CHICAGO--(BUSINESS WIRE)--Fitch Ratings has upgraded 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) to 'BBB' from 'BBB-'. The Rating Outlook is Stable. The short-term and commercial paper (CP) ratings for KCS have been affirmed at 'F3'. A full list of ratings follows at the end of this release.
KEY RATING DRIVERS
The rating upgrade reflects KCS' improved credit profile resulting from its efforts to control costs, improve operating margins, and maintain a strong balance sheet. Total adjusted debt/EBITDAR has remained relatively steady at around 2.5x over the past few years, which Fitch views as consistent with the 'BBB' rating. Fitch expects that leverage may decline incrementally over the intermediate term. Other credit metrics have improved materially, including a FFO fixed-charge coverage ratio that has gone from 4.4x as of year-end 2012 to 7.6x as of year-end 2015.
KCS has also made significant strides towards buying equipment off of operating leases, which has improved cash flow and operating margins. Fitch calculates KCS's EBITDAR margin at 49.7% for the LTM period ended March 31, 2016. Margins have trended steadily upward since 2012, and Fitch expects the company to produce solid margins through the forecast period. Fitch notes that the strong results produced in 2015 came amidst a relatively difficult year for the rail industry, where volumes across many operating segments were pressured by low commodity prices and economic uncertainties. KCS's credit profile also benefits from improved liquidity provided by an $800 million revolver that was obtained in the second half of 2015. The new revolver added $150 million of additional capacity to KCS's previous facilities.
Near-term Revenue Weakness but Long-Term Prospects Remain Healthy:
Fitch expects total revenues to be down in 2016 for the second year in a row driven by a weak Mexican Peso, lower fuel surcharges, lower energy-related volumes, and by a temporary drop in automotive volumes related to several plants being temporarily offline for major re-tooling. In 2015 total revenues dropped by 6.1% largely driven by the same factors.
Despite the near-term pressures, Fitch continues to view KCS's long-term prospects positively. KCS benefits from its unique position in the rail industry, having a deep connection to Mexico, where increasing industrial activity, growing shipments to the port of Lazaro Cardenas, and the prospects for more energy-related business should continue to drive KCS's top-line growth over the intermediate term. KCS also stands to benefit from positive trends in its chemical/petroleum segment as a result of the opening of the Mexican market and by increasing production from U.S.-based chemicals manufacturers driven by persistently low natural gas prices. Also notable is that a significant portion of the revenue decline is based on weaker fuel surcharges related to lower oil prices and the impacts of a weak Mexican Peso. Neither of these factors have material impacts on the company's operating income.
Strong operating margins:
Near-term concerns over top-line weakness are also offset by the company's continued strong margin generation. KCS's EBITDAR margins expanded by 2.2% in 2015 despite a 6.1% decline in revenue. KCS's operating margins have increased every year since 2009, and Fitch believes that the company has opportunities to incrementally expand margins further. The company does not have a current publicly stated longer-term operating ratio target, but has indicated that it is well-positioned to continue to drive operating ratio improvement. Fitch believes that an operating ratio in the low 60s, or several percentage points better than the 2015 level of 66.8%, is achievable given the company's track record in recent years.
Solid gains on pricing, the company's efforts to control costs, a reduced overall cost of debt, and efforts to improve things like dwell time and velocity are all contributing to KCS's margin performance. The company also continues to see benefits from its program of purchasing equipment off of operating leases. Fitch expects KCS to take advantage of opportunities to purchase and convert equipment leases in 2016, but at a significantly lower level than in 2015. Since KCS began purchasing equipment off of operating leases in earnest in 2012 the company has spent a total of $681 million purchasing equipment in this way, reducing its rent expense to $63.9 million in 2015 from $120.6 million in 2011. KCS's adjusted operating ratio was 66.8% for 2015, which is comparable to or better than some of KCS's larger competitors.
FCF Turning Positive, Solid Financial Flexibility
KCS consistently generates significant cash flow from operations but its free cash flow (FCF) is typically limited by its relatively heavy capital spending, and by increases in dividend payments that occurred between 2013 and 2015. KCS's capital spending through 2015, including lease conversions, totaled $832 million or 34% of the company's LTM revenue, which represents a capital intensity ratio that is notably higher than most other rail companies. Excluding KCS's purchase of equipment off of operating leases, capex totaled 28.5% of revenue, which is still higher than the industry average.
