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The rise in natural gas prices is leading utility companies to switch to coal, which enables railroad companies to increase their coal carloads. One such railroad company, Union Pacific (UNP), showed the best-ever quarterly results. Its operating expense ratio is locked at 65.67%, which is best ratio to date compared to 67% in previous quarters, and it reported year-over-year revenue growth of 5% to $5.47 billion. The stock reached its 52-week high of $162.3 per share on the day it declared its quarterly result, and it has given shareholders returns of around 132% in the last one year. Additionally, the boost in Mexico's automobile industry is expected to generate further growth opportunity and raise its future earnings. Let's discuss how these additional factors and the rise in the natural gas price will lead Union Pacific to generate higher returns for its shareholders in the future.

Black Gold will drive future revenue

Union Pacific's coal shipment segment is the major contributor to its revenue and showed growth of 12% year-over-year to $975 million in the second quarter. This is higher than its strong competitor Norfolk Southern (NSC). The competitive carload's tariff and increase in natural gas prices, which acted as headwinds in previous quarters, prompted the recent rise in coal shipments. The higher natural gas prices and the rising electricity demand forced utility companies to shift their focus towards coal. In June 2013, the total electricity demand in the U.S. grew by 16% year-over-year, and to fulfill these demands, utility companies will consume more utility coal. Union Pacific expects to benefit from its long distanced superior coal shipping capacity and expects to generate higher carloads revenue. It also planned for capital spending of $3.6 billion in 2013, and around $2 billion of this will be used to renew its track infrastructure. To date, the company has achieved half of target and expects to gain new coal contracts with the probable growth in the global economy. With these factors, its coal shipment segment may generate revenue of around $4.3 billion this year from $3.9 billion last year, and it expects strong year-over-year EPS growth of 15.25% to $9.53.

Norfolk Southern has a wide railroad network in the Eastern U.S., but it reported a quarter-over-quarter decline in coal shipment revenue of 1.4% to $626 million in the second quarter. This decline was due to the low-export demand of coal from its international market. Despite this, its coal shipment volumes increased by 3% annually to 6,000 carloads due to the higher coal demand from the utility companies because of the upsurge in natural gas prices. Its Northern region reported a year-over-year increase of 18% in coal shipments, offsetting the decline of 12% in Southern regions. The company expects more coal shipment from this region in second half of this year as coal demands from the utility and metallurgy companies will continue to increase with the continuous rise in natural gas prices. This will enable the company to enhance its coal shipment revenue.

It has also planned to improve its network velocity and transit times, which will drive its coal shipment revenue. In this regard, Norfolk is developing its track network towards the short distance Illinois basin compared to longer Central Appalachian, which will enable it to transport coal quickly to meet the rising coal demand from utilities and metallurgy companies, resulting in higher earnings. Through these efforts, Norfolk is in a better position to generate EPS of nearly $5.67 this year and $6.15 next year from $5.38 last year.

Mexico generating growth opportunities

Mexico's Government initiatives to promote Mexico, with its availability of cheaper labor and lower transportation cost than China and the U.S., prompted many automobile manufacturers like Nissan, Honda, and Ford to shift their plants to Mexico. This will benefit the railroad companies operating in Mexico, resulting in higher carloads and enhancing revenue.

Union Pacific's automotive segment showed year-over-year revenue growth of 12% to $534 million in the second quarter. It is serving all six major Mexico trade-ports and also has 26% stake in Kansas City Southern Mexico, a subsidiary of Kansas City Southern (KSU), Union Pacific's largest transportation partner to and from Mexico. Union Pacific is deriving half of its automotive revenue from Mexico, and it is expanding its rail facilities in Santa Teresa, New Mexico. It plans to open this facility by early 2014, and the company expects to use it to convert truckloads to railcars, amounting to around 3 million units. This will be in addition to current 10 million units transported between Mexico and the U.S. Mexico's automotive industry is expected to grow at a compounded annual growth rate of 7.73% over the period of 2011-2015 to reach 3.7 million units. Thus, we expect that Union Pacific's automotive segment revenue will grow to $2.02 billion this year from $1.81 billion last year.

Kansas City Southern is one of the major railroad companies in North America, which connects the main markets of Central U.S. with Mexico's industrial cities. The company placed itself in a better position to gain from the hefty amount of goods moving between these regions. It is generating nearly 50% of its revenue from Mexico and expects double-digit growth in its automotive segment from these industrial cities. Its automotive revenue grew by 25%, year-over-year, to $96.6 million, with a 13% increase in automotive carloads in the first half of 2013. To continue enhancing its automotive segment revenue, Kansas City Southern invested nearly $300 million in upgrading its tracks between Central Mexico and Houston. It has also gained a large number of car shipping contracts in the first half of this year, and it expects to generate more business from auto part companies as their operations reach full capacity. This will give Kansas City an opportunity to enhance its EPS to $3.34, a year-over-year growth of around 23% this year.

Conclusion

The higher coal demand from the utility and metallurgy companies and Mexico's emergence as an attractive place for automakers is reinforcing Union Pacific's presence in this region. With the continued rise in natural gas prices, demand for coal has increased and reduction of coal stockpiles is generating strong growth opportunities for Union Pacific to enhance its carloads revenue. Also, Union Pacific's strong forward EPS growth and its price-to-earnings ratio of 17.98, which is in-line with Industry's 17.3, are leading it to expect its stock price to touch new highs in the coming quarters, enhancing its investors' return.

Source: Union Pacific: Our Best Buy For The Month