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Union Pacific (NYSE:UNP) is one of our favorite ideas. We expect the firm's operating ratio to be among the best in the railroad group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast. The firm is levered to coal, though we note its mix is more of the PRB variety, which should continue to take share from CAPP coal in the domestic market. The firm also boasts a strong Valuentum Dividend Cushion score and a decent annual yield. But what is Union Pacific worth? Let's find out in this article.

We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Here's a graphical representation of our fundamentally-driven process with a technical/timing overlay.

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If a firm is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Union Pacific currently posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We like firms that register a 9 or 10 on our index. We compare Union Pacific to peers Canadian National (NYSE:CNI), CSX Corp (NYSE:CSX), and Norfolk Southern (NYSE:NSC).

Our Report on Union Pacific

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Investment Considerations

Investment Highlights

• One of America's most recognized companies, Union Pacific links 23 states in the western two-thirds of the country by rail, providing a critical link in the global supply chain. The railroad's diversified business mix includes agricultural products, automotive, chemicals, coal, industrial products and intermodal.

• We expect Union Pacific's operating ratio to be among the best in the railroad group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast.

• Union Pacific has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 19.5% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 31.2%.

• The firm is levered to coal, though we note its mix is more of the Powder River Basin variety, which should continue to take share from Central Appalachian coal in the domestic market. The firm also boasts a strong Valuentum Dividend Cushion score and a decent annual yield.

• The firm experienced a revenue CAGR of about 14% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Union Pacific's 3-year historical return on invested capital (without goodwill) is 9.4%, which is below the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Union Pacific's free cash flow margin has averaged about 13.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Union Pacific, cash flow from operations increased about 50% from levels registered two years ago, while capital expenditures expanded about 33% over the same time period.

Valuation Analysis

We think Union Pacific is worth $174 per share, which represents a price-to-earnings (P/E) ratio of about 21 times last year's earnings and an implied EV/EBITDA multiple of about 9.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 14%. Our model reflects a 5-year projected average operating margin of 37.9%, which is above Union Pacific's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.7% for the next 15 years and 3% in perpetuity. For Union Pacific, we use a 10% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $174 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Union Pacific. We think the firm is attractive below $139 per share (the green line), but quite expensive above $209 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Union Pacific's fair value at this point in time to be about $174 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Union Pacific's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $226 per share in Year 3 represents our existing fair value per share of $174 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Why We Like Union Pacific

Additional disclosure: UNP is included in the portfolio of our Best Ideas Newsletter.