Wolf’s Corona Discounts: Union Pacific Corporation – Union Pacific Corporation (NYSE:UNP)
(Author’s note: This article is part of a series where I attempt to identify and write about the highest-quality companies currently trading at undervaluation as a result of the corona-induced market panic. I try to combine companies with the highest credit ratings, highest safeties, and highest yields to form the basis of excellent, safe investments during this time.)
My article series goes on. I’ve reviewed rarely buyable weapons manufacturers, software companies, and food companies.
Today, we step into the realms of logistics and trains. Today, we’re looking at an A-rated logistics giant trading at below 15 times earnings, which should not be overlooked.
Today, we look at Union Pacific Railroad (NYSE:UNP).
Union Pacific Corporation – What does the company do?
The company is one of the few publicly traded railroad companies out there. Established in the early 1860s and with headquarters found in Nebraska, it has been acquiring railroad companies and transport companies for the past 50 years. It’s also a company with roots going back 170 years at this point, with origins in the Pacific Railroad Act signed by President Abraham Lincoln in order to provide the construction of railroads.
UNP is part of a duopoly or an oligopoly in the US – the other parts of that oligopoly being the BNSF Railway and Norfolk Southern (NYSE:NSC), and BNSF is no longer a publicly-traded company.
The UNP has a strong portfolio of US-spanning assets and businesses.
(Source: UNP 2020 Investor Presentation)
Aside from the hubs above, it also connects a nation-spanning food and beverage network with coast-to-coast transports of refrigerated boxcars, full-service logistics, warehouses, and other things, which keep the nation of USA fed.
In total, the company owns and operates over 32,340 miles of railroads which in turn link together 23 states, primarily (as you can see above) found in the western portion of the USA. Note, also, that the infrastructure connects some of the fastest-growing areas in the world, and the railroads also connect with Canadian infrastructure in the north. The company owns more than 8,600 locomotives and over 64,000 railcars.
So, Union Pacific corporation owns and maintains the railroads, trains, boxcars, and assets in order to facilitate nation-wide logistics. What do they transport?
Better to ask, what don’t they transport. The company has one reportable segment. Operations. In these operations, they transport this:
(Source: 2019 Annual Report)
Agricultural products refer to grains, commodities from these grains, fertilizer as well as food and beverage products. The company has access to most of the major grain markets of the US and serves grain processors, animal feeders, ethanol producers, fertilizer producers, and others.
Energy refers to three major product groups, namely coal, sand, and petroleum/LPG/renewables. The company’s revenue here in part comes from the transport of so-called frac sand generated by oil and gas drilling, which exposes UNP to crude differentials and movements on the energy market. The company also transports asphalt, biomass, and other products. Wind turbine products/components are also included here.
Industrial is a massive group – including everything from chemicals, construction, plastics, forest products, lime, salt and waste, metals, ores, soda ash, steel, cement, etc. Everything industrial required across the nation is found here.
Premium includes three segments. Intermodal, domestic intermodal and finished vehicles. What is found here are primarily shipping containers, container traffic as well as truckload carriers. Automotive/cars are found here as well, and UNP operates 38 vehicle distribution centers both in terms of imports and exports. This segment includes both finished vehicles as well as parts.
The railroad is by far the cheapest and most efficient mode of transportation for goods over land. It’s why I’m always interested in owning railroad and railroad companies, and why I’m annoyed that European operators, for the largest part, are state-owned and not buyable. Some of the advantages of this business are far from small:
- Huge barriers to entry, as you have to construct railroad networks as well as maintaining them – something not many companies are interested in in this day and age.
- Trains move 1 ton of goods 125 miles on one liter of fuel. Compare this to road-based freight and you quickly understand why logistics often prefer the train.
Over the past years, UNP has also spent over $34B in maintaining and making certain the transportation network is in good shape. The company continues to spend heavily here, with UNP being a company that inherently has a larger-than-average CapEx.
Perhaps most impressive is the company’s history of outperformance during recessionary or troubling periods. Rather than going down in the financial crisis, management was able to cut costs and boost company margins despite lower volumes. The same is true for the time in 2015 when the usage of coal declined. That’s not to say that the company’s earnings or revenues didn’t drop – I’m saying the company took actions and made certain things stabilized and weren’t hit as hard.
