Friday, April 03, 2009

Analyst: UP “has the most compelling growth opportunities”

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After a meeting with senior management, Morgan Stanley analysts William Greene and Adam Longson have concluded that Union Pacific—its only overweight-rated stock in freight transports—is well-positioned for long-term growth.

union-pacific-ac4400s-up.jpgGreene and Longson, expressing “increased confidence in our bullish view on [UP] shares,” said that UP “has the most compelling company-specific growth opportunities (i.e., outside of the cycle) of any stock in our freight universe. UP’s improved service, discipline on pricing, and substantial cost and productivity opportunities all suggest an ability to grow earnings and return on invested capital faster than peers. With increased conviction, we think the shares could appreciate 55% to $70 per share by year-end 2010, even with a tepid rebound.” (UP shares closed at $45.25 on April 2.)

In terms of its source of earnings and cash flow growth potential, Greene and Longson noted that UP has more legacy contract repricing than any other railroad, and that management has reaffirmed its view that long-term pricing growth is 5% to 6%. In terms of volume recovery, “while it’s too soon to say the trough has passed, UP volumes have stabilized—a point reiterated by management—and could be poised for a gradual rebound by fourth-quarter 2009, and incremental improvement before other railroads.” Also, “UP has the best opportunity for productivity gains of any railroad, and recent traffic results confirm that management is delivering.”

Greene and Longson said the market is missing several important points: 1) UP “has easier volume comps than peers,” especially in this year’s second half; 2) concerns about pricing risks “are overblown, as [about] 80% of pricing is locked in for 2009 and management reiterated its stance to hold firm even on that which isn’t locked in; and 3) UP “is an emerging cash flow growth story and we expect free cash flow to double through 2012, leaving plenty of opportunity to buy back shares.”

Greene and Longson did acknowledge, however, that further contraction in U.S. Gross Domestic Product could put UP’s volumes and earnings per share at risk. Though regulatory risks appear to be abating, “political winds could shift against the railroads again.” Also, “aggressive cost cutting during this downturn could leave UP unable to handle resurgent volumes efficiently,” (i.e., don’t let up on capital investment). The analysts did caution against rate discounting, because even though they saw no evidence of it, “any sign would cause rail valuations to contract.”

“The best value in freight transports”
Greene and Longson’s optimistic analysis of Union Pacific signals that the railroad industry overall may have hit bottom and will begin to rebound. “We’re lowering estimates again, but this may be our last time for 2009,” they said. “We’re lowering rail estimates 2-30%, as first-quarter volumes came in even worse than our bearish estimate. However, we now feel that the risk of further downward revisions is limited without another leg down in the economy (or fuel volatility). Railroads offer the best value within freight transports, and we see 5% to 40% upside for the group through year-end.”

However, Greene and Longson cautioned that railroad EPS trends are negative, and their estimates “are well below consensus for 2009. We also worry that the recent run in the stocks may lead to disappointment during [first-quarter earnings reports]. We suspect full-year estimates will likely remain too high even after first-quarter earnings. Although we see stabilization in traffic trends, there are no signs of recovery. Moreover, outside of UP, volumes may struggle to improve in the next few quarters at most of the railroads.”

What’s next? “We’ve maintained that railroads will show less negative operating leverage than past cycles given their pricing power and an ability to cut costs. First-quarter earnings will offer insights into the success in offsetting volume losses through cost cuts that will be critical for 2009 earnings performance. If the railroad surprise us on productivity, our 2009 EPS estimates could prove too low.”