The Dividend Mailbox

UNP Deep Dive: A Growing Dividend Is Just Around the Bend

October 18, 2023 Greg Denewiler Season 1 Episode 28
The Dividend Mailbox
UNP Deep Dive: A Growing Dividend Is Just Around the Bend
Show Notes Transcript

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To most investors, big returns are associated with exciting stories or cutting-edge technology. Since everyone is in the market to make as much money as possible, “boring” companies can be easily dismissed without much second thought. That line of thinking is straightforward enough but it may be misguided. Truthfully, some of the better-performing companies out there are actually pretty boring. When it comes to achieving attractive returns, it is not what a company does that is important, it is how well they do it. 

In this episode, Greg embarks on a deep dive into Union Pacific Railroad ($UNP) and the broader railroad industry. He makes the case that railroads are extremely predictable, well run, and have provided investors with decades of market-beating returns. Railroads are probably not your first idea for building wealth, but these companies are cashflow-compounding machines. This episode is a little bit deeper than we have gone in the past, but it makes for a compelling story. 

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Greg Denewiler 0:11

This is Greg Denewiler and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.

Greg Denewiler 0:41

Welcome to episode 28 of the Dividend Mailbox. As we mentioned in the last episode, we are going to look at the railroad industry and specifically Union Pacific. We are going to go into a fair amount of depth and what you're going to see is how we personally have come to the conclusion that this is not a boring business, but it is a great long-term compound machine. I hope today gives you a sense of what it takes to build some confidence as far as how you double your dividend in 10 years, and then hopefully doubling the investment value. It does take effort and you really do have to pay attention to what you're doing. So, as we go through the business and look at the past stock performance, and how it's currently valued, I think you're going to see that Union Pacific is a pretty compelling story. You really should keep an open mind on these things because they are really great cash flow compounding companies.


When you look at the railroads, first of all, we have to start with the fact that there are just six major railroads out there. There are some smaller lines, but the big ones are— Burlington Northern and Union Pacific basically compete with each other in the west. In the east, there's Norfolk Southern and CSX, and then sort of in the northern middle part of the country is Canadian Pacific and Canadian National. They both have lines that run down to the Gulf, but they don't have nearly as big of a presence in the U.S. They are here, but I'm not going to mention those really much at all. But one question you may have is, well, why did you pick Union Pacific? Well, fortunately, they all somewhat group together as far as long-term returns. There is a difference, but they don't deviate too much. However, the different companies have different dividend yields and policies as far as how they treat shareholders. A couple of them have pretty good dividend yields, and some of them are very low. We picked Union Pacific because the performance is similar to the others, it's somewhat in the middle of the pack. The 2.5% dividend gives us our sweet spot where it gives you a chance to either live off the income or at the very minimum, it gives you a little bit of confidence when you're getting the cash flow in your account. But as you will see, they've all done well. Union Pacific is one of the oldest public companies on the New York Stock Exchange and it's been paying dividends for more than a hundred years, so it definitely has a dividend culture. 

Just to give you kind of an overview, their revenue in 2002 was not quite $11 billion. Ten years later, 2012, it was up to about $19.5 billion. Five years later, out into 2017, it was not quite $20 billion. So, it didn't grow too much in that period, but by June of this year, it was up to almost $25 billion. So, they have really gotten, I hate to use this word, but back on track. 

Earnings have actually done much better, and part of this is just through really making the businesses more efficient. Earnings were $0. 94 in 2002, $3.35 in 2012, and $5.08 in 2017, so even though revenue didn't grow much, they did grow earnings by a fair amount. Then you get to the latest 12 months and they're up to almost $11 a share. So, they've actually had some pretty decent earnings growth. 

When you look at the dividend, in 2002, the dividend for Union Pacific was $0.20. 10 years later, it was not quite a dollar. In 2017 it was up to $2.25, and currently, it's running at a rate of about $5.08. So, looking back at the railroad business over a 20-year period, revenue has more than doubled, earnings have grown by more than 10 times, and the dividend has grown by almost 25 times. So, there is definitely a growth component here.

