2023-07-05 07:03:03 ET
Summary
- Union Pacific shares have returned a loss of 1.4% in the past 10 months, with the company's interest expense expected to continue growing.
- Traffic figures indicate a sluggish North American economy, with intermodal activity dropping 37.5% from the previous year.
- Despite a 3.3% increase in revenue for the most recent quarter, input costs have resulted in a 3.5% decrease in operating income compared to the same period last year.
It’s been about 10 months since I wrote my cautious note about Union Pacific Corporation ( UNP ) stock, suggesting that short puts were the most compelling way to “play” the stock. In that time, the shares have returned a loss of 1.4% against a gain of 15.6% for the S&P 500. The company has obviously reported financials since then, so I thought I’d review those and compare them to the valuation here. Additionally, I thought it would be helpful to comment on what we’ve seen with traffic, as ultimately that’s where the steel wheel meets the rail. If the amount of traffic hauled slows down, revenue and net earnings growth is sure to follow eventually.
Welcome to the “thesis statement” of my article. It’s at this point where I give the people who want to know my opinion, but definitely don’t want to read my bad jokes exactly what they need. You’re welcome. While it’s more attractively priced than it was previously, I’m going to continue to eschew the shares here for a few reasons. First, I think the interest expense will continue to grow, given the company's apparent propensity to add more debt. This will obviously start to act as a significant break on the dividend increases investors have grown accustomed to over the past several years. Second, an investor can receive just under 300 basis points more on a risk free investment at the moment. Since we’re all trying to find the best risk adjusted returns we can, it makes no sense to buy this stock in this context. Third, although the stock is cheaper, it’s not “cheap” by any stretch of the imagination. This is troublesome in the context of the obviously slowing traffic in my view.
Traffic Trends
I’ve compiled the latest traffic figures and put them in a handy table for your enjoyment and edification below. When I review the latest traffic figures, a few things leap out at me. First, intermodal activity has dropped off the proverbial cliff, down fully 37.5% from the same period a year ago. This is alarming, because this is actually a relatively constant series. For instance, the intermodal trailer business was about 83,795 containers to this point in 2019, virtually identical to what it was in 2022, so the sudden drop this year is noteworthy in my view. Most relevant, though, is the fact that traffic is down slightly from the same period a year ago. I look at rail traffic patterns, because I think such things offer some insight into the health of the North American economy. Based on these figures, I’d suggest to you that the overall economy is a bit sluggish at the moment.
Finally, if you review these figures, you may push back on the claim that these traffic numbers indicate that the economy has slowed, given that motor vehicle transport is up about 14% from last year to this. That may say more about 2022 than it does 2023, though. The fact is that the “higher” figure in 2023 is still 21,748 carloads lower than it was in 2018.
Unless something radical happens, I don’t expect much growth here over the next few years. That’s obviously going to inform my assessment of the investment worthiness of this business.
Union Pacific Traffic (Union Pacific investor relations)
Financial Snapshot
In spite of the slowdown in traffic compared to the same time last year, revenue for the most recent quarter was up about 3.3%. The problem is that input costs ate away those gains, and operating income was actually down about 3.5% compared to the same time last year. Net income over the same period was flat. Earnings per share managed to grow by about 3.9%, though, because there were about 3% fewer shares outstanding this year than last. So, EPS eked out a very small gain as a result of financial engineering.
