could be negatively impacted by slower than previously anticipated growth.

Linear Trend Model of Revenue

Revenue Growth 2010 2011 2012 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 12% 9% 4% 5% 1% 3% 3% 3%

Industrial and consumer products 24% 18% 9% 5% 14% 9% 8% 8%

Agriculture and Minerals 19% -‐3% -‐4% -‐6% 6% 0% 0% 0% Energy 27% 33% -‐1% 10% 15% 10% 9% 8%

Intermodal 35% 30% 22% 15% 16% 13% 11% 10%

Automotive 85% 42% 25% 15% 22% 15% 13% 12%

Carload Revenues, Carloads and Units 24% 16% 7% 6% 11% 8% 7% 7%

Percent of Revenue 2010 2011 2012 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 21% 20% 19% 19% 17% 16% 16% 15% Industrial and consumer products 24% 25% 26% 25% 26% 26% 26% 27%

Agriculture and Minerals 25% 21% 19% 16% 16% 14% 13% 13% Energy 14% 16% 15% 15% 16% 16% 16% 16%

Intermodal 11% 12% 14% 15% 16% 17% 18% 18%

Automotive 6% 7% 8% 9% 10% 10% 11% 11%


27

Appendix #15: Regression Models Cont.

We conducted a regression analysis to check for correlation between the West Texas intermediate crude and the stock price of Kansas City Southern. We chose to select WTI as an explanatory variable because of the geographic location of where the oil originates, as well as where the oil is transported. With the current spread narrowing between WTI and Brent, it was important to focus specifically on WTI because of the time period we were evaluating. In recent years, the spread between WTI and Brent have been materially different, and we believe that the close proximity relationship between where KSU operates, and where WTI crude originates, would provide us with the most statistically relevant results. The purpose of this regression was two fold. First, we were able to determine stock price sensitivity to WTI crude prices, which in turn would enable us to anticipate the effect that WTI crude volatility could have on KSU’s stock price. Secondly, it allowed for us to generate statistically significant reference points for our Monte Carlo assumptions. Below are summary statistics based on the daily prices for WTI Brent Crude and KSU stock during the time period of January 2005-‐ December 2013 at a 95% confidence level.

Regression Analysis: WTI Crude – KSU Stock Price

Revenue Growth 2010 2011 2012 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 12% 9% 4% 5% -‐1% 2% 0% 1% Industrial and consumer products 24% 18% 9% 5% 1% 2% 0% 1%

Agriculture and Minerals 19% -‐3% -‐4% -‐6% 8% 1% -‐1% 0% Energy 27% 33% -‐1% 10% -‐3% 3% -‐1% 1%

Intermodal 35% 30% 22% 15% 1% 5% 0% 3%

Automotive 85% 42% 25% 15% 1% 5% 0% 3%


Percent of Revenue 2010 2011 2012 2013 2014E 2015E 2016E 2017E

Chemical and Petroleum 21% 20% 19% 19% 19% 18% 18% 18% Industrial and consumer products 24% 25% 26% 25% 25% 25% 25% 25%

Agriculture and Minerals 25% 21% 19% 16% 18% 17% 17% 17% Energy 14% 16% 15% 15% 14% 14% 14% 14%

