Union Pacific: Is It Bottoming Soon?

| About: Union Pacific (UNP)


Union Pacific, the largest railroad in N.America commands an impressive 32K miles of rail network in western US.

The company is a Dividend Challenger having raised dividends for 9 consecutive years, with a 5-yr dividend CAGR of 29.70%.

The company is facing headwinds with falling crude and coal shipments, but things are expected to turn around with the oil market finally picking up.

Union Pacific Corp (NYSE:UNP) is the largest publicly traded railroad company in North America. The company commands an impressive 32,000 miles of rail network in western US. The following system map image demonstrates the scale and reach of Union Pacific.

(Image Source: Union Pacific 2015 Factbook)

The Railroad Industry

Railroads are considered a wide moat industry, as it entails immense capital requirements and new entrants in the industry are almost unheard of. Railroads are the pulse of the economy. Whether transporting crude, lumber, merchandise, agricultural or industrial products, railroads are what keeps the economy moving. Railroads are often closely observed by economists and analysts to get a sense of how the overall economy is doing. It is also considered a leading indicator for any recessions or slowdowns.

Since the railroads play such a crucial part of the economy and provide excellent long term capital appreciation, while providing investors with increased dividends year after year, the industry has attracted some of the biggest high-profile billionaire investors in the US. Warren Buffett's Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) tookover Burlington Northern Santa Fe (BNSF) in 2009; Bill Gates' Cascade Investments LLC own a 11.8% stake in Canadian National Railway (NYSE:CNI); and Bill Ackman's Pershing Square owns a 6.4% stake in Canadian Pacific (NYSE:CP).

The following table provides an overview of the railroad industry comparing Union Pacific with its competitors Canadian National Railway , CSX Corp (NYSE:CSX), Norfolk Southern Corp (NYSE:NSC), Canadian Pacific Railway , and Kansas City Southern (NYSE:KSU).

(Image Source: Created by author. Data from Google Finance & FinViz)

Current Trends

Railways have played a crucial part in transporting everyday goods such as crude, lumber, merchandise, agricultural or industrial products. Over the past decade, the highest growth has come from crude oil transportation. The rapid expansion of oil drills across the continent meant that fast and easy transportation of crude oil, whether from Canadian oil sands, or shale regions was necessary and railroads filled this need in the market quickly. However, with the current downturn in oil prices over the past two years, shipment volumes fell as the drill count reduced across the continent. More recently, with the uptick in the oil prices, shipments have increased steadily bringing some respite to the railroads.

Coal shipments, on the other hand, are seeing secular declines. As the world moves towards cleaner fuels and green alternatives, coal is being shunned by the market. Traditionally, coal has been the largest user of railroad service and this reduction in shipment volume has hurt most railroad operators. Union Pacific relies quite heavily on the coal shipments (coal made 16% of 2015 revenue segment, down from 18% the year before) and remains a headwind for the company.

The chart below shows the overall rail traffic in the US - and as can be seen, its been dismal so far in 2016. The shipments are finally picking up again for petroleum products, and there has been indication that grain shipments could also increase. How the rest of the season progresses remains to be seen.

(Image Source: Association of American Railroads)

Dividend Stock Analysis


Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations.

(Source: Created by author. Data from Morningstar)

Actual: UNP has continued to increase the revenue year after year except in 2009 (due to the recession) and 2015 due to the challenges mentioned above (crude and coal shipment issues). The earnings have followed the revenue.

Looking forward, revenue is expected to fall another 8% this year compared to 2015, but things are looking up going forward. For 2017, revenue is expected to grow by 5%. Earnings are also expected to fall a bit going forward.

UNP's debt/equity is 0.74 and the company's balance sheet shows a current ratio of 1.5. S&P gives the company a 'A' credit rating.

UNP's yield of maturity is as shown below. A few debt repayments are upcoming starting 2017.

(Image Source: Morningstar)

Dividends and Payout Ratios

Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future.

(Source: Created by author. Data from Morningstar)

Actual: Union Pacific is a Dividend Challenger having raised its dividend for 9 consecutive years. The current dividend stands at 2.48%, a historically high yield. The 1-, 3-, 5-, and 10-yr dividend CAGR (Compound Annual Growth Rates) are 21.9%, 20.9%, 29.7%, and 22.0% respectively.

Note that UNP has not raised its dividend since the first quarter of 2015. If the company intends to keep its dividend grower status, UNP needs to raise its dividends before the end of this year. Considering that the company has a current payout ratio of 41% and analysts expect earnings to grow at approx. 7% over the next five years, I am confident UNP will announce a raise before the end of the year.

Outstanding Shares

Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble.

(Source: Created by author. Data from Morningstar)

Actual: The number of shares have declined steadily over the years.

Book Value and Book Value Growth

Expected: Growing book value per share.

(Source: Created by author. Data from Morningstar)

Actual: The book value has increased steadily over the years although a dip was noted in 2015. At the time of this writing in mid-2016, the book value seems to have stabilized and remains flat for the trailing twelve months.

Operating Margins

Expected: A healthy operating margin of over 30%.

Actual: The company has an operating margin of 36.9%.


To determine the valuation, I use the Graham Number, average yield, average price-to-earnings, average price-to-sales, and discounted cash flow. For details on the methodology, click here.

The Graham Number for UNP with a book value per share of $24.34 and TTM EPS of $5.35 is $54.13.

UNP's average yield over the past five years was 1.83% and past ten years was 1.67%. Based on the current annual payout of $2.20, that gives us a fair value of $120.22 and $131.74 over the 5- and 10-year period, respectively.

UNP's 5-year average P/E is 17.2, and the 10-year average P/E is 16.61. Based on the analyst earnings estimate of $5.16, we get a fair value of $88.75 (based on 5-year average) and $85.71 (based on 10-year average).

The average 5-year P/S is 3.38 and average 10-year P/S is 2.7. Revenue estimates for next year stand at $23.23 per share, giving a fair value of $78.53 and $62.73 based on 5- and 10-year averages, respectively.

The consensus from analysts is that earnings will rise at 7% per year over the next five years. If we take a more conservative number at 5% and assume that UNP is growing its earnings by 4% thereafter, running the three-stage DCF analysis with a 10% discount rate (expected rate of return), we get a fair price of $78.72.

The following charts from F.A.S.T. Graphs provide a perspective on the valuation of UNP.

(Source: F.A.S.T. Graphs)

The chart above shows that UNP is fairly valued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-year return would be -4.6%.

(Source: F.A.S.T. Graphs)


Railroads are the pulse of the economy, and UNP operates an impressive 32,000 miles of rail network serving western US. While crude shipments are on their way to a recovery thanks to the rise in oil prices, coal remains in a secular downtrend - both of which play a crucial part in UNP's revenue. UNP operates at a great margin and directly competes with BNSF as the service map overlaps. The stock appears fairly-to-slightly overvalued currently. If we give equal weight to all valuation metrics used above, we get a fair value of $86.71. The revenue & earnings are expected to fall this year and may bottom out soon before they start growing again. Investors are advised to look for any dips as a buying opportunity.

Full Disclosure: Long CNI. My full list of holdings is available here.

Disclosure: I am/we are long CNI.

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.

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