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The State of the Union Pacific (UNP)
By: Martin Tillier
Union Pacific (UNP) has, it seems, done everything right over the last few years. As competitors such as CSX (CSX) feel the effects of lower coal demand, UNP has continued to power on upward. Their focus on the transportation of chemicals, oil and gas has paid off handsomely, as evidenced by Q4 2013 earnings of $2.55 per share released last week that beat expectations quite handsomely. One would expect a railroad stock to have done well as the US economy ground its way out of recession, but the 5 year chart for UNP is still impressive.
Despite my natural tendency towards contrarianism, I have remained positive on railroad stocks in general throughout the recovery. Share price, after all, is simply a reflection of earnings in a mature company such as this and, while UNP’s forward P/E (Price to Earnings Ratio) of 16.07 is high by industry standards it is hardly the stuff of which bubbles are made.
Add to that a decent (and growing) dividend that amounts to a yield of 2.65% and it has been a fairly obvious call. Unfortunately, though, the time has come for some caution in railroad stocks as a whole, and the very thing that has protected UNP from the problems others have faced may become their Achilles heel.
As I mentioned above, UNP has been less reliant on dwindling coal shipments than many of its competitors. Even if coal had rebounded that would seem to be a smart move, as, according to the Association of American Railrods (AAR), coal accounted for 41% of tonnage originated in 2012 but only 21.6% of revenue for major railroads. Coal, of course, has not rebounded, so a concentration on higher margin business such as oil and ethanol looks doubly smart. The problem, though, is not so much what is carried as what it is carried in.
Hazardous liquids are generally transported around the US in specially designed rail cars known as DOT 111s. In fact, DOT 111s make up around two thirds of the capacity to transport crude oil and other flammable and hazardous liquids. There have been concerns about the safety of these cars since 1991. It is believed that they have a tendency to split and spill out their contents in the event of a derailment, with obvious environmental and safety implications. Given that this has been known since 1991, though, why is it now a potential problem for UNP?
Well, firstly the shale boom in North Dakota and other areas not yet served by pipelines has resulted in a massive increase in the amount of oil being shipped around the US. According to this AAR study, the number of carloads of crude oil shipped increased from 9,500 in 2008 to over 200,000 in 2012, an increase of around 2000%. That trend is sure to continue when figures for last year become available. With that increase has come renewed concerns about public safety. The Canadian and US Transportation Safety Boards issued a recommendation last week that DOT 111s be retrofitted to improve safety.
That is still old news in market terms, though, so again the question arises, why is it a worry now?
Last night, as I watched the President’s State of the Union address, something occurred to me. President Obama has overcome uneasiness within his own party about possible environmental impact of the expansion of oil production and focused on the beneficial economic impact, but eventually he will have to offer something to appease the fears of that lobby. Addressing the concerns of environmentalists that have been around for decades would fit that bill.
Taking on the recommendation of the NTSB to order a safety upgrade in those tanker cars is something that the President could do within the boundaries of his executive power, and it should be fairly easy to achieve some degree of consensus around a measure to protect the public. The move would serve a significant political purpose, as it would be a sign that Obama is still prepared to stand up to big business when he has to. It may not happen tomorrow, but it would seem a reasonable bet that it is coming.
If that sounds a little cynical, forgive me. It’s just that decades of observing the words and actions of politicians and their effects on markets has led me to the conclusion that cynicism is usually a decent point from which to start. If such a decision is made I have no doubt that it will be born of a genuine concern for safety, but the political expediency of the move would make it doubly appealing.
It is, therefore, a belief that railroad companies will soon be looking at significant expenditure to upgrade many of their cars that leads me to conclude that over the next few months, the state of the Union Pacific will be anything but strong.