Fitch Ratings has affirmed Kansas City Southern's (KCS) Long-Term Issuer Default Rating (IDR) at 'BBB' and its Short-Term IDR at 'F2'.
The affirmation reflects Fitch's expectation that the combined Canadian Pacific Railway Limited (CP)/KCS will actively de-lever its balance sheet following CPs' purchase of KCS. The 'BBB' rating is supported by KCS's strong operating margins, ability to generate FCF and ongoing benefits from its precision scheduled railroading initiatives. Fitch believes that the business profile of the combined CP/KCS may support a higher rating in time, with the financial profile presenting a near-term headwind. KCS faced margin headwinds in 2021 from a higher fuel price environment and several operational disruptions.
Fitch expects margins to improve going forward for KCS and for the combined companies as operational issues ease and the companies begin to realize merger-related synergies. Rating concerns include elevated leverage from acquisition debt and a challenging operating environment due to regulatory uncertainties in Mexico, ongoing supply chain issues and inflationary pressures.
Key Rating Drivers
Combined Networks a Positive: Fitch views the combination of CP and KCS's networks as strategically sound. Combining KCS's strength in Mexico and the Midwest with CP's East-West Canadian network will give the combined entity a broad reach and is likely to create more efficient routes for freight flows. The combined companies will also benefit from increased diversity, decreasing KCS' reliance on the Mexican market and broadening the end markets served.
Both carriers utilize precision-scheduled railroading philosophies that have driven solid margins and sustained FCFs. The combination is likely to produce further efficiencies that should hold further upside for margins. While the combination is likely to receive scrutiny from the Surface Transportation Board (STB), the combined entity will remain one of the smaller class I rails, with revenues around those of Norfolk Southern, but still significantly smaller than either UNP or BNSF.
Pro Forma Leverage: CP funded the cash portion of the KCS acquisition with $8.4 billion in new debt and will assume roughly $3.8 billion in debt from KCS's balance sheet. Fitch estimates that pro forma Debt/EBITDAR for the combined companies will be around 4x by YE 2022, which is high for a 'BBB' rating. We anticipate that leverage will decline to roughly 3x by YE 2024. CP has publicly stated its target of de-leveraging to around 2.5x within 36 months of the transaction's close. The company intends to suspend its normal share repurchase program and will direct FCF towards debt repayment. Both KCS and CP generate strong operating margins and are highly cash flow generative. We expect that the combined companies will produce sufficient cash flow to readily de-lever following the acquisition, though our forecast is conservative to management's estimates.
Supportive Demand Environment: Fitch expects KCS's revenues will increase in the mid-single digits or better in 2022 supported by rising demand in most of the company's end markets and a solid pricing environment. KCS's pricing power mitigates risks around general inflationary pressures. KCS reports solid underlying demand in its Energy and Industrial segments. Automotive volumes may improve later in 2022 after experiencing headwinds last year due to microchip shortages that affected auto manufacturers globally. KCS's chemicals and petroleum segment faces near-term headwinds from Mexican regulatory actions that limit imports of refined products.
Over the longer-term, KCS remains well positioned to benefit from refined products exports to Mexico. Top-line revenues are also supported by increasing fuel surcharges as crude oil prices continue to increase, though higher fuel prices are modestly dilutive to margins. KCS reported a 12% increase in revenues for FY 2021 driven by a 5% increase in volume and a 7% increase in revenue per carload.
Sustained Positive FCF: Fitch estimates that the combined companies will generate FCF (after dividends) of $1.1 billion or more per year, which should allow the combined companies to de-lever efficiently. Prior to the acquisition announcement, KCS had expected capex to moderate as part of its precision scheduled railroading operations. Capex as a percent of revenue was expected to trend to around 17% compared to the mid 20% range a few years ago when the company was acquiring equipment off of operating leases. CP also had capital programs that it expects to decline in 2022 and 2023, including a multi-year investment in acquiring additional hopper cars along with locomotive remanufacturing programs.
Limited Regulatory Risks: Fitch expects the CP-KCS merger to ultimately be approved by the STB with limited required divestitures. The STB confirmed in September 2021 that its review of the merger will be subject to pre-2001 rail merger rules, setting a lower bar for regulatory approval. The pre-2001 standard effectively states that any mergers may not adversely impact competition, whereas the stricter post-2001 standards mandate enhanced competition. The CP and KCS networks are largely end-to-end with limited overlap, and the combined company will still be smaller than its primary competitors. CP has agreed to divest a 70-mile section of track between New Orleans and Baton Rouge where the two networks currently overlap.
Solid Financial Flexibility: Coming out of the pandemic, KCS has a manageable debt maturity schedule with no material debt maturing until 2023 and no commercial paper outstanding. Financial flexibility is supported by continued positive free cash flow generation, lower capex requirements, and an undrawn $600 million revolver. KCS has announced that it will reduce capex to around 17% of revenue from over 20% of revenue million a few years ago. KCS also has a flexible cost structure, with roughly 60% of its costs categorized as variable or partially variable.
Derivation Summary
Kansas City Southern is well positioned compared to other Class I railroad companies, which are generally rated in the mid 'BBB' to low 'A' category. Coming out of the pandemic, its leverage metrics are in-line or better than other large rail companies, with the exception of the two Canadian Class I rails. The company also exhibits operating margins that are better than most of its peers.
Solid credit metrics are partially offset by KCS' geographic concentration compared to its peers given its reliance on its U.S./Mexico. KCS is also the smallest Class I railroad, though Fitch does not consider KCS' size to be a materially limiting factor due to the nature of the rail industry where competitors have relatively fixed networks with limited overlap.
KANSAS CITY SOUTHERN 
