Union Pacific: All Aboard The Dividend Train
Summary
- Union Pacific is a Dividend Contender with 15 consecutive years of dividend growth. Shares currently yield 1.96%.
- The company is a wide moat business with a vast rail network that would be hard to duplicate.
- Buybacks aren't likely to be as prolific as they were over the last decade as leverage on the balance sheet has risen.
- Union Pacific is attractively valued with a high likelihood of 10% annual returns.
Union Pacific (NYSE:UNP) needs little introduction with their vast rail network consisting of 32K route miles, 26K of which are owned by Union Pacific. Their moat is built on those existing rail networks that would be near impossible without a Herculean undertaking and capital outlay to reproduce.
Dividend History
When I began investing on my own the dividend growth strategy just clicked for me. The idea is to focus on quality companies that have a history of paying and growing their dividends over time and don't pay too much.
Image by author; data source Union Pacific Investor Relations
According to the CCC list, Union Pacific has a 15-year streak of annual dividend growth. While Union Pacific's dividend history has seen its share of bumps in the road, dividend growth has come more often than not each year.
Starting in 2000 Union Pacific has delivered annual dividend growth in 18 of the 21 years. Year over year dividend growth has ranged from 0.0% to 104.0% with an average of 21.2% and a median of 19.3%.
There's been 17 rolling 5-year periods over that time with annualized dividend growth ranging from 8.5% to 46.2% with an average of 22.6% and a median of 18.5%.
Over that same period there's been 12 rolling 10-year periods with annualized dividend growth ranging from 15.8% to 31.1% with an average of 25.2% and a median of 26.8%.
The rolling 1-, 3-, 5- and 10-year period annualized dividend growth rates since 2000 can be found in the following table.
| Year | Annual Dividend | 1 Year | 3 Year | 5 Year | 10 Year |
| 2000 | $0.100 | ||||
| 2001 | $0.100 | 0.00% | |||
| 2002 | $0.104 | 3.75% | |||
| 2003 | $0.124 | 19.28% | 7.36% | ||
| 2004 | $0.150 | 21.21% | 14.47% | ||
| 2005 | $0.150 | 0.00% | 13.08% | 8.45% | |
| 2006 | $0.150 | 0.00% | 6.62% | 8.45% | |
| 2007 | $0.186 | 24.17% | 7.48% | 12.41% | |
| 2008 | $0.380 | 104.03% | 36.32% | 25.15% | |
| 2009 | $0.540 | 42.11% | 53.26% | 29.20% | |
| 2010 | $0.655 | 21.30% | 52.07% | 34.29% | 20.68% |
| 2011 | $0.965 | 47.33% | 36.43% | 45.11% | 25.44% |
| 2012 | $1.245 | 29.02% | 32.11% | 46.22% | 28.21% |
| 2013 | $1.480 | 18.88% | 31.22% | 31.25% | 28.17% |
| 2014 | $1.910 | 29.05% | 25.56% | 28.74% | 28.97% |
| 2015 | $2.200 | 15.18% | 20.90% | 27.42% | 30.81% |
| 2016 | $2.255 | 2.50% | 15.07% | 18.50% | 31.13% |
| 2017 | $2.480 | 9.98% | 9.10% | 14.78% | 29.55% |
| 2018 | $3.060 | 23.39% | 11.63% | 15.64% | 23.20% |
| 2019 | $3.700 | 20.92% | 17.95% | 14.14% | 21.22% |
| 2020 | $3.880 | 4.86% | 16.09% | 12.02% | 19.47% |
| 2021 | $4.180 | 7.73% | 10.96% | 13.14% | 15.79% |
Table by author; data source Union Pacific Investor Relations
While a growing dividend stream is what I'm after, I also want to make sure that the dividend isn't at risk of having to be reduced. The payout ratio can be used to determine the safety of the dividend in relation to the net income or free cash flow that the business generates. All else being equal, the lower the payout ratio the better, as there's a bigger gap should the business stumble without jeopardizing the dividend and there's also room for dividend growth to potentially outpace earnings or cash flow growth as the payout ratio rises.
