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Union Pacific: A Good Bet for the Long Haul

Matthew Coffina, CFA
Jeremy Glaser

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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Glaser: So, we've seen some improvements; but more recently, there have been a couple of headwinds that the railroads have been facing. Can you talk a bit about those?

Coffina: So, wide moats for the railroads result from their cost advantages. And if you need to ship freight from point A to point B and there doesn't happen to be a waterway like a river or a lake or something like that in between point A and point B, rails are really the cheapest way to get that freight around. They have four times the fuel efficiency of trucking. They use significantly fewer employees per ton mile of freight, and they have other advantages along those lines.

Currently, what we're seeing is some significant cyclical headwinds--in particular, in coal. So, coal is still a very important franchise, especially for the domestic rails--Union Pacific, CSX (CSX), and Norfolk Southern (NSC). Coal volumes have been down dramatically this year--which, more than anything else, I think can be attributed to low natural gas prices. So, with gas trading at maybe $2.50 per MMBtu, basically any utility that can switch coal-fired generation to gas-fired generation is doing that. We also have some export coal headwinds, lower steelmaking activity in China, lower need for U.S. coal exports, and then also very highly publicized are the headwinds from lower crude oil transportation volumes as well as other volumes that are related to crude oil drilling. So, for example, frac sand or pipe--things that are transported on rails--those volumes, although still a very small percentage of the total for railroads, [are lower]. They're much less significant than the coal headwinds, but it's also a bit of a headwind on the volume side. But really coal is the main one. Union Pacific, in particular--the rail that we brought in the Tortoise [portfolio]--has said that their coal volumes were down by about a quarter in the most recent quarter, down by about 25%. That's a very huge headwind for rails, considering especially that coal is their most profitable franchise, in general.

Glaser: So then, if this is impacting Union Pacific now, do you think that's creating a buying opportunity? Is that why you chose Union Pacific over its peers?

Coffina: What distinguishes Union Pacific, especially from the eastern rails like CSX and Norfolk Southern, is that I think the coal headwinds are temporary or at least that they're going to abate over time, and that's because Union Pacific links up with the Powder River Basin in Wyoming. That's still the lowest-cost coal to extract. It has lower sulfur content and, in the long run, the coal power plants that keep operating I think are very likely to be burning PRB coal. Or at least the plants that are already burning PRB coal are likely to stay open, whereas a lot of the plants that are burning eastern coals, which are expensive to extract and only becoming more so over time, those are mines that might be shut down on the producer side. They might be shut down permanently, and then the power plants that burn the coal also are at risk of being retired permanently.

So, I see that as more of a permanent headwind for CSX and Norfolk Southern, which makes Union Pacific, I think, a bit more attractive than those rails. That's not to say that any number of the rails might be attractive; Canadian Pacific (CP), which I've been looking at recently, doesn't have the same extent of coal headwinds as Union Pacific, and I think that's an interesting rail. Norfolk Southern stands out for trading at a pretty deeply discounted valuation, certainly at a price/earnings multiple basis. So, to some extent, these headwinds are already incorporated in the stock price. But I think Union Pacific gives you a nice combination of valuation, a diverse freight mix, and--despite the coal headwinds in the near term--I don't think that's going to be as much of a long-term headwind as it's going to be for the eastern rails where there's more of a permanent secular decline going on in coal.

Glaser: So, coal is not a big risk for Union Pacific. What do you think are some of the risks to the stock right now or to this firm?

Coffina: I don't want to downplay the coal risk. Coal volume is down 25% or so in the most recent quarter. It's a very severe headwind for Union Pacific. It's about a 4% headwind on overall volume. Besides coal, I would say the major risks are cyclicality and regulation. This is still a very cyclical business. They transport other things that tend to be cyclical--automobiles, for example, grain. And so volumes come and go over time. And in 2009, for example, Union Pacific's operating income was down by a high-teens percentage; I think about 17%. Granted, they recovered the very next year and, throughout this period, they've been steadily hitting record operating margins by improving efficiency. But it's definitely a cyclical business, and we need to be aware of that.

On the regulatory front, there's always concern that we're going to see more aggressive rate regulation by the Surface Transportation Board in the U.S. There have been some moves to make it easier to file rate cases. You also see some environmental mandates or safety mandates that could be expensive for the rails and aren't funded in any way by the governments. The big one right now is positive train control. The government wants the rails to install these systems that automatically slow or stop a train ahead of a dangerous situation--if the train is exceeding its speed limit or something like that.

So, the rails are struggling to meet the mandates. They're very expensive, and it's difficult to recover those costs. So, regulation and cyclicality, I'd say, would be the two big issues and then this ongoing coal decline.

Glaser: So overall, what are your return expectations from Union Pacific?

Coffina: The advantage that a rail has is, again, a very wide moat. I don't expect any new rails to be built in North America; it would be basically impossible to get the rights of way nowadays to build a competing rail. And the significant cost advantages--even with the lower-fuel-price environment--rail is still significantly less expensive for transporting freight than trucking or other modes.

And then also the rails tend to trade at reasonable price/earnings multiples--usually in the mid-teens and, in some cases, the low teens for the eastern rails. Union Pacific is trading somewhere in the 15 to 17 times earnings range--which, given such a wide-moat business, I think is relatively attractive.

In terms of total-return expectations, I think Union Pacific can probably grow volumes of maybe 0% to 1% over the long run. I'm not expecting much volume growth because you are going to have that coal headwind, which is going to largely offset the intermodal growth opportunities that they have. So, they'll continue to gain market share from trucking, but they will give some of that back on the coal side.

Pricing is really the main driver of revenue growth, and I think they can increase prices probably 3% to 4% a year. So, that should get you to maybe mid-single-digit topline growth. The operating-margin expansion is largely in the past. They've made huge gains over the past decade, and that's not going to continue. But I think there is still some room for improvement. They're on their way to a low 60% operating ratio, which is total operating cost as a percentage of revenue or, in other words, an operating margin approaching 40%. I think they can probably get to around that 40% level.

So, that should give you a couple percentage points of additional operating income growth. The company is also repurchasing about 2% to 3% of its shares every year. It's actually a decent cash flow business, despite being very capital-intensive. They still throw off a fair bit of free cash flow. And then they also pay a dividend yield, which is a little north of 2%. So, if you add all that up--a little bit of volume growth, 3% to 4% pricing, a couple percent from margin expansion, a couple percent from share repurchases, and a couple percent from the dividend--it gets me to maybe 10% long-run total return, assuming that the price/earnings multiple stays flat. And the shares have continued to trade down even since we purchased Union Pacific; it's down another 6% or 8%. As the shares continue to trade down, I think that total-return outlook gets incrementally more attractive.

So, at the time of purchase, I thought we could expect maybe a 10% total return. But keep in mind that this is a long-run total return, so you are definitely going to have to hold through some cyclical ups and downs to get that kind of return. And from the current price, we're probably looking at something a little north of 10%. In general, the lower the share price goes, the more attractive Union Pacific is because I think a lot of the headwinds are cyclical in nature. I think the moat is very likely to endure over the long run, regardless of what happens to coal or any of these other cyclical factors in the near term.

Glaser: Matt, thanks for your thoughts on Union Pacific.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.