Today we are analyzing the railroad freight company with more kilometers in the United States. A historic company, it was one of the main protagonists in the construction of the first railroad line that connected the East with the far West of the United States. We are talking about Union Pacific.
Introduction
Union Pacific (UNP) was created in 1860 and was one of two railroad companies designated by the US government in the Pacific Railroad Act of 1862 for the construction of the first transcontinental railroad line in the United States. The other designated company was the Central Pacific Railroad of California.
In 1860, you could only cross the country by caravan or sea. These were the means of transportation that most Americans chose during the Gold Rush of 1849 to 1855 to reach the West of the country, and the journey was long and dangerous.
One of the most used routes was the Panama route. One could go by steamboat from New York to Chagres, then continue by land to cross the 120km of the Strait of Panama by road and finally take a steamboat again from Panama to San Francisco.
But, although this route was perhaps the safest, it was still an excessively long route. To shorten it somewhat, a group of American entrepreneurs financed the construction of a railroad to replace the old Panama Strait route, which was inaugurated in 1855, allowing a greater volume of goods to be transported in a shorter time. But the boat trips were still very long.
With the settlement of new immigrants from California due to the Gold Rush and its subsequent agricultural development, the idea of a great construction project began to emerge: the connection by train of the two American coasts. While the first railway line in Panama was about 120 km long, the one that was about to be built in the United States was 2,700 km long … more than 20 times longer!
The idea was to connect Sacramento with Omaha, crossing two-thirds of the continent and the large empty space in the inland of the United States. This was not an easy task, both in terms of the choice of route and the financing of the project. An additional problem was the Civil War (1862-1865).
Central Pacific Railroad of California was assigned the route starting from the west, Sacramento, and Union Pacific the route from the east, Omaha.
The financing of the project was very complicated and was marred by corruption due to numerous political scandals that were unveiled throughout the construction. Construction began in 1863, lasted 6 years and required some 20,000 men. Central Pacific Railroad relied on a mostly Chinese workforce, whereas Union Pacific had mostly Irish employees. The junction of the two lines was made at Promontory Summit, Utah, and the travel time between San Francisco and New York was reduced from several months to only 10 days.
But the Omaha rail line did not yet link up with the existing eastern rail lines and the connection was made by loading trains on ferries on the Missouri River. In order to finally connect the two American coasts by rail, the final western section from Sacramento to San Francisco was opened in 1869 and in 1872 the eastern section between Omaha and Council Bluffs. At last, it was possible to travel from New York to San Francisco without getting off the train!
When this crazy construction (which has inspired some famous western movies such as “The Iron Horse” in 1924 by John Ford or “Pacific Express” in 1939) was finished, the exploitation of the railroad began. As the land was cheap, towns sprang up very quickly. UNP land became the largest beef quarry in Chicago.
The central United States was gradually filled with new railroad lines and cities. Numerous railroad companies were created and mergers and acquisitions among them were usual.
These were very turbulent years with fierce competition among the different railroad companies. In 1893 the railroad companies had expanded and speculated a lot, so they had very important debts. UNP went bankrupt that year and was bought by a small group of investors, including E.H. Harriman.
Over ten years, Harriman reorganized the company, repurchased pre-1893 portions of the company (which had been purchased by other investors after UNP’s bankruptcy) and invested millions of dollars in modern locomotives and railcars, replacing wooden bridges with metal or masonry ones, reducing curves and grades, improving water supply, installing heavier rails, and so on. These investments were key to ensure the company’s survival.
During World War I, the railroads were nationalized to coordinate military procurement under a single directorate, Railroad’s War Board, and were returned to the companies at the end of the war. But after the war, rail transport began to suffer from competition from the new means of transport that were developed during the 20th century: the automobile, road freight and airplanes. The boom in the expansion of railway lines was over and the following years were characterized above all by an improvement in locomotive technology and transport capacity.