Image by author; data source Union Pacific SEC filings
Union Pacific's net income payout ratio has averaged 36% over the past 10 years with a 5-year average of 39%. The average free cash flow payout ratios are 50% and 47%, respectively. The dividend is well covered by both net income and free cash flow.
Quantitative Quality
I like to see a healthy dividend growth streak that's just a starting point before determining whether the business makes sense as a potential investment. I want to look at a variety of financial measures to see how the business has performed and how things have evolved over time.
Image by author; data source Union Pacific SEC filings
To see that Union Pacific's revenues have been virtually flat over the last decade was a bit surprising. Total revenue growth has been -0.1% over the last 10 years. While the top line has moved much gross profits have shown total growth of 13.0% or ~1.4% annualized. Operating profits have improved dramatically, compared to revenues and gross profits, through better operational efficiency rising 36.9% in total or ~3.5% annualized.
Operating cash flow saw a similar increase climbing 45.4% in total over the last decade or ~4.2% annualized. However, free cash flow has seen tremendous improvement increasing 114.9% or ~8.9% annualized. Considering that's in the face of stagnant revenues, that's quite impressive.
The following chart shows the rolling 5-year period CAGRs from Union Pacific for revenues, gross profit, operating profits, operating and free cash flow.
Image by author; data source Union Pacific SEC filings
Union Pacific's gross margins have been strong over the last decade and rising more often than not. The 10-year average gross margin for Union Pacific is 41% and the 5-year average of 43%.
I prefer to see free cash flow margins greater than 10% as that means that the business is converting a sizable amount of revenues into free cash flow. Union Pacific has been above the 10% level every year over the last decade with margins improving significantly over the last 5 years. The 10-year average free cash flow margin is 18% with the 5-year average up to 23%.
Image by author; data source Union Pacific SEC filings
My preferred profitability metric is the free cash flow return on invested capital, FCF ROIC. The FCF ROIC represents the annual return of cash flow that the business generates compared to the capital invested in the business. My expectation is that great businesses will show at least stable and most likely rising FCF ROICs over time.
Image by author; data source Union Pacific SEC filings
With free cash flow expanding substantially over the last decade, Union Pacific's ROICs have followed suit. While Union Pacific hasn't routinely surpassed the 10% threshold, hitting it in just 5 of the last 10 years, the trend is definitely in the right direction and they have managed greater than 10% ROICs in 4 of the last 5 years. The 10-year average FCF ROIC for Union Pacific is 10.3% with the 5-year average at 11.4%.
To understand what Union Pacific does with its free cash flow I calculate three variations of the metric defined below:
- Free Cash Flow, FCF: Operating cash flow less capital expenditures
- Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payouts
- Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less cash spent on share repurchases
High quality businesses should generate plenty of excess cash flow that can then be used for other purposes. Things such as reinvest in the business, expand into adjacent businesses, pay a dividend, repurchase shares or retire debt. Ideally the business would generate strong FCFaD suggesting a lower FCF payout ratio and excess FCF above that would be used for other purposes.
Image by author; data source Union Pacific SEC filings
Union Pacific's FCF has performed nicely over the last decade rising more often than not. Over that time Union Pacific generated a cumulative FCF of $38.1 B. With that FCF management has paid out $18.7 B to shareholders via dividend payments putting the 10-year cumulative FCFaD at $19.4 B.
Union Pacific has been quite aggressive on the buyback front, as we'll see shortly, spending $36.7 B on repurchases over that time. That's nearly 100% of cumulative FCF and puts the 10-year total FCFaDB at -$17.2 B.
My preference is for excess cash flow sent to shareholders via higher recurring dividends or special dividends. I understand the desire for companies to utilize buybacks. No one bats an eye at a buyback program being temporarily or permanently stopped; however, a dividend reduction is not taken lightly by shareholders.
