Case Study

Union Pacific Corporation

Overview

Sector

Transportation

Industry?

Railroads

Description

Union Pacific Corporation offers transportation services for construction, automobile, energy, chemical, agriculture, and general consumer products through its rail network. It reports through three commodity groups: bulk, industrial, and premium. The bulk commodity group includes grain and grain products, fertilizer, food and refrigeration, and coal and renewables. The industrial commodity group includes construction, industrial chemicals, plastics, forest products, specialized products, metals and ores, petroleum, liquid petroleum gases, soda ash, and sand. And the premium commodity group includes finished automobiles, automotive parts, and merchandise in intermodal containers, both domestic and international.

Union Pacific operates 32,500 route miles that connect the Pacific Coast and Gulf Coast ports with the Midwest and eastern U.S. gateways and provide passageways to key Mexican gateways. Union Pacific serves the Western two-thirds of the country and maintains coordinated schedules with other rail carriers to move freight to and from the Atlantic Coast, the Pacific Coast, the Southeast, the Southwest, Canada, and Mexico. Export and import traffic moves through Gulf Coast and Pacific Coast ports and across the Mexican and Canadian borders.

Company History?

With its origins dating back to 1862 as part of the first transcontinental railroad project, Union Pacific merged with industry leaders across 23 states west of Chicago throughout the 20th century.

Industry History?

In 1980 the United States passed a law that changed the economics and prospects for railroad operators. It deregulated the railroad industry and gave railroad companies greater power over rail pricing and infused a free market system, instead of the earlier pricing model where regulators constrained how much railroads could charge. This deregulation allowed railroad operators to more fairly compete with the highly government-subsidized interstate highway trucking industry and reversed their historic loss of traffic to the trucking industry.?

Railroad industry costs and prices were halved over ten years, and railroad industry profits began to recover, after decades of low profits and widespread railroad insolvencies. The deregulation has led to a 50 percent reduction in average shipping rates and, since the deregulation, $480 billion has been reinvested by the industry into their rail systems.?

Industry Overview

The railroad industry in the United States is crucial to the transportation of physical products, especially long-distance travel. Rail accounts for 43% of all intercity freight transportation. Railroad networks stretch across the country and transport cargo between states at incredibly energy efficiency rates, and high speeds, and require no government subsidies for highway development and maintenance, while the trucking industry does. Railroad companies earn revenues by charging businesses for carrying cargo over their network of rails and railcars.?

Railroads played a crucial role in the development of the United States economy and will continue for many decades to come. There is no other mode of transportation that demonstrated the capability to transport thousands of tonnes of products across thousands of miles with the speed, cost, and range of railroad networks, including trucking, air, and water.?

The railroad industry in the United States is characterized as one with five major rail network operators and hundreds of significantly smaller and local companies. Also, railroad operators are highly regulated by various government authorities covering health, safety, labor, environmental, economic, tax, and other matters. Additionally, they are prohibited from engaging in certain competitive actions.?

Industry Statistics

There are approximately 140,000 miles of freight railroad tracks across the United States. As a rule of thumb, it would cost between $1M-$2M to build a single mile or $140B to $280B to build our current railroad system today, excluding railcars and other equipment.?

Industry Trends

Historically, railroad operators consolidated from thousands of local operators into an industry led by few major and exceptionally efficient players. Currently, railroad operators are working hard to increase productivity per employee, reduce costs, and improve overall operating efficiency ratios.?

GDP Correlation

The railroad industry is dependent on and fluctuates with the health of the US economy, global trade, and the overall consumption rate of physical products by consumers, businesses, and government agencies.?

Company Character and Competition

Competitors and Competitive Position

Union Pacific is the second largest railroad in the United States after BNSF, with which it shares a duopoly on transcontinental freight rail lines in the Western, Midwestern, and Southern United States.?

Competitive Advantages

Union Pacific differentiates itself from all other railroad companies, except for BNSF, with its transcontinental reach, scale, and operational excellence. It would cost many tens of billions of dollars and decades to replicate the infrastructure Union Pacific garnered and developed over time, even in the highly improbable chance regulators allowed it.?

