Welcome to the twelfth installment of the Value Investing for Main Street series, the fair trade edition, exclusively on Seeking Alpha.
Union Pacific Corporation (NYSE:UNP) operates a freight railroad that has benefited from the globalization of manufacturing that has produced distribution systems for raw materials and finished goods that help drive the new economy. The company has succeeded with a largely unionized workforce that is contradictory to the typical modern American workplace of at-will employment.
The current populist sentiment toward protectionism may create some headwinds for railroads such as Union Pacific that transport a free and open flow of freight to and from Canada, Mexico and from across the Atlantic and Pacific oceans. We think globalization is a natural economic force that will endure any politically motivated resistance.
Any adverse effects from trade deconstruction, such as border adjustment tariffs on imported freight, will likely be temporary. Although our current research indicates a relatively expensive stock price for UNP, counterproductive trade wars may produce value opportunities in the railroads. Our pick would remain UNP. Here's why.
The Other Omaha Railroad
Image Courtesy of Union Pacific Corporation
Union Pacific Railroad is the principal operating company of Union Pacific Corporation, which incorporated in the state of Utah in 1969 and now maintains its principal executive offices in Omaha, Nebraska. Omaha is also home to Warren Buffett's Berkshire Hathaway (NYSE:BRK.B) that infamously acquired Fort Worth, Texas-based competitor railroad, BNSF.
Serving the global supply chains of roughly 10,000 customers, Union Pacific is a Class l railroad that links 23 states in the western two-thirds of the country. It operates from all major West Coast and Gulf Coast ports to eastern gateways, connects with Canada's rail systems and is the only railroad serving all six major Mexico gateways.
UNP is a large-cap stock in the railroads industry within the industrial services sector. As of this writing, its market capitalization was over $85 billion. UNP's price-to-earnings ratio or current stock price relative to earnings per share for the trailing 12 months is approximately 20 times, versus ~22x for the railroads industry as a whole and ~24x for the S&P 500 Index.
Our perpetual skepticism in forecasting aside, the forward price-to-earnings ratio is approximately 18 times, compared to ~19x for the industrial services sector and ~18x for the S&P 500. The trailing and forward P/E ratios for UNP appear in line with those of its industry, sector and market peers.
As of January 19, 2017, Union Pacific's earnings per share (EPS) was $5.08 annualized, netting a 4.90% earnings yield, i.e., EPS divided by the most recent stock closing price. As of this writing, the company is paying a reasonably generous 48% of its EPS to shareholders in an annual dividend of $2.42 per share paid quarterly, resulting in a 2.30% dividend yield.
The Railroad Oligopoly Rolls On
Understanding a company's goods or services and its competitive advantages are essential to the Main Street value investor. We want to own businesses whose products are easy to comprehend.
Below is a snapshot of Union Pacific's freight revenues by commodity type from the company's most recent annual report, or Form 10-K filing with the Securities and Exchange Commission (SEC) for the year ending December 31, 2016:
Source: Union Pacific Corporation, Investor Relations
As widely reported after the company's Q4 and year-end 2016 earnings release - it outperformed analysts' estimates on EPS and revenue in the proverbial Wall Street quarterly competition called "beat, in line, or miss" - the real news was the company’s 9% year-over-year drop in total revenues. The declines were caused primarily by coal shipments and industrial products, such as construction materials, minerals, metals and paper. Another stark reminder that railroads are heavily dependent on the supply and demand for commodities and other basic materials.
I challenge readers who may be inclined to skip annual reports and other SEC filings to find organizational, product, regulatory and financial facts about the company that you were previously unaware of, as I often do. To be sure, these documents are avalanches of legalese and numbers crunching, but deep dives will often uncover slices of information that bring us virtually inside the company's board room.
For example, in addition to the revenue declines, note the following tidbits from Union Pacific's most recent 10-K:
- Unions represent 84% of full-time equivalent employees. As Main Street citizens, we advocate worker protection from corporate greed. We also note Union Pacific's vulnerabilities to artificially inflated wages, pension liabilities, or work stoppages that may result from breakdowns in contract negotiations between management and labor.
- Union Pacific, like its competitors, faces financial and human risks from the transport of hazardous materials such as crude oil (combustion) and chlorine (toxic release). In fact, the railroad has seen several notable accidents and derailments since the turn of this century. A fiery derailment in Iowa on March 10, 2017, occurred not long after the company had reported its lowest ever personal injury incidents for 2016 and an improvement in derailment incidents. Union Pacific is in the midst of spending $2.9 billion on accident prevention by implementing Positive Train Control as required by the Federal Railroad Administration.