The railroads as a whole have really done a great job with cash flow management, and some of these payout nice returns to shareholders. Looking at Union Pacific specifically, right now, they're paying out about 45% of their earnings in a dividend, and that is basically the target of the company right now going forward.

One of the things that Union Pacific has done in the last few decades is buy back stock. This is going to come out in the story a little later, partly how they achieved that, but in 2002 they had 974 million shares out. By 2017, they were down to 814 million, and they got fairly aggressive after that point. In the last six years, their share count is down to 609 million. So, not only have they increased the dividend somewhat aggressively, but they’ve also actually bought back stock. 


So now let's look at the business of railroads. What you're looking for are returns and that the business is profitable. The return on invested capital for Union Pacific was running around 5% in 2005. By 2010 it was up to 7.7%. In 2020 it just slightly cracked 10%. Last year they were up to 12.4%. So, are these high-tech type numbers? No. But when you have a nice, strong, consistent cash flow and you're earning more than your cost of capital, that allows companies to return cash to shareholders and build investor wealth, and it's what's happened with the railroads.

So now let's turn to just how profitable are these businesses. If you look at the gross profit margin— a simple explanation for that is what it costs to actually run the railroad every day directly related to what they do. In other words, they're running that train down the track. How much does it cost to actually run that train specifically? They have a gross profit margin of 44%, CSX is 39%, Canadian Pacific is 51%, and Norfolk Southern is 39%. Now you have to keep in mind there is a little bit of leeway in how they allocate these expenses, so you have to be a little careful taking these numbers 100% as far as a comparison. When we go out to operating profits, that's where we're getting farther down where they're adding in admin expenses, and here's where I'm going to make my point. Union Pacific is at 38%, CSX is at 39%, Canadian Pacific is at 37%, and Norfolk Southern is at 37%. So, as we get farther down the income statement, things really start to even out.

Another thing is to look at the risk of the business in the long term. For Union Pacific, coal represented 22% of their business two decades ago. One decade ago it was 20% and last year it was 10%. So, coal is one of the largest commodities that they deliver, but they're not extremely concentrated in any one area. They also are in transporting chemicals, petroleum, containers, etc. They have a well-diversified product base, and whether you like coal or not, the good news is they're relying less on it. From just a pure business standpoint, coal is not going to go away in the next 12 months. It probably will continue to decline over time, but that, in the long term, is a good thing. 

Another thing just to keep in mind, one of the huge issues for railroads is maintenance. You want a decent maintenance program because what you don't want is derailments. Those can get extremely expensive, extremely fast. One of the ways to check on this, or to get some feel for whether you potentially have a problem, is to look at CapEx and Depreciation. We'll start with CapEx, and I'm just going to run these numbers for all of them. It's not important that you remember the numbers, it's just important that you get the trend here. Union Pacific spends 15% of their revenue on CapEx. CSX is 14.5%, Canadian Pacific is 18%, and Norfolk Southern is 15%. So, they're all basically in line there. Then when you look at depreciation, that's the expense that they're actually taking on the balance sheet. Looking at depreciation, Union Pacific spends 9-10% a year on average. CSX spends 10-11%, Canadian Pacific spends 10%, and Norfolk Southern spends 9-11%. So, they're all basically in the same range as far as what they invest in their business. But another thing here— which is actually a net positive because you will see this in industries and in companies when you look at CapEx. The actual expense compared to depreciation, what you really want to see is the asset base continually being updated and renewed. CapEx right now is around $3.6 billion for Union Pacific. And depreciation expense is about $2.3 billion for depreciation expense. And in this case, for the last decade or more, CapEx has been running higher than depreciation. It runs a little more than one billion higher a year, so, they are out there constantly working on their asset base. If you're really going to dig deep into a company, it’s a good thing to know. And if they're running a little bit newer asset base, that potentially is a positive for them. 


So what drives the dividend growth bus, or maybe I should say train? Well, it's cash flow growth. That's the bottom line over time. In the last 10 years, Union Pacific has grown their continuing operating income by 77%, and over a 20-year period, 453%. Those are pretty attractive numbers. In 2022, cash from operations was $9 billion, they spent about $3.6 billion on CapEx, and the dividend was $3.2 billion. That leaves $2.2 billion left over they can use to either buy back stock, raise the dividend, or they can pay down some of the debt. 

