Must Read: Joint Outlook for the Railroad and Coal Industries
Union Pacific (UNP) showed why the company is included in the Best Ideas portfolio when it reported fourth quarter results Thursday. The company’s headline was nice: “Best-Ever Quarterly Results.” That’s saying quite a bit as coal shipments continue to provide stiff headwinds across much of the industry. Norfolk Southern (NSC), for example, recently reported an 8% decline in coal volumes during its fourth quarter, its results released Wednesday. Though revenue carloads of coal declined 10% during Union Pacific’s fourth quarter, strong pricing almost completely offset the weakness in this segment. Average revenue per car across all of Union Pacific jumped 6% in the quarter, far better than inflation. We continue to believe the domestic railroad industry has significant opportunities to drive further pricing gains, which works wonders on profitability and earnings:
Image Source: American Association of Railroads
Overall, Union Pacific’s operating revenue advanced 7% in the quarter, which via pricing expansion, the company leveraged into a 14% gain in operating income. Diluted earnings per share leapt 16%, and the company posted its best-ever operating ratio in the fourth quarter: 65% (2.1 points better than the fourth quarter 2012). Norfolk Southern’s operating ratio came in at 69.4% in the period (the lower the operating ratio the better). Part of our investment thesis on Union Pacific centers on the firm having among the best operating ratios by the end of the decade as it continues to drive pricing gains and control costs, and we continue to like the progress in this area. The company generated $3.3 billion in free cash flow during 2013 (about 15.1% of total revenue) and ended the year with a $6.8 billion net debt position. We expect both of these measures to be best among peers as we await for other railroad operators to report fourth-quarter results.
Valuentum’s Take
North American railroads operate as an oligopoly, benefit from substantial barriers to entry, and boast significant pricing power. Free cash flow generation trends are strongest at the largest operators—Union Pacific and Canadian National (CNI). Each railroad has its own unique strengths and weaknesses, but Union Pacific seems to have the most things going for it. We expect the firm’s operating ratio to be among the best in the group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast. The firm is levered to coal, though we note its mix is more of the PRB variety, which should continue to take share from CAPP coal in the domestic market. The firm also boasts a strong Valuentum Dividend Cushion score and a decent annual yield.