Description

Union Pacific: Quality franchise with strong entry barriers and duopoly economics

More than a year back in March 2019 we had taken an exposure in Union Pacific (UNP) triggered by the appointment of Jim Vena, protégé of Hunter Harrison, as the COO of the company. Even though the company joined the Precision Scheduled Railroading (PSR) bandwagon much earlier in September 2018, the announcement did not instil confidence to pull the trigger then. The initial investment started with a tumultuous journey as the freight volumes went from a mild recession in late 2019 to one of the worst (in 100+ years of history of freight) in March 2020. While jittery and shaken by the magnitude of destruction, a $ 2.1 m open market purchase by William Laney, former CEO of Sysco and director of UNP could not go unnoticed, as this was the largest purchase by an insider after 2015. After all, at the March-end price the Street was factoring a mere inflation-like growth of 3.5% (vs. 11% last 10 years) to an already depressed 2019 free cash flow implying no benefits of PSR. Subsequently, a marginal increase in allocation was done in June, when signs of volumes bottoming out emerged.

With the overall demand being low, the company is taking advantage of the crisis to accelerate PSR. The true earnings potential is being masked by the still depressed volumes. When structural advantages of a long haul, duopolistic market, attractive return ratios are combined with the industry best compensation incentives spearheaded by industry’s best operator, history has been kind in rewarding shareholders. Superinvestors such as Warren Buffet, Bill Ackman and Bill Gates have had a large proportion of their wealth multiplied during similar situations in BNSF, CP and CNI, respectively. UNP presents a similar opportunity today just as Berkshire invested into BNSF before the freight volumes rebounded after the 2008 recession.

“A climate of fear is their best friend. Late in 2009, amidst the gloom of the Great Recession, we agreed to buy BNSF, the largest purchase in Berkshire’s history. At the time, I called the transaction an all-in wager on the economic future of the United States.”

                                                                                                            -         Warren Buffet (2013 investment letter)

Jim Vena – An operator with an outstanding track record

Changing the culture of a firm is the most challenging aspect for the insiders yet thought easy by investors. And transforming a labour-intensive firm with innate productivity inefficiencies rather runs a risk of destroying value. As a result, banking on an operator with decades of turnaround experience is a smart move for investors to play in their favour. In the case of UNP – Jim Vena is our bet. With two decades of PSR experience at CNI, including more than 10 years under Hunter Harrison and Keith Creel, he can be easily ranked as the best operator for a PSR turnaround.

1. Thesis:

• How UNP’s structural advantage can help it achieve industry best margin

• Valuation: UNP’s Path to 55 O.R. (base case) and 50 O.R. (bull case)

2. Railroads 101:

• Strong entry barriers with duopoly market structure

• Competitive advantage vs trucks

• Understanding the unit metrics for the industry

• What do the rails carry?

3. Everything about PSR:

• Prisoners Dilemma - Berkshire Hathaway owned BNSF vs. UNP

• Rail Renaissance – The debate on return ratios Understanding the unit metrics for the industry

• What is Precision Scheduled Railroading?

4. Risk

I. Thesis

UNP’s structural advantage can help it achieve industry best margin

The Operating Ratio (O.R. = 1- EBIT margin) target of 55 given by UNP had stunned the Street, as this was a feat achieved nearly by only CNI having decades of PSR experience. UNP’s O.R. target, in our view, is not high considering its structural advantages of a long length of haul (LOH), easier geographic footprint and high exposure to merchandise traffic. A longer LOH should provide an advantage to move heavier cargos over longer distances driving better-fixed cost absorption. UNP’s LOH is second only to BNSF and CP. Still adjusted on a length of haul basis it had the most inefficient cost structure with a cost/RTM of ~$3.11. This also makes it a prime beneficiary of PSR. Imagine if UNP is successful in implementing PSR like the Canadian rails and bring its cost/RTM below the trendline. Not only a 55 O.R., but a successful PSR implementation could also bring its O.R. to even ~50.

UNP’s Path to 55 O.R. (base case) and 50 O.R. (bull case)

UNP is making substantial progress by rationalizing yards and improving efficiency. Productivity gains are exceeding targets. Average dwell time (hours) have declined by 27% since 2018. Dwell time (lower the better) is the time a train stands idle between stops to load/unload the freight. Train lengths have increased by 24% since 2018. Longer trains increase locomotive productivity, reduce train starts and train crews, and improve fuel efficiency. Trip plan compliance (percentage of cars on time) have improved between 75-82% from 67% in 2018. High trip plan compliance is important for more time-sensitive intermodal freight, including e-commerce related parcels (think Amazon, Walmart). Velocity (the higher the better) has increased by 15%. Imagine if UNP is successful in implementing PSR like the Canadian rails. Increased train length and density should drive outsized labour and fuel productivity.

Improvement in employee productivity is a hallmark of PSR. In a typical PSR implementation, compensation (GTM/employee) and fuel (fuel/GTM) are the largest buckets in terms of cost takeout. Both employee cost and fuel being at higher-end present enough cost takeout opportunity for UNP.

