1. Reasons for Recommendation

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1 Recommendation: BUY Target Stock Price (12/31/2015): $ Reasons for Recommendation Union Pacific Corporation will continue to lead the railroad industry in the years to come with continuous expansion of railroad network and increased operational efficiencies. The global and domestic economy greatly affects the performance of the company; overall economy condition is expected to improve over the period of interest. Increasing U.S. population, improvement in consumer spending and rising manufacturing activities in Mexico will create opportunities for Union Pacific to expand and generate revenues. Positives The volume of freight transported by Union Pacific will continue to grow. Freight volumes depend heavily on the overall economic conditions. For example, shipment of raw material depends on the industrial production index, coal shipments depends on the demand of coal and the prices of natural gas and other alternative sources of energy. There has been a gradual recovery from the recession in and the trend is expected to continue, industrial production has increased, unemployment rate has decreased below 6%; consumer s confidence in recovery has been on the rise and consumer spending has also increased. The production and sales of automotive and automotive parts have been strong. UNP is the largest automotive carrier west of the Mississippi river and has access to more than 40 vehicle distribution centers. The volume of agricultural products has increased due to strength in the domestic grain market and strong corn exports. Volume and revenue from business with Mexico has been increasing because Union Pacific is the only company to serve all six major Mexican gateways. The company is well positioned to take advantage of increasing manufacturing activities in Mexico. Union Pacific is committed to make their railroad network safe and reliable. Positive Train Control (PTC) is a federally mandated set of technology, which helps to monitor and control the movement of the train to provide increased safety. The company is expected to implement PTC by the end of The investment made in technology by the company not only enhance the safety but also increase operational efficiencies and help reduce costs. Cost reduction and improved operation ratios contribute to higher operating income and higher net income. Earning per share is expected to grow over the period of interest. Since EPS is expected to grow in the future, we can also expect higher dividend yields. Union Pacific will continue to enjoy high-entry barriers of the industry; new railroad operators cannot easily enter the market. The railroad industry is technologically sophisticated and very capital intensive; ability to raise capital, debt servicing and maintaining liquidity is very important to remain competitive. The company has been successful to utilize its internal sources i.e. cash, cash equivalents, receivables securitization facility and revolving credit facility combined with capital market instruments to source necessary financing and liquidity. The company maintains moderate working capital surplus, which signals a strong cash position and enhanced liquidity. The company will continue to have ample access to capital markets to meet any foreseeable cash requirements. 1

2 Negatives Fuel expense is the significant cost of Union Pacific. Rising fuel costs will pose a threat on the profit margins of the company in the future. Oil price is low at the moment but this trend is not expected to continue for a long period of time. Winter demand will kick in soon which will reduce the stockpile of fuel and in turn increase the fuel price (Passey, 2014). Currently fuel costs are passed to customers in the form of fuel surcharges but transferring the increased costs to customers is a temporary solution of the problem. Change on government policies on how the company can charge fuel surcharges to its customer could result in significant rise in cost of operation of the company. The company should continue to invest in fuel-efficient locomotives to guarantee steady margins and protect itself against change in market conditions and government policy changes. Negative impacts of climate change will continue to affect the smooth operation and revenues generated by the company. Weather patterns have changed in past few decades; long severe winter and major floods cause network delays and increased costs. Weather events like drought could result in significant decrease in volume of agricultural products thereby decreasing the revenue generated from agricultural commodity group. A significant decrease in volume of grain shipment due to drought in 2012 and decreased overall freight volumes in the first quarter of 2014 due to long severe winter are recent instances of weather related losses incurred by the company. Fluctuating demand is another major problem faced by the company. Some commodities transported by the company have peak shipping season, which puts pressure on the designated capacity of their network. The company will continue to face the challenge to accommodate the fluctuating demands without compromising the level of service. 2. Company Analysis Union Pacific Corp. (UNP) is the leader of the railroad transportation industry in America The company has vast 31,838 route miles of railroad network linking Pacific Coast to Gulf Coast ports with the Midwest and Eastern U.S. gateways and providing several corridors to key Mexican gateways and Canadian border. Union Pacific Railroad Company (UNRR) is the main subsidiary of the company. UNP has integrated all the subsidiaries to function as a single operating segment due to the integrated nature of their rail network. The revenues generated by the company are reported by commodity groups. There are six major commodity group i.e. agricultural, automotive, chemicals, coal, industrial products and intermodal. Union Pacific has continued to increase its profitability with the help of its outstanding management, use of technology and cost reduction. The operating ratio for 2013 was 66.1%, an all-time best and an improvement from previous year s operating ratio of 67.8%, despite the increase in operating costs due to bad weather conditions during the year. Freight revenues accounted for 94.17% of total revenues generated by UNP. Intermodal commodity group contributed the highest (20%) of total freight revenue, Coal (19%), Industrial products (18%), Chemicals (17%), Agricultural (16%) and Automotive (10%). Other revenues included revenues from operation of commuter rail and storage or switching. These revenues are reported when the company performs services or meet contractual obligations. Union Pacific Corp. has a strong brand recognition and large customer base. Their commitment to transport freight with most reliable railroad network and efficient operation has made them key player of the industry. The continued investment in technology has tremendously helped them to 2

