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Recommendation: BUY Target Price until (12/31/2015): $216
1. Reasons for the Recommendation
Positives: Union Pacific has been steadily running its operations throughout the past five years with good sense and consistency, and has positioned itself well to grow for the next five years. The corporation has kept its shareholders in mind in their pursuit of growth, and I recommend a buy because of the following:
The corporation has continued to set themselves up for the long-term knowing that their operations follow closely to the economic trends. It recovered quite well through the Great Recession, and as the economy gains traction, the sales in commodities, 95% of their revenue, will gain traction as well. It transports a well-balanced and diversified range of commodities that hedge against unpredicted impacts like economy, weather, and fuel. Each sector is forecasted to grow over the next year and throughout the next five years.
Union Pacific is a leader in this industry. In 2012, for example, UNP earned 27.5% of the industry’s business. It had over 30% market share in three commodity segments, Agriculture, Automotive, and Chemicals; over 40% in Intermodal, over 20% in Coal, and 10% in Industrial Products. Considering there are 575 companies in the industry, Union Pacific captures a large part of the industry’s business. In 2012, for example, Union Pacific transports the most car manufacturing commodities west of the
Mississippi River, and as the economy recovers, this sector is expected to have major growth especially in transports to and from Mexico. Because Union Pacific has portals to all 6 Mexican gateways, it has a major competitive advantage as the US turns to Mexico for more manufactured products. This sector should be a major growth for them. Other sectors like chemical, agriculture, and intermodal, which have traditionally been Union Pacific’s better revenue makers, are predicted to grow as well.
A sound financial structure is one of the major factors for a recommendation to buy. Union Pacific announced in late 2013 an aggressive additional 60 million common share buyback program (13% of outstanding shares) that will extend to 2017. This repurchase program will reward investors by raising the value of their earnings per share. Previously UNP announced a buyback program in 2008 and since then has repurchased at least 19% ($8.6 billion) of the outstanding common shares. It has met or come very close to meeting these goals with their previous buyback programs. It also has been raising dividends and lowering their debt-to-equity ratio, which will help them have little trouble rolling over debt in the future. It is mindful of rewarding shareholders with increasing returns, maintaining a strong balance sheet, and using their cash from operations to invest in capital to strategically grow the corporation with the economy.
The predicted 3.7% rise in fuel costs over the next five years will help Union Pacific with industry
competition. The railroad industry, in comparison to its other industry competitors: air transport (fastest
mode), water transport (cheapest mode) and truck transport (most mobile mode), may not be the fastest,
cheapest, or most mobile, but it has a fair balance of all of those benefits. When fuel prices go up, the rail
industry becomes the best and most reasonable choice amongst its competitors because it is the most fuel
cost efficient versus the timeliness, mobility and cost. And Union Pacific, being a leader in this industry,
will reap the benefits of customers choosing railroads over other transportation industries. Union Pacific
is keenly aware of this and has positioned itself to grow by investing in capital to expand its already
comparatively large network and infrastructures in the industry. It also has maintained a competitive
advantage by investing in more fuel-efficient locomotives. This keeps their own fuel costs down which is
a major expense for the corporation.
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Negatives: There are some downsides to Union Pacific. Even though the railroad industry is the best choice amongst its industry competitors when fuel prices are high, fuel prices are still a major risk that continues to affect Union Pacific Corporation because the costs are so closely tied to the industry. Fuel is a major expense for Union Pacific. Rising fuel costs directly affect prices, and can have an impact on margins and operating ratios. Traditionally, Union Pacific has been able to handle the rising costs of fuel through fuel surcharges absorbed by the customer, however, reinforcement of legislation passed regarding fuel surcharges to be directly related to the customer’s transport, will significantly change the way fuel charges is charged to the customer. In addition, the way surcharges have been applied to customers’
transportation purchases are under scrutiny, and the subject of extensive litigation. There are several pending lawsuits in regards to this and price fixing. This is a major risk to pay attention to since fuel charges are so volatile, directly affect the prices to customers, and are now under the microscope. For these reasons, Union Pacific cannot guarantee that the customer can still absorb the majority of fuel costs.
Additionally, any shortages in fuel can negatively impact operations and finances as well.
Labor Unions can also pose a risk to Union Pacific. Four out of five employees belong to a labor union.
