Sometimes the most difficult companies to assess and analyze are those that are doing everything right but are facing incredibly difficult external challenges. On one hand, there's huge appeal in a company that's reducing its costs, making the right investment decisions, and handsomely rewarding shareholders with higher dividends. But if all of this still ends in falling profitability, there's little investment appeal. That seems to be the case with Union Pacific Corporation (NYSE:UNP).
Union Pacific continues to implement major cost-cutting measures that are having a very positive impact on its operating ratio. In fact, its operating ratio reached a record 63.1% in the 2015 fiscal year, down by 40 basis points from the prior year. And with the potential for further progress on productivity, cost reduction, and generating efficiencies, Union Pacific could deliver further improvements in its operating ratio moving forward.
Additionally, Union Pacific continues to be a very shareholder-friendly business. It increased cash returns to its shareholders in 2015 through a rise in full-year dividends of 15% and a 7% increase in the value of shares repurchased, with the company having bought $3.5 billion in shares.
Furthermore, Union Pacific plans to cut back on capital expenditures, and this should help it to afford the current level of dividends in 2016. Having spent $4.3 billion in 2015, which was an increase of $200 million on 2014's capital expenditure, Union Pacific estimates that capital expenditure will total $3.75 billion next year, which would represent a cut of 12.8% because of challenging market conditions.
However, Union Pacific faces multiple threats to its sales and profitability in 2016 and beyond. As such, the gains it is making in terms of cost control, capital management, and winning over income investors through rising dividends are being wholly undone by double-digit falls in revenue, which are showing no sign of slowing. In fact, Union Pacific's operating revenue fell by 15% in the fourth quarter of the year, with five of its six divisions showing a decline versus the comparable quarter from the prior year.
The reasons for the decline are wide and varied. However, commodity prices are having a major impact on Union Pacific's top line. For example, coal demand is being affected by a lower gas price as well as high inventory levels, and this contributed to a 31% fall in quarterly revenue for the division. Similarly, declines in shale drilling activity resulting from lower energy prices hurt volumes in frack sand shipments, and with the potential for clean energy to become a greater part of the domestic energy mix over the long run, there are no guarantees that energy prices will begin a sustained recovery. Meanwhile, lower grain prices and a stronger dollar hurt grain shipments.
An appealing business?
This situation compromises a view many investors hold: that Union Pacific has a wide economic moat. It may not be exposed to the same level of competition as many of its S&P 500 peers, but it lacks defensive qualities and is highly dependent upon commodity prices. If they fall, its revenue declines, and even with the great work the company is undertaking to push its operating ratio to an all-time low, it's simply not enough to offset the external challenges it faces.
In addition, the company's policy on cash resources may be helpful in the short run to investors who are struggling to cope with a dovish Fed, but raising dividends and share repurchases at a time when earnings per share fell by 5% (in 2015) and are due to decline by a further 2% this year may not be a sound strategy. Sure, automotive sales have been robust and the division delivered a 1% gain in revenue in the fourth quarter of 2015, but the overall performance of the business remains poor.
A lack of catalysts
With regard to its valuation, Union Pacific offers a discount to the S&P 500. It has a forward P/E ratio of 13.4 versus 16.7 for the index, and it could be argued that a narrowing of this premium will take place. However, when compared to its sector peers such as CSX, Norfolk Southern, and Kansas City Southern, Union Pacific's value appears to be in line. That's because they have P/E ratios of 13, 13.5, and 16.6 respectively, so upward rerating prospects may be rather more limited than when Union Pacific is compared to the wider index.
The main problem, though, is a lack of catalysts. Union Pacific can seemingly do no more than it's currently doing to turn its fortunes around, and so it seems difficult to foresee a rising share price until external conditions improve. Therefore, while Union Pacific is running fast, it is at best only standing still.