In investing, time can make all the difference in the world. A stock that may have been an interesting buy one day could be a hold the next day, week, or month, or vice versa. This is because market sentiment can quickly (or gradually) swing from one direction to another.
That's why I believe it is so important to be selective in deploying capital in the stock market. There's no need to chase a stock when it appears to be unfavorably valued. With enough patience, the valuation will generally become more favorable.
That was my thought process with Union Pacific (NYSE:UNP) when I initiated a hold rating in January. The only gripe that I had was that shares of the railroad operator looked to be too richly valued to deliver the double-digit annual total returns that I target.
I was impressed by the company's leading presence in the western two-thirds of the United States via over 32,000 miles of route track. I also liked the financial stability that UNP offered with its A- credit rating from S&P on a stable outlook. The dividend was also well-covered.
Today, I am upgrading shares of UNP to a buy. When the company shared first-quarter results on April 25, its operating strength allowed it to post a double beat. This was enough for UNP to commit to resuming share repurchases in the second quarter. The company also shored up its balance sheet. Finally, shares have grown more valuable as UNP has topped expectations and more of 2025 is reflected in my fair value estimate.
Key Performance Indicators Are Trending In The Right Direction
UNP's financial results for the first quarter that ended on March 31 suggest that it is getting back on track. The company's operating revenue declined 0.3% year-over-year to $6 billion during the quarter. This was $50 million ahead of Seeking Alpha's analyst consensus.
At a glance, flat operating revenue doesn't seem as though it should elicit an upbeat mood from a shareholder such as myself. But as is the case with any investment, the context of results is as important if not more important than the results themselves.
UNP's freight revenue decreased by 0.7% over the year-ago period to $5.6 billion in the first quarter. Excluding the negative impact of lower fuel prices on operating revenue, freight revenue would have grown by 3.7% to nearly $5 billion for the quarter.
However, because fuel prices were lower, the company wasn't able to charge as much to customers for fuel surcharges. This led fuel surcharge freight operating revenue to dip by 24.7% year-over-year to $665 million during the first quarter.
Another headwind for UNP was that freight volume declined by 0.5% in the first quarter. When factoring out a 20% reduction in coal shipments, though, UNP's freight volume would have been up 2% per CFO Jennifer Hamann's opening remarks during the Q1 2024 Earnings Call.
Higher core prices and a more favorable shift in the company's mix drove a freight revenue 3.5% tailwind for the first quarter. Reduced coal and rock shipments and increased soda ash and petroleum carloads were behind the improvement in the mix, according to Hamann.
UNP's other revenue climbed 3.8% higher over the year-ago period to $415 million during the first quarter. Per Hamann, this was due to increased accessorial revenue from a one-time contract settlement of $25 million.
UNP's diluted EPS grew by 0.7% year-over-year to $2.69 in the first quarter. This was $0.15 better than the analyst consensus.
What made this earnings growth all the more impressive was that CEO Jim Vena noted the year-ago period included a $0.14 per share real estate gain. Factoring that out of the mix, diluted EPS would have been up by 6.3% for the first quarter.
The same factor that hurt UNP's operating revenue was a boon to its bottom line during the first quarter. A decrease in fuel expenses ($3.22 a gallon in Q1 2023 to $2.81 a gallon in Q1 2024) more than offset an uptick in compensation and benefits expenses in the quarter.
That is how operating expenses declined by 2.7% over the year-ago period to $3.7 billion for the quarter. This helped the operating ratio improve by 140 basis points to 60.7% during the quarter.
Looking ahead, the future is bright for UNP. The FAST Graphs analyst consensus is that diluted EPS will grow by 8.6% to $11.34 in 2024. This would be just above the record of $11.33 that was set in 2022.
That implies that in the final three quarters of 2024, UNP will generate $8.65 in diluted EPS. Extrapolating this further beyond the Q2 estimate of $2.78 or first-half diluted EPS of $5.47 would mean that an acceleration in the second half is currently anticipated by analysts.
In my view, these estimates make sense. Per Hamann, the company's layoffs of non-transportation employees decreased workforce levels by 2% in the first quarter. This will continue to be a positive move in the quarters to come. A downtick in purchased services and materials by 6% due to a smaller active locomotive fleet will be another driver of improved operating efficiency.
UNP also announced that it will be resuming share repurchases in the second quarter. This will lessen the pieces of the company pie over time, which will entitle shareholders to a bigger share of the growing profit pie.
As these changes are more fully absorbed and UNP faces easier comps, it's also reasonable to expect momentum to continue into 2025 and 2026. This is why the FAST Graphs analyst consensus is for the company's diluted EPS to climb by 13.1% in 2025 to $12.83. Another 9.6% growth in diluted EPS in 2026 to $14.05 is currently being projected.
As it stands right now, UNP is also in an appropriate position financially to restart its share repurchase program to juice diluted EPS growth. Thanks to debt repayment, the company's adjusted debt load fell by almost $1 billion to $33.3 billion. Along with a slight uptick in TTM adjusted EBITDA, this pushed the adjusted debt-to-EBITDA ratio down from 3 to 2.9 for the first quarter. That is what supports the company's A- credit rating from S&P on a stable outlook (unless otherwise sourced or hyperlinked, all details in this subhead were according to UNP's Q1 2024 Earnings Press Release and UNP's Q1 2024 Earnings Presentation).
