Union Pacific: Smart Play In A High Inflation Environment (NYSE:UNP)

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If we pull up a 5-year chart of Union Pacific Corporation (NYSE:UNP) (Railroad Business), we can see that shares have managed to remain above their 50-week moving average (Approximate 200-day moving average) with the exception of the corona virus-induced breakdown, which we witnessed in the early stages of 2020. This corresponds to bullish fundamentals at present irrespective of how the stock’s valuation may have changed in recent years.

In fact, bullish investors could use the stock’s 50-week moving average (taking into account a margin of error) as a hard stop-loss beneath UNP’s prevailing share price. Why? Because by investing in alignment with the underlying trend in Union Pacific, investors can take advantage of not solely capital appreciation but also of the dividend on offer from the company. In fact, being a relatively low beta stock (Implied volatility of 25% at present), the real calling card in Union Pacific at present is its dividend for the following reason.

Weekly Chart Of UNP

Union Pacific Bullish Trend (Stockcharts.com)

With the IMF recently announcing that inflation is expected to endure for some time to come, this should be a point of note for income investors. The reason being is that prolonged inflation can be devastating to a retirement account. Many income investors make the false assumption that a sizable drop in inflation over the next few years will protect their nest eggs. Alternatively, protecting one’s purchasing power is all about ensuring your money is growing above the average inflation rate from today until you retire.

For example, taking a conservative investment, let’s say you have 12 years to retire, and the average inflation rate over this time period beats your investment performance by 3% per year. What this essentially means is that the purchasing power of the cash flow which the portfolio is generating today will be worth 30% less in 12 years’ time. If we expand the duration (until retirement) to 24 years, your purchasing power has now been reduced by half. Where we want to be is on the other side of this formula. We want to make sure the dollars we have today will outperform inflation which essentially means they will grow faster than the greenback will decline.

This brings us to Union Pacific, which currently yields a 1.92% dividend. Despite the fact that UNP’s dividend yield is 26% above the sector median (1.52%), growth is the defining factor for income investors in the current climate.

Strong dividend growth rates not only protect purchasing power but also foster confidence with respect to future earnings growth. As we see below, despite the fact that dividend growth in Union has tapered off a tad in recent years, growth rates still considerably outperform the sector by a significant margin and are at least keeping pace with the hot inflation we are witnessing at present (vital).

Duration 10 Year 5 Year 3 Year 12 Month
Dividend Growth – UNP 15.39% 14.27% 11.92% 10.57%
Dividend Growth – Sector 8.86% 7.27% 6.15% 6.74%

With respect to cash flow, Union’s free cash flow jumped to almost $6.1 billion in fiscal 2021. Free cash flow has therefore grown by almost 9% on average per year over the past five years. Although the dividend has outpaced free cash flow growth, Union has been very aggressive with stock repurchases. In fact, shares outstanding have dropped from 802 million back in fiscal 2017 to a current 628 million. This means the cash flow dividend pay-out has actually declined over the past five years from 48% to 46% despite dividend payments increasing by 40%+ over this time period. (Impressive)

Although Union’s stated debt to equity ratio has increased from 0.65 to a current 2.05 presently, investors need to key into how Union’s balance sheet has changed. Treasury stock for example has more than doubled to $47.7 billion which means the stated amount of shareholder equity ($14.16 billion) in reality is a much higher number.

Apart from robust cash flow and a strong balance sheet, probably the most defining factor which will influence Union’s dividend will be forward earnings growth. Earnings per share grew by 26% in fiscal 2021 and 17% bottom-line growth is expected this year. EPS has grown by roughly 14.4% on average per year over the past five years, so the above numbers should encourage investors that present dividend growth rates can indeed continue.

Therefore, to sum up, Union Pacific has all the hallmarks of a smart dividend play. Dividend growth rates remain in strong double-digit territory and present cash flow, balance sheet, and earnings trends point to sustained growth in the payout going forward. In the present environment, it is all about growth. The yield comes in a distant second. Let’s see what Q1 earnings bring.

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