Union Pacific Downgraded - Analyst Blog

We are downgrading our recommendation on Union Pacific Corp. (UNP) from Outperform to Neutral, implying that the stock will perform mostly in line with the broader market. This move is based on the relatively unfavorable economic environment and the regulatory risks.

The current state of the U.S. and world economy is expected to keep Union Pacific’s top-line growth under pressure in the near future. It will not be feasible for the majority of sectors to escape this downturn unscathed. Volumes, as measured by total carloads, were down 16% for full year 2009, compared with a decline of 5% in 2008 and 1% in 2007.

Moreover, certain operating expenses are likely to increase in the coming years. While Union Pacific has caught up on its backlog of hiring, the company still expects significant labor cost inflation, though improved productivity and lower headcount could offset this somewhat.

Interest expense should also prove to be a headwind to earnings growth. The company has added $1.4 billion of long-term debt to fund share repurchases, in part. This will cost the company an additional $60 to $75 million per year in interest charges.

In the first quarter of fiscal 2010, total operating revenues soared 16% year over year to $4 billion. The results for the reported quarter primarily benefited from increased operating revenues, given the growth in business volumes. Stable Customer Satisfaction Index, core pricing gains and strong cash from operations were also among the positives. However, higher operating expenses, primarily as a result of increased fuel costs and depreciation, constitute the primary risk.

Freight revenues also showed an improvement over the prior-year quarter in all six business groups. During the reported quarter, freight revenues spiked up 16% year over year to $3.8 billion.

Despite Union Pacific’s efforts to curtail costs, operating expenses increased 8% year over year in the quarter, primarily due to a 51% rise in fuel costs to $583 million, largely related to higher oil prices as well as an 8% increase in depreciation.

On May 06, 2010, Union Pacific announced to increase its quarterly dividend on common shares by 22% to 33 cents per share, payable on July 1, 2010, to stockholders of record on May 28, 2010. In addition, Union Pacific also announced plans to resume share repurchases under its existing program, which authorizes purchases of up to 32.6 million shares by Mar 31, 2011.

We believe this decision reflects management’s confidence in the improving economy and free cash flow dynamics, which will support better-than-expected operating leverage, earnings growth and cash flow. Considering Union Pacific’s intermodal strategy, the board also approved an additional $100 million capital expenditure in 2010 to acquire intermodal equipment. The total investment for the full year 2010 now stands at $2.6 billion.

While the operating performance may gradually improve in FY10, we believe that one of the company’s most important segments, coal, will continue to lag through the remainder of FY10.

The company has tremendous potential to continue its positive pricing momentum and benefits from huge operating leverage in the near term. However, the long- term growth will be boosted if coal demand and the economy pick up in future. We believe these positives are already reflected in the current valuation, leaving little room for above market gain.

Union Pacific faces stiff competition from Burlington Northern Santa Fe Corporation, Canadian National Railway Co. (CNI) and CSX Corp. (CSX).