Union Pacific - An Industry Value

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Feb 28, 2015

Union Pacific (UNP) is a current pick of GuruFocus’ Undervalued Predictable Companies screener. With a decades long history of improved financial performance, UNP shares have shown an ability to heftily outpace the market over the long term.

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The Business:

The Union Pacific Railroad is the largest railroad in the United States, at about 32,000 miles. The railroad links 23 states in the western two-thirds of the country by rail, providing a critical link in the global supply chain. The network has access to ports on the Pacific Ocean and the Gulf of Mexico and it has the most extensive access to Mexico, with service to all six major US-Mexico gateways.

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Revenues are fairly diversified with the mix including agricultural products, automotive, chemicals, coal, industrial products, intermodal and more.

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Their vast network, diversified revenue mix, and inherent scale advantages have allowed the company’s shares to outperform their closest peers over the last decade (with the exception of CP). Let’s take a look at what has fueled that outperformance and if investors can expect that to continue.

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Outperformance Buoyed By Operational Gains:

UNP has clearly done a terrific job at improving operating margins compared to its peers, improving from last to second over the past ten years. The operating ratio is a financial term defined as a company's operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads. In railroading, an operating ratio of 80 or lower is considered desirable.

On this important metric, UNP scores close to the top of the industry, massively improving from 87.5% in 2004.

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Velocity is a measure of how quickly trains move through the network. It includes time spent on the main line, hauling cargo and dwelling in various yards. The higher the velocity, the more efficient the railroad is, the fewer assets (locomotives) it needs to move the same amount of cargo. Again, UNP ranks near the top of the industry.

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Top-Line Growth Still Dependent On U.S. Economy:

While railroads typically have healthy pricing power, long-term revenue growth is contingent upon higher volumes. 2014 represented one of the highest shipped volumes in company history, with growth across every product category.

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While the individual drivers for each component of the revenue mix vary, the health of the domestic economy is the largest macro driver. If the U.S. economy continues to strengthen, UNP anticipates capitalizing on higher industrial production, housing starts, and vehicle sales.

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Importantly, research from the Boston Consulting Group indicates that the manufacturing competitiveness of the U.S. continues to strengthen. With wages rising rapidly in many developing countries. For example, after Beijing scrapped preferential tax policies for foreign investors in 2009, China has been gradually losing its luster to overseas manufacturers who are facing labor costs that rise faster than overall inflation.

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Will Lower Oil Prices Hurt UNP’s Volumes?

Charting out UNP’s growth opportunities across their geographical network, it’s clear that the company is counting on demand for both crude-by-rail and ancillary services supplying energy firms (eg. fracking sand).

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About 2.5% of revenues is from fracking sand, about 1.5% from oil, and another 1% comes from materials such as pipes. At around 5% of total volumes it's fairly minimal. While it isn’t perfectly straight-forward, lower oil prices should negatively impact volumes in many of UNP'S categories. UNP's segments (agriculture, automotive, chemicals, coal, industrial products, intermodal) all are uniquely affected to a small extent. For example, while oil prices remaining low might lead to oil producers changing plans (therefore leading to the industrial products segment having less volume in certain areas like fracking sand), consumers should have more discretionary spending power, leading to higher auto and durable good sales volumes.

An analyst from Credit Suisse asked what managements take on this was during UNP's latest earnings call:

Credit Suisse: Some of your comments at the end I think, in terms of thinking about the broader economic benefit of lower oil prices sort of against the backdrop of weakness and shale related activity, how do we think about this in terms of overall volume growth? Obviously, there's a lot of puts and takes but are you thinking about it sort of as like a net-net neutral sort of on a relative basis with benefits maybe in autos, consumer products, etc. and then that being offset by crude by rail, frac? Could you help us think about that?

CEO John Koraleski: I think your heads in the right place on that. I think when you look at it, I think popular opinion says consumer drives two thirds of the economy. If consumers are having discretionary spending and they're going to buy automobiles, they're going to build houses, they're going to buy new furniture, consumer goods, those kinds of things, those kind of all hit right within the sweet spot of our franchise and we've seen that in the fourth quarter, the construction products up 17%, lumber up 10%, automobile business the SAR at 16.7% so it's not unreasonable to think that knocking on the door of $17 million for 2015. Again, when we add it all up pluses and minuses, we think at the end of the year barring anything that is unusual that we haven't seen at this point in time, we're going to still end up with positive volume by the time we get to the end of the year.

So lower fuel prices actually have a decent offset in rising consumer spending power. Credit Suisse came out with a note recently as well stating that the drop in crude oil prices can't stop the railroad business.

Additionally, the company experiences lower fuel charges. The average fuel price per gallon consumed was $2.66 for the 4th quarter, vs. $3.11 a year ago, a drop of 14%. 15 million more gallons were needed to be consumed for railroad operations, an increase of 5%. This led to the 4th quarter seeing $813 million spent on fuel, compared to $905 million in the 4th quarter of 2013, a decrease of 10% and a savings of $92 million.

Valuation:

Using GuruFocus’ Reverse DCF tool, we can estimate that investors are actually expecting a lower rate of financial performance going forward.

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If UNP were to match the previous decades growth rates, the shares would be attractively priced.

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On a relative basis, UNP trades at a lower EV/EBIT multiple compared to many peers despite their superior margin profile, operational improvements, and similar growth drivers.

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With an earnings yield of 7.3% and a dividend of 1.6%, UNP looks to be trading at an attractive valuation on both an absolute and relative basis.

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For more potential investment ideas like this one, please see GuruFocus’ Undervalued Predictable Companies screener.