Union Pacific Corporation Stock Pitch (NYSE:UNP)

Industrials

December 13, 2014

Presentation Overview

Industry Overview
Company Overview
Investment Thesis I: Leading Railroad Franchise
Investment Thesis II: Growth Opportunities in Mexico
Investment Thesis III: Investing for the Future
Catalyst & Risks
Valuation

United States Railroad Industry Overview

The Railroad Industry is Defined by High Concentration, Strong Barriers to Entry, and Stability
Railroad growth is driven by a strong economy and growing population, with manufacturing and coal mining heavily influencing
freight volumes. A growing population leads to both increased demand for goods and increased imports that will ultimately be
shipped to their destination by rail. Bulk freight and intermodal services account for 54% and 41% of total carloads, respectively
Rail transportation within the United States is highly concentrated, with four players of the 575 total railroads accounting for ~88%
of the $79 billion revenue achieved thus far in 2014. This reflects the dominance of the Class I railroads and high barriers to entry
within the railroad industry. Currently, seven Class I railroads operate in the United States, down from more than forty in 1980
Railroads have benefitted as one of the strongest modes of transportation in recent years due to cost cutting, fuel efficiency, and
mobility. Railroads are four times more efficient than trucks and emit 75% less greenhouse gases
Capacity overloads in other transportation industries have led to the delivery of goods that were not previously shipped by rail, such
as crude oil within the United States. Carloads carrying crude oil jumped four-fold from 66,000 in 2011 to 300,000 in 2013
Rail transportation is privately funded, meaning capital investment is not directly linked to U.S. government budget constraints.
Since 1980, $525 billion of private funds ($0.40 per dollar generated through operations) has been reinvested in the rail network

United States Market Share

Total Industry Revenues ($B)

Other
12%

$100.0

UNP
30%

NFS
15%

$90.0
$80.0
$70.0
$60.0

CSX
16%
BNSF
28%
Sources: IBIS World

$50.0
2005

2007

2009

2011

2013

2015E 2017E 2019E

Railroad Cost and Competition Breakdown

Costs
Fuel: Railroads have a significant advantage over truckers
because of their ability to implement fuel surcharges,
essentially passing excessive costs on to customers. They
are correlated to the cost of the freight being shipped and
were used in 2009 to compensate for declining profits
Wages: Investment in R&D has resulted in automation
that has led to less reliance on labour. Wages as a
percentage of revenue have decreased from 33.3% in
2009 to 26.1% in 2014. Labour productivity has also
improved, evidenced by rising revenue per employee
Depreciation: Depreciation expenses, relating to road
property and track materials, has risen in recent years to
7.3% of revenues due to strong infrastructure investment
and more fuel-efficient locomotive purchases

Barriers to Entry

Cost Breakdown
Profit
17.1%

Wages
26.1%

Other
16.9%
Marketing
1.0%
Depreciation
7.3%
Rent & Utilities
9.5%

Purchases
22.1%

Operations by Segment

Capital: Large amounts of capital are required to establish

a railroad network and purchase locomotives. According
to AAR, railroads typically have a capex-to-revenue ratio
of 17%, compared to 3% for U.S. manufacturers
Acquisitions: Class I railroads dominate the industry and
acquisitions of smaller, regional railroads are becoming
more common. Recently, CP Railway attempted to merge
with CSX, but a merger of this scale is unlikely to be
approved by the U.S. DOT due to industry structure
Internal Competition: Railroads compete on travel time,
fuel consumption, safety, regulations, and destinations. It
is difficult, if not impossible, to replicate the level of
competition that railroads currently operate at
Sources: IBIS World

