Well, so much for the railroad industry being a slow and steady kind of business. This past quarter, Union Pacific (NYSE:UNP) reported a staggering 27% increase in earnings per share. Numbers like that are pretty much unheard of in this business, but Union Pacific and a slew of other U.S. railroad companies have been reporting similar gains recently. Management is so confident in these results that it is giving mountains of cash back to investors now with more potentially on the way.
There's no way that Union Pacific can keep this up, can it? Let's take a look at the railroad's most recent earnings report to see whether investors can expect these kinds of gains for the foreseeable future.
By the numbers
|Metric||Q1 2018||Q4 2017||Q1 2017|
|Revenue||$5.47 billion||$5.45 billion||$5.13 billion|
|Operating income||$1.93 billion||$2.25 billion||$1.79 billion|
|Net income||$1.31 billion||$7.28 billion||$1.07 billion|
You can pretty much sum up Union Pacific's most recent results in two words: "tax" and "traffic." Total shipments were up 2% compared to last year as higher shipments in its energy segment were more than enough to offset lower agricultural product shipments. Strong traffic demand also allowed management to raise pricing across several segments that translated into a 6.6% revenue gain.
The biggest help to the bottom line was Union Pacific's much lower tax bill for the first quarter. Operating income may have increased 8%, which is impressive in its own right, but the company's tax bill for the quarter was $215 million (35%) lower than this time last year, which led to the 22% increase in net income for the quarter.
This past quarter, management made some small changes to the way it reports its segment results by combining some segments into four broader categories. It shouldn't really change anyone's investment thesis in the company, but it does help to mask weaknesses in some segments by combining them with fast-growing segments. A great example is its energy segment. Union Pacific's coal business has been trending downward for some time as overall coal demand in the U.S. continues to shrink, but shipments of sand for hydraulic fracturing were up 50% compared to this time last year and shipments of oil and other petroleum products are growing at double-digit rates, so it masks coal's weakness on the overall income statement.
One thing that investors should be appreciative of is the fact that even though volume growth and overall expenses were up and there was some congestion across its network in the quarter, the company was still able to lower its operating ratio to 64.6%. Management was able to offset rising costs for fuel, compensation and benefits, and purchases by raising prices across its entire network. Management expects it will be able to lower that result to 60% for the full year 2019 and ultimately to 55%.
What management had to say
The thing that likely has all Union Pacific investors happy right now is the amount of money that management has given back to shareholders lately. Here's CFO Bob Knight giving a quick recap of the company's shareholder return program.
[W]e bought back 9.3 million shares totaling $1.2 billion during the first quarter of 2018. This represents a 53% increase over 2017 in terms of dollars spent for share repurchases. Between our dividend payments and share repurchases, we returned about $1.7 billion to our shareholders in the first quarter, which represents 132% of net income over the same period.
This also represents a 39% increase in cash returned to shareholders compared to the first quarter of 2017. Looking ahead to 2018, we still expect full year volumes to be up in the low single-digit range.
What's more surprising is that Knight also hinted that the company could use its balance sheet to return even more to shareholders in the coming quarters.
In light of the higher earnings and cash flow that we expect to generate from tax reform, we are in the process of reevaluating our target leverage ratio and optimal capital structure. As we have stated before, we believe tax reform enables greater debt capacity for Union Pacific while still retaining a strong investment-grade credit rating.
"Can" and "should" are two very different things
It's a good time to be in the railroad business. Even though some of rails' largest customers aren't doing great right now -- grain and coal -- those are being more than offset by other segments and is allowing management to raise prices. Add to that its much lower tax bill and Union Pacific is able to generate lots of cash to return to shareholders.
One thing that may be a slight concern is management's hint that it could take on some additional debt that could lead to more buybacks. Lower taxes and more robust cash flows may make a higher debt load possible, but it seems like an unnecessary initiative when you look at the size of its share repurchases and its growing dividend payments. While there aren't any impending signs of a slowdown, I think it's fair to say that we are at a higher point in the economic cycle.
It would seem that it would be more prudent to de-leverage the balance sheet while times are good such that it can continue these shareholder-friendly initiatives when the market inevitably turns. After all, with an enterprise value to EBITDA ratio of 11.9 times right now, it's not as if management is buying shares on the cheap.