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Todd Parvis
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I have passed the first two CFA exams and worked at a mergers and aquisition investment bank as an analyst. I am a growth at a reasonable price investor who is interested in companies that are well managed and have solid long term potential. I am an investment consultant.
  • Union Pacific Is A Strong Buy With A Compelling Valuation And Margin Expansion 0 comments
    Aug 20, 2012 1:37 AM

    Union Pacific Report

    Information as of 8/17/12

    Price-125.01

    Trailing P/E-16.18

    EPS last year-7.73

    Dividend Yield-2.0%

    Market Cap-59.21 billion dollars

    Overview and long term credentials for Union Pacific

    Margins

    Union Pacific has significant operating leverage and has enhanced margins in the past seven years. Operating ratio has decreased from 89.6% in 2004 to 70.7% in 2011. The rate of improvement will slow as Union Pacific has experienced such a dramatic increase in the past seven years, but there are still plenty of margin expanding opportunities. Over this period a key component to increased margins has been the ability to increase core prices at about 5% to 6% annually. 2% of this pricing benefit has come in the form of repricing legacy contracts which is the practice of pricing outdated contracts to current market prices. The tailwinds that the legacy contracts provide will dissipate in the long term. However, the company should still be able to increase prices at least 3 or 4 percent annually which provide solid returns. Furthermore, volumes were over approximately 9,852,000 carloads in 2006 while there are only approximately 9,072,000 now. There is a tremendous amount of capacity on the network which provides Union Pacific with significant operating leverage. Moreover, there are operational improvements such as train size improvements, process improvements in terminals, process improvements in roads, and capital spend benefits which can enhance margins.

    1. The 65% project operating ratio is still on track by 2015. Management set a goal of decreasing the operating ratio below 65% by 2015 when the companies operating ratio first dipped below 70% in Q2 of 2010. Management is still committed to decreasing the operating ratio below 65% by 2015, despite the near term headwinds to coal and higher fuel expense. Additionally, management believes that they can continue and intend to decrease the operating ratio after they hit the 65% target.

    Volume

    1. There are opportunities for volume growth in emerging markets and Mexico. Union Pacific has access to trade with fast growing economies of the Pacific Rim with their Long Beach port. Additionally, they are the only large US railroad to have access to Mexico so they are poised to benefit from the trend of near shoring.
    2. Coal is a near term headwind, but eventually the pressure will dissipate. The prices on natural gas will likely rise in the long term and coal volumes will increase. The long term future of coal is not stellar due to regulatory issues and environmental issues, but it will rebound some from depressed 2012 levels.
    3. Intermodal is a long term bright spot. Railroads are more fuel efficient than trucks and in a world of high gas prices that is a significant competitive advantage. According to the AAR are four times as fuel efficient as trucks. Railroads continue to convert traffic from trucks and gain share in this segment.

    Capital Allocation

    Union Pacific has strong free cash flow deployed through dividend increases and share repurchases. The dividend yield is currently 2% and (share repurchase+dividend yield) is approximately 5%. Union Pacific returns almost all the free cash flow in the form of dividends and share repurchase. The dividend payout ratio has now increased to about 30% of earnings which is the target that management currently has.

    Returns

    Some claim that railroads have a low ROIC which constrains returns. ROIC is currently only 12.4%. It is true that the industry involves significant fixed capital outflows. However, returns on incremental capital over the last seven years have been strong leading to dividend growth, free cash flow growth, and substantial EPS growth.

    Balance Sheet

    1. Union Pacific has a solid balance sheet and an A- credit rating by S&P.
    2. The company credit rating metrics are improving and they have fairly low leverage compared to their cash flow.
    3. EBIDTA/Interest coverage ratio as of 2011 is 9.95 making it a solid investment grade credit.

    Regulatory Issues

    Railroads should have ample pricing opportunities in the long term, although regulatory issues limit their pricing to an extent. Shippers will always complain that pricing is too high and try to present the argument to the STB and Congress that railroads have a monopoly and their prices are not competitive. However, railroads have a compelling point that they need to earn a competitive return on their business or else they cannot invest in their network. Railroads returns were below their cost of capital before deregulation with the passage of Staggers Act in 1980. If they do earn their cost of capital railroads will not invest in their network which presents a significant cost to society. Railroads are more cost efficient than trucks due to their superior fuel efficiency and are more environmental friendly. Additionally, the industry hires large quantities of high paying union employees. These attributes do carry weight with Washington and help reduce regulatory pressure.

    Economic Moat

    Union Pacific has a very large economic moat. They are one of two major railroads in the western half of the United States and the possibility of new entrants due to the amount of fixed capital required is remote. Union Pacific has limited competition with many shippers which provide them with strong pricing opportunities. Railroads also compete with trucks, but they are much more fuel efficient and have continued to steal share for the last seven years as fuel prices escalate.

    Concluding Statement

    It trades at a 14 forward P/E which is not overly high. 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 potential margin expansion provides strong growth opportunities in the long term. In short, Union Pacific is a strong long term holding due to a compelling valuation and strong long term growth prospects.

    Disclosure: I am long UNP.

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