So, you know, the business is relatively strong, but let's look at the required return that we need to double our dividend in the next decade. For 2023, currently, they're paying $5.08. So, in 2033, the dividend has to grow to $10.16. Well, the good news is— it's nice to see this starting out— they are already earning $10. Of course, they're not going to pay out everything in a dividend, at least not on a sustainable basis. It's not unusual for a company to pay out more than what they earn over a short period of time because of a recession or some one-off event. Going back to Union Pacific, if they're going to pay a $10.16 dividend and continue to maintain that 45% payout ratio, that means that Union Pacific is going to have to have earnings of $22.50. What that means is, earnings are going to need to go up two times. Well, just as a point of reference, earnings have gone up three times in the last ten years. So it seems reasonable to assume that Union Pacific can grow their earnings by 7% or double them in the next 10 years. When we get a double in the dividend and the stock yields 2.5% or higher at the end of that time period, we will have achieved about 110% total return. That meets our hurdle rate, and that does not count compounding.


Finally, as far as business overview, we're going to look at debt because this is a piece of the story for Union Pacific. It has $35 billion dollars of debt. It has the highest debt of all the railroads and it's 2. 5 times equity. Well, one of the things you have to remember is that a lot of it has come from share buybacks. From 2018 to 2023, they basically spent $25 billion in buybacks. About half of that, they had to use debt. That was $13 billion of additional debt they raised just for share buybacks. One thing going forward, the share buyback, at least for the next few years, is probably going to slow down considerably. I don't think we really need to worry about that because we can still get the dividend growth without it. So, $28 billion of their debt is greater than five years, and their rates average between 2.2% - 7.1%. They have a billion dollars that's out in 2072, which is virtually 50 years from now, and their interest rate on that is 3.8%. Union Pacific has about 25% of its debt rolling over in five years. That's a little bit of a risk because going into a higher interest rate market is going to lead to more interest costs. Well, just another quick back-of-the-envelope calculation: 25% of their debt is basically $7 billion in the next 5 years. If that cost goes up by 3%, it means that they're going to pay an extra $210 million in interest cost. Well, when you're looking at $2.2 billion of excess cash flow over and above CapEx, and the dividend, that's just 10%. I think you can actually spin that to a positive. They have locked in low rates, and we may never see rates that low again. Also, Union Pacific earns 7.5 times more than what their interest expenses are, and you have $2.2 billion of excess cash flow, which is extremely likely to grow over time. You potentially can retire that debt in 10 years, maybe even faster, depending on how fast your cash flow grows. So, we are very cautious about debt, but because of the predictability of the business and just the core dependence of the economy on railroads, and they have strong cash flow, here, I'm not so concerned about it. They have huge moats. Nobody can go out and build a track across the country now. For all intents and purposes, it’s impossible. Just to confirm how predictable these businesses are, one of the railroads has a bond that matures in 2170. You kind of have to step back and wrap your head around that one. What business is there that in more than the last century, the business is basically still the same, and it potentially is going to be a version of the same business over a hundred years going forward? 

Unfortunately, there are a lot of numbers out here, but part of what we're trying to do is to show when you want sustainable dividend growth you have to really look at where it's going to come from and how likely you're going to get it. So, in summary, what we have here is a company that generates enough free cash flow to pay for CapEx, to maintain the business, is more than enough to grow the dividend, pay down debt, and even buy back some stock if they choose to. The revenue and earnings of Union Pacific should, at the minimum, grow at least as well as the economy does. And I think this is one that you could safely call a GDP-plus company because they've shown the ability to grow faster in the past through efficiency and productivity gains. And I hope that one of the big takeaways that you get from what we've just gone over is that these businesses are stable. They're predictable for the most part and they run somewhat similarly together because they're all doing virtually the same thing. There's not too much difference between them, but this is one of those situations where it's not too difficult to figure out how we can connect the dots over the next decade to potentially get at least a double in our dividend and the stock price should follow.

There can always be an outside event that changes the picture, but you don't need too many things to go right, really just more of what they're doing. It's an attractive industry as a whole and I think it just makes sense to have one of them, at least, in your portfolio. It's probably why Berkshire Hathaway does.

