Union Pacific Is Attractively Valued

 

I initiated a 200 Union Pacific (UNP) share position @ ~$142/share on March 11, 2020 through one of the 'Side' accounts within the FFJ Portfolio. In hindsight, I should have acquired more shares because that was the last time, up until just recently, that I considered UNP to be undervalued.

My prior UNP review dated January 23, 2022 was immediately following the release of Q4 and FY2021 results and FY2022 outlook. My conclusion was that UNP's valuation was too rich.

Now, UNP has recently released Q3 and YTD results and guidance for the remainder of FY2022. I, therefore, take this opportunity to revisit this holding.

Business Overview

I include a very high-level business overview in my prior post. The best way to learn about UNP, however, is to read Item 1 Part 1 in the FY2021 Form 10-K.

In addition, the company's website includes a wealth of information from which you can familiarize yourself with the company.

Financial Review

Q3 and YTD2022 Results

Details of UNP's Q3 results are provided in its Earnings Release, Earnings Presentation, NonGAAP GAAP measures reconciliation, and Form 10-Q.

Operating revenue totaled $6.566B, up 18% versus 2021 on 3% YoY volume growth.

UNP reported an operating ratio of 59.9% and EPS of $3.05 that includes a $0.114B change in estimate related to the Presidential Emergency Board recommendation and subsequently ratified through tentative labour agreements. This charge negatively impacted Q3's operating ratio by 170 bps and reduced EPS by $0.14.

NOTE: The operating ratio is operating expenses as a percentage of revenue. It is the opposite of the operating margin, which uses operating income divided by revenues.

Fuel expenses in Q3 2022 were $0.932B versus $0.544B in Q3 2021.

Q3 adjusted operating income totalled $2.747B, a 13% increase versus Q3 2021.

Other income increased by $86 million with details provided on page 12 of 37 in the Q3 2022 Form 10-Q.

Operating metrics steadily improved, aided by improving crew availability from hiring initiatives and improved crew utilization.

The hiring and training pipeline is strong. YTD, UNP has graduated 890 employees and there are an additional 518 employees currently in training who are all expected to graduate by January 2023.

Freight car velocity is approaching 200 miles per day versus a low set in April. This improvement was achieved despite moving 10,000 more weekly carloads.

In Q3, UNP continued to make progress at the West Coast ports as the number of stacked containers declined.

Operating Cash Flow (OCF) and Free Cash Flow (FCF)

The following table reflects UNP's 2021 and 2022 YTD FCF and cash flow conversion rate.

YTD FCF is ~$0.517B lower than in 2021. However, YTD2022 FCF includes $0.745B of increased cash capital spending and $0.317B in higher dividends but is well within overall guidance of less than 15% of revenue.

Given UNP's strong cash generation and solid Balance Sheet, the company has been able to reward shareholders with dividends and share repurchases totalling ~$7.9B YTD.

FY2022 Outlook

Warren Buffett, currently the chairman and CEO of Berkshire Hathaway, uses freight rail traffic as an indicator of the health of the economy.

Ian Jefferies, President & CEO of the Association of American Railroads, has stated that 'What we move is the economy. It’s the tangible economy. And so as the economy goes, rail goes. So when rail is doing well, it usually means the economy is running pretty strong.'

On the Q3 Earnings call, management stated it is closely watching UNP's markets to see how inflation and interest rates will impact overall volume. Markets are softening somewhat, and therefore, management has slightly lowered overall volume expectations; expectations are that FY2022's operating ratio will deteriorate slightly to ~60%.

The following images extracted from UNP's Q2 and Q3 2022 Earnings Presentations reflect changes in management's outlook for various sectors of the US economy. A lowered outlook for Industrial Production and Domestic Intermodal rail traffic relative to what was provided at the end of Q2 2022 suggests investors would be wise to be cautious.

Canadian National Railway (CNR.to) and Canadian Pacific Railway (CP.to) release their Q3 2022 and YTD results and FY2022 outlook in the coming days. It will be interesting to review their outlook.

The following high-level points regarding UNP's outlook for its 3 commodity groups were provided on the Q3 earnings call with analysts.

Bulk Commodities

Biofuel shipments for renewable diesel are expected to continue to grow due to solid market demand and business development wins.

Coal - management anticipates continued favourable natural gas prices to generate demand for both domestic and export shipments. However, the opportunity to capture demand is dependent on available resources.

Grain - This outlook is also dependent on UNP's service recovery.

Industrial

The forecast for industrial production is decelerating and demand is softening in forest products. Management, however, expects construction to be positive due to strong project demand in the south.

Premium

Management is closely monitoring domestic intermodal demand as spot truck rates fall and inventories climb.

Parcel and truckload demand is expected to remain soft as consumer preferences have shifted more to experiences versus goods.

The international markets are being closely monitored but for now, management expects positive results in Q4 2022 relative to Q4 2021.

Expectations are for growth in Automotive. This is to be driven by improving the supply of parts and inventory replenishment.

Risk Assessment

On July 29, 2002, Moody's upgraded UNP's domestic unsecured long-term debt to A3 from Baa1. Now, the 3 major rating agencies assign a rating at the bottom tier in the upper-medium-grade investment-grade category.