3 improve their operating efficiency. UNP s patented intermodal container called Arrowedge, which is designed to reduce wind resistance thereby increasing the efficiency, is an example of their continued commitment to provide world-class service reinforced with advance technology. The huge railroad network of the company, which has better connection with Canadian border and Mexican gateways, provides comparative advantage over their competitors. The freights transported by the company are very diversified; the revenues do not suffer significantly if transportation of any commodity product decreases due to various global and domestic market conditions because revenues are not dependent on a particular commodity. Union Pacific is dependent on few key suppliers of their high-tech locomotives. Due to the capital-intensive nature and highly advanced technology requirements new suppliers cannot enter the market. If the few major suppliers go out of business or will not able to supply the locomotives, it could result in significant rise in costs and operational difficulties. Unionized work force is one of the weaknesses of Union Pacific Corporation. Majority of Union Pacific s employee belong to labor unions and labor agreements. Inability to negotiate acceptable contracts could result in higher labor costs. Significant pension obligations and discrepancies between planned and actual expenses in pension funds in the past had forced the company to contribute additional cash to bridge the gap. Revenues from business with Mexico increased 9% to $2.1 billion in Union Pacific is the only railroad operator that serves all six major gateways to Mexico. The company is in an excellent position to benefit from growth in automotive production and manufacturing activity in Mexico. Union Pacific currently touches two-thirds of the goods crossing border by rail transportation and is positioned uniquely to meet the forecasted demand in Mexico. Rising labor costs and economic slow down in China has fueled the growth of automotive production and manufacturing in Mexico. The overall improvement of global economy creates opportunities for Union Pacific to expand and serve more markets. Rising fuel costs, government regulations and environmental concerns due to the shipment of hazardous material are the major threats of the company. Lower costs of fuel in the future may not necessarily help the company because it could make convenient mode of transportation like trucking industry more lucrative to the customers. The company and the railroad industry as a whole are regulated at various levels by local, state and federal governments. Violation of regulations could result in costly litigation and settlement fees. A portion of the shipment from diverse product mix that Union Pacific transports includes transportation of hazardous material. Potential leakage, combustion or exposure of the hazardous material like chlorine and crude oil during the process of transportation could result in significant costs to cover personal injuries, property damage and environmental penalties. 3. Industry Analysis The railroad industry has been operating for more than 180 years in the US. It has played key role in stimulating economic development and revolutionizing transportation by connecting thousands of American communities to the global markets (Freight Rail, 2011). Railroad industry includes large railroad companies (Class I railroads) and regional and local line-haul railroads that carry bulk freight and passengers. Scenic and sightseeing rail transportation, street railroads and, commuter rail or rapid transit rails are not included in this industry. 3

