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Funding Thesis
For my part, Union Pacific Company (NYSE:UNP) presents a sophisticated funding outlook, riddled with each monetary and operational hurdles. The corporate’s EPS progress, whereas seemingly spectacular, is essentially fueled by share buybacks funded by means of debt, a method that has been not too long ago halted. This strategy not solely artificially boosts EPS but in addition heightens the corporate’s monetary vulnerabilities, significantly in gentle of its substantial debt and curiosity obligations. Complicating issues additional are looming inflationary pressures and anticipated will increase in labor prices for the latter half of 2023, which UNP might solely be capable of partially mitigate by means of pricing methods. Moreover, the corporate is going through a softening demand setting throughout varied sectors, exacerbated by a bleak industrial progress outlook for 2023. If one have been to put money into UNP at its present share worth of $221.03, we mission a 5-year CAGR is a mere 1%, primarily based on our worth goal of $224.22. Given these elements, we charge Union Pacific Company inventory a Promote.
Firm Overview
Union Pacific Company is likely one of the largest railroad firms in the USA, offering freight transportation providers throughout a community of roughly 32,000 miles. The corporate performs a vital position within the American provide chain, transporting items starting from agricultural merchandise to industrial equipment. UNP competes with BNSF Railway, a enterprise wholly owned by Berkshire Hathaway (BRK.A, BRK.B).
Reliance on Share Buybacks for Progress
Over the previous 5 years, the corporate has demonstrated flat income progress, whereas steadily rising earnings per share. Its income has proven stagnation, rising from $21.384 billion in 2018 to $23.102 billion within the final 12 months in 2023, representing a compound annual progress charge (CAGR) of roughly 1.5%.
For my part, whereas Union Pacific Company has offered a powerful progress in Earnings Per Share, from delivering $7.91 in 2018 to $10.95 within the final twelve months, representing a Compound Annual Progress Fee of about 7%, the underlying story nonetheless is extra nuanced. A good portion of this EPS progress, in my opinion, has been inorganic, fuelled extra by share buybacks reasonably than by natural enterprise enlargement. The corporate has been utilizing debt to fund these buybacks, a method that comes with its personal set of dangers. Leveraging debt to repurchase shares can artificially inflate EPS and shareholder worth within the brief time period, but it surely additionally will increase the corporate’s monetary threat, significantly in the next rate of interest setting. As rates of interest rise, the price of servicing this debt will increase, placing stress on the corporate’s money flows and probably affecting its means to put money into progress alternatives or keep dividends.
It is value noting that UNP has paused its share buyback program for the remainder of 2023. To me, this alerts that the corporate can not keep the established order because of the elevated price of capital. This pause may be a pink flag for traders, suggesting that the corporate is perhaps bracing for monetary headwinds. With out the help of share buybacks to spice up EPS, and with the added burden of upper rates of interest on its debt, UNP might discover it difficult, in my view, to ship the form of shareholder returns which were seen prior to now.
Poor Allocation of Capital
For my part, Union Pacific Company’s steadiness sheet raises some issues, significantly with regards to its debt load. As of the newest quarter, the corporate reported money and money equivalents of $830 million, whereas its complete debt stands at a staggering $31.378 billion. This debt load is roughly 6x the corporate’s present earnings, which is a excessive degree of leverage that would pose dangers, particularly in a rising rate of interest setting. Moreover, the curiosity expense over the past twelve months was $1.323 billion, which is about 20% of the corporate’s present earnings. This sizable curiosity expense may change into a major burden if earnings have been to say no or rates of interest have been to rise. As we are able to see under, the debt load 12 months to 12 months has persistently elevated as debt has been used to repurchase shares.
Moreover, it is value noting that a lot of the share buybacks have been carried out at a time when, in my opinion, the corporate seems to be overvalued. This might imply that the corporate has been shopping for again its shares at premium costs, which isn’t essentially the most environment friendly use of capital.
Inflationary Pressures
For my part, Union Pacific Company faces a fancy monetary panorama, particularly within the context of inflationary pressures. The corporate is forecasting an extra $50 million to $70 million in labor bills on account of new agreements within the second half of 2023. This added price may put additional pressure on the corporate’s working margins, significantly if inflation continues to rise. Nonetheless, UNP has additionally indicated that its pricing {dollars} are in extra of inflation {dollars}. This implies that the corporate has some means to cross on elevated prices to its clients, probably mitigating the influence of inflation on its backside line.
Nonetheless, the power to cost above inflation would not essentially cowl all extra bills, such because the forecasted improve in labor prices. Furthermore, the effectiveness of this pricing technique might be influenced by market demand, competitors, and the general financial setting. In a high-inflation state of affairs, firms with important operational leverage and debt, like UNP, might discover it difficult to keep up monetary efficiency. The added labor prices and the necessity to worth above inflation create a fragile balancing act for UNP.
Weakening Demand
For my part, Union Pacific Company is going through headwinds from weakening demand throughout a number of sectors, which may considerably influence its income and profitability. As we enter a mushy demand setting, a number of elements are contributing to this downturn. Decreased export potash shipments and weaker beverage imports are affecting the corporate’s freight volumes. Moreover, low pure fuel costs are making this power supply extra engaging in comparison with coal, resulting in reducing coal demand. The weak housing market and lowered demand for corrugated packing containers additional exacerbate the state of affairs, impacting the corporate’s means to keep up freight volumes in these sectors.
The present 2023 full-year industrial manufacturing forecast of simply 0.1% progress provides one other layer of concern. Such a marginal improve means that the broader industrial panorama is just not poised for important progress, which may imply continued mushy demand for UNP’s providers.
Valuation
When contemplating valuation, I at all times think about what we’re paying for the enterprise (the market capitalisation) versus what we’re getting (the underlying enterprise fundamentals and future earnings). I consider a dependable manner of measuring what you get versus what you pay is by conducting a reduced money stream evaluation of the enterprise as seen under.
UNP’s present TTM money stream per share as of Q2, 2023 is $8.91. Based mostly on inflationary stress, the weakening macroeconomic setting, and the pause within the share buyback program, I consider that UNP’s TTM money stream per share will lower in 2023 to $8.40. From 2024 to 2028, I anticipate UNP to develop at 8% yearly. Subsequently, as soon as factoring within the progress charge by Q2 2028 UNP’s TTM money stream per share is predicted to be $11.43. If we then apply an exit a number of of 20, which relies on UNP’s imply worth to free money stream ratio for the earlier 5 years, this infers a worth goal in 5 years of $224.22. Subsequently, primarily based on this estimation, traders shopping for UNP at as we speak’s share worth of $221.03, would earn solely a CAGR of 1% over the following 5 years.
Conclusion
Union Pacific Company presents a fancy funding image marked by a number of monetary and operational challenges. Whereas the corporate has proven EPS progress, this seems to be largely inorganic, pushed by debt-funded share buybacks which have now been paused. This technique has not solely inflated the EPS but in addition elevated the corporate’s monetary threat, particularly given the excessive ranges of debt and curiosity bills. Including to the complexity are inflationary pressures and anticipated labor price will increase, which UNP might solely partially offset by means of pricing above inflation. The corporate can be grappling with weakening demand throughout a number of sectors, additional clouded by a minimal industrial progress forecast for 2023. We mission solely a 1% 5-year CAGR primarily based on our worth goal of $224.22.
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