UNP Equity Research Report

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This is another equity research report that another colleague and I worked on with our school's student managed investment fund.

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UNP Equity Research Report

  1. 1. Union Pacific Corporation (UNP) Brett Watts and Chris Parker November 1, 2011 Company Profile Summary Union Pacific Corporation (UNP) operates the Union Pacific Railroad as its principal operating company. The Union Pacific Railroad operates in 23 states, covering much of the western two-thirds of the United States. UNP links key western US ports to eastern US ports, and is linked to the east with major interchange points with other Class 1 Railroads in Chicago, St. Louis, Memphis, and New Orleans. They are the only railroad to serve all six major gateways to Mexico, and like many other railroads, have access to markets in Canada by interchanging with Canadian carriers at the US-Canada border. UNP is the nation’s largest hauler of chemicals and is one of the largest intermodal carriers (the transporting of truck trailers and marine containers via rail). UNP has a diverse commodity mix that includes chemicals, coal, food and food products, intermodal, metals and minerals, and automobiles and parts. They have over 25,000 customers that include steamship lines, vehicle manufacturers, agricultural companies, utilities, intermodal companies and chemical manufacturers. UNP has 50,000 miles of total track, employs approximately 43,500 people, and have a fleet of approximately 8200 owned and leased locomotives and approximately 78,000 owned and leased railcars. Union Pacific Corporation Current Price $102.02 Estimated Fair Value $113.46 Market Cap $47.3 billion 52-Week High $107.89 52-Week Low $77.73 Average Volume 3.9 million Price/Earnings 16.22 EPS (2011Est.) $6.52 Carload Segmentation One of the best practices to understand a railroad’s business is to first gain insight into how they classify their carload traffic. UNP classifies their carload traffic into three categories: Manifest, bulk, and premium. Manifest traffic encompasses 24% of carloads, bulk 32% and premium tops the list with 44% of carloads being categorized in its mix. Manifest Carload Traffic Manifest traffic includes individual carloads or less-than-train load business. This basically includes all traffic that isn’t moved in unit train segments and all traffic that doesn’t fall under UNP’s premium category. Some commodities that could be moved under these conditions are lumber, steel, paper, food and chemicals. UNP’s large manifest infrastructure includes terminal locations throughout its system and includes
  2. 2. storage-in-transit facilities in the Gulf Coast region that allows their chemical customers to store their products at UNP’s facilities prior to off-line delivery. The manifest category of traffic handles virtually every commodity that could possibly be shipped by rail. The pricing is mostly implemented by generic public price documents that set prices at a generous margin for UNP. Therefore, UNP’s pricing power in this area of their business is evident by manifest traffic only consisting of 24% of 2010 volume, but contributing 41% of 2010 freight revenue. Bulk Carload Traffic Bulk traffic primarily consists of coal, grain, soda ash and rock shipped in unit trains (a unit train transports a complete train with one commodity from one origin to one destination). Most of UNP’s coal traffic comes from the Southern Powder River Basin of Northwestern Wyoming and the Uinta Basin located in Colorado and Utah. Their grain and grain product carloads originate in the Midwestern states and deliver product domestically, to Mexico, and to ports in both the Pacific Northwest and the Gulf Coast for international distribution. Also, coming out of Wyoming near the Green River are unit trains of soda ash that make their way to the Gulf Coast ports and to ports in the Pacific Northwest for international distribution. The rock unit trains move primarily in and around Texas. Their lanes for bulk traffic have been designed and tweaked to maximize capacity, efficiency, and to maintain a focus on point-to-point moves. Most of the traffic under this business segment move under private multi-year contracts that face moderate competition from trucking companies and, depending on geographic location, some barge transport companies. These contracts often contain volume guarantees by the customer and capital provisions in which UNP might aid their customer with capital startup (laying track into industry, building storage and distribution facilities, etc.) in exchange for higher initial carload rates or volume commitments with shortfall provisions, or possibly a combination of the two. Because of the high switching costs that a customer of UNP might incur to leave UNP and go with another competitor, pricing practices in this market segment stay under regulatory watch. Pricing liability holds a significant legal risk if best pricing practices are not adhered to. In 2010, bulk traffic consisted of 32% of both freight carload volume and freight revenue for UNP. Premium Carload Traffic UNP’s premium traffic includes the transport of finished automobiles, auto parts, intermodal containers and truck trailers. UNP is the largest automotive rail carrier west of the Mississippi River. UNP serves vehicle assembly plants and connects to west coast ports and the port of Houston to accommodate import and export traffic. UNP holds a competitive advantage with Mexico automotive traffic due to their direct access to all six Mexico-US rail gateways. UNP has consistently met customers’ performance expectations in long-haul west-to-east moves of import autos coming to the US on the western seaboard and also on intermodal moves along the same routes and ports. UNP provides extensive door-to-door and ramp-to-ramp domestic intermodal shipments along its network. Premium traffic contributed 44% of volume and 27% of freight revenue in 2010.