At the same time, the company has about $1.5 billion more debt on the books than it did this time last year. That obviously increases the risk here, and the 9.5% uptick in interest expense over the past year may eventually crowd out dividend increases. To put the current interest expense in context, the company spent $336 million on interest payments, while spending $795 million on dividends. In my view, when interest expense represents about 42% of dividend payments, the growth potential of the latter is muted to some degree. Although I don’t like the level of long term debt here, I will acknowledge that most of it matures post 2027, per the following that I plucked from page 35 of the latest 10-K for your reading pleasure:
Union Pacific Contractual Obligations (Union Pacific 2022 10-K)
So, I don’t think there’s risk of a solvency crisis or anything like that here. The problem is that investors have grown to expect dividend growth, and that expectation may be dashed soon. Specifically, the dividend payment has grown at a CAGR of about 11.5% over the past 9 years. If the debt and resulting interest payments aren’t restrained, that growth will be a thing of the past. Based on conversations I’ve had with rail investors I can imagine that many of them cannot conceive of this, and they remain of the opinion that 11.5% growth can continue because “reasons.” The math of ever higher interest expenses will eventually collide with expectations of future dividend growth, though. In short, at some point, math doesn’t really care about hopeful opinions.
In spite of this sclerotic performance, I’d be happy to buy this stock at the right price.
Union Pacific Financials (Union Pacific investor relations)
The Stock
My view that the “business” and the “stock” are different things has been seen as controversial by different groups over time, especially rail investors who might misunderstand what the phrase “you’re not buying a stock, you’re buying a business” means. In my view, the business makes money by offering bulk transportation services, while the stock is a scrap of virtual paper that represents a claim on the cash flows of the business. The issue is that the stock gets traded up and down based on the crowd’s rapidly, and ever-changing moods. The crowd may become enamoured of a given stock because of an optimistic forecast put out by a popular analyst. The stock may move higher or lower because of expected changes in interest rate policies. The stock may be driven up in price because management spends shareholder capital on buybacks, which might be done in a “price insensitive” manner. For these and other reasons, the stock is often a very poor proxy for the underlying business, which is why I treat it as a separate element.
In my experience, the only way to profitably trade stocks is by buying when crowd expectations become too pessimistic, and selling when the crowd becomes too optimistic. Another way to say "too pessimistic" is "cheap" which is why I like to buy shares that are cheaply priced. I should also point out that no one's going to give you the shares of a wonderful company for a cheap price. In order to acquire shares cheaply, the company in question has to have some "hair" on it. There have to be identifiable problems, which is why I like it when one of you people rushes to my comments section to tell me that I’m crazy to buy a given stock because of this problem or that.
Anyway, I measure "cheap" in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value, like earnings, sales, book value, and the like. I want to see a company trading at a discount to both its own history and the overall market. When I last reviewed UNP, the PE was about 20, and the dividend yield was 2.3%. Fast forward to today, the traffic is lower by about 2%, and the shares are about 9% cheaper on a PE basis per the following, which I find compelling.
Source: YCharts
Source: YCharts
The problem, from my perspective, is the fact that the dividend yield is about 290 basis points lower than the risk free rate . I previously suggested stock investing is about playing expectations, by buying when the crowd's expectations are too dour, and selling when the crowd becomes too rosy. Being a bit of a math nerd, I want to try to quantify expectations as much as possible, and to do that I turn to the works of Stephen Penman and/or Mauboussin and Rappaport. The former wrote a great book called "Accounting for Value" and the latter pair recently updated their classic "Expectations Investing." These both consider the stock price itself to be a great source of information, and the former in particular helps investors with some of the arithmetic necessary to work out what the market is currently "thinking" about the future of a given business. This involves a bit of high school algebra, where the "g" (growth) variable is isolated in a standard finance formula. Applying this approach to Union Pacific at the moment suggests the market is assuming that earnings will grow at a rate of about 5% in perpetuity. This is fairly optimistic in my view.
In my view, the shares range between "fairly priced" and "expensive." Additionally, an investor can take on far less risk by buying government securities, and earn just under 3% more in the bargain. Taking on more risk with stocks while being paid considerably less makes little sense to me. The spread between the risk-free rate and the dividend yield is likely to be maintained in my view, given the rather large interest expense here. Put another way, I don’t expect the dividend to rise much, so I don’t expect this spread between the risky stock and the risk free government instrument to shrink.
For further details see:
Still Avoiding Union Pacific