U.S. markets closed
  • S&P 500

    +0.57 (+0.01%)
  • Dow 30

    +8.77 (+0.03%)
  • Nasdaq

    -33.88 (-0.30%)
  • Russell 2000

    -2.96 (-0.17%)
  • Crude Oil

    +0.46 (+0.42%)
  • Gold

    +3.90 (+0.21%)
  • Silver

    -0.03 (-0.13%)

    -0.0026 (-0.24%)
  • 10-Yr Bond

    -0.0680 (-2.38%)

    +0.0020 (+0.16%)

    +0.0560 (+0.04%)

    +709.76 (+2.43%)
  • CMC Crypto 200

    -23.03 (-3.42%)
  • FTSE 100

    +87.24 (+1.19%)
  • Nikkei 225

    +336.19 (+1.27%)

Union Pacific Looks Overvalued Despite Its Competitive Advantages

  • Oops!
    Something went wrong.
    Please try again later.
·3 min read
In this article:
  • Oops!
    Something went wrong.
    Please try again later.

One of the most interesting industries on the market is the railroad industry. This is a sector with a unique competitive advantage that has been developing for over 100 years.

Most railroad companies have been building their networks over the past century, and many started building their networks in the 1800s. When the railroad boom took off, there was a lot less regulation and legislation governing how companies developed and expanded their networks. This made it relatively easy for these businesses to expand across the country and cut huge swathes out of the landscape to build railroad tracks.

In many regions, such explosive growth would be almost impossible today. In areas such as New York, the cost of building new track is so prohibitively expensive it is easier to kick the can down the road rather than try and find the money. The Second Avenue Subway cost $2.6 billion per mile.

New York is an extreme example, but it highlights existing railroad operators' competitive advantage. No company will have the financial strength to be able to build a new network from scratch.

Even if an organization did have all the money in the world, it would take decades to receive all the correct regulatory permissions and acquire the property needed.

Union Pacific

Considering these competitive advantages, companies like Union Pacific (NYSE:UNP) appear attractive. I would be willing to bet that 100 years from now, this company will still be one of the largest railroad operators in the United States. Unless the government or another company takes it over, it seems unlikely the business will be throttled by new competition.

Warren Buffett (Trades, Portfolio) has stated that the best way to value any business is to analyze how much cash it will generate from now "until Judgement Day." With most corporations, this is a challenge. The business environment is so aggressively competitive it is impossible to predict with most companies whether or not they will be round in five or 10 years' time.

For the reasons outlined above, I do not think it is unreasonable to say that Union Pacific will still be around in 20 to 30 years. This makes it easier for me to try and place a value on the enterprise.

Over the past 12 months, the company has produced a free cash flow per share of $9.70. Using this cash generation rate, a 4% discount rate (the 10-year Treasury rounded up to 2% and an additional 2% on top) and a 10% terminal growth rate, the discounted cash flow model gives us a fair value of $368 per share.

I have used a 10% per annum long-term growth rate as the company has increased free cash flow per share by around 21% per annum over the past six years. I think it is unlikely this kind of growth will continue indefinitely as the business has been spending significant sums repurchasing shares.

Much of the funding for share purchases and capital spending has come from debt. Net debt has increased from $13 billion to $28 billion over the past six years. If one was to use an even more conservative growth rate of 5% per annum, the stock has a fair value of $215 per share, 18% below current values.

The bottom line

I think we will likely see a scenario between these two projections over the next 10 to 20 years, as interest rates increase and the company reduces spending on repurchases. As such, it looks as if the stock is fairly valued at current levels.

Despite its defensive business model, I do not think Union Pacific is not worth paying over the odds for considering the fact that this is a highly capital-intensive business.

This article first appeared on GuruFocus.