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By Matthew Coffina, CFA and Jeremy Glaser | 06-09-2015 01:00 PM

Union Pacific: A Good Bet for the Long Haul

Coal headwinds should only be temporary for wide-moat Union Pacific, which gives it an advantage over other rail companies, says Morningstar's Matt Coffina.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Matt Coffina, the editor of Morningstar StockInvestor newsletter recently purchased shares of Union Pacific (UNP). He is here today to talk about why he likes this firm and a little bit about the railroad industry as a whole.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start by looking at the broader industry. Railroads have really changed dramatically over the past decade or so. Can you talk about some of those changes and where it's left the industry?

Coffina: Definitely a very dramatic change over the last decade or so. I think the two big factors here were, one, an increased focus on efficiency. Rail lines have shut down unprofitable lines. They've cut the number of employees on the train; they've increased train length; they double-stacked the intermodal containers; they've sped up terminal dwell times. All of these factors have led to significantly improved efficiency and much higher operating margins, and then complementing that is also disciplined pricing.

So, in the past decade or so, the rails have taken to increasing pricing every year a little bit ahead of inflation, maybe 3% to 4% price increases versus 2.5% to 3% railroad inflation. So, that also boosts margins and has led to some steady revenue growth despite what had been relatively flat volumes over the past decade.

It's hard to say exactly what to attribute this to. In the early '80s, there was significant deregulation of railroads, and that sort of set the stage for industry consolidation. We went from 40 Class I rails to about eight, currently. But even more than that, I would say it's attributable to a more professional approach by management over the past decade, where you've seen some very high-quality managers come in and set a new standard in terms of how profitable a rail should be, and then peers have imitated that strategy and become just as profitable.

So, it's a much more attractive industry today than it was 10 or 15 years ago. And in some cases, we're seeing returns on capital now that are well above the cost of capital--15% or 20% in some cases.

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