Description

This is a follow-up recommendation of Union Pacific, which we first submitted six years ago. In 2012, we estimate that UP will earn approximately $7.00 per share and should be valued at $100+ per share. Before discussing these estimates, here's a brief overview of the company...

Union Pacific is the largest US railroad and has operations in the western two-thirds of the US (23 states). UP has 32,094 route miles, 26,223 of which are owned (the other is operated under track rights or leases). Of the 32,094 route miles, about 6,000+ miles are double tracked. In total, the company has 50,885 miles in the entire system when taking into account rail yards and passing lanes. One track mile costs about $2.5 million to build (for steel, concrete, engineering and construction costs, but excluding land, bridges, tunnels, etc.), so there is obviously significant replacement value. Given the impossibility of replicating UP's land position (an investor need not worry about the Chinese or Japanese putting down tracks next to the UP's), it is likely that UP has a multi-lifetime franchise that will be operating 200+ years from now. UP hauls the following commodities:

Agriculture (about 18% of normalized revenue): This segment includes grain products (such as soymeal) and whole grains (such as soybeans, corn), as well as food and refrigerated product. Key growth areas are ethanol/DDG, and produce (especially from California/Washington). In total, about 70% is domestic (some of which is eventually exported as protein), with the balance split between international and Mexico.

Automotive (8% of revenue): UP has very high Western U.S. market share in finished vehicles. The company also moves auto parts, which represents about 20% of the segment. A significant, and growing, amount of traffic involves Mexican origination. From a normalized level, this is perhaps the slowest growth segment within UP (fortunately, this segment is significantly smaller than the other five segments).

Chemical (15% of revenue): This is the highest return move, and UP has very high market share (due to its strong position in the Gulf of Mexico... about two-thirds of segment traffic originates, terminates, or travels through this area). Key segments are industrial chemicals, plastics, petroleum & other, soda ash, and fertilizer. About 25% of the traffic involve international shipments.

Energy (20% of revenue): Over 70% of segment revenue is derived from the Southern PRB (low-cost, low-sulfur), with about 25% from Colorado and Utah (high-BTU, low-sulfur) mines. The SPRB tracks are co-owned with BNSF, which also has access to the NPRB. Destination regions are 40% South, 27% North, 19% East (taking share from Eastern coal), 9% West, and 5% industrial. About 40% of this segment's revenues (as of 2010) are from legacy contracts, and thus this segment is not a large profit contributor (unlike for the Eastern railroads, where coal is a very high margin shipment).

Industrial Products (20% of revenue): This is the most diverse and most complex move (very few unit trains with large number of originations/destinations). Key products are metals, minerals/consumer, paper, construction products, lumber, waste, and machinery. Approximately, 85% of traffic is domestic only.

Intermodal (19% or revenue): Approximately 50% of segment is international (Asia) and 50% is domestic. One UP intermodal train equals about 290 trucks and the 1,700-mile LA to Houston route consumes 15,800 gallons of fuel (versus 89,500 for the equivalent trucks). UP has significantly improved its service levels and is now targeting sub-500 mile traffic.

 Earnings Power and Valuation

UP earned $3.75 in 2009, which was down from a record $4.54 in 2008. In 2012, we expect UP to earn approximately $7.00. Our assumptions are: Volumes: volumes rebound from the 2009 trough and 2012 carloads equal approximately 97% of 2008 levels. Pricing: price increases average just under 5% per year for 2010-2012 (of this amount, legacy re-pricings add approximately 200bp). Revenue growth: 8.5% revenue CAGR (keeping fuel surcharge constant) from 2010-2112. Costs per carload (keeping fuel constant): costs per carload decline by -1.5% in 2010 (significant operating leverage from underutilized locomotives, cars, etc.), and then increase by +1.5% in both 2011 and 2012. Other income: declines by $100 million from 2009 level. Interest expense: declines by $75 million from 2009 level. Tax rate: increases by 80bp from 2009 level. Shares outstanding: 3.7% lower in 2012 versus 2009 level. Valuation: Using an average market multiple of 14x earnings (and including dividends) would equal $100.

Regulation

Railroads are good for America. By removing trucks from highways, railroads reduce our dependence on imported oil, reduce greenhouse gas emissions, relieve congestion and improve the safety of our roads, and reduce government spending requirements on highways (railroads are self-funding). Ultimately, legislators want to incentivize railroad companies to spend billions maintaining and growing their networks. While this is a very complicated issue and it is difficult to discount politics, we believe that the Surface Transportation Board (STB) - when calculating revenue adequacy - will allow the railroads to earn fair returns on a modified replacement value of their assets. It is important to note that many of UP's assets are significantly undervalued on their balance sheet (as an example, a 100-year old bridge might be on the b/s for $1million, but might cost $100 million to replace). The recent BNSF transaction and related purchase accounting adjustments will illustrate to regulators the inadequacy of using GAAP when determining a railroad's revenue adequacy. Our $7 eps estimate for 2012 would be far below the "revenue adequacy" return threshold based on a modified replacement value methodology.

Catalyst