Betting on the Mexican Opportunity!

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

Increase in near shoring and rising demand from manufacturers are major growth drivers for rail services across the Mexico and U.S. borders. The high oil prices and rising wages are keeping manufacturers far from the once low cost Asian market. Businesses are increasing their manufacturing units in Mexico that has boosted both the flow of raw materials from the U.S. and finished products back to US. Another demand driver for rail transport is supported by the increase in population. Population in the US is estimated to grow by 12-15 million over the next five years. That growth would be a major demand increasing factor and help in the recovery of the weak markets.

These favorable macro conditions provide an opportunity for growth for Union Pacific (NYSE: UNP), the largest rail transport network in the United States with tracks measuring 32000 miles across the country's western half. The company increased its quarterly dividend by 15% to 69 cents per share. For the third quarter, Union Pacific has earned operating revenue of $5.3 billion and growth of 5% year over year. This quarter the company has earned record revenue with core pricing gains of 5% as a major growth driven contributor. The Company has achieved an operating margin of 66.6%, up 2.5 points Y/Y and 0.5 from the last quarter.

Union Pacific competes with Canadian Pacific Railway Limited (NYSE: CP) and CSX Corporation (NYSE: CSX). Let’s see how these companies are placed.

Canadian Pacific has recently announced restructuring of its operations through job cuts and divestment. The Company has laid out plans to reduce 23% of its headcount in parts through 2016. Alongside, it is considering selling of its Midwestern U.S. line which it gained through the acquisition of Dakota, Minnesota & Eastern Railroad in the year 2007. This announcement raised the stock of Canadian Pacific by nearly 4% and is now trading close to its all-time high of $101.09. The company is targeting to achieve an operating ratio of 65% in the next four years. The Company's layoff plans and divestment strategies are expected to bring operational efficiency and help it to focus on its core business areas to lower down its operating ratio.

Another competitor CSX Corporation has announced network expansion plan into intermodal rail transport. It has started construction of a rail terminal in Polk County, FL with a projected cost of $100 million. The terminal would enhance the company's intermodal business and cover the key markets of Tampa, Orlando and South Florida for its services. Additionally, CSX Corporation has also launched the National Gateway in order to enhance the operating efficiency of its freight network across the Mid-Atlantic ports and the Midwest. The expansion plans would give the company additional markets for revenue generation and will result in improved operational efficiency.

Coming back to Union Pacific, the company has marked out ventures to generate consistent returns on widespread growth areas. It is focusing on capitalizing upon the Mexico trade opportunities and re-pricing of legacy contracts to cash in for the long haul. Let’s discuss these points in detail.

Mexico Trade Boom

Major growth factor for the company lies in tracking the opportunities of trade in Mexico. Transport companies have identified automotive as a key growth market to maximize benefits. According to IHS Global Insight 4 million units will be manufactured in Mexico by 2019, up from 2.7 million in 2012. Due to the lower median age of cars in the United States and availability of easy consumer credit, transport companies will have more units for shipments. Union Pacific has marked volume growth up 9% last year and 6% ending September this year. Union Pacific is the only railroad service that operates all six major gateways to Mexico. It holds 26% stake in the Mexican railway company Ferromex. All major railroad and trucking companies in the United States are initiating capital investments to monetize the opportunities. Kansas City Southern has invested about $300 million in the last five years for network expansion and up gradation. Union Pacific is teaming up with Kansas City Southern for carload services in the United States at the locations where railroad services are not served.

Legacy pricing

Union Pacific has $1 billion of remaining legacy contracts to be re-priced through 2016. Of the total contracts Energy comprises of 85%. Total renewals for 2013 were expected to be ~$350 million. These contracts were priced prior to 2004 at which time Union Pacific had very less negotiation power. Rail pricing has improved in the last eight years with capital investments and industry pricing improvements. For Union Pacific legacy pricing has contributed towards core pricing gains for year to date. This re-pricing should allow the company to support the continuing upside earnings versus its peer group.

To conclude, the Union Pacific has well satisfied its investors with a fair dividend payment. The stock of the company has appreciated over the last one year by ~24% trading at the current price of $125.23. The Company has identified the growth opportunities in Mexico and prepared its plans accordingly. On the other hand, Union Pacific has built its network in a good shape in the recent years and is now planning to cut down on capital expenditures. It will now spend 16 – 17% of revenue down 100-200 basis points. Reduced spending will increase operating cash that the company could use for dividend payments and share buybacks. Overall, entering the stock at this time is not a bad idea as the shareholders will benefit by investing in it all the way.

ShwetaDubey 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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