Union Pacific’s Coal Freight Business Rebounds From Powder River Basin Activity

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Union Pacific

In Q2, almost all railroad companies took a beating from a slump in its coal freight businesses, but that was largely mitigated by improved performances from its other divisions. Union Pacific (NYSE:UNP) was no different but increased coal mining activity in Powder River Basin (PRB) region situated in parts of Wyoming and Montana could reverse the slide in coal freight volumes for the company. [1] The South Power River Basin region is critical for Union Pacific as it contributed nearly 75% to the total coal freight revenues in 2011, according to the company’s 10-k filing for 2011.

As per our analysis, Union Pacific’s stock derives nearly 20% value from its coal freight business, which is lower compared with similar divisions in other railroads like CSX Corp. (NYSE:CSX) or Norfolk Southern (NYSE:NSC) but is still large enough to move the stock price meaningfully. We take a look at the key characteristics of the PRB coal and how that can impact Union Pacific’s price estimate.

Our price estimate for Union Pacific stands at $128, which now stands at 5% premium to the current market price.

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See our complete analysis of Union Pacific here

The second quarter results speaks volumes about railroad’s diversified business model, riding on which they performed phenomenally despite declines in coal volumes. Another reason the shares didn’t tumble was the company’s superior core pricing ability and fuel surcharges. In essence, this has rendered railroads even more stable and secure in general and Union Pacific benefited. Union Pacific is in now better positioned to cater to a specific industry in a more dedicated way, leveraging its extended rail network that spans across more than two-third of the nation.

Union Pacific has its network well spread in the PRB region, which has witnessed an uptick in coal mining activity lately. Though the company reported reduced coal shipments from that region in the first half of 2012, the trend is likely to change in the second half. PRB is one of the largest source of coal mined in the United States. Even in the depressing coal environment in the U.S., PRB coal is the only coal enjoying rising prices. The coal produced in the region is ridiculously cheaper even if we consider its increasing price and lower energy output in terms of BTU per ton compared with Appalachia coal. Further, the coal is low on sulfur and fly ash content, which increases its attractiveness.

The utility companies burning coal in the eastern region are typically tied up in long-term contracts with Appalachian coal providers, the largest coal provider in the east. These utility companies are not oblivious to the benefits of the PRB coal and are likely to switch over to PRB coal after the termination of their existing contracts. It is believed that retrofitting existing plants for PRB coal, which are originally designed to consume Appalachian coal is not cost intensive and those expenses can be easily recouped in short duration by the increased profits from operations with PRB coal.

The only disadvantage with PRB coal is its location which is far away from many utilities in the eastern or southern part of the country. UNP has previously displayed interest in selling PRB coal to utilities in the eastern part of the nation, which will be cheaper for them even after adding the shipping costs. On a month-over-month basis, Union Pacific have noticed coal shipments from the region rising. This will bolster the coal freight franchise for Union Pacific which has been down for a while. Further, the export activities are also rising, which helped the company offset the domestic declines during first half of 2012. However, we believe the domestic coal demand is a more exciting opportunity for Union Pacific in the near-term because the export facilities available now are limited and inadequate.

Another region witnessing a similar trend of increased coal shipments is Colorado/Utah region. Coal shipments from the region were sound in Q2, 2012 and grew compared to same period last year. We believe that these two regions – PRB and Utah/Colorado – can help Union Pacific re-energize its coal freight business going forward. Tweak the trend line in the chart below to see the impact of revenue ton-miles of energy commodities freight on Union Pacific’s price estimate.

There is one risk to Union Pacific’s efforts. Environment Protection Agency’s ambitious plans for a cleaner America could curtain coal usage across nation, which might result in some downside to our estimates.

Understand How a Company’s Products Impact its Stock Price at Trefis

Notes:
  1. Union Pacific: July coal train loadings were ‘strong’ in PRB, Colorado/Utah regions, progressiverailroading.com, August 8, 2012 []