Union Pacific (UNP) recently reported 11% EPS growth in Q1 2020 despite a 3% decline in freight revenues. The company’s operating ratio improved 4.6 percentage points compared to Q1 2019. The company’s operating expenses decreased $338 million in the first quarter compared to 2019 driven by productivity initiatives, volume declines, lower fuel prices, and lower year-over-year weather-related costs. Out of this decrease, $220 million can be attributed to productivity savings achieved in 2019 and Q1 2020.
The company showed improvement in all of its key performance metrics in Q1 2020.
Source: Earnings Presentation
Like most of the other railroads, Union Pacific is also implementing Precision Scheduled Railroading [PSR] initiatives which helped it achieve ~$590 mn in productivity savings in 2019. The company is targeting another $400 to $500 mn in productivity in 2020 which should help it cushion some of the downside from declining volumes. In addition, the company is also improving its product and service offering which should help it gain market share from the other modes of transportation in the long term.
Looking forward, the company’s second-quarter has had a slow start with volume declining 22% in the first three weeks driven by auto production shutdowns and retail closures as U.S. demand is constrained by the pandemic-related social distancing and quarantine. I believe April will bear the most brunt with May and June sequentially better as the economy starts to open up.
Going into the back half of the year, the company will also benefit from easing comparisons. If we look at last year’s revenue progression, the company’s revenues were down 7% and 9.5% in Q3 and Q4 respectively versus down 1.3% in Q2. So, there is 570bps and 820 bps help from easing comparisons in Q3 and Q4 respectively versus Q2.
On the pricing front, management has a long term goal of price increases exceeding rail cost inflation and believes they will be able to achieve this target in the current year as well. So, pricing should be positive.
I believe that the company will see a decline in operating margin in Q2 as it will be difficult to completely offset the kind of volume declines, Union Pacific is witnessing in this quarter. However, as the decline become less severe in the back half, the company can see some improvement. Management has also guided between $400 mn and $500 mn of productivity savings this year and their benefit should become apparent as the year progresses.
However, I believe the real benefit of the company’s cost-cutting effort will be seen in 2021 as the economy recovers and the company starts seeing growth in its revenues. Management has given a longer-term operating ratio target of 55%. The company was already at 59% in Q1 2020 with a 4.6 percentage point year-over-year improvement. I believe the company should be able to reach this goal over the next two to three years given the rate at which it is achieving its cost-cutting goals.
Market share gain opportunity
One thing which I like about UNP is that it is not only focusing on cost-cutting, but also improving its product/services offering. This should help it gain market share in the long run. The company has enhanced its offering and launched various new services for its customers in recent years.
In 2019 the company started offering its coast-to-coast refrigerated service to move fresh foods with the aim to gain market share from the trucking industry. The company purchased over 300 new generation refrigerated box cars which it began deploying in late 2019.
In 2018, the company introduced its Dallas to Dock service solution for the plastics market. With a lot of plant expansions continuing and coming online in the plastics business, the company made investments in storage and transit facilities and related export capabilities.
Source: Investor Presentation
Another example is the company’s new Butler Intermodal terminal in central Iowa. In the past, containers would have either shipped via rail to Chicago and then back-hauled to Iowa or some businesses would have used trucks for the entire long haul route with no rail participation. Now with Union Pacific’s new service, a container from Los Angles is shipped to Council Bluffs, Iowa on the existing Union Pacific intermodal train and then placed in Union Pacific Manifest service to interchange with Iowa Northern railway. For the customer, the product is delivered in roughly the same time but without the use of trucks for the long haul or backhaul from Chicago.
Source: Investor Presentation
In addition to improving its logistics service offering the company is also investing in technology investments to deliver better customer experience. Union Pacific is the first railroad to offer a suite of external application programming interfaces or APIs to its customers. This allows the free flow of data between the customer system and Union Pacific’s, giving the customer direct access to their supply chain data. Using APIs has not only enhanced shipment visibility but has also reduced manual work, streamlined business transaction, and have embedded Union Pacific deep in the customer supply chain.
I believe the company will benefit from these investments going forward and its pace of gaining market share from trucking companies may accelerate.
Union Pacific has grown its EPS by 15.62% CAGR over the last decade. Before COVID-19 hit, analysts were expecting the company to post an EPS of $9.25 in the current year and the stock was trading in mid 180s with a P/E of ~20x. The current consensus EPS estimate for FY21 is $9.02. If we assume the company can achieve a P/E multiple similar to pre-COVID-19 levels, we get a target price of $180.4, or ~10.6% upside from the current levels. This coupled with ~2.4% dividend yield and multi-year earnings growth prospects from market share gains and cost reductions make it a good buy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.