- The company has identified 292 sites at which it may be liable for remediation costs associated with alleged contamination or for violations of environmental requirements. However, the rollback of environmental regulations by the current administration may kick this proverbial can down the road, for better or worse.
A Moat Made of Railroad Tracks
Image by J_Lloa
Within investing parlance, an economic moat is the subjective measure of the competitive advantages of a company's goods or services in the marketplace. A wider moat creates a barrier to entry for potential competitors. In the geographically segmented railroad oligopoly, wide moats are common.
According to Morningstar, four of the five railroad holdings represented in the Vanguard Industrials ETF (NYSEARCA:VIS) compete surrounded by wide moats: UNP, CSX Corp. (NYSE:CSX), Norfolk Southern (NYSE:NSC) and Kansas City Southern (NYSE:KSU). The barriers are built primarily from exclusive rights-of-way, the financially prohibitive laying of new track and capital expenditures that typically average 15% of revenue. The fifth railroad holding in VIS, Genesee & Wyoming (NYSE:GWR), is rated a narrow moat by Morningstar because of its historically lower returns on invested capital. Of note, UNP is the lone railroad in the top ten holdings of VIS.
To own a company, we must first understand the business that generates the numbers that comprise the stock's analysis, including its competitive advantages and developed barriers to entry.
Cash Flow is Rolling, Rolling, Rolling
Image by Code83
When considering the worthiness of a company's inclusion in the Value Investing for Main Street Model Portfolio (VIMS), the emphasis is placed on actual growth metrics as opposed to speculative forecasts of what may or may not occur with future revenues, earnings per share, free cash flow, or dividend growth. We look for positive trailing five-year increases in revenue, earnings, cash flow and dividends. As defensive investors, we prefer companies that are already growing, not just promising to grow.
In the most recent five-year period, Union Pacific's compounded annual revenue and earnings per share growth rates were 0.39% and 8.56%, respectively. Since the financial crisis in 2008, flat revenue countered by modest earnings growth is typical for an S&P 500 company.
Its most recent ten-year compounded annual dividend growth rate is a robust 22.00%. Contrary to its unexceptional compounding of revenue and earnings, we are intrigued by Union Pacific’s double-digit growth of dividend payouts to shareholders. Dividends keep us compensated in the short term as we wait patiently for capital appreciation of the stock over the long term.
We want to own companies with efficient and transparent management that leverage returns for customers and investors. Led by Chairman, President and Chief Executive Officer Lance Fritz, Union Pacific's impressively diverse executive team and ~43,000 other employees are delivering a trailing 12-month operating margin (EBIT or earnings before interest and taxes) at an attractive 36.47% of revenue; netting a 21.23% net profit margin, i.e., trailing 12 months of income after taxes divided by sales. We prefer double-digit profit margins, especially when preceded by the numbers "3" or "2," rare for large-cap companies.
From Union Pacific's cash flow statement for the year ending December 31, 2016, we note a steady increase in the five-year average growth in total cash from operations: $6.1 billion in 2012 to $7.5 billion in 2016. Strong cash management is further demonstrated by the company's recent cash flow margin of 31.45%, well above our minimum threshold of 10%. Cash flow margin is operating cash flow divided by sales, each measured over the trailing 12 months.
At VIMS, we prefer highly profitable, cash-generating companies that provide margins of safety in a literal sense. Union Pacific's sales may be flat or declining, but management is converting those revenues into working capital necessary for an infrastructure-heavy railroad committed to growing dividend payouts.
Returns on Management
As does Warren Buffett, we place a premium on the return on invested capital (ROIC), or how well a company is allocating its financial resources to generate returns for the business. We target companies producing 12% or higher in ROIC. Notably, Union Pacific's ROIC at the time of this writing was a marginal 11.96%, although in line with the typically lower ROIC for Class l railroads.
Stock buyback manipulation notwithstanding, the return on equity (ROE), or how well the company generates net income as a percentage of total equity in the stock, is another excellent measure of management effectiveness. Since we seek a minimum of 15%, we view Union Pacific's most recent ROE of 20.79% as net positive.
In a capital-intensive transportation operation such as that of Union Pacific, we also want to take a peek at return on assets (ROA), i.e., management's ability to use the company assets to generate earnings. As of this writing, the company was leveraging assets at an acceptable 7.61%.
