Union Pacific Corporation (UNP) is one of the leading railroad companies in the United States and the biggest publicly traded railroad west of the Mississippi. The company primarily generates revenues from freight transportation which includes agricultural products, automobiles, chemicals, energy, industrial products and intermodal freight. We currently have a $140 price estimate for Union Pacific, which is approximately 5% above the current market price. Our valuation is supported by (1) the company’s pricing power in its markets, (2) its improving operating ratio and (3) its exposure to the fast-growing Mexican market.
Pricing Power Can Pick Up Slack When Volumes Decline
Union Pacific’s freight revenues increased during 2012 even as its freight volumes remained flat year-over-year compared to 2011. The primary reason for this increase in the top-line was a 7% increase in average revenue per carload despite a slowdown in freight demand. Union Pacific was successful in growing average revenue per car for each of its segments in 2012, the largest of which was an increase of 11% in coal freight prices. 
In our opinion, these core pricing gains put the company in a great position to weather the potential slowdown in freight volumes going forward. We think that the weak global economy will continue to impact freight volumes, and if volumes decline, Union Pacific seems to have the pricing power to maintain its revenue growth.
Strong Margins Can Help Maintain Profits Even If Revenues Decline
One of the most important things to watch for in a railroad company is margins since the high amount of fixed costs can leave the company in trouble if revenues decline. Historically, Union Pacific has done a good job of keeping its costs under control and improved margins in 2012 as its operating ratio declined from 70.7 in 2011 to 67.8 in 2012. Overall, the company improved some of its efficiency metrics such as increasing the average speed of its trains by 4% in 2012 and decreasing its rail-car inventory year-over-year. We think that Union Pacific will be able to maintain these efficiency gains and it should help the firm keep its operating ratio in check.
Exposure to Mexico Will Drive Growth
In our opinion, one of the primary drivers of growth for Union Pacific over the coming years is its close proximity to the Mexican market. Revenues from Union Pacific’s Mexican business were $1.9 billion (10% of total revenues) in 2012, an increase of 8% year-over-year.
The Mexican economy is one of the leading emerging economies in the world and it is quickly becoming an important manufacturing hub as wages in China rise and given its proximity to the U.S.  Trade between the U.S. and Mexico is expected to rise as Mexico is forecast to export more goods into the U.S. than China by 2018, a factor which will provide a large boost to the Mexican economy.  If Mexico does in fact become a manufacturing substitute for the Chinese market, Union Pacific will be the railroad company which stands to benefit as it is the only major publicly traded railroad company in the U.S. to serve all six major trade junctions with Mexico.
Additionally, Union Pacific will also benefit from U.S. exports to Mexico. The country is currently the second largest goods export market for the U.S. as it purchased approximately $200 billion worth of goods in 2011, up 20% from 2010.  We think that as Mexico’s economy manufactures more goods, it will contribute to a rise in disposable income of the average Mexican consumer and is likely to increase Mexican consumption and imports from the U.S. over the coming years.
We currently have a $141 price estimate for Union Pacific, which is approximately 5% above the current market price.
- Union Pacific 10-K, SEC
- China Faces Years Of Double-Digit Wage Increases, Currency Appreciation, Forbes
- The Rise of Mexico, The Economist
- Office of United States Trade Representative
Disclosure: No positions