Continued growth opportunities will likely keep total capital spending relatively high in the intermediate term; however, 2016 capital spending should be moderately lower than in the last two years as leased equipment purchases and growth capex spending decline for the year. The company has indicated that total capital spending for 2016 (excluding purchases of leased equipment) is expected to equal $580 million-$590 million. Following 2016, Fitch expects capital spending to return to levels on par with the higher spending of the prior two years (around 27% of revenue) due to the company's investment in growth opportunities such as the recent agreement with the chemicals company Sasol to build a new rail yard to support a new ethane cracker facility. 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 KCS' network. Fitch expects FCF of $100 million-$150 million in 2016 and continued positive FCF over the longer term.
Credit Metrics Support the Rating:
Fitch expects KCS's total adjusted debt/EBITDAR to remain around 2.5x over the next year and to trend towards 2.25x or lower over the next 2-3 years, which we consider to be in-line with the 'BBB' rating. Fitch does not expect the company to reduce debt materially in the near term, but leverage may trend slightly lower on growing EBITDAR. KCS' leverage is down from as high as 5.2x at year-end 2009. Coverage ratios have also improved in recent years. As of Dec. 31, 2015 FFO fixed-charge coverage stood at 7.6x and FFO interest coverage was more than 13x, both of which are supportive of the ratings.
Debt-Funded Share Repurchases a Potential Concern:
The company announced a $500 million repurchase program in May 2015 and subsequently issued $500 million in new debt, a portion of which was used to fund share repurchases. Fitch expects KCS to be able to fund the bulk of its repurchases in 2016-2017 with internally generated cash and does not expect the company to need to raise additional debt over that time period. Should KCS use debt to fund shareholder-friendly activities and as a result increase leverage to a sustained range of 2.75x-3.0x, downward pressure could be put 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.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
--Moderate volume and revenue declines in 2016 followed by low-single-digit growth thereafter
--Continued slow macroeconomic growth in the U.S.
--Operating margins trending upward slightly throughout the forecast period
--Total debt balance remaining around or slightly below current levels.
RATING SENSITIVITIES
An upgrade in the near term is unlikely; however, future actions that may individually or collectively cause Fitch to take a positive rating action include:
--Total adjusted debt/EBITDAR sustained below 2.0x;
--Sustained free cash flow margin in the mid- to high-single digits;
--An operating ratio trending toward and maintained in the low-60% range.
Future actions that may individually or collectively cause Fitch to take a negative rating action include:
--More aggressive debt-funded share repurchases causing debt/EBITDAR to be sustained above 2.75x;
--A severe drop-off in demand for cargo flowing between the .S. and Mexico;
--EBITDAR margins falling toward or below the 40% range, and sustained negative free cash flows
LIQUIDITY
The company maintains solid financial flexibility through its cash on hand as well as availability under its CP program which together total $800 million. Total liquidity was $856.6 million at the end of 2015, which Fitch considers to be strong given the company's ability to generate cash from operations and the relatively low levels of cash needed to operate the business on a day-to-day basis. Cash on hand totaled $136.6 million plus $720 million in total availability under the new KCS $800 million CP program. KCS had $80 million of outstanding CP at the end of 2015. Near-term debt maturities are also manageable. Debt maturities total $356.1 million in 2016 and primarily consist of a $250 million note and the outstanding CP. KCS has no other significant maturities until 2020.
FULL LIST OF RATING ACTIONS
Kansas City Southern
--Long-Term Issuer Default Rating (IDR) upgraded to 'BBB' from 'BBB-';
--Short-Term IDR affirmed at 'F3'.
--CP affirmed at 'F3'
--Senior unsecured bank facility upgraded to 'BBB' from 'BBB-'.
--Senior unsecured notes upgraded to 'BBB' from 'BBB-'.
Kansas City Southern Railway Co.
--Long-Term IDR upgraded to 'BBB' from 'BBB-';
--Short-term IDR affirmed at 'F3';
--Senior unsecured notes upgraded to 'BBB' from 'BBB-'.
Kansas City Southern de Mexico SA de CV
--Long-Term Foreign currency IDR upgraded to 'BBB' from 'BBB-';
--Long-Term Local currency IDR upgraded to 'BBB' from 'BBB-';
--Short-term IDR affirmed at 'F3';
--Senior unsecured notes upgraded to 'BBB' from 'BBB-'.
Additional information is available on www.fitchratings.com
Summary of Financial Statement Adjustments - Fitch has made no material adjustments that are not disclosed within the company's public filings.
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
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