Fitch Ratings has affirmed Union Pacific Corporation's (UNP) long-term Issuer Default Ratings (IDR) and senior unsecured debt at 'A-'.

Fitch has also affirmed the Short-term IDR and CP ratings at 'F1'. The Rating Outlook is Stable.

UNP's ratings are supported by the company's strong financial flexibility, FCF generation and franchise strength. Shareholder-focused capital deployment that leads to leverage sustained near 3.0x, which is towards the high end of 'A-' rating threshold, and cyclicality in volumes, and therefore cash flows, are the main rating constraints.

Fitch has withdrawn the LT IDR on Union Pacific Railroad Company as there is no rated debt outstanding and it is no longer considered to be relevant to Fitch's coverage.

Key Rating Drivers

Rating Considerations: The ratings for UNP reflect its strong business profile, supported by its leading position in the oligopolistic rail market afforded by its large rail network. It also has strong financial flexibility due to its highly profitable operations, the resiliency of its cash flows and ability to unlock significant cash flows by reducing share repurchases if needed. Fitch also considers UNP's leverage profile, including expectations that adjusted debt/EBITDAR will be sustained at 3.0x or mildly below, which falls around the high end of Fitch's 2.5x-3.0x rating sensitivities.

Leverage Sustained at or Sub-3.0x: Fitch believes UNP may allow adjusted debt/EBITDAR to approach 3.0x over the next few years but is unlikely to allow leverage to drift materially higher as it continues to prioritize maintaining a strong investment grade rating with a healthy balance sheet. Leverage has climbed to the high-2.0x over the last few years, despite improvements in profitability, as the company balances shareholder returns with its balance sheet. While leverage has increased, Fitch believes UNP would stem share repurchase activity in a downturn rather than allowing leverage to rise materially. Fitch views the current financial policy of shareholder returns in excess of FCF generation, driving higher debt balances, as a limiting factor for the rating.

Buyback Focused Allocation Strategy Retains Financial Flexibility: UNP's consistent generation of sizable FCF, which Fitch calculates after dividends, represents a key credit strength supporting the 'A-' rating. Fitch expects UNP to generate FCF in the $2.5 billion to $3.0 billion range and FCF margins in excess of 10%. While shareholder returns typically account for all of discretionary deployment, Fitch believes there is significant financial flexibility to manage the debt load, should the need arise, by reducing shareholder distributions. Cash flow generation is supported by expectations of strong EBITDA margins, despite near-term weaknesses, and manageable capital spending. UNP expects to maintain annual capex below 15% of revenue while dividend growth is paced to earnings.

Strong Business Profile: UNP owns and operates one of the largest U.S. rail networks in the U.S., primarily serving the western region of the country. The insulated and oligopolistic nature of the rail market supports structurally high margins and cash flows. UNP's operating strength is also demonstrated in its ability drive pricing that covers cost inflation. The company competes against other modes of transport, namely trucking, but its service is particularly cost-attractive for heavy loads and fixed routes. While rail rates and volumes are cyclical, largely reflecting broader industrial economy trends, the mode has proven resilient and core to the economy's supply chains.

Margins Temporarily Lower in 2022: Fitch expects profitability to be modestly lower in 2022, largely reflecting the rise in fuel prices and of service challenges across the industry. The impact of higher fuel costs should moderate through a mixture of catch up in pricing and moderating fuel prices. Meanwhile service challenges have led to lower than expected volumes and therefore operating leverage due to capacity constraints and high costs associated with temporary efforts to maintain service levels. EBITDA margin in 2022 is likely to decline to about 50%, from 53% in 2021, before recuperating over the next couple years. Benefits from actions to improve service levels should start to materialize in late 2022, however; other variables such as a deep downcycle in freight rates are risks to the forecast.

Derivation Summary

UNP is the second largest North American railroad in terms of both revenue and volume and is considerably larger than the next largest railroad. The company's largest competitor is Burlington Northern Santa Fe , which operates in many of the same geographical regions and is the largest North American railroad. Fitch generally rates Class I rail companies are in the mid 'BBB' to mid 'A' range. UNP's service network is well positioned with long-haul routes and in regions with population growth. Its freight volumes are fairly well diversified whereas peers may be more concentrated in markets such as coal, industrial or intermodal.

In terms of Fitch-rated peers, UNP is rated two notches higher than Kansas City Southern (KCS; BBB/Stable). The differential is driven by size and diversification. KCS is the smallest of the seven Class I railroads and is more geographically concentrated than UNP, with a rail network in 10 states versus UNP's network in 23 states. KCS operates with a similar margin and leverage profile as UNP. UNP also competes with other forms of transportation such as trucks, ships and barges, leading to competition in terms of price, transit times, quality and reliability but remains a superior option in terms of fuel efficiency and transporting large quantities of goods efficiently.

Key Assumptions

Revenue growth in the low-double digits in 2022, primarily due to higher yields. Growth moderates to the low to mid-single digits as yield growth moderates;

EBITDA margins decline to about 50% in 2022 due to challenged service levels and cost inflation. Margin then improve with recovering service levels and moderated inflationary pressures;

UNP continues to raise its dividend on an annual basis;

FCF margins remain above 10%;

We assume that the company continues to pursue debt-funded share repurchases, with buybacks and debt issuances sized to maintain leverage near current levels.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

A shift to a more conservative financial policy leading to total adjusted debt/EBITDAR sustained below 2.5x;

A demonstrated commitment to a more conservative capital allocation strategy including a more FCF linked share repurchase policy;

Continued ability to price at least in line with cost inflation and demonstrate margin strength through business cycles.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A less conservative financial policy leading to adjusted debt/EBITDAR sustained above 3.0x;

A shift in capital allocation strategy leading to increased levels of debt funded share repurchases;

Regulations or policy changes that negatively affect the industry.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Comfortable Liquidity: UNP maintains solid financial flexibility through its CP program, and cash on hand. As of June 30, 2022, it had $788 million of cash and cash equivalents, full availability on a $2 billion revolver and $200 million of availability under its $800 million receivables facility. Fitch believes liquidity remains adequate given the company's ability to generate cash from operations and the relatively low levels of cash needed to operate the business on a day-to-day basis. In Q2 2022 the revolver's maturity was extended of 2027. It serves as a backstop for the company's CP program.

Issuer Profile

Union Pacific Corporation (NYSE: UNP) is a leading Class 1 railroad company in North America covering 23 states, primarily in the western region of the U.S. It connects with Canada's rail systems and serves six major Mexican gateways.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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