Union Pacific Corporation
Current Price: $98.58
Target Price: $87.44
NYSE: UNP
Recommendation: Sell
Analyst Information:
Investment Thesis
Union Pacific Corporation is a Class I rail transportation
provider operating in the western two-thirds of the United States.
Infrastructure size, location, brand, and a diversified commodity mix
give Union Pacific a competitive advantage creating stable sales.
However, these sales do not grow significantly or drop to the bottom
line because of operational inefficiencies, an infrastructure nearing
capacity, and the mature railroad industry. I believe that moderate
macroeconomic growth and falling interest rates will lead to average
returns for Industrial stocks. However, I forecast substantial
downside risk for Union Pacific because of its operational
inefficiencies and a current overvaluation of the railroad industry.
Analyst: Enoch Shih
Fisher College of Business
The Ohio State University
Columbus, Ohio
Contact: 330.554.2007
Email:
Shih.50@osu.edu
Updated: March 1, 2007
Fund:
OSU SIM (BUS FIN 824)
Manager: Royce West, CFA
Summary
I have assigned Union Pacific a one-year price target of
$87.44. The following are key assumptions supporting this
valuation:
 US GDP will grow at 5.5 percent in 2007.
 Federal Funds rate will fall to average 5 percent in 2007.
 Railroard industry revenues will grow with the economy.
 Union Pacific’s market share of Class I railroad revenues will
remain constant over the next year.
 Operating margins will widen but Union Pacific will continue to
operate less efficiently than its major competitior Burlington
Northern Santa Fe.
 The railroad industry is currently overvalued.
 Comparable Multiples and Discounted Cash Flow valuation
methods support this target price and suggest Union Pacific’s
intrinsic value is 10 to 15 percent below its current price.
Sector: Industrials
Industry: Transportation, Railroads
Market Cap:
26.56B
Outstanding Shares: 269.4M
ADV:
2,105,080
52 Week High:
52 Week Low:
YTD Return:
Beta:
$105.84
$78.65
6.6%
1.11
EPS (Diluted)
In dollars per share
NET INCOME
In millions of dollars
OPERATING REVENUE
In millions of dollars
Stock Information:
$6.04
1,585
15,578
13,578
11,159 11,551
$5.05
1,341
12,215
$3.85
1,026
$2.30
604
02
03
$5.90
1,606
04
05
06
02
03
04
05
06
02
03
04
05
06
Table of Contents
Investment Thesis ............................................................................................................................................................................. 1
Summary........................................................................................................................................................................................... 1
Company Overview .......................................................................................................................................................................... 3
Agricultural................................................................................................................................................................................. 3
Automotive ................................................................................................................................................................................. 3
Chemicals ................................................................................................................................................................................... 4
Energy......................................................................................................................................................................................... 4
Industrial Products ...................................................................................................................................................................... 4
Intermodal................................................................................................................................................................................... 4
Sector Analysis ................................................................................................................................................................................. 5
Macroeconomic Drivers............................................................................................................................................................... 5
Outlook ........................................................................................................................................................................................ 6
Valuation ..................................................................................................................................................................................... 6
Three Factor Model.............................................................................................................................................................. 6
Comparative Multiple Analysis............................................................................................................................................ 7
Industry Analysis .............................................................................................................................................................................. 8
Background.................................................................................................................................................................................. 8
Current Life Cycle ....................................................................................................................................................................... 9
Macroeconomic Drivers............................................................................................................................................................. 10
Revenue Drivers................................................................................................................................................................. 10
Cost Drivers ....................................................................................................................................................................... 10
Recent Performance ................................................................................................................................................................... 11
Competition ............................................................................................................................................................................... 12
Basis of Competition.......................................................................................................................................................... 12
Barriers to Entry................................................................................................................................................................. 12
Buyer / Supplier Power ...................................................................................................................................................... 12
Substitutes .......................................................................................................................................................................... 12
Rivalry ............................................................................................................................................................................... 12
Outlook ...................................................................................................................................................................................... 13
Valuation ................................................................................................................................................................................... 13
Company Analysis.......................................................................................................................................................................... 14
Strategy...................................................................................................................................................................................... 14
Competitive Advantage ............................................................................................................................................................. 14
Finanical Analysis...................................................................................................................................................................... 15
Dupont Analysis................................................................................................................................................................. 15
Common Size Income Statement analysis.......................................................................................................................... 17
Equity Valuation: Multiples....................................................................................................................................................... 18
Absolute valuation ............................................................................................................................................................. 18
Comparable valuation: S&P 500........................................................................................................................................ 18
Comparable valuation: Industrials sector ........................................................................................................................... 19
Comparable valuation: Railroads industry ......................................................................................................................... 19
Summary ............................................................................................................................................................................ 19
Equity Valuation: Discounted Cash Flow.................................................................................................................................. 20
Revenue Forecast ............................................................................................................................................................... 20
Income Statement and Balance Sheet................................................................................................................................. 21
Terminal Value .................................................................................................................................................................. 21
Summary ............................................................................................................................................................................ 21
Summary......................................................................................................................................................................................... 22
Strengths and Opportunities....................................................................................................................................................... 22
