Union Pacific

Union Pacific – Margins Improved Despite Sluggish Volumes

Railroad classes (Class I, II or III) are the system by which freight railroads are designated in North America. The Surface Transportation Board in the US assigned classes according to annual revenue criteria originally set in 1992. With annual adjustments for inflation, the 2019 thresholds were ~$0.505B for Class I carriers and ~$40.4 million for Class II carriers. Smaller carriers were Class III by default.

Union Pacific (UNP)’s, a Class I railroad, history dates back to the 1800s. In addition to having grown by way of acquisitions, its history includes bankruptcy…in 1893.

In addition to UNP, the other Class I railroads are:

  • BNSF Railway (owned by Berkshire Hathaway);
  • Canadian National Railway (CNI);
  • Canadian Pacific Kansas City Limited (CP);
  • Norfolk Southern (NSC); and
  • CSX Corporation (CSX).

The Surface Transportation Board maintains a National Rail Network Map thus enabling you to see the geographic coverage of the various North American rail networks.

Canadian Pacific acquired Kansas City Southern in December 2021 and Berkshire Hathaway acquired BNSF Railway in February 2010. Further industry consolidation is highly unlikely so investors should not expect much more than organic growth from each Class I railroad.

Occasionally a Class I railroad may acquire a much smaller Class II or Class III (short line) railroad. These acquisitions, however, do not have a material impact on a Class I railroad’s results.

In December 2023, for example, Canadian National Railway signed and closed an agreement to acquire Iowa Northern (IANR), an approximately 275-mile U.S. Class II (regional) railroad that it interchanges with in Waterloo and Cedar Rapids. The transaction has closed into an independent voting trust pending regulatory review by the Surface Transportation Board with a decision expected in 2024.

Railroads are attractive in that the barriers to entry are so high. It is to lay thousand miles of new track. Secondly, the approval process is extremely rigorous. As a result, the limited number of Class I rail carriers is unlikely to change in the foreseeable future. UNP and BNSF are the only options if goods imported to the US from the Far East require rail transport.

On the other hand, the capital intensive nature of the industry also has its drawbacks. Annual capital expenditures (CAPEX) are typically in the billions of dollars. Class I railroads need to spend this type of money annually just to remain competitive. A railroad that skimps on maintenance CAPEX coud inevitably encounter costs that exceed maintenance CAPEX.

Rail Accidents

Another consideration when investing in North American railroads is rail accidents.

The Federal Railroad Administration (FRA) Office of Safety Analysis website allows users to screen by rail carrier, accident cause, and other metrics.

This USA Facts website site shows that over the past decade an average of 1300 trains have derailed annually accounting for ~61% of all train accidents. This, however, is much lower than the 9400 derailments in 1978!

In 2023, the FRA sent a team of inspectors to determine the cause of a shipping container filled with toxic acid that exploded in a remote corner of UNP’s Bailey Yard in North Platte, Nebraska, about 250 miles west of Omaha in September 2023. The findings call into question the decision to load dozens of plastic barrels of perchloric acid inside a shipping container with a wood floor and possibly atop wooden pallets, even though this acid is known to react with wood or any other organic material.

The resulting explosion propelled shrapnel up to 600 feet away prompting first responders to evacuate everyone within a mile outside the railyard. Following the explosion of one container, a second metal shipping container fell on top of the first and also caught fire. No other cars, however, ignited.

The FRA claims UNP managers undermined the U.S. government’s efforts to assess safety at the railroad in the wake of several high-profile derailments (and other accidents) by coaching employees on how to respond to federal regulator inquiries.

The Federal Railroad Administrator wrote a letter to UNP’s top 3 executives stating that inspectors identified a 19.93% defect rate on rail cars and 72.69% defect rate for locomotives; both are twice the national average. While the letter did not detail the nature of the defects found in the Bailey Yard in North Platte, the Administrator wrote that:

The compliance of the rolling stock (freight cars and locomotives) on the UNP network is poor, and UNP was unwilling or unable to take steps to improve the condition of their equipment.

Furthermore, the FRA claims that UNP management intervention was so widespread across UNP’s 23-state network that the FRA suspended its safety assessment of the company. UNP, however, claims the issue was limited to one department.

The explosion at the North Platte Bailey Yard highlights:

  • potential problems at UNP’s sprawling railyard; and
  • the national rail network’s reliance on all involved parties to ensure proper precautions are taken with the shipment of hazardous materials.

It is evident that problems are often difficult to identify before potentially disastrous accidents occur.

Looking at rail accidents from a different perspective….

Not all rail accidents, however, are attributable to the rail carrier. Trains do not stop on a dime yet how many times have we seen drivers decide that flashing lights and lowered barriers at rail crossings do not, for whatever reason, apply to them?

