More Upside For Union Pacific After A 55% Rally?

by Trefis Team
-2.42%
Downside
200
Market
195
Trefis
UNP
Union Pacific Corporation
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Union Pacific’s stock (NYSE: UNP) lost almost 37% – dropping from $180 at the beginning of the year to below $115 in late March – then spiked 55% to around $177 now. That means it has fully recovered to the levels where it started the year.

Why? While the Covid-19 outbreak and associated lockdowns resulted in an uncertain outlook for the broader markets, the multi-billion-dollar Fed stimulus announced in late March helped the markets stage a strong recovery. Investors are now expecting a quicker economic rebound with economies opening up gradually, which will bode well for Union Pacific’s transportation business.

But is this all there is to the story?

No, not quite. Despite the recent rally, Trefis estimates Union Pacific’s Valuation at about $195 per share, roughly 10% above the current market price based on two key opportunities and a risk.

The first opportunity we see is to Union Pacific’s Revenue growth over the coming years. We know 2020 will be a year marking a drop in revenues led by lower volume as well as an impact on pricing. However, as we look beyond 2020, with the containment of Covid-19 and availability of vaccines pushing the virus out of the center of attention and resulting in economic growth, we believe Union Pacific will see a rebound in demand for railroad transportation. With the economy opening up and lockdown restrictions already being lifted in several cities, the industrial production is gradually picking up pace, and it will likely result in increased consumer demand in the near term.

The second opportunity we see is to Union Pacific’s Expenses, which have been trending lower, when looked at as a percentage of revenue, over the past few years. Union Pacific has been focused on reducing its operating ratio, and it managed to bring it down from 63.7% in 2016 to 60.6% in 2019. While the Covid-19 pandemic has resulted in increased costs for the company, Union Pacific aims to achieve an operating ratio of under 55% in the long run, thereby boosting the margins. In the near term lower crude oil prices will have a positive as well as adverse impact on the company. On the positive side, the fuel expenses will likely trend lower. Fuel accounted for $2.3 billion expenses or 10.4% of total revenues and roughly 14% of the company’s total expenses in 2019. However, the fuel surcharge is an important element of average revenue per carload garnered by the company. With lower fuel prices, the overall pricing will also be impacted.

That said, there is a risk associated with Union Pacific’s energy commodities freight business. There has been a decline in demand for coal as an energy source and an increased use of cleaner fuels, such as natural gas. Climate change consciousness is growing. There is considerable social and political pressure on fossil fuel producers to reduce emissions, and on consumers to reuse, reduce, recycle! Large investors are backing out. The result – a lower demand for coal. For perspective, the U.S. coal consumption is expected to decline by roughly 40% between 2018 and 2020, according to the US Energy Information Administration. This means lower production, and lower need for transportation. Another factor why there is increased dependency on natural gas as an energy source is its low pricing. In fact, natural gas prices have plummeted over 50% since early 2017. For Union Pacific, its energy shipments have declined 2% in 2018 and 15% in 2019. This trend could continue over the coming years, and weigh on Union Pacific’s overall performance.

The near term risk for Union Pacific stems from the impact of Covid-19. Increased unemployment, lower consumer spending power, and restrictions in place for various manufacturing plants means lower demand for railroad transportation, evident from the company’s Q2 performance. The company’s top line contracted 24% to $4.5 billion in Q2 2020, primarily due to massive declines in coal, automotive, and metal & mineral shipments. Looking at the bottom line, the company posted a 25% decline in its EPS, which stood at $1.67 per share. EPS decline was due to margin contraction, as the company reported operating ratio of 61.0%, compared to 59.6% in the prior year quarter. However, the situation is changing on the ground with the economy gradually opening up. The rebound in economic growth and its timing hinge on the broader containment of the coronavirus spread. Our dashboard forecasting U.S. Covid-19 cases with cross-country comparisons analyzes expected recovery time-frames and possible spread of the virus. Further, our dashboard -28% Coronavirus crash vs. 4 Historic crashes builds a complete macro picture. The complete set of coronavirus impact and timing analyses is available here. For Union Pacific, the key trend to watch out for will be the operating ratio in Q3, as the demand improves over the coming months.

Looking for outsized outperformance? Here is a shortlist of 4 companies that beat the S&P 500, every single year, year after year, for the last 10 years.

Also see – How we arrive at CSX’s Valuation of $81 per share.

See all Trefis Price Estimates and Download Trefis Data here

What’s behind Trefis? See How It’s Powering New Collaboration and What-Ifs For CFOs and Finance Teams | Product, R&D, and Marketing Teams

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