Railroads have been one of my top picks for some time. From their unsuspecting contribution to the global economy (ie. most cost effective form of goods transpiration ... by far) to top management, the industry has rightfully surged. Still, under-followed firm RailAmerica (RA) and rail equipment provider Kelso Technologies (KEOSF.PK) are still significantly undervalued. I expect the firms to outperform the broader market as press coverage improves. Toward that end, I will write a focus piece on the firms at a later time.
In the meantime, larger firms like Union Pacific (UNP) will get all of the attention. In this article, I will run you through my DCF analysis on Union Pacific and then triangulate the result with an exit multiple calculation and review of the fundamentals compared to CSX (CSX) and Norfolk Southern (NSC). I find that the firm is still heavily discounted to intrinsic value.
First, let's begin with an assumption about revenues. Union Pacific finished FY2011 with $19.6B in revenue, which represented a 15.3% gain off of the preceding year. Analysts model a 16.3% per annum growth rate over the next few years, and I view this as reasonable.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat 27% of revenue versus 33% for SG&A, and 16% for capex. This capex projection is on the higher-side … very few companies are at this level. Reductions on this item would significantly unlock value, but capital requirements have always been heavy in rail. On the plus side, this means significant barriers to entry.
We then need to subtract out net increases in working capital. I estimate this figure to hover around -1.5% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9.3% yields a fair value figure of $146.57, implying 33.2% upside.
All of this falls within the context of "room for improvement" despite already impressive gains:
"And while we still have plenty of room for improvement, faced with growing volumes, the Union Pacific team delivered even while our operating team was out there battling blizzards, flooding and droughts.
The advantage of a diverse franchise was again evident in the fourth quarter as volumes grew 3% despite our declines in Ag products and Intermodal. Core pricing improved 5% with gains in all six of our businesses. Those price gains, higher fuel surcharge revenue, and some positive mix as our carload business grew while Intermodal is a little soft, drove average revenue per car up 13%. The growth in volume and improved revenue per car produced a 16% increase in freight revenue to $4.8 billion."
From a multiples perspective, Union Pacific is equally attractive. It trades at 16.4x past earnings but only 11.9x forward earnings. This compares to 12.6x and 10x for CSX and 11.9x and 9.8x for Norfolk Southern. Assuming a multiple of 17x and a conservative 2012 EPS of $7.70, the rough intrinsic value of Union Pacific's stock is 130.90.
Consensus estimates for the firm's EPS are that it will grow by 24.4% to $1.68 and then by 14.3% and 14.6% more in the following two years. Assuming a multiple of 14.5x and a conservative 2012 EPS of $1.86, the rough intrinsic value of the stock is $26.97, implying 28.3% upside. Investors are overly worried about slowing coal shipments, which will allow for higher risk-adjusted stock returns when the industrial economy fully recovers. Extra labor could also be reduced to help unlock value, especially in light of "on and off" problems with the unions. The Maersk business provides a nice hedge against the domestic market in the meantime.
Assuming a multiple of 14.5x and a conservative 2013 EPS of $6.53, the rough intrinsic value of the stock is $94.69, implying 46.4% upside. The company has demonstrated strong momentum and is doing particularly well in intermodal. I like the firm, because it is highly exposed to coal (a plurality of business comes from this). Again, this will help drive high risk-adjusted stock returns. In addition, the direct connection to Appalachian and Illinois mines provides a strong sustainable advantage. Additional capex spending will further solidify the firm's already impressive fundamentals.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer.