We think Union Pacific's (UNP) shares are worth $170 each, about in-line with where shares are trading. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis it scores high on our scale. Union Pacific posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. We compare Union Pacific to peers Canadian National (CNI), CSX Corp (CSX), and Norfolk Southern (NSC). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score (10=best):
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Investment Considerations
Investment Highlights
• One of America's most recognized companies, Union Pacific links 23 states in the western two-thirds of the country by rail, providing a critical link in the global supply chain. The railroad's diversified business mix includes agricultural products, automotive, chemicals, coal, industrial products and intermodal.
• We expect Union Pacific's operating ratio to be among the best in the railroad group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast.
• Union Pacific has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 19.8% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 31.2%.
• The firm is levered to coal, though we note its mix is more of the Powder River Basin variety, which should continue to take share from Central Appalachian coal in the domestic market. The firm also boasts a strong Valuentum Dividend Cushion score and a decent annual yield.
• The firm sports a very nice dividend yield of 2%. We expect the firm to pay out about 33% of next year's earnings to shareholders as dividends.
Business Quality
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Union Pacific's 3-year historical return on invested capital (without goodwill) is 9.4%, which is below the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Union Pacific's free cash flow margin has averaged about 13.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Union Pacific, cash flow from operations increased about 50% from levels registered two years ago, while capital expenditures expanded about 33% over the same time period.
Valuation Analysis
The estimated fair value of $170 per share represents a price-to-earnings (P/E) ratio of about 20.5 times last year's earnings and an implied EV/EBITDA multiple of about 9.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 14%. Our model reflects a 5-year projected average operating margin of 38.7%, which is above Union Pacific's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.7% for the next 15 years and 3% in perpetuity. For Union Pacific, we use a 10% weighted average cost of capital to discount future free cash flows.
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Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $170 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Union Pacific. We think the firm is attractive below $136 per share (the green line), but quite expensive above $204 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Union Pacific's fair value at this point in time to be about $170 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Union Pacific's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $219 per share in Year 3 represents our existing fair value per share of $170 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Additional disclosure: UNP is included in the portfolio of our Best Ideas Newsletter.
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