Investors buy stocks for all sorts of reasons, and what might seem a boring investment to some will be core holding in a retirement portfolio for others. In the case of Class 1 railroad Union Pacific (NYSE:UNP), it's all about the safety and growth potential in its current 2.3% dividend yield. Here's why it deserves a close look for income-seeking investors.

The case for buying Union Pacific

You can think of Union Pacific as a relatively low risk with more income-generating potential. It's not the sort of stock that's going to shoot the lights out from here, but it should provide investors with good investment returns over the next decade.

A freight train

Image source: Getty Images.

That said, investing is rarely that simple, and before you rush to buy Union Pacific you have to consider the following:

  • What's the risk that Union Pacific's earnings will collapse in the years to come, and how sustainable is its dividend?
  • Does the company have any potential to grow its earnings, and consequently, its dividend?

Union Pacific is relatively low risk, but watch the economy

One of the key attractions of buying railroad stocks is their relatively stable market position. The two major railroads on the West Coast are Union Pacific and Berkshire Hathaway's BNSF, while on the East Coast the largest railroads are CSX (NASDAQ:CSX) and Norfolk Southern (NYSE:NSC). They operate as effective duopolies with their geographies and own their own infrastructure, granting them relatively unassailable market positions in rail freight.

While they do face competition from trucking, it's safe to say there's relatively low risk that they will face some sort of structural challenge to their business in the future. As long as physical goods need to be moved around, then Union Pacific will be around to move them.

As such, the two big risks facing Union Pacific are the trends in the industrial economy and its exposure to a declining coal industry. As you can see below, the revenues of all the railroads tend to move in line with U.S. industrial production. This is hardly surprising, given the heavy goods that railroads tend to move around. In this context, buying Union Pacific stock is really a vote of confidence in the ability of the U.S. industrial economy to grow after the shock of the COVID-19 pandemic.

UNP Revenue (TTM) Chart

Data by YCharts. Note, darker areas of the chart indicate a recession in the U.S.

What about coal?

The chart below shows that coal and renewables -- think wood and biomass -- only made up 9% of revenue in the first quarter, so decent growth in the rest of Union Pacific's end markets can offset ongoing declines in revenue from coal. The declining use of coal for energy production is certainly a headwind for the railroads, but there are plenty of other growth markets, for example e-commerce deliveries (intermodal) and chemicals, that can offset it.

Union Pacific revenue share

Data source: Union Pacific presentations.

Growth opportunity

In a sense, you can think of Union Pacific as a kind of "GDP growth" type stock with some headwinds from declining coal revenue. While that's not the most exciting growth outlook from a revenue perspective, it's worth noting that the company has aggressive plans for operating margin expansion through the ongoing adoption of precision scheduled railroading, or PSR, management techniques. 

PSR focuses on running trains between fixed points on a network on a fixed schedule, as opposed to the traditional hub-and-spoke model, where schedules vary considerably. All the evidence suggests that it works and before the pandemic hit, CSX, Norfolk Southern, Kansas City Southern (NYSE:KSU), and Union Pacific were all forecasting lowering their operating ratios (OR) in 2020 in spite of a mediocre revenue outlook. For reference, the OR is simply operating expenses divided by revenue, so a lower number is better.

Over time, Union Pacific believes it can lower its OR to 55% from 60.6% in 2019. To put this into context, consider the following table, which provides a rough illustration of matters.Union Pacific has grown its revenue at a rate of 3.15% over the last two decades, so let's use that figure as a baseline case for annual revenue growth over the next decade. 

The columns show two different scenarios for the OR. The first assumes Union Pacific's OR stays constant a 60.6% over the next decade. The second column assumes the OR is reduced from 60.6% to 55% over the next decade. 

The key point to take away is that even with annual revenue growth of just 2.15% the reduction in the OR leads to an annual operating income increase of 3.52%. This is a figure superior to the 3.15% increase generated by the baseline case of revenue growth of 3.15% with a constant OR. Simply put, reducing the OR will offset any slowdown in revenue growth. 

Annual growth in operating income based on revenue growth and margins

Revenue growth

Constant Operating Ratio of 60.6%

Operating Ratio Goes From 60.6% to 55% in a Decade

Revenue growth of 2.15%

2.15%

3.52%

Revenue growth of 3.15%

3.15%

4.53%

Revenue growth of 4.15%

4.15%

5.54%

Data source: Author's analysis.

A stock to buy?

There's no guarantee that Union Pacific will hit its intended OR target, and no one really knows if the U.S. industrial economy will grow at its historical rate in the future.

On the other hand, if economic growth is low, then interest rates are also likely to stay low, making the relative attraction of Union Pacific's 2.3% dividend yield even more attractive. In addition, through a combination of revenue growth, lower OR, and buybacks to reduce share count; Union Pacific has actually grown its dividend by an annual rate of 16% over the last two decades.  

Those are pretty good figures when compared with the yield of low risk investments like Treasury bonds. In addition, the relative safety of the company's market position means it's a useful option for dividend investors. As such, it looks a good place to park some cash for some long-term income.