Why Union Pacific Is Outperforming

union pacific

The rail transport industry has been one of the best performing sectors over the past several years. The shares of every major rail transport company are trading at several multiples of their prices in the early 2000s.

There are two reasons for this. The first is that rail transport companies operate as a de facto oligopoly. There are only a handful of them throughout North America, and with a couple of exceptions, in any given region there are only two or three competitors. This gives rail transport companies pricing power.

The second is that rail transport is more efficient than trucking. Rail transport uses less fuel and a train employs one person to do the the work that hundreds of truckers would need to do. While this doesn’t make trucks obsolete, it makes rail transport the preferable mode of shipment for industrial and consumer goods.  Furthermore, the advantage that rail transport has over truck transport has been growing.  Not only are trains more fuel efficient than trucks, but fuel has become more expensive, thus widening the gap.  Employing somebody is more expensive as well thanks to a more complicated regulatory environment.

Despite these longer-term positive trends the last couple of years have been tough for rail transport companies. This is the case because one of the primary goods shipped by each of these companies is coal, and coal prices are down, as is demand, as a result of stricter regulations on coal-based electricity.  While this hit some companies more so than others, every major railroad company was impacted.

However, one company that has continued to grow its sales and profits at an admirable pace is Union Pacific (NYSE:UNP). Union Pacific is the largest publicly traded rail transport company. It is also the only publicly traded rail transport company that predominantly operates in the western United States and in Canada, as Warren Buffet’s Berkshire Hathaway (NYSE:BRK.A) bought the company’s major competitor — Burlington Northern Santa Fe.

Union Pacific reported excellent fourth quarter results. It grew its profits by 13 percent, its earnings per share by 16 percent thanks to share repurchases, and its sales by over 7 percent. Year over year the numbers were just as impressive given the weak economic environment. Profits grew by 11 percent, EPS grew by 15 percent, and sales grew by 5 percent.

This is what we have seen from the rails for many years, although this performance is especially laudable considering the slumps we saw from the east coast rail companies.

Despite this performance, however, investors are well aware of Union Pacific’s “best of breed” standing in the industry. As a result it trades at just under 20 times trailing earnings and at 17 times 2014 earnings estimates. By comparison CSX (NYSE:CSX), which was hit harder by the coal slump, trades at about 15.6 times trailing earnings and at 15.4 times 2014 estimates.

In short investors believe that Union Pacific’s outperformance will continue. While the company was hit by the difficult coal market this was more than offset by the extremely strong agriculture market, which more than offset weakness in coal. East coast rail transport companies don’t have nearly as much exposure to agriculture — as farms are mostly located in the west, and so we see the decline in coal volumes more readily in their financials.

Ultimately I think investors should consider adding Union Pacific on weakness. While I like the east coast rails at their current valuations, I think that Union Pacific, given its stellar outperformance and its rail lines’ proximity to the booming agriculture and oil industries, is worth considering on weakness.

Like with many stocks in the S&P 500 and even in the rail space, Union Pacific shares are trading near an all-time high. Therefore I think investors should wait for weakness. The stock currently trades at $187/share, although it looks to be topping out somewhat. There appears to be long term support at around $165/share, although keep in mind that this is a large dip for a large cap company with a steady high-margin business such as Union Pacific. So it may not reach that price point. But I think it could if we see weak first quarter numbers.

While a lot of companies and economists are using the “cold weather excuse” to justify weak numbers this actually is a concern for rail companies. Union Pacific has a lot of business in the Northwestern United States and in Western Canada, and these are areas that get very cold. Another rail transport company — Canadian National Railway (NYSE:CNI) — saw a plunge in profits last year due to cold weather. If this leads to a pullback long term investors should use it to take a position.

Disclosure: Ben Kramer-Miller is long CSX Corp.

More From Wall St. Cheat Sheet: