In the last 30 years, the iconic American railroad industry has completely rebuilt itself. Business is booming for Class I carriers like Union Pacific (NYSE:UNP), in part because of steadily climbing oil prices (save for the last few months) and a regulatory environment that accommodates long-term investment.
As a case in point, the regulatory body that oversees the railroads, also known as the Surface Transportation Board, found that all five of the major U.S. carriers achieved "revenue adequacy" in 2013, up from just two of them in 2012. This means the railroads are covering their costs and earning "a fair, reasonable, and economic profit or return," according to regulatory language. Such a feat would have been unheard of even a decade ago.
So, what does this mean for railroad investors today? Is it too late to hop onboard the American rail renaissance?
Not so fast, my friend. As long there are goods to ship, railroad traffic will grow (because of cost advantages over trucking), and there are really two simple numbers you need to follow closely as a railroad investor: net capital expenditures and return on invested capital.
With a good grasp of what these metrics mean to a carrier like Union Pacific, for example, you'll be well on your way to answering an important question about the company: What does the future hold?
The two metrics that matter most
Now, it might sound counterintuitive to pinpoint things like invested capital at first. Why not focus on the stuff we hear about in the news every day, like revenue, profits, or even carload traffic?
Well, don't get me wrong. Those metrics matter as well, but it's easier for investors to tune out the numbers that can be influenced by external factors -- including seasonality, weather, or commodity prices -- and focus on the internal drivers of the business.
Think of invested capital as the engine in an automobile, which needs to be hitting on all cylinders at all times regardless of the road conditions or external environment. What we want to determine is whether Union Pacific is putting the right fuel in the tank, keeping the parts maintained and well oiled, and upgrading the components regularly to boost horsepower and efficiency.
To do this, we need to take a look at the amount of money this West Coast carrier is plowing back into operations on a regular basis, and the best way to do that is to calculate net capital expenditures. Here's a simple, third-grade equation that allows us to get there:
Net Capital Expenditures = Capital Expenditures-Depreciation
You might be wondering, "OK, that's it?" Well, sort of.
To be sure, the equation's not always this simple. Sometimes you need to account for research and development and acquisition expenses -- two other measures of future investment -- but those are less relevant for a 150-year-old railroad operation. Simplicity: It's just one of the many reasons Warren Buffett simply loves this business.
So, to put this equation to work, I pulled Union Pacific's data straight from S&P's Capital IQ database and calculated the net capital expenditures over the last five years. I've summarized the calculation in the table below:
As you can see, Union Pacific's investments significantly outweigh the money it's spending to simply maintain and operate its current freight cars, track infrastructure, and diesel-powered locomotives. In fact, capital expenditures are larger than depreciation by nearly a factor of two.
This has significant implications for the business and for investors. It means management sees growth opportunities and refuses to sit back and funnel UP's cash back to shareholders. Management explained why in the railroad's recent annual report:
Our rail network requires significant annual capital investments for replacement, improvement, and expansion. These investments enhance safety, support the transportation needs of our customers, and improve our operational efficiency. Additionally, we add new locomotives and freight cars to our fleet to replace older, less efficient equipment, to support growth and customer demand, and to reduce our impact on the environment through the acquisition of more fuel-efficient and low-emission locomotives.
As noted, investments are geared toward more than just replacement, but also "improvement" and "expansion." This is great news for shareholders, as long as the company's investments outweigh its own cost of capital. Fortunately, that seems to be the case at Union Pacific, where cost of capital has hovered around 11% but the return on invested capital has escalated to the mid-teens in recent years.
The takeaway for investors
As shown by Union Pacific's net capital expenditures, this company is more than willing to reinvest in ways that will make its business more competitive and prosperous over time. And considering its return on invested capital towers above where it was a decade ago, this trend bodes well for UP stockholders.
As you think about investing in capital-intensive industries, keep these two metrics in mind. Yes, railroads are an example of a business that requires a lot of up-front investment, but their unique assets generate a return almost any business manager would envy.
Isaac Pino, CPA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.