In addition, natural disasters (floods, avalanches, earthquakes, tornadoes) can lead to rail accidents.

We also have to consider that the frequency of transport trucks accidents is far greater than rail accidents. Truck accidents, however, are generally not as disastrous and typically do not make national news. Furthermore, not all truck accidents are the result of driver error. How many times have you seen cars swerve in front of a truck?

Just imagine how many more vehicle accidents we could have if our rail system was non existent!

Statistics are merely statistics. Unless we know the cause of these accidents, we can not pass judgment.


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Business Overview

The best way to learn about UNP is to review the company’s website and the Part 1 of the most recent Form 10-K.

Part 1 Item 1 in UNP’s FY2023 Form 10-K describes the company.

Union Pacific Railroad Company is the principal operating company of Union Pacific Corporation. One of America’s most recognized companies, Union Pacific Railroad Company connects 23 states in the western two-thirds of the country by rail, providing a critical link in the global supply chain. The Railroad’s diversified business mix includes Bulk, Industrial, and Premium. Union Pacific serves many of the fastest-growing U.S. population centers, operates from all major West Coast and Gulf Coast ports to Eastern gateways, connects with Canada’s rail systems, and is the only railroad serving all six major Mexico gateways. Union Pacific provides value to its roughly 10,000 customers by delivering products in a safe, reliable, fuel- efficient, and environmentally responsible manner.

Financial Review

Q1 2024 Results

The Q1 2024 results are available in the Form 8-K and Form 10-Q in the SEC Filings section of UNP’s website.

Operating revenue of $6B was flat versus Q1 2023 on a 1% volume decline that was significantly driven by a 20% reduction in coal shipments. Excluding coal, volumes would have been up ~2% YoY in what the company is classifying as a tough freight environment.

In Q1, UNP’s net income of $1.6B or $2.69/share versus $1.6B of $2.67/share in Q1 2023 The Q1 2023 results included a $0.14/share non-recurring real estate gain.

Core pricing gains and a positive business mix were offset by lower fuel surcharge revenue and reduced volumes. Normalizing for the impact from fuel surcharge, freight revenue was up 4% versus Q1 2023. Expenses YoY were down 3%, driven by lower fuel prices and productivity gains. This was partially offset by inflation, increased transportation workforce levels to compensate for new labor agreements and higher depreciation.

The Q1 operating ratio of 60.7% improved 140 basis points (bps) versus Q1 2023. This also represents a 20 bps improvement from Q4 2023.

The Q1 workforce levels decreased 2% as reductions in non-transportation employees more than offset a 4% increase in UNP’s active train, engine and yard (TE&Y) workforce; the TE&Y workforce is responsible for moving trains.

UNP’s training pipeline is significantly reduced. It, however, continues to carry additional train services employees as a buffer for its operations and to offset the impact of newly available sick pay benefits and employment agreements.

Equipment and other rents declined 8%, reflecting a more fluid network seen through improved cycle times and lower lease expenses. By controlling certain controllable expenses in its cost structure, UNP was able to generate $2.4B of operating income representing a 3% increase from Q1 2023.

UNP’s interest expense also declined 4% on lower average debt levels.

Operating Cash Flow (OCF) and Free Cash Flow (FCF)

In FY2014 – FY2023, UNP generated OCF of approximately (in billions of $) 7.385, 7.344, 7.525, 7.230, 8.686, 8.609, 8.540, 9.032, 9.362, 8.379, and ~2.122 in Q1 2024.

In FY2014 – FY2023, UNP generated FCF of approximately (in billions of $) 3.039, 2.694, 4.020, 3.992, 5.249, 5.156, 5.613, 6.096, 5.742, 4.773, and ~1.325 in Q1 2024.

FCF is a non-GAAP metric, and therefore, its means of calculation is not standardized. The method of calculating FCF that I have seen used the most is the deduction of CAPEX from FCF. UNP, however, calculates FCF and the cash flow conversion rate as reflected below.

UNP-Cash-Flow-Conversion-Rate-Q12024-and-Q1-2023
UNP-Cash-Flow-Conversion-Rate-FY2023-and-FY2022

Depreciation often serves as an indicator of investment requirements to maintain assets in good operating condition.

The annual depreciation (in billions of $) was ~$2.191, ~2.216, ~$2.21, ~$2.208, ~$2.246, and ~$2.318 in FY2018 – FY2023. In Q1 2024 it was ~$0.594.

Annual CAPEX (in billions of $) was 4.346,4.650, 3.505, 3.238, 3.437, 3.453, 2.927, 2.936, 3.620, and 3.606 in FY2014 – FY2023. In Q1 2024 it was ~$0.797 and the FY2024 CAPEX outlook is unchanged from prior guidance of $3.4.

