(The following story appeared on TheStockAdvisors.com on July 14.)
SALEM, Ore. — “Railroads are a play on three big secular themes: the drive for increased energy efficiency, growth in coal and the agriculture boom,” says Elliott Gue, a energy sector expert who has been in Japan covering the G8 Summit.
Meanwhile, in his The Energy Srategist, he states, “Railroads are now among the most fuel-efficient forms of freight transport available.” Here, he offers a bullish review of Union Pacific (NYSE: UNP).
“My long-held thesis on the group has been that the railroads are no longer totally dependent on the US economy for their growth.
“It’s no longer appropriate to look at this sector as viciously economy sensitive. The traditional relationship between the broader market and the rails has been breaking down for several years, but this trend appears to be accelerating.
“In 2007, according to the Association of American Railroads (AAR), the average railroad moved a ton of freight a distance of 436 miles on a single gallon of diesel fuel. That makes freight trains roughly three to four times more fuel efficient than trucks.
“Union Pacific is the largest railroad in the US and has long been one of my favorites. The company’s network is nearly 33,000 miles long and is concentrated in the West and Midwest. It also offers a convenient example of the bullish forces at work for the rails, particularly in the coal and agriculture industries.
“Union Pacific’s energy segment is its largest by revenue; it accounts for just shy of 20% of the company’s business. Coal transport from a region of the West known as the Powder River Basin comprises the majority of Union Pacific’s energy transport business.
“Strong demand for coal transport has made this segment a real bright spot for the railroad in recent years. Better still, Union-Pacific still transports coal under contracts signed years ago at lower freight rates. As these contracts expire, Union Pacific should see strong pricing gains as it signs new deals.
“Agriculture is its most profitable business lines in terms of average revenue per car. This segment is roughly 80% grain and grain products (like ethanol) shipments.
“Industrial products account for around 19% of total revenues; the trends in this business aren’t particularly positive. In particular, the housing bust has brought a severe slowdown in demand for construction-related products and commodities such as lumber.
“The chemicals segment is a solid, growing business for Union Pacific. Demand for fertilizers is booming because of rising prices for agricultural commodities. And shipments of petroleum-related chemicals have also remained firm.
“Overall, this rundown of Union’s business illustrates that the majority of the company’s segments aren’t particularly sensitive to US economic growth; some, such as coal and agricultural shipments, are driven more by overseas demand.
“Even more important, even in segments showing flat or falling volume growth, Union Pacific has been able to boost pricing. This is a phenomenon many analysts call the railroad Renaissance.
“In short, weak returns and profitability throughout much of the ’80s and ’90s meant that railroad operators didn’t invest much in expanding their networks. Much of the cash they did invest was directed at improving fuel efficiency or taking other steps to cut costs.
“With capacity constrained and demand for shipments rising, railroads for the first time in decades had real power to raise prices.
“This pricing power should continue; in order for the rails to invest the capital needed to expand their capacity, they’ll need to earn a decent return on their investment. Most of the big rails have begun to plow some of their free cash flow into expansions.
“A final trend is worth noting: The railroads are taking steps to cut their costs and improve the traffic flow across their lines. Union Pacific has implemented a scheduled railway, adopted a sophisticated computer system and locomotives designed to reduce fuel consumption, and added to capacity on parts of its network where there are visible bottlenecks.
“The result: Union Pacific’s costs have been falling, and network reliability improving. These steps have also added to profitability. Overall, I rate Union Pacific as a buy.”