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Union Pacific: Navigating Volume Pressures

Union Pacific (UNP) recently reported results for the fourth quarter of fiscal 2019.

Revenues in the quarter declined 9% to $5.2 billion as a result of a double digit decline in volumes. For the full year, revenues contracted 5% to $21.7 billion, with a 6% reduction in volumes partially offset by a 1% increase in average revenue per car. If you want a reality check on management's ability to forecast short-term network activity, they originally expected volume growth in 2019.


The top-line pressure in 2019 was attributable to weakness in Energy (-18% due to weakness in frac sand and coal), with a year-over-year decline in segment revenues of $850 million largely covering Union Pacific's revenue shortfall for the year (down $1.1 billion).

Despite the significant headwind on volumes, Union Pacific reported its third consecutive quarter with an operating ratio (OR) of less than 60% (an improvement of nearly 200 basis points relative to the fourth quarter of 2018). This reflects continued improvements in operating efficiency and asset utilization, including gains in freight car velocity, terminal dwell, locomotive productivity, fuel consumption and train length (up 16% over the past year). The fact that the railroad continues to deliver these results in the face of material volume headwinds is impressive. As in recent quarters, it appears that Unified Plan 2020 / Precision Scheduled Railroading (PSR) is working.

As a result of the declining operating ratio (down 210 basis points to 60.6%), Union Pacific was largely able to offset the 5% decline in revenues. Operating income of $8.6 billion was flat, with net income declining 1% due to rising interest expense and a higher tax rate (management expects a 2020 effective tax rate that's comparable to 2019). After accounting for a significant reduction in the share count, earnings per share (EPS) for 2019 increased by 6% to $8.40 per share. As shown below, the share count has fallen by 30% over the past ten years, which has had a material impact on the per share results.

The company generated $8.6 billion in cash from operations in 2019, down marginally from 2018. Cash outflows consisted of $3.5 billion for capital expenditures (which exceeded depreciation expense by $1.2 billion), $5.8 billion of share repurchases and $2.6 billion for dividends (at the current stock price of $186 per share, the dividend yield is roughly 2.0%). As those numbers suggest, Union Pacific has continued to rely on outsized debt issuance to fund capital returns. At year end, the company had more than $27 billion in debt, with the leverage ratio (debt / EBITDA) climbing slightly during the year to 2.5 times. As noted in the slide deck, management is targeting a leverage ratio of 2.7 times. I don't want to beat a dead horse, but I think it's worthwhile to recognize that the leverage ratio at Union Pacific has increased meaningfully over the past few years. It's also worth noting that management has increased their leverage ratio target over time.

Personally, I continue to question whether it's intelligent to go full throttle on the leverage ratio at this point in the cycle for a business that is exposed to cyclicality. In management's defense, I've held that concern for some time now - and during that period, they've repurchased tens of millions of shares at an average cost that is well below the current stock price. At least for now, it appears that they're right and I'm wrong.

Conclusion

I've followed Union Pacific closely for years. I owned it for part of that period - and based on recent price action, I wish I had owned it awhile longer! But stepping back from short-term price movements, my thoughts on the business are essentially unchanged:


"This 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 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).

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."



We have since encountered a period of significant volume challenges, with the company only posting mid-single digit EPS growth through operating leverage and significant share repurchases (EPS in the fourth quarter was down 5% year-over-year). Can Union Pacific continue to pull both of those levers long-term? Maybe. With shares trading at 22 times trailing earnings and a much higher level when measured on a multiple of free cash flow, I think Mr. Market's answer to that question is yes. For what it is worth, management has guided to an operating ratio in 2020 of 59%, along with some volume growth and $6 billion of repurchases.

Personally, I'm less confident that this can be sustained over the long run. And when I compare UNP's current valuation to another high-quality business like Comcast (CMCSA), it's unclear to me why I would want to own the former as opposed to owning more of the latter. The risk/reward trade-off implied in Union Pacific's current price doesn't look compelling to me.

For that reason, I'll stay on the sidelines for now.

Disclosure: Long CMCSA

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This article first appeared on GuruFocus.