unp union pacific corporation sector: industrials buy · union pacific nyse: unp intermodal, 20%...

AppliedPortfolioManagement Analysts:BobbyFlorence,XiaoyunYu

Report Date: 5/12/2014

Market Cap (mm) $77,834 Annual Dividend $3.18 2‐Yr Beta (S&P 500 Index) 0.98

Return on Capital 10.3% Dividend Yield 1.7% Annualized Alpha 28.8% Compared With:

EPS (ttm) $9.83 Price/Earnings (ttm) 19.1 Institutional Ownership 9.4% CSX Corp.

Current Price $188.00 Economic Value‐Added (ttm) $974 Short Interest (% of Shares) 1.0% Norfolk Southern Corporation

12‐mo. Target Price $205.00 Free Cash Flow Margin 15.1% Days to Cover Short 2.0 and the S&P 500 Index

Business Description

Total Revenue 9.0% Free Cash Flow ‐1.1%

EBIT 14.0% Total Invested Capital 4.9%

NOPAT 13.7% Total Assets 4.9%

Earnings Per Share 19.3% Economic Value‐Added 0.6%

Dividends Per Share 31.2% Market Value‐Added 25.9%

2009 2010 2011 2012 2013

23.9% 29.6% 29.3% 32.2% 33.9%

6.0% 9.6% 13.8% 11.6% 15.1%

5.9% 6.0% 6.4% 6.6% 5.6%1.7% 1.4% 1.8% 2.0% 1.8%

2009 2010 2011 2012 2013

3.76 5.58 6.78 8.33 9.47

1.08 1.31 1.93 2.49 2.96

4.27 6.33 7.37 8.90 10.01(0.24) 5.15 3.23 4.85 5.36

Datasource: Capital IQ

Margins and Yields

Operating Margin

Per Share Metrics

Earnings

NOPATFree Cash Flow

Dividends

Free Cash Flow Margin

Earnings YieldDividend Yield

Union Pacific Corporation, through its subsidiary, Union Pacific

Railroad Company, provides rail transportation services in the United

States. The company offers freight transportation services for

agricultural products, including grains, commodities produced from

grains, food, and beverage products; automotive products, such as

imported and exported shipments, finished vehicles, and automotive

parts; and chemicals consisting of industrial chemicals, plastics, crude

oil, liquid petroleum gases, fertilizers, soda ash, sodium products, and

phosphorus rock and sulfur products. It also provides transportation

Investment Thesis

ANNUALIZED 3‐YEAR CAGR

As the US economy recovers, the increasing demand of freight will boom

the industry.With our portfolio underweighted in Industrials, as analyts

previously studying the railroad industry, we became intrigued as we

studied UNP’s ability to create value for the portfolio With historic growth

that beats the S&P and still maintians a Beta of 1.Union Pacific’s 3‐Year

CAGR’s shows Total Revenue growth of 9.0%, EBIT growth of 14.0%,

Earning Per Share growth of 19.3%, Dividends Per Share growth of 31.2%,

and Total Invested Captial growth of 4.9%. With these numbers Union

Pacific shows continuous growth and efficiency while already solidifying

itself as the central and midwest leader in the railroad industry.We are

convinced the company's stock undervaluation presented the student

investment fund with a long‐term potencial opportunity.

Union Pacific Corporation Sector: Industrials BUY UNP

0%

5%

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15%

20%

25%

30%

35%

40%UNP ^SPX

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10%15%20%25%30%35%40%

UNP CSX NSC

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2008 2009 2010 2011 2012 2013

Price/Earnings Price/Free Cash Flow

$0

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2008 2009 2010 2011 2012 2013

EBIT Net Operating Profit After Tax

$0

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2008 2009 2010 2011 2012 2013

Economic Value‐Added Market Valued‐Added

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2008 2009 2010 2011 2012 2013

ROA ROE ROIC

Union Pacific

NYSE: UNP

Analysts: Bobby Florence, Xiaoyun Yu Student Investment Fund Portfolio

Recommendation: BUY Market Cap: $85.05 billion Current Price: $188.00

Sector: Industrial Dividend Yield: 1.9% 12-month target price: $206.66

Sub-Sector: Railroad P/E Ratio: 19.2 Beta: 1

Investment Thesis

As the US economy recovers, the demand for consumption increases year over year, which booms

the demand of freight and benefits the railroad industry. As the leading company in the industry,

Union Pacific has huge opportunities to gain profit in the future decade.