In addition to these benefits, Union Pacific has of yet mostly untapped market potential in Mexico as well. The company has been operating here for a few years now and is the only railroad provider to offer service to all six U.S/Mexico Gateways – from Brownsville in the east to Calexico in the west.
(Source: Union Pacific)
The fact that the company not only transports goods for the US market, but also manages shipping containers from A to B gives UNP some excellent growth potential with Asian and LATAM markets.
The simple fact is that there’s no more efficient, low-cost alternative to the bulk logistics solution that is the railroad. When large volumes of goods need transporting over land, whether it’s agricultural, industrial or otherwise, railroad will be one of the choices made. Because UNP is one of the best companies in its market, and with all the benefits mentioned earlier, it’s extremely hard for entrants to compete with this company.
And that is what UNP does. The company makes money by:
- Transporting a wide variety of goods from A to B, where “A” and “B” are locations across the continental United States, into Canada and Mexico.
Union Pacific Corporation – How has the company been doing?
4Q19 is the last quarter we have, and unfortunately, the company has been having some headwinds here. EPS was down 10 cents YoY, operating ratio was down a few percentage points, and overall volume growth in certain key areas was, for lack of a better word, bad.
Where does this come from?
(Source: UNP 4Q19)
Remember how I said UNP does have exposure to crude differentials? Well, here, we’re starting to see what a non-optimal energy market does to UNP’s earnings. This is like as not to get worse with the current market trouble we’re seeing in the energy sector. Premium, with its intermodal shipping and so forth, is of course affected by trade wars and corona as well.
In short, the company, despite being defensive and somewhat resilient, definitely feels some of the effects from the ongoing crisis here. Insofar as individual segments went during 4Q19, no particular segment really stood out as positive. The best that could be said was that industrial was flat YoY.
(Source: UNP 4Q19)
Interesting to see may be the volumes of the various industries – which appear to be quite well-balanced without any one particular area representing “too” large a product category. The same can be said for Agricultural (mostly)…
(Source: UNP 4Q19)
…but not for Energy, where PRB Coal still represents nearly 50% of freight volumes – almost 70% if you include “other” coal in the calculation. This exposure to what I consider to be a dying sort of fuel is perhaps part of the biggest problem for the Energy segment that UNP is facing at this time. Looking at the premium segment, this will snap back up as things return to normal.
(Source: UNP 4Q19)
In terms of 2020 outlooks – though this is pre-corona, the company expected lower volumes in coal, sand, and automotive, with growing volumes in biofuels, food, plastics, construction, and petroleum. The rest was flat or uncertain at the time of the outlook.
Despite these recent uncertainties, I want to point out that the company is excellent at what it does – and earnings growth since the recession has been excellent. UNP pays out below 50% of earnings in dividends and debt is – at 2.27 NTM net debt/EBITDA – something I consider a non-issue, with an 8.2X interest coverage ratio.
The company sports a high, Very Safe rating from SimplySafeDividends – but perhaps most impressive of all is its excellent dividend growth rate of almost 16% annually for the past 20 years. The company has an uninterrupted dividend streak of 21 years, of which 13 years include continued growth of the company shareholder payout.
So, despite some recent headwinds in the energy and international sector, which certainly aren’t unique for UNP in its current situation, the company has been doing well for the past 10 years. Despite the growth its seen, there are plenty of things to capitalize on going forward – with the Mexico traffic being only one of these things.
Union Pacific Corporation – What are the risks?
I’ve already highlighted some of the risks – but let’s make them even more clear.
- UNP is tied to cyclical industries and is overall tied to the cyclicality of the U.S. and international economy. While the company did address issues occurring during downturns, revenues still fall considerably whenever there is a fundamental issue with something that UNP transports. There’s little to suggest that this will change going forward.
- The company’s high dependence on coal shipments is very likely to become a liability going forward. Natural gas and other types of fuels will replace this in the longer term – and UNP needs to adapt. Not an easy thing to do, with much of the gas capacity being transported via pipelines as opposed to train tracks.