Intermodal 11% 12% 14% 15% 15% 16% 16% 16%

Automotive 6% 7% 8% 9% 9% 9% 9% 9%


Auto Regression (1 Period) Model

SUMMARY OUTPUT

Regression Statistics Multiple R 0.64

R Square 0.41

Adjusted R Square 0.41

Standard Error 20.86

Observations 2245.00

ANOVA

df SS MS Regression 1.00 683414.59 683414.59 Residual 2243.00 976177.63 435.21

Total 2244.00 1659592.22

Coefficients Standard Error t Stat Intercept -‐23.95 1.80 -‐13.29

X Variable 1 0.86 0.02 39.63

28


Appendix #16: Industry Evolution

0

500,000

1,000,000

1,500,000

2,000,000

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

In Billions

U.S. Ton-‐Miles of Freight Moved

Air Truck Railroad Domestic water transportation

Intercity Distance in Miles 0-‐250 250-‐500 500-‐1000 1000-‐2000 >2000

Weight

Retail Goods/Light Truck Truck Truck, Rail Intermodal

Truck, Rail Intermodal

Truck, Rail Intermodal

Consumer Durables and Other

Manufactured Goods/Moderate

Truck, Rail

Truck, Rail, Intermodal




Bulk Goods/Heavy Truck, Rail, Water

Truck, Rail, Water Rail, Water Rail, Water Rail, Water

Source: Bureau of Transportation Statistics, U.S. Department of Transportation

In an effort to provide a historical trajectory of the transportation industry, we graphed total U.S. ton-miles of freight moved. Over time rail has been able to increase market share over air, truck and domestic water transportation. While in the near term we imagine this relationship to hold, the distance between industrial cities in the United States is shrinking. As cities become closer rail becomes less efficient. KSU will be forced to adapt, or lose market share.

Source: Bureau of Transportation Statistics, U.S. Department of Transportation

29


Appendix #17: Industry Revenue Comparison

1) Agricultural includes grains, commodities produced from grains and food and beverage products. 2) Industrial Products consist of construction products, metals, minerals (including frac sand), paper, consumer goods, lumber and other miscellaneous. 3) Chemicals include Petrochemicals, Fertilizer and Soda Ash. Petrochemicals include industrial chemicals, plastics and petroleum products.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

KSU CSX CP NSC UNP

Revenue Comparison

Industrial Products Chemicals Intermodel Agricultural Coal Automotive


Appendix #18: Long Term Concessions

1995 2005 2015 2025 2035 2045 2055 2065 2075 2085 2095

Mexican Gov't

Republic of Panama

Term Renewal

KCSM has been granted a concession by the Mexican government to operate freight transport services by rail over a 50-‐year contract beginning in 1997 through 2047. The contract is regulated by the Secretariat of Communications and Transportation of Mexico (SCT). The SCT may revoke the concession if KCSM fails to make the capital investments required under its five-‐year business plan filed with the SCT or if KCSM fails to maintain obligations compliance bond and insurance coverage specified in the Mexican railroad services laws and regulations. At the current time, there are no known supportable sanctions or compliance issues with the SCT and KCSM. The concession will expire in 2047 unless renewed for another term of 50 years. Panama Canal Railway (PCRC) was awarded a 25-‐year concession from the Republic of Panama in 1998. This concession gave PCRC the privilege to reconstruct and operate a railway adjacent to the Panama Canal. The railway consists of a 47-‐mile track providing international container shipping companies with a railway transportation option in lieu of the Panama Canal. The concession has an automatic renewal of an additional 25 years in 2023.


30


Appendix #18: Fuel Surcharge Revenue Adjustment

KCS’s fuel surcharge is a mechanism to adjust revenue based upon changing fuel prices. These surcharges have traditionally taken two forms or a combination thereof. Mileage and/or rate based surcharges. Mileage based fuel surcharges raise total rates in proportion to shipping distances while rate based fuel surcharges depend on a prearranged ‘strike’ price. When fuel prices are below the strike price, there is no surcharge but once fuel prices exceed the trigger price, a surcharge is imposed as a function of the base rate. The fuel surcharge and base rate constitute the total rate paid to ship freight. This is referred to as the ‘All-‐in rate’. Railroad commerce is regulated by the Surface Transportation Board (STB). Appointed by congress, the STB is an economic regulatory agency charged with resolving railroad rate and service disputes and reviewing proposed railroad mergers. Railroads are required to submit their fuel surcharge plan to the STB for approval. KCS’s fuel surcharge is calculated as follows: There is no fuel surcharges if highway diesel fuel (HDF) price are below $2.30 for any month. Once HDF average $2.30 per gallon, an initial surcharge of 5 cents is charged and the surcharge increases 1 cent per mile for every 4-‐cent increase per gallon in HDF reported by Department of Energy.

APPROXIMATELY 24% OF TOTAL OPERATING EXPENSE IS RELATED TO FUEL EXPENSE

3Q13 2Q13 1Q13 4Q12

Total operating expense (Millions) 421.3 400 389.9 394.8

Fuel Cost (Millions) 102.7 93 90.9 94.9

% 24% 23% 23% 24%

KCS’s ability to adjust revenue for changes in fuel prices precipitates propitiously to the bottom line.

