Union Pacific: Reliably Overvalued

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About: Union Pacific Corporation (UNP)
by: Ray Merola
Summary

Union Pacific Corp. stock is an outstanding, long-term core holding.

2019 operational and financial results are shaping up reasonably well.

Nonetheless, current stock prices appear to be at or above fair value. At these levels, there's not much juice left.

I've taken some profits, holding onto the balance, and waiting to repurchase shares at lower levels.

Union Pacific Corp. (UNP) is one of my favorite stocks. It's a core holding.

There's a lot to like about this excellent company:

  • Union Pacific owns a strong franchise, meaning it is a "wide moat" business, thereby offering the enterprise a level of pricing power.
  • The balance sheet is sound.
  • The company earns its profits in cash.
  • The business is well managed and shareholder friendly.

What's more, in late 2018, UNP began to embark upon "precision railroading," a buzzword for running smarter, more efficient operations. Early results are encouraging.

Nonetheless, I contend shares remain overpriced, even after a 7% retracement from April highs. The stock is up 21% YTD.

Union Pacific Corp - YTD Price and Volume

Source: Bigcharts.marketwatch.com

Not only do I believe Union Pacific's stock is overpriced, but also it's reliably overpriced. By this, I mean the shares have a tight, long-standing price-and-earnings relationship. While investors cannot predict short-term price movements accurately, investors with a longer-term mindset may determine when UNP is discounted or dear with a higher probability than many other stocks.

Let's investigate.

First-Half 2019 Results Are Shaping Up Just Fine

When the management reported 1Q 2019 results, YoY volumes and revenue were down 2%. Weather (heavy snowfall and springtime Midwest flooding) contributed to the soft figures. Nonetheless, EPS rose smartly; up 15% versus 1Q 2018. Management indicated the weather factor shaved 160 bps off the operating ratio and 15 cents off EPS, settling at 63.6% and $1.93, respectively.

Earnings growth held up due to an improved operating ratio. Despite the snow and flooding, the OR was still a 100 bps better than the prior year: a testimony to the early success of the Unified Plan, aka "precision railroading."

Source: 1Q 2019 Union Pacific earnings call slides

Heading into the end of the first half, 2Q 2019 freight volumes through late May remain slightly lower versus 2018, still down about 2% YoY.

Source: Wolfe Research Transportation Conference UNP presentation slides

However, continued strength in the operating ratio is likely to offset the modest volume decline. Street analyst forecasts support this view.

We see 2Q 2019 CFRA consensus earnings estimates have been drifting upwards (the purple line on the chart).

Source: Ameritrade.com

Zacks.com's analysts report similar Union Pacific 2Q earnings expectations. Analysts have raised estimates heading into the quarter's close:

For its part, Union Pacific management meets Street estimates regularly:

Source: Ameritrade.com

Over the past 13 quarters, management beat EPS projections twice, met it 11 times, and recorded no misses.

Presuming earnings are in line with the current estimates, it means ~14% increase versus the prior year. Not bad.

A material operating ratio decline (lower is better) is driving results. The Unified Plan is being spearheaded by new COO Jim Vena. Vena is a former Canadian National Railroad (NYSE:CNI) exec and protege of the late E. Hunter Harrison, oft considered the godfather of precision railroading.

Mr. Vena offered these remarks on the 1Q 2019 conference call:

Despite the weather, nearly all of our metrics improved year-over-year. This is a testament to the work we are doing as part of Unified Plan 2020 to improve network efficiency and service reliability.

Our continued focus on asset utilization and minimizing car classifications led to a 19% improvement in freight car terminal dwell and a 7% improvement in freight car velocity compared to the first quarter of 2018. Train speed for the first quarter decreased 6% to 23.3 miles per hour as network disruptions impacted fluidity.

We improved locomotive productivity 6% versus last year as efforts to use the fleet more efficiently enabled us to park units. As of March 31st, we had approximately 1,900 locomotives stored.

The following trio of 1Q 2019 earnings conference call slides highlights key Unified Plan metrics:

Therefore, with all this good news (including a mid double-digit EPS growth rate), why are UNP shares "reliably" overvalued?

Union Pacific Price Follows Earnings: Reliably!

Union Pacific is a good company, and a good stock to own. The business appears to be doing well despite pundits' hand-wringing about China tariffs, interest rates, and a looming domestic recession.

Yet, even good companies with solid growth prospects can get overvalued...and overvalued is UNP stock.

I'll use a long-term, Union Pacific F.A.S.T. Graph to illustrate the long-term price-and-earnings relationship:

Please note the trimmed average P/E is ~18x.

Here's another chart depicting post-Great Recession UNP price and earnings:

We find approximately the same, trimmed average 18x multiple.

As a matter of fact, if we use F.A.S.T. Graphs to highlight the annual P/E ratio over the past 20 years, and trim off the highest and lowest one-year ratio, we see the multiple rarely ventures above 20x or below 15x.

Currently, the UNP stock has a 20.5x P/E.

Therefore, while the company is doing well, it's hard to get too excited about the stock at these prices. Personally, I've been trimming back on the rise, booking some good profits and hoping to repurchase the shares at such time the stock falls.

Nonetheless, I continue to hold a sizeable overall UNP position. I have no plans to exit the position.

UNP Price Follows Cash Flow, Too

While I won't duplicate the entire set of the aforementioned charts, UNP's price and operating cash flow likewise demonstrate a reliable, long-term relationship. Historically, Union Pacific enjoys a 10x to 11x P/CF multiple.

Currently, the TTM ratio is 14.6x, suggesting a confirmation of the "trading over fair value" thesis.

Conclusions

I believe Union Pacific is a great stock to own, but not at any price.

Today, the stock still seems overvalued despite the recent pullback. My most recent earnings model, based upon management commentary, indicates full-year 2019 EPS may reach ~$9.50. Therefore, after applying an 18x multiple, my Fair Value Estimate is ~$171. Shares fell 2.38% today, down to $167 today. The trigger was a Barclays downgrade.

There's just not enough juice there to get me excited.

Concurrently, BMO Capital Markets reported while there are 2019 freight volume risks, the Unified Plan remains tracked. That's a positive, long-term catalyst for continuing to own the UNP stock.

Having scaled out of some shares, I'd look to be a buyer again if I could pull in some stock at ~$140. This represents a 15x P/E multiple on my 2019 EPS estimate.

Of course, we all get another bite at the apple when Union Pacific management reports 2Q 2019 earnings sometime around the middle of July. I'll review the earning release, listen to what management has to say, re-run my model, and adjust my FVE accordingly.

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: Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2019 investments.