- Union Pacific has been facing less than optimal volume trends for a while now.
- The business is an excellent operator however, having steadily grown margins on the back of price hikes and good cost control.
- Continued share buybacks have provided a big boost to earnings, all while financial leverage is still in check.
- Recent woes about slower growth, higher rates and inflationary concerns have hurt the shares a bit, as current valuations look largely fair to me.
It is time to pick up coverage on Union Pacific (NYSE:UNP) again in a period of turmoil, or at least quite some bumps along the road. My last coverage on the railroad giant dates back to the summer of 2020 when I concluded that valuations were a bit rich given the underlying trends.
Early in 2020 the external environment was not so friendly for Union Pacific as the outbreak of the pandemic made that a $185 stock at the start of the year fell to $110 during the lows, albeit that shares had recovered to $150 by April.
With shares trading near their highs early in 2020, this positive share price performance did not rhyme with the underlying business performance as volumes have been trending lower in 2019 already, a trend which obviously continued in the first quarter of 2020. To shed some perspective: Union posted a 5% fall in 2019 sales to $21.7 billion, despite a positive price contribution, as volumes have been coming down even as Union had quite diversified operations.
Lower volumes were the result of volume declines in the energy business, although some other segments have seen some declines as well. Despite the decline in sales, Union posted a massive $5.9 billion net profit on the back of solid cost control, as a gradual reduction in the share count allowed for earnings per share to rise by 6% to $8.38 per share. This translated into a 21-22 times multiple early in 2020, with net debt of $24 billion translating into a 2.3 times leverage ratio with EBITDA coming in at $10.8 billion, with the business posting impressive operating ratios of 60%.
First quarter sales in 2020 fell 3% as a 7% fall in volumes was only partially offset by a 5% increase in prices. Earnings rose a bit amidst lower fuel costs, as net debt ticked up to $26.6 billion. The issue is that the pandemic only was seen late in the quarter and with sales down 20% in recent weeks at the time, and the pandemic trends being very uncertain, it was very difficult to model earnings going forwards. Nonetheless, I thought that even if sales would be down 20%, earnings per share before 2020 should still come in around $5 per share as the business model is quite flexible with regard to variable costs, although leverage would shoot up in such a case.
With shares trading at $150 at the time, valuations have fallen to 13-14 times earnings in 2019, yet there were many question marks on the (near term) future, leaving me a bit cautious as shares snapped back in quite an aggressive manner, as long term volume trends were not that exciting.
As it turned out, the woes were overdone as shares rose to the $200 mark later that year, hit a high of nearly $280 late in 2021, yet by now have fallen back to $195 per share again, in line with the share price in September 2020.
As it turned out, 2020 sales only fell to $19.5 billion as they recovered to $21.8 billion in 2021, in line with the revenue number in 2019. In the meantime the company has only improved the profitability of the business as operating profits of $9.3 billion resulted in an operating ratio which improved to 57%. Net earnings of $6.5 billion translates into earnings of $9.95 per share, comfortably ahead of the 2019 revenue earnings number, amidst higher margins and continued share buybacks.
Net debt is very controllable despite continued buybacks, with leverage reported at $28.8 billion, for a 2.5 times leverage ratio with EBITDA trending at $11.8 billion. With volume trends pressured for years already, the need for capital spending is not that high. Nonetheless, a near $3 billion capital spending budget exceeds deprecation charges by about a billion, not a massive surprise as railroads are capital intensive businesses with long duration assets, traditionally translating into large net capital spending requirements.
The company started with a strong first quarter of 2022 with revenues up 17% to $5.9 billion, albeit that volumes only contributed 4% to this growth. Operating earnings actually rose 19%, thereby increasing margins further, despite a 74% spike in the fuel bill, notably the result of flattish expenses with regard to depreciation and equipment. With earnings up 22% and a continued reduction in the outstanding share base, Union-Pacific posted a 29% increase in diluted earnings per share to $2.57 per share, firmly on track to surpass the $10 per share mark.
Net debt inched up further to $31 billion, albeit that the company uses a slightly other metric to arrive at a 2.8 times leverage ratio. In May, Union Pacific furthermore pleased investors with a 10% dividend hike, increasing the payout to $5.20 per share a year, adding to its track record which dates back 123 years by now!
The dynamic of higher prices and softer growth was evident in the second quarter results, with revenues up 14% on the back of a percent decline in volumes. Peak margins clearly arrived in the first quarter as expenses rose across the board during the second quarter, led by an 89% increase in the fuel bill. Nonetheless, with operating earnings coming in largely flat, earnings per share were up 7% to $2.93 per share.
This looks comforting as an $11 earnings per share number remain in the works, absent of a dramatic performance in the second half of the year, as valuations have become a bit less demanding. A 21-22 times earnings multiple in 2020 has fallen to 16-18 times earnings, in part driven by higher interest rates as well as the fact that investors are arguably concerned about lower activity levels, but moreover lower earnings as current operating margins are at historical high levels already.
The truth is that the near term outlook for earnings is not as rosy, but by now valuations have been de-risked a bit, albeit that a substantial part of the multiple contraction is the result of higher interest rates in all likelihood, as pressure on earnings could reveal further downside. On the bright side, Union Pacific is an excellent steward of capital and long term performer.
In the near term some pullback is likely seen. Inflationary trends impact the business in a number of ways. Pricing power could be up, yet costs are rising across the board, and while depreciation expenses are largely flattish, this inflation shows up in the need for higher capital spending, to date not yet seen in the capital spending guidance. Other near term threats includes the observation that weekly volume trends have fallen in the mid-single digits in recent weeks and labor inflation, albeit that it seems that some rest on this subject has been achieved in a recent agreement.
The further truth of the matter is that shares have been holding up quite well (on a relative basis) to its peers and wider market as I think the current price level is about fair. Union remains a well-led railroad with long term potential and, like the rest of the market, appeal is on the increase, but not necessarily more interesting than the market at large here.