Union Pacific Stock Vulnerable To Downside Risk After An 80% Rally

KIEV, UKRAINE – 2018/12/17: In this photo illustration, the Union Pacific Railroad Transport … [+] company logo seen displayed on a smartphone. (Photo Illustration by Igor Golovniov/SOPA Images/LightRocket via Getty Images) LightRocket via Getty Images Union Pacific stock (NYSE: UNP) is up 12% since the start of the year and […]

Union Pacific stock (NYSE: UNP) is up 12% since the start of the year and it has gained around 78% from its March lows. Union Pacific faces downside risk as the company’s revenues in the last three quarters have declined by 13%. The ongoing Covid-19 crisis and the economic uncertainty has hit the company’s transportation business. This is likely to impact the revenue growth rate of the company – leading to a drop in the stock price.

Following a large 78% rise since the March 23 lows of this year, at the current price near $203 per share, we believe UNP stock has reached its near term potential. UNP stock has rallied from $114 to $203 off the recent bottom compared to the S&P which moved 64% over the same time period. Though the company’s Q3 earnings missed the street estimates, a faster than expected rebound in economic activity has helped the stock in beating overall markets. Moreover, the stock is up 51% from levels seen in early 2018, over two years ago. UNP stock has fully recovered to the level it was at before the drop in February due to the coronavirus outbreak becoming a pandemic, and it is now 9% above the pre-Covid highs. This seems to make it fully valued as, in reality, demand and revenues will likely be lower this year than last year. Our dashboard ‘Buy Or Sell Union Pacific Stock’ provides the key numbers behind our thinking, and we explain more below.

Some of the stock price rise over the last two years is justified based on the company’s fundamentals. Union Pacific’s revenues have grown 2.2% from $21.2 billion in 2017 to $21.7 billion in 2019, primarily driven by its Premium Freight segment, which includes Automotive Freight and Intermodal. Union Pacific, in line with other railroad companies, has been focused on reducing its operating ratio over the recent years. The company’s operating ratio of 60.6% in 2019 compares with a 61.8% figure in 2017. This resulted in its Net Margins improving from 21.8% to 27.3%. Note that the margin figure for 2017 is adjusted for the tax gains recorded in 2017 due to changes in the U.S. tax laws. Higher revenues clubbed with improved margins has meant Union Pacific’s EPS grew 44.8% from $5.81 in 2017 to $8.41 in 2019. EPS was also aided by a 12% reduction in total shares outstanding due to share repurchases.

Finally, Union Pacific’s P/E ratio contracted from 23x in 2017 to 21x in 2019. While the company’s P/E has now increased to 24x, it is trading higher compared to the levels seen over the recent years, P/E of 17x in 2018, and P/E of 21x as recently as late 2019. We believe there is a possible downside risk for Union Pacific’s multiple, and the stock is unlikely to see much upside after the recent rally and the potential weakness from a recession driven by the Covid outbreak.

How Is Coronavirus Impacting Union Pacific Stock?

The global spread of coronavirus has affected industrial and economic activity across the world, including Union Pacific, as demand for its transportation services has declined. This resulted in Union Pacific taking a hit when the pandemic started. That said, now with economies gradually opening up, there has been an increase in demand for railroad services. For Q3 though, total revenues were down 11% to $4.9 billion while earnings declined 9% to $2.02 per share.

Diving into the individual segments, Premium segment revenues were flat at $1.6 billion, as growth in Intermodal largely offset the decline seen on the Automotive side. Industrial segment revenues were down 18% led by lower Energy and Metals shipments. Finally, Bulk segment sales were down 12% primarily due to lower Coal freight. In fact, Coal freight continues to be a drag on the railroad companies. While the pandemic has meant lower demand for power, and in turn coal, even before the pandemic coal volume has been on a decline given the increase in the use of natural gas as an alternative to coal. This trend is expected to continue over the coming years. That said, the company’s other segments, including Premium and Industrial will likely see pickup in demand as economies open up, given the availability of a vaccine in the near future. Despite the expected q-o-q growth, total revenues will be lower in 2020 as well as in 2021, when compared to 2019, leading us to believe that the stock is currently overvalued. In fact, overall revenues for the full year 2020 are estimated to decline 10% to around $19.4 billion, while earnings are estimated to be $7.95 on a per share basis, much lower than the $8.38 figure reported in 2019. Not only is the impact on revenues and earnings high when compared to the previous year, the recent rally in the stock has meant an expensive valuation multiple for UNP stock, making it vulnerable to downside risk. At the current price near $203, UNP stock is trading at 25.5x its 2020 expected EPS of $7.95 and 22x its 2021 expected EPS of $9.38, compared to levels of 17x and 21x seen in 2018 and 2019 respectively, seemingly making the stock vulnerable to downside risk.

Looking at the broader economy, the actual recovery and its timing hinge on the containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia. Following the Fed stimulus — which set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view. With investors focusing their attention on 2021 results, the valuations become important in finding value. Though market sentiment can be fickle, and evidence of an uptick in new cases could spook investors once again.

What if you’re looking for a more balanced portfolio instead? Here’s a high-quality portfolio to beat the market, with over 100% return since 2016, versus 55% for the S&P 500. Comprised of companies with strong revenue growth, healthy profits, lots of cash, and low risk, it has outperformed the broader market year after year, consistently.


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