After you receive this Alert, we will be initiating a position in Union Pacific (UNP) , buying 175 shares at roughly $212.85. Following the trade, UNP will represent 1.03% of the portfolio.
We are bringing UNP out of the Bullpen today and adding a position to the portfolio as our recent sale of JPMorgan Chase (JPM) has made room for a new name. You can read our initial Bullpen Alert on the company here. You can also find the company's fourth-quarter 2020 earnings release here.
Following our trims Monday of two outperforming reopening names (Ford (F) and Disney (DIS) ) into strength that you can read about here, one of our objectives today is to recapture that weighting in companies exposed to accelerating economic growth but with a stock that has lagged and consolidated and therefore may be primed for a catch up.
As we scan the market for opportunities to increase exposure to those names that will benefit from the economic reopening, we are drawn to Union Pacific, as the supply crunch we're seeing across many industries (due to a surge in demand coupled with companies that have focused on running lean inventories throughout 2020) means a need to transport goods to rebuild supplies. With this, we also want a company that can pass costs through and therefore serves as a hedge on inflation.
We note UNP has gained only 2% year to date and is roughly flat from its highs of October 2020 despite several positive developments that bode well for economic growth, namely the improving global rollout of multiple effective COVID-19 vaccines and the prospects of more fiscal stimulus and the potential for an infrastructure package.
Union Pacific, which connects 23 states in the western two-thirds of the country by rail and is the world's largest railroad company (by market cap), fits both these priorities as the company ships everything from autos and soybeans to oil and lumber and because of its importance in the global supply chain has significant pricing power -- pricing power being key to any inflationary hedge.
The company reports operations in three segments: Bulk, Industrial and Premium.
Per the company's annual report, "Bulk shipments consist of grain and grain products, fertilizer, food and refrigerated, and coal and renewables," and was responsible for 33% of 2020 freight revenue.
The Industrial segment accounted for 36% of 2020 freight revenues and consists of an extensive network that "facilitates the movement of numerous commodities between thousands of origin and destination points throughout North America."
The Industrial group consists of several categories, including "construction, industrial chemicals, plastics, forest products, specialized products (primarily waste, salt, roofing, and government), metals and ores, petroleum, liquid petroleum gases (LPG), and soda ash." Finally, Premium, 31% of 2020 total freight revenue, "includes finished automobiles, automotive parts, and merchandise in intermodal containers, both domestic and international."
Looking back, UNP navigated 2020 very efficiently, allowing the operator to generate best-in-industry cash returns, maintain its dividend policy (paying out a total of $2.6 billion throughout the year) and reduce shares outstanding by 4% via the repurchase of 22 million UNP shares. At the same time, the company was able to maintain investments, investing $2.84 billion in 2020 in growth productivity and efficiency (such as reduced fuel consumption -- a smart move given the rise in oil prices we're now seeing).
Looking at some of the recent accomplishments of the fourth quarter (FY4Q20), the company's efficiency efforts are paying off as UNP saw its fourth-quarter adjusted operating ratio (operating expenses as a percentage of operating revenue) decline 410 basis points annually to 55.6%, an all-time quarterly record thanks to the effective implementation of precision railroading.
We also saw all-time quarterly records in Locomotive Productivity (measured as gross ton-miles per average daily locomotive horsepower) and Workforce Productivity (measured as average daily car miles per employee). Other improvements included an increase in train length (think more capacity per trip) and freight car velocity as well as a decrease (a positive) in freight car terminal dwell (the time a rail car spends at the terminals).
Looking ahead, the 2020 annual report, management noted that they expect volumes to increase 4% "to as high as" 6% versus 2020. The team also expects "continued margin improvement driven by pricing opportunities in excess of inflation and ongoing productivity initiatives." This should result in ~$500 million of productivity savings as the team better leverages its resources.
The bottom line is that there is no economic reopening without an increase in supply chain/industrial transport activity. This makes Union Pacific levered to autos, soybeans, lumber, oil, all of which should see increased demand as economic activity accelerates. Union Pacific's leading market position and significant pricing power will allow the company to offset inflationary pressures and the strong rebound that we are seeing in the end markets of the company's main customers supports management's view of mid-single digit volume increases in 2021.
We are starting relatively small in UNP as we want to leave room to scale into the position over time. Cyclically oriented stocks like UNP have been extremely resilient to the recent rise in interest rates as investors have rotated out of tech and into more "value-based" names. Should this great bifurcation reverse and work against UNP in the near-term, we will happily scale deeper into this position.
We are initiating the position with a $240 price target, which reflects roughly 25x 2022 consensus EPS estimates. This is a rich multiple relative to the company's historical average, but we think the company's earnings power is likely underappreciated and the "E" will prove to be higher based on the fact that expectations for economic growth are rising fast.
Watching Tech
As for tech, we are watching names closely in the Tuesday rebound but are currently sitting on our hands as we are hesitant to pay up multiple percent on a single day in a volatile market. If we see the tech-heavy Nasdaq lose some later in the afternoon, we will be ready to pick at one or two of some of our favorite names in the portfolio like One-rated Salesforce (CRM) or even Two-rated Alphabet (GOOGL) or Marvell Technology (MRVL) .
As for those Twos, GOOGL is on our radar because it is a reopening stock that we think does not deserve to be 5% off its highs (before today's move) with the return of travel advertisements. The multiple is also getting very attractive here at just 29x 2021 EPS estimates.
In the case of MRVL, we sold a huge chunk of our position ahead of the quarter in our Alert here and we like the fact that an analyst who has been on the sidelines upgraded their rating yesterday citing an "appealing" risk-reward.