Key Factors for Success

The key factors that will determine whether Union Pacific will succeed or not are its operating efficiency and rail asset portfolio. For Union Pacific to remain competitive with BNSF, other railroad operators, and alternative transportation modes, such as trucking and air, it has to maintain and improve its operating efficiency. It could do that by lowering costs, increasing employee productivity, improving fuel efficiency, and other operational advancements. Also, Union Pacific’s success depends on its portfolio of rail assets. Union Pacific has to maintain and improve its current asset portfolio, develop and acquire new assets that complement its existing portfolio, and invest in new technologies and systems to augment its entire portfolio.??

Headwinds, Threats, and Risks

Consumption Rates?

Union Pacific, and the railroad industry as a whole, are dependent on consumer, business, and government consumption of physical products. A material decrease in consumption rates in the regions Union Pacific operates could hurt Union Pacific's sales and have an even greater effect on its profits, due to fixed expenses.?

Global Trade

The railroad industry and other transportation modes are highly dependent on global trade. A deterioration of trade between the US, Canada, Mexico, and other countries could materially affect Union Pacific’s transcontinental operations and cause a significant loss of business.?

Regulation

The railroad industry is highly regulated by various government authorities covering health, safety, labor, environmental, economic, tax, and other matters. Additionally, they are prohibited from engaging in certain competitive actions. Regulators to enact laws that materially affect Union Pacific's profits. It is in the best interest of the country for regulators to promote and support the railroad industry, rather than obstruct its operations.?

Weather and Seasons

Severe weather could negatively affect Union Pacific’s operations and unfavorable weather could hurt crop production, and other commodities, leading to a decline in Union Pacific’s revenues.?

Cyber and Terrorist Threats?

Foreign or domestic individuals or governments could attack Union Pacific’s computers or physically damage its infrastructure, causing a material negative effect on Pacific Union’s operations.?

Overleverage and Debt

Union Pacific has significant debt that it must services to remain solvent. If Union Pacific’s management fails to maintain adequate liquidity and continuation of current profit levels, Pacific Corp could act desperately or default on its debt.

Lawsuits and Claims

Union Pacific and the railroad industry are constantly in litigation with customers, suppliers, and regulators. A material claim could be filed against Union Pacific and cause it to pay a material sum.??

Innovation

If Union Pacific fails to innovate and constantly improve its operational efficiency, it could be squeezed and lose its current profit rates.?

Labor Unions

Labor unions could negotiate for higher compensation and benefits and demand for Pacific Union to halt employee layoffs.?

Chain of Power

Incombant Competitors

Existing railroad companies that compete with Union Pacific, predominately BNSF, pose little threat to the infrastructure and operations of Union Pacific but do compete with Union Pacific in pricing, on-time delivery, and routes.?

New Entrants?

There are astronomical barriers to entry into the railroad operator industry. It would cost many tens of billions of dollars and decades to replicate the infrastructure Union Pacific garnered and developed over time, even in the highly improbable chance regulators allowed it.?

Threats of Alternative?

Alternative transportation modes, especially the government-subsidized trucking mode, are highly competitive with the railroad mode in pricing, speed of delivery, and convenience. The railroad industry and Union Pacific have to maintain a strong offering proposition by remaining competitive with current and innovative future modes of transportation.?

Power Over Buyers?

Union Pacific has some power over its buyers, as it is a major player in the interstate transportation business. However, regulators placed pricing caps, and other prohibitions, hindering Union Pacific and the railroad industry’s ability to entirely capitalize on its market dominance.?

Power Over Suppliers

Union Pacific has significant power over its suppliers, which includes railcar manufacturers and contractors. Union Pacific has a 25% market share of all railroad operations in the United States and often has even greater market shares in some states, causing Union Pacific to have great power over its suppliers.?

Power Over Employees?

85% of Union Pacific’s full-time labor force is represented by labor unions. These employees could negotiate for higher compensation and benefits and demand for Pacific Union to halt employee layoffs.?

Cash Management

Union Pacific’s management has over the past few years and expressed interest to continue to distribute nearly all operating cash flows to shareholders through share repurchases and dividends. They have also issued debt to repurchase shares. Union Pacific invested the rest of its cashflows to improve its railroad infrastructure and operating efficiency. Union Pacific has material debt, so its management must ensure they have the cash flows and liquidity to pay interest and repay debts as they mature.??

Financials and Stats

Revenues?

