UNP - Union Pacific: Generous Shareholder Rewarding Coming To An End

2023-10-18 19:16:18 ET

Summary

• Union Pacific's financial data reveals a shift from years of generous shareholder rewards can be expected.
• Analysis of stock buybacks, debt, and earnings highlights potential challenges for the railroad giant's future.
• Some of their peers might be better investment opportunities at this moment.

During the last couple of years, Union Pacific ( UNP ) has rewarded shareholders with a quickly growing dividend and with very generous share repurchases. The company has even taken on significantly more debt to finance this. I believe that in the current high interest rate environment this strategy is unsustainable. If Union Pacific will continue to pause its share repurchases (which they did after Q2) and their dividend growth stagnates, I think the company's valuation is too rich at a P/E of 20. In this article I will take a deep dive into the data, and investigate if peers of Union Pacific might offer better investment opportunities at this moment.

Recent developments

Railroad giant Union Pacific has gone through dynamic times lately. Although the railroad industry should be a relatively boring sector for investors, there was much news during the last couple of months; Jim Vena was appointed as new CEO of Union Pacific after Lance Fritz stepped down. This change happened after hedge fund Soroban Capital called for changes at Union Pacific.

Also, an explosion at the Union Pacific railyard in North Platte raised questions about safety and maintenance. Furthermore, other safety incidents such as the Ohio derailment at their peer Norfolk Southern ( NSC ) have attracted the attention of policy makers, signaling stricter safety legislation could be expected in the future.

Share price, dividend and income

If we take a look at the share price and price-to-earnings ratio of Union Pacific over the last ten years, we can see that shares have performed really well. Between 2020 and 2022, the company enjoyed an elevated PE ratio, but since then, the ratio has come down to a value of around 20. This value is more or less in line with the median value over the last ten years.

Graph 1: Union Pacific share price and normalized PE ratio over the last decade (source: YCharts)

A PE ratio of 20 is not extreme, but in my opinion, a ratio this high should be coupled with some decent and healthy growth in order to be worthy of investment. Let us take a look at UNP's earnings per share over the last decade:

Graph 2: Union Pacific normalized diluted earnings per share over the last decade (source: YCharts)

Let us ignore the outlier year of 2018 in this graph and focus on the full decade. As we can see, earnings per share rose from about $4.8 ten years ago to $10.74 currently, which is an average annual growth of about 8.5%. For a mature industry like the railroad industry I consider this to be a decent growth percentage.

The company has been kind to investors with regard to their dividend. Although they did not raise their dividend each year I believe most shareholders will be happy with the following graph:

Graph 3: Union Pacific quarterly dividend and payout ratio over the last decade (source: YCharts)

Union Pacific's dividend has risen by leaps and bounds from a quarterly $0.455 in 2014 to $1.30 currently, an average annual increase of more than 11%.

But something seems off

If we take a look at the net income of Union Pacific, we can see that the net income has increased from a level of around $4.5B ten years ago to $6.72B at this moment:

Graph 4: Union Pacific net income over the last decade (source: YCharts)

This is an increase of 49%, which translates to an average annual increase of only a bit more than 4%. This is not a terrible percentage, but how is it possible that Union Pacific's earnings per share and dividend have grown by much larger percentages than their net income?

The answer is simple: a large decrease in the number of outstanding shares:

Graph 5: Union Pacific number of outstanding shares over the last decade (source: YCharts)

Between now and a decade ago, UNP's share count decreased by about a third. This indirectly increases earnings per share and gives the company more room to pay a growing dividend. If the company can afford this, there's nothing inherently bad about that. So let us focus on these buybacks right now.

Buybacks

We already saw that Union Pacific bought back about a third of their shares during the last decade. Of course, stock buybacks do cost money, so let us take a look at how much this has cost Union Pacific over the last decade, and compare it with their net income:

Graph 6: Union Pacific stock buybacks and net income over the last decade (source: YCharts)

Since 2018, there were multiple occasions when the total amount of money spent on stock buybacks by Union Pacific exceeded their net income. This does not necessarily need to be an urgent problem if the spikes are brief and if the company has the cash to pay for this. But of course, also dividends need to be paid, and if the percentage of dividend increases are higher than the percent of shares which has been bought back, costs of dividend payments rise:

Graph 7: Union Pacific total dividends paid over the last decade, values are negative but dividend payments are increasing (source: YCharts)

If you add up these numbers, it becomes clear that from 2018, Union Pacific spent more on stock repurchases and dividend payments combined than their net income every single year .

