The railroad industry is extremely durable, and Union Pacific (UNP) has proven to be no exception since its founding in the 1860s.

 

Railcars are a critical mode of transportation and move about 40% of U.S. freight as measured in ton-miles (the length freight travels). Without companies like Union Pacific, the country’s supply chain could not operate.

 

Perhaps it is no surprise why Warren Buffett acquired leading railroad company Burlington Northern Santa Fe (BNSF) in 2010 for $34 billion, adding the company to Berkshire Hathaway’s portfolio of high quality dividend stocks.

 

Union Pacific shares a number of qualities with BNSF and should be of interest to long-term dividend growth investors, especially since the stock has pulled back on weak commodity fundamentals.

 

Business Overview

Union Pacific owns and operates over 32,000 miles of railroads linking 23 states in the western two-thirds of the United States.

 

Its railways connect with all of the major ports on the West Coast and Gulf Coast and serve many of the fastest-growing cities in the country. Union Pacific’s rail network also connects with some of Canada’s railways and all of Mexico’s major gateways.

 

The company serves approximately 10,000 customers across a variety of industries including agriculture (17% of 2015 freight revenue), automotive (11%), chemicals (17%), coal (16%), industrial (19%), and intermodal (20%).

 

Business Analysis: Union Pacific

U.S. railroads were financially and operationally challenged under stringent government oversight until the Staggers Rail Act of 1980 deregulated the industry.

 

According to the Federal Railroad Administration, prior to 1980, railroads had little flexibility in pricing their services and restructuring their operations to become more efficient.

 

During periods of inflation, regulation slowed down rate adjustments that railroad operators could realize, crimping profits and causing a number of railways to declare bankruptcy.

 

In the 30 years leading up to 1980, railroads saw their share of revenue ton-miles plunge from 56.1% to 37.5%. The outlook was bleak.

 

The Staggers Rail Act of 1980 changed everything. Railroads implemented market-based pricing schemes on many routes, invested over $500 billion in capital improvements and maintenance to improve productivity, and train accident rates fell by 65% from 1981 to 2009.

 

Impressively, the lack of government oversight resulted in freight rates declining by 0.5% per year compared to an increase of nearly 3% per year in the five years leading up to act’s passage in 1980.

 

The industry’s market share also increased back to 40% of ton-miles and has remained stable. Today, about 20% of railway traffic is still regulated where competition is not deemed to be effective enough to protect shippers.

 

Throughout the last several decades, the railroad industry has significantly consolidated in an effort to further improve productivity, raise profit margins, and better combat alternative modes of transportation (e.g. trucks).

 

Of the 140,000 rail miles in the U.S. today, Union Pacific, BNSF, and Norfolk Southern account for more than 84,000 miles (over 60% of total rail miles).

 

The barriers to entry in the industry are high because building and maintaining railroads is extremely capital intensive.

 

While most types of businesses will spend between 2-4% of their total sales on capital expenditures to maintain and grow their operations, Union Pacific expects spending to average around 16-17% of revenue.

 

Over the last decade alone, Union Pacific has invested $33 billion in its rail network to maintain and upgrade its transportation infrastructure.

 

Smaller operators cannot match the company’s spending, and Union Pacific’s routes present another barrier to entry.

 

Simply put, the market is only big enough to support a small handful of operators in most areas because it is so expensive to build and maintain a railroad.

 

The large incumbents have the scale and efficiencies needed to underprice potential new entrants and remain in control of their key markets.

 

There are also only so many major transportation hubs and consumer markets, further limiting competition.

 

Union Pacific has the best access to Gulf and West Coast ports and is the only railroad that serves all six major rail gateways between the U.S. and Mexico. Through rail industry partnerships, the company can also access roughly 90% of the population in North America.

 

Major railroad operators have enjoyed strong pricing power due to many of the factors discussed above.

 

From 2012 through 2015, Union Pacific’s average annual pricing gain was 3.6%, and the company continues to realize pricing improvements even despite the current slump in commodity shipments.

 

Thanks to consistent pricing gains and efficiency improvements, Union Pacific improved its operating ratio from 87.5% in 2004 to 63.1% in 2015.

 

The company expects volume growth, core pricing increases, and productivity gains to further improve its operating ratio to 60% on a full year basis by 2019.

 

Looking even longer term, Union Pacific began its “G55 + 0” initiative in the fall of 2015. This program has a goal of achieving a 55% operating ratio over time with a goal of zero injuries.

 

As long as Union Pacific continues to invest in its infrastructure to maintain leading safety and efficiency metrics, it’s hard to imagine new rail competition disrupting its business.

 

The company’s competitive advantages should only strengthen in future years as it invests to become safer, more efficient, and extremely productive.

 

Finally, it’s worth acknowledging the long-term durability of the railroad industry. Freight volumes generally follow population growth over long periods of time.

 

According to the Federal Railroad Administration, the U.S. freight system will enjoy a 22% increase in the total amount of tonnage its moves between 2010 and 2035 as the U.S. population expands.

 

There will always be a need to connect consumers with agricultural, industrial, manufacturing, and logistics centers across the country. As a best-in-class operator with hard-to-replicate assets, Union Pacific will be there to meet this major need.

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Key Risks

Union Pacific’s stock slumped over 30% in 2015, driven by a 6% volume decline and an unfavorable shift in business mix. Each of the company’s business groups recorded a decline in freight revenues except for automotive.

 

The slump in grain prices, plunge in the price of oil, strengthening U.S. dollar, and continued decline in the use of coal all contributed to Union Pacific’s weakness in 2015.

 

While I view railroads as having an economic moat, that doesn’t mean demand for their services is inelastic. Macro volatility can whip quarterly results around and should be expected with an investment in Union Pacific.

 

However, in most cases, macro volatility (and potential safety or operational hiccups) shouldn’t impact the company’s long-term earnings power.

 

Coal could prove to be an exception. Union Pacific transports coal to power companies and industrial facilities and generated 16% of its freight revenue last year from the commodity.

 

Freight revenue from coal shipments fell by 22% in 2015 and show no sign of recovering – maybe ever.

 

Coal as a percentage of U.S. electricity generation fell from 38.5% in 2014 to about 33% in 2015. The Energy Information Association projects that coal will only comprise 31% of U.S. electricity generation in 2016.

 

The shift away from coal is being driven by new power plant emission regulations and low natural gas prices, which are accelerating the shift

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