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For investors looking for a large-cap company in a sector poised for long-term growth, Union Pacific Corporation (UNP) is a dividend paying railroad company that is exploring new ways to save on costs and create shareholder value.

Over the past five years, the railroad industry has had to adapt to many changes. With North American coal demand on the decline and a general economy in the state of malaise, company management has had to find innovative ways to reduce costs to maintain earnings and create shareholder value.

In the section below, I will analyze aspects of Union Pacific's past performance. From this evaluation, we will be able to see how Union Pacific Corp. has fared over the past four years regarding their profitability, debt and capital, and operating efficiency. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business's ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $2.780 billion
  • Net income 2011 = $3.292 billion
  • Net income 2012 = $3.943 billion
  • Net income 2013 TTM = $4.250 billion

The slow recovery in the economy is displayed in the company's increase in revenue over the past four years. In that time period, UNP's net profits have increased from $2.780 billion in 2010, to $4.250 billion in 2013 TTM, which represents a 52.87% increase.

  • Operating income 2010 = $4.981 billion
  • Operating income 2011 = $5.724 billion
  • Operating income 2012 = $6.745 billion
  • Operating income 2013 TTM = $7.198 billion

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past three years, Union Pacific's operating income has increased from $4.981 billion to $7.198 billion in 2013 TTM. This represents an increase of 44.51%.

Operating Ratio

A ratio that shows the efficiency of a company's management by comparing operating expenses to net sales.

1 - (Operating Expenses / Revenue)

  • Operating Expenses

    • Operating Expenses 2010 = $7.662 billion
    • Operating Expenses 2011 = $8.247 billion
    • Operating Expenses 2012 = $8.430 billion
    • Operating Expenses 2013 TTM = $8.573 billion
  • Total Revenue

    • Revenue 2010 = $16.965 billion
    • Revenue 2011 = $19.557 billion.
    • Revenue 2012 = $20.926 billion.
    • Revenue 2013 TTM = $21.583 billion.
  • Operating Ratio

    • Operating Ratio 2010 = 54.84%.
    • Operating Ratio 2011 = 57.83%
    • Operating Ratio 2012 = 59.72%.
    • Operating Ratio 2013 TTM = 60.72%

When looking at UNP's operating ratio, you can see that ratio has increased over the past three and a half years. The operating ratio has increased from 54.84% in 2010 to 60.72% in 2013 TTM. This indicates that the operating expenses have increased at a higher level from a percentage point of view than the revenue. A decrease in this metric indicates a strengthening in profitability.

ROE - Return on Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

Net Income / Shareholders' Equity

  • 2010 - $2.780 billion / $17.763 billion = 15.65%
  • 2011 - $3.292 billion / $18.578 billion = 17.72%
  • 2012 - $3.943 billion / $19.877 billion = 19.84%
  • 2013 TTM - $4.250 billion / $20.774 billion = 20.46%

Over the past three and a half years the ROE is showing improvement. Since 2010 the ROE has increased from 15.65% to 20.46%. As the ROE has increased over the past four years, this reveals that there has been an increase in how much profit has been generated compared to the amount that shareholders have invested, thus indicating an increase in shareholder value.

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $43.088 billion
    • Total assets 2011 = $45.096 billion.
    • Total assets 2012 = $47.153 billion.
    • Total assets 2013 TTM = $48.958 billion.
    • Equals an increase of $5.870 billion
  • Total liabilities

    • Total liabilities 2010 = $25.325 billion
    • Total liabilities 2011 = $26.518 billion
    • Total liabilities 2012 = $27.276 billion
    • Total liabilities 2013 TTM = $28.184 billion
    • Equals an increase of $2.859 billion

Over the past three and a half years, UNP's total assets have increased by $5.870 billion, while the total liabilities have increased by $2.859 billion. This indicates that the company's assets have increased more than the liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $3.432 billion
    • Current assets 2011 = $3.727 billion
    • Current assets 2012 = $3.614 billion
    • Current assets 2013 TTM = $4.064 billion
  • Current liabilities

    • Current liabilities 2010 = $2.952 billion
    • Current liabilities 2011 = $3.317 billion
    • Current liabilities 2012 = $3.119 billion
    • Current liabilities 2013 TTM = $3.655 billion
  • Current ratio 2010 = 1.16
  • Current ratio 2011 = 1.12
  • Current ratio 2012 = 1.16
  • Current ratio 2013 TTM = 1.11

Over the past three and a half years, Union Pacific's current ratio has slightly decreased. As the current ratio is currently above 1, this indicates that UNP would be able to pay off its obligations if they came due at this point.

Common Shares Outstanding

  • 2010 shares outstanding = 503 million.
  • 2011 shares outstanding = 490 million.
  • 2012 shares outstanding = 477 million
  • 2013 TTM shares outstanding = 464 million

Over the past three and a half years, the number of company shares has decreased. The company has decreased the shares from 503 million to 464 million.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2010 = $12.643 million / $16.965 billion = 74.52%.
  • Gross margin 2011 = $13.971 billion / $19.557 billion = 71.44%.
  • Gross margin 2012 = $15.175 billion / $20.926 billion = 72.52%.
  • Gross margin 2013 TTM = $15.771 billion / $21.583 billion = 73.07%.

Over the past four years, UNP's gross margin has dropped slightly. The ratio has decreased from 74.52% in 2010 to 73.07% in 2013 TTM.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $16.965 billion
    • Revenue 2011 = $19.557 billion
    • Revenue 2012 = $20.926 billion
    • Revenue 2013 TTM = $21.583 billion
    • Equals an increase of 27.22%.
  • Total Asset growth

    • Total assets 2010 = $43.088 billion
    • Total assets 2011 = $45.096 billion.
    • Total assets 2012 = $47.153 billion.
    • Total assets 2013 TTM = $48.958 billion.
    • Equals an increase of 13.62%.

