Union Pacific Appears Overvalued Into Earnings (NYSE:UNP)


Source: Forbes

Union Pacific (UNP) reports earnings on October 22nd. Analysts expect revenue of $4.89 billion and EPS of $1.98. The revenue estimate implies a double-digit percentage decline in revenue. Investors should focus on the following key items.

Revenue Continues To Decline

The pandemic has practically shut down business activity. Falling business activity leads to falling revenue traffic and falling revenue for Union Pacific. For the first 38 weeks of 2020, combined U.S. rail traffic (carloads and intermodal units) fell 10.9% Y/Y. That portends a decline in revenue for Union Pacific.

Union Pacific Q2 revenue. Source: Shock Exchange

Last quarter, rail traffic and average selling price (“ASP”) fell 20% and 6%, respectively. Each of the company’s major product categories experienced revenue declines.

The Bulk segment included coal, grain, food, fertilizer, coal and renewables. Revenue from the segment declined 17% on a 15% decline in carloads and 2% decline in ASP. Coal was negatively impacted by lower natural gas prices and overall softness in the market. General Electric (GE) recently exited the coal power market due to unattractive economics, implying weakness in the market may not abate anytime soon. The pandemic negatively impacted shipments of food and refrigerated products.

The Industrial segment fell 23% on an 18% decline in volume and 6% decline in ASP. Low oil prices hurt energy revenue, while weak economic activity likely stymied industrial revenue. Meanwhile, the Premium segment fell as the pandemic hurt international intermodal revenue.

Total carloads fell 20% Y/Y, with each major product segment experiencing double-digit percentage declines.

Union Pacific Q2 2020 carloads. Source: Shock Exchange

The Premium segment, which included intermodal and automotive, experienced the largest decline in volume. Intermodal volume will likely track movements in global economic activity. Automotive could face more headwinds if consumers shun big ticket items amid the pandemic. Industrial could also face headwinds until the economy fully reopens.

The company’s blended ASP fell 6% Y/Y. Falling ASP and falling carloads created a double negative impact on revenue.

Union Pacific Q2 2020 ASP. Source: Shock Exchange

The company was able to hike prices last year. Sans price hikes, revenue could fall in the double-digit percentage range for the rest of the year.

Cost Containment Efforts Helped

Union Pacific and CSX (CSX) have been the most aggressive in cost-cutting among U.S. railroads. Union Pacific has been delivering operating ratios below 60%, rivaling the efficiency of Canadian railroads. Total operating expenses of $2.6 billion fell down 22% Y/Y. Compensation and benefits expense declined 21% to $905 million, as headcount reductions helped:

“In terms of the different expense lines, compensation and benefits expense decreased 21% year-over-year, primarily as a result of workforce reductions and productivity initiatives. Second quarter workforce levels declined 22% or about 8,600 full-time equivalents versus last year and sequentially decreased 11%.”

The 21% reduction in compensation and benefits exceeded even my expectations. Compensation and benefits was 35% of total operating costs, the company’s largest expense bucket. Purchased services fell 4%, while fuel costs fell 56%. Falling fuel costs appear to be knock-on effect of waning demand for oil and a dismal economic outlook.

Union Pacific’s operating ratio was 61%, slightly higher than the 60% it reported in the year-earlier period. The company practically kept its operating ratio in line, despite the sharp decline in revenue. This was impressive. However, if cost take-outs run their course, it could be difficult to keep its operating ratio from ticking up.

The fallout was that EBITDA of $2.1 billion declined down 25% Y/Y. Union Pacific’s EBITDA margin was 49%, down only 100 basis points versus the year-earlier period. The company reported a robust EBITDA margin despite the fall in rail traffic and ASP. The question remains, “Can management keep it up?”

Valuation Matters

Stimulus from the Federal Reserve and other policymakers have buoyed financials markets. Broader markets have spiked off their March lows; the rebound was likely not based on earnings prospects, in my opinion. The rise in broader markets also helped UNP rebound. UNP has an enterprise value of $160 billion and trades at 15.5x last 12 months (“LTM”) EBITDA. UNP bulls have likely been energized by cost take-outs and the resiliency in the company’s margins. That said, I expect rail traffic to face headwinds until the economy full reopens next year. The valuation likely does not reflect these headwinds.

Conclusion

UNP is up over 25% Y/Y. If Fed stimulus dissipates, then broader markets and UNP could fall. Sell UNP.

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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.

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