Company Overview I
Business Overview and Recent Highlights
Union Pacific Corporation (UNP) operates one of the two largest railroads in North America that serve the western two-thirds of the
United States. The railroad operates on 31,868 route miles across 23 states, connects every West Coast and Gulf Coast port, and
serves the Chicago, Memphis, New Orleans, and St. Louis gateways. It is the primary link between the United States and Mexico
Headquartered in Nebraska and incorporated in Utah in 1969, UNPs story dates back to 1862 when President Lincoln approved the
Pacific Railway Act, providing for the construction of railroads from the Missouri River to the west coast as a war measure
The railroad has grown to become the largest in terms of its $100+ billion market capitalization and achieved revenues of $21.9
billion in 2013. EPS has grown at a 23% CAGR from $1.42/share in 2004 to $9.42/share in 2013. The railroads main competitor is
Burlington Northern Sante Fe Railway, now a subsidiary of Berkshire Hathaway
UNP has one of the most diverse commodity mixes in the industry. They are the largest hauler of chemicals and a top intermodal
carrier. Despite recent slowdowns, coal is one of the fastest growing segments and currently accounts for 19% of revenues
Between 2004 and 2013, $30 billion was invested in its rail network and operations. Since overcoming operating challenges in 2006,
UNP has successfully focused on cost-cutting and raising prices. In 2015, $300+ million of legacy contracts will be re-priced.
Additionally, they will be able to operate with higher rates than competitor BNSF due to their capacity constraints

2014E Revenue by Segment

Forest
Products
9.7%

Automotive
9.4%

Relative Performance
Intermodal
20.1%

150
140

140

130

Metals &
Minerals
9.7%

Chemicals &
Petroleum
16.4%

160

129

120
Coal
18.0%

Agriculture
16.6%

Sources: Bloomberg, Company Reports, IBIS World, UBS Securities

110

112

100

90
12-Dec-2013
UNP

12-Apr-2014

12-Aug-2014

S&P 500 Rail Index

12-Dec-2014

S&P 100 Index

Company Overview II
Rail Network

Track and Terminal Density*

2013 Freight Traffic Carloads

Comparison to Rival Networks

Manifest
26%

Premium
45%

Bulk
29%
Sources: Company Reports

*Lane density is based on carloadings. Line thickness depicts traffic density

Company Overview III

Recent Developments and Outlook
On October 23, Union Pacific reported an 11% YoY increase in operating revenue to $6.2 billion in Q3 2014 and a 7% YoY volume
increase
The company recorded a decline in its operating ratio to 62.3% of revenue, an all time low, due to lower diesel fuel prices, a lower
fuel consumption rate, and slower growth in equipment and rental costs
A 10% YoY decrease in average train velocity to 23.8 mph and a 13% YoY increase in terminal dwell to 29.7 hours were offset by
network expansions and volume increases
As rail becomes an increasingly popular mode of transport management anticipates significant volume increases. Network
performance will be a continual challenge over the coming five years as regulation hampers opportunities for velocity
improvements and congestion along central network corridors increases. Network interruptions increased by approximately 91%
YoY in Q3 2014 to 84 days where incidents causing delays of more than 50 operating hours occurred
Going forward, UNP is planning to invest heavily in track improvements and network expansions to support growth; forecasted
capital expenditures for 2014 are $4.1 billion, up approximately 14% YoY. Management plans to increase expenditures to between
16-17% of revenue by 2019

Management Team
Jack Koraleski, Chairman & CEO
Joined UNP in 1972 and promoted to CEO in
2012 after serving in various senior leadership
roles. Elected as Chairman in 2014

Holdings as a Multiple of Salary

Jack Koraleski, CEO

153.54x

Lance Fritz, COO

78.90x

Robert Knight Jr., CFO

71.57x

Diane Duren, VP HR

40.80x

Lance Fritz, President & COO

Elected President and COO in 2014, having
previously served as the Executive VP of
Operations. Prior work includes a role at GE
Sources: Company Reports

Executive compensation is appropriately linked to stock

performance, aligning managements incentives with
shareholder interests
7

Company Overview IV
Operating Ratio

Return Metrics (ROA Top, ROE Bottom)

100%

12.0%

90%

9.0%

80%

6.0%

70%

3.0%
62%

60%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 LTM

UNP

CNR

CP

NSC

KSU

CSX

10.30%

0.0%
25.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 LTM
23.30%

20.0%

History of Creating Shareholder Value

15.0%

$3.00

$7.50

$2.25

$6.50

$1.50

$5.50

10.0%
5.0%
0.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 LTM
$0.75

$4.50

$0.00

$3.50

2011

2012

Buybacks ($B) (LHS)

Sources: Capital IQ, Company Reports

2013

2014

Adjusted Dividend per Share (RHS)

UNP

CNR

CP

KSU

NSC

CSX

Union Pacific has improved its core operating metrics over

the past decade to become an industry leader, solidifying its
place as the best tier-1 U.S. railway

Investment Thesis I: Leading Railroad Franchise

Three-Pronged Advantage
Broad Network

Broad Network

Value
Creation

UNPs unique, broad and extensive network not only

creates a competitive advantage from a logistical
standpoint (getting from point A to point B) but creates a
natural hedge against commodity risk, given the wide
variety of cargo they ship

Cost
Efficiencies

Areas of Focus Next 5 Years

Cost Efficiencies
With the lowest operating ratio in its class and industryleading metrics in net profit margin, return on equity and
asset turnover, management has been able to successfully
leverage their huge asset base to drive revenues and
manage costs well enough to be able to drive margin
expansion as much as revenue growth
Value Creation
Apart from margin expansion and solid growth, UNP
focuses on returning value to shareholders in a multitude
of ways. During the last five years, their dividend per share
growth rate has been 31% (21% in the last ten years) while
its ten-year buyback ratio* is ~2.5, better than almost
every other railroad company. These go to exemplify
managements focus on consistently impressing investors
with additional value year after year
UNPs stellar network, its ability to manage costs efficiently
and its willingness and success in returning value to
shareholders have led it to become the leading railroad
franchise in the United States and should continue to be
differentiating factors moving forward

Sources: Company Reports

Investment Thesis II: Growth Opportunities in Mexico

Best-in-Class Access and Growing
Currently serving every Major Gateway
UNP serves all six major gateways between the United
States and Mexico, controlling 65% of the flow between
the two countries. Mexican cross-border traffic accounted
for 10% of UNPs volume in 2013
Already has 26% Minority Interest in a Mexican Railroad
An opportunity for growth may come in the form of an
acquisition within Mexico, as they do not currently operate
within Mexican borders. Kansas City Southern operates
one of the two largest railroads in Mexico, and UNP has a
26% minority interest in Ferrocarril Mexicano (FXE),
leading us to believe this stake could be increased
Rising Foreign Direct Investment in Automotive Sector
Of the $35 billion in foreign direct investments in 2013,
75% was invested in the manufacturing sector with a large
proportion allocated to the automotive production
expansion. Last year, 82% of the 2.9 million automobiles
produced in Mexico were exported, ranking Mexico as the
worlds fourth largest automotive exporter. Prominent
automobile manufacturers such as Audi, Honda, and GM
have decided to invest in Mexico, and automobile
production is expected to reach 4 million in 2017
Longer-term growth may even come from Mexicos energy
sector, with the 2013 energy reform allowing the government
to grant E&P licenses to multinational firms

Sources: Company Reports, Credit Suisse

2013 Cross-Border Carload Mix

Chemicals Coal
6%
1%
Industrial
Products
11%

Autos
47%

Agriculture
12%

Intermodal
23%

Mexican Share of U.S. Exports

Canada
16%

Mexico
11%

Other
62%

China
7%
Japan
4%

10

Investment Thesis III: Investing for the Future

Investing for the Future

Spending Discipline

Eyeing Efficiency Improvements

$12

UNP is looking to improve its operating margin going

forward; regulation and congestion have led to dwell time
increases and velocity decreases.
The company is engaged in a joint effort to invest close to
$4 billion for debottlenecking and route expansion
along the Chicago corridor. It expects that this will help
yield an outwards shift in its service-volume line that will
make it possible to improve velocity while handling
forecast volume increases

$9
$6
$3
$0
Q4
2012

Energy and Intermodal Opportunities

Despite current market downturns, UNP is investing in
capacity for the energy industry. While the company
anticipates crude shipments to decline, it forecasts strong
opportunity to ship frac sands to shale fields
The company opened a new intermodal facility in New
Mexico in April and continues to invest in intermodal
networks in order to be truck-competitive
Focus on Strategic Investments
ROIC increased to 14.7% in 2013 from 10.8% in 2010

