Union Pacific: Rolling Along and Crushing the Competition

If you see an industry leader that is clearly dominating its peers, it usually makes sense to consider buying the stock. In the railroad industry there are three big publicly traded competitors: CSX (NYSE: CSX  ) , Norfolk Southern (NYSE: NSC  ) , and Union Pacific (NYSE: UNP  ) . Among these three, Union Pacific is the dominant franchise. The company doesn't just beat its peers on one or two measures, it rolls over them like a runaway train.

A uniquely valuable industry
Buying a stock means that you get a small ownership interest in the company. You can do your homework and keep up with how the company is doing, but few stocks give you a full economic report like a railroad stock.

Each of the major railroads reports its operations slightly differently. Norfolk Southern lumps multiple categories of shipments under the heading "general merchandise", while CSX and Union Pacific are more specific about chemicals, industrial products, automotive, and additional industries. In short, investors get a multiple industry update every three months when these companies report earnings.

The second unique characteristic of railroad stocks is that there might not be a bigger moat in any other industry. Trucking and other forms of transportation might compete against the railroads, but shipping products by rail is arguably more cost effective. In addition, it's not like someone can come along and install thousands of miles of railroad track and set up a competing railway overnight. With a huge moat, and detailed information on multiple industries, each of the railroads could represent an opportunity, but what makes Union Pacific different?

Bucking the trend and setting the standard
One of Union Pacific's most important accomplishments in the last several years has been the company's ability to deal with depressed coal prices. Last quarter was no different with Union Pacific as the only one of the big three railroads to report positive revenue growth in coal shipments.

Prior to reporting earnings, Union Pacific warned that coal could be a culprit in its third quarter results being a few cents lower than expected . Though some might point to Union Pacific reporting earnings that missed estimates by $0.02, keep in mind this is a company that beat expectations by a combined $0.14 over the last four quarters. If you look at Union Pacific's results relative to its peers, the numbers speak for themselves.

With CSX and Norfolk Southern reporting coal revenues down 7 % and 9% respectively, reporting growth in coal revenues is an impressive feat by Union Pacific. It should come as no surprise that Union Pacific's superior performance in the weak coal segment also allowed the railroad to report an operating margin higher than either of its competitors as well. All things being equal, a company with a higher operating margin is more insulated from pricing challenges and weaker demand.

With an operating margin of over 35%, Union Pacific isn't just outperforming the competition, it's crushing them. Both CSX and Norfolk Southern reported margins of 30% or less. This may not sound like a huge difference, but with Union Pacific posting over $5 billion in sales each quarter, this 3% higher operating margin means millions more in profits.

Connecting the dots
Union Pacific's better coal performance and a better operating margin are two important factors in the company's better cash flow. Many investors use cash flow growth as a key factor in deciding what stocks to purchase. Since earnings can be manipulated, cash flow is a more pure measure of what a company can return to shareholders.

When comparing companies, using core operating cash flow helps to strip away some of the accounting line items that aren't real cash expenditures. Core operating cash flow is simply net income plus depreciation. By this metric, Union Pacific again comes out on top of its peers.

From the third quarter of 2012 to the third quarter of 2013, Union Pacific increased operating cash flow by nearly 8%. By comparison, CSX managed less than half this increase and Norfolk Southern performed even worse.

In addition, Union Pacific's better operating cash flow gives investors a better dividend payout ratio as well. As in other cases, the difference between Union Pacific's core free cash flow payout ratio of 51%, and its peers' ratios of more than 75% isn't insignificant.

As you can see, from better margins, to better cash flow, Union Pacific is beating up on the competition. The company's lower payout ratio could also mean bigger dividend increases as well. When you connect the dots, buying Union Pacific could put investors on the right track for superior returns.

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