Weaknesses and Threats ............................................................................................................................................................ 22
Conclusions ............................................................................................................................................................................... 23
Appendix 1: Union Pacific Financial Statements from Company 10-K ......................................................................................... 25
Appendix 2: Union Pacific Discounted Cash Flow Model ............................................................................................................. 28
2
Company Overview1
Headquartered in Omaha, Nebraska, and
incorporated in 1969, Union Pacific Corporation
Figure 1. Union Pacific Revenues by Segment 2006
operates primarily as a rail transportation provider
Other
through the Union Pacific Railroad Company, the
largest freight railroad in North America. It has
Agricultural
5%
15%
Intermodal
approximately 32,426 route miles linking Pacific
18%
Coast and Gulf Coast ports with Midwest and
9%
Auto
eastern United States gateways and providing
several north/south corridors to key Mexican
gateways.
Union Pacific serves 23 states in the
western two-thirds of the United States and
13%
21%
Industrial Products
Chemicals
19%
maintains coordinated schedules with other rail
carriers for the handling of freight to and from the
Energy
Atlantic Coast, Pacific Coast, Southeast,
Southwest, Canada, and Mexico. Export and import traffic is moved through Gulf Coast and Pacific Coast ports and
across the Mexican and Canadian borders.
Union Pacific’s freight traffic consists of bulk, manifest, and premium business. Bulk traffic includes coal,
grain, rock, and soda ash, and is transported via unit trains (trains transporting a single commodity from one source
to one destination). Manifest traffic is individual carload or less than train-load business such as lumber, steel,
paper, and food. Finally, premium business is the transportation of finished good and intermodal containers. In
2006, commodity revenue totaled $15.6 billion in six commodity groups: agricultural, automotive, chemicals,
energy, industrial products and intermodal.
Agricultural
The transportation of whole grains; commodities produced from these whole grains; food and beverage
products such as fresh and frozen fruit, vegetables, and dairy products; and ethanol made up 15 percent of Union
Pacific’s 2006 commodity revenue. The agricultural business primarily derives from unit trains shuttling between
producers in the Midwest and West and export terminals in the Pacific Northwest, Gulf ports, and Mexico. In
addition, Union Pacific operates a premium perishables service called Express Lane which moves fruits and
vegetables from the Pacific Northwest and California to the East. Union Pacific also carries frozen meat to West
Coast ports for export. Agriculture was the fastest growing segment in 2006 with a 21.5 percent growth rate.
Automotive
In 2006, the transportation of finished vehicles and automobile materials provided 9 percent of Union
Pacific’s total commodity revenue. Union Pacific transports finished vehicles from seven vehicle assembly plants
1
Adapted from 2005 Company 10-K
3
and seven Western ports to 38 vehicle distribution centers. Union Pacific also transfers automobile parts in boxcar
and intermodal containers to both domestic and Mexican assembly plants.
Chemicals
In 2006, the transportation of chemicals accounted for 13 percent of Union Pacific’s total commodity
revenue. In general, Union Pacific moves liquid and dry chemicals, plastics, liquid petroleum, soda ash, and
fertilizer from the Gulf Coast and Rocky Mountain regions to the East, Midwest, West, and Canada. In transporting
chemicals, Union Pacific utilizes its industry leading storage-in-transit yards for the immediate and proper storage of
plastic resins.
Energy
Energy transportation represented 19 percent of Union Pacific’s 2006 commodity revenue. Energy
transportation primarily consists of low-cost, low-sulfur coal from the Southern Powder River Basin of Wyoming,
Colorado, Utah, and southern Illinois as well as high-BTU, low-sulfur coal from Colorado and Utah. This coal is
transported to utility and industrial factories in 27 states, the Gulf, the Mississippi and Ohio rivers, and the Great
Lakes. In 2006, energy was the second fastest growing business segment with a 14.5 percent growth rate.
Industrial Products
Transportation of industrial products was Union Pacific’s largest business segment in 2006, accounting for
21 percent of total commodity revenue. Union Pacific transfers a variety of industrial products to numerous
locations. Lumber from the Pacific Northwest and Canada is moved throughout the United States for home building
and renovation. Steel and construction products such as rock, cement, and roofing are transported for commercial
and highway construction. Paper, furniture, and appliances are transported to major metropolitan areas for
consumers. Nonferrous (iron-free) metals and industrial minerals are transported for industrial manufacturing.
Union Pacific also moves hazardous waste for government entities and waste companies.
Intermodal
Intermodal transportation provided 18 percent of Union Pacific’s 2006 commodity revenue. Intermodal is
generally defined as transportation connecting different modes of transportation. Union Pacific’s intermodal
business is divided into international, domestic, and premium shipments. International shipments are transported
from West Coast ports throughout the US. Domestic shipments consist of domestic containers for shipping agents,
consolidators, and trucking companies. Premium shipments consist of less-than-truckload and package carriers with
time sensitive materials.
21.5%
Agriculture
Figure 2. Business Segment Growth Rates 2006
13.0%
13.4%
Auto
Chem.
14.5%
12.6%
4
Energy
Industrial
13.7%
Intermodal
Sector Analysis
Union Pacific is part of the Industrials sector. Industrials are composed of three major sub-sectors: Capital
Goods, Commercial Services, and Transportation. In general, Industrials are highly cyclical in that they flourish
when the economy grows, but struggle when the economy slows. Also, Industrials are in the mature phase of the
product life cycle so they display considerable rivalry as individual companies compete for market share.
Macroeconomic Drivers
After careful regression analysis, three main macroeconomic factors stand out as driving S&P Industrial
index returns: US Gross Domestic Product (GDP), the Federal Funds Rate (FFR), and consumer sentiment through
the University of Michigan Consumer Sentiment (UMCS) index.2 Performing a linear regression of these three
factors and S&P Industrial monthly returns3 from January 1980 to October 2006 delivers an adjusted R² of 0.942
with each factor exhibiting t-stats well above 2. This means that this three-factor model can explain 94.2 percent of
the variance from S&P Industrial returns and that each individual factor is statistically significant.
Figure 3. Three-factor Model Regression Statistics
Summary measures
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.971
0.943
0.942
3.499
322
ANOVA Table
Source
Explained
Unexplained
df
3
318
SS
63993
3894
MS
21331
12.25
F
1742
Sig. F
0
Coefficient
-37.352
0.005
0.868
0.144
Std Err
1.983
0.000
0.081
0.018
t Stat
-18.84
51.89
10.71
7.82
P-value
0.00
0.00
0.00
0.00
Lower limit
-41.25
0.01
0.71
0.11
Regression coefficients
Intercept
GDP (in $ BB)
Federal Funds Rate (x100)
UM Consumer Sentiment
Upper limit
-33.45
0.01
1.03
0.18
Within the model, all factors are positively correlated with S&P Industrial returns. The positive correlation
of US GDP makes sense because the Industrial sector is highly cyclical so its performance is consistent with the
economy. US GDP is a very sensitive factor as a 1 percent increase (decrease) in GDP correlates to a 1.44 percent
increase (decrease) in S&P Industrial returns.
2
3
Data from Federal Economic Data Research
Data from StockVal
5
At first glance, the positive correlation with FFR seems counterintuitive as a higher federal funds rate
increases the cost of debt, thereby decreasing sector profits and possibly market returns. However, one possible
explanation for this relationship is that the Federal Reserve sets the FFR retroactively to counteract the economy.
For example, when the economy does well, personal income and spending increase, which increases inflationary
concerns. The Federal Reserve often counteracts these inflationary concerns by raising the FFR to decrease
spending. Thus, the model’s FFR positive correlation could be a result of a positive covariance between the
economy and the FFR such that the FFR increases (decreases) as US GDP increases (decreases). Another
explanation could be that an increasing FFR negatively affects other sectors more than the Industrials sector, leading
market participants to purchase additional Industrial stocks as FFR increases. In the three-factor model, a 1 percent
increase (decrease) in the FFR correlates to a 1.83 increase (decrease) in S&P Industrial returns.
Finally, the model’s positive correlation with UMCS is reasonable because the more confident consumers
are in the economy, the more they are willing to invest in stocks, thereby driving returns up. This factor is the least
sensitive factor in the model as a 1 percent increase (decrease) in the UMCS correlates to a 0.30 percent increase
(decrease) in S&P Industrial returns.
Outlook
My outlook on the Industrials sector for next year is neutral. I believe the economy will grow moderately
in 2007, exhibiting nominal GDP growth of 5.5 percent. This 5.5 percent is slightly lower than the average nominal
GDP growth of 6.3 percent since 1980 and 6.8 percent since 1930. As such, the Industrial sector should follow the
economy and perform similar to 2006 when S&P Industrial returns were 11 percent.
Valuation
Three Factor Model
In addition to my belief that nominal GDP will grow at 5.5 percent, I also believe that the average FFR will
be 5 percent and the UMCS will decrease 5 percent. The current FFR is 5.25 percent, but I expect the Federal
Reserve to soon cut this rate as high energy prices and a cooling housing sector deflate inflationary concerns.
I expect the UMCS to decrease by 5 percent this year because consumers will likely react negatively to the
fact that this year’s economy will grow less than 2006. Using these assumptions, the three-factor model predicts an
S&P Industrial return of 11.1 percent. Schematic:
Figure 4. Schematic: Deriving S&P Industrial Returns in 2007
FFR = 5%
GDP growth = 5%
UMCS growth = -5%
Three-factor Model
S&P Industrials =
0.005 GDP +
0.868 FFR +
0.144 UMCS 37.352
6
Expected return
= 11.1 percent
Comparative Multiple Analysis4
In order to assess the reasonableness of this return prediction, I analyzed the Industrials sector on a
comparative multiple basis. For this analysis, I used a five year time horizon to mitigate the effects of the economic
recession in the early 2000s.
In terms of absolute valuation, Industrials are trading in line or relatively cheap with every major multiple
except absolute price. Focusing on price-to-forward earnings, which I feel is the most accurate valuation measure
