Union Pacific: A Compelling Dividend Growth Story

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 |  About: Union Pacific Corporation (UNP)
by: Josh Arnold

Summary

UNP shares have experienced a strong, multi-year rally.

Dividend growth is a priority for management, boosting returns to shareholders.

UNP represents a compelling opportunity for dividend growth investors going forward.

Investors who have held Union Pacific (NYSE:UNP) over the past five years have enjoyed enormous, steady gains. Shares traded for $30 five years ago and today, are knocking on the door to $100 after a long, steady rally. There is also a dividend growth component to UNP shares and in this article, we'll take a look at UNP's valuation and its dividend growth potential in order to see if it might fit within your dividend portfolio.

To do this we'll use a DCF-type model you can read more about here. The model takes inputs such as earnings estimates, which I've sourced from Yahoo!, dividend estimates, which I've set at 8% growth per year (more on that later), and a discount rate, which I've set at 9%. My discount rate was arrived at by adding a risk premium of 6.5% to the 10 year Treasury rate, which I use as my risk free rate when setting discount rates.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Prior Year earnings per share

 

$4.71

$5.54

$6.34

$7.27

$8.34

$9.57

x(1+Forecasted earnings growth)

 

17.60%

14.40%

14.73%

14.73%

14.73%

14.73%

=Forecasted earnings per share

 

$5.54

$6.34

$7.27

$8.34

$9.57

$10.98

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$23.85

$27.39

$31.57

$36.50

$42.32

$49.17

Earnings per share

 

$5.54

$6.34

$7.27

$8.34

$9.57

$10.98

-Dividends per share

 

$2.00

$2.16

$2.33

$2.52

$2.72

$2.94

=Equity book value at EOY

$23.85

$27.39

$31.57

$36.50

$42.32

$49.17

$57.21

               

Abnormal earnings

             

Equity book value at begin of year

 

$23.85

$27.39

$31.57

$36.50

$42.32

$49.17

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$2.15

$2.47

$2.84

$3.29

$3.81

$4.43

               

Forecasted EPS

 

$5.54

$6.34

$7.27

$8.34

$9.57

$10.98

-Normal earnings

 

$2.15

$2.47

$2.84

$3.29

$3.81

$4.43

=Abnormal earnings

 

$3.39

$3.87

$4.43

$5.06

$5.76

$6.55

               

Valuation

             

Future abnormal earnings

 

$3.39

$3.87

$4.43

$5.06

$5.76

$6.55

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$3.11

$3.26

$3.42

$3.58

$3.74

$3.91

               

Abnormal earnings in year +6

           

$6.55

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$109.22

               

Estimated share price

             

Sum of discounted AE over horizon

 

$17.12

         

+PV of terminal year AE

 

$65.13

         

=PV of all AE

 

$82.24

         

+Current equity book value

 

$23.85

         

=Estimated current share price

 

$106.09

         
Click to enlarge

As you can see the model produces a fair value of about $106 for UNP, or about 6% higher than shares trade for today. That represents a relatively small margin of safety but in order to make a decision about UNP, we have to first understand what the model is saying.

The model produces a fair value, which is different from a price target. The fair value of $106 means UNP shares are a buy at any price below that number as of today, given the present value of the company's earnings and dividend streams going forward, using the inputs I described above. A price target would likely be somewhat higher given your views on UNP over the medium term.

So UNP is cheap, right? It would certainly appear so and given that my model shows the company is undervalued and that analysts have been ratcheting up estimates for next year's earnings recently, I would say the case for UNP being cheap is pretty compelling. Not only are shares cheap but they are becoming cheaper when UNP posts stellar operating results. Last quarter the company boosted volumes and shipping rates, leading to 10% revenue growth. For a railroad that is practically ancient and enormous in scale that is very impressive and it is easy to see why analysts are boosting earnings estimates so readily.

In addition the company is buying back its own stock with excess cash. Last quarter alone saw $800+ million in shares repurchased and anyone that reads my articles knows I love buybacks. It is a great piece of the capital returns puzzle when executed properly and UNP is doing it right. It is also reducing the float in a meaningful way which will boost EPS in the years to come.

Finally, UNP is a dividend growth story as well. The company has been raising its dividend like it's going out of style in recent years and shareholders have been rewarded handsomely as a result. The most recent increase to 50 cents per share is just the latest in an impressive string of increases in recent years. I suspect a decent portion of gains shareholders have seen is a direct result of the anticipation of dividend increases coming and UNP is showing no signs of slowing that growth.

I've set dividend growth at 8% in my model but recent history has suggested UNP can do much more than that. If we see dividend growth in the 10% to 12% range, which is certainly possible, there is upside to my fair value for UNP. And not only would that make UNP cheaper but it would also boost total returns as cash was sent back to shareholders.

UNP is a compelling capital gains and dividend growth story. The company is absolutely crushing it right now and even after an enormous, multi-year rally, is only trading for ~15 times forward earnings. Couple that with a decent dividend that is set to continue growing at a rapid pace and you've got a great stock for a retirement portfolio. Long term holders of UNP, I suspect, will do very well going forward; just get on the train before it leaves the station.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in UNP over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.