Union Pacific (UNP) last week reported results for the second quarter of fiscal 2019. Revenue for the Omaha-based railroad declined 1% on lower volumes. Year to date, revenue has fallen 2%, with a 3% reduction in volumes offset by a 1% increase in average revenue per car (ARPC). The pressure on revenue has largely been attributable to weakness in the energy business, driven by a 7% decline in coal and a 50% decline in frac sand in the second quarter. As noted on the conference call, headwinds in the energy segment are expected to persist in the back half of the fiscal year:
“While year-over-year comps for sand ease in the second half of the year, local sand supply will continue to impact volume," Executive Vice President of Marketing and Sales Kenny Rocker said. "We also expect coal to experience continued headwinds throughout 2019 and weather conditions will always be a key factor for coal demand.”
Management expects overall volumes to decline by 2% in the latter half of the year. Even after accounting for higher APRC (with net core price up 3% in the first half of the year), Union Pacific is likely to report revenue in 2019 that is below what the company delivered in 2018.
The operating ratio (OR) in the quarter was 59.6%, an all-time quarterly record for the railroad. Year to date, the operating ratio has declined 220 basis points to 61.6%. Management expects the operating ratio to come in below 61% for the full year, and to fall to 60% in 2020 (on a longer term path to ~55%). Over the past 15 years, this has been a key contributor to earnings per share growth for Union Pacific.
As a result of a declining operating ratio, year-to-date operating income and net income both increased 5% year-over-year. The share count has also declined by 7% over the past year, with the share count over the past decade down by 30% (compounded annual reduction of 3.5% per year). The net result is a low double-digit increase in diluted earnings per share.
Year to date, UNP has generated $3.9 billion in cash from operations. From here, cash outflows have consisted of $1.6 billion for capital expenditures, $3.6 billion for repurchases and $1.2 billion for dividends (it has increased the dividend twice in the past year; the yield is 2.0%).
The outsized use of cash, particularly to fund share repurchases, has led to a material increase in Union Pacific’s debt load. The leverage ratio (adjusted debt to adjusted EBITDA) was 2.5x at the end of the second quarter, up significantly from the company’s leverage ratio a few years ago.
UNP is nearing the high end of their leverage ratio target (“up to 2.7x”). The tailwind to EPS growth on rising leverage that UNP has benefited from since 2013 will not be replicated in the years ahead.
Conclusion
When I discussed UNP a few months ago, I said the following:
“I believe it is a high-quality business that has greatly benefited from industry developments over the past 15 to 20 years. It has delivered stellar results that have led to a roughly 17% compounded annual growth rate in total shareholder return since 2002.
On the other hand, I think the capital returns have been aggressive. Management has taken a cyclical business and 'doubled down' through debt-funded capital returns. Considering where we stand, I don’t think this is the ideal time to be at the high end of the leverage ratio target (and well above the 1.5 times to 2.0 times leverage target that management used to target).
In the event of an economic slowdown, I think the company would be forced to significantly reduce repurchases, or even take them to zero – just like during the financial crisis when the stock price fell 60% from peak to trough. Said differently, 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.”
I think that still holds. It appears that Mr. Market is expecting a lot in terms of operating ratio improvement and capital returns over the next few years. Personally, I think the risk-reward at these levels is not particularly compelling. For that reason, I’m not currently interested in buying UNP.
Disclosure: None.
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