The railroad industry is extremely durable, and Union Pacific Corporation (NYSE:UNP) has proven to be no exception since its founding in 1969.
Railcars are a critical mode of transportation and move about 40% of U.S. freight as measured in ton-miles (the length freight travels). Without companies like Union Pacific, the country’s supply chain could not operate.
Perhaps it is no surprise why Warren Buffett acquired leading railroad company Burlington Northern Santa Fe (BNSF) in 2010 for $34 billion, adding the company to Berkshire Hathaway’s portfolio of high quality dividend stocks.
Union Pacific shares a number of qualities with BNSF and should be of interest to long-term dividend growth investors, especially since the stock has pulled back on weak commodity fundamentals.
Business Overview
Union Pacific owns and operates over 32,000 miles of railroads linking 23 states in the western two-thirds of the United States.
Its railways connect with all of the major ports on the West Coast and Gulf Coast and serve many of the fastest-growing cities in the country. Union Pacific’s rail network also connects with some of Canada’s railways and all of Mexico’s major gateways.
The company serves approximately 10,000 customers across a variety of industries including agriculture (17% of 2015 freight revenue), automotive (11%), chemicals (17%), coal (16%), industrial (19%), and intermodal (20%).
Business Analysis: Union Pacific
U.S. railroads were financially and operationally challenged under stringent government oversight until the Staggers Rail Act of 1980 deregulated the industry.
According to the Federal Railroad Administration, prior to 1980, railroads had little flexibility in pricing their services and restructuring their operations to become more efficient.
During periods of inflation, regulation slowed down rate adjustments that railroad operators could realize, crimping profits and causing a number of railways to declare bankruptcy.
In the 30 years leading up to 1980, railroads saw their share of revenue ton-miles plunge from 56.1% to 37.5%. The outlook was bleak.
The Staggers Rail Act of 1980 changed everything. Railroads implemented market-based pricing schemes on many routes, invested over $500 billion in capital improvements and maintenance to improve productivity, and train accident rates fell by 65% from 1981 to 2009.
Impressively, the lack of government oversight resulted in freight rates declining by 0.5% per year compared to an increase of nearly 3% per year in the five years leading up to act’s passage in 1980.
The industry’s market share also increased back to 40% of ton-miles and has remained stable. Today, about 20% of railway traffic is still regulated where competition is not deemed to be effective enough to protect shippers.
Throughout the last several decades, the railroad industry has significantly consolidated in an effort to further improve productivity, raise profit margins, and better combat alternative modes of transportation (e.g. trucks).
Of the 140,000 rail miles in the U.S. today, Union Pacific, BNSF, and Norfolk Southern account for more than 84,000 miles (over 60% of total rail miles).
The barriers to entry in the industry are high because building and maintaining railroads is extremely capital intensive.
While most types of businesses will spend between 2-4% of their total sales on capital expenditures to maintain and grow their operations, Union Pacific expects spending to average around 16-17% of revenue.
Over the last decade alone, Union Pacific has invested $33 billion in its rail network to maintain and upgrade its transportation infrastructure.
Smaller operators cannot match the company’s spending, and Union Pacific’s routes present another barrier to entry.
Simply put, the market is only big enough to support a small handful of operators in most areas because it is so expensive to build and maintain a railroad.
The large incumbents have the scale and efficiencies needed to underprice potential new entrants and remain in control of their key markets.
There are also only so many major transportation hubs and consumer markets, further limiting competition.
