Why Union Pacific Is Our Favorite Railroad Idea

| About: Union Pacific (UNP)

Summary

We like the railroad industry thanks to its significant barriers to entry.

Though each railroad has many things going for it, we like Union Pacific the best.

We expect the company to outperform in this market. The company resides in the Best Ideas portfolio.

Railroads generate revenue from transporting freight and other materials such as coal, grains and a variety of industrial products and chemicals across North America. The industry largely operates as an oligopoly and benefits from substantial barriers to entry as investing and maintaining track is no small capital investment. Track ownership usually translates into pricing power, something that we find to be an indication of the group's significant competitive strengths. Let's examine why Union Pacific (NYSE:UNP) is our favorite idea in the railroad space, running it through the Valuentum style.

But first, a little background to help with the understanding of some of the terminology in this piece. At our research firm, 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. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.

We liken stock-selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money-managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking "common sense."

Union Pacific posts a Valuentum Buying Index score of 6, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technical. With that said, let's now dig into the report!

Union Pacific's Investment Considerations

Investment Highlights

• 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. Pricing power has returned to the industry, and we think it's here to stay.

• 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 20.6% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 31.1%.

• 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. Learn more about the Dividend Cushion here.

• We hold Union Pacific in the Best Ideas portfolio, and we consider it one of our best ideas. We'd only consider removing Union Pacific if it registered a 1 or a 2 on the index, or the equivalent of a "we'd consider selling" rating. At any time, we like the portfolio holdings the best, and the Valuentum Buying Index serves up companies that register scores of 9 and 10 ("we'd consider buying rating") for consideration.

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 with its weighted average cost of capital. 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 10.9%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of GOOD. 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 17.3% 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 16% from levels registered two years ago, while capital expenditures expanded about 33% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Union Pacific's shares are worth between $150-$226 each. The midpoint of the range is our point fair value estimate, which is roughly where shares are trading (at about $190 at present). The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $188 per share represents a price-to-earnings (P/E) ratio of about 20 times last year's earnings and an implied EV/EBITDA multiple of about 9.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.2% during the next five years. We're expecting pricing power to be the primary driver behind the company's revenue and profit expansion in coming years. 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 10.1% weighted average cost of capital to discount future free cash flows. Though the firm's valuation matches its stock price, we won't consider removing Union Pacific from the portfolio until the market sours on shares.

Our discounted cash-flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money-managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earning-to-growth (PEG) ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash-flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We compare Union Pacific to peers Canadian National (NYSE:CNI), CSX Corp (NYSE:CSX), and Norfolk Southern (NYSE:NSC).

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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 $188 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 $150 per share (the green line), but quite expensive above $226 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. A rigorous DCF valuation is the first pillar of the Valuentum process.

Recent Events

Union Pacific reported record first-quarter results that showed diluted earnings per share increasing 17% and its operating ratio advancing 2 percentage points to 67.1%. The release supports our view of the company's operating ratio, which we believe to be among the best in the railroad group by the end of this decade. Shares are worth nearly $190, on the basis of our fair value estimate, roughly in line with where they are trading. However, it is very important to note that our 'consider selling' discipline is not purely valuation-based, but we'd also have to see confirmation in the technicals (pricing information) as well. Said differently, we'd be waiting for Union Pacific's technicals to turn lower for us to ever consider trimming/removing the position in the Best Ideas portfolio. This patience allows our winners to run higher (without taking on undue capital risk) and the portfolio to capture the "momentum" aspect of the Valuentum process (a key lever of outperformance). In any case, Union Pacific remains our favorite railroad idea, particularly in this market environment.

Future Path of Fair Value

We estimate Union Pacific's fair value at this point in time to be about $188 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 $242 per share in Year 3 represents our existing fair value per share of $188 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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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: UNP is included in Valuentum's Best Ideas portfolio.