Union Pacific has done a remarkable job reducing the share count over the last decade. In FY 2011 the shares outstanding stood at 979.6 M and by FY 2020 they were down to 679.1 M. That's a 30.7% total reduction or ~4.0% annualized decline in the share count. Unfortunately, that's been fueled by debt as we'll see below rather than cash flows as ~47% of the cash spent on share repurchases over the last decade were not supported by free cash flow.
Image by author; data source Union Pacific SEC filings
When investing in the equity of a business I want to make sure that my stake is protected by a strong balance sheet. That means that I don't want to see excessive leverage and use the debt-to-capitalization ratio as one way method to see how much debt is used in the capital structure of the business.
Image by author; data source Union Pacific SEC filings
With the excess spending over the last decade it should come as no surprise that debt levels and as well the debt-to-capitalization has climbed. Total debt has climbed ~$19 B from the end of FY 2011 through the end of FY 2020 with the excess spending of FCF coming in at $17.2 B. The 10-year average debt-to-capitalization ratio is 43% with the 5-year average at 52%.
I place more emphasis on the debt levels in relation to various income metrics as I believe that sheds more light on the leverage on the business. While I prefer less debt, given the prevailing interest rate environment over the last decade, it's not a surprise to see that Union Pacific has levered up.
Image by author; data source Union Pacific SEC filings
Union Pacific's 10-year average net debt-to-EBITDA, net debt-to-operating income and net debt-to-free cash flow ratios are 1.5x, 1.9x and 3.8x, respectively. The 5-year averages are 2.0x, 2.5x and 4.2x as well.
While debt and leverage have piled up for Union Pacific, the cost of debt has declined over the last decade thanks to the persistently low interest rates globally.
Valuation
After determining that a business is one that I'd like to invest in from a quality standpoint I want to make sure that I pay attention to the other part of the investing equation: don't pay too much. The valuation methods that I use are the minimum acceptable rate of return, "MARR", analysis, dividend yield theory and a reverse discounted cash flow analysis.
In a MARR analysis you estimate the future earnings and dividends that a business will produce over some time, apply a reasonable terminal multiple on those earnings and then determine what the expected return for that investment would be. If the expected return is greater than your MARR then you can feel free to invest in the business; otherwise you wait for the price:value relationship to come in line and look for other opportunities.
Analysts expect Union Pacific to show FY 2021 EPS of $9.71 and FY 2022 EPS of $10.98. They also expect Union Pacific to be able to show annual EPS growth of 9.4% across the next 5 years. I then assumed Union Pacific would be able to manage 5.0% annual EPS growth for the following 5 years. Dividends are assumed to target a 45% payout ratio.
For the reasonable future multiple I like to see how market participants have historically valued Union Pacific. As you can see in the following YChart, market participants have typically valued Union pacific between ~15x and ~25x TTM EPS. For the MARR analysis I'll use terminal multiples spanning that range.
The following table shows the potential internal rates of return that an investment in Union Pacific could produce provided the assumptions laid out above are reasonably close to how the future plays out. Returns assume a purchase price of $218.76, Friday's closing price. Returns assume dividends taken in cash.
| IRR | ||
| P/E Level | 5 Year | 10 Year |
| 25 | 15.15% | 11.13% |
| 22.5 | 12.55% | 10.01% |
| 20 | 9.73% | 8.78% |
| 17.5 | 6.63% | 7.42% |
| 15 | 3.17% | 5.89% |
Source: Author
Additionally, I like to use the MARR analysis to determine what price I could pay today in order to generate the returns that I desire from my investments given the same assumptions. My base hurdle rate is a 10% IRR and for Union Pacific I'll examine 8% and 12% IRRs.
