The Business Of

Transportation | Union Pacific | What Do They Do With Their Profits?

Morning All!

Yesterday we put together Union Pacific Corporation’s costs with their revenues. And we’ve covered a fair amount this week. So let’s have a quick recap…

• Low competition: Whilst there are 6 major railroad companies in N America, only 2 of them actually have rail tracks in the West of America!

• High pricing: The number of freight cars that UPC transport has DECLINED over the last 2 decades. But the price UPC charges has more than doubled!

• Low staff: Since 2015, UPC’s adoption of precision scheduled railroading (PSR) has seen the company cut ~35% of their staff and boost their margins!

And speaking of margin. It is a Thursday morning. Which means it’s time to take a look at our famous TBO EBIT Margin ranking! Below, we can see our ranking updated to include Union Pacific Corporation. And what an entry that is… straight in at number 4!

Now, the difference between the 40% margin we see at Union Pacific vs the 17% margin we see at Maersk is because of something we mentioned yesterday - pricing power. Maersk have very little pricing power. Whereas Union Pacific have a ton of pricing power, given they only really have 1 other railroad competitor - BNSF!

I really want to us to explore the pricing impact on margins a little more and so tomorrow - along with the trucks vs train debate - we’ll look at why pricing growth is often better than volume growth for EBIT margins. But for now, let’s crack on with the topic for today, and find out how the railroad giant uses all their profits!

TSMC Keeps The Capex Crown… Just!

So, to kick us off, let’s as always look at the waterfall chart below. Which shows us how Union Pacific have spent their cash from operations (CFO) since 2001. And we see something super interesting. Union Pacific have spent more than half of their CFO on capex!

And they spend a huge amount on share buybacks too. But just sticking with capex for a minute. This massive capex investment is very similar to what we saw last week. In The Business Of Maersk, we saw that the Danish shipping giant spent a significant amount of their cash on building ships.

But would you believe it, as the table below shows, Union Pacific actually spend even more of their cash on capex. Not quite as high as TSMC though!

There Are Around 3 Trail Derailments A Day In America!

Now, I know what you’re thinking. Maersk spent loads of cash on building and repairing ships. So, Union Pacific must be spending loads on building trains and tracks right? Well, it’s a great guess - but it’s not quite right!

Because as we can see from the chart below, over 50% of Union Pacific’s capex over the years has been spent on something called ‘road infrastructure replacements’. Which is basically Union Pacific just replacing and repairing their current tracks, trains, and equipment! It’s not about growing their number of trains, or tracks.

Now, some of us may be wondering - why on Earth do Union Pacific need to spend billions of dollars every year to just replace their tracks and trains?

Well, the answer is because train accidents and derailments are much more common than you would think. In 2022, there were >1,000 train derailments in America! Which is ~3 train derailments a day! And these are incredibly dangerous and painful moments. The image below shows us what the wreckage looked like when a Norfolk Southern train derailed just earlier this year in Ohio.

Now, why do these trains derail? Well, the most common reason is human error. Which I assume can be reduced through improved hiring and training. But the second most common reason is track defects. Tracks get worn down and broken. And when this happens, wheels can fall off tracks and cause serious damage as we’ve seen.

So, not the most upbeat topic - apologies! - but I just wanted to highlight that this is why railroad companies like Union Pacific spend so much money on repairing and replacing their tracks and trains. Train derailments cause injury and harm to Union Pacific’s employees. But they also damage the company’s reputation and their service to customers.

Expanding Is Expensive… Very Expensive!

Now, just before we wrap up on capex, there is one other thing I wanted to mention. And that is to look at why railroad companies don’t spend a lot of money on expanding their operations. I mean, it would make sense for them to do so right? If they built new tracks and trains, they could carry more containers, cars, grain, etc. and make more revenue?

Well, yes, that logic is correct. But that’s not what we see. In 2022, Union Pacific started the year with ~34,000 miles of track. And during the year, guess how many miles of new track they built? 44! That’s an increase of about 0.1%! Tiny!

And the reason why we don’t see Union Pacific building new track to expand their capacity is because of how expensive it is! Now, there isn’t one exact number here. But from several articles online, it seems that the average cost of building just one extra mile of track is ~$1-3 million dollars!

And if we look at Union Pacific’s annual reports, that number looks about right. Because although the company only built 44 new miles of track in 2022 - guess how much money they spent on ‘line expansion and other capacity projects’? A whopping $276 million! If we assume line expansion was about half of that ($138 million), that would work out to roughly $3 million per new mile! ($138 million/44 miles). Expensive!

Revenue Growth Of 4%… But Share Returns Of 16%?! How?

Okay, as we wrap up - let’s look at the other main ways Union Pacific uses their cash. Because whilst half of their cash is spent on capex, the other half is returned back to shareholders in the form of share buybacks and dividends!

Now, to understand buybacks, let’s start with revenues. We saw on Tuesday that Union Pacific’s revenue has increased by a fairly sedate ~4% per year since 2001. However, because of the margin improvement we saw yesterday, the company’s profit (net income) has grown by a healthier ~10% per year. But here’s a question - if net income has grown by ~10% per year, why has EPS (earnings per share) increased by ~13% per year? What’s going on here? By the way, earnings per share = net income per share.

Well, let’s think about it. We know ‘earnings’ and ‘net income’ are the same thing. And so, if Earnings PER SHARE is growing at a faster rate than net income - it can only mean one thing… the number of shares has gone down! For those of us who are a little confused here - don’t worry about it, it’s a little technical. But I recommend giving this nice, simple article from Investopedia a read.

The chart below shows us that since 2007, Union Pacific’s management has followed a consistent share buyback program. Which has meant that the company’s number of shares has decreased by ~3% per year since 2001. By the way, that 3% is the missing piece between the net income growth (10%) and EPS growth (13%) we saw earlier!

So, happy days for shareholders. The company’s profits have grown at ~10% per year for the last 20 years. And Union Pacific’s management have helped things further by buying shares and boosting EPS by ~13% per year!

Buttttt, there’s even better news to come! In the chart below, the blue line shows us how Union Pacific’s share price has increased from $13.2 (Jan 2001) to $229.8 (Dec 2023). Now, whilst this ~17x return is clearly pretty decent… is this accurate? Aren’t we missing something…?

And the answer is yes… we are missing something! We’re forgetting about dividends! The chart below shows us that if you bought Union Pacific shares in 2001, received dividends from the company and DID NOT REINVEST those dividends into Union Pacific (e.g. buy more shares of Union Pacific with the dividend cash), you would have made that ~17x return we just saw.

However, if you received your dividends from the company and DID REINVEST that cash into Union Pacific. You wouldn’t have made a ~17x return… you’d have made a ~27x return! Which works out to a total return of ~16% a year for 22 years - incredible! If you’re feeling a little lost on this point - I recommend checking out this article which explains the dividend reinvestment point a bit clearer!

So to sum up. From 2001-2022;

• Union Pacific’s revenue growth has been fairly slow at ~4% per year.

• But because of their control on costs, net income has grown at ~10% per year.

• The decision to buy back shares has seen EPS grow at ~13% per year.

• And dividends has meant a total share return of ~16% per year (~27x overall)!

21st Dec 2023

Nigel Jacob CFA