The company has increased capital investments to ~$4.0

billion this year from $2.5 billion in 2010. The bulk of new
expenditures were allocated to increasing capacity,
technology, and positive train control with little real
change to infrastructure spending
Target capital expenditures between 2014-2019 is 16%17% of revenues
Sources: Company Reports

Q1
2013

Total Debt ($B)

Q2
2013

Q3
2013

Q4
2013

Q1
2014

Free Cash Flow ($MM)

Q2
2014

Q3
2014

Capex ($MM)

Key Operating Metrics

32

27

30

26

28

25

26

24

24

23
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
2012 2012 2012 2013 2013 2013 2013 2014 2014 2014
Average Dwell Time (HRS)
(LHS)

Average Velocity - All Trains (MPH)

(RHS)

11

Catalysts & Risks

Catalysts

Risks

1) Spending to save

1) Concerns over Industry Consolidation

Capital expenditures made over the previous few

years and the replacement of older, less fuelefficient locomotives should provide a boost to
UNPs profit margin. $3.6 billion was spent on its
network in 2013 and $1 billion was spent on
growth opportunities in capacity, commercial
facilities, and equipment
2) Traffic Gains from BNSF and Trucks
BNSF has experienced slower train speeds (velocity
has fallen 23%) and capacity constraints, while UNP
has seen a modest decline in velocity. Combined
with rising fuel prices, UNP will likely see market
share gains from BNSF and trucking, and have the
opportunity to raise prices
3) Rising Fuel Prices
Crude oil is a major component in diesel fuel and
drives fuel expenses. Operators generally
implement surcharges to pass the costs on to
customers. When oil prices rise, truckers become
less attractive and goods are then shipped by rail

Sources: Company Reports, IBIS World, UBS Securities

Although the recent proposed merger of CP

Railway and CSX did not follow through, there is a
risk that UNPs dominant track network could
come under increased competition. Risk is
somewhat mitigated as any consolidation is likely
to only be achieved by Class I railroads purchasing
smaller, regional railroads
2) Fewer Opportunities to move Crude-by-Rail
UNPs crude-by-rail volumes have declined over
the past year and the pipeline for growth does
not look as favourable relative to its competitors.
Its largest market of Bakken oil is expected to
remain under pressure in the near-term
3) Unfavourable Regulatory Environments
Given increased government scrutiny of
derailments and spills, regulation over train
velocities when passing through city centres is
anticipated. Major rail corridors are already
crowded increased regulation could further slow
cargo movement, leading to inefficiencies causing
losses

12

What is the Likelihood of Industry Consolidation?

Short-term? No Longer-term? Maybe
- Industry CEOs are pessimistic on the case for
consolidation, at least in the near term. The outcome of a
CP-CSX merger would result in additional bidding wars
between BNSF and UNP, and like Mr. Mongeau stated, the
likely outcome would turn four major railways into two
- Both UNP and BNSF have the ability to pressure the U.S.
DOT through political influence. They are the two largest
U.S. railroads and are among the top three political
contributors to the railroad industry (second to AAR).
Rather than turning this into a bidding war, they would
likely influence the outcome through political pressure
The likelihood of industry consolidation in the near-term is
slim, but longer-term we may see even larger-scale mergers

Potential Rail Network Combinations

What the Players are Saying

CSX
in the past mergers there have been severe service
disruptors.
NSC
It is highly problematic for three reasons Putting these big
companies together is very difficult and at least historically a
lot of mergers were justified because of significant synergies.
You can save some money, yes, but its not necessarily order
of magnitude that it used to be. And most important I think it
would go into the face of a regulatory environment which is
not receptive in any way to major combinations.

UNP
I am not convinced that merging is the way you solve
service issues in this industry. When you look ahead to the
regulatory hurdles the new rules basically say that any
combination is going to have to enhance competition. And
secondly, that they will consider the triggering effects of
additional consolidations.
CNR
If there was a merger, I believe there will be network effects
and I believe it would likely start with the four railroads in
the U.S. going down to two.