Negotiations for new contracts will begin again next year. This is a more serious threat as demand in the industry rises and a series of negotiated contracts expire in 2015. This is also an important risk because if negotiations don’t go well, and strikes result, a sudden loss of available labor will also affect finances and operations negatively.
Likewise, legacy contracts have slowed down Union Pacific. A legacy contract is a contract that is outdated and below market prices. These contracts affected core prices and operating ratios. $350 million of these legacy contracts came due in 2013 and were renegotiated, but still 85% of legacy contracts are in the coal segment. If they cannot price these contracts to the cost of assets, then Union Pacific will walk away from the contract. There have also been some contracts lost in the coal sector, a development in part attributable to the expiration of certain legacy contracts. The coal industry was down 9% in 2013, in addition to the majority of legacy contracts in that segment. Consequently, Union Pacific might be compelled to accept short-term loss in the coal segment in order to hold out for some future gains in the long term. And finally, there are the common risks to be aware of in the industry as a whole.
Not only is Union Pacific vulnerable to the risks mentioned above, but its operations and success are additionally exposed to fundamental uncertainties (e.g., weather change, an unlikely but extreme increase in the cost of fuel, governmental regulations, catastrophic changes of the economy of China and Mexico).
2. Company Analysis
Union Pacific Corporation, (UNP) on the NYSE, is well known as the dominant force in railway transportation. The Union Pacific Railroad Company and its subsidiaries are integrated into a single operating segment of the corporation. The Railroad Company accounts for over 95% of Union Pacific’s operating income. Six commodity sectors of the Railroad account for that revenue: coal, intermodal, chemical, industrial products, agriculture, and automotive. The Class 1 railroad company delivers its goods to 10,000-plus customers, reaching key markets throughout North America. Its 31,868 route miles of railways connect to 23 states (roughly two-thirds of Western US), providing business to Western and Gulf ports while linking gateways throughout the Midwest and East and connecting Canada’s railways.
Additionally, Union Pacific is the only railroad to handle all six principle gateways to Mexico.
Union Pacific’s 10-K Annual Report 2012, says Union Pacific’s goals are to deliver its commodities “in a
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safe, reliable, fuel-efficient and environmentally responsible manner,” (p. 5). Almost 60% of the deliveries come from coal, intermodal and industrial products. Coal and petroleum coke, are transported throughout the United States. They pass through numerous gateways and ports, ending up across country as well as finding their way to international markets. These shipments are one of the two largest sectors of Pacific Union’s business, comprising 20% of total revenue.
Industrial products, 18% of revenue, are but a few of the miscellaneous products shipped mostly intra- nationally. These products include metals, minerals, paper, consumer goods and lumber. Moreover, Union’s key markets include oil and gas, highway construction, and industrial manufacturing plants. While Agricultural-related business is another key facet of Union Pacific’s operations,
contributing 17% to revenue. One-third of the agricultural shipments are dispatched to domestic markets.
Transporting chemicals brings in and additional 16% of revenue, with two-thirds of those chemicals originating in the Gulf-States. The three major commodities shipped are Soda Ash, Fertilizer, and Petrochemicals.
The sixth and final sector (and smallest in terms of revenue at 9%) is automotive. This piece of Union Pacific’s business is enough to make it the largest carrier of automotive goods in the West. These goods are transported throughout North America. In general, Union Pacific customers are made of various business and organizations that require the shipment of their goods across North America.
Strengths: Union Pacific is one of the oldest railroad companies in the United States; a well-established brand with a large customer base. Its extensive infrastructure can transport goods throughout the United States, linking with railways in both Canada and Mexico and up and down both coasts. It continues to be a leader in technological advances, which help maintain its status as an industry leader. Its commodities are varied, which diversifies its operations and works as a hedge during changing economic
conditions. For the past two years, Union Pacific has ran a surplus of working capital, providing much needed flexibility during a period of economic uncertainty.