for this industry because it is less sensitive to cyclical swings, Industrials are trading at a slight discount of 12
percent. This means that there is clearly enough upside potential for Industrials to grow 11.1 percent next year
without even fully reverting to the five year mean.
Comparative multiple analysis relative of Industrial returns to the S&P 500 confirms this upside potential
as Industrials are trading in line or at a slight discount to all of the major multiples including price-to-forward
earnings.
Figure 5. S&P Industrials Comparative Multiple Analysis: Five Year Horizon
High
Low
Mean
Current
Percent from
Mean
Valuation
Opinion
51
27
39
49
26%
High
P/Forward E
23.8
14.5
17.6
15.5
-12%
Low
P/S
1.78
1.17
1.51
1.48
-2%
In line
P/B
4
2.7
3.1
3.3
6%
In line
P/EBITDA
11.1
7.5
9
8
-11%
Low
P/CF
14.8
9.7
12.6
12.2
-3%
In line
1%
In line
Absolute Valuation
Price
Average
High
Low
Mean
Current
Percent from
Mean
Valuation
Opinion
1.1
0.94
1.01
1.03
2%
In line
1.12
0.95
1.06
1.01
-5%
In line
P/S
1.1
0.88
1
1.01
1%
In line
P/B
1.16
1
1.05
1.14
9%
High
P/EBITDA
1.39
1.03
1.2
1.07
-11%
Low
P/CF
1.19
0.97
1.06
1.05
-1%
In line
-1%
In line
Relative to S&P 500
Price
P/Forward E
Average
4
Data from StockVal
7
Industry Analysis5
Union Pacific is part of the transportation
Figure 6. Industry Revenues by Segment 2005
railroad industry within the Industrials sector. This
$56.9 billion industry (based on 2006 industry
revenues) consists of four major types of railroads
divided by function and size. Class I freight
Local Freight
2%
Passenger
4%
Other
2%
railroads, which must generate annual operating
revenues greater than $289.4 million, represent 88
percent of industry revenues. Regional freight
Regional
Freight
4%
railroads, which must generate between $50 and
$289.4 million in operating revenue and/or own over
350 miles of track, represent 4.3 percent of industry
Class I Freight
88%
revenues. Local freight railroads, which generate
less than $50 million in operating revenue and own
less than 350 miles of track, represent 2.3 percent of
industry revenues. Finally, passenger services represent 3.7 percent of industry revenues. The rest of this industry
analysis will focus on Class I freight railroads because they generate such a large portion of total industry revenues
and because Union Pacific operates as a Class I railroad.
Background6
It is important to analyze the background of the US railroad industry in order to understand its present and
future growth prospects. Railroad transportation dates back to the early 1800s, but it did not become a significant
industry until the 1850s. From 1850 to 1870, railroads experienced unprecedented growth. Then, as external
growth opportunities diminished, railroad companies began to consolidate as a result of industry economics. In
specific, railroads require large capital expenditures to build and maintain track infrastructure, but the cost for each
incremental dollar of revenue is low. Thus, consolidation, which takes advantage of low marginal costs, increases
industry profits. This consolidation and an ensuing price war resulted in the failure of many less efficient railroad
companies.
Surviving railroads soon realized the adverse effects of price competition so they colluded and formed
cartels to allocate traffic and revenues. However, at this time there was no competition to railroads in the long-haul
transportation business. Thus, the federal government intervened to prevent monopolistic pricing. With the
Interstate Commerce Act of 1887, the government assumed control of railroad mergers, infrastructure construction,
and divestiture of rail lines.
From that time to the 1940s, railroads experienced another growth period and the industry did exceptionally
well. However, in the 1940s, trucking arrived as competition due to innovations in motor technology as well as the
5
6
Data from IBIS World Industry Report, “Rail Transportation in the US,” January 18, 2007, unless otherwise noted.
Adapted from HBS, “The Acquisition of Consolidated Rail Corporation (A),” Benjamin C. Esty
8
federally funded highway infrastructure. This “free infrastructure” proved to be a major competitive advantage over
railroads, which had to build and maintain their own transportation lines.
During the 1940s through 1960s, the profitability of railroads significantly declined. In an attempt to
compete with trucking, railroads tried to abandon unprofitable routes, merge with other railroads, change pricing
strategies, and lower costs. However, federal regulations impeded them on all fronts, and by 1972, the six largest
Northeastern railroads had filed for bankruptcy.
In 1980, Congress deregulated the railroad industry with the Stagger’s Rail Act of 1980. Although this act
did not completely deregulate the industry, it gave railroads the ability to set prices, abandon unprofitable lines, and
merge with other railroads. Consequently, the railroad industry went through another period of consolidation, and
the number of Class I railroads went from 40 to nine over 15 years. In this same period, railroads also shut down
more than one-third of their route miles and fired 60 percent of their employees. By the 1995, these measures
dramatically improved the profitability of railroads, and railroads again became competitive with the trucking
industry.
Since 1995, the industry has experienced profitability that grows in line with the economy and has become
even more concentrated as the four major Class I railroads – Union Pacific, Burlington Northern Santa Fe, CSX, and
Norfolk Southern – now generate 80 percent of industry revenues.
Current Life Cycle
The US railroad industry is in the mature phase of the product life cycle. This is embodied by four main
facts. First, the industry is over 200 years old. Second, the industry experiences relatively low growth that is
dictated by the economy (the five year nominal industry CAGR is 5.5 percent and the five year nominal US GDP
CAGR is 4.6 percent). Third, no new products have been developed in the past ten years. Finally, the industry is
highly concentrated, which is consistent with most mature industries as companies try to grow through acquisition,
realize scale economies, and take market share from one another.
Figure 7. Timeline of the Railroad Industry
1800:
Railroads
begin
1800
1860:
First
consolidation
period
1820
1840
1850:
Railroads
become a
significant
industry
1860
1940:
Trucking
starts to
compete with
railroads
1880
1900
1887:
Interstate
Commerce
Act regulates
railroads
1920
1940
1980:
Staggers Act
deregulates
railroad
industry
1960
1972:
Six largest
NE railroads
companies
file for
bankruptcy
9
1980
2000
1995:
Railroads are
again
competitive
with trucking
Macroeconomic Drivers
Revenue Drivers
Figure 8. Railroad Revenue and GDP Regression Statistics
Industry revenue is driven by
downstream demand for products that use
transported commodities. Thus, overall industry
demand can be categorized into international
demand for US commodities such as coal,
minerals, agricultural goods, and chemicals, and
Summary measures
Multiple R
R Square
Adj. R Square
Standard Error
Observations
Regression coefficients
domestic demand for US commodities such as
metal, lumber, automobile, glass, stone, and
0.979
0.959
0.955
1265
13
Intercept
GDP (in $ BB)
Coefficient
-1410.536
5.094
Std Err
3080.324
0.319
t Stat
-0.458
15.962
P-value
0.656
0.000
food. With this in mind, there are many factors
that can individually affect railroad revenues such as world commodity prices, exchange rates, and world stock
levels for internationally destined freights and US construction, US discretionary income, and energy prices for
domestically destined freights.
Fortunately, these individual drivers collectively sum into one overall driver, US GDP. A linear regression
of industry revenues and US GDP from 1995 to 2006 delivers an astoundingly high R² of 0.95 and a US GDP t-stat
well above the statistically significant “t-stat greater-than 2” rule. While this regression only had 13 observations, it
still strongly suggests that industry revenues are highly correlated to the US economy through GDP.
A non-systemic performance driver that can affect industry revenue is the weather. The weather can affect
industry revenue by destroying railway infrastructure and disrupting freight services. For example, according to
Union Pacific’s 2005 annual report, Hurricane Katrina and Rita destroyed some of the southeastern US rail
infrastructure, which resulted in lower industry revenue than was otherwise expected.
Cost Drivers
In order to analyze industry cost drivers, I derived a common size income statement for 2005 using the four
major Class I railroads that generate 80 percent of industry revenues – Union Pacific, Burlington Northern Santa Fe,
CSX, and Norfolk Southern (using individual 10Ks). This common size income statement depicted an average
industry cost structure of wages (30 percent), fuel
(14), materials and supplies (10), equipment (8),
Figure 9. Cost Structure for Class I Railroads 2005
Earnings before tax
Other costs
Interest
Mat erials and Supplies
the main industry cost determinants are
5%
unemployment, fuel costs, and interest rates.
10%
9%
Equipment
8%
Wages
tax profits (14). This cost structure suggests that
10%
Depreciation
Fuel
depreciation (9), interest (5), other (10), and pre-
14%
Unemployment is negatively correlated
with industry wages because as unemployment
increases, the supply of serviceable workers
14%
30%
10
increases, and the cost to employ these workers
decreases. Wages are also dependant on the presence of unions and new
Figure 10. Performance Measures
Class I Freight Railroads
technologies that reduce the need for manual workers. Fuel costs are a major cost
driver because they are highly volatile and one of the few variable costs within the
industry. Finally, interest rates are positively correlated with costs because higher
Revenue Growth
7.1%
interest rates increase the cost of debt and new projects.
5.3%
5.9%
Recent Performance
As expected, railroad profitability has systematically increased with the
economy since 2004. In specific, industry revenues have grown by 7.1 percent
(2004), 5.3 percent (2005), and 5.9 percent (2006) as US GDP has nominally grown
6.9 percent (2004), 6.3 percent (2005), and 6.3 percent (2006) in the same time
period.
04
05
06
Operating Margins
Meanwhile, operating margins have increased 15 percent (2004), 19
22%
19%
percent (2005), and 22 percent (2006) for a few reasons. First, wages have
decreased from 32 percent (2004), to 30 percent (2005), to 28 percent (2006) as
15%
fixed cost employees scale with increasing revenues, the unemployment rate
remains steady at 4.5 percent, and railroads increase automation through
technology.
Second, the economies underlying the railroad industry exhibit very low
marginal costs. Thus, operating margins inherently increase as revenues increase.
This is illustrated by the fact that most of the predominantly fixed costs equipment, depreciation, materials and supplies, and other costs - have decreased
04
05
06
Net Income Growth
13%
11%
by approximately 1 percent for each of the past three years.
However, these increasing operating margins have been partially offset by
higher fuel costs and interest rate hikes. Since 2004, energy prices have risen
7%
dramatically causing fuel costs to increase from 11 percent (2004), to 14 percent