Before we move to the next section, I would like to mention that we do plan on building an investor presentation for Union Pacific. I am not going to promise a timeline yet, but it is our goal to do it, and one of the ways that you can get a copy is to join our newsletter. I try to realize that when you're listening to something, you cannot keep all these numbers straight. So, we do intend to put something out there so that if you want to review it, you can. Once we put it together, we'll send it out to the newsletter list, and also link it to the show notes.


Now we're going to move to probably what all of you have been waiting for, and that's stock performance. We've talked about the second-decade effect in past podcasts and the power of compounding. Well, here is an example living out in real life. When you look at these railroads, in the last 30 years, for Union Pacific the total return has been 2,300%. For CSX, it's up 2,140%. For Canadian Pacific, it's up 2,430%. Norfolk is up 1,530% percent. If you would've only invested in the S&P 500, you're up 470%. These things outperform the stock market by a fairly wide margin. If you say, “Well, okay, I want something more exciting, I want technology, I want those big gains.” Okay, well, let's look at the last 20 years. Union Pacific had 20%+ gains in 11 of those 20 years, and in 8 of those years, it showed 30%+ gains. Maybe it's not Apple or Microsoft or Amazon, but in my book, with the consistency and the predictability, it's a pretty close second. If you look at stock performance in a recession, I can virtually guarantee you, here, the railroads beat it— compared to the S&P 500, which in both ‘01 and ‘08 dropped by 50 percent or slightly more. So, if you look at stock prices from the beginning to the end of past recessions in 1973-75, Union Pacific was down 7%. In 1980, it was up 21%. In 81-82, it was down 29%. In 90-91, it was down 2%. In 2001, it was down 2%. From 2007 to 2009, it was down 17%, and in February to April of 2020, the stock was basically flat. So, they tend to hold up fairly well in recessions. 


Now let's look at valuation. The 10-year average price to free cash flow is around 25 and now it's 22.6. So, it's a little cheaper than it's 10-year average, not a lot. Price-to-sales at 5 is about the lowest since 2020. Again, it's a little cheaper but not by a lot. The P/E ratio is around 19 to 20 depending on earnings this year and that's roughly where the market is. It’s maybe slightly cheaper. So, it's not a fire sale, it's arguably trading just a little bit below what we might call fair value. But I think you've got a better risk reward and you've definitely had better performance in the last few decades. You're paying about the same price for what previously has performed better. I think it's definitely worth considering at this point and looking at chances to build the position over time. 


But, if you're still a little suspect, should I own a railroad? Now we're going to turn to Burlington Northern, BNSF. It is owned by Berkshire Hathaway, and they bought it back in 2009. You're going to be able to see just how strong of a return that Berkshire Hathaway has generated from it. 

Just looking at the business in the big picture, coal represents 16% of their business in 2022. So, it actually has a little bit more business risk from that standpoint. Revenue in 2022 was $25.8 billion, which is roughly the same size as Union Pacific. Operating income in 2022 was $8.6 billion, or 33% operating margin. That is, you may remember, a little bit below the other railroads which were up in the high 30s. So, actually, Burlington Northern is not quite as profitable. Return on invested capital in 2022 was a little under 8%. Compared to Union Pacific, which is at about 12.5%, it’s not as profitable. When you look at CapEx— is this a big warning flag? I doubt you can go that far, but for CapEx they spent 13% in 2022 versus the other railroads which are up around 15%. So, they're not spending quite as much keeping the railroad maintained. 

Here's where it gets kind of interesting. The operating cash flow for Burlington Northern is $8.7 billion. They spent $3.4 billion in capex. That left them with a free cash flow of $5.3 billion. They made a member distribution, which was to Berkshire Hathaway, for $5 billion. They basically paid out almost all their free cash flow, which is what happens when you own the whole company. 