At its November 2023 investor conference, UNP’s CEO stated that UNP was considering routes where it can cut transit times to be more competitive with trucks and other railroads.

Recently, UNP tightened its domestic intermodal schedules between the Los Angeles Basin and Chicago by two days. In doing so, it can now offer 3-day transit time that is competitive with team driver truck service. This CAPEX now allows UNP to offer 70-mph service thus enabling to compete for business, while reducing greenhouse gas emissions up to 75%.

Looking at the historical data, it is clear that Class I railroads are very capital intensive.

Return On Invested Capital (ROIC)

In FY20214 – FY2023, UNP’s ROIC (%) was 17.41, 15.26, 13.35, 29.02, 15.63, 15.17, 13.74, 16.29, 17.2, and 15.36.

High quality companies often generate a high ROIC. If a company generates a high ROIC, it needs to invest less to achieve a certain growth rate thus reducing the need for external capital.

A company that generates $0.15/profit for every $1 invested, for example, achieves a ROIC of 15%. I consider a ~15%+ ROIC to be a reasonable minimum threshold because most of the time, a company’s cost of capital will be lower than this level. In 8 of the past 10 fiscal years, UNP’s ROIC has exceeded 15%!

When a company consistently generates a high ROIC over the long term and it is growing its revenue, it can reinvest a portion of its profits under favorable conditions thereby leading to a compounding effect. I would much rather invest in a growing company that can reinvest to create greater shareholder value than to invest in a company that has limited growth opportunities and thus chooses to distribute a growing dividend.

FY2024 Outlook

The following reflects UNP’s 2024 outlook.

UNP-FY2024-Outlook-April-25-2024-1
Source: UNP – Q1 2024 Earnings Presentation
UNP-FY2024-Volume-Outlook-April-25-2024
Source: UNP – Q1 2024 Earnings Presentation

Its overall outlook on the freight environment is the same as that communicated earlier this year; it still sees economic uncertainty.

UNP anticipates continued challenges in coal as inventories are projected to be at record levels and natural gas futures remain depressed.

UNP is closely monitoring grain, particularly as it relates to new crop conditions and Q4 export demand. Domestic grain demand, however, is expected to be stable and growth is anticipated in biofuel feedstocks. UNP also recently won incremental grain products business out of Iowa that started moving earlier in 2024.

Petroleum and petrochem markets are expected to remain favorable.

The domestic intermodal side of the business continues to be weak.

On the international intermodal side of UNP’s business, it expects to see consistent strong West Coast imports in the near term. On the Q1 earnings call, however, management stated it is too early to predict what will happen in the second half of FY2024.

UNP expects continued strength in automotive due to business development wins and improved OEM production.

Risk Assessment

UNP repaid $1.358B of debt in March and issued $0.4B of new debt. It also issued $0.298B of commercial paper with maturities
ranging from 29 to 57 days. A the end of Q1, it had $0.298B of commercial paper with a weighted average interest rate of 5.4% outstanding.

At the end of Q1, UNP’s adjusted debt-to-EBITDA ratio declined to 2.9x from 3x at FYE2023.

Debt/Net Income for the trailing 12 months ending December 31, 2023 and March 31, 2024 is 5.1 and 5, respectively.

UNP filed an automatic shelf registration statement with the SEC that became effective on February 13, 2024. The Board authorized the issuance of up to $9.0B of debt securities, replacing the prior authorization which had $5.6B of authority remaining. Under this shelf registration, UNP may issue any combination of debt securities, preferred stock, common stock, or warrants for debt securities or preferred stock in one or more offerings.

During Q1, UNP did not issue any debt securities under this registration statement.

Moody’s currently assigns an A3 rating to UNP’s domestic senior unsecured debt. S&P Global and Fitch assign an A- rating. The outlook is stable from all 3.

All 3 ratings are the bottom tier of the upper medium grade investment-grade category. They define UNP as having a strong capacity to meet its financial commitments. UNP, however, is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.


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Dividends and Share Repurchases

Dividends and Dividend Yield

UNP’s dividend history reflects a $1.30 quarterly dividend since the June 30, 2022 dividend payment date.

Dividend metrics should not determine investment decisions. In some instances, dividend distributions are not the most optimal means by which a company can allocate its capital.

The case for/against dividend income depends upon your personal circumstances. The following are just a few things to consider.

  • Are shares held in tax efficient or taxable accounts?
  • Your marginal tax rate.
  • Are you a non-resident? If you hold UNP shares in a taxable account and you are a Canadian resident, for example, you incur a 15% dividend withholding tax.

