Markets & Finance

Union Pacific's Growth Track


By James Corridore With the U.S. economic recovery expected to pick up steam in the months ahead, we at Standard & Poor's believe that railroad stocks will continue to outperform the broader market over the next year. The name we like best in the group is Union Pacific (UNP), the largest railroad operator in the U.S. Its shares get our top investment rating of 5 STARS (buy), reflecting Union Pacific's superior position in the industry. We also like the fact that the stock is undervalued relative to its peers.

Year-to-date through October 25, the S&P Railroad index solidly outperformed the overall market, dipping 3%, while the S&P 500 declined 21.8% over the same period. This partly reflects the industry's cyclical nature, as railroads are among the first sectors to benefit in the early stages of an economic upturn. We expect continued investor rotation into rail stocks as the economy continues to firm up into the first half of 2003.

In addition, many railroads, including Union Pacific and others, have done a good job of trimming costs, cutting excess rail capacity, and reducing headcount. In the process, many outfits have improved profitability and positioned themselves well for the stronger demand that would result from an improved economy.

A WIDE SPREAD. Union Pacific operates more than 33,000 miles of track serving the western two-thirds of the nation. In addition, it also runs a major less-than-truckload (LTL) trucking company, Overnite. Both units should benefit from a strengthening economy, which will allow growth in most commodity groups that these companies ship.

Union Pacific is one of the most diversified railroads, with no commodity category accounting for more than 23% of its revenues in 2001. This allows it to benefit from those sectors seeing strong demand, while reduced demand for one or two commodity groups is unlikely to severely hurt results. For example, although coal revenues declined by 3% in the third quarter of 2002, strength in other sectors allowed Union Pacific to report 4% commodity revenue growth for the quarter. Energy (primarily coal) accounted for 23% of 2001 revenues, industrial products 19%, intermodal 18%, chemicals 16%, automotive 11%, and agricultural 13%.

The most efficient U.S. railroad in the U.S., Union Pacific had an operating ratio (the percentage of revenues eaten up by operating expenses) of 78.3% in the third quarter of 2002, better than any of its competitors. In 2001, its operating ratio was 82.7%, much better than the 85.2% the industry as a whole reported. It has achieved these strong margins due to an emphasis on employee productivity, cost controls, and strong asset utilization.

LESS EXCESS COAL. We at S&P expect Union Pacific's revenues to increase by about 7% in 2003, with the strongest growth expected to come from the automotive, intermodal (cargo carried by a railroad in a trailer or container that originates and terminates with either a motor carrier or ocean shipping line), and agricultural sectors. Industrial shipping should grow modestly, and coal should benefit from normalized inventories at energy producers, which have finally been worked down after a mild winter in 2001 led to excess stockpiles.

Profit margins should benefit from strengthening yields and increased tonnage at the railroad, offsetting likely increases in compensation costs and fuel prices. While oil has been rising of late due to the unrest in the Middle East and the possibility of war with Iraq, Union Pacific has a done a good job of hedging the cost of a large portion of its fuel needs for the fourth quarter and 2003.

Although it's currently adequately protected from upside risk for fuel prices, the continued rise in the cost of oil is a cause of concern. In addition, the West Coast port situation, which did not significantly affect Union Pacific in the third quarter, could have an impact on revenues if a strike or lock-out occurs once the federally mandated cooling-off period expires in December. While we feel the company has the ability to continue to improve revenues and earnings even if these two factors continue to buffet its business, they remain ongoing risks to Union Pacific's earnings growth.

BELOW FAIR VALUE. For 2003, we now forecast earnings per share of $5, which would represent 14% growth from the $4.40 from operations we see for 2002. The stock is currently trading at about $60.25, or 12 times our 2003 estimate, which is in line with its peer-group average. Given its leading margins, diversified revenue base, and position as the largest railroad in the U.S., we believe the shares deserve a premium to the peer-group average. Applying a p-e of 15 on our 2003 estimate implies a 12-month price target of $75.

Given our belief that Union Pacific's earnings will grow faster than the industry average, on a p-e-to-growth (PEG) basis, the stock trades at a discount to the company's peers. Using a 13% expected 5-year EPS growth rate, the shares are trading at a PEG of 0.9, vs. an average of 1.1 for the list of railroad stocks S&P covers. Applying a 1.1 PEG to Union Pacific's stock implies a price target of $71.50.

Our discounted cash flow model, which conservatively assumes one year of negative cash-flow growth after every three years, shows that the shares are trading significantly below fair value of $73.36. We assume that cash-flow growth will mirror gains in earnings, but in reality, given the great strides Union Pacific has taken to control costs and capital spending, cash flow should continue to grow much faster than earnings over the next few years.

Our $73 price target averages the three valuation methodologies discussed above. This price target implies 24% price appreciation potential over the next 12 months, which we feel will significantly outpace the overall market. Analyst Corridore follows transportation stocks for Standard & Poor's


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