Union Pacific (NYSE:UNP) is not only one of my all-time favorite dividend stocks, it's also one of my largest investments and a stock I always try to buy on weakness. Last month, I wrote an article titled "What To Expect From Union Pacific In 2022?", which included my fears that slower economic growth would make new highs unlikely. I went with an expected trading range of $240-$270. The stock is currently below $240 after peaking slightly above $270.
In this article, I will discuss the just-released quarterly earnings and explain what current developments mean for dividend (growth) investors. While the poor performance of UNP is hurting my portfolio, I'm honestly excited as the stock is once again yielding more than 2%. Historically speaking, buying corrections has generated significant wealth for investors. This time won't be different.
Below is an overview of my dividend growth portfolio (covering 95% of my total net worth).
So, let's get to it!
UNP started the year off with a bang. Despite weakness in the S&P 500, UNP very briefly made it to $280 as a result of the rotation from "growth" to "value" and the war in Ukraine, which benefited US exports like coal, grains, and related materials supporting UNP shipments.
Then, weakness hit UNP causing the stock to quickly lose ground, falling to roughly $235 after the just-released earnings.
In this case, UNP is not alone as the market, in general, started to weaken, once again entering contraction territory (down more than 10% from its all-time high).
What we're dealing with now, is a mix of weaker economic growth, evaporating liquidity on the stock market, and ongoing supply chain issues that make life tough for UNP and its peers. However, after I have discussed these problems, I will tell you why this means better long-term opportunities for investors.
On Thursday, April 21, Union Pacific reported its earnings. The Nebraska-based railroad giant did $5.86 billion in revenue, which beat analyst estimates by $100 million. This is an increase of 17.2% compared to the prior-year quarter.
Let's start with the very top of the income statement. Total transportation volumes rose by 4% despite headwinds in intermodal. The company saw strong growth in bulk thanks to soaring coal shipments (higher export demand due to the energy crisis) and continued growth in agriculture shipments. Industrial demand benefited from strong homebuilding and metals/chemicals demand. Even automotive shipments did rather well despite ongoing supply chain issues in the industry that are not expected to fade until the second half of this year. And even that outlook is on thin ice.
Intermodal weakness was driven by continued international supply chain disruptions. The good news is that domestic volume was up in the quarter, aided by business development wins, tight truck capacity, and continued strength in parcel shipments.
Thanks to pricing, the company turned 4% higher volumes into 17% higher sales. This is what the breakdown of the 17 points revenue growth rate looks like:
When adding pricing, even intermodal added 15% with 21% growth in bulk due to 49% revenue growth in coal and renewables. Also, the entire industrial segment did well as higher industrial production and positive business development supported the top line.
On a full-year basis, the company expects all segments but petroleum to remain strong with uncertainty in international intermodal, auto sales, and grains.
This is what the company commented on the "premium" outlook. Note that this was last week, which means it's pretty much up-to-date with regard to geopolitical and macro developments:
And lastly, for premium, we expect domestic intermodal to continue its benefit from inventory restocking, retail sales strength, tight truck supply and our business development wins. International intermodal is more uncertain with possible effects from ongoing supply chain challenges and pandemic shutdown in China. For automotive, while we do expect the supply of semiconductor chip to improve throughout 2022, recent events in China and Ukraine may disrupt the supply chain for certain key components. We are keeping an eye on whether this will have an impact on production and stand in close contact with our customers.
Note that China could turn into a big headwind. Right now, the port of Shanghai is clogged up. In last Friday's Europe Macro newsletter on Intelligence Quarterly, I highlighted the issues that come with it. In Europe, I expect that the next 3 to 4 weeks will impact supply chains due to lower supplies (ships that are now stuck would have arrived by then). In the US, I expect a similar timeline. This means a temporarily lower container load followed by an explosion in containers when China eases its lockdowns. In other words, railroads will have to deal with ongoing issues deep into this year (likely in 2023 as well).
With that in mind, the company's operating expenses also increased, but at a slower rate than revenue growth. In 1Q22, total operating expenses increased by 16% to $3.5 billion. This allowed operating income to increase by 19%, resulting in a 70 basis points decline in the operating ratio. Note that the operating ratio measures how "expensive" it is to operate the railroad as it compared operating expenses to operating revenues. The lower, the better.
Unfortunately, the lower operating ratio was not caused by core results. Core results caused the operating ratio to increase by 10 basis points. Higher fuel prices added another 80 basis points. Favorable weather conditions (compared to last year) caused the operating ratio to improve by 160 basis points.
Core results saw lower operating efficiencies due to supply chain problems. Total freight car velocity dropped from 209 to 198 daily miles per car. Only 71% of intermodal boxes arrived on time (down from 77%) with only 62% of cars arriving on time (down from 68%).
Total locomotive productivity declined by 6% as the company used locomotives in inventory to deal with shortages in its network. The company is also accelerating the hiring process, with 400 new employees entering the UNP workforce this year (to date). Prior to the pandemic, railroads used to consistently reduce workforce levels as supply chains ran smooth. Now, it's a total mess resulting in shorter trains and the need for more employees.