Weaknesses: Union Pacific major competitor in the rail business, Burlington Northern Santa Fe LLC, runs parallel lines alongside its own. Furthermore, motor carrier competition exists in five out of six of Union’s sectors. Barges also present competition along the Gulf Coast. Both types of competition have public rights-of-way, which are administered by the US Federal Government. Any legislation that alters the current landscape could pose a threat to Union’s status quo. Union Pacific has but two domestic flyers for their locomotives; any issues impacting these companies will directly influence Union Pacific operations. They also have only two suppliers for rails, one domestic, and one international. Again, any variation within these companies’ processes or operations could potentially force Union Pacific to
reevaluate its current strategy. Union Pacific has close to 46,000 full time employees and 86% of them are in one of the 14 rail unions. 2010 negotiations wrapped up this year, however new negotiations will commence in 2015. This issue will always be central to Union Pacific’s business model as their highest expenses are associated with labor costs.
3. Industry Analysis
The rail industry operates mostly line-haul, short line railroads and intercity passenger trains. Its major
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services are bulk freight, 54.1% of the services offered, intermodal, 41.3%, (freights that are transported using multiple modes of transit, i.e. ship, train, truck) and passenger services, 4.6%,
1transporting
commodities and passengers to major ports and gateways. The railroad industry is integrated and consists of the Class 1 railroads (railroads with operating revenues of $378.8 million at minimum), regional railroads, and line-haul (freight and passenger) railroads.
There are 571 businesses in the industry, grossing $74.5 billion in revenue resulting in $11.3 billion in profits. Competition from other transportation industries as well as increasingly smaller profit margins gave rise to a series of mergers over the past 30 years. Consequently, the number of competitors has been significantly reduced. e.g., in 1980 there were 40 class 1 operators while at present there are only 7. Such developments portend further consolidations with central players in the industry predicting the process will intensify over the next 5 years. Increasingly, we can expect to see transportation and service
companies as targets for acquisitions and merges as the industry adapts to the global trend of door-to-door delivery.
There are several main commodity industries that use rail transport: Coal mining, Mining, Petrochemical Manufacturing, Car and Automobile Manufacturing, Coal & Natural Gas Power, Agricultural, Forestry, Fishing and Hunting. Coal is one of the industry’s largest and most transported commodity revenues.
Growth in this industry is predicted to be smaller for several reasons. China’s reliance on U.S.
metallurgical coal will slow as their growth stabilizes. Australian coal is predicted to take a slice of U.S.’s market in China as well. However, the Appalachian Basin is world renown for its quality of metallurgical coal; the well known Wyoming Southern Powder River Basins, and other Western U.S. coal mining operations are generally cheaper which should keep U.S. coal transportation steady. Natural gas is increasingly substituted for coal and pressure on green house emissions will continue to put pressure on the coal industry. Natural gas is expected to increase in the next 5 years at an annual rate of. Firms in both Natural Gas and Coal are expected to grow at an average annual rate of 2.7%.
2Four major corporations have gradually come to dominate 90% of the market share. In the lead is Union Pacific, which at present has the largest market share (approximately 29.5%). In a close second,
Burlington Northern Santa Fe Corporation claims roughly 29.2% of the market. The final two among the four are also close to each other, but are substantially removed from the top two in the industry. CSX Corporation controls about 15.2% of the market, while Norfolk Southern Corporation shares 14.9% of the market.
3The dominance of these four corporations is such that high barriers of entry mark the industry.
The capital costs of laying new railroads and acquiring the land through which they would operate are extremely prohibitive. Smaller companies have emerged by contracting with the four majors to use their rails.
Outside the rail transportation industry are competing transportation industries. Road, water and air transportation have their competitive edge and their drawbacks. The road transportation industry is the biggest competitor because of their door-to-door services, and their access to public roadways that can
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easily reach local destinations. One of their drawbacks is fuel consumption. For every one ton of freight transported between the US’s two coasts, it takes 7 gallons of fuel for a train versus 27 gallons of fuel in a truck.
4Trucks are also confined to road regulations like strict weight limit regulations. The water
transportation industry is highly competitive and concentrated in areas like the Gulf Coast. It’s prices and costs are lower than that of the railroads and are the most efficient in the transport industry. However, water transport is limited to water locations and transport can be time consuming. Air transportation has a competitive advantage when transporting time-sensitive goods. However, air transportation is expensive and only small amounts of goods can be transported. In comparison with its other industry competitors, rail transportation has the benefits of having the advantages of its competitors. Pricing, fuel efficiency, costs, mobility, and timeliness make the rail industry the most reasonable choice amongst its competitors.
The rail industry has seen a number of technology investments to help improve efficient systems, cut fuel costs, reduce pollution, maintain infrastructure, and safety standards. Capital intensity is high and will remain high due to the nature of the industry. 40% of revenue is typically reinvested into capital.