Union Pacific's fundamentals are arguably a mixed bag of caveats. Its turtle-like horizontal top and bottom line growth are typical of a large-cap company, but vertical operating and net profit margins are exceptional. Cash flow management appears healthy, although management returns on capital, equity and assets meet industry averages at best. But do these juxtaposed fundamentals present a stock buying opportunity?
Stock Price Appears Fully Loaded
Photo Courtesy of Union Pacific Corporation
Determining the attractiveness of a stock's price based on valuation multiples relative to a company's fundamentals is a primary tenet of the Main Street value investor's search for stock investing nirvana, or alpha.
As of this writing, UNP appears a somewhat expensive stock of a fundamentally sound company in the context of its double-digit operating and profit margins, cash flow management and dividend payout.
Current valuation indicators are arguably in the neutral to bearish range, depending on an investor's multiple of choice.
UNP was recently trading at 10.44 times enterprise value-to-operating margin (EV/EBITDA). In general, 12 times or lower would reflect a reasonable stock price. EV/EBITDA is a useful indicator of whether the stock is overbought on the market, or oversold, as appears to be the present case for the company.
UNP's price-to-sales ratio was 4.34 times as of this writing; more than twice the <2.00x that we interpret as a good value when measuring a stock price relative to its revenue stream. Its peers in the railroad industry are trading at a slightly lower 3.70x. However, the industrial services sector had a reasonable P/S of 1.56x, as did the S&P 500 at 2.06x.
UNP does appear somewhat expensive when considering its price-to-book or P/B ratio. As of this writing, the stock is trading at 4.23 times its net asset value. We focus on fundamentally sound companies selling at a P/B ratio of less than 2.00 or at least below the industry average. In UNP's case, its P/B is trading at a near-equal ratio to that of 4.16x of its peers.
Some investors prefer a measurement of tangible book, where intangible items such as patents, intellectual property and goodwill are absent from the denominator. At the time of this writing, the price-to-tangible book for UNP was similar at 4.29x, reflecting the nonexistence of intangible assets on its balance sheet. Accounting for intangible assets is more often an exercise in balance sheet bloat. Nonetheless, we are impressed by the company's apparently straightforward approach to its financial operations.
The price-to-earnings growth ratio (PEG) is a favorite among Wall Street's growth and momentum crowds. As value investors, we are more cautious based on the projection nature of PEG as opposed to actual trailing results. Nonetheless, PEG can provide a substantive peek into a stock's price worthiness. We prefer a PEG ratio below 2.00, and UNP was recently trading at just 1.83 times based on a five-year growth projection. The railroads industry was trading at a slightly more expensive 2.20x, suggesting that UNP and its peers are reasonably priced based on projected five-year revenues.
We also measure cash flow multiples as a reliable predictor of the intrinsic value of a stock price. UNP's price-to-cash flow ratio (P/CF) was 11.34x, compared to 12.11x for the industrial services sector as a whole. At VIMS, we look for stocks trading at a single-digit P/CF, or at least significantly below the sector or industry average.
By most measures, UNP appears fully priced for the value investor focused on owning quality companies over long holding periods. That written, we do not know what the price will be one, three, or five years from now, never mind next week. Anybody who says he or she does know what the stock price will be at any given time in the future should save face and just buy or sell model trains, not the underlying equities of real ones.
Tracks and Trains are Debt Magnets
Image by Bykst
An important measure of risk is a company's balance sheet liquidity, e.g., current assets divided by long-term debt. Higher than 1.50 is ideal, as we want to own businesses that theoretically can pay down debt with liquid assets at least one and a half times. However, in the debt-laden railroads industry, liquidity is virtually non-existent. Our most recent measure of UNP's current assets to long-term debt was 0.25. In theory, the company could not pay off its debt obligations using its liquid assets such as cash and equivalents, short-term investments, accounts receivables and inventories. Adding UNP's long-term investments to its current assets improves the debt coverage to just 35%.
Current Ratio (CR) is another simple but telling measure of a company's financial stability. CR is current assets divided by current liabilities - thus the higher above 1.00 it is, the better. UNP's most recent available balance sheet had a CR of 0.99, demonstrating that liquid assets are merely adequate in funding near-term liabilities such as accounts payable, accrued expenses, debt service and income taxes.
