Union Pacific Worth $112: High Fuel Prices Support Rail Demand & Margin Upside

Union Pacific Corporation (NYSE:UNP) is the largest railroad network in the United States by the number of route miles owned. The company operates on nearly 32,000 miles of track, of which it owns about 26,000 miles of track outright. Union Pacific Railroad (UPRR), the largest class-1 railroad in the United States, is the core subsidiary of Union Pacific Corporation. UPRR’s route map covers most of the central and western United States serving 23 states and operates on key north/south corridors and is the only railroad to serve all six major gateways to Mexico. Although Union Pacific Railroad’s primary role is transporting freight, it also runs a substantial commuter train operation in Chicago. Union Pacific competes with Burlington Northern Santa Fe Corporation, which covers much of the same territory and was acquired by Berkshire Hathaway (NYSE:BRK.A). It also competes with smaller railroads like CSX Corp (NYSE:CSX) and Norfolk Southern (NYSE:NSC).

Launch of Coverage on Union Pacific Corporation; $112 Price Estimate

We recently launched coverage activity on Union Pacific Corporation with a $112 price estimate for the company’s stock, which is around 5% ahead of the market price.

We have broken down our analysis of Union Pacific into 7 main divisions:

1. Energy Commodities Freight
2. Intermodal Freight
3. Agricultural Commodities Freight
4. Industrial Products Commodities Freight
5. Chemical Commodities Freight
6. Automotive Commodities Freight
7. Commuter Rail and Other services

North American Railroads at a Glance

Railroads are an important segment of freight transportation industry in the United States. They serve many of the fastest growing U.S. population centers and provide Americans with a fuel-efficient, environmentally responsible and safe mode of freight transportation. They move everything – coal and lumber, automobiles and scrap iron, grains and vegetables as well as chemicals and oils. Rail transports 42% of United States’ freight (measured in ton-miles), which is more than any other mode of transportation. With numerous consolidations and acquisitions, U.S. railroads are monopolistic in nature in that they require massive scale and carry high barriers to entry for new entrants.

The demand for freight is highly correlated with economic conditions. For examples, volume levels slumped considerably in 2008 leading to a record decline in the railroad freight revenues. However, strong demand recovery in 2010 helped railroads bounce, and we think there’s room for more growth especially for coal and intermodal freight. The total volume levels for 2010 including carloads and intermodal units are still below 2008 levels and so we believe railroads have further opportunities for volume growth. Additional margin expansion will occur from renegotiated legacy contracts bolstered by high fuel prices for trucking, which is rail’s main competitor.

Energy Demand Will Drive Volume Growth

The energy commodities freight service of Union Pacific consists of transportation of coal and petroleum coke and accounts for the largest share of Union Pacific’s total freight volume with 43% in 2010.

Coal production is rapidly shifting westward, driven by the rapid growth of production in Southern Powder River Basin (SPRB) region and the continuing decline of eastern coal sources in Central Appalachia. The energy commodities volume recovery was relatively slow in 2010, and we think that coal volumes have further room to grow looking ahead. We expect coal freight demand growth in SPRB to accelerate in near future, presenting upside to volume recovery.

Margin Improvement in Intermodal Transport

The segment carries high incremental margins as train lengths are extended because the additional costs associated with adding containers to existing trains are low. The intermodal freight segment of Union Pacific has stiff competition with several truck carriers. Given the surge in fuel prices, the trucking industry has been struggling to and forced to raise freight rates. This in turn benefits UNP which is increases pricing flexibility.

The coal and intermodal segments are highly impacted by contract renewals and repricings due to a high amount of legacy contracts. Union Pacific has steadily improved rates during the past few years primarily through legacy contract renewals and repricings. If pricing discipline persists and UNP can renew legaciy contracts on favorable terms, this could present upside to margins and our forecasts.

See our full analysis of Union Pacific.