Undervalued Dividend Growth Stock of the Week: Union Pacific Corporation (UNP)

Benjamin Graham, the forefather of modern value investing and teacher of Warren Buffett, explained his view on investing by stating that the stock market is like a voting machine over the short term and a weighing machine over the long term.

What that means is that the stock market likes to run popularity contests over short periods of time – popular stocks can and often will run up over the course of days, weeks, or months, all while unpopular stocks will drop precipitously over that same period. Even though the popularity of a stock might not have much to do with underlying fundamentals of the business, the effect on price is all the same.

However, the weighing machine concept relates to value eventually trumping popularity.

A company’s actual weight – its actual intrinsic value – will shine through over the long run.

While this is easy to understand, it can be difficult to actually live through in real-time.

It’s tough to stomach a 20% or 30% drop on a stock you’ve already purchased, even if you know deep down inside that the value of the business hasn’t dropped nearly as much.

Losing a popularity contest, while probably meaningless over the long run, still hurts quite a bit in the moment of it all, especially when your money is at stake.

But it’s important to keep perspective and use value as your guiding star rather than price.

For instance, I see many stocks that have dropped 30% or 40% over the course of 2015 as they’ve been clearly losing the popularity contest.

At the same time, though, I can look at the fundamentals and see that, in my cases, the long-term fundamentals haven’t deteriorated by that same 30% or 40%.

See, stocks simply represent ownership in real businesses that sell real products and/or services.

As such, we can look at a real business and use a valuation system to arrive at a reasonable estimate for intrinsic value.

We can look at the cash flow (or dividends they pay out to shareholders) a business generates and look at the rate at which the cash flow is increasing and discount that back to the present day to “weigh” the business.

Once you are able to actually weigh a business, you can use short-term popularity contests to your advantage and buy when the market is “voting” an unpopular stock in at a price lower than that which it’s likely worth.

This can be an incredible advantage for the cool-headed investor focused on long-term value.

First, it allows you to lock in a higher yield.

A stock losing at a popularity contest can easily put more money in your pocket. All else equal, a lower price correlates with a higher yield.

The more unpopular a stock gets, the more I tend to like it. A cheaper price means a higher yield, which effectively means more income.

Second, it reduces your risk.

When a stock drops from $100 to $80, you only have to pony up $80 per share rather than $100 per share. That’s less money you have to risk for each share of a business. That’s less possible downside as well, since the fall from $80 to $0 is certainly less than $100 to $0.

In addition, it adds a margin of safety since your estimate of intrinsic value could be off due to unforeseen circumstances. The lower the price you pay, the larger the margin of safety you have, which means the fair value of a business could fall somewhat and you’d still come out ahead over the long run.

Third, it increases your potential long-term total return.

That aforementioned higher yield already contributes to more potential long-term total return since yield is one component of total return. And the other, capital gain, is potentially boosted when the voting machine gives way to the weighing machine over the long run.

A stock priced at $40 but really worth $60 is likely to see a $60 price tag once short-term opinions matter less than long-term fundamentals. Meanwhile, an investor buying in at $40 locks in the higher yield that lower price affords while also seeing the $20 per-share capital gain.

So you can see exactly why I’ve long aimed to buy high-quality stocks temporarily losing popularity contests as I’ve built out my six-figure portfolio.

Over and over again I’ve been able to snag shares after substantial drops in price, only to see the weighing machine eventually take over.

However, I only invest in dividend growth stocks – stocks that routinely and regularly pay and grow dividends.

A business that can afford to pay a dividend at all tells me a lot about profit and cash flow. But a dividend that’s growing year after year for decades on end tells me even more about the quality and consistency of a business. Having the wherewithal to share profit is one thing, but the ability to grow cash payouts for decades is quite another.

You’ll see exactly what I’m talking about by perusing David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish has taken the time to compile information on almost 800 US-listed stocks that have increased their dividends for at least the last five consecutive years.

Well, I recently came across one stock on Mr. Fish’s CCC list that is clearly losing the short-term popularity contest. The voting machine is giving this stock a big “thumbs down”.

But I believe the weighing machine will eventually allow this stock’s weight to shine through.

In the meantime, there appears to be an opportunity one can take advantage of…

Union Pacific Corporation (UNP) is the largest US railroad, operating more than 32,000 miles of track that serves the western two-thirds of the country.

Rail is one of America’s oldest industries, yet it continues to thrive.

And that’s because goods have to be moved. The more goods that are consumed (due to more people consuming more goods), the more goods that have to be transported from one point to another. And companies will always choose to have those goods moved in the cheapest (and most profitable) manner possible.

Well, this is why the railroad industry continues to do well all these years later. The rail network has a sizable cost advantage over other forms of transport, especially when there’s no waterway to connect the origin to the destination. It’s estimated that railroads are four times as fuel efficient as trucks per ton-mile of freight, which means that railroads are the obvious choice for long-haul transport in a lot of cases.

In addition, there is limited competition in the industry, which promotes healthy competition and rational pricing. There are only eight major railroads in North America, and it’s highly unlikely this will ever change due to the extremely high barriers to entry – building a new major railroad line would be almost impossible today due to the right-of-way that would be necessary.