The VIMS Model Portfolio ranks UNP's overall market risk profile as above average. We target companies with low volatility and the cash on hand to pay their bills, both short and long term. UNP entices us with its attractive profit and cash flow margins, and earnings and dividend yields, but gives us pause when analyzing its industry-specific debt levels from capital requirements as well as downside risk vulnerabilities from safety and environmental impacts.
Margin of Safety
A stock's margin of safety is an estimate of the difference between the intrinsic value of the stock and its current market price. Some professional value investors prefer to calculate the margin of safety with discounted free cash flow projections. For example, Morningstar recently published its view of UNP's "fair value" at $113.00 per share, about a 7% premium to the stock price as of this writing.
These types of overly sophisticated margin of safety or intrinsic value measurements are what allegedly justify the high fee structure of Wall Street. However, we are suspect of the projection nature of these formulas. If we have to start predicting future cash flows, interest rates and capital expenditures, haven't we become more of speculators and less of investors?
At Value Investing for Main Street, we take a modest and frankly realistic approach to estimating margins of safety. We prefer to measure intrinsic values in a broader sense, as opposed to Magic 8 Ball specificity. Wall Street in general continues to regurgitate complex, assumptive financial models of predominantly pie in the sky price targets. If those models consistently worked, wouldn't we all be overnight stock market millionaires?
To the contrary, the VIMS Margin of Safety calculation (MoS) follows a concept created by infamous value investor and author Joel Greenblatt that looks for cheap stocks with good earnings yields (EY) and ROIC. VIMS simply adds EY, ROIC and the reciprocal EBIT/EV to determine the overall profitability, fundamental strength and market valuation of the company. We believe our Greenblatt-based calculation of margin of safety is a useful measure of a company's intrinsic worth based on current and trailing indices as opposed to assumptive future cash flows and other crystal ball projections.
In contrast to the one-year get in and get out laddering approach of Greenblatt's theory - similar to the Dogs of the Dow philosophy - we measure MoS for longer-term value investing as opposed to shorter-term value trading.
As of this writing, the Value Investing for Main Street Margin of Safety rating for UNP reiterates a neutral view based on our expanded formula.
UNP: EY of 4.90% + ROIC of 11.96% + EBIT/EV of 6.72% = VIMS MoS of 23.58%.
- 25.00% and higher MoS is interpreted as bullish.
- 15.00% to 24.99% MoS is interpreted as neutral.
- 14.99% or lower MoS is interpreted as bearish.
Of note, UNP's MoS is almost identical to the 23.44% weighted average of the VIMS Model Portfolio as of February 28, 2017.
It is important to stress that our measure of margin of safety is a screenshot of our research and not a buy, hold, or sell signal.
We own common shares for the long-term benefit of partnering with a company that supports its customers with in-demand, useful products or services, that rewards its employees with sustainable career opportunities and compensates its shareholders with positive returns protected by world-class internal financial controls. But attempting to predict explicit future prices or percentage gains and declines is a Wall Street game that we respectfully choose to avoid on Main Street.
An Intersecting Market Consensus
Image by AppletonOnfoot
According to data miner TipRanks, the Wall Street analysts' consensus on UNP, based on the models of 7 analysts, is a moderate buy with a price target of $117.00, a noteworthy upside to current trading levels.
The financial blogger consensus, including contributors from Seeking Alpha, is also bullish, per TipRanks. At VIMS, we place most weight on the blogger consensus, as it tends to be more of a Main Street view, although we are mindful that many bloggers focus on fundamentals, growth and dividends, not necessarily value. However, it is evident, as of this writing, that both Wall Street analysts and Main Street bloggers recognize the cash flow and dividend-generating characteristics of Union Pacific.
Short interest, or the percentage of shares that are traded based on a bet the stock price is poised to drop, was bullish for UNP at 1.2% of shares outstanding as of this writing. We think of short interest as the hedge fund consensus, since the Wall Street money manager elite executes a significant shorting of stocks. However, per TipRanks, hedge fund holdings of UNP had decreased in the most recent quarter, suggesting a bearish view.
A unique contribution of the Value Investing for Main Street series is the measurement of employee satisfaction, including the rank and file's evaluation of the CEO. Although gathered from non-scientific data of the all-too-biased Internet, we believe a snapshot look at employee morale is worth the peek to quantify a company's cultural dynamic.
