What Does A Monopolist Look Like? It Looks Like Union Pacific (UNP)
At the end of last month, I published an investment idea to the members of our service regarding Union Pacific (UNP). The investment expresses a bearish view on the company’s value based on my analysis as a long-time value investor, and is structured using option contracts.
One of the points I brought up in a summary published publicly is that, according to my analysis, the company had been able to generate enormous profits thanks to what I think boils down to un- (or under-) regulated anti-competitive pricing on part of Union Pacific and its Class I freight railroad peers.
My comment about Union Pacific’s pricing was only tangential to my valuation (it is a bullish element of it), but it proved to be contentious. A reader who had seen a summary of my valuation report called me a “socialist,” and people came out of the woodwork to tell me how wrong I was. One reader, a trader at a hedge fund, wrote me saying that my analysis contradicted that of a famous analyst at the premier sell-side research house on Wall Street, Sanford A Bernstein.
The Bernstein analyst, David Vernon, had written a 100+ page report in May 2016, which maintained that railroad pricing power was not a function of quasi-monopoly power, but of increases in trucking rates that allowed Union Pacific to undercut truckers while still boosting profits. Vernon provided pages upon pages of impressive scatterplots and statistical arguments to prove his point.
Despite all the scatterplots, his contention seemed suspicious to me. I decided to take a simple look. When I did, the picture that emerged was that of an unregulated monopolist.
Union Pacific: Portrait of an Unregulated Monopolist
When accused of monopoly pricing, representatives from the rail industry use what I call the “trucking argument.” Shippers, according to the trucking argument, always have another transportation option, so if they don’t like the price offered by rails, they can take their business elsewhere.
If trucks were a true alternative to railroads, we would expect the profit margins for both industries to be roughly the same. Competition drives out differentials in pricing as naturally as water seeks the lowest point. In contrast, one of the hallmarks of a monopoly is pricing that is significantly higher than marginal cost (i.e., profits are excessively high).
Here is the actual profit differential between Union Pacific’s Owners’ Cash Profits and an aggregate of publicly-traded trucking companies…