For a few years yet, trains managed to remain a premium passenger service. Lesisure trains were created, with more powerful locomotives to reach the mountainous areas of the country and transport wealthy hikers. UNP even opened a ski resort in the northwest in 1936, Sun Valley, which attracted national celebrities and wealthy people, and which UNP retained until 1964.
Just before and after World War II, Union Pacific offered luxury passenger trips between various points on the West Coast and Chicago, with panoramic dining cars and menus worthy of the finest restaurants. Even Ronald Reagan appeared in one of Union Pacific advertisements.
But the passenger service did not manage to survive the competition from automobiles and airplanes for long. It became an increasingly unprofitable service that train companies wanted to get rid of. Faced with their reluctance to maintain the passenger services, the US government created the public company Amtrak in 1971, which took back all passenger rail service in the United States, leaving the more profitable freight transport to private companies.
Since 1971, UNP has operated virtually no passenger transportation services.
But, as we have said before, the 20th century is the century of technological advances in locomotives: from steam locomotives, used until the end of the 1950s, to diesel locomotives until the end of the 1980s and finally to diesel-electric locomotives. Each change in technology involved significant investment and partnerships with companies such as General Electrics or General Motors for the manufacture of new locomotives. Starting in the 1970s, TCS (Transportation Control System) technology was also implemented: an electronic train tracking and control system that was developed both to improve train safety and to improve train control and maintenance.
The second half of the 20th century saw UNP’s most important acquisitions that allowed it to build the track map we know today. The most notable acquisitions were those of Missouri Pacific and Western Pacific in 1982 and Southern Pacific in 1996.
Missouri Pacific had some 20,000 kilometers (more than UNP had at the time) of North-South lines that complemented UNP’s East-West lines and allowed it to connect to the South and the Gulf of Mexico. With this 1982 acquisition, UNP became the third longest railroad in the United States.
Southern Pacific was the railroad company that had acquired Central Pacific in 1885, the second company in the construction of the transcontinental railroad. Union Pacific had tried to buy it as early as 1901, but the acquisition had been rejected by U.S. anti-trust laws. Union Pacific therefore had to wait almost a hundred years to acquire the company. With this acquisition, UNP became the largest U.S. railroad company.
In 2012, UNP celebrated its 150th anniversary and it can be said that it is a company deeply anchored in the history of the development of the United States. As a curiosity and symbol of the attachment that American society has towards its trains, we can highlight that UNP has participated twice in the transport of the Olympic Torch.
During the Atlanta 1996 Olympic Games, the Olympic Torch traveled across much of the country and did so for the first time by train, in a car specially designed by UNP for its transport. And the experience was repeated in 2002 in the Salt Lake City Winter Olympics.
Business:
Today, Union Pacific is one of America’s leading transportation companies. Its principal operator, Union Pacific Railroad, is the largest railroad franchise in North America, covering 23 states in the western two-thirds of the United States. It also connects to the Canadian rail system and is the only railroad company that connects to all six major gateways in Mexico.
The length of its lines is about 52,000 km, it has about 7,300 locomotives, 37,000 employees and 10,000 customers. 42,000 km are owned, and the rest under very long-term leases.
The goods transported are as follows: Bulk (33%), Industrial (35%) and Premium (32%).
- Bulk: grains, fertilizers, food and beverages, coal, sand, oil, gas, and renewable
- Industrial: construction products, industrial chemicals, plastics, wood, paper, waste, metals, minerals and soybean ash.
- Premium: Intermodal containers and
100% of Sales are concentrated in the USA, but at least we do appreciate a great diversification in the type of goods transported by UNP.
But Union Pacific is not the only freight carrier in the United States. Its main competitor is Burlington Northen Santa Fe (BNSF). This company has a number of lines equivalent to that of Union Pacific and with very similar routes. In the eastern part of the country, the main rail transportation companies are CSX Transportation and Norfolk Southern Railway.
