Sector

Transportation & Logistics

Background

Matt Reustle is the CEO of Colossus and a former transport analyst. We cover the consolidation of the freight railroad industry, how they have been revived by a change in operating philosophy, and contrast rails with other modes of transportation.

Cover

Date

August 10, 2022

Episode Number

69

Union Pacific Business Breakdown

Background / Overview

Union Pacific (UNP) is a Class I freight railroad operating primarily in the western two-thirds of the United States, covering 30,000 miles of track. Founded in the 1860s as part of the transcontinental railroad, it has evolved into a critical component of the U.S. supply chain, moving industrial goods, bulk commodities, and intermodal containers. With a market capitalization of approximately $140 billion, UNP operates as a duopoly in the western U.S. alongside Burlington Northern Santa Fe (BNSF), owned by Berkshire Hathaway. The company employs a significant workforce, though exact full-time employee numbers are not specified, and its operations are capital-intensive due to the maintenance of tracks, locomotives, and rail cars. Historically, UNP has benefited from land grants that provided valuable real estate, notably in oil and gas, which it monetized by selling its resources business for $4 billion in the 1990s.

Ownership / Fundraising / Recent Valuation

UNP is a publicly traded company, and no specific private equity ownership or recent fundraising events are noted. Its valuation is reflected in its $140 billion market cap, with a price-to-earnings ratio implying a free cash flow yield of approximately 5%. The company has increased its leverage from one turn to slightly over two turns in recent years, which is considered reasonable given its stable revenue streams. No recent enterprise value multiples or specific transactions are provided, but the stock has outperformed the S&P 500 significantly from 2005 to 2020, beating the market in all but one year.

Key Products / Services / Value Proposition

Union Pacific’s core service is freight transportation across three main segments:

1. Industrial (35% of revenue): Includes plastics, metals, and ores tied to industrial production. The value proposition is cost-effective transport for heavy, high-volume goods over long distances (400–500 miles), where rail is 10–15% cheaper than trucking.
2. Bulk (33% of revenue): Comprises commodities like grains, fertilizers, and coal. These are “captive” volumes with high pricing power due to limited transport alternatives for facilities located near UNP tracks.
3. Premium/Intermodal (30% of revenue): Primarily intermodal containers (standardized shipping boxes) and some automotive transport. Intermodal offers efficiency through standardized containers that transfer seamlessly between ships, rails, and trucks, though it has the lowest pricing power.

The value proposition lies in UNP’s ability to move heavy, low-value goods economically over long distances, leveraging its fixed infrastructure and oligopolistic market structure.

Segments and Revenue Model

UNP’s revenue model is segmented into Industrial, Bulk, and Premium/Intermodal, each with distinct dynamics:

• Industrial: Revenue is driven by contracts with manufacturers, with annual price increases of 3–4%. Volume is tied to industrial production cycles.
• Bulk: High-margin, captive business with pricing power due to geographic monopolies. Volume depends on commodity supply-demand cycles (e.g., coal has declined from 25–30% to high single-digit revenue share due to reduced coal usage).
• Premium/Intermodal: Lower-margin, competitive segment where UNP works through intermediaries like JB Hunt. Pricing is wholesale, with less control due to competition from trucking.

Revenue is generated by a mix of carload volume and dimensional pricing (based on weight and size), with heavier loads incurring higher fuel costs. Intermodal accounts for 50% of volume but only 25% of revenue, indicating lower pricing power.

Splits and Mix

• Channel Mix: UNP deals directly with producers for Industrial and Bulk segments, while intermodal involves intermediaries. No specific channel revenue split is provided.
• Geo Mix: Operates in the western two-thirds of the U.S., with key exposure to western ports (LA, Long Beach) handling 40% of U.S. imports.
• Customer Mix: Includes manufacturers, commodity producers, and intermodal operators. Bulk customers are captive, while intermodal customers have more options.
• Product/Segment Mix: Industrial (35%), Bulk (33%), Premium/Intermodal (30%). Historical shift from coal (25–30% to high single digits) to intermodal (25% to 50% of volume).
• End-Market Mix: Tied to industrial production (35%), commodity cycles (33%), and consumer economy (30%).

No specific EBITDA splits are provided, but Bulk likely contributes the highest margins (45–50%), followed by Industrial (40–45%), and Intermodal (35–40%). The mix shift toward intermodal has reduced overall margins due to its lower profitability.

KPIs

• Operating Ratio (OR): Key metric (1 – operating margin). UNP’s OR has improved from ~90% (10% margins) in the early 2000s to ~60% (40% margins) today, driven by precision scheduled railroading (PSR).
• Volume Growth: Flat to declining in recent years, with intermodal offsetting losses in coal and other bulk commodities.
• Pricing Growth: 3–4% annual increases in Industrial and Bulk, less in Intermodal.
• Recent Performance: UNP cut volume guidance recently due to supply chain issues and economic slowdown, indicating potential deceleration.

