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An Update on Union Pacific

- By The Science of Hitting

Union Pacific Corp. (UNP) reported financial results for the first quarter of fiscal 2019 in April.

Revenues were down 2% for the period, led by a 16% decline in energy and a 3% decline in agricultural products. The quarter was negatively impacted by serve weather, including snowfall in the Midwest and the Pacific Northwest, as well as flooding across the network that led to a nearly two-week outage for the company's East-West Mainline in Nebraska. As noted on the conference call, these weather issues were the primary driver of the 2% volume in the first quarter (as noted at an investor event in February, volumes were up 4% through the first six weeks of the year).

Negative mix masked a strong increase in core pricing (up 2.75%) - the strongest core pricing growth Union Pacific has delivered since 2015.

The company also did a good job controlling costs (down 3% year over year), resulting in a 1% increase in operating income; the operating ratio (an industry metric that's simply the inverse of the operating margin) fell 100 basis points to 63.6%. In addition, management noted the weather issues were an additional 160 basis point headwind (that was largely offset by a payroll tax refund and the combined impact of lower fuel prices and the fuel surcharge lag).

Moving down from operating income, the company benefited from below the line items and a lower effective tax rate, with net income climbing 6% year over year. Finally, the share count declined by nearly 8%, with diluted earnings per share up 15% to $1.93 per share.

The lower share count is an important part of the story. As a reminder for those that have not closely followed the company, the railroad company has aggressively repurchased its own stock over the past several years; as a result, the share count is down roughly 20% since the end of 2014.

But as shown below, that has come with meaningful financial leverage (debt to Ebitda):

This trend continued in the first quarter, when the company spent $600 million on dividends and $3.5 billion on share repurchases (inclusive of a $500 million accelerated share repurchase that is pending settlement), compared to $1.2 billion in free cash flow.

Looking out over a longer time horizon, Union Pacific has returned $25.6 billion to shareholders through dividends and repurchases since 2016. Over that same period, cumulative free cash flow was $14.5 billion - a cumulative shortfall of roughly $11 billion. That's a long way of saying the company has been pushing the pedal to the floor over the past several years (and especially in the last 18 months). Now that the company is near the high end of its leverage target - a number that has drifted higher over time - the outsized spending will soon come to a stop.

Despite the weak first-quarter results, management reiterated 2019 guidance (low single-digit volume growth, pricing to exceed inflation and a sub-61% operating ratio). By my math, if the company is able to deliver on this expectations, Union Pacific should report nearly $9 of diluted earnings per share. At a recent price of approximately $176 per share, the stock trades at a forward price-earnings multiple of 19 to 20 (by the way, that's before adjusting for outsized capital expenditures relative to deprecation and amortization expenses).

To put that valuation in content, the forward price-earnings ratio over the past seven years has been closer to 17 times earnings. Remember that during much of this period, Union Pacific had lower operating margins, much lower financial leverage and a significantly higher effective tax rate.

As I think about the company and the stock, I'm torn by two conflicting thoughts.

First, 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 has been 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 shoot to).

In the event of an economic slowdown, I think the company would be forced to significantly reduce repurchase activity, or even take it to zero - just like it did 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-earnings ratio.

To be clear, I have no ability to predict changes in the macroeconomic environment. But my sense is that the risk-reward at these levels is not particularly compelling, especially in a scenario when world isn't as kind to investors as it has been over the past several years.

Disclosure: No position.

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This article first appeared on GuruFocus.