Recommendation: SELL Estimated Fair Value: $80 – $110
1. Reasons for the Recommendation
The growth in revenues for the railroad industry is expected to slow in the years to come. Since 2006, excluding the drop in revenues in 2009, the industry revenues have been growing at a rate of 5.5% per year. Union Pacific was able to grow faster than its industry in these years, with growth of 9.8% in revenues per year. The average growth in industry revenue per year over the next 6 years is projected to be around 3% per year.
1The consensus amongst analyst is a forecast with an annual growth in earnings of around 16% over the next 5 years for Union Pacific, leading to the high median target price of $128.
2It seems unlikely that Union Pacific will be able to live up to these markets high expectations. The expected growth in earnings will not be coming from revenue growth, and there are several indicators that limit Union Pacific’s potential to improve its profit margins.
Coal shipments have been declining in 2011. This trend continued in early 2012, with coal traffic being down by 7.6% so far this year. There are several reasons for a continuation of this downward trend. One being the substitution of coal used for generating electricity with cheaply available natural gas. Another reason is the higher regulatory standard on coal-fired plants proposed by the EPA, making coal less attractive.
3The energy sector, which includes coal and petroleum products, accounted for the largest share of Union Pacific’s revenues of all business segments. It was responsible for 22% of the overall revenue in 2011.
Union Pacific’s energy revenues have not yet been hit by this downward trend, mainly because 75% of Union Pacific’s energy revenue comes from Southern Powder River Basin coal.
4Coal from this region has remained competitive versus natural gas, but this could change very soon.
5Some shippers have filed complaints with the Surface Transportation Board (STB). The case that the railroads customers are making is that the big four (Union Pacific, BNSF, CSX, Norfolk Southern), which account for over 90% of the revenue in the railroad business, are fixing prices and taking advantage of captive shippers, who are only connected to one railroad network.
6A decision by the Surface Transportation Board will be made over the next month, settling this yearlong feud between railroads and shippers.
7A ruling of the STB in favor of the shippers could have a strong negative effect on profitability in the railroad industry.
New legislation, called the Railroad Antitrust Enforcement Act, is currently under debate in the US Senate. This bill would remove some antitrust exemptions, which railroads are currently benefiting from.
It would also allow shippers to bypass the Surface Transportation Board and allow them to file complaints in federal court.
8If signed into law, this piece of legislation could affect the pricing power of railroads, and as a result hurt their margins.
EBITDA over sales has been lower than the previous year for the first time in years. This indicates, that Union Pacific has reached a level of efficiency, where it is no longer able to improve its margins. Due to the stable capital structure of the firm and the continuing low interest rates, the operating margin (after-
1
Setar, L.: Rail Transportation in the US, in: IBISWorld Industry Report 48211, December 2011, p.9
2
from finance.yahoo.com, retrieved on March 31, 2012
3
Denning, L.: A Lump of Coal for Gas Bulls, in WSJ, March 29, 2012
4
Union Pacific Corporation 2011 10-K, p 28
5
Denning, L.: A Lump of Coal for Gas Bulls, in WSJ, March 29, 2012
6
Kimes, Burke: Showdown on the Railroads, in: Fortune Vol. 164 Issue 5, 9/26/11, p. 160-172
7
Sechler, B.: US Regulators Seen Nearing Decision In Rail, Shippers Standoff, in: WSJ, February 29, 2012
8
Sechler, B.: US Regulators Seen Nearing Decision In Rail, Shippers Standoff, in: WSJ, February 29, 2012
tax EBIT over sales) and return on sales have both leveled out at 18% and 26 % respectively. Lower pricing power and demand will hinder the corporation from improving its margins on the revenues side, while there aren’t many opportunities for cost cutting. Rising interest expense in the future could further hurt Union Pacific’s profitability.
Union Pacific is currently trading at a higher multiple (Enterprise Value over Revenue) than its competitors in the railroad industry. This can be explained with Union Pacific’s lower dependency on the coal business. But even when adjusting the number by using a weighted multiple for each business segment, the multiple analysis still points to Union Pacific being overvalued compared to its closest competitors. When compared to the company’s historical multiples, Union Pacific is trade at higher multiples, than its 5-year average in both price over earnings and price over sales.
92. Company Analysis
The Union Pacific Corporation, through its’ main operating subsidiary, the Union Pacific Railroad Company, is one of America’s leading transportation companies. Its railroad network covers 23 states in the western United States and connects to the eastern part of the country through major gateways in Chicago, New Orleans, St. Louis, and Memphis. It connects to the Canadian and Mexican railroad networks through several gateways. Union Pacific also holds a 26% stake in the Mexican railroad Ferromax.