Headline Financials

UNP’s financials reflect its high-margin, capital-intensive nature:

Long-Term Trends:

• Revenue growth is modest due to flat volumes, reliant on pricing power.
• EBITDA margins have expanded dramatically (10% to 40%) through cost efficiencies.
• FCF conversion has improved, supporting higher shareholder returns.

Value Chain Position

UNP operates midstream in the freight transport value chain, between suppliers (e.g., commodity producers, manufacturers) and customers (e.g., retailers, exporters). Its primary activities include:

• Inbound Logistics: Receiving goods from producers at rail yards.
• Operations: Moving goods via locomotives and rail cars across 30,000 miles of track.
• Outbound Logistics: Delivering goods to customers or intermodal handoff points (e.g., ports, truck facilities).
• Service: Managing schedules, demurrage fees, and customer contracts.

UNP’s go-to-market strategy involves direct contracts with Industrial and Bulk customers and wholesale pricing with intermodal operators. Its competitive advantage lies in its fixed infrastructure (tracks), which is nearly impossible to replicate due to land ownership and regulatory hurdles.

Customers and Suppliers

• Customers: Manufacturers (Industrial), commodity producers (Bulk), and intermodal operators (e.g., JB Hunt). Bulk customers are captive, while intermodal customers are price-sensitive.
• Suppliers: Fuel providers, locomotive/rail car manufacturers, and maintenance contractors. UNP owns 60% of its rail cars and leases the rest, partly through TTX, a shared industry entity that lowers costs.

Pricing

Pricing is based on carload volume and dimensional weight, with 3–4% annual increases for Industrial and Bulk contracts. Intermodal pricing is less flexible due to competition. Contracts are typically annual, with longer-term commitments for speculative volumes. Demurrage fees for delays enhance revenue. Pricing power is strongest in Bulk due to captive volumes, weaker in Intermodal.

Bottoms-Up Drivers

Revenue Model & Drivers

UNP generates revenue through:

• Industrial: Contract-based, tied to industrial production. Price increases (3–4%) and volume growth drive revenue.
• Bulk: Captive, high-margin business. Revenue depends on commodity cycles (e.g., coal decline, grain cycles).
• Intermodal: Wholesale pricing through intermediaries. Volume-driven, with 50% of total volume but only 25% of revenue due to low pricing power.

Revenue Drivers:

• Price: 3–4% annual hikes in Industrial/Bulk; limited in Intermodal. Driven by captive volumes, mission-criticality, and low price elasticity in Bulk.
• Volume: Flat overall, with intermodal growth offsetting coal declines. Tied to industrial production, commodity cycles, and consumer demand.
• Mix: Shift to intermodal (lower margins) has reduced blended margins. Coal’s decline has been a drag, though intermodal supports volume.

Cost Structure & Drivers

UNP’s cost structure is:

• Variable Costs:
• Fuel: ~10% of revenue (down from mid-teens). Improved through longer trains and fewer stops.
• Purchased Transportation: ~20% of revenue (down from 25%). Includes intermodal handoffs and equipment costs.
• Fixed Costs:
• Labor: ~20% of revenue (down from 30%) due to PSR (longer trains, fewer stops, job cuts).
• Depreciation & Amortization (D&A): ~10% of revenue. Low due to long asset lives (tracks, locomotives).
• Maintenance: Significant but not quantified, tied to track and equipment upkeep.

Operating Leverage: High fixed costs (tracks, locomotives) create strong operating leverage. Margin expansion from 10% to 40% reflects reduced labor and fuel costs as a % of revenue. Incremental margins are high, but further cost cuts face diminishing returns.

EBITDA Margin: ~40%, driven by:

• Revenue growth (pricing power).
• Cost reduction (labor down 10%, fuel down 5–10%, purchased transportation down 5%).

FCF Drivers

• Net Income: High margins drive strong earnings.
• CapEx: 10–15% of revenue, reduced recently but still significant. Maintenance CapEx dominates; growth CapEx is limited.
• NWC: Not detailed, but rail’s cash conversion cycle is favorable due to upfront payments and demurrage fees.
• FCF Conversion: Improved to ~100% of earnings from 80%, reflecting lower CapEx and higher margins.

Capital Deployment

• Dividends: 45% of net income, yielding ~2.25%.
• Share Buybacks: ~3% of market cap annually, contributing to 5–6% total cash return.
• M&A: No recent activity noted; focus is on organic efficiency.
• Leverage: Increased to ~2x net debt/EBITDA, supporting buybacks and dividends.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Market Size: North American freight transport is a $900 billion market, with rails comprising ~10% ($90 billion). UNP’s share is significant within the western U.S.
• Growth: Low single-digit, driven by pricing (3–4%) rather than volume. Intermodal volume has grown, offsetting declines in coal and other bulk commodities.
• Industry Growth Stack: Tied to GDP (historically correlated), industrial production, and consumer demand. The shift to a services economy since 2015 has weakened this correlation.

