6 Reasons to Invest in This Railroad

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When investing in a publicly traded business you want that company to maintain its ability to generate and grow free cash flow over the long term. Western railroader Union Pacific (NYSE: UNP) possesses the qualities to make that happen.

Barriers to entry

If new competitors want to enter the railroad arena they would need to spend billions of dollars to build infrastructure such as rail bridges and tunnels, not to mention regulatory approval and the acquisition of land to lay track. This provides a pretty wide moat for Union Pacific.

Lack of railroad competition

Union Pacific only faces one major competitor on the western front: Berkshire Hathaway’s Burlington Northern Santa Fe. This gives Union Pacific greater ownership of the lucrative railroad market allowing the company greater leverage in capitalizing on the recovering American economy.

Pricing power

Lack of competition gives Union Pacific the ability to raise prices when necessary. Considering the company’s volume declined 1% during the most recent quarter, this represents one of those times. Union Pacific still reported a 5% increase in freight revenue due to gains in pricing during the same quarter.

Even revenue stream

Unlike other railroads Union Pacific draws in a fairly even revenue stream from each of its segments and doesn’t need to lean too heavily on one particular segment. Union Pacific’s segment distribution in terms of percentages of revenue include intermodal, industrial products, coal, chemicals, agriculture, and automotive clocking in at 19%, 19%, 19%, 17%, 15%, and 10% of total revenue, respectively.

Other railroads experience heavy concentration in one particular segment. For example, Midwestern company Kansas City Southern (NYSE: KSU) derives the highest amount of its revenue from its industrial and consumer products division at 25%. Its next highest segment, chemicals and petroleum, comprises 19% of its revenue, a 6% drop. The housing recovery should bode well for this company stemming from the fact that forest products makes up 46% of the industrial and consumer products division.

Eastern railroader Norfolk Southern (NYSE: NSC) derives the largest portion of its revenue from coal, standing at 22% of its revenue. CSX (NYSE: CSX) derives 31% and 25% of its revenue from the industrial and coal segments, respectively. Revenue growth of these companies will remain constricted as long as natural gas remains relatively cheaper than the price of coal.

Low operating ratio

Greater diversity in revenue streams and lack of competition gives Union Pacific a better opportunity to keep its trains going, allowing the company to leverage its expenditures into more revenue. Union Pacific’s operating ratio clocked in at 65.7%, versus the operating ratios of 69%, 70.2%, and 68.6% for Kansas City Southern, Norfolk Southern, and CSX, respectively. This means that Union Pacific only spent 65.7% of its revenue on operating expenses leaving more money for the bottom line and better opportunity to strengthen its balance sheet.

Best balance sheet

Union Pacific’s cash stands at 9% of stockholder’s equity, exceeded only by CSX, where its cash stands at 11% in the most recent quarter. Union Pacific possesses the best balance sheet in terms of debt. As of the most recent quarter, Union Pacific’s long-term debt to equity ratio clocked in at 44% versus 51%, 83%, and 91% for Kansas City Southern, Norfolk Southern, and CSX, respectively.

Union Pacific’s operating income exceeded interest expense by 14 times. General rule of thumb for a margin of safety resides at five, meaning Union Pacific stands more than capable of making its interest payment.

Dividends

In the most recent quarter, Union Pacific paid out 43% of its free cash flow in dividends. Currently, Union Pacific pays $3.16 per share per year in dividends, yielding about 1.9% as of this writing. So, you can collect an income stream while waiting for capital appreciation.

Conclusion

Drought conditions in the west will continue to negatively affect nationwide agricultural freight and low natural gas prices will serve as friction with coal freight throughout the transportation industry, including railroads. Moreover, a softening Chinese economy could put the skids on outgoing intermodal freight. However, other sectors of the economy, such as petroleum and housing, should serve as a balance. Union Pacific’s diverse revenue stream puts the company in the best position to benefit from the positives and minimize the negative impacts from the overall economic shifts.

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William Bias owns shares of Union Pacific. The Motley Fool has no position in any of the stocks mentioned. 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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