  3. 3. Balance Sheet Analysis Analyzing Union Pacific’s balance sheet reveals an overall solid bill of financial health. Reviewing Union Pacific’s leverage ratios reveals that the firm ranks in the bottom fiftieth percentile in each category compared to the industry averages. Union Pacific has maintained debt/equity ratios of less than 83% over the past decade. Over the past five years it has maintained debt/equity ratios of 57% or less, which is well below the industry average of 70%. As of 3Q’s end, Union Pacific had a financial leverage ratio (TTM) of 2.43%. Throughout the last ten years this figure has remained much lower than the level of concern: 4%. Although Union Pacific’s debt/capital of 36% in 2010 may seem quite large, higher amounts of debt are common for rail companies, and Union Pacific’s high interest coverage ratio of 8.3 makes potential problems with supporting this leverage highly unlikely. Although accounts receivables in 2010 grew by an unusual 77% compared to the 20% increase in revenues, this is not cause for great concern. Union Pacific has been very efficient in collecting their debts, as it has the highest accounts receivables turnover rates when compared to its closest competitors: CSX, Norfolk Southern, Canadian Pacific Rail, and Kansas City Southern, Canadian Northern. Union Pacific has historically had current ratios below 1.0 caused by deficits in net working capital. Normally this indicates a lack in liquidity, but this is common within the railroad community. Union Pacific’s large financial capacity allows them to meet its current liabilities and, if necessary, Union Pacific has access to capital through its adequate resources to meet both daily and short-term cash requirements. In 2009 the company decided to start putting aside additional cash reserves to enhance liquidity given the uncertain economic conditions. It is because of this decision that Union Pacific had above average current ratios of 1.37 and 1.17 respectively in 2009 and 2010. Income Statement Analysis Over past years and year-to-date Union Pacific’s profit margins rank among the top 89% or better when measured against industry averages. Union Pacific’s revenues and net income grew in 2010 by a solid 20% and 46.6% respectively. While revenues totaled $16,965 million for the year, net income totaled $2,780 resulting in a growth margin of 16.39% in 2010 and up 22% from the year before. Operating income has increased seven out of the last ten years with 2003, 2004, and 2009 operating income amounts being less than their previous years. The negative growth in 2009 was no surprise, as revenues were much lower that year due to economic conditions. However, the operating margin for these three years did increase due to
  4. 4. COGS being lower for the years as well. Union Pacific’s operating income bounced back strong from 2009 with operating income increasing by a hefty 47% in 2010 to $4,981 million. Taking into account 2010’s revenues of $16,965 million provides us with an operating margin of 29.36% for the year. The company has had steady increases in operating margins over the last six years. Union Pacific’s operating ratios (OR) have decreased every year since 2006 as the company has been extremely successful at improving operational efficiency. Each year, Union Pacific has been becoming increasingly more cost effective, which is how it has managed to decrease its annual OR by more than thirteen percent in just four years. Although the company’s 3Q OR of 69.1% increased slightly from the year before, the increase was 30bsp less than analyst’s forecasted increase, and the OR still remains below 70%, which is considered to be a great achievement in the railroad industry. Revenues and Earnings UNP reported its third quarter earnings on Thursday, October 20, 2011. They posted $1.85 EPS, and beat consensus analyst estimates of $1.81. Yield growth was up 14.3% to drive up