Value Investing

The Short Case For Union Pacific Corporation (UNP)

Union Pacific

Union Pacific Corporation (UNP) – Rail Renaissance? by Dale Wettlaufer, Charlotte Lane Capital

November 2, 2015

This is why I believe the “rail renaissance” has been a cyclical move, not secular. This will take a few paragraphs or pages, but to introduce my conclusions:

  1. The rails didn’t take off until the Fed started to juice the economy in 2003. Industry consolidation that had been taking place since the middle of the 19th century, culminating in the late 1990s, is frequently cited as the reason for the move. I disagree. They didn’t move until the Fed stomped on the gas pedal and emerging markets demand for heavy goods exploded.
  2. The commodity cycle imploding and the dollar normalizing will hurt the rails and they already have.
  3. If the class I railroads insist on taking core pricing in excess of inflation, they will invite upon themselves a regulatory response. Their customers are in a near Depression and the railroads are taking huge chunks of their profits. Taking pricing in a commodity upturn is easy. In a downturn, the rails are exposing themselves to a reaction in causing pain for their customers.
  4. Industrial sectors exhibiting full cycles of 15-30 years have half-lives spanning a huge chunk of people’s careers on the Street. What seems secular, just because its natural life overlaps with a huge portion of one’s career, is often cyclical.
  5. Rail volumes have not grown in the last ten years. They have not taken share from trucking.
  6. Buffett didn’t buy BNSF because rails haul a ton of freight 500 miles on a gallon of diesel, in my opinion. That’s certainly true, but that’s like saying the Bulls won five championships due to their second string guard. Buffett bought it because it has monopoly / duopoly characteristics. I also believe, were I Buffett, I would have bought BNSF to hedge Berkshire, which was negatively exposed to inflation due to its underwriting liabilities.
  7. The cash flow characteristics of rails make these expensive assets now, not cheap.
  8. Fuel surcharge benefits to the P&L over the last ten years have been extractive and may have no duration left. Underlying this phenomenon, a nasty loss of fixed cost suspension is already underway.

The year is 2006 and I was doing lots of work on transports. The housing bust was getting started and truckers were getting hammered. Driving from one destination to the next in rural Missouri, Kansas, and Arkansas that spring, I was getting the full complement of old-line truckers with one fantastic visit to JB Hunt (JBHT). Understanding the sector was pretty bad, I knew I was playing with fire (the value investor’s lot in life), but the JB Hunt connection with BNSF was really interesting, so I started to do work on the rails.

My first target was NSC. My original take on it was no-go, but I continued to think about it and then made the trip down to Norfolk early that summer to get the full Wick Moorman and Jim Squires treatment. Sitting there in the reception area of the executive offices, I eyed from my Anthony Hay side chair a beautiful 18th century tall case clock. Behind me hung an incredible Hudson River School painting (or some lovely Realist work), which may have been a Thomas Cole. In other words, this corporation had been accumulating an array of beautiful assets for probably 150 years, not all of which were ferrous. I soon thereafter wrote it up as a buy recommendation. The commodity cycle was still raging and it was easy to see the pricing power and operating leverage that existed there. NSC was the cheapest at the time (BTW, I mistyped NSC as “BSC” and got the chills) and had improvability to it, so I was in.

As I climbed the learning curve, I began to see the geographic appeal of the Western rails, and reflecting upon what I learned from visiting JBHT and covering the truckers, I began to see the wisdom in paying up for BNSF. I wrote that up in 2007 and as I was editing the report, news emerged that Buffett was in BNI. I’m fine being in the same names as well as being on the other side of the big man when I see it differently, but no Buffett student minds when his investment predates the master’s (as NSC had and which, in this case, BNSF didn’t, but I was confident I wasn’t doing follow-the-leader). I say all of this to set the scene and establish I was once a rail long and I liked them.

Where I Began to Question the Cyclicality Sometime in late 2007 or 2008, Kiril Sokoloff at 13-D Research published a report mentioning the CRB Raw Industrials index (or CRB RIND), which is an index of commodities that are not publicly traded and are therefore not pushed around by futures markets and money flows.i. My best friend in the business, Ian McDonaldii, overlaid the CRB RIND vs. the S&P 500 Rails index and told me about the strong relationship he saw there. The overlay was nearly perfect. In meetings with the managements of two class I railroads, I asked why that might be. I could also show a negative correlation between the dollar index and the rails. Neither management team could answer very clearly, if at all.

It always makes me dig deeper when a management team can’t answer a macro question when they’re macro-exposed (often when this is the case, I think they don’t believe they’re macro-exposed). For instance, we owned the homebuilders in 2005-2006 and I could never get a good answer from management teams to the question, “What’s the real return to a home owner from holding residential real estate?”iii Not satisfied with what I heard and being intrigued by these exceedingly strong relationships, I began to look into it further.

Union Pacific
Union Pacific
Union Pacific
Union Pacific

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