Union Pacific generated $22B in revenues in the fical year 2021. Union Pacific’s breakdown of revenues by commdoity type include over $3B grain & grain products, $700M in fertalizer, $1B in food & refrigirated, $1.8 in coal & renewables, $2B in industrial chemicals & plastics, $1.8B in metals & minerals, $1.4B in forest products, $2.2B in energy & specialized markets, $1.8B in automotive related, and $4.5B in intermodel.?

Revenues by commodity type depend on the number of carloads transported and revenue per carload transported. Revenues from different commodity types fluctuate with the rates railroads charge to transport them and the number of carloads of a given commodity type. Overall, revenues fluctuate with physical product consumption across all industries. Also, revenues fluctuate by season for each commodity type due to things like weather, harvesting season, and holiday season demand for consumer goods.??

Operating Expenses?

Union Pacific had just under $12.5B in operating expenses in the fiscal year 2021, including approximately $4B in compensation and benefits, approximately $2B in depreciation, $2B in fuel, $2B in purchased services and materials, under $1B in equipment and other rents, and $1B in other expenses.?

Overall, Union Pacific’s expenses are relatively fixed and probably cannot be decreased by more than 30% without causing negative long-term effects. Compensation expenses are relatively fixed on a year-by-year basis, with an ability to probably reduce compensation expenses by up to 15%-20%. Fuel is a significant expense and often fluctuates materially with changes in crude oil prices. Union Pacific is usually able to pass most fuel price increases to its customers through fuel surcharges. Depreciation is a high fixed expense depending on fixed operational assets that do not easily decrease. Purchased services and rented equipment are relatively fixed but could be marginally increased or decreased if Union Pacific has to.?

Operating Ratio

Union Pacific had a 57% operating ratio in the fiscal year 2021, a significant improvement from 63% in 2015 and 87% in 1997. Most of the improvement came from reduced compensation expenses and better fuel-efficient engines. Union Pacific decreased its employee count significantly from 48,000 in 2009 to 30,000 employees in 2021, and greatly increased the productivity per employee with advanced systems and technologies. The operating ratio is used to find how efficiently a railroad company conducts its operations and how much it earns for its shareholders before non-operating expenses. The operating ratio is calculated by dividing operational expenses by revenues.?

Tax Rate?

Union Pacific has a 23% effective tax rate. The tax rate also affects Union Pacific's more than $12B deferred tax liability. A tax rate increase would also increase Union Pacific’s deferred tax liability. Union Pacific has little influence over its tax rate and the US government could increase or decrease it.?

Net Income?

Union Pacific earned over $9B in pre-tax operating income in the fiscal year 2021. After the 23% tax, Union Pacific earned approximately $7B.?

Fixed Asset Turnover?

Union Pacific had a fixed asset turnover of just under 0.4. Fixed assets account for a large majority of Union Pacific’s assets. Fixed asset turnover is used to find the revenues a dollar of fixed asset generates. Fixed asset turner is calculated by dividing revenues by fixed assets.?

Invested Capital

Union Pacific had $45B in invested capital in the fiscal year 2021. Union Pacific’s largest operating asset is its fixed assets, including over $5B in land, $40B in road-related assets, nearly $8B in locomotives and other equipment, and $3B in other fixed assets. Also, Union Pacific’s largest operating liability is its over $12B deferred tax liability. Union Pacific has net-zero working capital. Invested capital is the total net cash investments a business uses to run its operations. Invested capital is calculated by adding working capital and fixed assets.?

Return on Invested Capital?

Union Pacific earned about 15% return on invested capital. Return on invested capital is used to find the return a business generates for every dollar of cash it invests into its operations. Return on invested capital is calculated by dividing net profits by invested capital.

Return on Invested Capital — Including Debt and Interest

Union Pacific, like the rest of the railroad industry, has a strong earning power and uses debt to bolster its return on invested capital without taking on too much extra risk. Including the effects of debt and interest, Union Pacific had a return on leveraged invested capital of greater than 50%.?

Equipment and Operations Statistics

Union Pacific operates 34,000 route miles, including 26,000 that it owns and 8,000 that it has trackage rights or leases. Also, Union Pacific has 7,500 locomotives, 52,000 freight cars, 50,000 containers, and 44,000 chassis.?

Union Pacific had about 400B revenue ton-miles, 24 hours of average terminal dwell time, car miles per employee of 1,000, intermodal car trip plan compliance of about 70%, and automotive car trip plan compliance of about 65%.?