KCS RECAPTURES 85% OF TOTAL FUEL COSTS THROUGH FUEL SURCHARGES

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 120%

2 2.5 3 3.5 4 4.5 5 5.5 6 Price/Gallon (Highway Diesel Fuel)

Fuel Surcharge Revenue as % of Fuel Expense*

current fuel price level

Surcharge recoups 85% of total fuel expense

100% recovery of fuel cost

Source: Company quarterly reports, Company website, Department of Energy *at current operating efficiency Note: Increasing operating efficiency will improve this ratio

31


Appendix #19: Competitive Landscape

COMPARABLE FIRM CRITERIA Our team used the following set of criteria to determine the appropriate group of comparable companies: Geographic proximity, market capitalization, revenue mix and railroad classification. All comparable firms fit into Class I railroad status, which is defined as a rail carrier with annual operating revenue of $433.2 million or more. These diagrams display how KCS fits into the industry of comparable railroads.

US Track Class I railroads KCS US railroad track

-‐25.00%

-‐15.00%

-‐5.00%

5.00%

15.00%

25.00%

2009 2010 2011 2012 2013

REVENUE GROWTH -‐ YOY

CSX

CP

NSC

UNP

KSU

CSX

CP

NSC

UNP

KSU

REVENUE (% OF PEERS)

CSX CP NSC UNP KSU

Market Cap (%) 16% 15% 16% 47% 6%

Track Miles (%) 22% 16% 21% 34% 7%

GTM* (%) 20% 13% 18% 45% 4%

0%

10%

20%

30%

40%

50%

MARKET SHARE (% OF PEERS)

32


Appendix #20: Mexico Economic Outlook

The main risks facing KCS regarding their Mexico operations is two-‐fold. First, the strength and vibrancy of the Mexican economy as a whole, and second, a fluctuation in Peso/USD exchange rate. Economically, Gross Domestic Product (GDP) growth has averaged 1.08 percent since 1994 in the United States while GDP growth averaged 2.05 percent in Mexico. We expect GDP growth in Mexico to continue to outpace the US economy. For 2014, we estimate GDP growth for the US at 1.8% and Mexico's GDP growth rate to be 3.3%. Inflation in the United States has averaged 1.75% over the last two years compared to 3.9% in Mexico. In December 2013, unemployment in Mexico has reached a 5-‐year low at 4.25%. Average wages rose in 2013. Core inflation has been decreasing steadily in Mexico and currently stands at 2.8%. Developing accurate exchange rate forecasts remains elusive for economists and investors alike. Nonetheless, there have been found several methods for determining currency fair values, the simplest of which is the purchasing power parity (PPP) based method. With this method, “fair value” is simply the exchange rate that equalizes the prices of the same goods and services across two countries. PPP theory implies that all else being equal, inflation in one country will lead to a nominal depreciation of that country’s currency against that of a country with lesser inflation, leaving the real exchange rate unchanged. With this method in view, we are slightly bullish toward the USD strengthening in value against the MXN Peso.

-‐10

0

10

PERCENT CHANGE IN GDP

MX US

12,300 13,300 14,300 15,300 16,300

850 950

1,050 1,150 1,250

GDP (Billions)

MX US

0.00% 2.00% 4.00% 6.00%

Mar-‐12

May-‐12

Jul-‐12

Sep-‐12

Nov-‐12

Jan-‐13

Mar-‐13

May-‐13

Jul-‐13

Sep-‐13

Nov-‐13

MEXICO UNEMPLOYMENT -‐ INFLATION -‐ INTEREST RATE

Unemployment rate Core Inslation

Interest rate

0 1 2 3 4 5

Mar-‐12

May-‐12

Jul-‐12

Sep-‐12

Nov-‐12

Jan-‐13

Mar-‐13

May-‐13

Jul-‐13

Sep-‐13

Nov-‐13

INFLATION RATE

MEX Inslation US inslation

400 900 1,400 1,900 2,400

10,000 20,000 30,000 40,000 50,000

STOCK MARKET

Mexico Stock Market (IPC) S&P 500

11 12 13 14 15

USD/MXN EXCHANGE RATE

USD/MXN

33


KCS KANSAS CITY

SOUTHERN Transportation holding company

KCSR KANSAS CITY

SOUTHERN RAILWAY HQ in Kansas City, KCSR is a Class I railroad operating 3,500 route miles

in a 10 state region.