The good news is that despite challenges, the company generated $2.2 billion in cash from operations in its first quarter. That's up 14% compared to the same quarter last year. Unfortunately, the cash conversion rate (as a % of net income) dropped from 106% to 85%. In the quarter, the company returned $3.5 billion to shareholders through dividends and repurchases, which includes $2.2 billion under the company's accelerated share repurchase program. The adjusted debt to EBITDA ratio was 2.8% as the company maintains a strong investment-grade credit rating.
With that said, 2022 guidance was mixed. The company expects the operating ratio to begin with "55", up from 55.5%, which means it's likely close to 56% if we're lucky as rising fuel prices and ongoing supply chain issues make it close to impossible to stick to old targets. This is what UBS commented on the company, which downgraded the stock price outlook from $283 to $267:
We expect the current capacity constraints and service issues to weigh on volume performance and these issues also reduce our conviction in UNP’s ability to execute on its volume growth strategy," the downgrade explains. "The added resources necessary to handle more volume could work against UNP’s margin performance while the current level of resources appear to be insufficient to support stronger volumes.
Moreover, the Surface Transportation Board is looking to change some rules for emergency reasons, which will allow for more competition. If, for example, a railroad customer cannot be serviced by railroad XYZ, a competitor is allowed to step in to deliver the service. This is based on ongoing issues in agriculture and others. This issue is turning into a national security issue as (for example) fertilizer cannot be shipped in time. This is not favorable for railroads as it increases competition. Next month, multiple hearings are scheduled to work on the issue.
Other than that, the company confirmed all targets, which are listed below:
With regard to share repurchases, the company bought back 5% of shares outstanding in 1Q22. This boosted diluted EPS from $2.00 to $2.57 (up 29%). That's the power of buybacks as net income was up 22%.
Now, on to more good news:
As I said, it's never fun when one's second-largest position isn't doing so well. However, I'm not at all worried. If anything, I'm enjoying that the stock is hovering close to the lower bound of my expected trading range. There's so much more value "down there".
For example, as the graph below shows (used in my last article), UNP always drops when economic growth expectations start to fall. However, it always rebounds (hard) when economic growth strengthens again.
While UNP sees steeper downturns during weak economic times, it has a long history of outperforming the S&P 500. Over the past 10 years alone, UNP investors have generated 432% including dividends. That's well above the S&P 500 total return.
On a long-term basis, UNP's EBITDA and free cash flow are in a steady uptrend. Next year, free cash flow is expected to be $7.4 billion, which is roughly 5.0% of the company's current market cap. As free cash flow is basically net income adjusted for non-cash operating items and capital expenditures, it's cash UNP can use for dividends and buybacks as the balance sheet is already healthy (no need to prioritize that).
As a result, UNP scores extremely high on Seeking Alpha's relative dividend scale (compared to industrials. The worst grade is a B- for the company's 2.0% yield. All other grades are As.
Over the past 10 years, dividend growth has averaged 15.4%! Bear in mind that this company was founded in 1862, which makes it one of the oldest dividend stocks in the world that's still a dividend growth company (instead of a high-yield stock).
Right now, the dividend yield is 2.0%. The graph below excludes the 10.3% hike announced on December 10, 2021, which pushed the annual dividend to $4.72. In general, I think buying UNP at a yield of more than 2% is a good deal on a long-term basis. 2.0% seems to be the long-term median with some outliers during bigger sell-offs. Moreover, the implied 5.0% free cash flow yield I calculated in this article is close to the higher bound of the longer-term range (lower part of the graph below).
The third valuation indicator I added to the graph above is the EV/EBITDA multiple. For that, we need the company's $147.2 billion market cap, roughly $30 billion in expected net debt, and $500 million in pension-related liabilities. This gives us an enterprise value of $177.7. That's 13.0x next year's expected EBITDA of $13.7 billion.
That valuation is fine, but not anywhere close to deep value. Great value would be a dividend yield of more than 2.3% and an EV/EBITDA of 11x or lower.
This month was tough on Union Pacific and its peers. Slower economic growth, ongoing supply chain issues, and new geopolitical and macro risks from Russia and China are causing investors to de-risk their portfolios. The just-released quarterly results display a mix of strength based on the recent economic recovery and the need to put more assets to work to combat supply chain problems. It was still a win for shareholders as free cash flow generation was high and because the company did rather well.
However, from a short- to mid-term perspective, pressure on the stock remains high as it is unlikely that supply chain issues will meaningfully improve in the months ahead due to China. Also, if the Fed starts to take away liquidity (hike rates and reverse QE), the market could continue to sell-off.
Yet, for UNP investors it's still good news. We have reached a favorable point with a yield of more than 2.0% and an implied free cash flow yield of 5.0%.
I am looking to re-invest dividends at current prices. Investors who do not have exposure yet (and are looking to buy) should break up their initial (expected) investment into parts to take away some entry risk. For example, buying in intervals of 2-3 weeks means that investors can average down if prices continue to drop. It also means that investors have a foot in the door if prices start to recover rather quickly. I think this is the best strategy on a long-term basis.
While the current downtrend isn't a lot of fun, I have little doubt that UNP will remain a source of great wealth, which makes regular weakness a blessing instead of a curse.
(Dis)agree? Let me know in the comments!
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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.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.