An Efficient, Fuel-Efficient Investment

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As "green" investments with near-insurmountable barriers to entry, growth prospects, and great value for the long haul, railroads offer enticing long-term value. Since Warren Buffett acquired Burlington Northern Santa Fe in 2009, railroad stocks have doubled on average. But even after the run-up, they still offer solid opportunity for the long-term investor -- especially in the case of Union Pacific Railroad (NYSE: UNP).

Why choose Union Pacific over competitors Norfolk Southern (NYSE: NSC), CSX Corporation (NYSE: CSX), and Kansas City Southern (NYSE: KSU)? While these other railroad stocks are not bad investments, Union Pacific stands out from the pack in two distinct ways:

  1. Management has effectively decreased the the railroad's operating ratio by over 11% in 6 years, highlighting their determination to continue to become more efficient.
  2. Union Pacific still has room to improve its profitability and returns on invested capital, which lag the rest of the industry.

The operating ratio -- operating expenses divided by operating revenue -- is closely scrutinized by railroad-industry analysts. Since railroads require such a large percentage of revenue to maintain operations, investors should expect management to focus intensely on shrinking this ratio.

Union Pacific's operating ratio improvements over the last five years have been nothing short of astounding:

Improving operating ratios leave more cash left for activities that add shareholder value: dividends, investment in growth opportunities, share repurchase programs, and repayment of long-term debt. So investors have plenty of reason to applaud management for such an astounding improvement in Union Pacific's operating ratio over the last five years.

For a once-underdog, Union Pacific's operating ratio now stands as a true contender to its competitors:

Company 2011 Operating Ratio
Union Pacific 70.7%
Norfolk Southern 71.4%
CSX Corporation 70.9%
Kansas City Southern 71.6%

It turns out that Union Pacific isn't much of an underdog anymore. In 2011 it clocked in with the most efficient operating ratio among its key competitors.

Aside from opportunities for further improvement in profitability and returns on invested capital, Union Pacific faces three distinct macro opportunities for continued growth. As the company maps out in its 2011 annual report, Union Pacific is positioning itself to benefit from all three:

1. Expanding global economy: The expanding global economy will result in greater international demand, which already accounts for almost one third of Union Pacific's revenue base. Therefore, any increase in international demand for Union Pacific will result in a significant increase in revenue.

2. The U.S. population: According to the Department of Transportation, the U.S. population alone is expected to increase freight demand by 30% and further crowd our highways over the next 20 years. As a result of the expected population growth, railroads have the Department of Transportation on their side: Recently, the Department of Transportation set a goal to develop strategies to attract 50% of all shipments over 500 miles to intermodal rail.

3. Demand for "green" practices and fuel efficiency: Transportation of freight by rail is three times more fuel-efficient than transportation of freight on the highway. With rising fuel prices, we all know how desperate Americans are to save money on fuel. But "going green" is often more than an economic decision--it improves companies' "green" image. With growing appreciation for Union Pacific's "green" profile and fuel efficiency clearly in its favor, railroads are very enticing to transportation heavy businesses.

The bottom line
Union Pacific is no longer an underdog. It has a great track record of improvements in terms of its operating ratio and it still has room to improve in terms of profitability and returns on invested capital. These improvements should come naturally as a lower regular operating ratio benefits the bottom line. Plus, it benefits from macro opportunities that should have a positive affect on the railroad industry for many years to come. With a 2% dividend yield and a forward P/E ratio of just 12.5, Union Pacific's current price offers an enticing entry point into a terrific investment for the long haul.


DanielSparks has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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