Union Pacific Corporation owns the largest railroad network in the U.S. From the time it stopped running passenger trains in 1971, the company has emerged as America's leading logistics company, carrying millions of tons of freight every year. Between 2009 and 2014, Union Pacific's core revenue surged by a whopping 53.7%.
Former Union Pacific CEO Jim Young once said, "This is a business model that works -- invest, grow the business, increase returns and invest again." Let's analyze the railroad major's business model to better understand its success story.
Continue Reading Below
How does Union Pacific earn a living?All businesses across the country need to efficiently and reliably transport goods -- raw materials need to reach factories and finished goods need to reach end markets. Union Pacific transports these goods on behalf of shippers. Its trains run on nearly 32,000 route miles in 23 states and coordinate with other railroads to carry goods to and from the major Atlantic, Pacific, Southeast, and Southwest gateways. It also serves ports across the Canadian and Mexican borders for international trade.
The company generates 94% of its revenue from freight charges. The balance comes from commuter rail operations and accessorial revenue. In 2014, Union Pacific generated freight revenues totaling $22.6 billion from six key commodity groups as shown in the chart below. Industrial and intermodal are the two largest segments, each contributing one-fifth to the company's total top line.
How have the sources of revenues/earnings changed over time?In the past, Union Pacific had diversified into the natural resources and energy business lines, but in the last 25 years, it has concentrated on its core railroad operations. It has derived most of its revenue from the six commodity segments.
However, during this period, Union Pacific reduced its exposure to coal. Around 60% of America's coal is moved on rails every year -- but oversupply and environmental regulations by the U.S. Environmental Protection Agency has taken a toll on demand. Instead, the company has grown its intermodal and industrial businesses. Between 2008 and 2014, these two businesses grew at a CAGR of 6.8% and 5.1%, respectively. This outpaced the overall freight revenue CAGR of 4.7% in the period.
Union Pacific's diversified railroad mix -- contribution of each segment to total freight revenues. Source: Union Pacific Annual Reports; chart by author
How does Union Pacific's business model work?Two things characterize the railroad industry -- capital intensity and cutthroat competition. Railroads are the only mode of transport where companies need to maintain their own infrastructure -- unlike trucks that run on highways built and maintained by the government. Infrastructure upgrade and modernization, together with safety, reliability, and service become key differentiators among the players.
Union Pacific's business model hinges on two things -- its ability to differentiate itself from peers and get more business; and improving productivity without over-the-top capacity additions. It makes huge capital investments every year on upgrading tracks, adding capacity, and enhancing productivity by adopting new technology, among other things.
Every day, Union Pacific wears out two to three miles of track that has to be replaced at a whopping cost of $500,000 to $750,000 per mile. In the last seven years, the company's capital expenditures have grown at a CAGR of 7.9%.
A break out of Union Pacific's capital investments reveals that it has added more locomotives to its fleet, stepped up its investments in technology and initiatives like positive train control, while maintaining track replacement costs. The investment pattern indicates that management is focused on getting more out of the existing infrastructure, which is already the largest among North American railroad companies.
Union Pacific Capital spending ($millions). Source: 10Ks; chart by author
The capital investments have helped Union Pacific grow its business volumes (measured through revenue carloads), gain pricing power and improve productivity (these two are reflected in average revenue per car). The company's revenue carloads have gone back to prerecession levels, while average revenue per car has increased for five straight years. In 2014, Union Pacific's return on invested capital was a record 16.2%, up 1.5% from the previous year.
Revenue carloads (in thousands units) and average revenue per car. Source 10Ks; chart by author
Net-netThough Union Pacific is a 150-year-old company, it's still growing at a rapid pace. The growth can be traced to its core business model, which involves concentrating efforts on the one thing that it does best -- running a successful railroad operation.
Management has spent adequately on infrastructure and capabilities for the company to grow volumes, gain pricing power, and improve productivity. At the same time, Union Pacific has maintained a well-balanced freight mix that shields it from the changing trends of the commodity market.
The article Is Union Pacific Corp.'s Business Model the Key to Its Success? originally appeared on Fool.com.
ICRA Online and Eshna Basu have 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.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.