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In recent years, the Union Pacific stock has not only delivered rising dividends, but also juicy price gains. The dividend has risen by 21 percent per year over the past 10 years. On top of that, the stock price has increased by almost 16 percent per year in the same period.
The company is proof that even “boring” business models can lead to investing success. In this analysis you will find out if the Union Pacific stock is still an attractive purchase today.
| Union Pacific Stock | |
| Logo |  |
| Country | USA |
| Industry | Railway |
| Isin | US9078181081 |
| Market cap. | 115.4 billion € |
| Dividend yield | 2% |
| Dividend stability | 0.94 von max. 1.0 |
| Earnings stability | 0.96 von max. 1.0 |
The business model: How Union Pacific earns money
The Union Pacific Corporation is a US-based freight transport company and is organized as a holding company. It is the parent company of the Union Pacific Railroad. Through the holding you can invest in the railroad. Since the railroad is the primary operating company of the holding, I will refer to both of them as Union Pacific.
Union Pacific’s rail network stretches across the West and Central USA. The total length of the rails is 32 200 miles (approx. 51 800 km). Union Pacific employs around 37,000 people. 7,700 locomotives move the freight across the country.
Network map of Union Pacific (Source: Union Pacific)
Union Pacific generates its revenues by transporting freight over the rail network. Those revenues are divided into 4 segments: “Agricultural Products”, “Energy”, “Industrial” and “Premium”.
Revenues by segments of Union Pacific (Source: FactSet Workstation)
Agricultural Products
In this segment, Union Pacific transports a wide variety of agricultural products. These include grain and fertilizers, but also food and beverages. In 2019, Union Pacific generated 22 percent of its sales with this segment.
Energy
As the name suggests, this segment is concerned with the transport of energy sources such as coal, oil and gas. It is the smallest segment in terms of sales. 18 percent of total sales in 2019 came from this category.
Industrial
Union Pacific generates the second-largest share of sales (29 percent) with the transport of industrial goods. These include chemicals, plastics, wood, metals, ores and all other components necessary for industrial production.
Premium
Unlike the other business segments, the “Premium” segment does not immediately reveal its activities with its name. Under this term, Union Pacific combines intermodal transport and automobile transportation. Intermodal means that goods are transported to their destination using various means of transport within a transport chain. For example, Union Pacific receives containers and then delivers them to their destination via the rail network. Union Pacific is also the largest automobile carrier west of the Mississippi. The premium segment makes the largest contribution to total sales. In 2019 it accounted for 31 percent.
Union Pacific is in direct competition with other freight carriers. However, the company has only one competitor on the rails: The BNSF Railroad. Its parent company is fully owned by Warren Buffett’s Berkshire Hathaway. The two railway companies together form a duopoly for US rail freight. A duopoly has its advantages, but Union Pacific still has to compete against other companies. Customers choose the fastest, safest, and cheapest means of transport. Therefore, Union Pacific not only competes within the railway duopoly, but also with all other transport methods, such as trucking.
Union Pacific’s business model is cyclical and seasonal by nature. Agricultural transportation is unevenly distributed throughout the year due to harvesting times. Industrial transport in particular, but also automobile freight is dependent on the economy. That’s why you will usually see a drop in sales during economic downturns.
How profitable is Union Pacific?
You can see that Union Pacific is dependent on the economy from the decline in sales in years with economic crises. As a result of the financial crisis, sales were down in 2009 and they are expected to fall again this year due to the corona pandemic. These declines in sales will also affect profits and cash flows. However, the declines have been moderate so far and dividends have continued to rise even in difficult economic times.
Development of profits, cash flows and dividends per share of Union Pacific
In general, business models that are less dependent on economic cycles are more interesting to investors. Nevertheless, fluctuations are okay if the company is well managed and uses the good years to set money aside for the bad ones. With its dividend policy, Union Pacific keeps a conservative payout ratio. In recent years, only about half of free cash flow has been paid out as dividends. The rest can either be used for other purposes or saved for later.
When it comes to saving money, I would like to see a little more effort from Union Pacific. Despite the cash surpluses of recent years, the cash position has not increased.
Evolution of the cash position and amortization power of Union Pacific
This is because Union Pacific has been very aggressive in buying back its own stock in recent years and the purchases have eaten up the surpluses. To a certain extent, I think it makes sense to exchange stock for debt in times of low interest rates. However, with a cyclical company like Union Pacific, I would like to see a larger cash position that covers the dividend for at least one year. Unfortunately that is not the case with Union Pacific.