Over the past three and a half years the revenue growth has increased by 27.22% while the assets have increased by 13.62%. This is an indication that the company from a percentage point of view has been more efficient at generating revenue.

Based on the information above we can see that Union Pacific has produced strong results from a fundamental point of view. Revenues over the past three and a half years, have increased by 27.22%, the ROE has increased from 15.56% to 20.46% in the same time period. The company's revenues have increased more than the assets indicating the company is more efficient at generating revenue with its assets. A notable blemish on the company is that the operating ratio has been declining.

Moving Forward - Transition from Diesel to LNG Locomotives

One way the railroad companies are looking at to save costs and create shareholder value is by exploring the viability of liquid natural gas (LNG) locomotives.

With the burden of rising fuel costs and stricter emissions standards for locomotives set to take effect in 2015, major railroad companies such as Canadian National Railway (CNI), Union Pacific Corp., Norfolk Southern Corp. (NSC) and CSX Corp. (CSX) are searching for cheaper and more environmentally friendly alternatives. One alternative that these companies are exploring is powering their locomotives using LNG instead of diesel.

In conjunction with General Electric (GE), Caterpillar Inc. (CAT), and Cummins Inc. (CMI), Union Pacific is currently beginning to field test liquid natural gas-fueled locomotives. Conclusions from these tests are expected to take at least one to two years and according to railway magazine if these tests are positive, "LNG locomotives could be in widespread use by 2016 or 2017."

As the price of natural gas is expected to be lower for a long period of time, the conversion process looks to make economical and environmental sense for railroad companies. Lorenzo Simonelli, chief executive officer of GE's transportation unit, recently stated: "If you believe the price advantage over diesel is going to stay here for the next 10 to 15 years, then LNG is a revolutionary fuel."

Even though there is considerable upside for the railroad companies regarding this transformation, the capital costs and industry organization to convert to LNG would be a very expensive and erroneous task. Some of the challenges that need to be addressed from an industry point of view before a wide spread conversion can take place are: A lack of rail refueling infrastructure, how to manage the infrastructure throughout the industry from a long-term point of view and maintenance of these facilities including upkeep costs and safety.

In an interview addressing the infrastructure issue Paul Bingham economist at CDM Smith stated: "The Class 1 rails will make the investment and put in the fueling systems, but they still have to get the gas to those locations, Some other third party is going to have to play in that."

This gap should provide an opportunity for General Electric. General Electric currently makes equipment that they say can liquefy natural gas at any point along a distribution network. Last year, GE sold two of the MicroLNG units to Seal Beach, a California-based Clean Energy Fuels company, to help create a coast-to-coast network of LNG fueling stations for trucks.

From an individual company point of view capital costs in the short term look to be very immense. As a company expects between 15 and 20 years out of a locomotive and they cost ~$2 million each to make, conversion costs for those locomotives less than 10 years old are estimated to be between $600,000 to $1,000,000. Conversion costs for older locomotives (10 years +) are estimated to be between $400,000 and $600,000. According to Railway Age, at current natural gas prices the savings associated with the conversion are ~$200,000 per locomotive per year. Based on the age and viability of the locomotive it would take between 2 and 5 years for the company to make a return on their investment.

Tony Hatch, an independent transportation consultant based in New York, said in an interview "Like the move from steam to diesel, if it's going to be that radical a transformation, that's a lot of opportunity for sales in a lot of places."

Valuations

In the section below, I will use a couple of different methods to find a valuation of the stock price. In this section, I will use the Discounted Cash Flow valuation model and forward P/E ratios to estimate the current value of each share.

I believe using the Discounted Cash Flow valuation model for Union Pacific to be fair because DCF analysis can help one see where the company's value is coming from and one can generate an opinion based on that.

(click to enlarge)

Even though there are variations in calculating this formula, this model is based off of a terminal value of $89.700B and a WACC of 6.52%. The terminal value of $89.700B is based off of the company trading at a very conservative 10X EBITDA. Using these valuations, I have concluded UNP's value to be $166.00 per share.

In another method, I will use Union Pacific's forward P/E ratios with estimated earnings to find the value. Currently, Union Pacific has a forward P/E of 15.13 and FY 2015 earnings projected at $12.06. These two metrics lead to a target price of $182.46.

As of November 19th, UNP's stock was trading at $158.10 - Using the Discount Cash Flow Formula, this indicates the stock is trading at a 5.06% discount to today's price. If I calculate a valuation using forward P/E ratios this indicates a valuation $182.46 or a discount of 15.19%.

Strategy

At this point in the market, I would not be surprised if there was a 5-10% correction sometime before the end of the year. If such a correction were to occur, this could present an excellent opportunity to add positions in a company with excellent growth prospects. Currently, I believe there is further upside to equity markets as major world economies are either recovering or on the verge of recovering. As interest rates continue to remain near zero this should favor equities.

Conclusion

Even though Union Pacific's stock price has had a solid increase so far in 2013, I believe any significant pullback in the market would provide an excellent opportunity to add a position or add to your position. As railroad companies are looking for cost saving options along with improving environmental standards, the adaptation of LNG locomotives looks to be a very interesting option. As locomotive technologies improve, there will be a decrease in fuel costs and a reduction, which will lead to a decrease in the operating ratio. If you are looking for a company with strong management that is adapting to environmental demands and pays a 2.00% yield, Union Pacific is a strong long-term candidate for your portfolio. At current levels using the Discounted Cash Flow Formula, I have calculated that Union Pacific is currently trading at a 5.06% discount to today's price.

Source: Union Pacific: Exploring Innovative Ways To Create Shareholder Value