2023-07-26 13:51:05 ET
Summary
- Union Pacific faced challenging earnings due to macro headwinds affecting volumes and sticky inflation, but benefits from business improvements.
- The announcement of Jim Vena as the new CEO is well-received by shareholders, as he has a strong track record in the industry.
- Despite a strong long-term outlook, caution is advised, and waiting for a short-term decline before buying is recommended.
Introduction
It's time to talk about Union Pacific ( UNP ) , my current largest investment. This company is also a holding in almost every single portfolio that I advise and manage.
This may not come as a surprise to most readers, as I have frequently covered this stock in recent years - for almost a decade.
After consistently buying this stock below $200, we get to discuss two important things in this article.
- The company's earnings. These were challenging, as macro headwinds are doing a number on volumes. Meanwhile, inflation remains sticky. While the company lowered its guidance, it did benefit from ongoing business improvements that are likely to have a lasting positive impact on its operations.
- The new CEO. As I discussed earlier this year, UNP was looking for a new CEO. Today, the company announced that Jim Vena, likely the desired candidate of most shareholders, is taking over from Lance Fritz. This also helps explain the stock price surge!
Now, let's dive into the details as we discuss the risk/reward at current levels.
Union Pacific Shareholders Love The New CEO
The second quarter of this year was challenging. I cannot sugarcoat that.
For example, revenue came in at $5.96 billion, which was $160 million below estimates and 4.9% below the prior-year quarter. GAAP EPS came in at $2.57, which missed estimates by $0.20.
So, a double miss.
That was not an encouraging start when I started researching the quarterly performance.
The outlook was also disappointing, but I'll get to that in a bit.
What saved the day was the announcement of a new CEO.
During the earnings call, the company announced that Jim Vena would take over for Lance Fritz in August.
Mr. Vena was the candidate of choice of activist hedge fund Soroban Capital Partners, who urged the company to make changes earlier this year. I covered this in great detail in an article published in March titled Why Union Pacific Could Potentially Double By 2025.
I believe that Vena is the perfect candidate for the job.
This is what I wrote in the aforementioned article:
Jim Vena was the COO of UNP from 2019 to 2020. During his tenure, UNP was the second-best railroad in terms of shareholder returns. When he served at CNI as VP and COO, the company had the industry's best operating ratio and best safety ratios.
The slide below was used by Soroban to pitch Vena. Not only does he know every detail of UNP's operations, but he's one of the most desired executives in the industry, as he's known for his ability to spot areas of improvement in railroad operations.
This is definitely something UNP needs after its somewhat lackluster performance during the past few years and a lot of supply chain-related issues that upset some customers after the pandemic.
I'm not blaming this on Lance Fritz, but I think it's a good thing Jim Vena is taking over, given his track record.
Investors seem to agree, as UNP shares are soaring more than 10% while I'm writing this.
As this is my largest position, I'm obviously quite happy at the moment - especially because I was such a public supporter of the company when it was below $200.
Having said that, it's too early to take a victory lap. Way too early.
Now, we need to look into the company's numbers and guidance. After all, we need to assess the risk/reward at current prices.
2Q23 Wasn't Something To Write Home About
I already briefly mentioned that UNP missed both revenue and EPS estimates.
During its earnings call, the company made clear that the business environment in the second quarter faced challenges, with volume down 2% due to weak market conditions in premium and bulk business groups.
The decline in volume led to a 5% decrease in freight revenue, which was partly offset by solid core pricing gains.
While certain markets experienced growth, consumer-facing markets remained soft, causing the volume decline. This mainly applies to intermodal, which is extremely consumer-focused. Total premium revenues were down 11%.
Key sectors such as bulk commodities and industrial also faced various challenges, including reduced grain supply and weaker industrial production levels.
On the other hand, the automotive sector saw growth driven by strong OEM production and inventory replenishment, which is a secular growth trend caused by easing post-pandemic supply chain bottlenecks. It's a tailwind now, but not sustainable growth.
However, in general, I have to say that I am pleased with the 2% decline in total carloads. I expected worse. I'm especially pleased with the strength in industrial chemicals, metals, and energy. These cyclical segments tend to do much worse in economic environments like we're currently witnessing.
Unfortunately, the revenue performance was worse than that, as I already highlighted.
The decrease was primarily caused by lower year-over-year volume and a reduction in fuel surcharge revenue, impacted by falling fuel prices and surcharge program lags. Sometimes, these lags are tailwinds. Sometimes they are headwinds. I wouldn't read too much into this, as it's a timing issue.
Furthermore, On the positive side, the combination of price and mix in the quarter increased freight revenue by 150 basis points, which reflects strong pricing in certain markets.
However, the mix remained negative due to fewer lumber shipments and more short-haul rock shipments, offsetting the positive impact of lower intermodal volume on pricing. Bear in mind that rails make much more money on bulk than on intermodal.
With that said, expenses are almost as important as revenues, as they are a major driver of operating income and (related) profitability.
Looking at the table above, we see that operating expenses in the second quarter totaled $3.8 billion. This was unchanged versus 2Q22. While that is not great, I expected it to be worse, as inflation has proven to be sticky.
- Compensation and benefits expenses increased by $177 million from 2022, with a significant portion attributed to the brake person agreement (more on that later).
- Fuel expenses decreased by 29%, thanks to a 29% decrease in fuel prices.
- Purchased services and materials expenses increased by 5%, driven by inflation, while equipment and other rents rose by 8% due to higher lease expenses for freight cars to support business volumes.
