Union Pacific: Pay Consideration To FCF (NYSE:UNP)

Introduction

My thesis is that buyers want to concentrate to free money move (“FCF”) for railroad corporations like Union Pacific (NYSE:UNP), particularly throughout instances of excessive inflation. The distinction Union Pacific sees between web revenue and FCF tends to be extra significant when inflation is excessive.

By FCF, we imply money offered by working actions much less capital expenditures (“capex”). One of many methods administration’s definition for FCF differs from that is that in addition they subtract dividends. Administration calculates money conversion through the use of a numerator of money offered by working actions much less capex; they then divide this numerator by the denominator of web revenue.

The Numbers

The condensed consolidated assertion of money flows within the 2Q22 launch reveals that capex has gone up 38% from $1,190 million in 1H21 to $1,645 million in 1H22:

This is among the explanation why railroads must be evaluated from a free money move (“FCF”) perspective versus only a web revenue perspective. Whereas calculating FCF, administration subtracts the entire money utilized in investing actions whereas I solely subtract the capex portion. Additionally, administration subtracts dividends paid and I don’t. Union Pacific noticed web revenue rise from $3,139 million for 1H21 to $3,465 million for 1H22. Nonetheless, FCF fell from $3,029 million [$4,219 million – $1,190 million] for 1H21 to $2,522 million [$4,167 million – $1,645 million] for 1H22. The FCF margin fell from almost 29% [$3,029 million/$10,505 million] for 1H21 to underneath 21% [$2,522 million/$12,129 million] for 1H22.

FCF fell from over 96% of web revenue in 1H21 to lower than 73% of web revenue in 1H22. This money conversion fall from 96% to 73% is proven on slide 18 of the 2Q22 presentation:

Right here is the best way administration reveals the mathematics behind the money conversion price from the 2Q22 10-Q:

Now we have numbers going again a long time that can be utilized to compute money conversion. The years 1971 to 1980 are coated within the 1980 annual report. The 1981 to 1987 interval is roofed within the 1987 annual report. Notice that the 1987 annual report says that capex consists of exploratory expenditures and capital expenditures of unconsolidated affiliated corporations. There’s a hole from 1988 to 1991 however EDGAR has 10-Okay filings going again to 1993 and the 1993 submitting has numbers going again to 1991. Utilizing these numbers, I put collectively a spreadsheet that reveals how effectively Union Pacific has achieved with FCF for the reason that financial downturn of 2007 to 2009.

Earlier than wanting on the spreadsheet, we’ve to be aware of inflation and deregulation. The Staggers Rail Act of 1980 was an inflection level for the railroad trade; comparisons for years earlier than that point are apples and oranges because the trade economics improved dramatically afterwards. We additionally had excessive inflation within the Seventies which is very unhealthy for capital intensive industries like railroads. FRED reveals annual inflation primarily based on client costs from January 1st of every 12 months:

Listed below are the FCF and money conversion numbers going again over time:

*For 2017 above, I used the money conversion share of 86% versus the share we’d see when dividing by GAAP web revenue. The 86% comes from web page 102 of the 2020 Construct America report during which it’s defined that 2016 and 2017 are adjusted to incorporate the retrospective adoption of ASU 2017-07 and that 2017 is adjusted to exclude the influence of Company Tax Reform. In that report in addition they adjusted 2020 all the way down to 101% from 105% as they excluded the Brazos non-cash impairment change however I left 2020 alone. For 1991, I added a particular cost of $870 million again to web revenue. I used web revenue of $485 million for 1986, ignoring particular costs that introduced GAAP web revenue all the way down to damaging $460 million for that 12 months.

It’s simpler to visualise these numbers in a chart and the numbers are extra constant from 2000 to current. We see that FCF and the FCF margin have gone up properly since 2009:

Having many similarities with Union Pacific, Burlington Northern Santa Fe was acquired by Berkshire Hathaway (BRK.A) (BRK.B) in 2009. Given elements like low money conversion charges within the years main as much as the acquisition, I’m positive Berkshire CEO Warren Buffett was focusing extra on FCF than GAAP web revenue when wanting on the annual studies. Immediately’s buyers have to focus intently on money conversion now that it has gone all the way down to 73% for 1H22.

Valuation

In October 2021 I wrote about how issues like longer practice lengths have boosted FCF margins over time. Nonetheless, we have to watch capex very intently now that inflation is on the rise. A method railroad buyers can assuage themselves is by remembering that the upper gas costs we’re seeing on this inflationary setting have a tendency to harm trucking opponents greater than they damage railroads. Wanting on the 2Q22 10-Q and the 2021 10-Okay, trailing-twelve month (“TTM”) web revenue is $6,849 million [$3,465 million + $6,523 million – $3,139 million]. Utilizing web revenue alone as a valuation metric is dappled and the extra significant TTM FCF is $5,589 million [$2,522 million + $6,096 million – $3,029 million].

The 2Q22 10-Q reveals 624,478,594 shares excellent as of July fifteenth. Multiplying this by the July twenty second share worth of $213.40 offers us a market cap of $133 billion. The enterprise worth is $32.8 billion greater than the market cap. This is because of long-term debt of $29,673 million and long-term lease liabilities of $1,295 million plus short-term debt of $2,334 million and short-term lease liabilities of $314 million; these issues are solely partially offset by money and short-term investments of $834 million. Each web revenue and FCF are lowered by the curiosity expense line which was $623 million for 1H22 and $1,208 million for the TTM by means of June [$623 million + $1,157 million – $572 million]. As such, I like to make use of market cap as an alternative of enterprise worth when making comparisons.

Proper now, Union Pacific’s market cap is about 24x TTM FCF and this is likely to be a bit wealthy as rates of interest preserve rising. Nonetheless, betting towards railroads for prolonged intervals of time has been disastrous since 2009 and possibly Mr. Market is true about right this moment’s share worth.