Is Union Pacific Stock a Buy?

Investors buy stocks for all sorts of reasons, and what might seem a boring investment to some will be core holding in a retirement portfolio for others. In the case of Class 1 railroad Union Pacific (UNP 1.04%), it's all about the safety and growth potential in its current 2.3% dividend yield. Here's why it deserves a close look for income-seeking investors.

The case for buying Union Pacific

You can think of Union Pacific as a relatively low risk, bond-like investment, only with more income-generating potential. It's not the sort of stock that's going to shoot the lights out from here, but it should provide investors with good investment returns over the next decade. Let's put it like this: You can buy a 10-year U.S. Treasury note at a current yield of just 0.7% or you can buy Union Pacific stock with a current yield of 2.3%.

Image source: Getty Images.

That said, investing is rarely that simple, and before you rush to buy Union Pacific you have to consider the following:

• What's the risk that Union Pacific's earnings will collapse in the years to come, and how sustainable is its dividend?
• Does the company have any potential to grow its earnings, and consequently, its dividend?

Union Pacific is relatively low risk, but watch the economy

One of the key attractions of buying railroad stocks is their relatively stable market position. The two major railroads on the West Coast are Union Pacific and Berkshire Hathaway's BNSF, while on the East Coast the largest railroads are CSX (CSX 0.56%) and Norfolk Southern (NSC 0.55%). They operate as effective duopolies with their geographies and own their own infrastructure, granting them relatively unassailable market positions in rail freight.

While they do face competition from trucking, it's safe to say there's relatively low risk that they will face some sort of structural challenge to their business in the future. As long as physical goods need to be moved around, then Union Pacific will be around to move them.

As such, the two big risks facing Union Pacific are the trends in the industrial economy and also its exposure to a declining coal industry. As you can see below, the revenues of all the railroads tend to move in line with U.S. industrial production. This is hardly surprising, given the heavy goods that railroads tend to move around. In this context, buying Union Pacific stock is really a vote of confidence in the ability of the U.S. industrial economy to grow after the shock of the COVID-19 pandemic.

Data by YCharts

What about coal?

The chart below shows that coal and renewables only made up 9% of revenue in the first quarter, so decent growth in the rest of Union Pacific's end markets can offset ongoing decline in revenue from coal. The declining use of coal for energy production is certainly a headwind for the railroads, but there are plenty of other growth markets (for example e-commerce deliveries and chemicals) that can offset it.

Data source: Union Pacific presentations.

Growth opportunity

In a sense, you can think of Union Pacific as a kind of "GDP growth" type stock with some headwinds from declining coal revenue. While that's not the most exciting growth outlook from a revenue perspective, it's worth noting that the company has aggressive plans for operating margin expansion through the ongoing adoption of precision scheduled railroading, or PSR, management techniques. 

PSR focuses on running trains between fixed points on a network on a fixed schedule, as opposed to the traditional hub-and-spoke model, where schedules vary considerably. All the evidence suggests that it works and before the pandemic hit, CSX, Norfolk Southern, Kansas City Southern (KSU), and Union Pacific were all forecasting lowering their operating ratios (OR) in 2020 in spite of a mediocre revenue outlook. For reference, the OR is simply operating expenses divided by revenue, so a lower number is better.

Over time, Union Pacific believes it can lower its OR to 55% from 60.6% in 2019. To put this into context, consider the following table, which provides a rough illustration of matters.

It shows the annual growth rate in operating income with an OR of 60.6% compared to an OR of 55% -- remember a lower OR implies a higher margin rate -- with various revenue growth scenarios. The long-term GDP growth rate of the U.S. economy is around 3.5%.

The key point to take away is that even if coal leads to a "GDP Minus" revenue growth rate of just 2.5%, but the OR gets to 55%, Union Pacific will still grow its earnings/dividend more than if it only grows at GDP growth rate (3.5%) with an OR of 60.6%. Simply put, the OR matters a lot. 

Data source: Author's analysis.

A stock to buy?

There's no guarantee that Union Pacific will hit its intended OR target, and no one really knows if the U.S. industrial economy will grow at its historical rate in the future.

On the other hand, if economic growth is low then interest rates are also highly likely to stay low, making the relative attraction of Union Pacific's 2.3% dividend yield even more attractive. Moreover, the relative safety of the company's market position means it's a useful option for dividend investors. It's not the most exciting stock out there, but it looks a decent place to park some cash for some long-term income.