revenue growth, while core pricing was at 4.5%, much in line with Q1 and Q2 of this year. Some of the yield growth can be attributed to product mix shifts to revenue moves with a longer length of haul (incremental margins for rail carriers improve with every mile added to a carload move) and to shifts to freight moves with a higher revenue per carload. UNP’s operating ratio deteriorated 80 bps to 69.1% but still beat most analyst expectations (a deteriorating OR was expected in Q3 for all rail carriers due to increases in fuel costs and weather conditions). Volume increased 1.1% by quarter and expenses excluding fuel rose 8.7%. Revenue grew 15.7% beating most analysts’ expectations by 200-400 bps. Domestic intermodal volume growth was only 2% for Q3, but growth was soft in the early part of the quarter and accelerated in the end of the quarter, signaling possible growth through Q4:2011 and into the early part of 2012. UNP increased manifest train length by 2.3% and intermodal train length by 1.2%, further aiding in an excellent quarterly earnings report. Q1:2011 Q2:2011 Q3:2011 Volume Growth Agricultural 4.4% 11.3% ‐2.6% Automotive 4.0% 3.8% 9.6% Chemicals 9.9% 11.5% 5.4% Energy (Coal) 4.3% 2.1% 6.9% Industrial 8.7% 3.8% 8.2% Intermodal 3.8% ‐1.0% ‐6.1% Total Vol Growth 5.1% 3.1% 1.1% Yield Growth Agricultural 5.7% 9.2% 11.6% Automotive 7.6% 10.8% 12.1% Chemicals 2.8% 7.0% 8.1% Energy (Coal) 8.2% 11.3% 13.0% Industrial 6.2% 11.4% 14.6% Intermodal 10.9% 13.8% 14.8% Total Yield Growth 7.6% 12.7% 14.3% Other Statistics Operating Ratio 74.7% 71.3% 69.1% Avg Fuel Price ($/gal) $2.88 $3.29 $3.18 EPS $1.29 $1.59 $1.85 EPS % Growth 18.7% 13.5% 18.6% Key Statistics for UNP Year‐To‐Date
  5. 5. UNP has consistently improved revenues, dividend distributions, earnings, operating margins, return on assets, and return on equity over the past ten years and has also continued that trend over the most recent five years. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011(est) Revenue (millions) 11,973  12,491  11,551  12,215  13,578  15,578  16,283  17,970  14,143  16,965  19,435     Year over year % change 4.33% ‐7.53% 5.75% 11.16% 14.73% 4.53% 10.36% ‐21.30% 19.95% 14.56% 10 Year Revenue Growth = 5.56%, 5 Year Revenue Growth = 3.87% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011(est) Earnings Per Share 1.89 2.15 2.04 1.45 1.70 2.96 3.46 4.54 3.61 5.53 6.56 Year over year % change 13.76% ‐5.12% ‐28.92% 17.24% 74.12% 16.89% 31.21% ‐20.48% 53.19% 18.63% 10 Year Earnings Growth = 20.5%, 5 Year Earnings Growth = 17.92% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011(est) Dividends Per Share ($) 0.40 0.40 0.46 0.60 0.60 0.60 0.68 0.93 1.08 1.31 1.71 Earnings Per Share ($) 1.89 2.15 2.04 1.45 1.70 2.96 3.46 4.54 3.61 5.53 6.56 Dividend Payout Ratio 21% 19% 23% 41% 35% 20% 20% 20% 30% 24% 26% Dividend Payout Ratios 2001‐2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011(est) Operating Margin 27.1% 28.3% 27.7% 19.7% 21.9% 26.5% 28.8% 30.4% 34.2% 38.1% 37.5% Year over year % change 4.4% ‐2.1% ‐28.9% 11.2% 21.0% 8.7% 5.6% 12.5% 11.4% ‐1.6% Operating Margins 2001‐2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011(est) ROA 3.1% 4.2% 4.8% 1.8% 2.9% 4.5% 5.0% 6.0% 4.6% 6.5% 7.1% Year over year % change 34.1% 14.9% ‐62.8% 64.0% 52.4% 11.9% 20.7% ‐23.1% 40.7% 8.5% Return on Assets 2001‐2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011(est) ROE 10.6% 13.3% 13.8% 4.8% 7.8% 11.1% 12.0% 15.1% 11.7% 16.0% 17.2% Year over year % change 25.2% 3.9% ‐64.9% 61.1% 42.3% 8.5% 25.5% ‐22.2% 36.7% 7.6% Return on Equity 2001‐2011 Cash Flow With the exception of 2009, Union Pacific’s year-over-year operating cash flows have been growing at a rate of 12% or better since 2004. Operating cash flows decreased in 2009 due to a variety of reasons, which include lower net income for the year, reductions to its receivables securitization facility, increased pension contributions, and changes made to working capital; most of which were a result of the recession. In the past decade Union Pacific’s year-over-year free cash flows (FCF) have increased each year by significant rates of 18% or more with the exception of years 2004 and 2009.
