The two largest listed U.S. Class 1 railroads make for an interesting comparison for investors. CSX (CSX 1.67%) and Union Pacific (UNP 0.94%) are effective oligopolies within their geographies, and their long-term security of earnings and cash flows can be used to reward investors seeking dividend income. That said, let's take a strategic overview of three key parameters that investors use to compare investing in the two.
Operating margin and precision scheduled railroading
The key development in the railroad sector in the last few years has been the widescale adoption of precision scheduled railroading (PSR) management techniques and how it's improving profitability. In a nutshell, PSR is a set of initiatives based on running engines on fixed times between fixed points on a network. This is opposed to the traditional hub-and-spoke model.
Image source: Getty Images.
The key benefit of PSR is that it tends to allow railroads to run the same amount of traffic with fewer assets. As such, railroads have been lowering their operating ratio, or OR (operating expenses divided by revenue) and conversely raising their operating margin. For reference, a lower OR is better.
CSX initiated PSR in 2017, and you can see the dramatic improvements in the OR below. In comparison, Union Pacific began in 2018, and here again, you can see clear improvement. Union Pacific's management believes it can ultimately reach an OR of 55%, while CSX's OR of 56.9% in the third quarter and 59.4% in the first nine months puts it significantly ahead of management's target of an OR of 60% by 2020.
On balance, it appears CSX is doing better than Union Pacific in this regard in 2020.
Data source: Company presentations.
Exposure to coal
It's no secret that coal is an industry in decline. The share of electricity produced from coal appears to be inexorably falling, and coal is not seen as the fossil fuel of choice by most energy observers. Add in the prospect of some unfavorable regulatory changes from the new administration and coal's challenges are likely to continue.
All of this is bad news for the rail industry, but as you can see below, it appears to be more of an issue for CSX. Not only does CSX generate more of its revenue from coal, but its revenue per car is higher, implying that it will suffer more due to a drop in volume. Moreover, CSX transports coal from the Appalachian region while Union Pacific transports from the lower-cost Powder River Basin.
For reference, CSX's revenue per car is relatively high because around 75% of its current export coal revenue comes from metallurgical coal (steel production) which is seen as less at risk from the growth of renewable energy.
However, the majority of its domestic coal volume comes from thermal coal, so it's still highly susceptible to changes in external demand. In addition in 2019, around 45% of Union Pacific's energy revenue came from non-coal sources.
Simply put, if you are just looking at coal exposure, then Union Pacific is the more attractive stock.
|
First Nine Months 2020 |
Coal as Share of Revenue |
Coal Revenue |
Change (YOY) |
Average Revenue per Car |
|---|---|---|---|---|
|
Union Pacific* |
8.8% |
$1,177 million |
(28%) |
$1,938 |
|
CSX |
13.2% |
$1,022 million |
(37%) |
$2,207 |
Data source: Company presentations. *Coal and renewables
Free cash flow to dividend coverage
Union Pacific's near-2% dividend yield compares favorably with CSX's 1.2%. However, investors also need to look into the railroads' ability to grow the dividend and valuations too. As you can see below, both transportation stocks' dividends are very well covered by free cash flow (FCF), with CSX's greater coverage seemingly giving it the edge.
On the other hand, the two stocks trade on similar price-to-FCF multiples, which implies they could theoretically pay the same dividend yield -- assuming all of FCF is paid out in dividends. Similarly, FCF can be used to make share buybacks which should also add value for ongoing investors. As such, investors focused on income now might opt for Union Pacific, while those more willing for management to invest and grow FCF in the future might favor CSX.
Data by YCharts.
Better buy?
On balance, Union Pacific looks like the better buy. While CSX's OR performance has been more impressive in 2020, it's worth noting that Union Pacific started its PSR initiatives later and may well have more room to run in reducing it. In addition, Union Pacific is a lot less burdened by the challenge of a declining coal industry than CSX is. Moreover, income-seeking investors will prefer Union Pacific's higher dividend yield right now.
