A lot of value investors have been taking a close look at Union Pacific (NYSE: UNP) lately, and it is easy to see why. The historic railroad’s shares were trading at $78.45 on December 28, 2015, yet it reported a net income of $5.086 billion and a profit margin of 23.37% on September 30, 2015.
That makes the UP a classic value investment of the first order. Some of the railway’s other numbers seem to justify this assessment, including a return on equity of 24.13% and a dividend yield of 2.81%. Investors that stick with Union Pacific could expect a nice payday, but is it a classic buy and hold play?
Union Pacific Makes Money
The numbers seem to say yes even if Mr. Market disagrees. A few intriguing numbers at Union Pacific, or UP, include:
- A market capitalization of $66.96 billion and an enterprise value of $79.55 billion, meaning that the UP is underpriced.
- Assets that were worth $53.76 billion in the third quarter of 2015.
- Liabilities of $33.16 billion.
- $1.078 billion in cash and short-term investments.
- A diluted earnings per share figure of 5.78.
- $7.652 billion in cash from operations during the third quarter.
- A free cash flow of $736 million.
The financial numbers tell us that Union Pacific is a very well-run company that makes money, but there is one dark spot here: revenue. UP reported a TTM revenue of $22.76 billion in September 2015, down from $23.46 billion in September 2014. Revenues are off because of the declining price of commodities, mostly oil, and the slow but steady collapse of the North American coal business.
That means we need to take a look at Union Pacific’s future prospects to see if it is a good buy and hold play. The best way to do this is with a Strengths, Weaknesses, Opportunities and Threats, or SWOT, analysis.
Union Pacific SWOT Analysis
Union Pacific is a fascinating and historic company; it is only one of two Class One U.S. railroads that still largely operates over its original route with its original name. The other, strangely enough, is the Kansas City Southern (NYSE: KSU), which is also a transcontinental railroad connecting the Pacific Coast and the Midwest. The difference is that the Kansas City connects to ports in Mexico, while the UP connects to U.S. ports.
Union Pacific’s history is also rather colorful. It is the only one of the original U.S. transcontinental railways left. The others were all absorbed by the Burlington Northern Santa Fe, or BNSF, which is now part of Warren Buffett’s Berkshire Hathaway (NYSE: BRK.B) empire.
UP has also been the subject of movies and of TV shows, most recently Hell on Wheels, but what of its future? Can a railroad with roots in the 19th century and the Civil War survive in the 21st century? Let’s see if the SWOT can answer that question.
- Direct connections to major West Coast ports, including Los Angeles, Long Beach and Oakland. These ports are in the United States, so they are not threatened by Mexican drug violence.
- Large, well-maintained railroad system
- Rail lines to connect to existing and growing industries, including Elon Musk’s Gigafactory in Northern Nevada
- Monopoly on rail transportation in some growing markets, including Las Vegas
- Well positioned to take advantage of container traffic to West Coast ports
- Well positioned to take advantage of exports, including oil and possibly electric cars and lithium batteries
- Historic name and great reputation
- Extensive real estate holdings, including properties in Southern California, Las Vegas and some regions with high property values
- Limited rail capacity can lead to gridlock, especially in the West Coast ports. Rail capacity might not keep up with future demand for freight haulage.
- Dependence on commodities makes UP very vulnerable to the commodities market and underlying economic conditions that influence it.
- Aging rail infrastructure. Many of the lines date to the 19th century; even many bridges and tunnels are over a century old. This requires extensive maintenance and could lead to expensive construction work in the future.
- Aging infrastructure leads to accidents, which create delays and raise operational costs.
- There is little room for expansion of the rail system in some areas, particularly in crowded urban areas such as Los Angeles.
- A critical weakness of all U.S. rail systems is the large number of surface-level crossings, which leads to lots of accidents and numerous delays. This raises operational and insurance costs. It also antagonizes the public with accidents and the need to use air horns when approaching crossings; many residents hate the noise. Others are annoyed by the delays experienced when waiting for a train to pass.
- Dependence upon diesel-burning locomotives. This can increase operational costs when oil prices go up, and it also necessitates the use of an expensive fueling infrastructure. A long-term problem that antagonizes the public is pollution from diesel locomotives.
- Heavy dependence upon international freight traffic, particularly Chinese imports, makes it very vulnerable to recessions and other economic downturns. Among other factors, it is very vulnerable to the U.S. retail market.
- Growing international trade, particularly with the Far East
- The beginning of U.S. oil exports could create a new export opportunity.
- Growth of new industries in the Western U.S., including electric cars and lithium batteries in Nevada, could provide new freight opportunities.
- Growth of ecommerce and its dependence on centralized fulfillment centers could provide new opportunities for rail freight traffic.
- S. underinvestment in highways increases gridlock and traffic delays, which drives customers to seek alternatives to truck traffic.
- Next generation transportation technologies such as Hyperloop could use some of Union Pacific’s routes, increasing their potential value.
- New technologies could lead to increased efficiency and cost savings in UP’s core business.
- Growth of Mexican industry could lead to increased business on UP’s Southern Pacific lines.
- Increased real estate values in some areas like San Francisco and Los Angeles could benefit UP’s bottom line.
- Labor strife can shut down West Coast ports and leave the UP without freight to haul.
- Falling commodities prices can undermine UP’s revenues.
- Aging infrastructure could need costly replacement and modernization.
- Environmental legislation could force UP to electrify its lines, which could require purchase and construction of costly infrastructure.
- Government could force railroads to carry more passenger trains, which could delay freight trains.
- Government could seize some UP lines for use as high-speed rail corridors. Such a corridor is already under construction in California.
- Technologies such as self-driving trucks could make some competing forms of transportation cheaper, more efficient and more competitive.
- Lack of rail capacity can lead to gridlock, which can drive customers to alternative means of transportation.
- Building of high speed rail lines could create taxpayer-financed competition for some Union Pacific routes.
- Next generation transportation technologies such as Hyperloop could create competition that is faster and more efficient than existing rail lines.
My take is that the Union Pacific is a good buy and hold play because of the opportunities. The threats are mostly existential ones that can be mitigated by good management, which the UP seems to have.