With our portfolio underweighted in Industrials, as analyts previously studying the railroad

industry, we became intrigued as we studied UNP’s ability to create value for the portfolio with

historic growth that beats the S&P and still maintians a Beta of 1 to the S&P 500.

Looking deeper at the major players in the railroad industry, Union Pacific impressued us with its

solid performance to bounce back from the recession and produce constant stable returns

thereafter.

While already being the nations leader in the railroad industry, the company’s high degree of

management throughout the company as it pursues its strategy to increase efficiency, rather than

focus on revenues, promises well for future gains in profits, margins, and stock stabability.

Union Pacific’s 3-Year CAGR’s shows Total Revenue growth of 9.0%, EBIT growth of 14.0%, Earning

Per Share growth of 19.3%, Dividends Per Share growth of 31.2%, and Total Invested Captial growth

of 4.9%. With these numbers Union Pacific shows continuous growth and efficiency while already

solidifying itself as the central and midwest leader in the railroad industry.

Union Pacific, a United States based company, diversifies our position into industrias while keeping

risk low in the Student Investment Fund.

Union Pacific

NYSE: UNP


Macroeconomic Thesis

As the economy has come back, many cyclical sectors have seen impressive strength. This is especially true in the transportation industry, as surging demand has greatly helped this key market sector, which also forms the backbone of the development of economy. In the modern economy, as the most efficient and affordable freight service, the railroad industry plays a very important role in U.S. economy, and also is representing as a barometer of US economic health. As statistics, almost 40% of the US intercity freight is served by railroad. As the US economy recovers, the demand for consumption increases year over year, which booms the demand of freight.

In consideration of a growing U.S. population and in recognition of the need for fuel efficient solutions, the US Department of Transportation estimates that the U.S. population alone is expected to increase freight demand by 30% over the next 20 years as U.S. highways are further crowded.

Positive outlook for the US agricultural trade will increase the demand of railroad freight rapidly, which contributes to 20% of UN’s revenue.

As the recovery of Economy in US, the continuing strength in housing and constructive market increases the demand of freight dramatically.

In the short run, rapid expansion of oil production in the Bakken with volumes increased nearly ten-fold between 2005 and 2013,which are expected growing more, strained the capacity of existing pipelines and of refiners able to process the oil. Rail as a means of transporting crude supplies in U.S. markets will be benefit from the booming demand of transportation.

Union Pacific

NYSE: UNP

Intermodal,

20%

Industrial Products,

18%

Engry Including coal, 19%

Agricultural, 16%

Automotive, 10%

Chemicals, 17%

FREIGHT REVENUE (2013)


Business Segments

UNP has 6 main Freight Segments

Intermodal – $4,392.6M (20%) consists of a jumble of container and trailer shipments as well as time-sensitive business delivery requirements. UNP’s intermodal business includes both domestic and international clients.

Industrial Products - $3,953.3M (18%) includes several categories such as lumber, minerals, steel construction products, paper, consumer goods, metals and other miscellaneous products. Transportation services for government entitles and waste companies are also included.

Energy including coal - $4,173M (19%) primarily comprises coal and petroleum coke shipment to utilities, factories, and water terminals. Water terminals allow the railroad to move western U.S. coal east. And through interchange gateways and ports, UNP’s reach extends to eastern U.S. utilities, Mexico, Europe, and Asia.

Agricultural - $3,514M (16%) contains whole grains, commodities produced from grains, and food and beverage products including fresh and frozen fruits and vegetables, dairy products. UNP accessed to most of the United States’ major markets, linking Midwest and Western U.S. to export terminals in the Pacific Northwest and Gulf Coast ports, as well as Mexico.

Automotive - $2,196.3M (10%) are shipped for seven vehicles assembly plants and distrusted imported vehicles from six West Coast ports and Houston. UNP is the largest automotive carrier west of Mississippi River and access over 40 vehicle distribution centers. It also transports automotive parts.

Chemicals – $3,733.7M (17%) comprehends four broad categories: Petrochemicals, Fertilizer, Soda Ash, and Other. Petrochemicals include industrial chemicals, plastics and petroleum products, including crude oil and liquid petroleum gases at chemical-producing areas along the Gulf Coast and in the Rocky Mountain region

Union Pacific

NYSE: UNP

BNSF

UN


Peers & Industry Analysis

The chart allow investors to compare UNP versus its industry peers and S&P 500 Railrads Index regarding to the return on stock price in the past five years. Since the beginning of 2012, UNP has started outperformance and still has a clear uptrend of its EPS, apparently beating the other leading railroad companies’.

