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UNP- Union Pacific


AJDelphi
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Kind of surprised this didn't have a thread already given Berkshire and BNSF. Below is a short write-up I did for a blog post about the Powder River Basin and some companies with operations there. I added how I got my owner earnings estimate.

 

 

The Union Pacific is one of the two largest Class I railroads in the United States. With the lowest operating ratio, 63.5%, UP is arguably the best managed railroad in the industry. The company derived 18% of its revenues from the coal business in 2014. Coal from the Southern Powder River Basin, including Cloud Peak Energy coal, makes up the majority of this business. In 2015 Burlington Northern Santa Fe, UP’s biggest competitor, had some big issues delivering its customer’s goods on time and lost market share to Union Pacific.

 

In 2014 I estimate that UP had owner earnings of $4.7 billion or $5.24 per share.

Cash from Operations=$7.385 Bil

Stock Based Comp=    $118 Mil

Maintenance Capex= $2.580 Bil  (59% of 2015 Capital Plan)

Diluted Shares= 901.1 Mil

           

Page 36 of 2014 10-k

While asset replacements will fluctuate as part of our renewal strategy, we expect to use 55% to 60% of our capital investments to renew and improve existing capital assets. Our major investment categories include renewing track infrastructure and upgrading our fleet of locomotives, freight cars, and domestic intermodal containers.

 

 

With the current stock price of $95.85 we would be accepting an initial return of 5.4%. UP does not interest me at this stock price. Especially when you take into account that the business is operating at a world class level, at some point all businesses make mistakes or run into problems. The coal business also generates some concern because if there is a secular decline then those revenues will have to be made up elsewhere. This year coal carloads are down 7% but revenues are only off 5% because of increased prices. Now, I don’t think Union Pacific will have major problems with its business overall. But, they may struggle to grow the business at an exceptionally high rate like in the past.

 

http://delphivalueinvestments.blogspot.com/

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"With the lowest operating ratio, 63.5%, UP is arguably the best managed railroad in the industry."

 

This is an incorrect statement as CN Rail has the lowest CR in the industry and is arguably the best managed class I railroad. 

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Has anyone done a deep dive on this name? I would be interested hearing peoples thoughts on continued pricing power and potential volume growth.

 

The last 10 years has seen the rails exhibit tremendous pricing power. It is unlikely that the next 10 years will be the same but there are arguments to be made that rail's cost advantage over trucks is increasing with driver shortages, increased regulations and more capital intensive truck fleet requirements. Is it too optimistic to think that they can get 2-3% pricing power vs the 6-7% they received previously?

 

The last decade at UNP has had very little volume growth. They have purposefully shed volume to focus on the most profitable lines of business. It looks like  the next decade will not be able to rely solely on pricing to keep increasing revenue and that strategies to increase volume will have to be executed on. How are you thinking about potential volume growth? Rail still has a very small share of US transport and the intermodal segment is sure to continue stealing market share from trucks on long haul routes. With a diversified but largely cyclical product mix how do you think about volume?

 

Does anyone have thoughts on how to think about normalized coal shipping? Outside of the recent material drop in coal shipments, should we see a much slower bleed over the years? If gas settles in around $3 can coal shipments at UNP remain fairly stable with their focus on PRB coal?

 

Finally- any thoughts on margins as the mix changes and we see more growth from intermodal volumes? The segment is generally thought to be lower margin, especially when compared to a more captive customer segment like coal (which could be in decline).

 

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I think that given their target of 40% operating margins and a bit of pricing power, they could probably provide solid mid-teens returns over the next decade.

 

I could definitely see that. I'd just rather buy at a bit lower price. Increase my chances of that mid-teen return  :)

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I think that given their target of 40% operating margins and a bit of pricing power, they could probably provide solid mid-teens returns over the next decade.

 

I could definitely see that. I'd just rather buy at a bit lower price. Increase my chances of that mid-teen return  :)

 

I hear ya. I reluctantly passed because the return was too low, but the moat here is fantastic.

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UP is conservatively run and is a great franchise.  There is a recent Fortune article that describes the current issues pretty well.  As merkhet said, the moat is about as wide as they get.  Railway costs $2-3M per mile to construct, not including land.

 

UP had a blockbuster year in 2014 and simultaneously witnessed the ill effects of BNSF's well-publicized service issues in early '14 (some caused by lack of capacity), so YTD, UP was likely slow to cut capacity and put locos back in storage (they had taken >400 out of storage for '14, which is incredible to fathom).  The flip side of this is UP is more concerned with running the business for the long-term: maintaining a consistent level of quality service and treating employees well rather (minimizing layoffs via furlough, etc) than running the business on a string and constantly scrambling.

 

Crude-by-rail business is misunderstood by the market.  CBR was only 1% of UP volume in 2014 and likely less this year.  Frac sand, pipe, etc are slightly bigger pieces of the pie and will certainly hurt this year, but at least those cars can be switched to other cargoes.

 

The long-term growth driver is intermodal and UP is investing heavily in the segment after trailing BNSF for some time.  The obvious structural driver is that it costs ~4x more to move a ton of cargo/mile by truck vs. rail.  Perhaps less obvious is the emerging truck driver shortage driven by heightened regulation and focus on highway safest - hours worked, drug testing, GPS monitoring, etc.