  6. 6. During these two years FCFs were lower than the year before, resulting from decreases in operating cash flows. The decrease in 2009 is explained in the above paragraph, while the decrease in operating cash flows for 2004 was caused by lower income from continuing operations and lower cash from discontinued operations recognized in the year before. Free cash flows for 2010 rebounded strong off of 2009’s poor performance to $4,105 million, resulting in a 31% increase. As of September 31, 2011, year-to-date free cash flows for Union Pacific were in excess of $2.1 billion (15% of sales for the same period). This is $1.1 billion more than last year’s amount for the same year-to-date period. Although Union Pacific’s free cash flows haven not been greater than 5% of revenue for each year over the past decade, they have been for the last five consecutive years by 16% or more; and from 2008 to 2010 free cash flows have been 20% of revenues or more. Valuation By using the discounted cash flow model and incorporating a margin of safety of 35%, we have determined Union Pacific’s fair market value to be $113.46. To reach this conclusion we first began by calculating Union Pacific’s free cash flows for the past ten years. We did this by subtracting capital expenditures from cash flows from operations for each of the corresponding years. Next, we had to estimate the company’s free cash flows over the next ten years into the future. In order to do this, assumptions had to be made for the perpetuity growth rate, discount rate, average FCF growth rate for years 2011 through 2015, and the average FCF growth rate for years 2016 through 2020. We assumed a 3% perpetuity growth rate because this is roughly the long term growth rate of the United States’ GDP. Although Union Pacific is financially healthy and does not have any profitability problems, we selected an above average discount rate of 12.5% after taking into account the cyclical nature of its industry, its susceptibility to regulation changes, and the current global economic environment. For our FCF estimates we assumed an average growth rate of 16.5% for years 2011-2015, and 11% for years 2016-2020. To develop these assumptions we first evaluated the year- to-year FCF percentage increases over the last ten years for Union Pacific. Based upon our future expectations, we then created hypothetical growth rates for each of the next ten years and calculated the averages for each of the five year periods. This resulted in average growth rates of 19.2% and 11.2% for 2011-2015 and 2016-2020. After taking into consideration the potential for unforeseeable risks to occur in the future, our final results were 16.5% and 11%. Upon entering our assumptions in the in the model along with the rest of the data we derived Union Pacific’s total equity value, which was then divided by the number of the company’s shares outstanding. Resulting in a per-share value of $174.55, we then
  7. 7. factored in our conservative 35% margin of safety to achieve our fair value estimate of $113.46. Company Key Indicators vs. Competition Union Pacific is the largest publicly traded railroad in America. As shown below, Union Pacific’s year-to-year revenue and EPS growth in 2010 were higher than all but one of its rivals, Kansas City Southern (KSU). Although KSU’s growth is impressive, it happens to be the smallest class 1 railroad company in the country, and large growth rates are not uncommon for smaller, less established companies. KSU has only 3,200 miles of track in the US. This pales in comparison to Union Pacific’s 32,000 miles of track. Therefore, KSU will not likely be a significant threat to Union