The graphics shows the comparison of UNP and its industry peers by Argus Universe of Coverage. The long-term growth and value as two critical characteristics indicates that UNP is more growth-oriented.

This bar chart indicates the EBITDA of UNP and the strong competitor BNSF Railway for Western US feright, owned by Warren Buffett’s Berkshire Hathaway (BRK.B) in the past five years. UNP’s EBITDA grows much faster than BNSF’s since the middle of 2010. And the strength is expected to increase in the future.

Union Pacific

NYSE: UNP

Pic: Restoring locomotive: “Big Boy” 4014


UNP’s Sustainable Competitive Advantage

• Largest railroad company

UNP operates 8,300 locomotives over 31,800 route-miles in 23 states in the Midwest and western part of USA, occupying the largest market share in the industry. Moreover, UNP is the only one railroad company serving all 6 major gateways to Mexico.

• Strong operational network

UNP’s capital investments on network play a critical role in meeting the long-term demand for freight transportation in the U.S. UNP has invested $21.6 billion in the past 6 years on network ad operation to support American Transportation infrastructure. Over half was spent on replacing and hardening the infrastructure to further enhance safety and reliability.

By 2015, mandatory (and costly) installation of positive train control systems (PTC) will finally be complete. Completing PTC system installation could reduce CapEx by as much as 10%.

• Diversified revenue streams

With diversified six segments, UNP benefits year over year even though experiencing cyclical industry. In the past few years, the increasing revenue from the expanding sectors like automotive, construction, chemical products and agriculture somehow offset the decreasing profit from the coal consumptions.

Union Pacific

NYSE: UNP


Model Assumptions

Our analysis for UNP was based on conservative model assumptions. Our Free Cash Flows

valuation model estimates UNP’s intrinsic value at $192.18 per share for 2014 and a 12-month

target price of $206.66. Even with conservative modeling forecasts for margin expansion and

cost structure, the model indicates Union Pacific is undervalued at the current price of $188.00.

Income Statement Assumptions

Historical Growth and Margins:

Revenue Growth: Despite having a solid five-year historical growth rate of 4.1%, UNP faced a

negative revenue growth of -21.3% in 2009. This was due to the effects of the recession and

declining manufacturing orders. However, UNP was able to respond quickly earning revenues at

an increasing rate. Our forecasted income model indicates year-by-year revenue growth: starting

at a rate of 7% in 2014 and then continuing with a rate of 6% until 2017. In perpetuity, the model

forecasts a long-term growth rate of 3.5% while tapering down to our long-term growth rate of

3.5% in 2018. The growth rate was determined by Union Pacific’s position in the market equally

with increases in new manufacturing orders and consumer spending.

Forecasted Growth and Margins

Union Pacific

NYSE: UNP


Gross Margin: UNP has seen a

consistent increase in efficiency

concerning their gross margin.

From 2008 through 2013,

Union Pacific has been able to

increase their Gross Margin

from 38.8% to 45.9%. UNP was

able to accomplish this with

superior pricing power below

inflation from contracts and

their suppliers. Starting in 2014, the model forecasts an increase in margins of 46.3%. Based on

conservative modeling forecasts, an increase of 0.3% every year is noted until perpetuity.

Management aims to improve efficiency across all aspects of the company. We will notice the

effects throughout the assumption.

Operating Margin: Historically, UNP has increased their operating margin consistently from

23.9% in 2009 to 33.9% in 2013. This is an example of incredible income statement efficiency as

the model anticipates the trend to continue. In the model, the operating margin increases to a

moderate value of 34.3%.

Thereafter, a 0.3% increase

year by year is applied until

perpetuity. This is due to

Union Pacific increasing

revenue relative to expenses,

improving costs along the

railroad, improving fuel

efficiency, and increasing

railroad delivery times.

Union Pacific

NYSE: UNP


Net Margin: Union Pacific has

realized improving income

statement efficiency from 13.4%

in 2009 and improving to 20.0%

in 2013. The model implies a

steady increase in margin

expansion, starting at 20.3% in

2014 and increasing by 0.3%

year by year until 21.5% in

perpetuity. The model suggests

the trend will continue because

of improved efficiency and costs savings.

Common Shares: UNP has historically repurchased common shares at an average rate of 1.9%.

Union Pacific has continued the trend by announcing a 60 million share repurchase plan in 2013

that expires 2017. Therefore, with respect to common share the model states a 2.5% rate of

repurchase until 2017, then reverting back to the average of 1.9% in perpetuity.

