2023-09-03 09:46:12 ET
Summary
- Union Pacific has reported disappointing earnings.
- Yet, the company is one of America's most important businesses.
- In this article I explain how I am considering and assessing the current situation after Jim Vena has been appointed as CEO.
Introduction
Union Pacific (UNP) Railroad is one of America's iconic companies, serving the western two-thirds of the country by rail. Even though it is exposed to the major West Coast and Gulf Coast ports and to many fast-growing cities, in the past few years its performance has disappointed more than one of its shareholders up to the point it had to appoint a new CEO , choosing Jim Vena.
We are before a company with a huge moat whose returns have mainly been boosted to huge buybacks, while its operating efficiency deteriorated. In this article, I would like to show why this company is currently a dilemma. On one side, it keeps on performing inefficiently. On the other, it has a unique network and has many reasons to be considered a one-of-a-kind business. What will make the needle move will surely be linked to how the new management operates.
Summary of previous coverage
I got interested in Class-1 railroads when I studied how Warren Buffett chose to invest in BNSF, acquiring it all. This was an important turn-around in Buffett's investing style because it helped him understand what can make a capital intensive business an alluring investment.
In short, I researched and found out the main criteria Buffett used to assess his railroad. Since then, I have been covering the other 5 publicly traded railroads to understand if and when to invest in them. To those readers who want to understand the foundation of my research, I recommend reading this article: " Learning From Buffett and Berkshire About Investing In Railroads: The BNSF Case Study ".
Here are the main metrics to assess a railroad like Buffett:
- earning power (ability to cover interest, calculated as pre-tax earnings/interest expense) must be high, to prevent the company from being distressed even during tough economic cycles. This is crucial for companies whose capex and debt is usually high
- operating efficiency: not only the operating ratio but also the really important fuel-efficiency
- use of capital ((I)): an important metric is ROIC to see the returns a railroad has from its use of capital.
- use of capital ((II)): although dividends and buybacks are much welcomed by investors, a railroad needs to invest to maintain and improve its assets, from time to time railroads tend to raise debt for massive buybacks, but this can endanger a balance sheet
- As always, Buffett teaches the value of a company is linked to the present value of its future cash flows
A few months ago, I published another in-depth article to study the financials of the company from 2012 to 2022. The most important results outlined were these:
- Union Pacific's top-line growth has been minimal, (13.26% in ten years)
- Operating income has grown much faster: 60% since 2012
- This is explained thanks to the implementation of PSR (precision scheduled railroading)
- EPS growth has been 270% from 2012 ($4.14) to 2022 ($11.21)
- This was possible because of huge buybacks which made the company repurchase around 33% of its stock since 2012
- This was done not only through FCF, but also by increasing debt as I showed in this graph
Author with data from UNP Sec Filings
While in a low rate environment this could be still an acceptable move (the company uses its high credit rating to borrow cash and then hand it over to its shareholders at no interest) it is not something I like. In fact, it is unsustainable over the long run. This is the main reason why, even though some believe Union Pacific could easily double in a few years if it would concentrate more on efficiency, I don't think we can expect the stock to soar as quick as in the past. As far as I saw it, Union Pacific was starting to lack the possibility to further increase its debt to fund shareholder returns.
Recent Results
When Union Pacific released its Q2 earnings, right from the beginning of the press release it was clear that the report was not going to be that good. In fact, it immediately stated that "softening consumer markets, inflation, a one-time labor expense, and increased workforce levels" had an impact on the quarter. The correct wording should have been: margins decreased as operating efficiency decreased.
The company reported an operating revenue of $6 billion, down 5% YoY. The reason given by the company leads us into one of the main operating aspects of a railroad. Railroads, in fact, apply fuel surcharges based on fuel prices. Usually, the impact of the surcharge has a time lag of about 60 days compared to the commodity price. This means that when fuel prices rapidly increase, Union Pacific will at first experience margin compression because it will have to pay more for the fuel it uses without charging immediately something extra to its customers. On the other hand, when fuel prices come down and the fuel surcharge is still being applied, the company can still charge high prices, increasing its margins. This is clearly shown by this slide taken from the latest results presentation.
UNP Q2 2023 Results Presentation
Business volumes, (measured by total revenue carloads) were down 2%.
