UNP reported revenue growth of 5% and EPS growth of 10% y/y (mostly thanks to share repurchase and a lower tax rate). However, UNP consolidated today on network fluidity issues, lower pricing than expected and poor Intermodal growth. Just a reminder that prior to today, the stock had climbed 34% in the past 6 months. We are seeing no degradation to our long-term thesis of a management team focused on productivity and returns. We are increasing our price target to $145 after rolling over our model to 2018.
Current Price: $133.6 Price Target: $145 (NEW)
Position size: 2% TTM Performance: +21%
Thesis intact. Takeaways from the quarter:
1. Revenues were up 5% y/y. Core pricing was +1.75% (lower than expected), and volume +1%.
a. Total freight volume +1%: Industrial Products led the way with +17% (thanks mostly to shale drilling activity), while Agricultural Products was the worst at -7%
o Intermodal growth was flat, which is a negative surprise as the trucking industry is being constraint by the lack of drivers to meet the demand, but the management team sees this turning around “we are certainly very hopeful that that ends up being a good market for us in 2018”
o Capacity expansion in the Canadian ports shifted the demand away from the Pacific Northwest US ports
o Fluidity issues from the implementation of new technology Positive Train Control (PTC) being implemented
b. Operating ratio was 62.6%, a 0.6 points above last year. Lower core pricing, and higher fuel prices were headwinds to the margin expansion
c. UNP was impacted by higher diesel fuel prices (+27%) and higher service contracts (+6%)
d. 2017 ROIC 13.7%, 100bps improvement from 2016
2. 2018 outlook:
a. Management expects low-single-digit carload growth, driven by Agriculture, Industrial and Premium, while Energy remains unknown
b. The operating ratio should improve towards their 2019 goal of 60%:
o inflation is expected below 2% in 2018 vs. 2.5% in 2017, increasing the spread between core pricing and inflation
o in addition, productivity improvements of $300-350M equal 140-160bps improvement in the operating ratio
c. Regarding the EPS, a lower tax rate and accelerated share buyback will drive y/y growth
d. Tax rate to be 25% (from 37-38%) from Tax reform; this will bring an additional $1B in cash, that will be used for additional investments, dividends and buybacks
3. Valuation: updating our price target to $145
a. The company continues to return capital to shareholders, buying back $4B shares in 2017 (4% reduction in share count), and distributing ~$2B in dividends (2% yield)
b. The balance sheet is still solid, with leverage below 2x
Investment Thesis:
1. Pricing power: Railroads offer 4x the fuel efficiency of trucking per ton-mile of freight – a secular tailwind
2. History of compelling long term shareholder returns
3. Industry leading operating ratio and improving ROIC driving returns to shareholders via dividends/buybacks. Real shareholder yield of 6.5% (2.5% dividend yield, 4% buyback)