Market Structure

• Oligopoly: Six Class I railroads dominate 95% of rail revenue and 75% of volume. UNP and BNSF form a western duopoly, with CN/CP in Canada and CSX/Norfolk Southern in the east.
• Barriers to Entry: Extremely high due to track ownership, land rights, and regulatory hurdles. New track costs $75,000 per mile, and easements are nearly impossible.
• MES (Minimum Efficient Scale): Large, favoring incumbents. The market supports only a few players at efficient scale.
• Cyclicality: Less cyclical than trucking or air freight due to captive volumes and pricing power, though recent volume cuts indicate exposure to economic slowdowns.

Competitive Positioning

UNP is a premium operator in the western U.S., focusing on high-margin captive volumes (Bulk) and efficient intermodal transport. Its PSR strategy prioritizes profitability over volume, unlike BNSF, which maintains a customer focus and higher volumes at lower margins (35% vs. UNP’s 40%).

Market Share & Relative Growth

• UNP has lost 400–500 basis points of market share to BNSF over the past decade due to its margin focus.
• Volume growth lags the market due to PSR’s emphasis on profitability over volume capture.

Competitive Forces (Hamilton’s 7 Powers)

1. Economies of Scale: Strong, with high fixed costs (tracks, locomotives) spread over large volumes. MES is large, deterring new entrants.
2. Network Effects: Limited, but track ownership creates a “flywheel” where captive customers reinforce UNP’s dominance.
3. Branding: Minimal; rail is a commodity service, though reliability enhances reputation.
4. Counter-Positioning: PSR is a superior business model, focusing on efficiency. BNSF’s volume focus is less profitable but attracts less regulatory scrutiny.
5. Cornered Resource: Track ownership and land rights are unique, non-replicable assets.
6. Process Power: PSR (longer trains, fewer stops) drives unmatched efficiency, pioneered by Hunter Harrison.
7. Switching Costs: High for Bulk customers (captive to UNP tracks), low for Intermodal (competitive market).

Strategic Logic

• PSR: Focus on efficiency (longer trains, fewer stops, less labor) has driven margin expansion but risks network degradation and regulatory scrutiny.
• Capital Allocation: Prioritizes shareholder returns (5–6% cash yield) over network reinvestment, unlike BNSF’s long-term focus.
• Vertical Integration: Limited; UNP focuses on core transport rather than owning suppliers or customers.
• Horizontal Expansion: No significant M&A; growth is organic through pricing and efficiency.

Valuation

UNP trades at ~20x earnings, implying a 5% FCF yield. Its $140 billion market cap reflects strong margins and stable cash flows, though recent volume cuts suggest near-term challenges. Returns on invested capital are low teens, up from high single digits, indicating capital intensity. The stock’s outperformance (2005–2020) stems from margin expansion and share buybacks, but future growth depends on volume recovery and regulatory stability.

Key Dynamics and Unique Aspects

UNP’s business model is unique due to:

• Oligopolistic Structure: The western duopoly with BNSF, enabled by consolidation post-Staggers Act (1980), grants significant pricing power, especially in Bulk.
• Captive Volumes: Bulk customers (33% of revenue) are tied to UNP tracks, creating monopoly-like economics (45–50% margins).
• Precision Scheduled Railroading (PSR): Pioneered by Hunter Harrison, PSR’s focus on longer trains, fewer stops, and reduced labor has transformed margins from 10% to 40%. UNP’s adoption, led by Jim Vena, underscores its shareholder focus.
• Intermodal Growth: Despite lower margins (35–40%), intermodal’s 50% volume share reflects its role in offsetting coal declines and capturing import/export flows (40% of U.S. imports via western ports).
• TTX Entity: A shared rail car pool lowers costs (200 basis points margin savings) through off-balance-sheet financing, a rare industry collaboration.
• Regulatory Dynamics: The Surface Transportation Board’s light oversight (shippers must initiate rate cases) enables pricing power, though shipper pushback is growing.
• Capital Intensity vs. FCF: Despite high CapEx, improved FCF conversion (100%) and leverage (2x) support robust shareholder returns (5–6% cash yield).

Critical Observations:

• PSR’s efficiency gains risk network degradation and customer dissatisfaction, potentially inviting regulation.
• The shift to intermodal, while volume-supportive, dilutes margins due to lower pricing power.
• UNP’s shareholder focus contrasts with BNSF’s customer-centric approach, raising questions about long-term sustainability vs. regulatory risk.
• The business is less cyclical than peers due to captive volumes, but recent volume cuts highlight economic exposure.

Conclusion

Union Pacific’s business model leverages its oligopolistic position, captive volumes, and PSR-driven efficiency to deliver high margins (40%) and strong FCF (~20% margin). Its unique dynamics—track ownership, TTX, and regulatory light-touch—create a defensible moat, though risks include regulatory scrutiny, network capacity, and intermodal competition. The model prioritizes profitability over volume, distinguishing it from peers like BNSF and underscoring its shareholder-centric strategy.