Well, you're probably thinking, “Jeez, I wish I could do what Warren Buffett does. I'd be rich, too.” Well, let's look at what he did. In November of 2009, he spent $34 billion to buy Burlington Northern. I just told you that they took a distribution last year of $5 billion. That's a yield on his cost of 15%. Now, let's look at Union Pacific. You could have bought the stock in November of 2009 for $30 a share. If you look at the current dividend of $5.08, that's a 17% yield based on if you would have purchased the stock at $30 back in November of 2009. Last I checked, 17% is bigger than 15%. You could have done exactly what Warren Buffett did and right now you can buy a railroad that appears to be a little bit better run, more efficient, and a little bit more profitable than what Warren Buffett has.\

But then you have to ask, why does he own it? I think the answer is pretty simple. Number one, he's got 15% cash flow coming out. He's letting the thing run, which is what he does with his investments. Here's the biggest picture. You may remember I mentioned sort of in passing that there is one of the railroads that has a bond out there in 2170— that is when it's going to mature. I think Warren Buffet looks at this business and he loves the predictable cash flow and reinvesting it. He's probably extremely confident that it's going to be around for decades to come. You have almost zero risk of any major disruptions. They only compete in any significant way— there are two companies in each region. They’re basically monopoly businesses. The only significant risk you have— there is the derailment risk that is out there. That can affect the business model, especially short term. I would argue there's probably a little bit of a political risk too. Although there's no way of telling and there's no prediction that this is what's going to happen, you could possibly say, well, there'll be some kind of a carbon tax or there'll be some kind of a tax on diesel fuel. But the bottom line is every company has some form of risk to it.


 So if you're not quite convinced yet and you can't quite figure out why do I want to own one of these boring businesses? How is the company really going to grow? Well, it's just as simple as GDP continues to grow and there's inflation. Prices over time go up and railroads raise their prices. Plus I think there are a few catalysts for Union Pacific which will be a positive here in the future. They just brought in a new CEO in August of this year, Jim Venna. He went to work for Union Pacific five years ago and joined as Chief Operating Officer, but he comes from a 40-year background at Canadian National Railroad. He's known for the Precision Railroading Method which tries to target increased capacity, reduced dwell time, cost savings, and enhanced service reliability, and it does appear that Jim has a pretty good track record of actually executing.

And then, not that I'm an AI expert, but it's not too hard to start to imagine where scheduling gets much more efficient with AI. They can reduce dwell time and potentially put more cars on the track. It doesn't seem like a very big reach to figure out how you could get some real productivity gains with technology. 

The one thing we haven't talked about is trucks versus trains. Trucks are much more versatile, they go to the last mile definitely, but the problem with trucks is they're more expensive. Trains are supposed to move at the rate of 5.1 cents per mile, and a truck costs 15.6 cents a mile to ship on, so there's a pretty big cost advantage. And also, by default, they are much cleaner. It just takes a lot less energy to drive the same weight. If you get a new energy source— our transportation system going to electric, or going to hydrogen, or whatever else that may come up, you just have to think that that same technology would go straight to the railroads.

And then you think about more production coming back over to the U.S. because of fear of China and Russia and we got caught big in 2020 with supply chain problems. If they actually do move a little bit more production back to the U S that is just potentially a long-term plus for trains. 

And I'm going to throw out a challenge here, and if you can meet the challenge, you're going to get a free Dividend Mailbox Yeti mug, and the challenge is: Which industry can you name that has more staying power, has more predictability, and that you can say with some confidence 50 years from now, it's still going to be around and it's still going to be a key part of the American economy? I can't imagine anything else that can compete on that level besides railroads.


In summary, we are looking at it. We fully intend to build a position in it. You know, we may have a position by the time you listen to this. The other thing that's extremely important is this is one idea. You know, this is really, really just an overview of our process of going through how we look at something. This is in more detail than we've done anything in the past but the takeaway is, these are great long-term compounding tools. And it's how well they manage their balance sheet, allocate their capital, and what they return to shareholders. That is really what makes the railroads a compelling story. And I have to admit that I really haven't looked at them in the past because my general impression was, without knowing too much about them, it's pretty hard to connect the dots that I'm going to make any real money here. But in fact, these are some of the better-performing businesses in the last several decades. Really, in the end, it's not what the company does that is what's so important. It's how well they do it.


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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks including dividend stocks are volatile and can lose money. Denweiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.