5New technology has also replaced and reduced some labor costs and will continue to do so. High labor costs will also continue to prevail to maintain assets and because certain labor is irreplaceable by technology.
Businesses within the railroad industry are part of the private sector; therefore, they must maintain their own infrastructure. Because the industry is mostly privatized it has an advantage over its competitors who must rely on public infrastructure that continues to decline, and are at the mercy of the government.
This will serve the industry and its railroads well as they prepare for an increase in transportation.
Most recently, the railroad transportation industry brought $74.5 billion in revenues and $11.3 billion in profit, but in the past 5 years, the recession caused a chain of events that lead to diminished demands and resulted in a 22.4% fall in revenues.
6It recovered well through the recession and grew at a hefty 7.3%
average annual rate between 2009 and 2014. In 2014 revenue prediction for the industry will rise 1.4%.
By 2019, the average annual revenue is estimated to rise at 3.9% to $90.2 billion and profit margins will rise from 15.1% in 2014 to 16.6% in by 2019.
7Profit margins will slow due to the rising cost of fuel, but investments in increasing capacity over the past 5 years will help accommodate the rising demand.
The rail transportation industry has experienced revenue volatility mostly because of fuel prices. Fuel prices alter what railroad companies can apply to fuel surcharges making prices fluctuate. Lower fuel prices also cause businesses to move to industry competitors. Demand for goods and commodities play a key role in the volatility as well. The recession proved that when demand for goods declined, the use of freights declined in number reducing the revenue and increasing the prices. As the economy grows the opposite will apply.
The past 5 years has proven to be a growth cycle for the industry, and the next 5 years will continue the trend. Due to the recovering economy, the growing U.S. population, the demand for manufacturing productions, and the estimated 4.2% rise in trade value (over the next 5 years), the industry will continue
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to expand its networks, improve infrastructures in anticipation of a rise in organic business. The rising global price of crude oil (3.7% estimated rise in a 5 year forecast), positions the industry as the best solution for customers from the industry’s competitors who want to save on fuel costs, and lower their carbon footprints.
8Overall, there is a promising future outlook for the rail transportation industry.
Appendix: Inputs into valuation using multiples
* Analyst's own calculations. Source of basic data: company's 10-K; Yahoo! Finance
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Works Cited
1
Rivera, T. (2014). IBISWorld Industry Report 48211. Rail Transportation in the US. Retrieved February 04, 2014 from IBISWorld database.
2
Yang, D. (2013). IBISWorld Industry Report 22111a. Coal and Natural Gas Power in the U.S. Retrieved February 03, 2014 from IBISWorld database.
3
Kaicher, G. (2013). IBISWorld Industry Report 32511. Petrochemical Manufacutring in the U.S.
Retrieved February 03, 2014 from IBISWorld database.
4 ,5
Ruiz, B. (2014). IBISWorld Industry Report 33611a. Car and Automobile Manufacturing in the US.
Retrieved February 04, 2014 from IBISWorld database.
6
Antel, N. (2013). IBISWorld Industry Report 42451. Corn, Wheat, and Soybean in the US. Retrieved February 05, 2014 from IBISWorld database.
7
(2014). IBISWorld Business Environment Profiles. Rail Total Value of World Trade. Retrieved February 04, 2014 from IBISWorld database.
8, 9
Rivera, T. (2014). IBISWorld Industry Report 48211. Rail Transportation in the US. Retrieved February 04, 2014 from IBISWorld database.
10
"Form 10-K." (2013). Securities and Exchange Commission. BNSF Form 10K. Retrieved February 2, 2014.
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"Form 10-K." (2013). Securities and Exchange Commission. CSX Corporation Form 10K. Retrieved February 2, 2014.
12
"Form 10-K." (2013). Securities and Exchange Commission. Norfolk Southern Corporation Form 10K.
Retrieved February 2, 2014.
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13
Setar, L. (2013). IBISWorld Industry Report 48412. Long Distance Freight-Trucking in the US.
Retrieved February 02, 2014 from IBISWorld database.
14, 15, 16, 17
Rivera, T. (2014). IBISWorld Industry Report 48211. Rail Transportation in the US. Retrieved February 04, 2014 from IBISWorld database.
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