A Commodities Play Close to Home

07/23/2008 12:00 am EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Elliott Gue, editor of The Energy Strategist, recommends a famous US railroad as a good way to play the commodities boom.

Union Pacific (NYSE: UNP) is the largest railroad in the US. The company's network is nearly 33,000 miles long and is concentrated in the West and Midwest.

It also offers a convenient example of the bullish forces at work for the rails, particularly in the coal and agriculture industries.

Union Pacific's energy segment is its largest by revenue; it accounts for just shy of 20% of the company's business. Coal transport from a region of the West known as the Powder River Basin comprises the majority of Union Pacific's energy transport business.

Strong demand for coal transport has made this segment a real bright spot for the railroad in recent years. But what's more impressive is Union Pacific's ability to boost prices. 

Better still, Union-Pacific still transports coal under contracts signed years ago at lower freight rates. As these contracts expire, Union Pacific should see strong pricing gains as it signs new deals.

Agriculture accounts for about 16% of Union's revenues and is its most profitable business line. Again, stronger pricing is a function of high demand for shipments and a limited number of railroads capable of handling all that demand.

Industrial products account for around 19% of total revenues and offer above-average profitability, [but] the housing bust has brought a severe slowdown in demand for construction-related products and commodities such as lumber. There's little sign of improvement to come in this business.

The chemicals segment makes up 14% of revenues and also offered a high revenue per carload. This segment is dominated by petroleum-related products, fertilizers, plastics, and soda ash, a commodity in high demand abroad. Demand for fertilizers is booming because of rising prices for agricultural commodities. And shipments of petroleum-related chemicals have also remained firm.

[So,] the majority of the company's segments aren't particularly sensitive to US economic growth; some, such as coal and agricultural shipments, are driven more by overseas demand. Even more important, even in segments showing flat or falling volume growth, Union Pacific has been able to boost pricing.

This pricing power should continue; in order for the rails to invest the capital needed to expand their capacity, they'll need to earn a decent return on their investment. Most of the big rails have begun to plow some of their free cash flow into expansions.

A final trend is worth noting: The railroads are taking steps to cut their costs and improve the traffic flow across their lines. Union has plenty of additional room to cut costs, and management has proven it's capable of improving the operating ratio over time. I expect that Union Pacific will gradually close the cost gap with its competitors. This cost-structure improvement should power earnings growth in the mid-teens for the foreseeable future.

I'm adding Union Pacific as a Buy. (It closed Tuesday above $74—Editor.)

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