According to Glassdoor, about 744 alleged present and former Union Pacific employees that submitted online reviews have collectively rated the company 3.1 out of 5 stars. The most cited positive comments are "great training, pay, and benefits." The most mentioned drawbacks are "work/life balance" and "literally on call 24/7 if working over the road." Welcome to the American workplace, which is arguably in dire need of a bottom-up transformation across most sectors. For its part, Union Pacific does publish various online tools illustrating commitments to diversity, inclusion and the balancing of work and family. Nevertheless, 3.1 is a relatively low score on Glassdoor.
Based on about 189 reviews, Union Pacific employees give CEO Lance Fritz a 57% approval rating, again a relatively low score on Glassdoor. Anytime a company CEO is respected - or disrespected - by those that work within the same culture as him or her, we take notice.
Happy employees producing quality products and services typically translates to loyal customers and sustainable profitability. Of course, the dominant market share of a major player in the railroad oligopoly will deliver faithful customers, no matter the level of employee morale or CEO popularity. To be sure, a heavily unionized shop such as Union Pacific will typically present as a divergence of principles between workers and management.
From "Take a Ride on the Reading" to Owning UNP
The Value Investing for Main Street Model Portfolio (VIMS) has owned UNP since August of 2010 at a sunk cost average price of $38.93 plus dividends. At the time, Berkshire Hathaway's legendary acquisition of BNSF, combined with the attractive valuations of competitors such as Union Pacific, compelled us to buy our first railroad stock other than the Reading, Pennsylvania, B&O, or Short Line when playing Monopoly.
We believe abandonment of reasonable trade agreements or the rollout of so-called border adjustment tariffs will ultimately backfire, and thereby have no more than temporary ill effects on otherwise healthy railroads such as Union Pacific. Demanding fair trade is right and just, but the globalization of supply and demand economics is bigger than any one country. Thus, politically motivated attempts at slowing the inevitable will likely create buying opportunities in UNP when Wall Street overreacts in customary fashion.
Moreover, the current mixed bag on UNP as discovered throughout the research and writing of this article reminds us of the importance of following a disciplined investment philosophy.
Value Investing for Main Street Investment Objective:
Buy and hold U.S. exchange traded, dividend-paying, well managed, financially sound businesses, or funds of companies, that produce easy to understand products or services, have enduring competitive advantages from wide economic moats, enjoy steady free cash flow, and are trading at a discount to their perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.
Despite our concerns with Union Pacific's balance sheet liquidity challenges, mixed valuation multiples and an overall neutral measure of margin of safety, we are grateful to have ridden this otherwise fundamentally strong, wide-moat Class l railroad since 2010. The cliched seven-year itch may be upon us, but we believe Union Pacific remains worthy as a core holding in our portfolio as we weather the political macro and industry micro ups and downs of this commodity-dependent freight transportation powerhouse.
Thank You for Reading the Value Investing for Main Street Series Exclusively on Seeking Alpha
I invite interested new readers to "Follow" the Value Investing for Main Street series by clicking the orange button at the top of this article and choosing to receive alerts for future articles here on Seeking Alpha. Then join me, one primary ticker at a time, in literally seeking alpha with limited capital, lower costs and less risk than the titans of Wall Street. Comments are strongly encouraged and always welcomed.
Please read the important accompanying disclosures.
The Main Street Value Investor and the Value Investing for Main Street Model Portfolio (VIMS) are trademarks of David J. Waldron, LLC.
Union Pacific logo, brands and proprietary content are trademarks or copyrighted material of Union Pacific Corporation.
S&P 500 is a copyright of Standard & Poor’s, a subsidiary of S&P Global, Inc. (NYSE:SPGI).
Magic 8 Ball fortune-telling toy brand is a trademark of Mattel, Inc. (NASDAQ:MAT)
Monopoly brand board game is a trademark of Hasbro, Inc. (NASDAQ:HAS)
Images courtesy of Pixabay unless otherwise noted.
Data Sources: Seeking Alpha (FactSet), YCharts, Union Pacific Corporation, Glassdoor, TipRanks, Charles Schwab & Co. (Morningstar, Thomson Reuters and S&P Capital IQ).
Disclosure: I am/we are long UNP.
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: Data is for illustrative purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs or intended for portfolio construction beyond the contributor’s model portfolio which is presented solely for educational purposes. David J. Waldron is an individual investor and author, not an investment adviser. Readers should always engage in further research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or qualified attorney before making any investment, income tax, or estate planning decisions.