Union Pacific rail lines:
BNSF train lines:
While Union Pacific has better access to Mexico, BNSF is more established in the northern border of the country. BSNF also has a different distribution of the type of goods it transports, as it is more focused on premium products and less on agricultural products.
In addition, it should be noted that BNSF was purchased in 2009 by Warren Buffett’s Berkshire Hathaway, which also owns 3.1% of UNP shares. UNP’s other major shareholders are The Vanguard Group with 8.4% of the equity, Capital Research & Management with 6.9% and State Street with 4.5%.
Let’s move on to the analysis of its Financial Statements.
1) FINANCIAL HEALTH: Balance
Despite the numerous acquisitions of companies, Union Pacific has practically no Intangibles, in fact, they are so low that they are not even mentioned in the Annual Report. Let’s go point by point.
Short-Term Assets and Liabilities
The worst point of UNP’s Balance Sheet is its Liquidity Ratio. Until 2017 the Liquidity Ratio had hovered around the unit, a not too conservative value, but not worrying either. However, in the last 5 fiscal years this Ratio has dropped to much less prudent values. Without going any further, UNP’s Liquidity Ratio in 2022 was 0.72 and the Cash Ratio also shows an insufficient value of 0.18.
We will see later that UNP is a great cash generator, and that this allows it to make up during the year for the insufficiency of current assets to meet its short-term obligations. However, this is a point that does not reassure us too much and that denotes a certain lack of financial prudence in the short term.
Long-Term Assets and Liabilities
The Net Debt in 2022 is the highest in the last ten years with a ratio (Net Debt/EBITDA) of 2.66. It is curious to note how the reduction in UNP’s Liquidity Ratio is accompanied by a progressive increase in the Ratio (Net Debt/EBITDA) steadily over the last 10 years, going from (0.93) in 2012 to (2.66) in 2022.
It is natural to use leverage in order to maintain, renew and expand railroad tracks, locomotives and railcars: the railroad sector is very capital-intensive. Despite being lumpy, UNP’s Net Debt is not yet a concern. However, once again we see the ratios worsening year by year, and we would prefer to see UNP reverse this trend at some point.
On the other hand, UNP’s Debt has lights and shadows. On the one hand, more than 80% of it matures after 2027. Some maturities are even as far back as 2072. However, the interest that UNP pays is between 2.2% and 7.1% (UNP does not give details of all the interest on each loan it has). These are undoubtedly high interest rates for the reliability and recurrence of the company’s revenues, and UNP would do well to repay the higher interest loans as soon as possible.
The interest coverage ratio exceeds 11 times, which means that UNP could pay its financial expenses more than 11 times with its operating profit. This ratio shows that Debt is not yet a problem for the company. But it is also true that the company’s Net Profit could increase by almost 20% if UNP had no Debt.
The positive part of the Balance Sheet is that UNP has practically no Intangibles and does not detail them in its Balance Sheet. This point seems to us to be very positive, especially considering the important acquisitions it has made throughout its history.
Moreover, such a large amount of Net Debt is backed by very real assets: railroad tracks, locomotives and railcars of all kinds. Unlike in other countries, U.S. railroad tracks belong to the companies, which are responsible for their operation and maintenance. This is not the case as we saw in the article on Aurizon: in Australia, railroad tracks belong to the State, which leases them on a long-term basis to the companies. Therefore, we can state without doubt that UNP’s Fixed Assets are very real and valuable.
The Financial Autonomy is 19%, a very low value, which has been decreasing as the Company’s Net Debt has been increasing. We will see in a moment that this reduction of the Financial Autonomy is also partly explained by UNP’s aggressive policy of share repurchasing.
2) PROFITABILITY: Income Statement 2022
Sales
UNP’s sales have remained flat over the last decade, ranging from approximately $20 billion to $25 billion.
It is interesting to note that between 2012 and 2022 UNP has slightly increased its revenues from the Industrial and Premium segments, at the expense of reducing the weight of the Bulk segment. But overall, the proportions have remained fairly stable.