 

 

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The long-term growth driver is intermodal and UP is investing heavily in the segment after trailing BNSF for some time.  The obvious structural driver is that it costs ~4x more to move a ton of cargo/mile by truck vs. rail.  Perhaps less obvious is the emerging truck driver shortage driven by heightened regulation and focus on highway safest - hours worked, drug testing, GPS monitoring, etc.

 

What do you think the comparison would look like if made driver costs $0? I definitely agree there's a moat here, but that moat may be protecting a cottage home instead of a castle. I'm not sure as much volume will be physically moved in the future so part of the bet is that the competitive advantage in shipping you mention is true and that the rails having pricing power as a result if their volume ever disappeared permanently (coal shipping not being replaced).

 

I definitely agree that CN Rail has the sweetest rails out of all the publics. Canada seems to be signaling so big issues so there may be better opportunities later.

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UP is conservatively run and is a great franchise.  There is a recent Fortune article that describes the current issues pretty well.  As merkhet said, the moat is about as wide as they get.  Railway costs $2-3M per mile to construct, not including land.

 

UP had a blockbuster year in 2014 and simultaneously witnessed the ill effects of BNSF's well-publicized service issues in early '14 (some caused by lack of capacity), so YTD, UP was likely slow to cut capacity and put locos back in storage (they had taken >400 out of storage for '14, which is incredible to fathom).  The flip side of this is UP is more concerned with running the business for the long-term: maintaining a consistent level of quality service and treating employees well rather (minimizing layoffs via furlough, etc) than running the business on a string and constantly scrambling.

 

Crude-by-rail business is misunderstood by the market.  CBR was only 1% of UP volume in 2014 and likely less this year.  Frac sand, pipe, etc are slightly bigger pieces of the pie and will certainly hurt this year, but at least those cars can be switched to other cargoes.

 

The long-term growth driver is intermodal and UP is investing heavily in the segment after trailing BNSF for some time.  The obvious structural driver is that it costs ~4x more to move a ton of cargo/mile by truck vs. rail.  Perhaps less obvious is the emerging truck driver shortage driven by heightened regulation and focus on highway safest - hours worked, drug testing, GPS monitoring, etc.

 

Fisch- How are you thinking about volume growth over the long term. I agree with pricing due to rail gaining share over trucks but I dont see how the stock works if you only get 2-3% revenue growth. Even with margin expansion and using all excess capital to  buy back shares I can't come up with a return in the double digits per annum. Revenue needs to grow or margins need to be above 40% for the investment to provide a satisfactory return and I am looking for solid rationale for either. I realize that they have always beat guidance in the past on the margin front but I would rather have a thesis as to why volume should grow an additional 2-3% on top of the pricing gains. ANy thoughts?

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Wait, I have a seeking alpha presentation on UNP, why don't we turn it into a REIT!    I see tremendous undervalued assets!  ;)

 

That's actually an awesome idea.

 

I forgot to add to my post, the 4x factor may be coming down as well because driverless trucks are sure to beat cars to the road. What will that ratio look like when driver costs go to $0? I also don't like capital intensive businesses or ones that have numerous substitutes. The density of the future shipping volume matters quite a bit as high density reduces options significantly (and increases demand for rail transport).

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Setting aside PSR related gains in margin, this feels like a potential short against other high quality businesses (namely owned BNSF through Berkshire). Whenever I’ve looked at BNSF, revenue / EBITDA / Net Income always comes out pretty similarly to UNP and they have almost the same amount of debt, so my lazy way to value BNSF has always been “UNP market cap with wide error bars”.

 

There are too many ways to calculate the “implied price of BNSF via Berkshire” (too many variables) but I don’t think it’s near that of UNP.

 

No position; I have owned Berkshire over the years because it always seemed to trade cheap to similar high quality “real” businesses and that gap seems even bigger now with UNP and Some utilities trading where they are. In the past I’ve just owned long Berkshire and not tried to be too cute about it. With the present uncertainty and headwinds to long term corporate profitability ( and not that low valuations for regular corporate equities) buying Berkshire’s owned businesses for far cheaper than similar ones and shorting the others (maybe via OTM puts) May make sense.

 

Just some wish-y wash-y low conviction morning ramblings from yours truly

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I don't think it makes much sense shorting UNP here. I'd have to double check the metrics side by side, but almost positive UNP has dramatically outperformed BNSF over the past decade --- if you just want to use the OR as a simple benchmark (admittedly not perfect), UNP's first quarter this year outperformed BNSF by ~700bps; looking at 2019, BNSF was ~65% OR and UNP was 61%. Through PSR, the railroad has improved operations and service significantly as well. Using the first from UNP, if coronavirus weren't hurting volumes so much, normal seasonality would imply UNP's OR could be closer to a mid-high 50's OR this year. If UNP is outperforming BNSF significantly on cost and has improved service, they should be able to price business more competitively and take share back from BNSF, similar to what CNI did to CP a decade ago, and more recently what CP did to CNI (both under Hunter Harrison).

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Hmmm it’s tough for me to see UNP outpwrforming BNSF over the past 10 years based upon revenue EBITDA or earnings on Bloomberg. I am aware of their differences with respect to adoption of PSR which does give me pause.

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