Union Pacific Stock: Not Everything Is On Rails (NYSE:UNP)

In the fall of last year, I believed that Union Pacific (NYSE:UNP) was moving along, albeit at a slower speed. This came as an excellent operator was posting still solid nominal results, but this was entirely driven by price hikes and cost control, with volume trends not being that inspiring.

On top of this dynamic it were share buybacks which provided a boom in earnings per share, while financial leverage remained in check, as valuations looked largely fair to me in an inflationary environment. In a more difficult 2023, with earnings power and sales being down, relative leverage ratios have risen a bit, as the near term outlook for the shares is not too inspiring.

About Union Pacific

Traditionally strong in the Western and Central parts of the United States, Union Pacific has become a stronghold, covering a vast part of the nationwide network. The company’s network is denser in the Western parts of the country, with connections made to the rail networks in both Canada and Mexico.

The country’s properties entail over 50,000 miles, which are utilized by more than 7,000 locomotives and over 50,000 freight cars. Despite the long term promise and goal to use the railroad more intensively, actual revenues have been flattish between 2017 and 2021, in both years reported at $21 billion and change. The stagnation cannot be attributed to a post-pandemic fall, as they were at par with the 2019 numbers.

What has changed is that the business has become a lot more productive over this period of time, with the operating ratio down 5% (which is an improvement in the railroad industry) to 57% of sales in 2021. This was largely driven by an employee count, which was down by about 30%, all while unit growth (as a proxy for volumes) was down about 5%.

The company has seen some additional growth on a per-share basis, thanks to rather aggressive buybacks, which pushed up leverage ratios a bit as well along the way, helping to fuel the shares which doubled from $100 in 2017 to $200 over this five year time window.

Peak Performance Has Come Down

Alongside the rise of the stock market and economy, shares of Union Pacific peaked in 2022 as shares hit a high of $275 per share that spring, ending the year around the $200 mark. Shares have largely been trading around the $200 mark so far this year, with exception to a temporary peak at $240 per share this summer, now trading at $224 per share.

This is not unexpected as Union Pacific saw a strong 2022, aided by inflationary pressures, with full year sales up 14% to $24.9 billion, although volumes were up 2% as well. This suggests strong pricing effects as well, but despite his pricing power, operating ratios deteriorated (rose) 3 points to 60% of sales, mostly attributed to higher fuel expenses, as the fuel bill jumped 68% to $3.4 billion.

Operating profits rose by 6% nonetheless to $9.9 billion, with net earnings up 7% to $7.0 billion. A 5% reduction in the share count to 624 million shares for the year meant that earnings per share rose by 13% to $11.21 per share. Net debt ticked up to $32.3 billion all while EBITDA is reported at $12.1 billion, for a 2.7 times leverage ratio. Moreover, cash flow conversion typically lags with new tracks or replacement tracks being more expensive than past investments and their depreciation charges.

The 2023 outlook, although somewhat cryptic, guided for improvements in the operating ratio, pricing in excess of inflation, and similar capital allocation plans as to what has been practice in the past.

2023 – Mixed

The current year has been somewhat of a mixed bag with first quarter sales up 4%, but volumes were down, and the same applied to a 3% fall in operating earnings. Second quarter revenues fell 5%, with operating earnings down 12%, as a much lower fuel bill could not offset the combined pressure of both lower volumes and lower pricing.

In October, Union Pacific reported a 10% fall in sales to $5.94 billion amidst a 3% fall in volumes, but mostly lower pricing. Operating ratios rose by 3.5% to 63.4% of sales with this ratio hurt by higher fuel expenses which made that operating earnings fell 17% to $2.18 billion, as net earnings were down 19% to $1.53 billion.

Year to date, revenues are down 4% to $17.96 billion, with operating earnings down 11% to $6.67 billion and net earnings down 12% to $4.73 billion. A much more modest pace of share buybacks, with the share count being about 3% smaller than this time last year, meant that earnings per share so far are 9% to $7.75 per share, pushing up the dividend payout ratio rather dramatically, with dividends now paid out at an annual rate of $5.20 per share.

Net debt is flattish at $32.2 billion and change with EBITDA trending at $11.2 billion, pushing up leverage ratios further towards 3 times, merely on the back of lower profitability so far this year. The lack of increase in absolute debt levels is due to a near halt of the share buyback program here.

What Now?

With shares of Union Pacific trading at $224 per share, the company trades around 22 times earnings, with earnings power topping the $10 per share mark this year, but this is somewhat of a tough year. Of course investors receive a modest 2.3% dividend yield, as this comes after Union Pacific has a real strong dividend track record, now involving 125 years of uninterrupted dividends being paid out to investors.

Net debt has ticked up a bit, mostly because of the combination of a slightly higher dividend, share buybacks in the past, and net capital investments into properties, which runs at about $1.5 billion per annum here. Given this, I am cautious on the near term free cash flow conversion, as the company has dramatically cut the pace of share buybacks, as it adopts to this new reality.

This is needed as the company does have a substantial net debt load of $32 billion on which it currently still pays a relatively modest $1.3 billion in interest expenses, suggesting it only pays a near 4% interest rate, levels at which you cannot refinance today. Saving every dollar out there, the company is looking to improve efficiency, eliminating 5% of its 5,600 management jobs in recent weeks.

A Final Word

What we have seen now is a disinflationary reaction to the very strong 2022 results, as continued inflationary pressures mean that part of the historical huge operating ratio improvements have reversed, albeit railroads, on a net basis, have become much more efficient with the passage of time.

Given all this, I am seeing a much more representative performance here by the business over the cycle, although shares are by no means cheap at 22 times earnings here. That said, Union Pacific remain a long term juggernaut with a very strong track record, and rosy long term prospects.

On the negative side is debt load and upward pressure on interest expenses, but these are likely offset by a lengthy maturity profile and the expectation that interest expenses will fall over time again, at least that is what the curve suggests. That is not the biggest risk, but electrification of the fleet is needed as well at some point in time.

Weighing it all together, I still find it a bit early to commit to the shares here. Believing that the current earnings power is more representative of a realistic operating environment, a 4.5% earnings yield trails risk-free rates, making me cautious to get involved with the shares which still trade at a little bit too rich multiple for my taste.

Given all this, I am taking a cautious and patient approach as the near to medium term negatives are offset by continued long term rosy prospects and monopolistic features, making me interested at an entry point of around the $200 mark, preferably a bit below that.