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Summary

  • With the 20% increase over the past few months, is UNP currently overvalued?
  • U.S. and Mexican growth to provide catalyst for the company.
  • Management's focus on lowering the operating ratio is adding to profitability.

Over the past four months Union Pacific's (NYSE:UNP) stock price has had a stellar run. Driven by the slow economic recovery, the company's share price has increased from ~$150.00 to the current price of ~$185.33. As this has been an extensive run, this poses the question, at this point in the market, is UNP still a buy?

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Chart sourced by (Finviz)

In the evaluation below, we will be able to see how Union Pacific has fared over the past four years regarding its 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' 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 = $4.388 billion

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UNP Net Income (Annual) data by YCharts

The slow but steady recovery in the economy is displayed in the company's increase in income over the past four years. In that time period, UNP's net profits have increased from $2.780 billion in 2010 to $4.388 billion in 2013, which represents a 57.84% increase.

  • Operating income 2010 = $4.981 billion
  • Operating income 2011 = $5.724 billion
  • Operating income 2012 = $6.745 billion
  • Operating income 2013 = $7.446 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 four years, Union Pacific's operating income has increased from $4.981 billion to $7.446 billion in 2013. This represents an increase of 49.49%.

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 2011 = $13.833 billion
    • Operating Expenses 2012 = $14.181 billion
    • Operating Expenses 2013 = $14.517 billion
  • Total Revenue

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

    • Operating Ratio 2011 = 70.73%
    • Operating Ratio 2012 = 67.76%.
    • Operating Ratio 2013 = 67.26%

When looking at UNP's operating ratio, you can see that ratio has been declining over the past three years. UNP has a goal of reaching and sustaining an operating ratio below 65% by 2017. As discussed in my article Union Pacific: Exploring Innovative Ways To Create Shareholder Value, the initiation of LNG locomotives looks to be a long-term cost saving initiative that will have a positive impact on the company's ability to sustain a lower operating ratio.

Chart Sourced by (UNP)

A decrease in this metric indicates a strengthening in profitability as it is a measure of expenses vs. revenue.

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 - $4.388 billion / $21.225 billion = 20.67%

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UNP Return on Equity (TTM) data by YCharts

Over the past four years the ROE is showing improvement. Since 2010 the ROE has increased from 15.65% to 20.67%. 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 = $49.731 billion.
    • Equals an increase of $6.643 billion
  • Total liabilities

    • Total liabilities 2010 = $25.325 billion
    • Total liabilities 2011 = $26.518 billion
    • Total liabilities 2012 = $27.276 billion
    • Total liabilities 2013 = $28.506 billion
    • Equals an increase of $3.181 billion

Over the past four years, UNP's total assets have increased by $6.643 billion, while total liabilities have increased by $3.181 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 = $3.990 billion
  • Current liabilities

    • Current liabilities 2010 = $2.952 billion
    • Current liabilities 2011 = $3.317 billion
    • Current liabilities 2012 = $3.119 billion
    • Current liabilities 2013 = $3.791 billion
  • Current ratio 2010 = 1.16
  • Current ratio 2011 = 1.12
  • Current ratio 2012 = 1.16
  • Current ratio 2013 = 1.05

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
  • 2014 shares outstanding = 455.06 million

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UNP Shares Outstanding data by YCharts

Driven by the company's 2011 plan to repurchase 40 million shares by April 2014 the number of company shares has decreased significantly. Over the past four years the company has bought back just under 48 million shares.

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 = $16.114 billion / $21.963 billion = 73.36%.

Over the past four years, UNP's gross margin has dropped slightly. The ratio has decreased from 74.52% in 2010 to 73.36% in 2013.

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 = $21.963 billion
    • Equals an increase of 29.46%.
  • Total Asset growth

    • Total assets 2010 = $43.088 billion
    • Total assets 2011 = $45.096 billion.
    • Total assets 2012 = $47.153 billion.
    • Total assets 2013 = $49.731 billion.
    • Equals an increase of 15.42%.

Over the past four years the revenue growth has increased by 29.46% while the assets have increased by 15.42%. 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. Revenue over the past four years has increased by 29.46% while the ROE has increased from 15.56% to 20.67% 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 and the company plan to reduce the operating ratio to below 65% by 2017 is "on target."

