Source: Flickr/Loco Steve.
Over the past decade, the Class I railroad Union Pacific (UNP 1.03%) has been on a roll. Its stock outperformed the market in eight out of those 10 years, spurred by economic growth, an increase in oil-related traffic, and effective cost-cutting programs. Investors who held during that time period are undoubtedly patting themselves on the back.
For the rest of us, however, is it too late to get on board? What if the tailwinds propelling this railroad stock suddenly change course?
Before you go out and load up on shares of Union Pacific, here are three key risks you need to consider:
1. The rail industry lives and dies at the hand of regulators
The regulatory environment has been quite favorable for railroads in recent years. The Staggers Rail Act of 1980 dramatically changed the way major carriers conduct their operations, and the oligopoly it created has -- for the most part -- balanced the pricing concerns of customers with the high costs of running a railroad.
But that dynamic can change on a whim, especially as Class I railroads like Union Pacific rake in record profits and consistently earn returns that exceed their cost of capital. Union Pacific, in fact, barely crossed that threshold in 2010, after at least 50 years of missing the hurdle.
Now that higher returns are business as usual, it provides customers with leverage when protesting price increases. Powerful interests in the chemicals or manufacturing industry can point to certain routes where competition is limited or nonexistent and prompt lawmakers to re-evaluate the current structure.
On the whole, it is very difficult to gauge how lawmakers will respond to ongoing complaints. Chemical companies have suggested an idea that would allow them to quickly switch carriers if they found a better price. This proposal is called "competitive switching," and it's a solution that could result in higher costs for railroads. Obviously, the worst-case scenario would be if regulators put a cap on carriers' pricing power, which would dampen their profits even more.
Because regulation can have such a profound effect on rail, this storyline is one that investors need to become familiar with. Bureaucratic regulators, as you may know, can be highly unpredictable, and every aspect of the rail industry can be touched by their actions.
What happens, for instance, if developing economies follow in the U.S.' footsteps and de-emphasize the use of coal for electrical generation? In some ways, it might be in their best interest, economically speaking, but it would have dire consequences for railroads that depend on America's coal exports.
2. Safety concerns could affect oil transport
Source: Flickr/Roy Luck.
The ongoing American energy revolution has been a boon for railroads, but along with it came increased risk for carriers.
The growth of fracking and horizontal drilling has led to a dramatic increase in energy-related shipments. In 2009, only 3% of rail carloads were hauling petroleum or petroleum products across America. Today, roughly half of all carloads are carrying goods for the oil and gas industry.
Consequently, railroads have found that transporting a highly flammable liquid is much different than moving grain or household products. In April, three crude oil cars on a CSX train bust into flames and spilled some of their contents into the James River. No one was injured in the accident, but it was the latest in a series of mishaps that have caused the oil and rail industries to re-evaluate their safety standards.
In a best-case scenario for railroads, carriers will work quickly with manufacturers to build more robust railcars for transporting crude oil. This would add new expenses but avoid a stoppage in terms of traffic.
Of course, any future accidents could lead regulators to press the brakes on this area of the business altogether, an outcome that would not bode well for Union Pacific. The company does not disclose the portion of its revenue that comes from oil, but this commodity gets lumped in with the chemicals business, which generates 17% of sales.
3. Unpredictable weather is likely to cause more scheduling chaos
In Union Pacific's midyear presentation to investors, management made the following crystal clear about its 2014 outlook: "Weather will be a factor."
Without context you might find that statement unnecessary. Isn't weather always a factor? While this is true, more and more companies are recognizing that the increasing unpredictability of weather patterns poses challenges for their businesses. Railroads are no exception.
And railroads, in particular, loathe unpredictability.
Just as you probably hate waiting on trains at the station, their customers resent late arrivals. Their schedulers can't stand delays on the track. And, of course, the tracks themselves can't do much to offset the effects of unpredictable and sometimes disastrous weather patterns. Flooding, for example, severed a number of key corridors for Union Pacific this summer, including an important artery referred to as the East-West mainline.
These types of disruptions can have a severe impact on a railroads' performance. There is a domino-like effect when one line experiences a delay, which can then ripple across the entire network.
If the climate in a certain region changes over time, that can present both risk and opportunity for an industry. That's true for rail as well. But if unpredictable patterns and increasingly severe storms become the new normal, there's really no upside for a logistics-oriented business. Instead, it just makes a typically steady and reliable business a whole lot more volatile. And that poses additional risk for investors.
The takeaway for investors
Railroads like Union Pacific might seem invincible right now after an incredible 10-year run. But investors should not lose sight of the fact that the industry requires heavy reinvestment, thereby creating only a sliver of wiggle room in which to generate returns beyond their cost of capital.
Should pricing power decrease, oil volumes slacken, or volatile weather cause disruptions, Union Pacific's market-beating track record could come to an end.