Sources: Bernstein Research

13

Valuation: Comparable Companies

Comparable Companies
Railroads
Company Name

EV / EBITDA

Dividend
Yield

LTM

2014E 2015E

FCF
Yield

2014E

2015E

11.1x
11.7x

1.3%
0.7%

24.6x
30.0x

19.9x
24.1x

17.4x
18.2x

2.3%
0.5%

1.4x
1.6x

1.2x
1.3x

9.1x
8.6x

8.4x
7.8x

1.8%
2.2%

18.9x
16.1x

18.3x
15.7x

16.1x
13.9x

(4.9%)
(6.0%)

1.8x
1.7x

1.7x
1.5x

9.9x
4.8x

13.0x
11.0x

11.3x
9.8x

1.0%
0.0%

25.0x
21.7x

22.9x
20.1x

19.9x
16.8x

3.6%
19.6%

1.7x
2.8x

1.5x
2.5x

$35,487
$39,921

14.8x
15.6x

11.4x
11.7x

10.0x
10.5x

1.2%
1.2%

22.7x
23.1x

20.2x
20.0x

17.0x
17.1x

2.5%
1.4%

1.8x
1.7x

1.6x
1.5x

$111,929

36.5x

10.6x

9.6x

1.7%

20.7x

20.0x

17.4x

(4.3%)

0.9x

0.8x

Market
Cap ($MM)

Enterprise
Value ($MM)

LTM

2014E 2015E

Canadian National Railway Company

Canadian Pacific Railway Limited

$61,031
$35,910

$68,696
$40,479

12.8x
24.3x

12.3x
14.1x

CSX Corp.
Norfolk Southern Corporation

$35,058
$31,742

$43,644
$39,364

18.7x
18.4x

Kansas City Southern

Genesee & Wyoming Inc.

$12,103
$4,803

$14,313
$6,428

$30,108
$33,400
$102,311

Mean
Median
Union Pacific Corporation

Commentary

Sources: Capital IQ

EBITDA Growth
6.40%

6.90%

7.40%

7.90%

8.40%

7.7x $121.89 $124.40 $126.95 $129.53 $132.15

EV/EBITDA

- We note that all tier-1 rail operators trade at P/E multiples

significantly higher than historical averages the
historically high multiples are being supported by higher
forecast growth rates for the industry

Net Debt / EBITDA

2017E EV/EBITDA Sensitivity

- UNP trades at a discount when compared to forward

EV/EBITDA and P/E multiples of comparable companies,
implying undervaluation
- UNP pays a higher than average dividend than peers and
is less leveraged

P/E

8.2x $130.47 $133.15 $135.86 $138.61 $141.40

8.7x $139.05 $141.89 $144.77 $147.68 $150.64
9.2x $147.63 $150.63 $153.67 $156.76 $159.89
9.7x $156.21 $159.38 $162.58 $165.83 $169.13

14

Valuation: Discounted Cash Flow

Discounted Cash Flow Calculations

Commentary & Assumptions

WACC Calculation
Risk-Free Rate
Market Risk Premium
Levered Beta
Cost of Equity

2.32%
5.50%
0.99
7.77%

Cost of Debt
Tax Rate
After Tax Cost of Debt

6.50%
36.37%
4.14%

Capital Structure
Debt
Equity
Total:
WACC

35.00%
65.00%
100.00%
6.50%

Share Price Calculation

PV of UFCF
Terminal Year Growth Rate
Discount Rate
PV of Terminal Value
Enterprise Value

27,413.80
3.00%
6.50%
111,037.94
138,451.74

Enterprise Value
Less: Total Debt
Plus: Cash and Cash Equivalents
Implied Equity Value

138,451.74
11,505.00
1,887.00
128,833.74

Shares Outstanding
Implied Share Price

Sources: Capital IQ, Company Reports

We anticipate aggressive revenue growth over the

coming years due to UNPs Mexican expansion plans
Expense margin reductions are due to lower fuel costs as
well as lower marginal personnel costs in anticipation of
streamlining certain functions
Slight tax rate decreases are anticipated due to increased
foreign operations
MRP is derived from NYU Stern School estimates; Riskfree rate is the U.S. 10-year bond yield
Capital structure estimates are based on historic debt and
equity weightings targeted by UNP

