Union Pacific vs. CSX: Which Railroad Has the Most Profit Potential?

Source: Union Pacific.

The railroad industry has blossomed over the past decade, thwarting the beliefs of skeptical investors who once believed that rail transport was an obsolescent method of moving goods that the trucking industry had supplanted. Yet as energy prices have soared, both Union Pacific (UNP 1.03%) and CSX (CSX 0.81%) have seen demand for more fuel-efficient rail shipments climb, and both companies have sought to take full advantage of favorable industry conditions as long as they last.

Many investors don't know how to decide which railroad offers the best opportunities for investors. To help answer that question, one thing that seasoned investors often do is to look at the return on equity that companies produce from their investment in their own businesses. By using what's known as a DuPont analysis, a method that investors have used for nearly a century now, you can get a better sense of how CSX and Union Pacific are generating profits and which has the better chance of doing so in the future.

The basics of DuPont analysis
Return on equity is a relatively simple concept: It measures the amount of earnings a company generates in any given year and compares it to the shareholder equity on the company's balance sheet. In general, the higher the ROE, the better a company is performing.

But what the DuPont analysis does is break down the ROE calculation further to get insight on the multiple drivers that determine return on equity. Specifically, by taking a company's net profit margin, its asset turnover ratio, and its equity multiplier ratio -- three separate company metrics that when multiplied together produce ROE -- you can get a better sense of where that company is producing the bulk of its ROE and how it compares with other companies in the industry. Let's do exactly that with Union Pacific and CSX.

Profitability: Net profit margins
Net profit margins take the most recent earnings for the past year and compare it to revenue over the same period. The results show how much pricing power exists in a given industry, taking into consideration factors like competition and inherent costs in running a business.

Source: S&P Capital IQ, author calculations.

Both Union Pacific and CSX have done a good job of producing high profit margins. But Union Pacific has been more effective with its pricing power, perhaps because of its particular exposure to higher-margin oil-tanker transport. Meanwhile, CSX has greater exposure to the lagging coal industry. Moreover, CSX pays the price for larger expenses related to financing costs. All in all, that gives Union Pacific a nearly 6-percentage-point advantage in net profit margin.

Effectiveness at asset management: Asset turnover ratio
Profit margins in a vacuum are easy to compare, but what they leave out is the amount of assets necessary to invest in the business in order to generate those profit margins. The asset turnover ratio addresses that factor by comparing total sales in a given year with the total amount of assets on the company's balance sheet. Doing so gives you a sense of how capital-intensive a given business is.

Source: S&P Capital IQ, author calculations.

Union Pacific has a much larger asset base than CSX on which to draw revenue. Yet when it comes to squeezing the most from those assets, CSX falls short, generating just over half the sales despite having more than 60% as large an asset base. Union Pacific does more with its rail network and equipment to boost its sales, and that shows up here with a better than 6-percentage-point advantage in asset turnover.

Leverage: Equity multiplier ratio
The last factor of the DuPont analysis is the equity multiplier ratio. This metric tells you how much leverage a company is employing by comparing assets on the balance sheet to the company's shareholder equity. The more debt and other liabilities a company has, the greater this ratio will be, and therefore the higher the ROE will be for a given level of profitability and asset management effectiveness. Many investors aren't as comfortable with ROE produced by high levels of leverage than from other factors.

Source: S&P Capital IQ, author calculations.

Union Pacific has more assets than CSX, so it stands to reason that it would also have greater shareholder equity on its balance sheet. But CSX is actually much more leveraged than Union Pacific, with more than $21 billion in liabilities against a smaller asset base compared to about $30 billion for Union Pacific. As a result, Union Pacific has twice the shareholder equity of CSX, and you can see the disparity in the equity multiplier ratio.

The final tally
When you multiply those three figures together, you get total returns on equity for both CSX and Union Pacific.

Source: S&P Capital IQ, author calculations.

Overall, Union Pacific tops CSX handily on the final return on equity score, with almost 5 percentage points of outperformance. Moreover, with Union Pacific generating better profit margins and more effective asset management with less leverage, the railroad bests CSX on all three major points.

The results show that Union Pacific arguably is better placed to produce higher growth rates in the future. Still, both figures are high enough to show the general health of the railroad industry. With different geographical exposure, both CSX and Union Pacific present intriguing investment opportunities for investors who believe that the future of rail transport is bright.