(2005), to 16 percent (2006) of industry revenues. Based on energy prices alone,
fuel costs should actually be even higher, but railroads have partially mitigated this
risk by building fuel surcharge agreements, which allow railroads to pass through
04
05
06
higher fuel costs to customers, into their long-term service contracts. Finally, the
federal interest rate hikes of 2005 have kept industry interest expense at 5 percent
Return on Equity
of revenue over the past three years in spite of the fact that they should also scale
14%
14%
05
06
down with increasing revenue.
Because both revenues and operating margins have increased, profitability
8%
has increased by all measures. Operating profit before tax increased from 10
percent in 2004 to 17 percent in 2006. Estimated operating profit after tax
increased from 6.5 percent (2004), to 9.5 percent (2005), to 11.4 percent (2006).
Net income, which includes non-operating income, increased from 7 percent
11
04
(2004), to 11 percent (2005), to 13 percent (2006). ROE increased from 7.7 percent (2004), to 13.6 percent (2005),
to 14.4 percent (2006). Finally, ROI increased from 2.5 percent (2004), to 4.5 percent (2005), to 5.0 percent (2006).
In closing, the Class I freight industry is highly levered to the economy, and since the economy has down so well in
the past three years, so have railroad companies.
Competition
Basis of Competition
Railways compete in three major areas:
price, transit time, and reliability. Consequently,
Figure 11. Five Forces
High
Very Low
Low
High
operational efficiency is the key to success in
this industry. In specific, railroads can
differentiate themselves by increasing
automation, managing fuel price risk, improving
internal control systems to identify potential cost
cutting activities, maximizing throughput on
infrastructure, increasing train velocity while
ensuring safety, and maintaining infrastructure
in good condition.
Medium
Barriers to Entry
Barriers to entry are extremely high in this industry because of high capital costs, scale economies, and
existence of major players. Largest amounts of capital are required in order to build track infrastructure and an
integrated supply chain management system. Large economies of scale also act as a major barrier. Finally, the
existence of major players prohibits new entrants from individually setting prices. As a result, new entrants must be
price-takers, leading to low initial profit margins.
Buyer / Supplier Power
Buyer power is high while supplier power is low in this industry. Buyer power is high because long haul
transport customers can choose between a variety of carriers such as rail, trucking, water, and pipelines. As a result,
buyers display some countervailing power to demand concessions from rail companies. Supplier power is relatively
low because the railcar manufacturing industry is fragmented and saturated.
Substitutes
There are many substitutes to railroads such as trucking, water carriers, and pipelines. This dramatically
increases industry competition because railroads must compete with many other forms of transportation in addition
to other railroad companies.
Rivalry
The railroad industry is highly consolidated, which initially points to low rivalry. Yet in spite of this, the
railroad industry exhibits medium rivalry because it is mature so current players must compete with one another to
grow and gain market share.
12
Outlook
My outlook on the Class I railroad industry is neutral for next year. Given my belief that nominal US GDP
will grow moderately at 5.5 percent in 2007, industry revenues should increase 5 percent as prices rise due to
renewed long-term contracts and shipping volumes rise with the economy. I also predict industry operating margins
to improve by 1 percent to 23 percent based on fixed costs scaling with increasing revenue. However, improving
margin will be counteracted by high fuel costs and increasing wage expenses. Finally, taking into account my belief
that the federal funds rate will average 5 percent in 2007, I expect industry earnings before tax to increase 10.7
percent in 2007.
My long term outlook on the railroad industry is also neutral. Since the industry is so highly levered to the
economy, if the economy falters, railroad profitability will falter even more. Nonetheless, I believe there is still
room for railroads to improve margins by decreasing unionized wage expenses and utilizing new information
technology systems to identify other cost cutting ventures.
Valuation
I performed comparative multiple valuation analyses on this industry using the S&P Railroads Index and a
five year time horizon. In broad strokes, the S&P Railroad Index has a beta of 0.83 which means that it is less
volatile than the overall market (beta = 1.00). In 2006, it outperformed the market with a 13.6 percent increase
versus 13.3 percent for the S&P 1500. On an absolute basis, the S&P Railroad Index is expensive relative to historic
prices and in line with price-to-forward earnings multiples. Relative to the S&P 500 and the S&P Industrials sector,
the Railroads Index is expensive on both a price and price-to-forward earnings basis. Thus, I must conclude that the
railroad stocks are expensive at this time.
Figure 12. S&P Railroad Index Comparative Multiple Analysis: Five Year Horizon
High
Low
Mean
Current
Percent from
Mean
Valuation
Opinion
Price
392
148
193
372
93%
High
P/Forward E
19.1
10.7
15.3
15.9
4%
In Line
High
Low
Mean
Current
Percent from
Mean
Valuation
Opinion
Price
1.81
0.94
1.17
1.63
39%
High
P/Forward E
1.13
0.62
0.94
1.03
10%
High
High
Low
Mean
Current
Price
1.67
0.96
1.16
1.58
Percent from
Mean
36%
Valuation
Opinion
High
P/Forward E
1.06
0.64
0.88
1.03
17%
High
Absolute Valuation
Relative to S&P 500
Relative to Industrials
13
Company Analysis
Strategy
Union Pacific operates on a cost differentiation strategy that focuses on driving volume and increasing
operating efficiency. In practice, Union Pacific has acted this strategy by implementing two new projects: the
Customer Inventory Management System (CIMS) and the Unified Plan. The goal of CIMS is to generate more
terminal throughput with existing capacity by managing terminal inventory and increasing asset utilization. It was
first rolled out in Phoenix in 2005 and has since been implemented in several other Union Pacific terminals.
The Unified Plan was also rolled out in 2005 in order to “increase velocity and improve customer service
by reducing workload on the network.” This main reason for this plan was because Union Pacific was nearing
capacity on its current infrastructure. Preliminary results from this project have been promising as train stops
declined 16 percent and car switching declined 12 percent in 2005.
Competitive Advantage
Union Pacific has three main competitive advantages within the railroad industry – the size and location of
its infrastructure, its brand, and its diverse commodity mix. First, Union Pacific has the largest track infrastructure
in the United States with 32,426 miles in the western two-thirds of the US. In fact, Union Pacific only has one
competitor in terms of size and location, Burlington Northern Santa Fe. This combination of size and location has
allowed Union Pacific to capture many customers including its two largest, APL Limited, a steamship company in
the Pacific, and General Motors. Recently, Union Pacific has realized strong revenue growth in transporting coal
because of its access to the Wyoming Powder River Basin. Union Pacific is also the primary rail connection
between the US and Mexico, which has provided substantial revenue since the passing of NAFTA in 1994.
Union Pacific also has one of the most recognized railroad brands due to its “Building America” marketing
campaign. Started in April 2002, the “Building America” marketing campaign focuses on images of railcars
traveling through distinctively American backdrops. From 2002 to 2003, Union Pacific developed six “Building
America” commercials that won four awards from the American Advertising Federation.
Finally, Union Pacific has one of the most diverse commodity mixes in the industry. This diverse
commodity mix allows Union Pacific to mitigate the risk of depending too much on one specific commodity.
In terms of sustainability, Union Pacific’s size, location, and commodity mix can be sustainable
competitive advantages against new market entrants, but Burlington Northern Santa Fe already competes with Union
Pacific on all of these measures. This leaves Union Pacific’s brand as its most sustainable competitive advantage.
This suggests that the keys to Union Pacific’s future profitability are improving its brand equity and becoming more
operationally efficient than Burlington Northern Santa Fe.
Figure 13. “Building America”
14
Financial Analysis
Figure 14. Dupont Decomposition
Five Year Average
Dupont Analysis
To start my financial analysis, I performed a Return on Equity (ROE)
Dupont Decomposition over the past five years to analyze Union Pacific’s
Profit Margin
profitability and operational efficiency versus its three major Class I competitors.
11.8%
Profit Margin (EBIT / Sales) measures operational efficiency as higher
profit margins imply more efficient operations. Due to its volume-driving, cost
9.0%
9.7%
9.6%
8.0%
differentiation strategy, Union Pacific’s profit margin should inherently be lower
than its competitors focusing on product differentiation. Thus, it is not surprising
that Union Pacific’s 9 percent profit margin over the past five years is less than
the industry average of 9.6 percent. However, Burlington Northern Santa Fe’s
UP
BNS F
C SX
Norfolk
Avg
9.7 percent profit margin illustrates that it is more efficient than Union Pacific.
Asset Turnover (Sales / Assets) measures asset management as higher
asset turnover implies better asset management. Since it focuses on driving
Asset Turnover
0.38
0.41
0.36
volume, Union Pacific’s asset turnover should be higher industry averages.
0.37
0.33
Thus, it is reasonable, but not a completely positive signal, that Union Pacific’s
0.38 asset turnover is only slightly higher than the industry average of 0.37. In
addition, this asset turnover is well below that of Burlington Northern Santa Fe,
which means that Burlington Northern Santa Fe is outperforming Union Pacific
UP
BNS F
CSX
Norfolk
Avg
in both operational efficiency and asset management.
Return on Investment (Profit Margin * Asset Turnover) measures the
Return on Investment
profitability of a company’s operating assets. It is a very important ratio because
3.9%
it can compare companies with different strategies. Specifically, some
3.9%
3.5%
3.4%
2.9%
companies, like Union Pacific, differentiate by cost, which results in lower profit
margins and higher asset turnover, while other companies differentiate by
product, which results in higher profit margins and lower asset turnover. Thus,
companies must strategically trade off profit margin and asset turnover in order
to maximize ROI. Union Pacific has not done well on this measure as it falls
below the industry average and ranks third among the four major companies. In
UP
BNS F
CS X
Norfolk
Avg
Leverage
addition, while Union Pacific’s three major competitors have seen their ROIs
3.3
3.2
increase dramatically since 2004, Union Pacific’s ROI has only increased
3.1
modestly.
3.0
The Leverage Multiplier measures capital structure management as a
