UNP - Union Pacific: Less Attractive Than The Risk-Free Alternative

2023-10-17 01:17:55 ET

Summary

• Union Pacific Corporation's financial performance has been subpar in my view. Revenue and profits are down compared to last year. The capital structure has deteriorated massively since 2019.
• Traffic has been soft, with total carloads down about 2% for the first 40 weeks of this year compared to last. This softness is coming home to roost obviously.
• In a world where you can earn a higher yield on a "sleep at night", predictable, risk-free investment, why would you buy this?

It’s been a little over three months since I reviewed Union Pacific Corporation ( UNP ). I decided to continue to avoid the shares. Right on time, they went on to jump in price, reaching a peak of $238 before steadily dropping back down in price. From the time I published the article, the shares are up about 4.2%, against a loss of about 1.5% for the S&P 500. The company has reported earnings since, so I thought I’d review those to see if there are compelling reasons to buy at the moment. I’ll make that determination by comparing these results to the current valuation. Additionally, I’m going to make this determination in the context of the current risk-free environment.

You’re busy, and I’m busy, so we don’t have time to wade through articles trying to piece together the writer’s point. This is one of the reasons why I put a “thesis statement” very near the beginning of each of my articles, so you’ll know what my perspective is right up front. This will give you the option to then skip my article before you’re exposed to too many of my tiresome puns or correct spelling. You’re welcome. Anyway, I think it is prudent to continue to avoid this stock at current prices, impenetrable moat, or not. Although we see continued softness in traffic figures, revenue for the first six months of 2023 was down by only about .5% relative to the same period a year ago. Given the lower margins facing many rail customers, their wellspring of patience with higher transport costs is not infinite. Additionally, profit was down substantially from the year-ago period, indicating that higher input costs take a bite out of this business too. Most alarmingly, the level of indebtedness has grown by just under ? over the past four years, and net income has exploded higher as a result. The dividend remains well covered but is far less so now than it was just a few short years ago.

Most troubling is the fact that investors are taking on way more risk than risk-free alternatives while earning much less. The notion of taking more risk and being compensated less doesn’t sit well with me. I feel obliged to remind investors that we’re not seeking “returns.” We’re seeking “risk-adjusted” returns. Put another way, the lower dividend yield means that the stock needs to generate capital gains at a CAGR of about 2% over the next decade just to break even with the risk-free alternative. That is a heavy lift in my view and doesn’t even compensate investors for any of the relative risks here. Given that TINA is no longer “a thing”, as the young people say, why would you buy this?

Traffic Review

You could characterise the traffic patterns I’ve observed earlier as “unchanging” or “intractable”, depending on whether you’re a “glass half empty” person or irrationally optimistic. The fact is that this is a company that is paid to haul stuff, typically very heavy stuff that has a lower per unit cost than many other items. A bushel of microchips is worth much, much more than a bushel of wheat.

Anyway, in spite of a nice 11.4% uptick in motor vehicle transportation, total traffic for the year ending Week 40, 2023 was down about 2.1%. “Farm & Food”, “Metals and Related”, and intermodal containers were down by 4.6%, 4.7%, and 2.7%, respectively. All of this pales in comparison to the eye-watering drop of 36% in intermodal container traffic.

In my view, there are only three points to make at this juncture. This is a company that makes its money by hauling stuff, and you can only squeeze so much juice out of an onion. Thus, at some point, revenue will be affected in lockstep with the slowdown in business.

Financial Snapshot

The latest financial results have been soft in my estimation. Although revenue for the first six months of 2023 was down about .5%, operating income and net income were both down by 7.7%. The rails, just like their customers, are not immune to higher input costs. That written, I think it is fair to point out that compared to the same period in 2019, the most recent half-year was not awful in some ways. Revenue and net income for the first six months of 2023 were higher by 2.2% and 8%, respectively. This is one of those companies that has fully recovered from the pandemic.

One way in which the company is much worse than it was prior to the pandemic is in the capital structure. Over the past four years, the level of indebtedness has grown by 32%, while cash and short-term investments are down by about 25%. It’s no coincidence, then, that interest expenses have exploded higher from then to now, by about $169 million or 33%. Please keep in mind that the most recent interest expense of about $675 million was for the first half of 2023. The company paid only about $506 million in interest by this time in 2019.

Although I think the dividend remains secure, I think its coverage has deteriorated. The payout ratio is now about 49.7%, up from 42% four years ago, and interest took 21% of net income in 2023, up from 17% in 2019. So, the dividend is secure, so I’d be willing to buy, but the price has to be right in my estimation.

The Stock

I've written it before, and I'm absolutely certain that I'll write it again. A stock and a business are conceptually two very different things. This business makes money by hauling stuff around. The stock represents the crowd’s aggregate view about the long-term health of the business. The crowd can be affected by many things, some of which are more relevant to the actual enterprise than others. I’ve also observed that the more you pay for $1 of future gains, the lower will be your subsequent returns. This is why I try my best to buy shares when they are cheaply priced.

The corollary of this is that I seek to avoid companies when they’re priced too richly. This is because there’s a strong negative correlation between the price paid for an investment and the subsequent returns. Given that capital losses cause greater emotional pain than gains of the same magnitude bring happiness, this is a guiding principle of my investing life. I try to never overpay for an investment.

My regulars know that I measure the value of an investment in a few ways, from the simple to the more complex. On the simple side, I look at ratios of stock price to some measure of economic value, like earnings, sales, cash flow, and the like. When I decided to continue to avoid the shares bought back in early July, the P/E ratio was floating around 18.2 times, and the dividend yield was hovering around 2.5%. Fast forward to the present, and the shares are about 6.5% more expensive, and the dividend yield is about 6 basis points lower than it was in July. Coincidentally enough, the spread between the current dividend yield and the 1-year risk-free rate is the same today as it was back in July: 290 basis points .

An argument could be made that the comparison to the 10-Year Treasury Note is more appropriate, though, given that stocks are long duration assets. On that basis, the spread between the current dividend yield and the 10-Year Treasury Note has exploded higher by about 90 basis points, as 10-year yields have spiked higher.

This gets to another of my definitions of “cheaply priced.” We’re not only trading in cash in the public markets in my view. We’re also trading in units of relative risk. In my view, any return needs to be seen in the context of risk needed to endure in order to achieve that return. In my view also, all investment risk is priced off of the “zero risk” option, namely the Treasury Note. So, if an investor buys a stock with a dividend yield that’s about 2% lower than the risk-free rate, that stock is “in the hole” an absolutely minimum 2%, compounded annually over the life of the Note. If we add business risk to this, the stock is even deeper in this proverbial hole, perhaps by as much as 4%. In such a scenario, the stock will need to generate capital gains of a CAGR of 4% to break even with the risk-free investment in my view. That is a heavy lift, in my estimation. Further, I like my sleep, and I like predictability, and so, on a risk-adjusted basis, it makes no sense to buy these shares at the moment. My perspective would have been much different a few years ago, but we’re no longer in the age of TINA, so there very much is an alternative. At the moment, that alternative involves receiving a decent enough “sleep at night” yield.

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