Thursday, May 21, 2015

Recent Buy - Union Pacific

I’m incredibly fortunate to stay busy on the stock purchasing front, with May being a blockbuster month in terms of fresh capital deployment.
Most of my attention this month has been focused on REITs, adding to my positions inW.P. Carey Inc. (WPC) very early in the month and then just a day later Omega Healthcare Investors Inc. (OHI). I think both stocks are trading at reasonable valuations here with extremely appealing combinations of yield and growth.
Interest rates, corrections, and currencies! Oh my! I keep hearing about all of it. Yet I continue to regularly invest and turn cash into its far more interesting and superior cousin, cash flow. If you let the noise distract you from focusing on what you can control, you’ve already lost the battle. Don’t let Mr. Market bully you around.
But REITs aren’t the only game in town. And I had a few other high-quality stocks on my watch list for May. I decided to deploy what cash I had left for the rest of the month into a stock I’ve long wanted to get my hands on.
I purchased 10 shares of Union Pacific Corporation (UNP) on 5/6/15 for $106.43 per share and an additional 5 shares on 5/13/15 for $102.29 per share.

Overview

Union Pacific Corporation (UNP) is the largest public US railroad, operating 32,000 miles of track that serves the western two-thirds of the country which includes some of the fastest-growing US population centers across 23 states.
UNP connects with Canada’s rail system and they’re the only railroad that serving all six major Mexico gateways.
Founded in 1862, they now serve roughly 10,000 customers.
2014 freight revenue breaks down via the following six commodity groups: Industrial Products (20%), Intermodal (20%), Coal (18%), Agricultural Products (17%), Chemicals (16%), and Automotive (9%).
2014 carload composition was 61% domestic and 39% international.

Fundamentals

Union Pacific is a massive company, with a market cap north of $89 billion. They operate one of the largest freight railway networks on the entire planet.
But where railroads might be thought of as a boring or staid business, UNP’s fundamentals are nothing short of impressive.
I’m going to take a look at growth over the last decade first, followed up by expected growth over the foreseeable future. Then I’ll highlight some of the other key fundamentals, including the dividend metrics.
Looking at the top line, revenue has increased from $13.578 billion in fiscal year 2005 to $23.988 billion in FY 2014. That’s a compound annual growth rate of 6.53%.
Meanwhile, earnings per share grew from $0.96 to $5.75 over this time frame, which is a CAGR of 22%. Not so staid after all, huh? The large difference in terms of bottom-line growth was fueled in part by major improvements in margins and a buyback policy that saw the company reduce its outstanding shares by almost 16%.
S&P Capital IQ is calling for 12% compound annual growth for EPS over the next three years. That would be a significant drop from the historical numbers, though still pretty stellar.
Now, a company’s dividend tells me a lot. Are they so profitable that they have all this excess profit that flows to shareholders? Are they growing that dividend? Is the dividend sustainable?
Well, UNP doesn’t disappoint here.
First, they’ve increased their dividend for the past nine consecutive years. The company maintained a static dividend for a number of years around the turn of the century, but has been growing it since.
Nine years isn’t bad. But where the dividend really catches my attention is the rate at which it’s grown – the five-year dividend growth is an astounding 27.3%.
That growth rate is pretty incredible, but you can see it’s largely been supported by huge growth in underlying profitability. So the payout ratio here, at 37.5%, is still quite reasonable. As such, the dividend appears to be not only very sustainable, but also in a great position to continue growing at an attractive rate.
And you have to like the yield right now, which is 2.15%.
UNP, like most railroads, does operate with some leverage due to the capital-intensive nature of the business. However, they have one of the best balance sheets in the entire industry. The long-term debt/equity ratio is 0.52 and the interest coverage ratio is just over 15. So that means the company’s earnings before interest and taxes cover interest expenses about 15 times over. Obviously, they have no issues here.
Profitability for UNP is also outstanding, and really speaks to the efficiency of the railroad. They’ve averaged net margin of 18.73% and return on equity of 19% over the last five years – some of the best numbers in the industry.
For perspective, both of these ratios have more than doubled over the last decade. On the flip side, the low-hanging fruit has probably already been picked, which means growth in the future may be much more timid.

