Union Pacific has the best access to Gulf and West Coast ports and is the only railroad that serves all six major rail gateways between the U.S. and Mexico. Through rail industry partnerships, the company can also access roughly 90% of the population in North America.
Major railroad operators have enjoyed strong pricing power due to many of the factors discussed above.
From 2012 through 2015, Union Pacific’s average annual pricing gain was 3.6%, and the company continues to realize pricing improvements even despite the current slump in commodity shipments.
Thanks to consistent pricing gains and efficiency improvements, Union Pacific improved its operating ratio from 87.5% in 2004 to 63.1% in 2015.
The company expects volume growth, core pricing increases, and productivity gains to further improve its operating ratio to 60% on a full year basis by 2019.
Looking even longer term, Union Pacific began its “G55 + 0” initiative in the fall of 2015. This program has a goal of achieving a 55% operating ratio over time with a goal of zero injuries.
As long as Union Pacific continues to invest in its infrastructure to maintain leading safety and efficiency metrics, it’s hard to imagine new rail competition disrupting its business.
The company’s competitive advantages should only strengthen in future years as it invests to become safer, more efficient, and extremely productive.
Finally, it’s worth acknowledging the long-term durability of the railroad industry. Freight volumes generally follow population growth over long periods of time.
According to the Federal Railroad Administration, the U.S. freight system will enjoy a 22% increase in the total amount of tonnage its moves between 2010 and 2035 as the U.S. population expands.
There will always be a need to connect consumers with agricultural, industrial, manufacturing, and logistics centers across the country. As a best-in-class operator with hard-to-replicate assets, Union Pacific will be there to meet this major need.
Key Risks
Union Pacific’s stock slumped over 30% in 2015, driven by a 6% volume decline and an unfavorable shift in business mix. Each of the company’s business groups recorded a decline in freight revenues except for automotive.
The slump in grain prices, plunge in the price of oil, strengthening U.S. dollar, and continued decline in the use of coal all contributed to Union Pacific’s weakness in 2015.
While I view railroads as having an economic moat, that doesn’t mean demand for their services is inelastic. Macro volatility can whip quarterly results around and should be expected with an investment in Union Pacific.
However, in most cases, macro volatility (and potential safety or operational hiccups) shouldn’t impact the company’s long-term earnings power.
Coal could prove to be an exception. Union Pacific transports coal to power companies and industrial facilities and generated 16% of its freight revenue last year from the commodity.
Freight revenue from coal shipments fell by 22% in 2015 and show no sign of recovering – maybe ever.
Coal as a percentage of U.S. electricity generation fell from 38.5% in 2014 to about 33% in 2015. The Energy Information Association projects that coal will only comprise 31% of U.S. electricity generation in 2016.
The shift away from coal is being driven by new power plant emission regulations and low natural gas prices, which are accelerating the shift of electricity generation away from coal to natural gas.
While no one knows when and where coal fundamentals will begin to stabilize (coal will likely remain an important source of power generation), investors are very aware of the headwind at this point.
At less than 15% of total freight revenue in the first quarter of 2016, Union Pacific’s exposure to coal looks increasingly manageable.
While there is risk that the company overinvested and might have too much capacity the next few years, it has so far done an excellent job tightening up its costs in response to the challenging operating environment.
Union Pacific’s operating ratio continues improving, and the company remains in good financial health.
Aside from the secular decline in coal, competition from other modes of transportation could pose a threat to Union Pacific’s long-term earnings power if they take share away from railroads.
Trucks, barges, ships, planes, and pipelines all compete with railroads to efficiently and reliably transport goods.
Rail transportation has been, and will likely continue to be, the best option for shipping bulk commodities such as grain, construction materials, and energy products.
These materials have a high weight-to-price ratio and generally do not require time-sensitive deliveries. Railroads can transport these bulk materials using less fuel than trucks over long distances and are usually faster than using waterways, which face physical limitations. I expect rail’s market share of ton-miles to remain stable around 40% just like it has for a couple of decades.
Overall, barring a secular decline in commodity consumption, it’s hard to find many risks that could impair Union Pacific’s long-term earnings power.
The next few quarters could remain rocky as unpredictable commodity markets fluctuate, but that has no bearing on Union Pacific’s competitive advantages.