Target Price
Current Price

$112.55

Price Target

$144.77

Dividend Yield
Implied Return

1.70%
30.33%

889.94
144.77

15

Appendix: Discounted Cash Flow Model

Discounted Cash Flow Valuation
Revenue

2009

2010

2011

2012

2013

2014 3Q

2014 Q4

14143

16965

19557

20926

21963

17835

6150.2047

20%

15%

7%

5%

8650

9778

11434

11633

11891

Y/Y Change
COGS
% of Revenue
Compensation & Benefits

9%
9344

61%

58%

58%

56%

54%

52%

4063

4314

4681

4685

4807

3787

27%

29%

25%

24%

22%

22%

21%

20%

1763

2486

3581

3608

3534

2726

-327.4795

% of Revenue
Equipment & Other

12%

15%

18%

17%

16%

15%

-5%

1644

1836

2005

2143

2315

1893

505.52047

12%

11%

10%

10%

11%

11%

8%

1180

1142

1167

1197

1235

938

261.26023

% of Revenue

8%

7%

6%

6%

6%

5%

Gross Profit

5493

7187

8123

9293

10072

8491

% Margin

39%

42%

42%

44%

46%

48%

Operating Expenses

687

674

782

788

849

696

% of Gross Profit
EBITDA
% Margin
Depreciation & Ammortization
% of EBITDA

13%

9%

10%

8%

8%

8%

4806

6513

7341

8505

9223

7795

34%

38%

38%

41%

42%

44%

1427

1487

1617

1760

1777

1415

30%

23%

22%

21%

19%

18%

1084

1653

1972

2375

2660

2296

2017

2018

2019

10%

8%

8%

7%

7%

46%

46%

45%

44%

44%

44%

4%

21%

18%

18%

10%

13%

13%

13%

18%

18%

4280.66 4580.306
13%

13%

2398.52 2638.373 2564.498 2769.658 2963.534 3170.981

10%

10%

9%

9%

9%

9%

1199.26 1319.186 1282.249 1230.959 1317.126 1409.325

5%

5%

4461.0105 12952.01 14247.21

73%

18%

2398.52 3429.884 3704.275 4000.617

54%

54%

5%

4%

4%

4%

15814.4 17233.43 18439.77 19730.55

56%

56%

56%

56%

340.16084 1036.161 1139.777 1265.152 1378.674 1475.181 1578.444

8%

8%

8%

8%

8%

8%

8%

4120.8497 11915.85 13107.43 14549.25 15854.75 16964.59 18152.11

67%

50%

50%

51%

52%

729.85294 2144.853 2228.264 2473.373 2695.308

18%

18%

17%

17%

17%

52%

52%

2883.98 3085.858
17%

17%

1196.7447 3492.745 3661.745 4064.537 4429.246 4739.294 5071.044

39%

37%

38%

38%

38%

38%

2295

3373

3752

4370

4786

4084

63%

15%

21%

11%

1427

1487

1617

1760

1777

1415

729.85294 2144.853 2228.264 2473.373 2695.308

2354

2482

3176

3738

3496

3226

673.74157 3899.742 4289.716 4632.893 5003.524 5353.771 5728.535

17%

15%

16%

18%

16%

18%

2,896

2,263

2,307

3,363

38%

38%
32%

1,525

36%

36%

36%

36%

36%

2194.252 6278.252 7217.426 8011.343 8730.199 9341.312 9995.204

15%

11%

9%

7%

7%

2883.98 3085.858

11%

16%

16%

16%

16%

16%

533

533

(314)

(114)

136

186

44

1,718

3,991

6,286

6,686

7,309

0.25
98.44%
1,690.80

Sources: Capital IQ, Company Reports

2016

1249.893 5036.893 4749.071 5128.996 5539.316 5927.068 6341.963

Fuel & Utilities

Purchased Service and Materials

2015

1689.1941 11033.19 12136.51 12680.02 13540.55 14488.39 15502.58

% of Revenue
% of Revenue

2014

23985.2 26383.73 28494.42 30773.98 32928.16 35233.13

0.25

5,470

5,966

16%

1.25

2.25

3.25

4.25

5.25

92.43%

86.79%

81.49%

76.52%

71.85%

5,055.98

5,177.41

5,122.33

5,115.92

5,251.37

16