• Moody's: A3 with a stable outlook;
• S&P Global: A- with a stable outlook; and
• Fitch: A- with a stable outlook.

These ratings define UNP as having a strong capacity to meet its financial commitments. However, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

These ratings satisfy my conservative investment preferences.

Dividends and Share Repurchases

Dividends and Dividend Yield

UNP's YTD dividend payout ratio is ~44.3% ($3.78 in YTD dividends/$8.54 in diluted EPS). This is within UNP's target payout range of 40% - 45% of net income.

UNP's dividend history has been somewhat inconsistent with periods in which the dividend has been held constant for several consecutive quarters. In FY2012 - FY2021, UNP distributed $1.24, $1.48, $1.91, $2.20, $2.26, $2.48, $3.06, $3.70, $3.88, and $4.29.

When I last reviewed UNP (January 23, 2022), shares were trading at ~$246. The quarterly dividend at the time of that post was $1.18. Had the quarterly dividend remained stable at $1.18/share throughout FY2022, then the annual $4.72 dividend would have yielded ~1.9%. On May 12, 2022, however, UNP announced an increase in its quarterly dividend to $1.30.

The next quarterly dividend announcement is likely in November and I do not expect an increase. Using a $5.20 annual dividend and the current ~$189.50 share price, the dividend yield is ~2.74%.

Share Repurchases

Details on UNP's Share Repurchase Programs and Accelerated Share Repurchase Programs are found commencing on page 18 of 37 in the Q3 2022 Form 10-Q.

The weighted average number of shares outstanding is 953, 932, 901, 869, 835, 802, 754, 706, 679, and 655 (in millions) in FY2012 - FY2021. The diluted weighted average number of shares outstanding in Q3 2022 amounted to 621.5.

UNP aggressively repurchased shares in Q3. YTD, UNP has repurchased $5.497B of shares and management expects FY2022 share repurchases of $6.5B in FY2022. However, UNP has been impacted by higher-than-anticipated inflationary pressures and service costs and the extent to which shares are repurchased may need to be reduced in 2023.

Valuation

UNP's FY2012 - FY2020 diluted PE levels are 15.20, 18.52, 22.02, 13.51, 20.78, 23.73, 9.28, 21.32, and 26.52.

At the time of my January 23 post, UNP had reported $9.95 in diluted EPS in FY2021. With shares trading at ~$264, the diluted PE was ~26.5.

The following were the forward-adjusted diluted PE levels using guidance from the two online trading platforms I use.

• FY2022 - 30 brokers - mean of $11.45 and low/high of $10.78 - $11.78. Using the mean estimate, the forward adjusted diluted PE is ~23 and ~22 if I use $11.78.
• FY2023 - 25 brokers - mean of $12.71 and low/high of $11.05 - $13.45. Using the mean estimate, the forward adjusted diluted PE is ~21 and ~20 if I use $13.45.
• FY2024 - 5 brokers - mean of $13.93 and low/high of $13.09 - $14.91. Using the mean estimate, the forward adjusted diluted PE is ~19 and ~18 if I use $14.91.

Shares now trade at ~$189.50 and UNP has generated YTD diluted EPS of $8.54. Should UNP generate diluted EPS of ~$2.85 in Q4, then FY2022 diluted EPS would be ~$11.39. This gives us a forward diluted PE of ~16.6.

The following are the forward-adjusted diluted PE levels using guidance from the two online trading platforms I use.

• FY2022 - 26 brokers - mean of $11.56 and low/high of $11.44 - $11.72. Using the mean estimate, the forward adjusted diluted PE is ~16.4.
• FY2023 - 31 brokers - mean of $11.93 and low/high of $10.06 - $12.75. Using the mean estimate, the forward adjusted diluted PE is ~15.8.
• FY2024 - 18 brokers - mean of $13.00 and low/high of $10.53 - $14.40. Using the mean estimate, the forward adjusted diluted PE is ~14.6.

I consider these valuations attractive.

Final Thoughts

Other than the addition of 4 shares by way of dividend reinvestment, I have not added to my UNP exposure after initiating a position just as COVID-19 was resulting in the 'shutdown' of the global economy. My failure to take a more significant advantage of the brief period in which UNP shares were undervalued over the past several years resulted in UNP not being a top 30 holding when I completed my Mid 2022 Investment Holdings Review. I do, however, hold positions in CNR.to and Canadian Pacific Railway CP.to.

Now that UNP's valuation is FINALLY attractive, I should be increasing my exposure despite a possible railroad strike in November that could wreak havoc on the supply chain and cost the U.S. economy up to $2B/day. I, however, have insufficient liquidity to acquire additional shares. I disclose the reason for this in recent posts.

Although the risk of a rail strike is currently applying pressure on UNP's share price, investors would be wise to approach an investment in UNP (or any other high-quality company for that matter) from a long-term perspective.

The Association of American Railroads is forecasting a 30% increase in the demand for freight transportation by 2040 is subject to debate. Even if the demand only increases by half this level, this bodes well for the major North American railroads.

My suggestion is to acquire UNP shares while they are currently undervalued. If the North American economies slip into a recession in 2023 and UNP's financial results come under pressure...buy more shares. Don't try to time the market. Share prices in the short term often do not reflect a company's true value.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long UNP, CP.to, CNR.to.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.