Union Pacific: Can This Stock Double Again?

About: Union Pacific Corporation (UNP)
by: Small-Cap Detective

Union Pacific has generated a return on invested capital of 15% annually over the past decade.

Management wants to squeeze even more profitability out of their business through their Vision 2020 plan.

If successful, Vision 2020 could present a massive catalyst for Union Pacific stock.

Some folks can't help playing around with their portfolio.

They're always buying this and selling that. Each time, they hope to hit the jackpot on some stock that doubles or triples in a month or two.

Dividend investors don't think like that. Their get-rich-slowly mentality requires patience and discipline. But, by owning wonderful businesses that regularly boost their distributions, this group can build wealth without the stress (and frequent losses) that comes from other trading strategies.

Case in point: Union Pacific Corporation (NYSE:UNP). Fueled by a growing asset base and steady cash flows, the railroad operator has paid growing dividends for decades, including a 9.6% bump announced last summer. Over the past three years, shares have delivered a total return, including distributions, of 127.3%. That easily beats the broader S&P 500's total gain of about 42% over the same period.

But that's looking in the rear-view mirror. What does the future hold?

Union Pacific operates an outrageously profitable business, to begin with.

Over the past decade, the company has generated a return on invested capital of 15% annually. While any business can earn returns like these from time to time, it's rare to see a business sustain such profitability like this over an extended period.

Union Pacific's owes its success to a low-cost advantage. Railroads can ship a ton of freight 430 miles on a single gallon of fuel - nearly four times more fuel-efficient than moving the same goods by truck. As a result, the company can undercut rivals while still earning gross margins in the 50% range (comparable to great businesses like Coca-Cola (NYSE:KO)).

Moreover, it would be almost impossible to replicate Union Pacific's network of track. The cost to buy out landowners and acquire right-of-ways would easily top hundreds of billions of dollars. This allows management to raise prices year after year without the fear of a new rival muscling onto their turf.

Executives, however, think they can do even better.

Last year, the company unveiled their new operations strategy called "Unified Plan 2020." The program aims to squeeze more profits out of existing operations through a four-part approach:

  • Minimizing the amount of time locomotives spend idle in the yard.

  • Shifting the focus of operations to moving cars rather than moving trains.

  • Reduce the number of times cars are sorted at facilities.

  • Improve fuel efficiency by running longer trains.

  • Blend different types of cargo on one train.

In essence, Union Pacific has stolen the "precision schedule" playbook from other railroads. But if executives can implement the new strategy, it could serve as a massive trigger event for the company's stock price. Rivals like CSX (NYSE:CSX), Canadian Pacific (NYSE:CP), and Canadian National (Canadian National) delivered triple-digit gains after trying the same program.

Unified Plan 2020 could have a similar impact on Union Pacific's profitability. Last year, the company generated an operating ratio - a common measure of businesses performance in the railroad business - of 62%. Management hopes to drop this ratio down to 55% over the next few years, which would make it one of the more efficient railroads in the industry.

This cost-cutting could bode well for dividend investors.

Union Pacific shares already represent a cash machine. The business paid out a combined $10.6 billion in dividends and share buybacks last years, which comes out to a total shareholder yield of 9.6%.

But if management can achieve their cost-cutting target, it would free up an enormous amount of cash flow to boost those payments further. Over the next five years, analysts project the company will grow earnings per share at a mid-teen annual clip. Investors can expect their dividends to grow more or less in line with profits given Union Pacific's modest payout ratio.

Chart Data by YCharts

Of course, you can't call Union Pacific a sure thing.

Coal makes up a big chunk fraction of railroad revenues. As utilities continue to switch to cheaper natural gas, the number of coal shipments will likely continue to decline.

A trade war also presents a big headache for investors. Railroads represent the arteries of the U.S. economy. So, anything that slows down economic growth will have a negative impact on profitability.

That said, Union Pacific has positioned itself well. Coal accounts for only 5% of the company's revenues, far less than most of its peers. Union Pacific's light debt load and clean balance sheet should also allow it to keep paying out dividends even through a recession.

I can't guess where Union Pacific stock will go over the next few months. They could rally, drop, or trade sideways. But, over the next few years, this company has a number of catalysts that could lift earnings and, hopefully by rough extension, the stock price. That should translate into respectable returns for shareholders.

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.