Union Pacific Corporation (UNP, Financial) announced its second 10% dividend increase of the year on Dec. 10. While I generally feel that a double-digit dividend increase is a solid signal from management that the business is performing well, the fact that Union Pacific made a second such raise within a single year is impressive.
This strong streak of divided raises, combined with solid quarterly numbers the last time the company reported, has me believing that Union Pacific, despite some headwinds from supply chain issues and an elevated valuation, is on the right track to continue providing returns for investors.
Recent earnings results
Union Pacific reported its third-quarter earnings results back on Oct. 21. Revenue for the quarter grew 13.2% to $5.57 billion, beating Wall Street analysts’ estimates by $175 million. Earnings per share of $2.57 was a 56 cent, or 28%, improvement from the same period a year ago and 7 cents better than expected.
Union Pacific’s operating ratio improved 240 basis points to 56.3%. Total carloads were flat from 2020, but pricing was up 13.2%.
The bulk category had 14% revenue growth, driven by a 9% increase in price per car load and a small contribution from a gain in volumes. Within this category, coal and renewables were the best-performing due to heightened demand. Grain revenue fell 1% on lower supply.
The industrial category had 22% revenue growth, mostly due to a 14% improvement in volume. A strong housing market led forest products higher while energy faced a weak comparison. The reopening of the economy also drove demand for a variety of products.
The premium category was the weakest area of Union Pacific’s business. Revenue did grow 1%, but it took a double-digit increase in price per car load to offset a 9% decline in volume. Automotive volume was down 18% and intermodal declined 6%. One good sign was that it wasn’t for a lack of demand, as customers paid a sizeable increase in car load compared to the prior year. Automotive was weaker due to the global shortage of semiconductor chips. Intermodal was down on account of port congestion and supply chain issues.
The company also updated guidance for the year. Volume growth for the year is expected to be 5%, but this is down from the prior expectation of a 7% gain due to supply chain constraints and congestion at key pots. This isn’t just a Union Pacific issue as supply chain and congestion are an industry-wide issue. As a result, leadership now sees a 175 basis point improvement in the operating ratio as opposed to the previous estimate of 200 basis points.
According to Wall Street analysts, Union Pacific is expected to earn $9.94 per share in 2021, which would be a 22.4% increase from the prior year.
Takeaways
Union Pacific produced a solid third quarter against a fairly weak comparable period. Top- and bottom-line results also compared favorably to pre-pandemic quarters. Revenue improved 1% while earnings per share increased nearly 16% from the third quarter of 2019. The operating ratio also stood out, improving 320 basis points from the same period of 2019.
Union Pacific’s improvement on multiple metrics from last year’s Covid-19 impacted results are a positive, but the real story to me are the gains seen from a more normal operating environment.
Volumes were flat year-over-year, but pricing growing by low double-digits shows that demand for shipments is very high. Nearly all product categories, save grain, had increases in revenue. Volumes were down in some areas, such as intermodal, but pricing power usually made up for this weakness.
Ongoing port congestion has caused customers to try to move their cargo by any transportation means available, which is why they paid such a steep price to ship cargo. These issues aren’t likely to abate in the near future, with some calling for these headwinds to persist well into 2022.
This could limit volume growth for Union Pacific, and the rest of the transportation industry, next quarter and into the new year, but higher prices are likely to occur due to limited shipping options. The company, which is one of the key movers of cargo from the West Coast to the rest of the country, sits in a prime spot to capitalize on the current environment.
Dividend analysis
All of this is likely behind the company’s decision to raise its dividend by 10% for a second time in 2021. Just as important, that dividend looks extremely safe. As stated above, the most recent increase was the company’s second such announcement of the year. Shareholders received the first 10% increase for the June 30 payment date.
Prior to that raise, Union Pacific held the quarterly dividend steady at 97 cents for seven quarters in a row. Such a move was warranted and prudent as the company dealt with the unknown situation in 2020.
Historically, Union Pacific has been very shareholder-friendly. The share count has been reduced by nearly a third over the last decade. Even with the same dividend for seven quarters, shareholders have seen a higher annual dividend total for 14 consecutive years. The last decade has seen a compound annual growth rate of almost 17% for the company’s dividend.
The new quarterly dividend of $1.18, which will be paid on Dec. 30, will be 21.6% higher than what shareholders received in the same period of last year. Shares yield 1.9% based on the new dividend, not too far off the 10-year average yield of 2.2%, according to Value Line.
Most companies known for their dividends raise the dividend once per year, but Union Pacific has a history of doing so multiple times within a four-quarter span even before this year. For example, the company raised its dividend for both the first and third quarters of 2019. Then the company increased its dividend three times from the fourth quarter of 2017 through the end of 2018. Going even farther back, shareholders were given a dividend increase six times from the fourth quarter of 2016 through the end of 2019. Each year-over-year increase given during this time wasn’t a small token raise just to say that the company could do so. Each increase was represented at least 9.5% growth from the previous year.
Union Pacific’s dividend looks extremely safe as well, a leading reason why the company can go off book and make multiple increases per year.
Shareholders will receive $4.29 of dividends per share in 2021. Wall Street analysts expect that the company will earn $9.95 per share this year, equating to a projected payout ratio of 43%. This is in-line with the five-year average payout ratio of 44%, but slightly above the 10-year average payout ratio of 39%. The company is expected to earn $11.33 in 2022, so the payout ratio would be 42% if the dividend is kept at the same level.
The dividend looks just as secure when using free cash flow. Union Pacific has distributed $2.7 billion of dividends per share over the last four quarters while generating free cash flow of $6.5 billion, giving the company a free cash flow payout ratio of 42%. This compares to a free cash flow payout ratio of 48% for the 2017 to 2020 time period.
Last year, free cash flow grew $500 million from 2019. This shows that the pandemic didn’t stop Union Pacific from generating higher free cash flows from its business. Earnings per share fell only slightly for 2020 compared to 2019. Covid-19 had a limited impact on Union Pacific’s ability to grow profitability, since the need to transport goods didn't change.
Valuation analysis
Union Pacific closed Friday’s trading session at $248.46, which would have shares trading at 25 times this year’s earnings estimates. For context, shares of the company have traded at an average price-earnings ratio of 19.3 over the last five-year period and 18 over the last 10-year period.
Shares are not cheap at the moment. However, analysts expect that the business will see some normalization next year and Union Pacific will see a high level of growth in 2022. The stock has a forward price-earnings ratio of 22 based off of next year’s earnings estimates, which is still not cheap, but it is closer to the medium-term average valuation.
Final thoughts
Union Pacific is one of the few companies that often raises its dividend more than once every four quarters. This had been the company’s style recently up until last year. That changed when leadership provided yet another 10% increase to its dividend for the June payment and the upcoming December payment.
This was likely done as demand for shipping cargo doesn’t appear to be suffering. Volume in most categories held up last quarter, with some even seeing significant strength from the prior year. Automotive and intermodal stand out as the two weaker components of the business, but this isn’t due to lower demand or a Union Pacific-specific issue.
Another plus is that customers were willing to pay higher freight costs in order to move their products in the last quarter. That likely hasn’t changed since the release of results, especially with the economy continuing to see growth with the holiday season approaching.
Volume might be challenged in the near term, but the demand should remain robust as long as the economy doesn’t descend into a recession. Union Pacific should continue to see solid growth in its business as a result.
Shares of the company aren’t trading with any discount, but the dividend increases and the strong outlook make me think the stock still has room to run.
