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The Science of Hitting
The Science of Hitting
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Union Pacific: A Tough Road Ahead

A look at the railroad's first quarter results

April 24, 2020 | About:

Union Pacific (UNP) recently reported results for the first quarter of fiscal 2020.

Following a difficult 2019, when revenues and volumes both declined mid-single digits, UNP started 2020 with a 2.5% decline in freight revenues, with a 7% decline in volumes partially offset by a tailwind from business mix and core pricing gains.

Unsurprisingly, given the significant impact on the global and U.S. economies from Covid-19, it’s about to get a lot worse: for the second quarter, management expects volumes to decline 25%, with quarter to date volumes down 22%. The company withdrew its 2020 guidance.

Despite another quarter of lackluster volumes, Union Pacific reported the best operating ratio (OR) in the company’s history at 59%, as well as the fourth consecutive quarter below 60%. This was a material improvement from the first quarter of 2019, with help from outsized declines in compensation expense and fuel costs. Over the past decade, UNP’s operating ratio has improved by more than 1,000 basis points. 

The first quarter marked a continuation of improvement in operating efficiency and asset utilization, including advances in freight car velocity, locomotive productivity, terminal dwell, fuel consumption and train length. I’ve said this before, but it’s worth repeating: the fact that Union Pacific continues to deliver these results in the face of volume headwinds is impressive. As Chief Operating Officer Jim Vena noted on the conference call, “there are still many opportunities ahead of us to further improve safety, asset utilization, and network efficiency.”

As a result of the declining operating ratio, Union Pacific more than offset the decline in revenues, with operating income climbing 9% year-over-year to $2.1 billion. After accounting for higher net interest expense and a slightly higher effective tax rate, net income increased 6% in the quarter to $1.5 billion. A continued focus on repurchases resulted in a 5% decline in the share count and an 11% increase in diluted earnings per share (EPS) to $2.15 per share. As shown below, the share count has fallen by more than 30% over the past ten years.

The company generated $2.2 billion in cash from operations in the quarter. Cash outflows consisted of $800 million in capital expenditure and $3.6 billion in capital returns to shareholders, including $2.956 billion in repurchases and $660 million in dividends. At the current stock price of $152 per share, the dividend yield is roughly 2.6%.

As those numbers suggest, Union Pacific has continued to rely on outsized debt issuance to fund capital returns. At quarter end, adjusted debt was just shy of $30 billion, compared to $27.6 billion a year ago. The debt-to-Ebitda ratio currently stands at 2.7 times, which is in line with management’s target.

As I have noted in the past, my concern has been that UNP has been running full throttle on the leverage ratio. My worry was that when the economy took a turn for the worse and life became more difficult for UNP, their hands would be tied. Here’s what I wrote a few months ago:

“Personally, I continue to question whether it’s intelligent to go full throttle on the leverage ratio at this point in the cycle for a business that is exposed to cyclicality. In management’s defense, I’ve held that concern for some time now – and during that period, they’ve repurchased tens of millions of shares at an average cost that is well below the current stock price. At least for now, it appears that they’re right and I’m wrong.”

With volumes expected to fall by 25% next quarter, we’re entering an environment that will be much less accommodating to UNP. In management’s defense, this will likely exceed the worst volume declines they saw during the 2008-2009 financial crisis. Unsurprisingly, given what this likely means for profitability and cash generation in the coming quarters, management has suspended repurchases. This is exactly what I expected given the company’s aggressive capital allocation decisions when times were good.

It’s still early, but the decisions UNP has already made just a month or two into the current crisis suggest there may have been some validity to my argument.

Conclusion

Here’s what I wrote after the fourth quarter results:

If the economy continues to provide support for low single-digit volume and revenue growth, accompanied with a lower operating ratio and large share repurchases, the stock will probably do well from here. But if that economic outlook changes, I wouldn’t be surprised if all three of those variables worked against the company – a scenario that would likely coincide with a contraction in the price-to-earnings ratio.”

With Covid-19, the outlook has changed dramatically, and practically overnight. In the coming quarter, we’ll see a significant reduction in the company’s volumes, revenues and profitability. We’ll also see the capital returns tailwind slow dramatically.

I continue to believe this is a high-quality business that I would like to own at the right price. There’s nothing they could’ve done to specifically prepare for a pandemic, but I hope they take this opportunity to revisit their approach to capital allocation.

As it relates to a potential investment in the company, I couldn’t make the math work near $190 per share. At $150 per share, we’re moving in the right direction. I’ll stay on the sidelines for now, but I’m much closer to adding UNP to my portfolio again than I was last quarter.

As noted on the conference call, things could get interesting in the short-term:

“There remains quite a bit of uncertainty surrounding this global pandemic that we are facing. With the freefall in economic indicators over the past few weeks and uncertainty about when we will see the COVID pandemic curve starts to flatten out, an accurate assessment of 2020 is hard to pinpoint at this time.”

Hopefully, this uncertainty will present an opportunity to invest in UNP at a more attractive price.

Disclosure: None

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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