KCSM KANSAS CITY

SOUTHERN MEXICO HQ in Mexico City, KCSM

operates 3,100 route miles through Mexico

PCRC PANAMA CANAL

RAILWAY COMPANY 50% ownership by KCS

Ocean to ocean transshipment between the Atlantic and Pacific oceans by

47.6-mile railroad service

Panarail Tourism 100% owned subsidiary of PCRC

Offers luxury passenger service for business commuters, tourists and

private charters.

Tex Mex TEXAS MEXICAN

RAILWAY COMPANY 100% owned by KCS, Tex Mex is a 157-mile railway linking KCSR and

KCSM

MSLLC MERIDIAN SPEEDWAY,

LLC Majority owned by KCS, MSLCC

owns the Meridian speedway, which is a rail route between

Meridian, Mississippi and Shreveport, Louisiana.

GWER GATEWAY EASTERN RAILWAY COMPANY

100% owned by KCS, GWER provides rail service over approx. 17 miles in East St. Louis, Illinois

area.

Pabtex, Inc. HQ in Port Arthur, TX, this

firm transfer’s freight from rail to ship for transport. Mainly exporting coal and petroleum

coke.

TransFin Insurance, Ltd. HQ in Burlington, Vermont, this company provides KCS property and casualty insurance coverage.

Appendix #21: Company Organizational Structure

Source: Company Report

34


Appendix #22: Porter’s 5 Forces

0 1 2 3 4 5

Power of buyers

Power of suppliers

Competition in industry

Threat of new entrants

Threat of substitutes

Scale of interaction 0 No interaction 1 Insignificant 2 Low 3 Moderate 4 High 5 Severe

Power of buyers: 1) Few railroad companies. 2) Relatively low switching costs. 3) Shared access to competitors track. 4) Standardized service in the industry. Score: 3.4

Power of suppliers: 1) Few suppliers of rail equipment. 2) Complex equipment needed. 3) Low threat of vertical integration. Score: 3.8

Threat of new entrants: 1) High capital requirements. 2) Economies of scale 3) Distribution channel access. 4) Industry growth outlook. Score: 1.2

Threat of substitutes: 1) Trucking. 2) Lower pricing of substitutes over certain distances. 3) Low switching costs 4) Substitutes are comparable in terms of delivery quality. Score: 4.7

Competition in Industry 1) Highly concentrated industry. 2) Limited growth and expansion opportunities. 3) Low product differentiation. 4) Competitor's large size. Score: 4.1

35


KSU Risks: Political Economic Social Technology

Probability

High Opening of the Panama Canal.

Train derailments forcing new

regulation of the rail industry.

Increased movement away

from coal.

Improved roads for trucking.

Growth of cross border traffic at the Nuevo

Laredo-‐Laredo gateway.

Crude oil price fluctuations.

Moderate Increased supply of truck drivers.

Peso/USD fluctuations

Drug trafficking at Port of Lazaro

Cardenas US GDP decline.

Failure or

disruption of IT systems.

Decrease in the demand for

American made goods.

Failure to implement positive train

control technology.

Mexico GDP decline.

Increased regulation of the

railroad industry.

Low Capital constraints.

Free trade issues between US and Mexico.

Loss of Mexican concession for

railroad network.

Loss of Mexican concession for

Lazaro Cardenas.

Insignificant Moderate Severe

Impact

Appendix #23: Risk Matrix

Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report [holds/does not hold] a financial interest in the securities of this company. The author(s), or a member of their household, of this report [knows/does not know] of the existence of any conflicts of interest that might bias the content or publication of this report. [The conflict of interest is ] Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA Society Kansas City. CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

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