Employees and Operations

Union Pacific has 30,000 employees and serves approximately 10,000 businesses.?

Senior Shareholders

Union Pacific has $30B of debt paying an average of 3.3% interest, with $2B due in 2022 and $24B due past 2026.?

Shares Outstanding

Union Pacific has 655M common shares outstanding.?

Valuation Variables

Quantity of Carloads

The quantity of carloads that Union Pacific transports affects its revenues, ability to absorb fixed costs, and profits. If you have reason to believe that Union Pacific's cargo volume will be maintained, decreased, or increased, proceed with that assumption in your evaluation.

Commodity Mix

The mix of commodity types affects Union Pacific's revenues per cargo transported due to the varying rates Union Pacific charges for different commodity types, and it ultimately affects Union Pacific's profits. If you have reason to believe that Union Pacific's commodity mix will change, proceed with that assumption in your evaluation.

Rates Per Carload

The rates Union Pacific charges for different commodity types effects Union Pacific's revenue per cargo transported, its ability to absorb costs, and its profits. If you have reason to believe that Union Pacific will maintain, decrease, or increase cargo rates, proceed with that assumption in your evaluation.

Oil Prices and Fuel Efficiency?

Oil prices and Union Pacific’s consumption of fuel significantly affect its expenses, operating efficiency, and profit. If you have reason to believe that Union Pacific will maintain, decrease, or increase fuel efficiency and/or oil price levels will change, proceed with that assumption in your evaluation.

Employee Productivity

Employee productivity affects Union Pacific’s compensation expense, operating efficiency, and profits. If you have reason to believe that Union Pacific will maintain, decrease, or increase employee productivity, proceed with that assumption in your evaluation.

Fixed Asset Turnover

Fixed asset turnover affects Union Pacific’s return on invested capital, and indicates how much in revenue each dollar of fixed assets produces. If you have reason to believe that Union Pacific will maintain, decrease, or increase its fixed asset turnover, proceed with that assumption in your evaluation.

Cyclicality and Expense Variability

Union Pacific’s demand for transporting physical products?

Cashflow Investment Management

The value of Union Pacific is significantly dependent on management’s ability to recognize and intelligently invest in fixed assets, innovative solutions, and new technologies. If you have reason to believe that Union Pacific's management will deploy cashflows intelligently, proceed with that assumption in your evaluation.

Regulation

The railroad industry is highly regulated and the regulators could significantly affect Union Pacific’s valuation. If you have reason to believe that regulators will get more stringent, less, or maintain their current laws, proceed with that assumption in your evaluation.

Expiration

Union Pacific's valuation is also dependent on how far into the future will its services be demanded, will it maintain operational excellence, and innovate to compete with new transportation technologies. The expiration timeline of Union Pacific’s business affects the years its shareholders will earn profits.?

Tax Rate

The tax rate affects the net profits and overall cash flow available to shareholders. A tax change would also increase or decrease Union Pacific’s deferred tax liability. Union Pacific has little influence over its tax rate and the US government could increase or decrease it.?

Interest Rates

Union Pacific has and will continue to use debt to increase its shareholders' return on leveraged invested capital. Interest rates affect how much Union Pacific pays for its debt and its net income. If you have reason to believe that interest rates will be maintained, decreased, or increased, proceed with that assumption in your evaluation.

Evaluation

Advice and Calculation

Before you try to value Union Pacific, we advise you to study the business and its industry and try to figure out how strong Union Pacific's competitive advantage is. Focus on the input of information, and not the output of evaluation.?

To calculate Union Pacific’s present value of future cash flows distributed to shareholders, postulate a range of scenarios, attach probabilities to each scenario, and discount those cash flows by your discount rate.?

Don’t forget to subtract cash flows reinvested into Union Pacific’s operations from cash flows available to shareholders and add them to capital investments.?

We advise you to use risk-free government bond discount rates, take Union Pacific’s valuation markdown to market valuations, then compare that markdown to other assets using the same discount rate. If Union Pacific has the highest markdown, and, in absolute terms, you are satisfied with the discount on risk-free government bonds, purchase Union Pacific shares as you would purchase a private business.?

Conclusion

If you have an opinion on Union Pacific’s operating efficiency and rail asset portfolio, you have an opinion on Union Pacific’s value.?

July 18, 2022

Yoseph C. Pinto