Revenue Breakdown

Using the chart below supplied by UNP, you can see the company's revenue breakdown over the past three years. The chart indicates that there has been a significant increase in the Automotive, Chemical, Industrial and intermodal revenue. Increases in these aspects have offset the essentially flat revenue in coal shipping.

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Chart sourced by (UNP)

Looking forward

In 2014, UNP expects volume growth to increase by ~4 to 5%. This expectation is due to the increased demand for building materials driven by the housing market. Along with a resurging chemical industry fueled by the low price of natural gas, UNP expects a strong year for Industrial Products, Chemical and Intermodal.

In late 2013 UNP introduced a new intermodal service between Chicago and Monterrey, Mexico. This new service will give companies another reliable transportation option to move goods across the U.S./Mexico border six days a week.

Chart sourced by (UNP)

As UNP is the only railroad that serves all six Mexico gateways, they are well positioned to capitalize on any increase in the Mexican economy. This new international service will provide companies with opportunities for growth in the ever-expanding Mexico market.

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 EV/EBITDA ratios to estimate the current value and target price for 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 can generate an opinion based on that.

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Even though there are variations in calculating this formula, this model is based off of a terminal value of $91.123B and a WACC of 5.93%. The terminal value of $91.123B is based off of the company trading at an industry average of 9.88x EBITDA. Using this valuation, I have concluded UNP's value to be ~$174.78 per share.

EV/EBITDA = Enterprise Value / Earnings before interest, Taxes, Depreciation and Amortization

In the next section, I will use the EBITDA to calculate the EV/EBITDA. The adjusted EBITDA takes into account foreign exchange and share-based payment expenses. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm. Integrated oil and gas stocks typically have an EV/EBITDA ratio that trades in the 4.0x to 5.0x trading range.

Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents.

  • EV - 85.750 billion + $9.577 billion - $1.432 billion = $93.895 billion
  • EV = $93.895 billion
  • EBITDA = 9.223 billion
  • EV/EBITDA = 10.18

As the Railroad sector often trades in the 9.88x trading range, an EV/EBITDA ratio of 10.18 supports the DCF valuation by indicating at current levels the stock is trading just over fair value.

As the DCF and the EV/EBITDA both indicate that Union Pacific is slightly overvalued at this point in the market, what does a future target price look like? Using the EV/EBITDA ratio along with calculating future EBITDA, cash and debt we should get a 2015 target price.

2015 Target Price

  • Estimated Net debt = $10.028 billion
  • Estimated cash and cash equivalents = $1.5 billion (same)
  • Estimated future EBITDA (2015) $11.061 billion
  • EV/EBITDA = 9.88 (industry average)
  • Shares Outstanding = 456 million (same)
  • 2015 equity value = 9.88 x $11.061 billion = $109.28 billion
  • Equity Value - net debt + cash = Enterprise Value = $100.75 billion
  • EV / Shares outstanding = $100.74 billion / 456 million
  • Target Price of = $220.94 per share

Based on the EV/EBITDA formula to find a target price, I have calculated a target price in 2015 of $220.94 per share.

As of April 9th, UNP's stock was trading at $185.33 - Using the Discount Cash Flow Formula, this indicates the stock is trading above its fair value of $174.78 by 6.04%.

In calculating a target price for 2015 using the EV/EBITDA formula ratio, this indicates a valuation $220.94 per share or potential upside of 19.21%.

Seasonality

According to a 20-year seasonal average supplied by equity clock, April has been a positive month for Union Pacific. Having stated that, after an excellent run, I believe we will be entering a period of consolidation for the stock. As the DCF calculation and the EV/EBITDA ratio has revealed the valuation may have "outpaced itself."

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Chart sourced by (Equity clock)

Strategy

At this point in the market, I would not be surprised if there was a 5-10% correction over the next few months. 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

As Union Pacific's stock price has had a solid increase thus far in 2014, I believe we will be entering a period of consolidation. Having stated that, I believe any pullback in the market would provide an excellent opportunity to add a position or add to your position.

Driven by the slowly expanding economy and a strong management team that is adapting to an ever changing economic landscape, 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 overvalued by ~6.04%, having stated that, I still believe this is an excellent opportunity to invest as I have a target price for 2015 at ~$220.94.

Source: Union Pacific: At This Point In The Market, Is The Company Still A Buy?