2.8
higher leverage multiplier implies higher debt levels and poor capital structure
management. Union Pacific’s leverage multiplier of 2.8 falls below the industry
average of 3.1, which is a positive sign of capital structure management.
15
UP
BNS F
CS X
Norfolk
Avg
Return on Equity (ROI * Leverage
Figure 15. Return on Equity – Five Year Average
Multiplier) measures the profitability of owner
invested funds in a company. In general,
12.7%
11.6%
higher ROEs imply higher profitability.
10.8%
9.5%
However, it is also important to understand
9.4%
how much of ROE is determined by ROI,
which suggests operational improvement,
versus leverage, which only suggests higher
debt levels. Union Pacific exhibits low ROEs
relative to its competition on both a five year
average basis as well as across time since
UP
BNSF
CSX
Norfolk
Avg
2004. This is due to both below average ROI,
which is a negative sign of operational performance, and below average leverage, which is a positive sign of capital
management.
Finally, I also analyzed ROE and ROI over the past three years to see who has improved the most. From
this analysis, it is clear that Union Pacific’s improvement is significantly lower industry average as well as all three
major competitors.
In sum, Union Pacific ranks third or last in profitability behind Burlington Northern Santa Fe, Norfolk
Southern, and even CSX the past few years. In addition, Burlington Northern Santa Fe, Union Pacific’s biggest
competitor, is the industry’s best-of-breed and clearly outperforms Union Pacific in profit margin, asset turnover,
ROI, and ROE. On the positive side, this analysis suggests that Union Pacific has room to grow in operational
efficiency. However, in the meantime, Union Pacific should trade much cheaper than its more profitable
competitors.
Figure 16. Return on Equity and Investment since 2004
Return on Investment
UP
BNSF
CSX
Return on Equity
Norfolk
Avg
UP
BNSF
CSX
Norfolk
Avg
20%
7.0%
18%
6.0%
16%
5.0%
14%
12%
4.0%
10%
3.0%
8%
2.0%
6%
4%
1.0%
2%
0%
0.0%
2004
2005
2006
16
2004
2005
2006
Common Size Income Statement analysis
My common size income statement analysis between Union Pacific and industry averages reveals mostly
predictable results. In general, Union Pacific spends more on wages, fuel, equipment, and other costs than its three
main competitors. Union Pacific’s higher wage percentage is largely the result of unionized labor. As such, it is one
of Union Pacific’s major operational inefficiencies and a potential item for future cost cutting. On the other hand,
Union Pacific’s high fuel cost percentage does not seem to point to operational inefficiencies, but rather Union
Pacific’s concentration on volume, which increases variable fuel costs. Nonetheless, these higher fuel costs could be
another potential item for future cost cutting through additional fuel surcharge contracts. Higher equipment cost
percentages are also not necessarily a negative because they could simply represent Union Pacific’s investment in
future revenue generating activities or excess use due to Union Pacific’s volume-driven strategy.
On the positive side, Union Pacific spends less on materials and supplies and interest relative to the
industry. The difference in materials and supplies can likely be explained by the fact that materials and supplies are
largely fixed costs that scale with Union Pacific’s industry-leading revenues. Also, the lower interest expense
percentage is predictable given the ROE analysis, which showed that Union Pacific’s leverage multiplier was the
lowest in the industry.
Operating Ratio (Operating Expenses / Revenues) is the most important ratio for the railroad industry. It
measures how much of every dollar in revenue is spent on operating expenses. In general, the lower the operating
ratio, the more efficient a company’s operations are. Union Pacific’s operating ratio is 3.9 percent greater than the
industry average, which means that Union Pacific is very inefficient relative to its competitors.
In sum, Union Pacific is less profitable than its competitors, exhibiting earnings before tax that are 2
percent less than industry averages. This coincides with the ROE analysis which showed Union Pacific’s ROE was
also lower than industry averages. Thus, Union Pacific should be valued lower than its more profitable competitors.
Figure 17. Union Pacific versus Industry Cost Structure 2005
UNP
Industry Average
Earnings before tax
Other costs
Interest
Materials and Supplies
Depreciation
Equipment
Fuel
Wages
0%
5%
10%
15%
17
20%
25%
30%
Equity Valuation: Multiples
I used several five-year comparative multiple valuation methods to determine the intrinsic value of Union
Pacific’s stock. First, I began with an absolute valuation analysis and set my initial intrinsic value to the average
target price. Then, I confirmed the reasonableness of this target price by examining Union Pacific’s stock price
relative to the S&P 500, S&P Industrial sector, and S&P Railroad industry.
Absolute valuation
Union Pacific is very expensive on an absolute basis. The current price of $98.58 is 12.5 percent above the
average target price of $87.66. In addition, the price-to-sales multiple, which I believe is the most accurate multiple
for Union Pacific because sales have been steady the past five years, is also much lower than the current price.
Figure 18. Union Pacific Absolute Valuation – Five Year Horizon
Absolute Valuation
P/Forward E
P/S
P/B
P/EBITDA
P/CF
Average
High
Low
Mean
Current
Target
Multiple
Target x
per Share
Target
Price
25
1.82
1.8
8
11.8
10.6
1.22
1.1
4
6
15.1
1.46
1.5
5.3
8.8
14.1
1.72
1.8
6.3
9.6
15.1
1.46
1.5
5.3
8.8
5.84
60.15
56.68
15.7
10.69
88.17
87.82
85.02
83.21
94.07
87.66
Comparable valuation: S&P 500
Union Pacific is also trading high in comparison to the S&P 500. In fact, all multiples except price-toforward earnings show that Union Pacific is trading well above the five-year means. Specifically, Union Pacific is
trading near all time highs of price-to-sales and price-to-book as well as above the price-to-EBITDA and price-tocash flow historic means.
Figure 19. Union Pacific relative to S&P 500 – Five Year Horizon
Relative to S&P 500
P/Forward E
P/S
P/B
P/EBITDA
P/CF
Average
High
Low
Mean
Current
1.47
1.23
0.63
1
0.98
0.47
0.79
0.39
0.51
0.52
0.98
0.97
0.49
0.72
0.75
0.91
1.17
0.61
0.85
0.82
18
Percent from
Mean
-7%
21%
24%
18%
9%
13%
Valuation
Opinion
Low
High
High
High
High
High
Comparable valuation: Industrials sector
Union Pacific is even more expensive in comparison to the Industrials sector. Although the price-toforward earnings multiple is in line with the five-year mean, all of the other multiples illustrate that Union Pacific is
priced much higher than historic means. Union Pacific is currently trading near all-time high levels of price-to-sales
and price-to-book means, above the price-to-EBITDA mean, and above the price-to-cash flow mean. Of these
multiples, price-to-sales is the probably the most indicative since sales have been steady the past five years, and it
clearly shows that Union Pacific is expensive relative to the Industrial sector.
Figure 20. Union Pacific relative to S&P Industrial – Five Year Horizon
Relative to S&P Industrial
P/Forward E
P/S
P/B
P/EBITDA
P/CF
Average
High
Low
Mean
Current
1.35
1.2
0.57
0.93
0.91
0.48
0.79
0.37
0.44
0.51
0.93
1
0.46
0.56
0.68
0.91
1.16
0.54
0.79
0.79
Percent from
Mean
-2%
16%
17%
41%
16%
18%
Valuation
Opinion
In line
High
High
High
High
High
Comparable valuation: Railroads industry
As expected from the financial analysis, Union Pacific is trading low relative to the S&P Railroads industry
in both relative price and price-to-forward earnings. Specifically, Union Pacific is trading 11 percent below the
relative price five-year mean as well as 23 percent below the price-to-forward earnings five-year mean.
Figure 21. Union Pacific relative to S&P Railroads – Five Year Horizon
Relative to Railroad
Industry
Price
P/Forward E
Average
High
Low
Mean
Current
1.08
1.54
0.7
0.71
0.87
1.14
0.77
0.88
Percent from
Mean
Valuation
Opinion
-11%
-23%
-17%
Low
Low
Low
Summary
Union Pacific stock currently trades expensive on an absolute basis, relative to the S&P 500, and relative to
the S&P Industrials sector, but cheap relative to other railroads. As a whole, I believe Union Pacific is currently
expensive and that the cheap valuation relative to railroads is more of an indictment of Union Pacific’s low
profitability relative to its competitors and the fact that the entire railroad industry is trading expensive. Thus, my
comparative multiple target price for Union Pacific is $87.66, the average of my absolute valuation target prices.
This target price is well below the current price and is supported by the fact that Union Pacific is expensive relative
to the S&P 500, Industrials sector, and much less profitable than its competitors.
19
Equity Valuation: Discounted Cash Flow
I believe my discounted cash flow (DCF) model provides the most accurate intrinsic value of Union
Pacific. Using the assumptions explained below, it generates an intrinsic value of $87.22, very close to the multiple
intrinsic value of $87.66.
Revenue Forecast
Similar to the S&P Industrial returns and overall railroad industry revenues, most of Union Pacific’s
revenues are highly correlated to US GDP as the agriculture, automobile, energy, industrial, and intermodal business
segments all return R²s higher than 0.85 when annual segment revenues since 1993 are regressed to US GDP. The
other two business segments, chemicals and other revenues, return R²s of 0.71 and 0.46 respectively. These varying
R²s show that Union Pacific’s individual business segments vary significantly in cyclicality, thereby providing
numerical support to my premise that Union Pacific’s diverse commodity line is a competitive advantage.
As a result, I forecasted revenues for each business segment depending on its cyclicality. For the five more
cyclical business segments, I used individual US GDP forecast models with the assumption that US GDP would
grow at 5.5 percent in 2006, 4.5 percent in 2007, 5 percent in 2008, 5.5 percent in 2009, and 6 percent thereafter.
These GDP growth assumptions are based on my belief that the economy will soon enter a soft landing for two years
followed by a reversion to historic GDP growth rates.
For the chemical and other revenue business segments, I forecasted segment revenues using their respective
historic growth rates of 5.7 percent for chemicals and 1.65 percent for other revenue.
The summation of these forecasts resulted in Union Pacific revenue growth rates of 4.0 percent, 5.5
percent, 5.9 percent, 6.4 percent, and 6.9 percent for 2007 through 2011. I believe these revenue growth rates are
very reasonable because US GDP is expected to grow moderately in 2007, overall railroad industry revenues should
grow with the economy, and Union Pacific is nearing capacity on its current infrastructure so it can only grow as fast
as it builds additional infrastructure.
Figure 22. US GDP and Union Pacific Growth Rate Assumptions
US GDP Growth
UP Revenue Growth
8.0%
6.9%
6.4%
7.0%
6.0%
5.5%
5.5%
5.9%
6.0%
5.0%
4.0%
3.0%
4.5%
5.0%
5.5%
4.0%
2.0%
1.0%
0.0%
2007
2008
202009
2010
2011
Income Statement and Balance Sheet
The assumptions I made regarding the income statement and necessary balance sheet line items are listed
below:

Operating Revenue: Regression models and historic growth rates by individual business segments.

Salaries, wages, and employee benefits: Set as percent of revenue based on weighted average of last three
years with emphasis on most recent years.

Fuel and utilities: Set as percent of revenue based on weighted average of last three years with emphasis
on most recent years.

Equipment and rents: Set as percent of revenue based on weighted average of last three years with
emphasis on most recent years.

Depreciation: Set as percent of revenue based on weighted average of last three years with emphasis on
most recent years. Adjusted to equal capital expenditures in ten years.

Materials and Supplies: Set as percent of revenues based on moving average of last three years.

Purchased services and other costs: Set as percent of revenue based on moving average of last three years.

Operating Margin: Set as result of above assumptions. Generally widening due to possibilities to improve
operational efficiencies but offset by depreciation increasing to equal capital expenditures.

Other income: Historic growth rate.

Interest expense: Set as percent of revenues based on weighted average of last five years with emphasis on
most recent years.

Income taxes: Assumed 35.5 percent tax rate.

Accounts receivable: Set as percent of revenues based on weighted average of last three years with
emphasis on most recent years.

Accounts payable: Set as percent of revenues based on weighted average of last three years with emphasis
on most recent years.
Terminal Value
The assumptions I made regarding the terminal value are listed below:

Market risk premium: 5 percent.