But when it comes to profitability, Union Pacific shines. Thanks to the pricing power the duopoly offers, Union Pacific achieves very high margins. As you can see in the chart, the operating margin has risen steadily over the years and is currently sitting at an impressive 40 percent. Revenues, on the other hand, have developed more unevenly. A few years of growth are always followed by declining sales. But Union Pacific manages well against these fluctuations by cutting costs in bad years. You can see this from the fact that the operating margin has generally not fallen even in years with declining sales.
Evolution of revenues and the operating margin of Union Pacific
Are Union Pacific’s dividends safe?
Union Pacific pays its dividend on a quarterly basis. For the entire year, shareholders currently receive 3.88 USD. This makes the dividend yield of the stock 2.31 percent. Union Pacific can score points for the stability of its dividend. The dividend has not been reduced in 21 years and there have been uninterrupted annual increases over the past 13 years.
Union Pacific Dividend History
The ability of Union Pacific to pay a secure dividend despite its cyclical nature is due to the company’s conservative payout policy. As you can see in the chart below, the payout ratio measured in terms of profits has only exceeded the 50 percent threshold once in the last 20 years. In general, payout ratios above 50 percent are also common in many companies. For Union Pacific, I believe this conservative payout policy is the right strategy considering the fluctuations in revenues. A higher payout ratio would make it possible to pay a higher dividend, but in bad years the dividend would have to be reduced again. Union Pacific’s strategy of paying a dividend that can be financed even in bad years is therefore the right choice.
Evolution of the payout ratio of Union Pacific
Union Pacific has been very aggressively buying back its own stock in recent years. There is nothing wrong with that in principle. But as I mentioned earlier, I think that Union Pacific should have higher cash reserves. At present, these are not even sufficient to finance the dividend for half a year. For this reason, I would prefer if Union Pacific put more money aside first, rather than immediately spending the entire excess cash flow on buybacks.
Evolution of debt and treasury stocks of Union Pacific
Fortunately, the debt does not pose a threat to the dividend. The operating profit is easily sufficient to service the annual interest payments. The interest burden also only eats up about 12 percent of the operating profit. In addition, almost all of the debt has been borrowed on a long-term basis. Some of it has maturities up to 2067, so I don’t consider Union Pacific’s debt to be an issue.
Is the Union Pacific stock undervalued?
In recent years, the price of the Union Pacific share has largely moved close to the fair values of the Dynamic Valuation. However, there have also been breakouts above and below the fair values. In 2015 the stock was undervalued because the price was below the fair values. Between 2017 and 2019, however, the price was above the fair values most of the time. Back then, the stock was slightly overvalued. Due to the Corona pandemic, the price fell quite a bit. If profits continued to rise as they have in recent years, the stock would now be fairly valued or perhaps even undervalued. Unfortunately, a decline in profits and cash flow is expected for 2020. As a result, the fair values of profit and cash flow will also fall. The current price is higher than both of those values. According to the forecasts, the fair values of profit and cash flow will not reach the current price again until 2021.
Fair value estimates for the Union Pacific stock
There is also a positive signal. The fair value dividend is above the current price and will increase in the coming years due to the forecasted dividend increases. In my opinion, however, this alone is not enough to justify an undervaluation. After all, dividend increases with lower profits simply translate into a higher payout ratio. If a company does not earn higher profits, but only pays out a higher amount, you as a shareholder have no benefit. After all, there is less money available in the company, which ultimately belongs to you as well.
I would therefore rather focus on the fair values of profit and cash flow. At least until profits rise again and dividend increases are more meaningful. That’s why I think that the stock is slightly too expensive at the moment.
Conclusion: Union Pacific stock is a buy in tranches
The Union Pacific stock represents a solid company with high growth and strong margins. The stock buybacks are a little too aggressive in my opinion. Apart from that, the management is doing everything correctly. Unfortunately, the stock has now recovered to the point that the price has risen above the fair value, which signals an overvaluation. According to expectations, the fair values of profit and cash flow will not reach the current price again until 2021. So, anyone who buying now is paying a high price for the year 2020. Therefore, I would personally wait for a price drop. If you are afraid that there will not be any price drop soon, you can consider buying intervals and using the cost-averaging effect.