Focusing primarily (solely?) on dividend metrics is apt to result in poor investment decisions. Look at an investment’s total potential shareholder return (dividends AND capital gains).

Share Repurchases

In FY2014 – FY2023, UNP’s weighted average diluted outstanding shares (in millions) is ~901, ~869, ~835, ~802, ~754, ~706, ~679, ~655, ~624, and ~610. In Q1 2024 it was ~610.

Effective April 1, 2022, UNP’s Board authorized the repurchase of up to 100 million shares by March 31, 2025. As of March 31, 2024, UNP repurchased a total of 19.6 million shares under this authorization. Management’s assessments of market conditions and other pertinent factors guide the timing, manner, and volume of all repurchases.

In Q2 2023, UNP paused all share repurchases and did not expect to be back in the market for the remainder of 2023. This decision was made in recognition of cash flows that were negatively impacted by the current environment which resulted in lower volumes and higher costs. The decision was no reflection of UNP’s existing capital allocation strategy:

  • reinvest in the business;
  • dividend distributions; and
  • share repurchases.

On the Q2 earnings call, management stated that UNP plans to restart share repurchases in Q2 2024.

Valuation

UNP’s FY2014 – FY2023 PE levels based on GAAP earnings are 22.02, 13.51, 20.78, 23.73, 9.28, 21.32, 26.52, 26.97, 18.49, and 23.57.

As I compose this post, UNP shares trade at ~$240 and UNP generated $2.69 in diluted EPS in Q1. The following are the current forward-adjusted diluted EPS broker estimates by which to estimate UNP’s forward adjusted diluted PE:

  • FY2024 – 27 brokers – ~21.2 using the mean of $11.33 and low/high of $10.88 – $11.70.
  • FY2025 – 27 brokers – ~18.8 using the mean of $12.74 and low/high of $10.85 – $13.45.
  • FY2026 – 11 brokers – ~17.2 using the mean of $13.93 and low/high of $10.96 – $15.40.

In Q1 alone, UNP generated ~$1.325B of FCF. If it can generate $1.1B in each of the next 3 quarters, its FY2024 FCF would be ~$4.625B.

The weighted average diluted shares outstanding in Q1 was 0.61B. With management’s plans to restart share repurchases in Q2, it is possible that 0.6B could be the FY2024 weighted average diluted shares outstanding. Using this estimate, the approximate FCF/share is $7.71 ($4.625B/0.6B).

Divide the current ~$240 share price by $7.71 and we get a P/FCF of ~31.1.

It is not surprising that UNP’s P/FCF projection is higher than its forward adjusted diluted PE. As noted earlier in this post, the cash flow conversion rate in Q1 2024 was 81% (66% in Q1 2023) and 75% and 82% in FY2023 and FY2022.

Final Thoughts

UNP’s FY2014 – FY2023 Revenue (in billions of $) is 23.99, 21.81, 19.94, 21.24, 22.83, 21.71, 19.53, 21.80, 24.88, and 24.12. Q1 2024 revenue was just over $6B. Top line growth is anemic but we can not compare UNP’s results against rapidly growing and less capital intensive businesses.

Class I railroads are generally a bellwether of economic growth and they are generally good at forecasting how different industrial sectors are likely to perform. This is because they receive input from their customers who need to ensure that the railroads can deliver their products in a timely manner. It makes no sense for grain producers, for example, to produce grain only to have the grain sit in silos because of a logistics oversight.

I have exposure to UNP, CNI, CP, and BNSF knowing that Class I railroads are an oligopoly. Looking at the National Railway Network Map, we know the existing North American rail network is very unlikely to change significantly. CSX, for example, is unlikely to expand its network to encroach on UNP’s turf.

Naturally, UNP’s financial results will experience ebb and flows. Fortunately, its customer base is sufficiently diversified so a slump in coal shipments, for example, might be offset by strength in the petroleum and petrochemicals sectors.

My concern with UNP lies with its current valuation; it becomes increasingly difficult to generate a reasonable total rate of return when we purchase richly valued shares. The time to invest in decent companies is when they experience temporary headwinds and have fallen out of favor with many investors. Such does not currently seem to be the case with UNP.

Should UNP be of interest to you, I suggest you place it on your ‘watch list’. Something will happen to make its valuation more appealing. I just don’t know when this will happen.

I wish you much success on your journey to financial freedom!

Disclosure: I am long UNP, CNI, and CP. I disclose holdings held in the FFJ Portfolio and the dividend income generated from the holdings within this portfolio. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

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I am a self-taught investor and run the Financial Freedom is a Journey blog. I have invested in the North American equities markets for over 34 years. I retired from a career in banking and continue to invest as this is something about which I am passionate.

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