Combining this with the greatest capital allocation policy in company’s history by leveraging at cheap credit (2.9x net debt/EBITDA) and buying back stocks worth $ 20 bn (15% of market cap) is expected to reward equity shareholders. Unlike CSX, which implemented PSR in a short time (creating service disruptions), UNP is implementing PSR in stages with a target O.R. of 60 by 2020 and 55 without giving any timeline. Our estimate suggests a base case and a bull case upside of 40-60% by only giving the benefit of O.R. improvement to a depressed 2019 number.

Our approach does not give importance to the earnings in the next quarter/year. We will continue riding the train until the capital allocation policy is intact. A risk towards opportunity coast of capital remains if it takes longer. Also, while Warren Buffet went all-in in BNSF, it was because BRK generates a high amount of cash every year which it needs to invest that may not be the case for individuals with limited capital.

However, to communicate the drivers of growth in the form of multiples, UNP trades at a PE of 22 x 2021 estimates. Two reasons – one the earnings are depressed (PE looks high) and second, PSR players trades at a premium (see below) justify a high multiple.

II. Railroads 101:

Railroads: Strong entry barriers with duopoly market structure

The North American rail industry is made up of seven Class I rail operators and several regional and local railroads. Class 1 railroads are defined as having annual revenues of at least $ 250 m (based on 1991-dollar terms) and carry 90% of market share. Class 1 operate are a duopoly within their respective regions.

Starting a new railroad is today unviable for a new player. There used to be over 40 class I railroads. Then after the 1980s Stagger Act, the 40 railroads merged into seven with four railroads taking the largest share. BNSF (owned by Berkshire Hathaway) is the largest freight railroad by volume and revenues. Along with UNP, they have a duopoly on transcontinental freight rail lines in the west. CSX Corp. (CSX) and Norfolk Southern (NSC) compete in the east of the Mississippi River where they have a shorter and much complex network. Canadian Pacific (CP) and Canadian National (CNI) are based out of Canada with fright lanes extending till the US.

UNP’s Hidden asset: Interestingly, UNP’s unique franchise provides it with the best access to Mexico. It is the only railroad to serve all six major rail gateways between the U.S. and Mexico. It also holds a 26% minority ownership interest in Ferromex (FXE), a rail network covering ~70% of Mexico. UNP can interchange traffic at the border, working with both Ferromex and KSU. It derives ~10% of revenues from Mexico.

Competitive advantage vs trucks

Rails have a significant barrier to entry with irreplaceable networks-built 100+ years ago. A high fixed cost provides significant operating leverage to improving volumes. Rails primarily compete with Trucking for market share. They have lost a substantial amount of share to truck over the last few decades for traffic that economically should move via rail - but shifted to truck given historically unreliable and inconsistent rail service. Rails are much more fuel-efficient with Class 1 railroads able to move a ton of freight between 450-500 miles using a single gallon of diesel.

“With a very high degree of certainty, in my view, BNSF will be carrying more carloads 10 years from now, 20 years from now; that there will be no substitute for the service that they provide; that there will be two important railroads in the west and two important railroads in the east; and that they will have an asset that has incredible replacement value, nobody could turn out something like it, and that they’ll get paid fairly for what they do. It’s not very complicated.”

                                                                                                               - Warren Buffet at 2013 AGM

III. Prisoners Dilemma - Berkshire Hathaway owned BNSF vs. UNP

Both Warren Buffet and Charlie Munger have been repeatedly asked in Berkshire Hathaway’s AGM about their view on PSR and why BNSF remains the only Class 1 rail to be a laggard in deploying it. For example, despite being the longest-haul BNSF has the worst O.R. of 65.3%, which is 60 bps behind NSC and 470 bps behind UNP. Comparing this to 2015, BNSF’s O.R. was 670 bps above NSC. Besides, BNSF’s service has struggled since late 2018. Being a privately owned entity, BNSF often misses investors scrutiny despite having the industry worst O.R.

Interestingly, Hunter Harrison has spent most of his early career with BN, which has been touted by insiders that elements of PSR are always been long present with BNSF.

Will the management change in BNSF bring it at war with UNP?

This is a question which I would love to ask Warren Buffet in the next AGM. Matt Rose (who shares great bonhomie with Warren Buffet) retired last year as Chairman of BNSF after 26 years of service. He has been a vocal opponent of PSR. Service disruptions for higher profitability will attract heightened regulatory risk, according to him. But a closer look suggests that BNSF has a heavy mix towards intermodal (51% of volumes) which requires high service to shippers. So this means that BNSF cannot ignore to disrupt service. Additionally, its cost efficiency is not bad either which means it has a problem with its mix. Could this be the reason for BNSF to not adopt PSR?

So, this is a prisoner’s dilemma. Will BNSF allow UNP to develop a much leaner and reliable PSR network or will it also join the game? If BNSF ignores, it continues to gain low-margin intermodal share but lose the high-margin merchandise to UNP. If BNSF also jumps, service disruption risk becomes imminent in the western corridor with both competing for a larger share of merchandise. In both the scenarios, UNP is well placed and stands to gain, considering its early headstart.

