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The Science of Hitting
The Science of Hitting
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Union Pacific: Navigating Short-Term Volume Pressures

A look at the railroad's first half financial results

July 28, 2020 | About:

Union Pacific (UNP) recently reported results for the second quarter of fiscal 2020.

As expected, it was a difficult quarter for the railroad, with volumes declining by 20% - the worst result that Union Pacific has reported since the financial crisis (the second quarter of 2009). In addition, average revenue per car declined by 6% due to mix headwinds; as noted on the conference call, “the automotive business is a very good ARPC business – and in the first half of the quarter, it literally went to about zero." As a result, revenues in the second quarter declined by 24%. That said, it’s encouraging to see that railcar volumes have improved meaningfully in recent weeks.

Given the ugly results in the second quarter, the financials have deteriorated for the first half of the year. Through the six months, revenues and EPS were down 14% and 8%, respectively.

Despite the 20% decline in volumes, Union Pacific did a pretty good job controlling expenses, with the core operating ratio only climbing by 430 basis points (the reported operating ratio was up 140 basis points to 61.0%). This was helped by a 22% reduction in the number of employees, with the train, engine and yard (TE&Y) workforce down by a third from a year ago. As noted on the call, the implementation of "Unified Plan 2020" helped the company largely mitigate the impact of the volume declines.

As a result of the higher operating ratio and lower revenues, operating income declined by 27% year-over-year in the second quarter to $1.65 billion. After accounting for higher net interest expense, net income fell 28% to $1.13 billion. A continued focus on repurchases resulted in a 4% reduction in the diluted share count, resulting in a 25% decline in earnings per share (EPS).

As shown below, the share count has fallen by nearly one-third over the past ten years.

The company generated $4.4 billion in cash from operations in the first half of 2020, up 13% from the first six months of 2019. Cash outflows consisted of $1.6 billion in capital expenditures, $2.6 billion in repurchases and $1.3 billion in dividends (the current yield is 2.2%). As those numbers show, Union Pacific has continued to rely on outsized debt issuance to fund capital returns. At quarter end, adjusted debt exceeded $30 billion, an increase of $5 billion over the past 24 months. The leverage ratio (debt / EBITDA) currently stands at 2.9 times, ahead of management’s target of 2.7 times.

Conclusion

Here’s what I wrote about Union Pacific six months ago:

If the economy continues to provide support for low single-digit volume and revenue growth, accompanied with a lower operating ratio and large share repurchases, the stock will probably do well from here. But if that economic outlook changes, I wouldn’t be surprised if all three of those variables worked against the company – a scenario that would likely coincide with a contraction in the price-earnings ratio.”

The pandemic changed the economic outlook - basically overnight - with volumes, revenues and EBIT margins (the inverse of the operating ratio) responding accordingly. As expected, this has led to a decline in earnings and an increase in the company’s financial leverage – above the high end of management’s target – which will limit their ability to repurchase shares for the foreseeable future. That said, time will tell if this has any sustained impact on the stock price. After falling meaningfully in February and March, reaching a low around $110 - $115 per share, Union Pacific is back near $180 per share - around where it traded at the start of the year. As I’ve noted in the past, this is a high-quality business that I would like to own at the right price (and one I've owned previously). While I continue to believe that they should take this opportunity to revisit their aggressive approach to capital allocation, I won’t hold my breath. It sounds to me like they remain committed to running the balance sheet at full throttle.

Disclosure: None

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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