Union Pacific Railroad: An all-time high and still valuable?

While some might argue that it is difficult to truly identify an economic moat, you can't deny the durable competitive advantage when it comes to railroads in the United States. In fact, even Buffett himself recently acquired Burlington Northern Santa Fe Railroad–Berkshire Hathaway's largest acquisition ever. So, I feel like I'm in good company when I conclude that Union Pacific Railroad also possesses durable business economics. But is there value?

#5 on Bloomberg Businessweek Magazine's BBW50, its annual list of stocks that were (a) great performers last year and (b) are expected to do well in the future, Union Pacific sounded the most interesting for further research. Turns out that it definitely deserves its #5 spot among the list of 50.

I always like to start off by looking at the top line. Investing in businesses with declining revenue is like watering the weeds on the side of your house instead of the flowers in your garden. As the old Buffett saying goes:

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

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Over the last 10 years there has been a solid incline in revenue. Furthermore, a close look reveals that in the past 7 years revenue has increased quite dramatically: 8% annually. Even more impressive, revenue has already recovered from the shadow of the economic recession, reaching a record high this year of $19 billion. So, there is demand for freight transportation, but can it be sustained? And even better, can it continue to increase? After all, Union Pacific is already the largest public railroad in North America. Is there room for growth?

Management has outlined several clear opportunities for continued increases in demand:

• Expanding global economy: The expanding global economy will result in greater international demand, which already accounts for almost one third of UPs revenue base. Therefore, any increase in international demand for UP will result in a significant increase in revenue.
• The U.S. population: The U.S. population alone is expected to increase freight demand by 30% over the next 20 years.
• Demand for “Green” and fuel efficiency: Freight transportation is a fuel efficient alternative, believe it or not. With rising fuel prices we all know how desperate American's are to save money on fuel. Also, there is a growing appreciation for UPs “green” profile.

Revenue is split into 6 different operational categories:

After a quick glance at these categories you can tell that the demand for most of these categories is sure to continue or even grow. It's automotive demand is the category that is most affected by economic downturns and it is, fortunately, the smallest portion of UPs revenue.

How is management doing?

• Probably the most important ratio for railroads is the operating ratio, which is defined by operating expenses divided by operating revenue. UP management has dramatically improved its operating ratio:

• Increasing free cash flow (FCF), hitting an all time high in the most recent quarter

Union Pacific (UNP) Free Cash Flow (FCF)

graph courtesy of Vuru.co

• Considerable pricing power

Union Pacific (UNP) Gross Margin

graph courtesy of Vuru.co

• 15% return on equity
• Management is buying back shares at good prices
• Dividend increased by 50% last year
• Maintaining returns on invested capital above 10%, recently hitting an all time high of 12.4%
• Has a high customer satisfaction index, recently hitting an all time high of 92

Valuation

Morningstar gives UP a 4-star buy rating.

10% FCF yield

2.1% dividend yield

Discounted cash flow (DCF) valuation (Intro to DCF [PDF]), with the initial growth rate set to a reasonable 10%, shows UP as fairly valued.

But if you take into consideration some of the opportunities discussed above, the possibility of better economic conditions, the 30% FCF growth rate for the last two years, its considerable pricing power, improving operating margins, improving gross margins, and the current growth rates in its operational segments (below), 10% might seem to be a bit too conservative.

Summary of Fourth Quarter Freight Revenues

• Automotive up 26 percent
• Industrial Products up 24 percent
• Energy up 21 percent
• Chemicals up 18 percent
• Intermodal up 13 percent
• Agricultural up 2 percent

If you try sliding the growth rate from 10% to 20% on the Vuru valuation tool (above) we get quite a different valuation. In this scenario UP has a 40% margin of safety. If reality is somewhere between our conservative estimate and our more speculative estimate, UP just might be a great investment.

But beyond the numbers and analysis there are some other reasons UP might be considered a good investment:

1. It's a great business model. 

This is a business model that works–invest, grow the business, increase returns and invest again - James Young, Union Pacific Chairman and CEO

2. Railroad assets are real assets

3. Railroads can can handle growth, unlike roads that become too congested

4. Though there is competition, it's more like an oligopoly. Union Pacific isn't going anywhere.

Past performance?

Note: UPC stands for Union Pacific Corp., it is not the stock ticker.

Sometimes the best way to beat the market is to invest in businesses that are in the business of beating the market.

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What do you think?