Union Pacific - Fully Valued After This Year´s Runup Amidst Continued Volume Challenges

| About: Union Pacific (UNP)
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Summary

Union Pacific just finished a difficult quarter although the operating environment is slowly becoming friendlier.

Lack of volume growth is a long term challenge for the business as strong pricing and efficient operations have allowed for big margin expansion over the past decade.

With shares trading at a very modest premium to the overall market, being an excellent inflation hedge, the valuation is full given the lack of volume growth.

Union Pacific (UNP) remains a bellwether as its network covers most of the US and Canada, totaling over 50,000 miles. The company is well diversified, transporting agricultural, automotive, chemicals, coal, industrial products and intermodal.

While the company has seen somewhat of a recovery in the recent quarter, volumes continue to fall by pretty large numbers. Going forwards, easier comparables and a recovery in oil & gas prices should be helpful.

That being said, the market has been anticipating improvements, as shares trade with healthy year to date returns, even as actual earnings keep falling. Given the valuation multiple inflation and lack of real volume growth over quite some period of time, Union Pacific is more or less an inflation hedge which is fully valued at this point in time.

No Recovery In Sight

UNP has shown steady growth over the past decade, having grown revenues from $15 billion in 2006 to a peak of $24 billion in 2014. Most of the growth was realized by price hikes and not volume gains. This helped the company to expand margins from levels around 20% of sales in 2006 to a high of 36% in 2014.

Revenues fell towards $22 billion in 2015 on the back of lower volumes and lower fuel surcharges as the topline continued to come down throughout 2016. Margins have been relatively solid on the back of lower fuel costs of course and costs savings measures.

Third quarter sales were down some 7%, and while that looks weak it has been an improvement from the first half of the year as volumes are down by 11% in the first three quarters of the year.

Pricing power is limited with volumes down 6% for the quarter and 8% so far this year. Coal continues to be the laggard with volumes being down some 14%. A recent run-up in coal and gas prices has slowed down the pace of declines in volumes. The bright spot has been an 11% increase in agricultural products.

Valuation, Topline Sales Are Down, Margins Remain Intact

With sales being down on the back of lower volumes and lower fuel surcharges, revenues are set to come in around $20 billion this year, down by $4 billion from the peak in 2014. Despite the pressure on revenues, operating margins totaled 37.9% of sales in the third quarter, being down 180 basis points from last year. As fuel expenses were down by ¨just¨ 19%, it is no longer providing a big boost to margins given that volumes are down as well of course, as fuel prices are increasing on a sequential basis again.

Sales declines and modest margin pressure has weighted on profits which were down by 13% as share repurchases result in a 10% decline in earnings per share. Based on the current trends, earnings are set to come in around $5 per share, translating into an 18 times multiple at $90 per share. At these levels, UNP supports a 5.5% earnings yield.

A substantial amount of earnings goes to cater the 2.4% dividend yield, for a payout ratio of roughly 45%. Share buybacks require a lot of funds as well. The company bought back 32 million shares over the past year, at a cost of $2.9 billion at current levels, equivalent to roughly two-thirds of annual earnings. That suggests that all of the earnings are used to please investors, through both buybacks and dividends.

Of course the network requires investments as well even as volumes are down. The cumulative impact of years of inflation makes modest repairs and expansion more expensive than historical depreciation charges, resulting in a constant need to invest, even if volumes are down. Capital investments surpassed depreciation charges by $1.1 billion in the first three quarters of the year, boosting the balance sheet value of the network & property towards $50 billion.

UNP ended the quarter with $2.2 billion in cash and equivalents as debt has risen towards $15.6 billion, for a $13.4 billion net debt load. Including operating leases this net debt load is roughly $2.5 billion higher. With EBITDA running at $9.5 billion a year, leverage ratios remain modest at 1.7 times. The company itself reports a 1.9 times leverage ratio, closing in on the 2 times leverage target which suggests that the pace of share buybacks will come down a bit in the coming years unless earnings improve drastically.

Final Thoughts

Union Pacific has seen a decent rise in its stock price this year, just like the rest of the industry while volumes, sales and earnings have been trending downwards. This has resulted in increased valuation multiples.

The company is trading at market-equivalent multiples more or less, pays a fair dividend yield and has a solid balance sheet. What it does not have is volume growth amidst a strong dollar and unstable global economy, although volume trends have been disappointing for quite a while. At the same time one can not reasonably expect that the very fat margins will be expanded going forward.

With shares up 15% year to date, even after losing more than 5% in response to the softer than expected third quarter results, it might be too early to go bottom fishing. That said, UNP remains a core holding for the long term given the inflation protection properties which the company provides to investors.

Appeal is found in my eyes when the earnings yield hit 6%, for a 16-17 times multiple, suggesting that the $80-$85 region seem fair levels to pick up stock. This should create some margin of safety, taking into account the recent strengthening of the dollar as well.

Disclosure: I/we 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.