10The company has a diversified mix of six business units (listed by revenue high to low): Energy, Intermodal, Agricultural, Industrial Products, Chemical, and Automotive. Since the customer base is spread over different sectors of the economy, Union Pacific is less reliant on single customers or segments. This diversification helps the company to take advantage of growth opportunities in various sectors.
Union Pacific’s key strengths are its brand name recognition and strong operational network. The company has better connections to the Mexican railroad network than its biggest competitor Burlington Northern Santa Fe. Recent investments in the network of tracks should help the company capture future growth in traffic.
One of Union Pacific’s weaknesses is its’ considerable pension obligations. In the past years, there have been discrepancies between the planned and actual expenses. This is a result of the decline in the value of the pension funds, forcing the company to contribute cash to bridge the gap.
11In 2011, the pension and OPED obligations were $996 million higher than the corresponding plan assets. This is $323 million more than 2010. The unfunded obligations account for about 2.2% of the company’s assets, and 30% of the company’s 2011 net income. Union Pacific made cash contributions to the pension plan of $200 million in 2010 and 2011.
Union Pacific is dependent on its suppliers of locomotives. There are only two suppliers that Union Pacific utilizes, that meet the company’s specifications.
12This poses high risk for the corporations, in case one of its suppliers discontinues its manufacturing operations. It also put Union Pacific in a weak negotiating position with its suppliers.
9
Morningstar Investment Research Center, UNP Valuation Analysis, Data as of March 3
rd, 2012
10
Union Pacific Corporation: 2010 Analyst Fact Book, p. 32
11
Datamonitor: Union Pacific Corporation – Company Profile, 2011, p.7
12
Datamonitor: Union Pacific Corporation – Company Profile, 2011, p. 7
The Mexican market is becoming increasingly attractive, since prices for production in China are rising.
More American corporations are shifting their production to Mexico, which leads to higher demand for railroads serving this market.
13Union Pacific has good connections to the Mexican railroad network and 26% stake in the Mexican railroad Ferromax.
14This should help the company in capturing a large share of this growth.
Union Pacific faces strong competition in its market. The competition is not limited to other railroad, such as Burlington Northern Santa Fe, CSX, or Kansas City Southern, but also includes motor carriers, ship and barge operators, and pipelines. BNSF, the company’s major competitor, serving many similar routes, has recently received large amounts of fresh capital through the incorporation into Warren Buffets’
Berkshire Hathaway Corporation. This gives BNSF more flexibility for investment projects or acquisitions.
Union Pacific and its main competitor BNSF have been sued by one of their customers, coal and coke miner Oxbow Mining, over allegedly engaging in monopoly behaviors and price fixing in violation of antitrust laws. The allegations are similar to the ones given in the complaints by other railroad customers in the Surface Transportation Board proceeding on railroad competition. Both companies deny the allegations.
15There is no decision in this case as of right now. If Oxbow Mining wins this case, it could become a precedent case for other shippers alleging unfair pricing practices.
3. Industry Analysis
Union Pacific operates the largest railroad in the United States.
16More than 80% of all revenues in the industry are generated by the five largest railroads in the United States (listed by revenue high to low)
17: Union Pacific, Burlington Northern Santa Fe, CSX, Norfolk Southern, Kansas City Southern. Union Pacific also has the highest market capitalization, since Burlington Northern Santa Fe no longer is a publicly help corporation. Union Pacific holds a market share of 25.65 %.
The railroad industry has seen a phase of consolidation after the Staggers Act of 1980.
18The four major competitors can be broken down into two groups, one serving the Western United States, one serving the Eastern United States. As a result, there are only two major competitors in each of these markets. Union Pacific and Burlington Northern Santa Fe operate in the western states of the United States, while CSX and Norfolk Southern serve the market in the eastern states. Kansas City Southern serves routes in the Midwest of the United States and Mexico. In recent years Canadian National Railways has been expanding into the United States, serving routes in the Great Lakes area connecting it to Louisiana.
The United States railroad industry has an oligopoly-like structure. The railroads are competing for customers, but are also cooperating by completing customer movements and sharing assets. Since most customers are only connected to one railroad network, there is little price competition.
The barriers for new competitors to enter the market are very high. Building a nation-wide railroad network would be only achievable with very high investments. There is also little reason to build new tracks, since the network of the current railroad companies is very competitive.
13
Lahart, J., Orlik, T.: China’s Export Pain May Be Mexico’s Gain, in WSJ 2/6/2012, p. C6
14
Union Pacific Corporation: 2010 Analyst Fact Book, p. 32
15
Boyd: Coal Shipper Sues UP, BNSF for Price-Fixing, in: JoC Online, 6/9/2011, p 5-6
16
Standard & Poor’s: Union Pacific Corp Stock Report, 2/11/12, p. 2
17
Standard & Poor’s: Union Pacific Corp Stock Report, 2/11/12, p. 2
18
Eakin, Bozzo, Meitzen, Schoech: Railroad Performance Under the Staggers Act, 2010
The average return on revenue in the industry in 2011 was 16.33 %
19. Union Pacific was able post a slightly higher return, but in general is very close to its peer group.
Railroad locomotives use diesel as their fuel. The fuel accounts for a large amount of the operating costs of a railroad. For example, over 20% of Union Pacific’s operating expenses are fuel expenses.
20The industry’s fuel efficiency in comparison to other modes of transportation is a strength that can help the industry compete.
21Higher oil prices have a positive effect on the industry in two ways. They make railroads more competitive against trucking companies, because of fuel efficiency. Higher oil prices also make coal a more attractive source of energy, leading to higher volumes in this important business for railroads
Most railroads have excess capacity since the fall of demand, due to the economic downturn and the increased efficiency of the railroads. As of the end of October 2011, 17.2% of all railcars in the United States are in storage and not utilized. The railroads also have a corresponding amount of parked locomotives. These numbers are declining, with traffic growing steadily, but there is still over capacity.
22This overcapacity should decrease over the next years, since demand is growing. Overcapacity can heighten pricing competition within the industry.
19
weighted by market capitalization (excluding Burlington Northern Santa Fe)
20
Datamonitor: Union Pacific Corporation – Company Profile, 2011, p. 9
21
Standard & Poor’s: Union Pacific Corp Stock Report, 2/11/12, p. 4
22
Kirkeby, K.: Industry Surveys Transportation: Commercial, 1/5/2012, in: S&P Capital IQ Industry Surveys, p. 7
Appendix A: Inputs into the Discounted Cash Flow Valuation
Risk-‐Free Rate 1.04%
23Default Spread
242.50%
Pre-‐Tax Cost of Debt 3.54%
Marginal Tax Rate 35.00%
After-‐Tax Cost of Debt 2.30%
Bottom Up Beta 1.21
Market Beta
251.27
Equity Risk Premium US
265.50%
Cost of Equity (bottom-‐up) 7.69%
Cost of Equity (market) 8.03%
Weight of Equity
2780.97%
Weight of Debt
2819.03%
WACC (bottom-‐up) 6.67%
WACC (market) 6.94%
Growth Rate 5.66%
Glossary:
Bottom-up beta
This is calculated by taking a weighted average of the unlevered betas for each business segment, and then relevering the weighted average unlevered beta using the firm’s D/E ratio. Each segment is weighted by revenues from that segment.
23
Rate of 5-year T-Bill on March 30, 2012, http://www.treasury.gov/resource-center/data-chart-center/interest- rates/Pages/TextView.aspx?data=yield
24
UNP non-callable corporate bonds with a maturity of 5-10 year have a S&P rating of BBB+
25
finance.yahoo.com, retrieved on March 31, 2012
26
CXO Advisory Group: The 2011 U.S. Equity Risk Premiums from Academia and Practitioners, http://www.cxoadvisory.com/13357/equity-premium/the-2011-equity-risk-premiums-from-academia-and-
practitioners/
27
using Market Cap. from finance.yahoo.com, retrieved on March 31, 2012
28
Union Pacific Corporation 10-K, Book value of debt plus present value of leases
Appendix B: Inputs into valuation using multiples Comparable Firms
Competitor Multiple
29Union Pacific 3.38
CSX 2.69
Norfolk Southern 2.75
Kansas City Southern 4.53
Historical Multiples
302002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ttm P/E 11.9 17.1 29.2 20.9 15.6 18.2 10.5 17.0 16.8 15.8 15.8 P/B 1.4 1.4 1.4 1.6 1.6 2.1 1.6 1.9 2.6 2.8 2.7 P/Sales 9.9 11.9 11.6 10.8 11.1 11.6 6.8 9.1 9.3 8.5 9.4
29
Enterprise Value over Freight Revenue
30
