Seeking Alpha

Union Pacific Is Relatively Overvalued

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About: Union Pacific Corporation (UNP)
by: Vasily Zyryanov
Summary

But it by no means indicates that I am bearish on the stock, as the company has been demonstrating an excellent ability to manage costs and ease pressure on margins.

Given its market share in impossible-to-enter railroad industry, Union Pacific has decent growth prospects in the long term.

Yet, the stock is overpriced now, and the trade war has been already taking a toll on its fundamentals.

Despite a few merits like 15.8% FCF margin, at the moment, Union Pacific does not present a buying opportunity.

Union Pacific Corporation (UNP), an American railroad company, is trading at 13.02x LTM EV/EBITDA, which is well above the 5-year average of 10.72x and also above the Industrials sector median of 11.37x. At the same time, Forward EV/EBITDA is lower, stands at 12.57x, as analysts anticipate earnings before interest, tax, and D&A to improve this year due to continuous cost-cutting and strict opex management that lead to better operating ratio even with weaker freight revenues. At the same time, its Return on Total Capital equals 12.35%, which looks like a stellar result compared to the sector, but quite lackluster if compared to the 5-year average.

For broader context, the gross and EBITDA margins are approaching a 5-year high, indicating that the company has been perennially optimizing its cost structure and putting much effort into enhancing profitability even amid the repercussions of the trade war that has been weighing on the top line this year. Also, despite high trading multiples, UNP has been rushing to all-time highs since it bottomed in 2016 after an abrupt plunge in 2015 when its fundamentals (plummeted EPS and revenue) severely disenchanted the market. Now the stock is, unfortunately, clearly not apt for a value portfolio, yet might look fit for the GARP strategy, as analysts anticipate EPS to increase in low double-digit percentage from 2019 to at least 2024.

However, as the market sentiment now oscillates between fear and greed moved by news headlines related to the US-China trade confrontation and mounting investor skepticism, I anticipate the share price to remain volatile for the rest of the year. Now let’s delve deeper.

The top line

Union Pacific Corporation, through its subsidiary, Union Pacific Railroad Company, operates in a highly cyclical, but mature and predictable industry; being the largest Class I railroad, the company owns a critical part of the US railroad infrastructure, 32,236 route miles; it links Pacific Coast and Gulf Coast ports with the Midwest and eastern US gateways and also provides a few corridors to principal Mexican gateways. The corporation reports revenue by the following groups:

  • Agricultural Products (e.g., grain, fertilizers),
  • Energy (e.g., coal),
  • Industrial (e.g., metals and ore),
  • Premium (e.g., finished vehicles).

All these groups have relatively equal contribution to the freight revenues, but in 2018 Premium was slightly ahead with a 31% share. This year both 2Q and half-year freight revenues declined. One of the main culprits was the Energy segment weakness.

UNP's top line depends on refinery utilization rates, demand for grain, biofuels, diesel, heating oil, ethanol, soda ash, etc., and also on consumer sentiment that impacts automobiles manufacturers, and a plethora of other variables. Clearly, its operating results (and, hence, valuation) are inextricably linked with the pace of the economic growth in the US, and, indirectly, across the globe, as railroads are at the crux of the American economy because they serve as its bloodstream (surely, together with roads and pipelines).

Source: Wikimedia Commons

An obvious conclusion is that if the pace turns glacial when the economy loses steam (e.g., when industrial output drops amid trade war repercussions), the P&L statement of the railroad companies immediately reflects it. In this sense, 0.9% 2019 revenue decline anticipated by analysts is not coincidental, as tariff confrontation is taking its toll.

An important remark is that transportation is an operating expense related to day-to-day activities of companies. It is not an investment in future growth, nor spending necessary to offset depreciation of the asset base. When executives are bearish on the pace of the economy, they tend to trim capital spending, thus curtailing expansion to reduce pressure on operating cash flow and protect the balance sheet. So, as transportation is an opex, reduction of capital budgets will have little to no impact on it. However, there is a slight indirect connection between capex and freight revenues. Let's look at a simple example. When businesses decide to postpone asset growth, manufacturers of, for instance, machinery lose orders; as a result, they need less steel, plastic, chemicals, etc., and railroad companies consequently lose possible revenue that they could earn while transporting both commodities and finished goods ordered by machinery manufacturers and their customers.

Another essential matter to bear in mind is the changing energy mix and plummeting volumes of coal that are used as an energy source. The slump of the rail-centric coal industry and its painful repercussions for revenues of railroad companies have been predicted and discussed multiple times. But I still should briefly reiterate that as the decay of the coal industry takes a toll on the top line, UNP has to figure out how to offset pressure on margins in the longer term.