A point to note is that BNSF’s growth capex provides a source of capital to Berkshire Hathaway though deferred taxes. Semper Augustus investment letters are a great source to understand.

IV. Rail Renaissance – The debate on return ratios

Estimating the true returns for a railroad is a tricky concept. Investments are done from a perspective of 10-20-30 years’ time horizon. Since GAAP requires the use of historical cost as the basis of reporting, a mismatch occurs between the book value and replacement cost. Long periods of inflation significantly increase asset replacement costs for capital-intensive companies like railroads. As an example of UNP, for every dollar of assets in its book, it had to spend $1.9 over the last 12 years (BNSF was also close at 1.85x). Hence inflation is a critical driver as the assets are replaced at an inflated cost.

If this is the case then which metric is the best indicator to determine the economics of a capital-intensive industry like railroads? While EVA metric such as CFROI will be better in my perspective, but as the regulators, shippers and rail companies give importance to RoIC, let us compare that.

Recent PSR turnarounds – such as CP and CSX have not only substantially improved their return metrics but also have the highest RoIIC (incremental investment return) over others. BNSF lags overall, partly because of the increase in paid-up capital when it was acquired by Berkshire Hathaway. Eastern players (CSX/ NSC) have historically been the worst, but CSX’s improvement showed that PSR is possible even with structurally disadvantaged rails.

Investment in the industry gathered momentum starting in the early 2000s after the railroaders gained pricing power. The industry’s capex to sales percentage jumped from 13-14% to 17-18% as they realised the gains from incremental investments supported by freight demand. This period is termed as ‘Rails Renaissance’.

There has been a long-standing debate between the STB (regulator), shippers and railroads on the usage of replacement value vs. the book value to determine the revenue adequacy. Without going into much detail (for this article), the use of replacement value will lower the return ratios dramatically and hence will be a boost for the companies from a regulatory aspect.

V. What is Precision Scheduled Railroading?

Ever imagined if airlines and passenger rails would wait for their seats to get filled rather than starting on time? Scary? Yes! Imagine how inefficient the system would have been. Awkwardly, this has not been the case for the freight industry. They instead wait for the carloads to arrive and be sorted, risking delays and congestion in the network. No wonder that railroads lost market share to trucks, especially for time-sensitive freights. However, this started to change with the implementation of PSR which was pioneered by the iconic Hunter Harrison.

PSR’s key tenet is that a train should leave at a scheduled time. The objective of PSR is to have the right people in the right place at the right time. An effective implementation leads to maximize asset utilisation as the speed of trains accelerates, dwell declines and safety improves. This results in significant cost reduction, better Operating Ratio (O.R. = 1- EBIT margin) and ROIC. But it is not easy as thought since it requires a change in the culture of the entire company with a dominant unionised workforce.

How effective has been the PSR in railroad companies?

CNI, considered to be a gold standard within the industry has been a pioneer and earliest adopter of PSR when it acquired Illinois Central in 1998. And the part of the deal was also to have Hunter Harrison join CNI, who was later appointed as CEO in 2003. Since then, CNI’s O.R. went from worst to best among its Class I peer group. This was followed by CP when Bill Ackman won a proxy war and installed Hunter Harrison as its CEO in early 2013. The turnaround at CP was termed as one of the greatest corporate turnarounds. CP’s network structure, geography, weather and freight mix were considered an impediment to PSR by the management and in fact, they came up with a $ 5 m study to substantiate their claims.

Later Hunter joined CSX in 2017. As he realised that he has limited time at his side, he spearheaded the PSR in the shortest time possible. CSX handsomely outperformed since the implementation of PSR as its O.R. went from an industry worst of ~70% to an industry best of sub-60% in two years. Being turned as the “CN of the South”, CSX’ success can be attributed to the fact that much of its current management team rose in the field together under the guidance of Hunter Harrison.

VI. Risks:

1. The risk to the thesis could be from:

2. UNP is unable to substitute coal with merchandise, including e-commerce

3. The advent of electric trucks (with better fuel and battery technology) which can move long-haul more economically and take market share back from the rails

4. Surface Transport Board (STB) declaring that the railroads have become ‘Revenue Adequate’, hence restricting their pricing power

5. Service disruption from PSR, leading to regulatory discontent

6. Any changes to the long-term economic competitiveness with the reduction in Capex

Catalyst

Volume recovery when combined with full benefits of PSR will be a strong catalyst in my opinion. Having Jim Vena at the helm of affairs is a major positive for this to play out. Railroads (primarily UNP) have given a TSR of 20% over last 20 years and I don't see it to fade over the next few years. 

Personal Note:

Apologies for a long write-up. To make it concise I skipped the basics. Reading a few books along with every filing available helped me get a grasp of the sector. I’m sharing the link of the summary of those books I wrote recently. 

Also a big thanks to the VIC community for reactivating my membership early this year on CARR US, with overwhelming votes. Happy that it has more than doubled! Feels great to contribute with VIC exclusive thesis after having learned so much from this platform. I started a blog wherein I plan write more short thesis and hope to connect/learn with all of you! https://theinvestingprinciples.com/blog-2/

Hope your family remains safe!