The way to achieve these revenues is basically due to two factors. On the one hand, the volume of railcars of each segment that UNP manages to transport (Carloads). And on the other hand, the price it manages to charge its customers per railcar (ARC).
We see that, on a per unit basis, UNP is very well compensated for transporting Bulk and Industrial products, since it is able to charge more per railcar. However, it makes up for the lower price of the Premium railcars with much more volume. Given that this segment is basically composed of transportation of the automotive sector and containers with cargo of all kinds, it is undoubtedly the most versatile segment and the one where UNP can grow more.
As a side note, the railcars .for which UNP manages to charge the most are forest products (Industrial) and those transporting food and refrigerated goods (Bulk), at an average of $6,092 and $5,844 respectively.
In the last fiscal year, UNP has seen its operating costs increase by more than 20%, mainly due to the increase in the price of fuel caused by the war in Ukraine. However, UNP has agreements with its customers to pass on the cost of fuel to them. Thanks to this and a slight increase in the volume transported (+2%), UNP has managed to increase its Operating Profit by +6% and its Net Profit by +7.3% compared to the previous year. This undoubtedly indicates that UNP has an extraordinary pricing power.
In the future, UNP explicitly states in its reports that it intends to grow through 3 strategies. Firstly, increasing the volume of their most profitable railcars. Secondly, by increasing the range of services and products they offer to their customers. And finally, by modernizing their services and supply chain to be able to serve more geographical areas. We will see if in the future we see any progress in this regard, given that for the moment UNP’s sales have remained fairly stable for years.
Margins
UNP’s Net Margin in 2022 is 28% and its Operating Margin is 40%. This is one of the best points of the analysis of its Financial Statements as both Net Margin and Operating Margin have grown very steadily and significantly over the last decade:
+8% and +9% respectively. Undoubtedly, these are extraordinary margins.
This growth in Margins is mainly due to the company’s operational optimization, as Sales remain relatively stable.
And this optimization could be even greater if UNP were to reduce its high Net Debt: by also reducing its financial expenses, it would achieve an even better Net Margin.
It should be noted that UNP’s Net Margin is somewhat higher than its competitor’s BNSF, which remains at around 25% but has also been on an upward trend over the last ten years.
Rail freight is a business with high entry barriers. It is very difficult for new competitors to invest enough capital to build parallel lines to those of UNP. This is a huge Competitive Advantage, which explains the high Margins that these companies reach.
Profitability Ratios
ROA: 11% (Net Income/Total Assets)
ROE: 58% (Net Income/Equity)
ROCE: 22% (EBIT/(Equity + Net Debt))
Profitability Ratios are very good. With no Intangibles, we are not surprised that the ROA is high; but it must be said that it is still very good considering how capital intensive this company is.
ROE is also very high, although it is not very relevant, given its low Equity. The ROCE still shows a correct value, although the high Net Debt compensates the distortion of the low Equity.
In any case, the most relevant ratio is the ROA, which shows us that UNP’s very expensive assets (tracks, locomotives, railcars…) are very profitable. To give us an idea of this, the ROA of its competitor BNSF is only 6.5%, almost half than UNP’s.
Earnings per Share (EPS)
UNP’s EPS has grown very much over the last few years, almost tripling between 2012 and 2022. Given that Sales are more or less stable, this positive EPS evolution is due to two main reasons: a cost optimization (increase in Net Margin), and a generous Share Buyback policy that we will see in detail later.
If we look at UNP’s Net Profit (to disregard the effect of share repurchases), it has increased 1.7 times over the last decade. This means that it has grown at an average rate of almost 6% per year. This is certainly not bad for a company as mature as UNP.
In 2017 we see EPS soaring but this is due to Trump’s tax reform and does not reflect the reality of UNP’s business.
3) DIVIDEND
Dividend per Share (DPS)
UNP has been paying dividends since 1989, and has followed a policy of increasing dividends over the last few years with an average annual growth rate of 15% over the last decade. A very high value, and always maintaining a payout below 50%.