Pacific’s business any time soon. Direct Competitors Current Market Price Market Cap ($ billions) P/E (TTM) Revenue Growth (1yr) EPS Growth (1 yr) Union Pacific $102.02 $47.3 16.22 20% 47.47% Canadian National $80.20 $35.7 15.37 18.8% 20.58% CSX $23.11 $23.5 14.24 17.64% 39.52% Norfolk Southern $74.89 $24.3 14.59 19.4% 44.93% Canadian Pacific $64.57 $10.1 19.6 15.76% 4.9% Kansas City South. $65.03 $6.8 24.84 22.6% 173.77% Technical Analysis The technical analysis of Union Pacific showed promising signs. As shown on the chart on the following page, Union Pacific’s stock price is above all significant moving averages (MAs). The 50-day MA is converging on the 200-day MA, which is a good sign. Also, recent price appreciation has been occurring on increasing volume, which helps to confirm the upward trend. UNP has healthy momentum and does not seem in danger of reaching overbought levels anytime soon. FINAL OPINION: BUY – good momentum supported by increasing volume.
  8. 8. Expectations We feel that UNP has positioned itself to continue to outperform financially and put downward pressure on its operating ratio, a key indicator of growth and profitability in the rail industry. UNP will begin repricing of approximately $1.05 billion in legacy pricing in Q4:2011 and in the beginning of 2012. We expect UNP to take advantage of this repricing opportunity to add bottom line revenue growth to increase EPS by around 8% or $0.63/share. We also have high expectations for intermodal growth through the holiday season and also in continuous growth in intermodal in regards to US and global recession fears subsiding. With our continually increasing optimism in regards to the macroeconomic picture, we have high hopes for continued top and bottom line revenue growth, operating ratio improvement, and overall yield growth which will all aid UNP at meeting or beating consensus estimates in Q4:2011 and throughout 2012. Greed vs. Fear Greed: Legacy contract repricing is expected to have a significant positive impact on earnings per share in 2012. Recent signs that the US economy is improving have been increasing. If the strength of the economy continues, as we suspect it will, it will benefit to the entire rail industry. Union Pacific’s yield growth has been increasing each quarter this year, directly impacting the growth of EPS.
  9. 9. OR efficiency is expected to continue, further adding to Union Pacific’s bottom line profitability. Fear: Increased price competition between the western rail and trucking companies could have a negative impact on forecasted earnings. Unfavorable regulatory rulings could result in a large increase to operating costs, but we do not expect this to happen during our OFG tenure. A sudden slowdown in the US economy could be detrimental to Union Pacific’s Q4 earnings and share price. Although very unlikely, the possibility of a union railroad strike to occur in the near future must be considered, as this would cause significant volume decreases and create uncertainty in the industry. Recommendation We believe the current share price of Union Pacific to be undervalued. After analyzing the company and its share prices, we have determined a fair value market price of approximately $113.46. We expect overall continued growth for Q4 and a strong performance throughout 2012 aided by the legacy contract repricings and increased operational efficiency. After the market’s strong performance last week Union Pacific’s share price rose to the current level of $102.02 per share. However, due to the intensity of last week’s sudden price appreciation and the current volatility in the market we believe the likelihood of Union Pacific’s share price temporarily falling below the $100 range is very high. Therefore we recommend overweighting Union Pacific with a full position plus one half (1-1/2) with a limit-buy set at $99.87.

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