These built-in competitive advantages have helped Union Pacific build up a nice dividend growth streak – nine consecutive years of dividend raises and counting.

While not extremely lengthy, the rate at which Union Pacific has increased its dividend more than makes up for that. Over the last five years, for instance, they’ve increased their dividend at an annual rate of 27.3%.

While that kind of growth rate is highly unlikely to persist, the low payout ratio of just 38% indicates that the company has plenty of room in the tank to continue delivering dividend increases for a long time to come.

It’s also worth noting that the payout ratio isn’t markedly higher now than it was a decade ago, so it’s not like the company has been fueling that significant dividend growth with simply a higher payout ratio.

unp sOn top of all that, the stock yields 2.85% right now.

That’s more than 100 basis points higher than the five-year average yield for this stock, which is 1.7%.

The current yield is near an all-time high.

So there’s just a lot to like here with the dividend. You’re getting a yield near an all-time high that’s comfortably supported by a moderate payout ratio. Meanwhile, the company has both the wherewithal and the willingness to share its growing profit with shareholders in the form of a growing dividend.

But what just kind of growing profit is Union Pacific working with?

We’ll take a look at revenue and profit growth over the last decade to discover that, which will also tell us a lot about where the business is going and what it might be worth.

First, the top-line growth is pretty impressive when you consider the railroad industry is one of the oldest and most mature of them all: Union Pacific grew its revenue from $13.578 billion to $23.998 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 6.53%.

Profit growth, however, was substantially greater over this period. Earnings per share grew from $0.96 to $5.75, which is a CAGR of 22%.

Union Pacific was able to expand its margins rather considerably, which helped propel a good portion of that excess bottom-line growth. In addition, the company regularly bought back large chunks of its stock, reducing its outstanding share count by more than 15% over the last decade.

S&P Capital IQ believes that Union Pacific will be able to compound its EPS by an annual rate of 12% over the next three years, citing the potential for lower volumes offset by lower fuel costs. Possible margin compression is also factored in here. This growth rate would be pretty wonderful, if it comes to pass. While much lower than what Union Pacific has delivered over the last decade, double-digit EPS growth for a mature company is never disappointing, in my opinion.

One aspect of this business that further goes to prove its high quality is the balance sheet.

Union Pacific’s long-term debt/equity ratio is 0.52 and its interest coverage ratio is over 15. These numbers compare very favorably to every other major railroad out there.

I mentioned expanding margins earlier. I’ll show you what that looks like.

Over the last five years, the company has averaged net margin of 18.73% and return on equity of 19%. Net margin and ROE a decade ago was below 10%. There has been a clear and secular expansion in company efficiency and profitability over the last decade.

While outstanding in the sense that these numbers are at or near the top of the industry, there’s probably limited room for further expansion moving forward. As such, growth expectations should likely be moderated, which is what you see with the prediction laid out above.

This stock is down over 35% YTD. The S&P 500, meanwhile, is about flat over that same time frame. To say Union Pacific’s stock is losing a short-term popularity contest would be an understatement.

But is the business actually worth 35% less now than it was at the beginning of the year?

Consider that the railroad’s third quarter report for FY 2015 reported EPS of $1.50. That’s a 2% decline year-over-year. Volumes were down about 6% YOY. But some of the volume decrease was offset by pricing gains, which led to a record quarterly operating ratio.

So you’ve got a business that, when weighed out, is coming in a little less than it was last year. Yet the stock’s vote is coming in about 35% lower than this time last year.

What kind of opportunity is that leading to?

The stock is trading hands for a P/E ratio of 13.33 right now. This is a best-of-breed railroad that has averaged a P/E ratio of 17.5 over the last five years. Every other simple valuation metric (price-to-book ratio, price-to-sales ratio, etc.) is lower than its five-year average, even while the business continues to put out numbers near its all-time high. And there’s the aforementioned spread in yield, which is rather large.

Appears to be quite cheap. But how cheap? What’s this stock likely worth?

I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 8%. That’s on the higher end of what I normally allow for, but I think it’s sensible here considering the inherent competitive advantages, moderate payout ratio, historical EPS and dividend growth, and forecast for growth moving forward. The DDM analysis gives me a fair value of $118.80.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

I believe we have a high-quality dividend growth stock that is losing a short-term popularity contest, but very likely to win a long-term weighing contest. Don’t believe me? Let’s see what some professionals have to say about it…

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates UNP as a 4-star stock, with a fair value estimate of $110.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates UNP as a 4-star “buy”, with a 12-month target price of $112.00.

You can see a trend here – UNP appears to be worth much more than the ~$77 the stock is priced at right now. Whether you believe in the weighing machine or voting machine depends on your time horizon, but a disconnect does seem to be present. Averaging out the three values gives us $113.60, which would mean this stock is potentially 47% undervalued right now.

unpBottom line: Union Pacific Corporation (UNP) is a high-quality railroad operating in a unique industry where competitive advantages are practically built in. There are always risks with any stock, but the risks after a 35% drop appear to be much less now than before. The yield is near an all-time high while the fundamentals remain as solid as ever. In addition, there’s the potential for 47% upside. I recently added to my position; you may want to consider the same.

— Jason Fieber, Dividend Mantra

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