4 There are 575 businesses in the industry. The railroad industry is highly concentrated with top four companies controlling 88.3% of total industry revenue in Union Pacific Corp. has the largest market share of 29.6%, followed by Burlington Northern Santa Fe Corp. at 28.3%, CSX Corp. at 15.6% and Norfolk Southern Corp. at 14.8% (Rivera, 2014). Seven Class I railroad companies dominate the industry with extensive railroad network and efficient operations. The companies that generate a minimum of $250 million in carrier operating revenue annually are categorized as Class I railroad companies. There is a high barrier of entry in this industry because it requires continuous source of capital to lay new railroad network and purchase locomotives. According to American Association of Railroad (AAR), $525 billion has been reinvested to expand railroad networks since 1980 to present day. For every dollar of revenue generated, $0.40 is reinvested (Rivera, 2014). Despite the huge capital expenditures, the industry will continue to be attractive due to the increasing revenues. The industry is forecasted to generate $79.4 billion in revenue and $13.6 billion in profits for the fiscal year 2014, a growth of 3.4% from last year (Rivera, 2014). Majority of the revenue (95.4 %) is derived from freight services in the railroad industry. Freight service is further divided into bulk and intermodal freight service. The process of transporting unpackaged commodities in large quantities is called bulk freight. Intermodal services transports commodities in large intermodal containers, the freight is not required to change the container when the mode of transportation changes. Intermodal freight has become increasingly popular in past two decades due to the efficiency and decreased risk of goods being damaged. Intercity passenger contribute 2.9 % of total industry revenue, Amtrak is the sole provider of passenger service across the country. Other services are the integrated transportation services, which provide door-to-door delivery services by using multiple modes of transportation in domestic and international markets. Integrated services make for 1.7% of total revenue for the industry. Commodities transported by the industry are agricultural products, chemicals, coal, industrial goods and consumer goods. Industrial products will generate 22.3% of total industry revenue in Coal is the most transported bulk freight accounting for 41% of total tonnage and 20.9% of industry revenue. Chemical products, which includes crude oil, plastics and soda ash accounts for 13.5 % of revenue. Food and consumer goods contribute 7% of revenue and residual revenue is generated from miscellaneous mixed shipments. Industry revenue is highly influenced by import and export volumes. The railroad industry is not directly involved in import and export of commodities but the industry s largest markets are export-oriented. Similarly, railroads are used to transport imported goods to various domestic markets. The industry is in the growth stage of its life cycle and has positive long-term outlook. The revenue for the railroad industry is expected to grow at an average rate of 3.4% to $94 million in the next five years to 2019 (Rivera, 2014). Due to the capital expenditures made in last few years, profit margins are expected to increase. Industry margins are projected to reach 18.6% of revenue from 17.1 % in The increasing population, higher consumer spending and improvement in labor markets will increase demand for the railroad transportation. Large railroad companies will expand through acquisitions of small and regional railroads as the economy recovers and profit margins improve. Railroads will continue to be integrated with other modes of transportation to provide customers with door-to door solutions. Fuel prices, the key driver of costs in the industry are expected to increase by marginal 0.2% in the next five years. Higher volume will result in an increase of employees at an average rate of 3.2% over the same period. Freight volumes are expected to increase by 88% in 2035 compared to freight levels in Railroad industry s growth depends on expensive infrastructure; as the 4

5 demand continues to increase, the industry growth will suffer due to limited capacity. Huge capital expenditures will continue to service demand. The use of advanced technology for cost reduction and efficient operation, effective risk management, premium products, world-class customer service and ability to raise capital will be the key success factors of the railroad industry. Appendix: Inputs into valuation using multiples 2007 A 2008 A 2009 A 2010 A 2011 A 2012 A 2013 A 2014 F 2015 F Stock Price $63.70 $48.85 $64.31 $91.08 $ $ $ $ $ Diluted EPS $3.46 $4.54 $3.74 $5.53 $6.72 $8.27 $9.42 $5.04 $5.46 Sales (millions) $16,283 $17,970 $14,143 $16,965 $19,557 $20,926 $21,963 $23,830 $25,379 Sales per share $30.33 $34.89 $27.96 $33.73 $39.93 $43.92 $47.15 $26.34 $28.38 P/S P/E * Analyst s own calculations. Source of basic data: UNP s 10-K, Yahoo! Finance 5

6 Reference Freight Rail. (2011). Retrieved November 1, 2014, from Rivera, T. (2014). IBISWorld Industry Report Rail Transportation in the US. Retrieved October 12, 2014 from IBISWorld database Rail Industry Trends ArticleRail Outlook 2014: Railroads believe burgeoning crude oil demand and mounting passenger ridership will be foundation for 2014 business growth. (n.d.). Retrieved November 1, Industrial Production and Capacity Utilization - G.17. (2014, October 16). Retrieved November 3, Passey, J. (2014, October 13). Oil should stay cheap for at least a few months. Retrieved November 19, 2014, from 6