- Union Pacific Corporation (and railroads, in general) have been strong performers over the past 15 years
- UNP is up 11.8% in the past 3 months
- The volume of rail transport for 2021 was significantly higher than in 2020
- The Wall Street analyst consensus outlook is bullish, with modest upside potential
- The market-implied outlook for UNP is bullish to mid-year and neutral for the full year.
Union Pacific Corporation (NYSE:UNP) gained a total of 15.9% over the past 12 months, albeit with a substantial drop from mid-August through the end of September. Investors brave enough to buy shares in the railroad operator at the end of September, when they traded as low as $196, could have gained a stunning 25.6% in the subsequent 3 ½ months.
Source: Investing.com
Rail volumes for 2021 were 5.7% higher than in 2020 and UNP reported strong quarterly earnings, beating analyst estimates in Q2 and Q3. The consensus estimate for 3-5 year EPS growth is 12.3%, in line with the 5-year annualized dividend growth rate of 13.7%. This alignment is notable because the dividend growth looks supportable from earnings growth, without increasing the payout ratio.
Source: E-Trade. Green (red) values are amount by which quarterly earnings beat (missed) the consensus expected value.
For investors seeking stable growth, UNP looks especially attractive in that the company has delivered quarterly earnings that tend to be very close to the consensus expected level. Granted, much of the analyst outlook is based on management’s guidance, but not many companies can consistently get this close to expectations.
Source: Morningstar.com
Many readers will be surprised to learn that UNP has delivered total returns that are far above the US equity market over the past 15 years. UNP’s 15-year annualized total return is 18% per year, as compared to 10.5% for the S&P 500. UNP’s total returns have beaten the S&P 500 over the trailing 3-, 5-, and 10-year periods as well.
The most obvious concern with UNP is the current valuation, with a TTM P/E of 26.5. Historically, UNP has ranged between P/Es of 10 and 20, so the current valuation looks somewhat stretched.
I last analyzed UNP on Apr.18, 2021, at which time I assigned a neutral rating to the stock. At that time, the Wall Street consensus rating on UNP was bullish, but the consensus 12-month price target was only about 4.5% above the share price. With the 1.74% dividend yield, the expected 12-month total return was only about 6.25%.
Along with the valuation, which was high, and the analyst consensus, I also relied on the market-implied outlook for UNP, which represents the consensus view from buyers and sellers on options. In mid-April of 2021, the market-implied outlook for UNP to mid-January of 2022 was neutral. I settled on a neutral overall rating for UNP, rather than a bullish rating, largely because of the high valuation, the modest expected price appreciation from the consensus price target, and because of the neutral market-implied outlook. Since my post, UNP has gained 10.3% (price appreciation only) vs. 11.56% for the S&P 500.
My previous analysis looked at the market-implied outlook using options that expire on Jan. 21, 2022. With that date rapidly approaching and with UNP reporting Q4 earnings on Jan. 20, 2022, I have updated the market-implied outlook for UNP and, as in my previous analysis, compared the Wall Street consensus outlook.
Wall Street Consensus Outlook for UNP
E-Trade calculates the Wall Street consensus outlook from ratings and price targets published by 21 ranked analysts over the past 90 days. The consensus rating is bullish, as it has been for the past year. The consensus 12-month price target is 7.5% above the current share price. With the current dividend yield of 1.9%, the expected total return for the next 12 months is 9.4%.
Source: E-Trade
Investing.com’s version of the Wall Street consensus outlook is based on ratings and price targets from 30 analysts. The consensus rating is bullish and the consensus 12-month price target is 4% above the current price.
Source: Investing.com
These two calculations of the Wall Street consensus outlook are consistent, with bullish ratings. The 12-month price targets are slightly different, with an average of 5.75%. The anticipated 12-month price appreciation is low, albeit still slightly higher than the value back in April (4.58%).
UNP has performed better than one would have expected based on April’s consensus price target, so I am inclined to be somewhat optimistic that the current outlook is conservative. The expected 7.65% total return for the next year is less than half the trailing annualized 3-, 5-, 10- and 15-year values.
Market-Implied Outlook for UNP
The price of an option on a stock reflects the market’s consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level between now and when the option expires.
By analyzing call and put option prices at a range of strikes, all with the same expiration date, it is possible to calculate a probabilistic price forecast that reconciles the option prices. This is the market-implied outlook.
I have calculated market-implied outlooks for the next 2 months (using options that expire on Mar. 18, 2022), the next 5 months (using options that expire on June 17, 2022) and for the next 12.1 months (using options that expire on Jan. 20, 2023). I selected these three expirations dates to provide outlooks over the next year.
The standard presentation of the market-implied outlook is in the form of a probability distribution of price returns, with probability on the vertical axis and return on the horizontal.
Source: Author’s calculations using options quotes from E-Trade
The market-implied outlook for UNP for the next 2 months is generally symmetric, although the peak in probabilities is tilted to favor positive returns. The maximum probability corresponds to a price return of +2.25% and the annualized volatility calculated from this distribution is 23.9%. This is a low level of volatility for an individual stock.
To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).
Source: Author’s calculations using options quotes from E-Trade. The negative return side of the distribution has been rotated about the vertical axis.
This view shows that the probabilities of positive returns are higher than for negative returns of the same size for a wide range of the most probable outcomes (the solid blue line is consistently above the dashed red line on the left half of the chart). This is a bullish outlook. The probabilities of large-magnitude negative returns are slightly higher for large-magnitude outcomes (returns greater than +/-15%), but these occur with a low overall probability.
Theory suggests that the market-implied outlook is likely to have a negative bias because risk-averse investors are willing to pay more than fair value for downside protection (put options). Considering this potential bias, the market-implied outlook for the next 2 months looks even more bullish.
The market-implied outlook for UNP for the next 5 months (calculated using options that expire on June 17, 2022) is also bullish, although the spread between positive and negative return probabilities is somewhat narrower. The annualized volatility calculated from this outlook is 25.7%.
Source: Author’s calculations using options quotes from E-Trade. The negative return side of the distribution has been rotated about the vertical axis.
Looking out a full year, the market-implied outlook calculated using options that expire on Jan. 20, 2023, slightly favors negative price returns. Considering the expected negative bias, this outlook is best interpreted as neutral. The annualized volatility calculated for this distribution is 27.7%.
Source: Author’s calculations using options quotes from E-Trade. The negative return side of the distribution has been rotated about the vertical axis.
The market-implied outlook is bullish for the next 2 months and the next 5 months, although the bullish tilt is smaller for the 5-month outlook. The 12.1-month market-implied outlook is neutral. The expected volatility rises slightly through the year.
Summary
UNP has provided investors with consistent long-term performance. The total return over the past year is close to, albeit slightly lower than, the annualized 3-, 5-, 10- and 15-year returns. The Wall Street analyst consensus is bullish, but the analysts see the potential upside as quite limited. The consensus 12-month price target implies a 7.65% total return.
As a rule of thumb for a buy rating, I want to see a 12-month expected return that is at least half the expected (annualized) volatility. With expected volatility in the range of 24%-28%, the 7.65% expected return does not make UNP look like an attractive risk-return proposition. That said, the analyst consensus price target from April was well below current price.
The market-implied outlook to the middle of 2022 is bullish, although the 12-month market-implied outlook is neutral. Heading into earnings, with a bullish Wall Street consensus rating and the bullish near-term market-implied outlooks, I am giving UNP a bullish rating. The fairly high valuation and the neutral outlook for the next 12 months suggest revising this analysis somewhere around the middle of 2022, however.