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By Keith Schoonmaker, CFA | 09-27-2017 11:00 AM

Union Pacific Full Steam Ahead on Dividends

The wide-moat firm leads all North American railroads in dividend yield.

Keith Schoonmaker: Union Pacific pays the greatest dividend yield among North American railroads, and we believe shares are slightly undervalued as well. The massive western railroad has increased its dividend per share from $0.34 in 2007 to $2.26 last year, and based on today's market price we expect shares to yield 2.1%. 

We view the dividend as safe, and able to grow because of UP's increasing earnings power. Let me emphasize three key drivers of earnings growth. First, Morningstar rates Union Pacific as having a wide economic moat due to rail's cost advantage compared to trucking, and because of an efficient market structure wherein only two large competitors operate in each geographic region. This structure facilitates pricing power, and we believe the rail can increase core pricing 2% to 3% per annum, or slightly in excess of cost inflation.

Second, we also believe Union Pacific can expand volume about 1.5% annually, on average, with intermodal containers the secular growth source, helping to offset long-run declines in coal. We do believe coal is in secular decline, despite an increase this year due to slightly more expensive gas. However, when it comes to new power generation, the U.S. plans to build more natural gas plants and alternative sources, but no new coal plants are on the books.

Third, we model UP to improve from a 63.5% operating ratio in 2016 to 56% by 2021, by pulling on the same powerful levers it has for a dozen years: namely, pricing and more effective use of both manpower and fuel. We consider one measure of Union Pacific's quality to be its high free cash flow yield, and at 19% in the trailing 12 months, only Canadian National is in the same ballpark. However, railroads require a greater proportion of sales be invested into capex than nearly any other industry. And capex really is the first call on cash, but the firm pays its dividend reliably and buys back shares as well.

We estimate just over 40% of this year's earnings will be paid in dividends, and because this is a relatively low value, we view the dividend as not only safe, but having room to expand along with increasing earnings in the future.

Discounted cash flow is our primary valuation methodology, but by several market multiples such as forward P/E, forward EV/EBITDA, or forward price/free cash flow, UP ranks as the cheapest or second cheapest among the Class 1 railroads.

In sum, this is a long-haul, high-return, wide-moat railroad, with a rich free cash flow yield and the leading dividend yield in its industry, and we believe shares are currently  slightly undervalued.

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