Union Pacific: Rolling Through The Economic Cycles (NYSE:UNP)

Union Pacific (NYSE:UNP) is back on my buy list as the company is down 19% from 52-week highs and sits at a reasonable 17.4x TTM P/E. Since I last wrote about Union Pacific back in March 2020 during the beginnings of COVID, UNP stock has given shareholders total returns of 51.4%, including dividends. The company remains highly profitable with near record returns on invested capital around 21% for the past couple years. Union Pacific looks set for a changing economic environment with healthy financial leverage and interest coverage ratios. This is a company I will be adding to my portfolio on a cyclical swing in the economy.

Latest Q1 2023 Updates

In Union Pacific’s latest Q1 2023 report, the company grew operating income 3% year-over-year and EPS growth of 3.9% to $2.67 per share for the quarter (Q1 2022 – $2.57). On the negative side driving some pessimism in analysts is that carloads were down 1% YoY which does not signal great things for the pace of the economy. Union Pacific’s all-important operating ratio of 62.1% deteriorated 270 basis points. Falling fuel prices in the quarter positively impacted the operating ratio by 190 basis points.

The company maintained 2023 guidance with operating ratio improvements and price increases expected to be in excess of inflation (to be discussed more later when we talk long-term growth). Union Pacific expects the long-term dividend to take up 45% of earnings with capital expenditures to be 15% of earnings with the excess being used to repurchase shares. We will dive into our own long-term cash flow analysis later as we estimate the yield investors are getting on their capital.

Union Pacific continues to perform well alongside my original long-term thesis. Over this three-year time frame from my last article, the company has repurchased 13.1% of their outstanding shares (4.2% annualized) and also increased the dividend 31% to now sit at $1.30/share per quarter for a 2.62% yield at the current $198.29 share price. On an annualized basis, the current dividend yield and annualized share repurchase rate of 4.2% means total shareholder cash returns of approximately 6.8%. These returns look set to continue as this article will discuss with a cash flow analysis and implied shareholder yields.

A Highly Profitable And Growing Company

Union Pacific’s premier rail network with 32,452 route miles covering 23 U.S. states with connections into Canada and Mexico provides the company with a large economic moat that they have used to generate superior returns. While the company is cyclical along with the broader economy, their favorable position in the railroad industry’s oligopoly allowed them to generate strong returns even in the depths of the financial crisis.

Since 2007, the company has achieved average return on equity and return on invested capital of 21.9% and 15.7%, respectively. This level of profitability is well above my rule of thumb of 15% ROE and 9% ROIC allowing me to be confident that, in my opinion, the company is able to maintain and continue to increase its intrinsic value in the future.

On the growth side, book value per share has grown from $14.94 in 2007 to $19.49 in the latest quarter which when combined with the dividends paid out from equity has averaged growth of 11.9% annually. Keep in mind that the decrease in book value in the latest couple years is not due to poor performance at the company but rather the mathematical effect of Union Pacific repurchasing their shares at much higher values than the price-to-book value as calculated from the financials. This decrease in equity on the balance sheet company due to lots of repurchases also makes the ROE metric not useful, so the above graph only highlights the more relevant ROIC metric.

Share Buybacks, Growth And Leverage

Since 2007, growth at Union Pacific has been impressive with EPS growing at an average annual rate of 13.3%. However, revenue growth has been more moderate growing at an average rate of only 2.9%. The outsized growth in EPS has been driven by increased operational performance (as witnessed by increasing ROIC in the previously graph above) and also by increased use of financial leverage in the business being used for share repurchases (as can be seen in the graph below).

Since 2007, financial leverage has grown from 2.4x to be at 5.4x to end 2022. However, due to the falling interest rate environment since the financial crisis, the interest coverage ratio has remained relatively the same around a healthy 7.2x in 2007 to 8.4x in the latest quarter. The debt raised has been used to increase share repurchases with shares outstanding having fallen from 1,073 million in 2007 to 624 million in the latest quarter. These repurchases have averaged 3.5% annually and when combined with the current 2.6% dividend indicate a total shareholder yield of 6.1%.

How Is The Cash Flow?

Strong businesses with wide moats such as Union Pacific are able to generate cash beyond what is needed to fund sustainable operations. As can be seen in the graph below, capital expenditures have averaged only 51% of cash flow from operations since 2007. This is clearly a great business to be in and indicates Union Pacific has an economic moat.

With capital expenditures and acquisitions only taking up on average 51% of cash flow from operations over the past decade, this leaves approximately 49% to be returned to investors in the form of dividends and share repurchases. With average cash flow from operations of $8.8 billion over the past five years, this 49% would imply free cash flow to shareholders of $4.3 billion for around a 3.6% free cash flow yield at the current $119.7 billion market capitalization.

While this free cash flow yield might not sound too enticing, remember that the other 51% of cash flows are being reinvested back into operations and the economic moat that drives that 2.9% annualized revenue growth since 2007. While this of revenue growth is not too impressive relative to inflation of 2-3%, remember the economic moat of Union Pacific has achieved EPS growth 13.3% as mentioned earlier through operational improvements and share buybacks.

The revenue stream of this essential transportation company is repeatable and a great long-term hedge to the current high inflation we are seeing. The revenue growth being in line with inflation would be the low estimate for growth from Union Pacific. Without getting too aggressive and adding the 13.3% EPS growth to the FCF yield, a more conservative estimate could be placed in the middle at 8.1%. Adding this average revenue/EPS growth rate on top of the current FCF yield of 3.6% would imply solid long-term shareholder returns around 11.7%.

Price Ratios And Potential Returns

With Union Pacific’s P/E at 17.4x (5.7% earnings yield), it might be hard for some value investors to get their head around being an owner at this price. When looking at steady growth companies such as Union Pacific, a good tool to use is legendary investor Peter Lynch’s PEG ratio. To get an idea of how Union Pacific’s market valuation compares to competitors CSX (CSX) and Canadian National Railway (CNI), I have placed them all side-by-side and used 3-year average growth rates to compare their valuations.

As can be seen, Union Pacific’s ratios are in line with the pack and only the PEG Revenue ratio is within Peter Lynch’s rule of thumb of being under 2x (a PEG ratio over 2 suggests that earnings growth is already built into the price). I am a fan of the company and railroad industry in general but would like to see the stock price come down a bit further before I add back to my position. I will keep watching the car load stats to get a sense on the economy and keep Union Pacific on the watch list in case of a correction in the market.

Conclusion

Union Pacific is a highly profitable company with a wide economic moat that helps it stay profitable even during cyclical downturns. While the company’s valuation might look expensive at 17.4x TTM P/E (5.7% earnings yield), investors taking a long-term perspective might be rewarded with long-term revenue growing with inflation and EPS further benefiting from share buybacks as has occurred in the past. Union Pacific is a company to ride up and down economic cycles, taking advantage of any downturns such as this building 19% slide to load up on more shares at favorable valuations.