Fair Value Could Now Be $250+ A Share
Since my last article, shares of UNP have declined by 7%. All the while, the S&P 500 index (SP500) has gained 11%. Throw in higher analyst estimates for 2024 and 2025 and this makes shares all the more appealing here.
UNP's current-year P/E ratio of 20.1 is a bit below the 10-year normal P/E ratio of 20.9 per FAST Graphs. I believe that an eventual return to this valuation multiple is a reasonable expectation. That would also be below the sector median of 21.5 per Seeking Alpha's Quant System.
The interest rate environment in the years to come will almost certainly be moderately above that which has been the case over the past decade. On the flip side, however, UNP's forward diluted EPS growth outlook for the next three years is solid.
The 10.6% annual diluted EPS growth consensus is better than the 10-year average of 8.3% per FAST Graphs. So, I believe that these vigorous growth prospects compensate for the higher interest rate environment that would otherwise weigh on UNP's valuation.
After this week is complete, 2024 will be 44% behind us. That leaves another 56% of this year and 44% of 2025 ahead in the next 12 months. This is how I'm accounting for the 2024 and 2025 diluted EPS analyst predictions of $11.34 and $12.83, respectively. That gives me a $12 12-month forward diluted EPS input.
Applying a 20.9 valuation multiple to this diluted EPS input, I get a fair value of $251 a share. Compared to the $228 share price (as of June 4, 2024), that represents a 9% discount to fair value. If UNP reverts to my fair value estimate and grows as expected, it could produce 35% cumulative total returns through 2026.
Enhanced Dividend Sustainability
Relative to the 1.5% forward dividend yield of the industrials sector, UNP's 2.3% forward dividend yield is appealing. This is enough to earn a B+ grade for forward dividend yield from Seeking Alpha's Quant System.
UNP isn't just an immediate income story, either. Even with no dividend growth for the last two years, the five-year compound annual growth rate is 9.1% according to the Quant System. That is moderately above the 6.9% median of the industrials sector. Thus, the B grade for five-year dividend growth from the Quant System.
By the end of this year, I expect dividend growth to resume. The company's diluted EPS is on pace to climb to a new all-time high this year to support such dividend growth. That's why I believe high-single-digit annual dividend growth should continue in the years to come.
UNP's 47% EPS payout ratio is also better than the 60% that rating agencies like to see from the railroad industry, per the Zen Research Terminal.
Additionally, the company's free cash flow is adequately covering its dividend. For context, improvements in operating cash flow helped free cash flow to rise by 24.1% year-over-year to $1.3 billion in the first quarter. Against the $795 million in dividends paid in that time, this equates to a 60% free cash flow payout ratio (better than the 74.4% payout ratio in the year-ago period).
Given that the payout ratio was 66.5% in 2023, and it is already considerably lower to start 2024, I am expecting an improvement in the free cash flow payout ratio for 2024 to the mid-to-high 50% range. That would be more than enough for the company to balance a resumption of share repurchases, dividend raises, and incremental debt repayment (unless noted otherwise, all info in this subhead was sourced from UNP's Q1 2024 Earnings Press Release and UNP's 10-K Filing).
Risks To Consider
UNP is a business that's on the rebound. However, risks to the investment thesis remain.
Operationally, UNP transports hazardous materials. This opens it up to the possibility of a derailment similar to what Norfolk Southern (NSC) experienced in East Palestine, Ohio in February 2023. Such an event wouldn't likely put UNP out of business, but it would certainly be a setback to the investment thesis.
Pending approval from the U.S. District Court for the Northern District of Ohio, NSC will settle for $310 million to resolve all remaining claims associated with the incident. Including environmental cleanup costs, settling class action lawsuits of residents within 20 miles of the site, and direct financial support, total cumulative costs will be nearly $2 billion.
UNP heavily relies on its IT network to conduct its operations. If any of its technology systems (including third-party systems) were breached, its operations could be disrupted. That could negatively impact UNP's financial results and result in litigation being brought against it.
Finally, a worse-than-expected recession could temporarily harm the company's financial results.
Summary: An Appealing Valuation For A Wonderful Business
UNP is a world-class company, accounting for a 0.7% weighting within my portfolio. The fundamentals of the business look to be bouncing back. The share repurchase program has returned. Adjusted debt is gradually decreasing. Yet, shares look to be discounted by close to double digits. This is why I'm upgrading shares to a buy right now.
Kody's Dividends
Hi, my name is Kody. Aside from my five to six weekly articles here on Seeking Alpha, I am also a contributor to Dividend Kings and iREIT on Alpha. I have been investing since September 2017 and interested in dividend investing since about 2009.Since July 2018, I have ran Kody's Dividends. This is a blog that is documenting my journey towards financial independence using dividend growth investing as the means to transform the dream of financial independence into a reality. It's also the inspiration of my pseudonym here on Seeking Alpha.By God's grace, I owe everything to my blog for introducing me to the Seeking Alpha community as an analyst. That's my story and I hope you enjoy my work examining dividend growth stocks and the occasional growth stock!
Analyst’s Disclosure: I/we have a beneficial long position in the shares of UNP, NSC 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