| Purchase Price Targets | ||||||
| 10% Return Target | 8% Return Target | 12% Return Target | ||||
| P/E Level | 5 Year | 10 Year | 5 Year | 10 Year | 5 Year | 10 Year |
| 25 | $268.19 | $241.04 | $289.58 | $282.16 | $248.76 | $206.80 |
| 22.5 | $243.30 | $220.92 | $262.63 | $258.28 | $225.74 | $189.80 |
| 20 | $218.41 | $200.81 | $235.68 | $234.41 | $202.72 | $172.80 |
| 17.5 | $193.52 | $180.70 | $208.73 | $210.53 | $179.70 | $155.80 |
| 15 | $168.63 | $160.58 | $181.77 | $186.66 | $156.68 | $138.30 |
Source: Author
Dividend yield theory is a valuation method based solely on the dividend that the business pays out and reversion to the mean around a normal dividend yield over time. This valuation method is best suited for large, stable companies. For Union Pacific I'll use the 5-year average forward dividend yield as a proxy for the fair value of the business.
Image by author; data source Union Pacific Investor Relations and Yahoo Finance
Union Pacific shares currently offer a forward dividend yield of 1.96% compared to the 5-year average of 2.16%.
A reverse discounted cash flow analysis can be used to figure out what the current share price implies about the future cash flows of the business. I used a simplified DCF model built on revenue growth, a static EBIT margin of 38.9%, a tax rate of 23%, and a terminal growth rate of 3.2%. To discount the cash flows to the present I use a WACC of 7.2% derived from a cost of equity of 8.0% calculated using the dividend capitalization method. Under those assumptions Union Pacific needs to grow revenues 4.2% across the forecast period in order to justify the current market valuation.
Conclusion
Union Pacific is firmly in the great company camp with a rail network that hits just about every major city and port west of the Mississippi River. That network includes over 32k route miles, 26k of which are owned by Union Pacific, the remainder are utilized through track rights.
It's pretty safe to say that a major rail network is not likely to ever be built again as there is very much a NIMBY effect as well as a prohibitively expensive capital outlay requirement to even think of competing with the major rail networks already in existence.
Despite stagnant revenues over the last decade, Union Pacific has done a tremendous job becoming more efficient in their operations which has led to significant improvement in cash flow. Union Pacific generates strong free cash flow margins greater than 20% over the last 5 years and free cash flow ROICs greater than 10%.
Dividend yield theory suggests a fair value for Union Pacific between $180 and $220. With shares trading around $218 they are on the upper end of fair value. Meanwhile, the MARR analysis based on 10% IRRs suggests a fair value between $193 and $243, assuming a 5-year exit multiple between 17.5x and 22.5x. Shares appear fairly valued around current prices if you believe ~9% annual EPS growth over the next 5 years is reasonable.
COVID shed light on the issues facing much of the manufacturing base both domestically and internationally. In pursuit of higher efficiencies and profitability, many companies have moved to just-in-time manufacturing in order to keep excess inventory off their books. That's aided in profit margins, but introduced a lot of risks that few people could have foresaw. I can't imagine global pandemic and disruption to supply chains for just about every business was on the bingo cards of investors heading into last year.
The question is how do businesses respond to the issues that popped up last year. I doubt that we see hyper local manufacturing cutting out the national rail networks and nor do I see massive onshoring of manufacturing facilities. Even if the latter occurs, finished goods are still best transported long distances via rail networks as they provide the most efficient means to move lots of goods from point A to point B.
The last decade has been great for shareholders as Union Pacific levered their balance sheet and repurchased ~30% of outstanding shares over that time. Moving forward, I wouldn't bank on the same over the next 5-10 years, especially not to the same extent of the last 10. Based on the 3-year average FCFaD and the current market cap, Union Pacific could still buy back ~2% of outstanding shares each year.
Union Pacific appears to be attractively valued here with a high likelihood of delivering 10% annual returns based on the MARR analysis. Dividend yield theory also shows shares as fairly valued although the reverse DCF seems to imply that returns are more likely in the 7% area although buybacks could potentially boost the per share return up another 1-3% annually. I'll be looking to add to my position in Union Pacific at prices closer to $200 per share or lower.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of UNP either through stock ownership, options, or other derivatives. 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.
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