Dividend: The growing profitability of Union Pacific has allowed them to increase their dividends

at an average of 24.7%. We are confident UNP will keep returning cash to investors, therefore

the models shows an increase in dividends at a rate of 14% in 2014 and staggering down to a 5%

growth rate in perpetuity.

Union Pacific

NYSE: UNP


Balance Sheet Assumptions

Cash and Equivalents: Union Pacific has historically kept below a 6.5% cash and equivalents ratio

to sales. However, in 2009 UNP held 13.1% of cash and equivalents due to reduced debt

payments and a lower repurchase of shares. In 2014 and into perpetuity, the model suggest a

7.0% cash ratio to sales based on improving net margins and UNP’s intention to improve their

liquidity position.

Net PP&E to Sales: Union Pacific invests heavily each year in replacement, improvement, and

expansion in their railways. However, despite massive investments UNP’s property plant and

equipment ratio to sales shows a

decrease from 261.1% in 2009 to a

value of 197.3% in 2013. The model

implies a continued pattern of

decreasing PP&E relative to sales.

The 2014 forecast will hold a 194%

PP&E to sales while conservatively

declining by 2% year by year until a

value of 186% in perpetuity.

Total Debt: UNP has decreased their debt to sales from 68.1% in 2009 to 40.4% in 2013.

Compared to sales, Union Pacific has decided to refinance their position in their debt. Therefore,

the model gives a bump to 43% as the standard value.

Cost of Capital

Cost of Equity: The cost of equity 7.8% was calculated using a risk-free rate of 4.25%, market risk

premium of 6% and a beta of 1. Evaluating UNP’s 5-year beta of 1.078 and 2-year beta of .98, a

value of 1.0 was considered.

Weighted Average Cost of Capital: The W.A.C.C. was calculated using the costs of 5% for total

debt with a weight of 10.2%. The cost of equity was calculated at 8.7% with a weight of 89.8%.

The calculation came to a weighted average cost of capital of 8.1%.

Long-Term Growth Rate: A value of 3.5% was applied for the long-term indicating a conservative

growth rate while maintaining the sector’s leader in railroads.

Union Pacific

NYSE: UNP


Financial Analysis

ROA & ROE: UNP has sustained

an increase of ROE from 11.2%

to 20.7% since the recession.

The same trends can be seen in

the ROA increasing from a

value of 4.5% to 8.8%. The

forecasted ROA and ROE will

continue a modest increase

even considering the

conservative forecasts. These are signs of increased efficiency and value within the organization.

EPS & DPS: Relative to the

recession, Union Pacific’s

earnings per share is

historically stable. The EPS has

increased from $3.76 per

share in 2009 to $9.47 per

share in 2013. UNP has also

increased dividends at an

average rate of 24.7% even

through the recession. With

conservative rates for the forecast, Union Pacific is able to maintain a stable increase in both

earnings per share and dividends per share.

Union Pacific

NYSE: UNP


Value Creation Metrics

NOPAT and Free Cash Flow: Over

the past five years, UNP has

grown NOPAT at an average rate

of 12.2%. The historic growth in

NOPAT has sustained UNP’s

ability to return on invested

capital. Also since 2011 Union

Pacific has been growing their

free cash flow with their NOPAT.

The forecast anticipates an

increasing trend into the future.

Even though Union Pacific is a capital-intensive company, they have been able to generate a free

cash flow relative to their investments

EVA & MVA: Recession and post-recession, Union Pacific’s EVA remained negative through the

years 2008-2010. However in

2011, UNP’s economic value

added jumped from a negative

value of $18 million to a positive

$247 million. Leading with a

strong return on capital, Union

Pacific continues to produce EVA

to the current value of $974

million. Relative to conservative

assumptions the model forecasts

UNP to continue to add value.

The historic and future Market Value Added is stable correcting after the recession and more

recently becoming stable with EVA. The future MVA is projected to remain steady with EVA.

Union Pacific

NYSE: UNP


Value Spread

ROIC: Union Pacific’s average five-year return on invested capital is 8.3%. Considering the

negative impact of the recession, UNP recovered well, delivering current values of 10.3% A value

aboev 10% for the railroad industry is astonishing. For the forecast, the ROIC is projected to

increase based on their ability to grow

NOPAT relative to capital.

W.A.C.C.: The Weighted-average cost

of captial was calculated to 8.1%. As

mentioned above, a conseravtive basis

was considered when determing the

alternative beta.

Value Spread (ROIC – W.A.C.C.):

During the recessionary period the

return on investment dipped below the 8.1% value spread. The negative spread continued into

2009 because of declining cunsumer confidence. However, Union Pacific was able to sharply

bounce back in 2010 and began building a positive spread. Due to their focus on income

statement efficiency and contiunued effort of investing, UNP is forecasted to keep improving

their value spread.

Valuation

Present Value of Free Cash Flows: Since 2008, Union Pacifc has an increasing fiscal year-end

stock price starting at $118.80 to the current price of $188.00. The value creation model

forecastes an intrinsic value of $192.18 compared to the current value of $188.00. The twelve

month target price sits at a

relative value of $206.66. In

the model, conservative

forecats were taken into

account. For example, the

adjustments in the income

statement were small

compared to Union Pacific’s

Union Pacific

NYSE: UNP


goals of increasing margins. Also, a beta of 1.0 was used instead of a .98 two-year beta. Values

generated by the model suggest Union Pacific to be undervalued by $4.18. UNP being the

leading railway system in the west and central region of the United States a long-term growth

rate of 3.5% was applied. With Union Pacific’s focus on efficiency and historical metics to back up

their improving management system, provides conficdence the model provides conservative

values for the future.

Dividend Discount Model: Union Pacific has grown their dividend every year even through 2009

where they suffered a drop in earnings per share. With UNP’s current rate of dividend growth at

an average of 24.7% per year the model forecasts a conservative increase of 14% in 2014 to a

perpetual growth of 5%. Based on their current dividend of $2.96, the expect growth and an

equity required rate of return of 8.7%, UNP is worth $102.85 per share, vs. a current stock price

of $188.00. Over half of the frims value is recorded in dividends alone.

Risks to Investment

If the U.S. economy were to slow down, pertaining to the recession in 2008, new manufacturing

orders would slow down and consumer confidence would drastically decrease. The slowdown of

the economy would decrease the demand for supplies to be transported along the railway

system. Due to Union Pacific’s high dependence on suppliers, if one or more of their suppliers

suffer bankruptcy, this could have a drastic impact on their competitive advantage of pricing.

Union Pacific also is at the risk of inflating oil prices. If diesel oil prices rise unexpectidly, this

would negatively impact UNP’s margins. Weather is also a conern for the company. If there is

severe weather in a region of the country, then efficiency along the railway system will be

slowed.

Union Pacific

NYSE: UNP


Other Analyst Recommendations

According to the world-wide data gathering company Reuters, Union Pacific has a strong Buy,

Outperform, and Hold positions while not a single analyst recommending an Underperform or

Sell option. The analysts positions align with the recommendations from our forecasts, which

only adds to the conviction Union Pacific is a strong buy and hold for any portfolio.

Union Pacific

NYSE: UNP


Recommendation Summary

As the US economy recovers, the demand for

consumption increases year over year, which

booms the demand of freight and benefit the

railroad industry. As the leading company in the

industry, Union Pacific has huge opportunities to

gain profit in the future decade.

Union Pacific’s 3-Year CAGR’s shows Total Revenue growth of 9.0%, EBIT growth of 14.0%,

Earning Per Share growth of 19.3%, Dividends Per Share growth of 31.2%, and Total Invested

Captial growth of 4.9%. With these numbers Union Pacific shows continuous growth and

efficiency while already solidifying itself as the central and midwest leader in the railroad

industry.

From the intrinsic value estimates, we can see that UNP’s current stock price is slightly undervalued in every category, except the dividend disount model. UNP has a low dividend yield of 1.9% but the intrinsic value of the dividend discount model is still valueing over half of the current stock price in the form of dividends.

Despite the low dividend yield UNP has been growing dividends per share at a rate of 31.2% over the last three years. This again shows Union Pacifics ability to create value for the portfolio.

Ultimately the present value of FCFs model states Union Pacific stock is slightly undervalued even with reduced margin growth rates and a beta of 1.0 to the market. This results also suggest continued growth into the future with appreciation of capital, economic-value added, free cash flow, NOPAT, earnings per share, dividends per share, and with the intrinsic value of the firm.

The macroeconomic outlook created by the Apllied Portfolio Management class indicated a moderate upturn expected to occur within the next year. This indicated by an increase in new manufacturing orders and an increase in consumer confidence. All these varaibles signify an increase in the demand to move more good across the United States. There is no better way to move goods than the railway system.

For all of these reasons, we rate UNP as a BUY.

unp union pacific corporation sector: industrials buy · union pacific nyse: unp intermodal, 20%...

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