QuickTake on Union Pacific’s 1Q18 Earnings

We took a short break from our series on Netflix to look over the numbers published by Union Pacific UNP last week after its first quarter 2018 earnings announcement.

The bearish call spread investment we highlighted in early February frustratingly has been trading above our Effective Sell Price of $130.50 for most of its tenor. This investment expires in two weeks and a day (May 18th) and it is anyone’s guess how the share price will move during that time.

The synthetic short investment we highlighted a bit earlier in February has more time to expiration, but has not performed any better, save for when the stock temporarily dipped into the $120 range.

Despite the frustrations on the investing side, our valuation driver projections continue to reflect a clear understanding of the company’s operating dynamics, and we are standing behind our intrinsic value range of $80 per share to $139 per share with a most likely value in the $90 per share range.

The stock underperformed the market by over 400 basis points on the day earnings were announced, which we take as a sign that the market is increasingly coming to weigh Union Pacific according to the same scale we are using.

Quarterly Highlights & Model Calibration

Revenues

The company generated $5.1 billion in revenues in 1Q18, up 6.6% from the $4.8 billion in revenues generated in 1Q17.

In contrast, our best- and worst-case revenue change projections for full-year 2018 are 9% and 4%, respectively. Actual results are very close to the mathematical mid-point of our projection range, which suggests that our forecasts are well calibrated.

One irritation is that Union Pacific is reshuffling its freight class reporting into four segments, compared to the five that it has historically reported on and on which our model is based.

The biggest difference in the representation is that Coal has been added with freight related to oil production (fracking sand, etc.). The former business continues to fade rapidly while the latter continues to boom. Reporting volumes and results for the combined “Energy” segment means that typical growth rates will show in the low to mid single-digit percentages (this quarter’s Energy carloads increased by 6%). There will probably also be more noise in the segment reporting as the effects of Coal compete with the effects of Frac Sand.

It will take time to rebuild our revenue model with the new freight category classifications, but perhaps it’s not bad to rebuild the model and get a fresh look at the company.

Profits

The firm generated Owners’ Cash Profit (OCP) margins of 25% this quarter, which is just at the top of our profitability range of 23% to 25%.

It is worth pointing out that there is some seasonality to Union Pacific’s OCP. In the first quarter of 2017, the company generated an OCP margin of 29%, significantly higher than the full year margin of 23%.

With the uncertain effects of seasonality taken into consideration, we believe that our profitability projections are also well calibrated.

Investment Spending

During the time I have been covering Union Pacific, I’ve been surprised by how much the firm has cut back on investment spending. For this year’s projection, I had carried over the 15% of OCP assumption from last year’s model.

In contrast, in the first quarter of 2018, the firm spent 30% of its OCP on expansionary projects and guided for $3.3 billion in spending — higher than our forecast by a few hundred million dollars.

Increasing our assumption for investment spending this year does not make much of a difference on our valuation range, so we will leave the assumption as it is. That said, we will be watching investment spending closely this year. Union Pacific’s Southern District — which includes several fracking areas — is running at full capacity; this anecdote suggests that the firm will seek to spend more in capacity-increasing projects, so we think there is a good chance our investment forecast for this year will be too low. Over the longer term, it looks right now as if our assumptions are about right.

Full Valuation

As a reminder, we are reattaching our Valuation Waterfall for Union Pacific. I’ll be happy to discuss the valuation and our investments in Union Pacific during Office Hours!