Bullish on Rail? Buy Union Pacific: A SWOT Analysis

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although fundamental analysis is definitely a foundational step to sensible long-term investing, investors can't stop at merely analyzing numbers and reading letters to shareholders. They need a wholesome picture of a company's competitive landscape before making an investment. For instance, ten years of positive and upward trending free cash flow is nice, but investors need some perspective to evaluate its sustainability. With an understanding of the competitive landscape the business operates in, an investor can gain the necessary perspective to estimate how sustainable the free cash flow is and how likely it is to grow (or dwindle).

Thankfully, in the 1960's Albert Humphrey introduced a simple approach to conduct this sort of analysis by evaluating a company's Strengths, Weaknesses, Opportunities, and Threats -- a SWOT analysis.

In this article I'll dissect Union Pacific's (NYSE: UNP) competitive landscape using a SWOT analysis to gain a better understanding of the company's position in its respective competitive landscape.

What Does The Company Do?

Union Pacific is the largest public railroad in North America, covering 23 states in the U.S. Its revenue comes from hauling coal, industrial products, intermodal containers, agriculture goods, chemicals, and automotive goods. One third of revenue is derived from international demand.

A Union Pacific SWOT Analysis

Strengths

  • Management has effectively decreased the railroad's operating ratio -- operating expenses divided by operating revenue -- by over 11% in 6 years.
  • Union Pacific now has the lowest operating ratio (the lower, the better) among its competitors.
  • Barriers to entry for railroads are extremely high; obtaining rights-of-way to build track is challenging and costly.
  • The company is extremely profitable. In 2011, Union Pacific converted 13.8% of sales into free cash flow ($2.7 billion) and paid out $837 million in dividends.
  • Only about 20% of Union Pacific's business is exposed to coal--much less than CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC), both which derive approximately 30% of their revenue from coal shipments. 
  • 75% of Union Pacific's exposure to coal comes from PRB coal, or coal mined in the Powder River Basin region which, measured by BTU per ton, is far less expensive than Appalachian coal. 
  • PRB coal is actually witnessing increasing demand and rising prices. 

Weaknesses

  • Union Pacific earns a higher percentage of revenue from chemicals than other railroads, putting the company at greater risk to the liabilities associated with accidental hazardous material spills than other rails.
  • Though Union Pacific's returns of invested capital and profitability have improved, they still are the lowest among its peers.
  • Union Pacific generates a higher percentage of revenue from auto motives than other railroads. This could have a positive impact on earnings in the case of a booming economy, but in 2008 and 2009 it proved to be a liability as the company's auto volume plummeted. 

Opportunities

  • By 2015, mandatory (and costly) installation of positive train control systems (PTC) will finally be complete. Completing PTC system installation could reduce CapEx by as much as 10%.
  • According to the Department of Transportation, the U.S. population alone is expected to increase freight demand by 30% over the next 20 years as U.S. highways are further crowded.
  • Union Pacific claims that, on average, railroads are four times more fuel efficient than trucks. This value proposition is steering many companies toward rail that have traditionally used trucks.
  • In consideration of a growing U.S. population and in recognition of the need for fuel efficient solutions, the US Department of Transportation agrees that the U.S. needs more rail: Recently they set a goal to develop strategies to attract 50% of all shipments over 500 miles to intermodal rail. 
  • Management claims that the expanding global economy will result in greater international demand, which already accounts for almost one third of Union Pacific's revenue base. 

Threats

  • The process of hydraulic fracturing, or "fracking," has led to a natural gas boom as many utilities substitute coal for inexpensive gas, resulting in a severe decline in demand for coal, a high-margin business for railroads.
  • There is a clear trend toward a decline in coal use across the United States. For example, just four years ago coal generated 50% of electrical power in the U.S. Today, coal generates just 34% of our electricity.
Valuation-By-Comparison
 
Company Price-to-Book Price-to-Sales FCF Yield P/E
Union Pacific  3.11  2.93   3.4%  15.91
CSX  2.33  1.78  3.6%  11.27
Norfolk Southern  2.20  1.93  3.5%  11.57 
Kansas City Southern (NYSE: KSU)  2.87  4.30   1.8%  24.9
 
When measured by price-to-book, price-to-sales, and P/E, Union Pacific appears to be considerably more expensive than CSX and Norfolk Southern. With a P/E of 15.9, Wall Street has high expectations for Union Pacific. With less exposure to the risk associated with declining coal demand, investors consider Union Pacific's earnings to be more reliable. But Union Pacific's FCF yield, which shows you what percentage of a company's share price is represented by the cold, hard cash it's churning out (the higher this percentage, the better), of 3.4% is in line with its peers, giving credence to Union Pacific's ability to generate cash.
 
Though the company's dividend yield of 2.15% is more than 60 basis points lower than both CSX (2.78%) and Norfolk (3.16%), it is still a reasonable yield that investors should be able to count on for years to come. Plus, Union Pacific has consistently increased its dividend for years, averaging an annual dividend growth rate of 28% over the past five years.
 
The Bottom Line
 
The SWOT analysis reveals that Union Pacific is in a unique position among its peers (thanks to increasing demand for PRB coal) that isolates it from much of the risk its peers face from a decline in coal demand. In the long-term, two major external opportunities should help to offset any downside Union Pacific may experience from a decline in coal demand: U.S. population growth that further crowds the highways and an expanding global economy.
 
With a distinct durable competitive advantage associated with railroad economics (at least among the large rails), investors might wait forever if they attempt to wait to buy Union Pacific at a significant discount to fair value. At today's price, however, there is no question that Union Pacific is throwing off plenty of cash for reinvestment and dividends. If you are long on the external competitive environment facing railroads in general, Union Pacific is a great stock to invest in the fuel-efficient future of rail.


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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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