Union Pacific's Getting Bigger and Better

UP's $24 billion of 2014 revenue was heaviest in coal, intermodal, and industrial products. Powder River Basin coal is still a giant franchise for the rail. We estimate coal will produce more than $3 billion of revenue at UP this year. UP historically was less exposed to intermodal shipping than its Western peer, BNSF, but intermodal now constitutes 20% of its top line, and we consider that the secular growth driver.

For years, part of the UP story was the upside potential remaining in repricing old contracts, some of which lacked effective fuel surcharges or failed to fully reflect market rates, but no material legacy contracts remain at this point. In addition to improving prices, UP has steadily decreased the fraction of its revenue spent on salaries and benefits and fuel.

We are impressed by progress made so far and project more record-setting margins in coming years, as well as additional share buybacks. UP produced a prodigious $3 billion of free cash flow (cash from operations less capital expenditures) in 2014--greater than 12% of sales--or $1.8 billion after paying $1.6 billion of dividends to shareholders. The firm has tripled dividends per share from the start of 2010 through 2014, making the stock attractive to yield-seeking investors.

Fuel Efficiency, Low Cost Add to Moat While the rails don't outearn their cost of capital by much, our wide moat rating stems from our confidence that rails will generate positive economic profits for the benefit of share owners with near certainty 10 years from now, and more likely than not 20 years from now; by our methodology this defines a wide economic moat.

UP's wide moat is based on cost advantages and efficient scale. While barges, ships, aircraft, and trucks also haul freight, railroads are the low-cost option by far where no waterway connects the origin and destination, especially for freight with low value per unit weight. Moreover, railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight, and thanks to greater railcar capacity and train length, they make more effective use of manpower despite the need for train yard personnel. Even for goods that can be shipped by truck, we estimate railroads charge 10%-30% less than truckers to transport containers on the same lane.

Efficient scale followed industry consolidation escalated by the 1980 Staggers Act, which permitted extensive rail line sales, abandonment, and combination. North America numbered more than 40 Class I rails in 1980, but today there are just eight major railroads (a Class I generated at least $452.7 million in 2012 operating revenue). Staggers also allowed private contracts and rate setting. On all but the busiest lanes (like Wyoming's coal-rich Powder River Basin), generally a single railroad serves an end-of-the-line shipper, and only two railroads operate in most regions in North America. Indeed, we opine that absent government intervention, the rational number of competitors on the continent would be two, via additional consolidation, since in most regions customers already have only two capable providers.

The network of track and assets that U.S. Class I railroads have in place is impossible to replicate. The UP system spans the Western U.S., from the Pacific to the Mississippi, capturing about half of the rail volume in the region. UP has strength in hauling imports from Asia arriving at busy West Coast ports and in coal, as it hauls dozens of long trains daily southbound out of Wyoming's rich PRB. UP's rights of way and installed track form a nearly impenetrable barrier to entry. The steep barrier to entry formed by the need to obtain contiguous rights of way on which to lay continuously welded steel rail spanning a significant portion of a huge continent fends off would-be entrants. Railroads may build new spurs or restore abandoned lines, but we anticipate no new mainlines will be built, given the massive barriers to entry.

Union Pacific is subject to weakness in the economy, particularly in industrial products. Because UP carries more chemicals than other rails, it is more subject to the liabilities associated with hazardous material spills. Regulation has potential to increase costs (via changes in hours of service rules or unfunded positive train control mandates in safety bills) and constrain pricing. Coal demand has been driven lower during the past couple of years as utilities substitute inexpensive natural gas, but PRB coal is cheaper than Central Appalachian or Illinois Basin coal and positions UP well for a modest increase in natural gas rates.

Improving Margins Despite Weak Volume We recently decreased our fair value estimate to $110 per share from $114 as a result of volume shaping up weaker than we previously estimated. Coal fell off a cliff at UP during the second quarter, with carloads down 26% due to high stockpiles from mild weather and cheap natural gas. We model a 15% decline in 2015 and a 5% drop in 2016.

Third-quarter profitability increased to a record 60.3% operating ratio, buffering the full brunt of the demand decline. As recently as 2011, the annual OR was 1,000 basis points less favorable than this quarter's results, and the 2011 performance was 1,100 basis points better than the 2006 numbers. UP has furloughed more than 1,000 employees this year but continues to adjust staffing. We increased our projection of labor cost as a percentage of revenue for 2015-16, but we still believe the rail will attain a 61% OR next year. In 2014, UP's OR was 63.5%. We now model 62.7% for 2015, whereas we previously projected 62%. The rail struggled to match labor to rapidly shifting demand in the first half, but improved this balance in the third.

UP has improved profitability in times of plenty and times of need. Management has set and achieved a series of OR targets during the past decade, and we doubt this team is setting a goal the rail is unlikely to achieve. In late 2014, UP indicated it targets an OR of "60% plus or minus" by 2019, but management has been conservative in declaring targets publicly. We project salary and benefits as a percentage of revenue to cost 18% in the long run versus 21% in 2014. We believe the firm will make more efficient use of manpower, a trend displayed since the rail renaissance began around 2004. Salaries and benefits are the rail's greatest expense line (fuel is second), so this is a powerful lever.

We predicate our margin optimism on several quarters of record operating ratios, including a series of impressive sub-70% ORs after the first quarter of 2012 (and a record 61.4% in the fourth quarter of 2014). We model revenue per car to improve 2%-3% per year on average, but fuel surcharges bring uncertainty, and mix shifts (growth of lower revenue per unit intermodal) may suppress the overall mean yield even as the railroad improves core rates. In the long run, we think UP can achieve at least a 59% OR. Our valuation is constrained by heavy reinvestment in UP's network. We project that 16% of sales will be deployed annually on capital investment in the long run and more than 17% near term.