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Cash-Gushing Union Pacific Looks Undervalued

While most rails are fairly valued today, Union Pacific is trading at a discount, and it is poised to benefit from an intermodal recovery.

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Keith Schoonmaker: When thinking about wide-moat North American railroads, there are three key points to keep in mind. First, industry carloads are recovering following a two-year freight recession, and total traffic is up 3% year to date. Coal cars are about 15% above 2016 levels, but due to abundant cheap natural gas, we project no permanent reversal in coal's secular decline. Intermodal containers inflected positive in the fourth quarter and are slightly positive year to date. Several commodities are below prior year levels, but long term, we project 1.5% total carload growth, coupled with 2% to 3% pricing gains, and a percentage point of margin improvement per year.

Second, CSX just appointed as CEO Hunter Harrison, Morningstar's 2013 CEO of the year. This will be his fourth rail turn around. While CSX is in better shape than was CP, which improved its EBIT margin nearly 20 percentage points during Harrison's tenure, we believe he is a powerful catalyst for excellence and expect CSX's operating ratio to improve at a faster pace now that he's on board. That said, we think CSX shares already have this improvement baked in, and are fairly valued.

Finally, we view most of the rails as fairly valued at this point, but suggest investors consider Union Pacific. It gushes cash, trades below our fair value estimate, offers the highest dividend yield among rails, and stands to benefit well from intermodal recovery, given that its long lengths of haul amplify advantages of rail over trucking.

Keith Schoonmaker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.