Is Union Pacific Stock Overvalued?

Union Pacific (NYSE:UNP) has been a critical part of America’s transportation infrastructure since the 1860s. Following less-than-stellar second quarter results, is Union Pacific stock overvalued and a short opportunity?

The Case for Overvaluation

Two red flags suggest the stock is overvalued.:

1. The company’s debt-to-equity ratio, which at 2.4 represents a serious concern for the company’s balance sheet. 
2. Its 2.2 price-to-earnings-growth ratio. Traditionally, a PEG ratio of 2.0 or more indicates overvaluation.

It’s worth noting, however, that the case for Union Pacific being overvalued isn’t a cut-and-dry one. The forward P/E ratio of 21.5, for instance, is well below the current S&P 500 average of 26.5.

The stock is also priced at 15.4 times cash flow, which is a reasonable level for a dominant, profitable company.

Operating Revenue & Income Fall, But Shares Pop

Union Pacific’s Q2 earnings report was quite negative, with operating revenue slipping 5 percent relative to Q2 2022. Operating revenue was $6 billion while operating income totaled $2.2 billion. This represented a 12 percent decrease in profits on a year-over-year basis.

Beyond its pure financial metrics, Union Pacific also reported several operational challenges in Q2. Workforce productivity, for example, dropped 5 percent.

Total carload volume was down 2 percent, and the average maximum length of the company’s trains dropped 1 percent. While none of these figures is massively negative in and of itself, they do point to a cumulative slowdown in business at Union Pacific.

The company’s net margin is also trending downward from its recent highs. In Q1 of 2022, the railroad’s trailing 12-month net margin rose to about 30 percent. That metric is now down to about 27 percent. Union Pacific still produces an admirable 55 percent return on equity and 10.4 percent return on assets, but the company will have to turn its margins around in order to regain momentum.

Investors, though, seem to be taking the most recent quarter’s struggles in stride. Much of the general optimism around the stock comes from the installation of a new CEO at the request of Soroban Capital Partners.

The hedge fund, which holds over $1.5 billion in Union Pacific shares, encouraged management to place Jim Vena at the company’s helm. Vena, who previously served as COO, will be tasked with cutting costs and increasing efficiency. If successful, Vena could restore the railroad’s waning margins and generate higher future earnings.

Even with the temporary downturn, analysts still expect decent long-term earnings growth from Union Pacific. Over the next five years, the company’s projected average earnings growth rate is 8.2 percent. For a company as mature as Union Pacific, this rate is likely healthy and sustainable.

Analysts Forecast UNP Shares Will Rise 9.5%

The median target price for Union Pacific based on 26 analyst forecasts is $255.50. This would give the stock a 9.9 percent upside from the most recent price of $231.70.

Comparing this forecast to the 9.5 percent gains expected from the S&P 500 in the coming 12 months, it seems likely that Union Pacific will more or less track the broader market unless a major earnings upset occurs.

In addition to returns from increasing share prices, Union Pacific also pays an annual dividend of $5.20 per share. At today’s price, this amounts to an additional 2.25 percent return.

At 47.5 percent, the dividend payout ratio is low enough that Union Pacific likely won’t have any trouble maintaining and raising its distribution.

In fact, management has been eager to return cash to shareholders in recent years. The 3-year dividend growth rate for Union Pacific has been over 11 percent, and management appears to have a decent amount of room left for future increases.

Cost Cutting Is High Priority

Union Pacific’s incoming CEO has a clear mandate to cut costs at the railroad. While desirable from a long-term earnings standpoint, there’s also potential for negative disruption in a drive to improve margins.

Management shake-ups and course corrections can prove risky for investors, especially in a business as large, complex and capital-intensive as a major railroad.

Union Pacific’s growing debt load could also be a stumbling block as the company attempts to move forward. At well over double total equity, the railroad’s debts are larger than many investors will be comfortable with. If the company continues to borrow in this higher interest rate environment, its cost of debt service could eat into its profit margins.

Investors are also losing the support that management had provided to the stock by repurchasing shares. In Q2, the company bought back $120 million of its own stock.

However, Union Pacific does not plan to pursue further buybacks in 2023. While management can likely deploy its capital more effectively by paying down debt and improving efficiency, the end of the buyback program will temporarily shut off a useful mechanism for rewarding shareholders.

Finally, many of Union Pacific’s problems are related to the macroeconomic environment. As noted in the Q2 release, inflation and lower consumer demand both played roles in dampening the company’s profits.

With the Fed still raising interest rates to tamp down inflation and consumer confidence still well below pre-pandemic levels, Union Pacific may struggle until a more solid economic recovery is in progress.

Is Union Pacific Overvalued?

Despite some concerning valuation metrics, Union Pacific appears to be at worst only slightly overvalued.

If management is successful in bringing down costs and boosting earnings, the stock could prove to be more or less fairly valued. As a key mover of goods and materials, UNP also enjoys a strong moat that it is unlikely to lose any time soon.

The railroad’s long-term prospects still appear positive. Investors could, however, see a period of somewhat low returns ahead as management cuts costs and temporary economic pressures continue to impact earnings.

Overall, Union Pacific appears to be a reasonably valued stock that is likely to produce returns in line with the broader market along with a decent stream of dividend income.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.