In particular, if we break down freight revenues by segment, we see that the only strong increase came from automotive (+11% for the quarter and 14% YtD), which is easily understandable as most automakers are still busy destocking, after the supply chain bottlenecks of last year. The only two other positive sources of revenue are energy and grain, up 8% and 3% respectively for the quarter.
But the most important sign of a slowing economy is the 20% drop in intermodal which helps us feel the pulse of the overall health of freight transportation in and out of the country. As said, Union Pacific is particularly linked to the West Coast. The manufacturing reshoring process which is trying to move part of this activity back from Asia to North America may actually hurt this source of revenue. However, being Union Pacific also linked to Mexico and the Gulf Coast should at least partially offset the impact of this undergoing process.
Now, let's look at a few other items of the report before we move on to our "Buffett-metrics".
The operating ratio spiked up to an unexpected 63.0%, which is an increase of 280 basis points.
Therefore, operating income was down 12% YoY to $2.2. billion.
Union Pacific also pointed out its improved service performance, with higher freight car velocity and locomotive productivity. However, the average maximum train length declined a bit. When traffic decreases, it is easier for a company to operate its trains at an increased speed and productivity. So even this performance improvement is linked to the weakening macro-economic context.
Buffett metrics
Let's see where the company's earning power is at. Considering a TTM pre-tax earning of $8.7 billion and a TTM interest expense of $1.3 billion, the ratio is 6.7. Among railroads it is not the highest, but it can be considered safe since it means that Union Pacific's current pre-tax earnings cover almost 7 times the current interest expense.
In terms of efficiency, we have seen how the operating ratio deteriorated. Now, what I didn't like is to see how fuel consumption rate deteriorated too by 1% to 1.086 gallons of fuel/ 1.000 GTM. In a situation where there is less rail traffic, fuel consumption should improve because trains can seamlessly through the network. Since Union Pacific stored excess locomotives due to decreasing traffic, it may be that the company decided to keep using older locomotives to finish their life-cycle. This is my explanation, because the company didn't give any explanation for this.
Unlike other peers, Union Pacific doesn't report its return on invested capital, so we have to calculate it ourselves. Currently, its ROIC (NOPAT/invested capital) is at 11.5%, which is quite a decrease from the 16.4% where the company was at the time of my last earnings review.
As far as capital allocation goes, we have a big change which, as I have tried to show in my previous research, was warranted.
The company announced it plans on spending $3.6 billion on capex and on maintaining its dividend of $1.30/quarter. The big news is this: "no further 2023 share repurchases planned".
Considering Union Pacific spent in the last quarter another $120 million to repurchase its shares, bringing the total amount spent on buybacks at $750 million so far. This was already a big decrease YoY, considering the company spent $3.5 billion for this in the first six months of last year. Pausing share buybacks, though positive for the balance sheet, will cause some downward pressure on the stock. During the earnings call, Union Pacific's CFO Jennifer Hamann explained that
While there's no change to our long-term capital allocation strategy, which is first dollar into the business, industry-leading dividend payment and excess cash to shares, we recognize our cash flows are impacted in the current environment with volumes and costs.
Having a debt/net income ratio of 4.9 and an adj. debt/adj. EBITDA ratio of 2.9 the company clearly had no more room to increase its debt without receiving a credit rate downgrade.
Valuation
Though Mr. Vena has a strong track-record in managing a railroad, the stock is still trading at a rather expensive valuation considering the weakness of the report and weakening economy. Don't get me wrong: railroads have always been a bit expensive, given the great business they are. However, a fwd PE of 21 and a fwd EV/EBITDA of 14.4 don't make Union Pacific a steal right now. In particular, the stock still has not shown how it will trade without the support of the strong buybacks the company used to do. Any weakness that brings the stock in the $190-$200 range could be a chance to initiate or increase a position.
Conclusion
One could ask: if Union Pacific has so many issues, why are you long the stock? I think it is one of the best candidates to see a turnaround story which will leverage its unique footprint thanks to improved efficiency. No doubt about the moat its network gives. Now that the management has changed, I will closely follow the next reports to see if there are signs of improvement which could make me upgrade my rating to a buy.
For further details see:
Union Pacific: What A Dilemma