Risk free rate: 3 percent

Beta: 1.11

Terminal discount rate: 8.6 percent

Terminal free cash flow growth rate: 3 percent
Summary
Using the assumptions above, I derived a DCF intrinsic value of $87.22. This value is very close to the
multiple valuation target price of $87.66. In addition, it further supports my conclusion that Union Pacific is
overpriced at its current $98.58 valuation and faces 10 to 15 percent downside risk.
21
Summary
Strengths and Opportunities
Figure 23. Union Pacific Technical Chart
Union Pacific has several
strengths and opportunities in the
current market. First, Union Pacific
has competitive advantages in its size,
location, brand, and diverse commodity
UNION PACIFIC CORPORATION (UNP) Price 98.58
2002
2002
2003
2003
2004 2004
2005
2005
2006
StockVal®
2006 2007
2007
2008
103
99
95
92
88
mix. These advantages will provide
85
Union Pacific with steady earnings that
81
are somewhat less cyclical than its
competitors.
From a fundamental
HI
102
LO
53
ME
63
CU
99
GR 10.3%
78
75
72
70
67
perspective, long and short term
railroad fundamentals are neutral as the
64
62
60
economy is expected to grow
moderately in 2007. Revenues should
increase in line with the economy and
57
55
02-22-2002
02-28-2007
53
PRICE
operating margins should widen as fixed costs diminish due to economies of scale. In addition, there are obvious
opportunities for Union Pacific to increase operating margins beyond that of fixed costs through streamlining
employees, mitigating fuel risk, and increasing throughout on existing railroad networks.
In terms of comparative multiple analysis, Union Pacific is undervalued relative to the overall railroad
industry. Finally, from a technical perspective, Union Pacific is in an upward trend with strong support at $88.
Weaknesses and Threats
Union Pacific also faces many threats and risks. If the economy goes into a recession, Union Pacific will
immediately feel the negative effects.
Furthermore, even though Union Pacific is the largest railroad in terms of revenues and track, it clearly
lacks operational efficiency in comparison to its competitors such as Burlington Northern Santa Fe. This is partially
due to Union Pacific’s dependence on unionized labor and fuel, which is currently expensive relative to historic
means. Union Pacific is also operating near capacity on its current track infrastructure so it may struggle in the short
term to meet demand.
Union Pacific is subject to a variety of non-systematic risk factors as well. It is materially affected by
major storms, which can destroy infrastructure and disrupt operations; governmental regulation; and litigation
related to personal injury and environmental destruction.
In terms of comparative multiple analyses, railroad stocks are expensive on an absolute basis, relative to the
S&P 500, as well as relative to the S&P Industrials. In addition, Union Pacific is expensive relative to the S&P 500
22
and the S&P Industrials sector. Most important, even when factoring in increasing revenues and widening margins,
current valuations are still well above DCF target prices, leaving significant downside risk.
Conclusions
Figure 24. Target Prices versus Current Price
While Union Pacific is in mature business that
$98.58
this poised to grow with the economy and generate stable
sales and cash flow, its potential growth does not come
$87.44
$87.66
$87.22
Final targe t
pri ce
Multiple
targe t pri ce
DC F targe t
pri ce
close to supporting the current price of $98.58. I am
recommending Union Pacific as an immediate sell and
assigning it a one-year price target of $87.44, which is the
average of my multiple and DCF intrinsic values. A
change in the economy, railroad mergers and acquisitions,
or governmental deregulation would warrant a
C urre nt pri ce
reassessment of this recommendation.
Figure 25. The Rocky Mountains
Photo by: Don Winslow ©
23
Table of Figures
Figure 1. Union Pacific Revenues by Segment 2006...................................................................................................3
Figure 2. Business Segment Growth Rates 2006.........................................................................................................4
Figure 3. Three-factor Model Regression Statistics ....................................................................................................5
Figure 4. Schematic: Deriving S&P Industrial Returns in 2007..................................................................................6
Figure 5. S&P Industrial Comparative Multiple Analysis: Five Year Horizon ...........................................................7
Figure 6. Industry Revenues by Segment 2005 ...........................................................................................................8
Figure 7. Timeline of the Railroad Industry ................................................................................................................9
Figure 8. Railroad Revenues and GDP Regression Statistics ....................................................................................10
Figure 9. Cost Structure for Class I Railroads 2005 ..................................................................................................10
Figure 10. Performance Measures - Class I Freight Railroads ....................................................................................11
Figure 11. Five Forces .................................................................................................................................................12
Figure 12. S&P Railroad Index Comparative Multiple Analysis: Five Year Horizon ................................................13
Figure 13. "Building America"....................................................................................................................................14
Figure 14. Dupont Decomposition - Five Year Average .............................................................................................15
Figure 15. Return on Equity - Five Year Average.......................................................................................................16
Figure 16. Return on Equity and Investment since 2004.............................................................................................16
Figure 17. Union Pacific versus Industry Cost Structure 2005 ...................................................................................17
Figure 18. Union Pacific Absolute Valuation - Five Year Horizon.............................................................................18
Figure 19. Union Pacific relative to S&P 500 - Five Year Horizon ............................................................................18
Figure 20. Union Pacific relative to S&P Industrials - Five Year Horizon .................................................................19
Figure 21. Union Pacific relative to S&P Railroads - Five Year Horizon...................................................................19
Figure 22. US GDP and Union Pacific Growth Rate Assumptions.............................................................................20
Figure 23. Union Pacific Technical Chart ...................................................................................................................22
Figure 24. Target Prices versus Current Price .............................................................................................................23