- The company, as all train companies do, have high amounts of CapEx, in the form of maintenance for tracks and locomotives, fuel and other things. While the low price for diesel currently benefits UNP, the oil war certainly does not.
- UNP is one of the last businesses in the US that’s highly unionized. More than 85% of the company’s workforce is a member of one of about a dozen different unions. This opens for the risk of strikes, rising labor costs, etc. Not a risk typical to the geography. One I’m familiar with here in Sweden – but not as much over there.
- There’s also a high amount of regulatory risk tied to the operation of train tracks and this type of transportation. The red tape is thick as a wall, with 7 different regulators that UNP must deal with on a very frequent basis.
So, I would characterize UNP as having an above-average sort of regulatory risk.
Union Pacific Corporation – what is the valuation?
Thankfully, here things get more fun.
(Source: F.A.S.T. Graphs)
As you can see, it’s not unheard of for UNP to drop below fair value even outside of a recession. Due to commodity differentials when it comes to certain types of commodities to which UNP has exposure, there is potential for non-recessionary drops in this company. The last one was in 2015.
Historically speaking, and there’s little to indicate that this time will be different even if recovery can take longer, UNP has always commanded a very high premium on the market, trading closer to 18 times earnings rather than 15.
In short, this sort of situation is indeed rare. UNP is now yielding ~3.3%, and this is a Grade-A conservative company with an A- credit rating and an excellent sub-50% EPS payout ratio. The risk of a dividend cut at this time, or even if this goes on for some time, I would consider to be very low.
Currently trading at a blended P/E of 13.8X, this hasn’t been seen for over 4 years. The company is forecasting about 8.3% of EPS growth annually until 2023.
(Source: F.A.S.T. Graphs)
Returning to normal valuation of at least 15 times earnings, this is what you’d be netting if things hold up. The same number turns onto a ~22% CAGR if we use the company’s historical premium of nearly 20 times earnings – but I consider this to be too optimistic to base a forecast on. Let’s instead say that your potential annual return would likely exceed 10% per year, and that from investing in a conservatively safe and resilient company like UNP. Even if some of its segments are suffering, the freight of foodstuffs and industrial goods continues unabated. Only a truly devastating event could bring this company’s safety into a “rocking” state.
(Source: F.A.S.T. Graphs)
Analyst accuracy is acceptable. The three misses over 10-year periods were understandable ones, with them being limited to the recession in ’09 as well as the company’s issues during the energy crisis in 2015-2016. Outside of that, analyst accuracy is good. We can perhaps expect a second miss going into this crisis, one should mention.
Company dividend is easily covered by FCF looking historically – and currently, the projected FCF for 2020 looks to once again easily cover the company dividend. Numbers for this company look good no matter which way you slice it – the issue is the uncertainty, and that’s a big one.
Me, I choose to use this as the basis of my current thesis on UNP.
While I’m completely unwilling to consider UNP “fairly” valued at 18-20 times earnings as the market does, I do believe the current share price marks an undervaluation compared to a fair value of 15X. Not a big one, mind you – around 8% – but still a very good one for this company.
UNP is not a company typically acquired on the cheap. So, when NYSE starts discounting this sort of quality company as though it’s a clearance sale, I become very interested.
The combination of an A- credit rating with a low payout ratio, a high moat, excellent dividend safety and a “VERY SAFE” rating from SimplySafeDividends, which compiles many of these factors in an excellent manner, means that this is one of those stocks I consider to be on my “Ultra-safe” stock lists.
In my monthly portfolio update, I’ll review the list of stocks I actually consider to be part of this list – though I update it quite often these days, as businesses become undervalued on seemingly a daily basis.
The point is this. UNP is currently undervalued at least 5% to fair value. For a company that’s almost never undervalued, this is remarkable enough to make UNP a “BUY” for certain. I’ve wanted this company as part of my portfolio for many years.
Now, I can finally buy it – and I think you should consider doing the same.
Thank you for reading.
Due to recent corona-induced undervaluation, a 5-8% undervalued UNP (to fair value) is currently a “BUY”.
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: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.
I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.