A few words on competition

The railroad industry is impossible to enter, as it is barely imaginable to rebuild a railroad from scratch; the risk of the incursion of new competitors who are able to seize the market share is zero percent. Nevertheless, there is competition outside of the industry, as trucking is the most apparent alternative to railroad transport. Apart from that, as it was mentioned in UNP's 2018 Form 10-K, trucks use "public rights-of-way maintained by public entities." Hence, their capital budgets include only investments in fleet repair, modernization, and expansion, while companies like UNP have not only to repair and replace their locomotives and railcars but also constantly meticulously examine the integrity of tracks (e.g., rails, fasteners) and necessary infrastructure (e.g., an overhead electric power line) and pour funds in maintenance.

However, railroads are far more efficient regarding energy consumption and CO2 emissions (e.g., see the IEA report "The Future of Rail"), and that might serve as an additional long-term catalyst, as the investing community, and especially institutions, are becoming more concerned with ESG issues.

Revenue growth and profitability

In the past, UNP investors have seen a severe sell-off caused by weaker fundamentals, which in turn, were hammered by lower shipments of coal and petroleum products. Speaking about the hardships of FY15, in the 2015 Form 10-K, the CEO mentioned "dramatic declines in volumes and shifts in our business mix."

Chart Data by YCharts

However, in 2017 its position significantly improved, as revenue jumped 6.6%. An essential matter I should draw my esteemed readers' attention to is that UNP's revenue CAGR is lower than EBITDA CAGR over a 10-year period (3.64% vs. 7.77%), which indicates that the company optimized its operating costs and improved margins. During the last 3 years, we see revenue CAGR of 3.62% combined with EBITDA CAGR of 4.73% (see data provided by Seeking Alpha Essential). I regard this trend as a clearly healthy sign. Also, its principal KPI, operating ratio, which draws the attention of the investor community every single quarter or industry conference, reached an all-time best of 59.6% in 2Q19.

Despite the anticipated 2019 revenue decline, analysts also forecast 2019 EPS to improve amid G&A reduction to lower operating ratio as a part of the Unified Plan 2020. The bitter truth is that higher EBIT margin is backed by layoffs. However, if the strategy lives up to expectations, 2019 EPS could rise by 13.5%, and 2020 EPS by 13.4%, which will surely be supportive of high valuation.

FCF and Capex. Quality of earnings

The railroad industry is capital-intensive, as companies have to invest in rail equipment (locomotives and freight cars (covered and open hoppers, boxcars, etc.)), track and rail facilities; high depreciation that weighs on EBIT is not a coincidence. Yet, despite substantial reinvestment needs, one of the apparent merits of UNP is its free cash flows, both levered and unlevered. The corporation has never been FCF negative since at least 2009 (see the cash flow statement data). Moreover, FCF per share has increased with 23.9% CAGR during that period. Now the stock offers a ~3% FCF yield. Importantly, net CFFO margin is higher than the profit margin (37.7% vs. 27%), and that denotes a high quality of earnings.

It is also worth highlighting that Union Pacific has a stellar dividend track record backed by consistent FCF growth. In this regard, I rate it as a reliable dividend payer.

A brief valuation

In the introduction, I have mentioned that UNP is overvalued compared to the sector, but it is also worth putting the firm in the closest peers' context to uncover if it is properly priced or not. Its key competitor BNSF Railway is not a publicly-traded company, so, let's take a closer look at ratios of the following public companies:

  1. CSX Corporation (CSX),
  2. Norfolk Southern Corporation (NSC),
  3. Kansas City Southern (KSU),
  4. Canadian Pacific Railway (CP).

As the firm uses more debt than equity, its ROE figure (32.08%) is distorted and should be adjusted using total capital, which encompasses both funds contributed by common equity holders and debt investors. P/E is also not a perfect ratio for benchmarking. So, comparing EV/EBITDA ratios together with ROTC is a simple litmus test to check if the firm's lofty valuation is justified by operating excellence and proficient use of capital or not.

EV/EBITDA, Return on Total Capital, and Debt/Equity ratios are summarized here:

UNP valuation. Data from Seeking Alpha Essential

Author's creation. Data from Seeking Alpha Essential

ROTC comparison of the key railroad companies

The key outcomes are as follows:

  • Union Pacific is the most expensive in the peer group, as its ROTC is slightly higher than the average, but below CP's result.
  • KSU is better regarding capital structure, as it is far less leveraged than the peers.

Conclusion

The Federal Highway Administration forecasted that total US freight shipments would increase by 35% by 2040 compared to 2017. So, there is no shortage of reasons why UNP and its railroad peers represent a long-term investment opportunity; yet, the question is if the industry will be safe and sound in the medium term amid the possible recession. And if so, is it reasonable enough to go long now, or wait until the stocks presumably bottom. There is no unambiguous answer to that question. As the Fed is embarking on a new stimulus path, it is a perplexing matter of how far these measures will finally go. To be frank, I am highly skeptical of a scenario when the Fed ultimately turns to sub-zero yields to bolster growth, as they can derail the financial system by destroying the profits of banks.

Apparent merits of UNP is its substantial market share, FCF, and improved operating ratio together with higher margins. However, as valuation approaches record highs, it is reasonable to be leery and slightly skeptical, as with no margin of safety the plunge could be painful. So, UNP is a "Hold."

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.