Figure 25. The Rocky Mountains ................................................................................................................................23
24
Appendix 1: Union Pacific Financial Statements from Company 10-K
Union Pacific Corporation
Income Statement (in millions of dollars)
2004
2005
2006
$12,215
$13,578
$15,578
$4,167
$1,816
$1,374
$1,111
$488
$694
$1,270
$10,920
$1,295
10.6%
$4,375
$2,562
$1,402
$1,175
$546
$411
$1,312
$11,783
$1,795
13.2%
$4,599
$3,012
$1,455
$1,237
$691
$410
$1,290
$12,694
$2,884
18.5%
Other income
Interest expense
Income before income taxes
Income before tax margin
$88
($527)
$856
7.0%
$145
($504)
$1,436
10.6%
$118
($477)
$2,525
16.2%
Income taxes
Net Income
Net margin
($252)
$604
4.9%
($410)
$1,026
7.6%
($919)
$1,606
10.3%
$2.33
$2.30
259.1
262.2
$1.20
$3.89
$3.85
263.4
266.5
$1.20
$5.96
$5.91
269.4
272.0
$1.20
Operating Revenues
Operating Expenses:
Salaries, wages, and employee benefits
Fuel and utilities
Equipment and other rents
Depreciation
Materials and supplies
Casualty costs
Purchased services and other costs
Total operating expenses
Operating Income
Operating Margin
Earnings per share - Basic
Earnings per share - Diluted
Weighted average number of shares - Basic
Weighted average number of shares - Diluted
Dividends declared per share
25
Union Pacific Corporation
2005
2006
Assets
Cash and cash equivalents
Accounts receivable, net
Materials and supplies
Current deferred income taxes
Other current assets
Total current assets
Investments in and advances to affiliated companies
Other investments
Total investments
Road
Equipment
Other
Accumulated depreciation
Net properties
Other assets
Total assets
Balance Sheet (in millions of dollars)
$773
$747
$331
$304
$170
$2,325
$789
$17
$806
$33,812
$7,675
$210
($9,722)
$31,975
$514
$35,620
$827
$679
$395
$319
$191
$2,411
$865
$12
$877
$35,634
$7,637
$177
($10,575)
$32,873
$354
$36,515
Liabilities
Accounts payable
Accrued wages and vacation
Accrued casualty costs
Income and other taxes
Dividends and interest
Debt due within one year
Equipment rents payable
Other current liabilities
Total current liabilities
Debt due after one year
Deferred income taxes
Accrued casualty costs
Retiree benefits obligation
Other long-term liabilities
Commitments and contingencies
Total liabilities
$783
$415
$478
$212
$252
$656
$130
$458
$3,384
$6,760
$9,482
$876
$855
$556
$0
$21,913
$684
$412
$409
$279
$238
$780
$108
$629
$3,539
$6,000
$9,696
$868
$504
$596
$0
$21,203
Equity
Common shares
Paid-in-surplus
Retained earnings
Treasury stock
Accumulated other comprehensive loss
Total common shareholders equity
$689
$3,915
$9,932
($599)
($230)
$13,707
$690
$3,943
$11,215
($394)
($142)
$15,312
Total liabilities and common shareholders
$35,620
$36,515
26
Union Pacific Corporation
Cash Flow Statement (in millions of dollars)
2004
$604
Net Income
Cash flows from operating activities
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
$1,111
Deferred income taxes
$359
Stock-based compensation expense
$21
Net gain from asset sales
($69)
Other operating activities, net
$135
Changes in current assets and liabilities, net
$96
Cash provided by operating activities
$2,257
2005
$1,026
2006
$1,606
$1,175
$320
$21
($135)
$37
$151
$2,595
$1,237
$235
$35
($72)
($175)
$14
$2,880
($1,876)
$145
($674)
$674
($1)
($1,732)
($2,169)
$185
($872)
$872
($63)
($2,047)
($2,242)
$133
($536)
$536
$67
($2,042)
($310)
($588)
$745
$80
$0
($2)
($75)
($314)
($699)
$0
$262
$0
($1)
($752)
($322)
($657)
$0
$160
$29
$6
($784)
Net change in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
$450
$527
$977
($204)
$977
$773
$54
$773
$827
Changes in Current Assets and Liabilities, Net of Acquisitions
Accounts receivable, net
Materials and supplies
Other current assets
Accounts, wages, and vacation payable
Other current liabilities
Total
($40)
($42)
$101
$100
($23)
$96
($201)
($22)
$12
$224
$138
$151
$68
($64)
($21)
($102)
$133
$14
$82
$76
$103
$78
$106
$80
($517)
$187
($510)
($29)
($492)
($549)
Cash flows from investing activities
Capital investments
Proceeds from asset sales
Acquisition of equipment pending financings
Proceeds from completed equipment financings
Other investing activities, net
Cash used in investing activities
Cash flows from financing activities
Dividends paid
Debt repaid
Debt issued
Net proceeds from equity compensation plans
Excess tax benefits from equity compensation plans
Other financing activities, net
Cash used in financing activities
Supplemental Cash Flow Information
Non-cash investing activities
Capital investments accrued but not yet paid
Non-cash financing activity, cash dividends declared but not yet paid
Cash (paid) received during the year for:
Interest
Income taxes, net
27
28
-
$16,008,718,500
NPV of terminal value
68%
32%
1.11
Beta
$7,490,255,570
Current Price
5.0%
NPV of free cash flows
Shares Outstanding
3.0%
Market Risk Premium
Implied equity
value/share
Upside/(Downside) to
DCF
Free Cash Flow Yield
Risk Free Rate
Projected Equity
Value
-2%
575,000,887
3.0%
16%
585,325,498
Term. FCF Growth =
29%
502,541,134
14.0%
2,697,725,340
0.0%
-
-78.6%
11.0%
2,119,641,339
-24.6%
1,153,084,888
0.0%
-
35.5%
1,313,406,851
3.2%
8.6%
388,159,179
-15.2%
2,760,061,822
0.0%
4,064,447
65.6%
10.0%
1,811,064,188
-2.3%
1,530,258,686
0.0%
-
35.5%
(842,235,401)
3.2%
616,622,935
16.0%
3,083,114,674
6.4%
19,269,466,716
2010E
Term. Discount Rate =
YOY growth
Free Cash Flow
-15.2%
Capex % of sales
-15.2%
2,605,206,396
2,469,882,865
Subtract Cap Ex
3,551,799
(11,697,678)
0.0%
59.1%
52.5%
9.0%
1,538,507,714
-0.5%
1,565,688,017
0.0%
-0.1%
% of Sales
% of Capex
Plus/(minus) Changes
WC
8.0%
1,296,526,438
% Growth
Add
Depreciation/Amort
% of Sales
1,573,213,284
Net Income
0.0%
35.5%
(861,735,265)
(865,877,079)
35.5%
3.2%
3.2%
16.3%
(579,540,540)
17.4%
(547,024,965)
18.3%
(518,610,575)
5.9%
18,110,641,879
2009E
2,952,034,626
5.5%
17,094,530,160
2008E
2,974,448,248
2,957,700,938
16,206,580,480
2007E
% of sales
Equity Income, net
Tax Rate
Taxes
Interest % of Sales
Interest and Other- net
Operating Margin
Operating Income
% Growth
Revenue
Year
Ticker: UNP
03/01/2007
DCF Valuation
Union Pacific
-11.5%
87.23
98.58
269,400,000
1.65%
$23,498,974,070
51%
870,058,973
13.0%
2,676,471,047
0.0%
-
-88.5%
11.5%
2,367,647,464
2.2%
1,178,882,555
0.0%
-
35.5%
1,374,059,059
3.2%
658,823,642
15.6%
3,211,765,256
6.8%
20,588,238,820
2011E
38%
1,202,147,497
12.0%
2,638,216,891
0.0%
-
-100.0%
12.0%
2,638,216,891
2.0%
1,202,147,497
0.0%
-
35.5%
1,436,069,394
3.2%
703,524,504
15.2%
3,341,741,395
6.8%
21,985,140,758
2012E
28%
1,532,839,741
11.0%
2,581,130,831
0.0%
-
-109.1%
12.0%
2,815,779,089
8.0%
1,298,191,484
0.0%
-
35.5%
1,541,052,430
3.2%
750,874,424
15.3%
3,590,118,338
6.7%
23,464,825,739
2013E
21%
1,857,265,901
10.0%
2,503,222,456
0.0%
-
-115.0%
11.5%
2,878,705,825
14.1%
1,481,782,533
0.0%
-
35.5%
1,697,309,987
3.2%
801,031,186
15.9%
3,980,123,706
6.7%
25,032,224,563
2014E
5%
1,950,292,056
10.0%
2,669,256,219
0.0%
-
-110.0%
11.0%
2,936,181,841
13.6%
1,683,366,434
0.0%
-
35.5%
1,866,744,337
3.2%
854,161,990
16.5%
4,404,272,761
6.6%
26,692,562,189
2015E
Terminal
5%
2,046,649,682
10.0%
2,845,137,529
0.0%
-
-105.0%
10.5%
2,987,394,406
13.1%
1,904,392,805
0.0%
-
35.5%
2,050,348,360
3.2%
910,444,009
17.1%
4,865,185,175
6.6%
28,451,375,291
2016E
39,471,594,781
4%
2,126,867,486
10.0%
3,031,453,087
0.0%
-
-100.0%
10.0%
3,031,453,087
11.7%
2,126,867,486
0.0%
-
35.5%
2,238,424,959
3.2%
970,064,988
17.6%
5,335,357,433
6.5%
30,314,530,869
2017E
Forecast
Appendix 2: Union Pacific Discounted Cash Flow Model