Hence, the operating ratio rose by 280 basis points to 63%, which is not a good performance - but expected given lower revenue, inflation, and wage issues.
Using the overview below, we see that core results were the biggest headwind. Fuel prices were a 200 basis points tailwind.
The 2023 Brakeperson Buyout Payment was a 110 basis points headwind.
This brings me to labor.
During the quarter, Union Pacific has ratified agreements with all 13 of its labor unions, implementing paid sick leave as an important quality-of-life initiative for employees.
This not only improves morale but also helps Union Pacific in improving the attractiveness of jobs at the company. However, it also comes with an additional labor expense that will need to be offset.
The company also allowed for more flexible work schedules, which was a long-term demand of employees and their unions.
While costs are rising, Union Pacific expects a larger training pipeline in the near term and elevated workforce levels in the future as the agreements are implemented. The current forecast indicates an additional 400 to 600 employees when fully implemented.
Despite the costs, the long-term benefits of these agreements include positive impacts on employee satisfaction and improved service, which will enable the company to excel in the marketplace.
Having said all of this, the company also adjusted its outlook.
The Adjusted Outlook
Despite facing challenges in certain consumer-facing markets like intermodal and lumber, UNP remains confident in its ability to meet available demand with its service product.
The outlook for coal has weakened, but there are potential near-term opportunities due to extreme heat. However, the full-year volume outlook is below current industrial production estimates, primarily due to weak demand for consumer goods. This is a big deal, as the company usually aims to grow its volumes above industrial production. Because of poor consumer health, that won't likely be possible this year.
The company plans to continue generating pricing dollars in excess of inflation dollars to offset higher inflation impacts. However, it also expects a shift in fuel prices from a tailwind to a headwind, potentially resulting in a negative impact of around $0.50 per share in the second half of the year.
Nonetheless, I'm still very satisfied with the pricing power of railroads, which is why I'm not too worried about the pricing power comments.
The aforementioned implementation of labor agreements, including sick leave agreements and the brake person agreement, will result in upfront costs.
The sick leave agreements are expected to add roughly $50 million to labor expenses in the second half of 2023, and the expected payback period for the brake person agreement is approximately two years.
Additionally, the company anticipates potential challenges in the intermodal market due to continued inventory destocking, inflationary pressures, and shifts in consumer spending.
The good news is that UNP expects growth in automotive shipments to continue, driven by strong OEM production and high shippable ground count.
Shareholder Distributions & UNP Stock Valuation
Let's start with the bad news.
In the first half of 2023, Union Pacific's cash from operations decreased to $3.9 billion from $4.2 billion in 2022. The main contributing factor was $445 million in payments related to the aforementioned labor union agreements.
These payments obviously also had an impact on the company's free cash flow and cash flow conversion rate.
Having said that, year-to-date, the company returned $2.3 billion to shareholders through dividends and share repurchases. Additionally, Union Pacific finished the second quarter with an adjusted leverage ratio of 2.9x (EBITDA), bringing it back to 2022 levels.
The company's credit rating remains strong at A, as rated by all three credit agencies.
In other words, this should somewhat ease the worries of people who believe that UNP is spending too much on buybacks. I've always made the case that UNP only took on debt to repurchase shares in recent years because its debt level was unnecessarily low. It remains flexible in spending and I believe it will always protect its balance sheet.
Furthermore, the company currently yields 2.2%. This is backed by a 47% payout ratio and 16 years of consecutive dividend growth. The five-year average annual dividend growth rate is 13%.
With regard to the valuation, UNP is expected to generate $6.4 billion in free cash flow next year. This will obviously change dependent on the direction of the economy and potential business improvements caused by Jim Vena. However, for now, this implies a 4.4% free cash flow yield - or a 22.7x free cash flow multiple.
Given that the long-term median is 24x free cash flow, it implies roughly 7% more upside to the company's fair value.
This would put the current fair value at roughly $252.
The current target price is $220. While I expect that number to increase, I'm once again one of the most bullish analysts.
On a long-term basis, I expect the stock to rise to $400, which was my long-term base case established in the article I mentioned in the introduction.
FINVIZ
With all of this in mind, I do NOT suggest that investors jump in at current prices. I hate chasing rallies. This is no exception.
I was lucky (dare I call it skill? - I'm joking) to buy aggressively below $200. Now, I won't buy until we get another short-term decline.
Given economic developments, I believe we are not out of the woods yet. As much as I believe Jim Vena deserves this stock price jump, the earnings call revealed weaknesses.
If economic growth continues to decline, we'll, more than likely, get another buying opportunity.
I will maintain a bullish rating. However, bear in mind that this is my longer-term outlook. Short-term corrections are likely.
Takeaway
Union Pacific remains my largest investment and a crucial part of my advised portfolios. Despite facing challenges in its second quarter, including missed revenue and EPS estimates, there's reason for optimism.
The announcement of Jim Vena as the new CEO, a candidate known for his operational expertise, has sparked a surge in the stock price.
While the current outlook is not without risks, I believe the company's strong pricing power and focus on improving operations will have a lasting positive impact.
As a long-term investor, I see the potential for UNP to reach $400, but I'm not advocating buying at current levels.
Economic uncertainties may lead to short-term declines, presenting better buying opportunities.
I remain bullish on UNP but advise cautiousness and strategic entry points to maximize returns.
For further details see:
Union Pacific Stock Goes Boom, Is It A Buy Now?