Union Pacific (UNP, Financial) recently reported results for its third quarter of fiscal 2020. After a difficult second quarter, when volumes declined by 20% (the worst result at Union Pacific in more than a decade), results meaningfully improved for the railroad in the third quarter, with revenues down 11% year-over-year on a 4% decline in volumes and a 7% contraction in average revenue per car due to less favorable business mix. The 11% revenue decline reflects double digit decreases in the Industrial and Bulk businesses, partially offset by growth in Premium.
As in the second quarter, despite a decline in volumes, Union Pacific did a good job controlling expenses, with the operating ratio improving by 80 basis points to 58.7% - the lowest quarterly operating ratio that Union Pacific has reported in the company's history. This outcome was due to lower fuel prices and an 18% reduction in the number of employees, inclusive of a 22% decline in the train, engine and yard (TE&Y) workforce. As shown below, the operating ratio at Union Pacific has improved by nearly 30 percentage points over the past 15 years, with operating margins (the inverse of the operating ratio) expanding from the low-teens to more than 40% over the same period.
Through the first nine months of the year, revenues declined by 13%, with a 140 basis point improvement in the operating ratio to 59.5% resulting in a smaller drop in operating income (-10% to $5.8 billion). Management's focus on repurchases over the past year resulted in a 4% reduction in the share count, resulting in a 8% decline in earnings per share (EPS). In the third quarter, the weighted average shares outstanding totaled 677 million – down by one third from a decade ago.
Cash flow from operations through the third quarter totaled $6.0 billion, down 4% from the year ago period (with the gap to net income reflecting higher cash flow conversion). Cash outflows have consisted of $2.3 billion in capital expenditures, $3.0 billion in repurchases (resumed in October) and $2.0 billion in dividends.
As those numbers suggest, Union Pacific has continued to rely on outsized debt issuance to fund its capital returns. At quarter's end, adjusted debt totaled $30 billion, with the leverage ratio (debt / Ebitda) at 2.9. As shown below, Union Pacific's leverage ratio has more than doubled since 2015.
Conclusion
Union Pacific's financial results over the past six months tell an interesting story. In the second quarter, when volumes cratered, the company quickly adjusted its cost structure in a tough environment to do anything it could to lessen the pain. Then in the third quarter, when volumes quickly came back into the network (+19% sequentially), they still held costs in check, with operating expenses up 11% sequentially. The net result through the first nine months of the year has been a 140 basis point in the operating ratio – despite facing a 10% reduction in business volumes. This railroad will report roughly 40% operating margins in 2020 - higher than technology companies like Alphabet (GOOG, Financial)(GOOGL, Financial), Microsoft (MSFT, Financial) and Facebook (FB, Financial).
As I've discussed previously, my concern with Union Pacific in the past few years has been their ability to easily weather a more difficult economic environment, particularly given the additional financial leverage management has put on the business. From where we sit today, I'm starting to wonder if that concern was misguided. Over the past six months, this business has shown an ability to flex its cost structure to deal with short-term volume pressures in a way that I did not anticipate. Kudos to management for the results they've managed to deliver in a difficult period.
On the conference call, outgoing Chief Operating Officer Jim Vena said the following: "I am going to keep my Union Pacific stock. I'm not going to go out there and sell it because I'm very confident that we're going to do the right thing."
Personally, I sold my shares in the company a few quarters back - but I'm starting to wonder if that was the correct decision. It looks like I may need to reconsider some of the beliefs I've held about this business.
Disclosure: Long Microsoft and Facebook
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