Qualitative Aspects

The railroad business is one of my favorite business models, which is why I’m now a shareholder in two major US railroads – UNP and Norfolk Southern Corp. (NSC).
The competitive advantages are about as strong as you can possibly get for these companies, with economic moats that are wide and built right in.
First and foremost, the very business model and how railroads came to be is the biggest advantage of all. When’s the last time you saw a major railroad erected? You’re just not going to really see that because the rights of way are about impossible to get now with the US becoming increasingly populated and dense. All the major ports are already covered and all the best routes are already taken. It wouldn’t only be nigh impossible for a new competitor to spring up, but it’d be a bad idea. I think you could give someone $90 billion (the approximate market cap of UNP) and they still wouldn’t be able to recreate anything close to UNP. The barriers to entry are just enormous.
There are also major economies of scale here. You have rail that extends out thousands of miles, which allows UNP to move plenty of goods a long distance for very little money. And there’s relatively little competition, since there are only seven Class I railroads in North America. As such, the choices are somewhat limited in terms of moving goods by rail.
But it isn’t just lack of choice that affords UNP competitive advantages. They’re a low-cost mover of goods since it’s generally cheaper to move goods by rail than it is via truck, largely due to fuel efficiency. For instance, UNP has noted before that railroads are, on average, four times more fuel efficient than trucks. Furthermore, one train can move a ton of freight an average of 480 miles on just one gallon of fuel.
Goods have to be moved. That’s been true since the mid-1800s (when railroads were first built). And it’s true today. I see no reason why that won’t continue to be true another 100 years from now. In fact, with the increasing population across the world, it’s more likely that UNP and other railroads will be moving more goods across their tracks in the future than they are today. There will be fluctuations in volume – UNP noted a drop in volume for Q1 2015 when they released their earnings report – but, by and large, the long-term picture seems bright.
Moreover, UNP remains diversified across their commodity groups. Although the trends in the energy industry involve moving away from coal, the company remains strongly diversified across their lines and remain capable of increasing volume in other segments. You’ll notice that volume for coal in terms of revenue carloads dropped 7% YOY in the recent earnings report, but gains elsewhere means overall volume dropped just 2%. And, like I just mentioned, the long-term picture means that overall volume will likely only increase over the long term.

Risks

There are numerous risks with UNP and other railroads.
There are extensive costs to maintaining a railroad. Unlike a lot of other methods of transportation, railroads must maintain their own networks. This is expensive – UNP has invested more than $31 billion in its network and operations from 2005 to 2014. So the infrastructure there remains extremely valuable and probably impossible to replicate, but also expensive to maintain. In addition, there are significant input costs varying from labor to fuel.
Regulation remains omnipresent. Any negative changes here could have material impacts on UNP’s costs to operate and/or ability to maintain profitability in a competitive manner.
As a railroad, UNP is exposed to the broader economy and all the ups and downs that comes with. Any major drop in activity across the economy as it relates to demand for goods could reduce demand for their services. However, they performed quite well during the recent Great Recession.
There are also black swan risks, including derailments and spills.

Valuation

UNP trades hands for a P/E ratio of 17.43. That’s attractive both in absolute terms and relative terms. Relative to the market’s P/E ratio of 20.73, you can see a lot to like here. In addition, this is in line with UNP’s own five-year average P/E ratio. So you’re getting a stock in line with recent historical norms against a market that’s quite a bit higher. As always, I think one should look at stocks on an individual basis instead of trying to judge the entire market at any given time.
I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. That growth rate seems fair considering it’s less than half that of UNP’s own long-term growth rates for EPS and the dividend. I’m factoring in the low payout ratio, growth forecast moving forward, and the extremely strong business model. The DDM analysis gives me a fair value of $118.80.

Conclusion

This is just one of my favorite business models. And you can see Warren Buffett shares that affinity for railroads, buying up the whole of BNSF Railway in 2009 – BNSF is now the most important non-insurance subsidiary under the umbrella of Berkshire Hathaway Inc. (BRK.B). I actually plan over time to make UNP a major position in my portfolio. In addition, I’d like to own another one or two railroads as well. Just like when I used to play Monopoly as a child, I’m inclined to “own them all”.
I think this is a really appealing investment here. But UNP has been on a tear over the last five years, both in terms of its stock price and operational performance. And I see limited room in terms of efficiency improvement from here. However, my desired rate of return of 10% includes a sizable margin of safety even if the company’s growth slows down considerably. As such, I think this stock makes a lot of sense here as long as you have your eye on the long term. The odds of goods still moving across rail in 10 years seem quite high to me. And with the way population trends are tilting, I think the odds are even better that more goods will be moving across rail over time. It’s an incredibly old business model that has stood the test of time. I see that as very likely continuing for many years.
I will quickly note that this transaction was split in two. I purchased the first tranche in my new TradeKingaccount where the $4.95 commission allowed me to pick up 10 shares at a reasonable cost. However, the stock took a dip recently and I saw that as an opportunity to use up a free trade in my Scottrade account and average down on another five shares.
The first purchase of shares was when UNP was down ~10% YTD. I pulled the trigger a second time when the stock was down about 14% YTD (the S&P 500 is up 3.1% YTD). Keep in mind that this is a $90 billion company, so a 14% swing is a major change in its valuation. I saw that pullback as a chance to initiate a position in one of the best railroads in North America. I look forward to future pullbacks, if we get them. Not only does that mean I get to acquire shares cheaper, but UNP’s own buyback program – as of January 1, 2014, they’re authorized to repurchase up to 120 million shares by December 31, 2017 – becomes more effective.
These purchases add $33.00 to my annual dividend income, based on the current $0.55 quarterly dividend.
I’m going to include current valuation opinions from professional analysis services, as I use these to concentrate my reasonable fair value estimate:
Morningstar rates UNP as a 4/5 star value, with a fair value estimate of $119.00.
S&P Capital IQ rates UNP as a 4/5 star “buy”, with a fair value calculation of $117.90.
I’ll update my Freedom Fund in early June to reflect these recent purchases.
Full Disclosure: Long WPC, OHI, UNP, and NSC.
What’s your opinion on UNP? Think this makes sense as a long-term investment? Like the railroads? 
Thanks for reading.

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