This means that the company has to pay for this, either with cash or by taking on more debt. The last is exactly what happened, as we can see in the graph below:

Graph 8: Union Pacific total long term debt over the last decade (source: YCharts)

Of course, it has been historically cheap to take on more debt during the last couple of years. But eventually, this debt need to be paid back or refinanced. Also, it seems less and less opportune to continue to finance growing debt loads which are used to reward shareholders with current higher interest rates.

Are there better options?

Let us take a look at some peers of Union Pacific in order to see if there exist better options. First, we observe the annual net income growth of UNP and some of its peers:

Graph 9: Union Pacific and some peers net income percentual change over the last decade (source: YCharts)

As we can see, Union Pacific performance is quite average here, with CSX ( CSX ) looking good. Canadian Pacific Kansas City ( CP ) data are heavily influenced by their merger in the beginning of 2023, so their data cannot be compared with the others.

Also, let us take a look at whether other railroad companies also took on more debt during the last decade:

Graph 10: Union Pacific and some peers total debt percentual change over the last decade (source: YCharts)

As we can see, Union Pacific's debt percentage increase is much higher than most of its competitors (CP data is likely to be heavily influenced by their merger again).

When we observe net income compared with share buybacks of the different railroad companies, we obtain the following picture:

Graph 11: Union Pacific and some peers net income versus stock buybacks over the last decade (source: YCharts)

Every single of these companies has bought back shares quite aggressively during the last decade (with the exception of CP during the last 2 years), but UNP has been the top dog here in terms of how much their stock buybacks have paralleled and even went over their net income. Canadian National Railway ( CNI ) looks quite good in this graph, having never spent more money on share buybacks than their net income during the last decade.

Valuation and looking into the future

Union Pacific is a steadily growing railway company, but their earnings per share and dividend growth can be deceiving. Since 2018, the company has taken on much debt to finance its share buybacks and dividend growth. While debt has been relatively cheap during the last couple of years, this is not the case anymore.

With the CEO change, the hedge fund pressure and the interest environment, a couple of important things have changed for Union Pacific. I expect that the company will not be able to continue its aggressive share repurchase activities in combination with strong dividend growth during the coming years.

Union Pacific's Q2 earnings news release included the following information about 2023 returns to shareholders:

2023 Capital Allocation:

• Capital plan of $3.6 billion
• Maintain dividend of $1.30/quarter
• No further 2023 share repurchases planned

Also, their presentation listed the following graph, which highlights again how generous their past share repurchase program was:

Figure 1: Union Pacific cash returns to shareholders ( source: Union Pacific Q2 earnings presentation )

Although I believe it is very unlikely that Union Pacific will cut or lower its dividend, their growth is probably going to be more modest during the coming years. Lower dividend growth can indirectly lead to shareholders valuing the company at a lower multiple, and with decreasing share buybacks the stock might experience some strong downward pressure during the coming years. If their dividend growth stagnates, I believe the current normalized P/E ratio of 20 is too rich, and would expect the stock to go down to the range of a P/E ratio of 15-17, especially when treasury bonds yield considerably more. Such a P/E ratio has not been uncommon for Union Pacific in the recent past, and would mean that shares have room to drop to $156-177, a potential drop of more than 20%.

Even though the amount of debt which Union Pacific took on during the last decade might not be an urgent problem, the company quitting the spoiling of shareholders might lead to lower share prices on the short to medium term. I rate Union Pacific a sell for the coming short to medium term.

Graph 12: Union Pacific and some peers normalized PE ratio over the last year (source: YCharts)

When looking at the current valuation (PE ratio) of Union Pacific and its peers (again, CP data is influenced by their merger), UNP is by far the most expensive option in the railroad industry. Based on the data I used in my comparison, although it is the second most expensive stock, Canadian National Railway looks like it could be a good option to investigate as a replacement of Union Pacific in an investors' portfolio, because their earnings growth and relatively modest past share repurchase program.

On the 19th of October, Union Pacific releases its Q3 financial results and we will know more about their potential future plans. If the company announces no new share repurchases and keeps their dividend stable, I believe the stock is ripe for a correction.

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