Union Pacific's Superior Position Over Eastern Railroads

Over the past 200 years, multiple game-changing events have created a boom in industry and business. The railroads of the 1800s produced countless millionaires, much like the Internet produced in modern times. Marijuana legalization is arguably another game-changing event, much like the 1849 California gold rush. Smart investors want to get behind the right idea to make money in these industries, much like Edward Harriman did with Union Pacific (UNP 0.09%) in the 1890s.

Railroads went through a stifling period of change with the peak of American passenger service in the 1950s, followed by decline. Railroads that survived moved freight. Now freight is 99% of the business of modern Class 1 Railroads.

The reasons for getting behind the rail industry today are compelling. Railroads are three to four times more efficient than trucks in moving freight. Rail traffic is picking up due to pent-up demand created by weather delays in January and February. Total U.S. rail traffic, including carloads and intermodal shipments increased 3.1% for the first 15 weeks of 2014, according to the Association for American Railroads. That's a big increase in railroad numbers.

First quarter 2014
When you examine the performance of Class 1 Railroads in first quarter of 2014, you see that Union Pacific handled the tough winter weather season better than CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC). Both CSX and Norfolk Southern operate in the eastern third of the country, where weather hammered the population zones and ports in January and February. 

Union Pacific operates in the western two-thirds, including the Southwest, where weather was more moderate than the East Coast.

In first quarter of 2014, CSX's revenue grew 2% to $3 billion on volume increases of 3%, with strength in intermodal and merchandise markets more than offsetting declines in coal. However, operating income declined 16% to $739 million and the company's operating ratio increased 520 basis points to 75.5%, primarily due to the impact of harsh weather.

Norfolk Southern's first-quarter earnings were down 18% to $368 million from $450 million a year ago. The company was hurt by weather delays and a 15% decline in coal revenues. Railway operating revenues were $2.7 billion, 2% lower compared with first-quarter 2013, and shipment volumes decreased 1%. Operating ratio was 75.2%.

Union Pacific's revenue increased 7% in the first quarter 2014 to $5.6 billion, versus $5.3 billion in the first quarter 2013. First-quarter business volumes, as measured by total revenue carloads, increased 5% compared to 2013. Union Pacific's operating ratio of 67.1% was a first quarter record, 2.0 points better than the first quarter 2013. Operating income grew 14% while earnings per share grew 17%.

Union Pacific hauls coal from the Powder River Basin in Wyoming, which is low-sulfur coal that utilities are still burning. Union Pacific's coal revenues were actually up 3% in first quarter 2014. Union Pacific is in a great position to take advantage of the grain trade as well, which will be huge this year because of record harvests in 2013. Here's a look at Union Pacific's business categories in first quarter 2014:

• agricultural products up 16%
• industrial products up 10%
• intermodal up 4%
• coal up 3 %
• chemicals up 2%
• automotive flat

Geographic advantage
One of the big advantages that Union Pacific has over CSX and Norfolk Southern is the result of Edward Harriman's vision for the railroad 100 years ago. Harriman had hoped to merge Union Pacific with Southern Pacific, but regulators refused for decades. That lasted until 1996, when the two merged after approval by the Interstate Commerce Commission. The merger gave the company larger scale, access to the important ports in California, and greater efficiency over time. Union Pacific can participate directly in trade with China and Asia through ports on the West Coast. Norfolk Southern's track does not go west of Kansas City, and CSX's western point is St. Louis.

Only BSNF Railway, owned by Berkshire Hathaway (NYSE: BRK-B), can compete with Union Pacific in the western United States. However, BNSF Railway has been losing business to Union Pacific due to insufficient capacity. BNSF Railway is spending a record $5 billion in capital improvements in 2014 in order to improve its business. Union Pacific plans to spend $3.9 billion in capital improvements in 2014.

Valuation
Let's take a look at P/E ratios to see whether Union Pacific is overvalued compared to its peers.

Source: Morningstar and Yahoo Finance

The chart tells us that the estimated forward P/E ratios for these railroads are below their historic averages. Warren Buffett bought BNSF Railway at 18 times its forward earnings in early 2010. CSX, Norfolk Southern, and Union Pacific are all trading below Buffett's metric.

Barriers to entry are huge, as no one could buy all of the land necessary to build a new railroad that could compete with any of these railroads. Railroads can improve revenues when the U.S. economy is growing at 2% annually. We may see much higher GDP growth in 2014. If that is the case, look out. All these rail valuations will go higher.

Stock price for these companies tends to follow earnings. If Union Pacific continues growing operating earnings  at 14% annually -- as it did in the trailing 12 months -- earnings will double in 5.1 years. The company's stock could double during that time too. Risks going forward are weather, a weak economy, and competition from BNSF Railway. When the economy tanks again, so will rail stocks... but I don't see that happening in 2014.

Conclusion
Just like the railroad barons of old, it's time for you to become your own rail baron. Don't get left behind. Warren Buffett knew a good thing when he saw it: BNSF Railway is one of his best assets today. Union Pacific is a formidable competitor with a huge future. Union Pacific's stock tends to trade at a premium to its peers, but I believe it's worth every penny.