Union Pacific (UNP) operates in an industry that has substantial pricing power. The largest four class 1 railroads in the United States have lowered their operating ratios dramatically over the years. Union Pacific is well positioned to increase prices at a relatively brisk pace, make continued productivity improvements, and generate healthy volume growth. Therefore, the company should be able to lower their operating ratio significantly over time. A lowered operating ratio will drive EPS growth, and combined with a reasonable valuation should create conditions for meaningful capital appreciation.
Union Pacific has a large economic moat. They are one of two major railroads in the western half of the United States, and the possibility of new competitors due to the amount of capital required to replicate the extensive network is remote. The sprawling landscape of the western region increases the length of haul to move cargo by truck and thus increase the cost to ship via truck. Furthermore, there are limited navigable waterways in the western geographic area so their competition with barges and sea carriers is relatively muted. Railroads are far more fuel efficient than trucks which has lowered their costs relative to truck in an environment where fuel is expensive.
Union Pacific has significant operating leverage and has enhanced margins in the past seven years. A turning point in the railroad industry was in 2004, which was the first time that prices rose above the 2 dollars per gallon and railroads competitive advantage as the more fuel efficient form of transportation compared to trucks became amplified. A favorable period for Union Pacific began generating significant core price gains and increasing effective fuel surcharge mechanisms. The operating ratio has decreased from 89.6% in 2004 to 70.7% in 2011. A major reason for the significant decline in operating ratio has been increasing core prices by 4.5% to 6% annually. An estimated 1.5% to 2% of this annual pricing benefit has come in the form of renegotiated legacy contracts. A legacy contract is a contract that is outdated and below market prices. Union Pacific still has 950 million dollars of legacy contracts to price to current market levels. 350 million dollars of these legacy contracts will come due in 2013 and 85% of the legacy contracts are in their coal segment. There are 100 million dollars of legacy business in 2014 and 500 million dollars of legacy business in all years after that.
Union Pacific's management philosophy to pricing is to price every contract where they can at least generate returns that are equal or greater than the cost of assets they are replacing. If they cannot price the contract at or above the cost of the cost of the assets they are replacing, Union Pacific will walk away from the business. An example of Union Pacific's commitment to return based pricing is that Union Pacific has not lower prices for utility companies struggling with weak coal demand. Management does not believe it is in the best interest of shareholders to trade short term volume gains at the expense of solid price increases on long term contracts.
Productivity and Capacity
Volumes were over approximately 9,852 thousand carloads in 2006 while there are only approximately 9,072 thousand carloads at the end of 2011. There is capacity on the network which provides Union Pacific with operating leverage. A benefit of the capacity on the network is that management states that they do not need to hire employees at the same rate as volume increases. Various productivity metrics have improved significantly since 2007 such as a decrease in slow order miles, an increase in car utilization, and increase in train size all increase productivity. Productivity improvements have lead to better expense control and Union Pacific has shown the ability to successfully vary expenses with volume. The productivity enhancements and capacity in the network has allowed Union Pacific to improve their operating revenue per employee. Their operating revenue per employee increased from 325 to 435.6 from 2007 to 2011, despite the fact that carloads are still below 2006 levels. Union Pacific management also stated in November of 2012 at their investor day that they can decrease the operating ratio below 65% by 2017, and the company intends to decrease it further once they meet their target. This operating ratio guidance indicates a slower rate of improvement than the company has seen in the last 5 years, but there appears to be a degree of conservatism on the part of management and it will be harder to improve at the same rate as in the past.
EPS Growth Projection
The company should be able to raise core price by about 5% in 2013 with 350 million dollars of legacy pricing in 2013. Pricing gains are diminished by 4.0% in 2014 with only 100 million dollars and 3.5% in 2014 and the remaining years thereafter since the legacy tailwinds dissipate. Volume growth over the period should be about 2% annually with coal flattening out in 2013, and the rest of the franchise growing at the rate of economic growth. Union Pacific can potentially lever flat volume growth, but declines of greater than 3 percent would be difficult to overcome. If volumes are greater or less than plus or minus three percent, Union Pacific's earnings could turn out materially higher are lower than expected. Expect total expenses to increase at about 4%. Moreover, the company has solid free cash flow and should be able to reduce its share count by about 3% annually. Union Pacific should be able to still grow its EPS by approximately 14.4% for the next 5 years due to the ability to achieve solid core pricing gains and lever its expenses effectively.
9.15 is the consensus EPS in the upcoming year, so the forward P/E is 13.3. The S&P 500 trades at a forward P/E of 13.42 currently. Union Pacific has traded at a forward P/E ratio relative to the S&P 500 of .88 to 1.11 since 2004. Currently, Union Pacific trades at a forward P/E ratio of .99 relative to the S&P 500. Union Pacific trades at a trailing P/E of 15.16 compared to 10.71 for Norfolk Southern and 11.15 for CSX. A primary reason that Union Pacific trades at a higher multiple is that coal represents a significantly lower part of Union Pacific's franchise than its eastern peers. The PEG for Union Pacific assuming the EPS target is met including the 2.0% dividend yield is approximately .913. Union Pacific appears to be trading at a fair price.
A main risk is that the macro picture domestically or abroad worsens. Tightened regulation on coal and low natural gas prices pose threats to that segment of business. Railroads are heavily regulated and changes in the regulatory environment could negatively affect pricing opportunities in the future.
Union Pacific's forward P/E multiple is slightly less than the S&P 500 forward multiple. Management often states in their investor presentations that they believe Union Pacific that will be able to grow at a rate that is faster than the economy in the long term. While management is inherently biased this idea has merit. Their volume opportunities combined with operating ratio declines provides Union Pacific with strong earnings power. In short, Union Pacific is a strong long term holding due to a reasonable valuation and significant opportunities to improve their EPS highlighted by potential to decrease operating ratio.