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Union Pacific Corp. (NYSE:UNP) recently reported results for the third quarter of fiscal 2019.
Revenue in the quarter declined 7% as a result of a high single-digit decline in volumes. Year to date, revenue has fallen 3%, with a 5% drop-off in volumes offset by a slight increase in average revenue per car (net core pricing was up 2.5% in the third quarter). The pressure on the top line has largely been attributable to weakness in intermodal and energy (down 16% year to date and down 20% in the quarter), driven by a sustained drop-off in frac sand (volumes down 45% in the quarter) and continued challenges in coal.
Management expects overall volumes to decline by roughly 8% in the fourth quarter, implying a mid-single-digit decline for the full year. Even after accounting for higher annual percentage rate change, Union Pacific is likely to report a mid-single-digit decline in revenue as well in 2019.
The operating ratio (OR) in the quarter was 59.5%, another all-time quarterly record for the railroad (with help from some normal weather after a couple of disruptive quarters). Year to date, the operating ratio has declined 220 basis points to 60.9%. The fact Union Pacific is delivering these results in the face of material volume headwinds is impressive. It's also worth noting they've seen material gains in metrics like car velocity, terminal dwell and train length, which has led to improved asset utilization (and allowed them to park 2,600 locomotives). That's a long way of saying that precision scheduled railroading appears to be working well at this point.
Looking forward, management still believes the operating ratio will be below 60% in 2020. (But as CEO Lance Fritz noted on the call, "If we can get a little cooperation from the economy that would be very helpful.")
As a result of a declining operating ratio, Union Pacific was largely able to offset the decline in revenue (operating income fell 2% in the quarter). Year to date, operating income and net income have both increased 2%. After accounting for a 7% decline in diluted share count, earnings per share has increased by roughly 10% year to date.
As shown below, continued repurchases have had a material impact on the per-share results, with the diluted share count down by roughly 30% over the past 10 years.
Through the first nine months of 2019, the company has generated $6.3 billion in cash from operations (flat year over year). Cash outflows have consisted of $2.5 billion for capital expenditures, $5.1 billion of repurchases and $1.9 billion for dividends (at the current stock price of $162 per share, the dividend yield is roughly 2.4%).
While current shareholders are likely happy with outsized capital returns, the reality is that they've been partially covered by incremental debt issuance (the adjusted debt balance now stands at $28 billion). At quarter-end, the leverage ratio (adjusted debt / adjusted Ebitda) was 2.6 times, an increase of 0.3 from the year ago period (for what it's worth, the company has said it is comfortable with leverage "up to 2.7x"). As shown below, the leverage ratio at Union Pacific has increased meaningfully over the past several years.
I've followed Union Pacific closely for years (and owned it for part of that period). Considering where we stand currently, I still think the conclusion that I shared a few quarters ago is still reasonable:
"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 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."
While the stock price has struggled a bit lately, I still think Mr. Market is expecting a lot in terms of operating ratio improvement and capital returns. And to be fair, there's reason for some confidence if the railroad gets a tailwind from higher volumes. That said, I personally do not think that the risk-reward trade-off is attractive enough relative to the current valuation. For that reason, I do not plan on investing in Union Pacific at this time.
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This article first appeared on GuruFocus.