If we had purchased UNP shares in 2017 for $134, the Dividend Yield we would have in 2022 would be 3.8%.
If we had purchased shares in 2012 for $65, the Dividend Yield we would have now would be 7.8%. In addition to a revaluation of more than +200% in the share price.
Payout (Dividends/Net Income)
EPS has been growing somewhat faster than EPS over the last few years: Payout has gone from 30% in 2012 to 45% in 2022. But it has never exceeded 50%. This is a sustainable Payout which indicates that UNP has a responsible Dividend policy.
Cash Flow
Operating Cash Flow has grown strongly and fairly steadily over the last ten years, increasing by 50% in this period. This trend is very similar to that of Net Profit, which is explained by a gradual optimization of costs and improvement of margins.
In addition, we see a slight downward trend in Maintenance CAPEX. This is very good news, given that this company’s maintenance investments are very relevant. UNP’s main investments are in the maintenance of its existing lines (52%), the purchase of locomotives and railcars (22%), the acquisition of technological tools (10%), and the expansion of lines (16%).
The growth of OCF and the slight decrease of CAPEX make the Free Cash Flow very increasing. Over the last decade it has grown at an average rate of +9% per year. This growth in FCF makes UNP’s dividends fully sustainable, as they only represent 55% of Free Cash Flow.
It is not necessary to analyze the CAPEX of Investment and Others, given that in the case of UNP there has not been any acquisition of a relevant company in the last decade and the financial investments it makes aren’t relevant.
Share Repurchases
UNP has dramatically reduced its shares since 2012 with an average Share Repurchase of 4.15% of total shares per year. It has 34.5% fewer shares in 2022 than it did in 2012. An outrageous amount.
As mentioned above, this reduction in the number of shares results in an increase in EPS and DPS, which is a significant return to shareholders.
However, it also has less positive repercussions such as the reduction of Financial Autonomy and above all the increase in Debt. It does not make much sense for UNP to increase its Debt so considerably in order to buy back its own shares. Moreover, in the last financial year it has done so at an average price of $201, which does not look like a bargain either.
In addition, UNP’s board has authorized a new Share Buyback program of up to 100 million shares over 3 years. This would mean reducing the number of outstanding shares by -16%.
Of course, share repurchases are an extra shareholder reward, but we hope that UNP will not do so at the cost of further increasing debt and worsening its Balance Sheet.
Conclusion
Union Pacific is a company whose history has inspired Western movies, and also has attacted our attention today for having a business with strong Entry Barriers and a Dividend Growth policy.
We have seen a Balance Sheet marred by a Liquidity Ratio below 1, a significant reduction in Cash and an increase in Debt; as well as Sales somewhat stagnant from a decade ago.
Otherwise the company has very positive characteristics: it has no Intangibles, has a very high Net Margin (somewhat higher its main competitor). Its Profitability Ratios are very good and it has managed to carry a Dividend Growth policy with an average annual growth of 15% since 2012 while maintaining Payout levels below 50%.
Perhaps by wanting to please its shareholders too much, UNP has carried out too large share buybacks over the last ten years, which has contributed to an increase in its Net Debt and a decrease in its Financial Autonomy. In any case, it seems to us to be a very suitable company for our strategy.
Hopefully, over the next few years Union Pacific will be able to improve its Liquidity Ratio, reduce its Debt and improve its Sales in order to continue to maintain a high EPS growth and ensure a sustainable Shareholder Remuneration policy.
In addition, we believe that rail freight will continue to be a very important mode of transport in the coming years because, when the infrastructure is sufficiently dense, it can operate at lower costs than road or air transport, generate fewer CO2 emissions, and is better suited to transporting heavy materials and large volumes.
What do you think of Union Pacific? Is it the right type of business for your portfolio?
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Bibliography:
Annual Reports 2012-2022