Union Pacific made a lot of money in the second quarter, but the reaction is decidedly negative
Union Pacific Corporation (NYSE: UNP) turned in a solid second quarter—as measured in earnings per share, its best ever—but it didn't leave analysts happy.
In an earnings call that was notable for several questions that compared UP to other railroads in an unfavorable light, UP chairman, president and CEO Lance Fritz echoed some of what he said in the company's earnings release: "Overall, I am pleased with the effort put forth by the entire Union Pacific team. However, I recognize the results could have been better."
Many of the key financial metrics for UP were strong. EPS of $1.98 was a record for a quarter. Agricultural and energy revenues were both up 5 percent compared to the second quarter of 2017, and total freight revenues were up 8 percent from a year ago. Expenses were up 10 percent but that was boosted by a 48 percent rise in fuel costs. Operating income was up 4 percent, and net income was up 29 percent.
But clearly, several analysts on the call agreed with the "could have been better" analysis. In particular, they focused on the company's operating ratio of 63 percent, which was just a 1.1 percentage point improvement from the second quarter of 2017. But in that second quarter, CSX Corporation (NASDAQ: CSX), whose performance was so bad in 2017 that at it came under fierce scrutiny from the Surface Transportation Board, reported an operating ratio of 58.6 percent for the second quarter. The 110 point improvement for Union Pacific pales compared to the CSX jump of 880 points from the first quarter of 2017. The 63 percent improved from the 64.6 percent reported in the first quarter.
Asked if there was a "sense of urgency" at the railroad, Fritz pushed back against any sense that there wasn't. "Not withstanding what any other railroad is doing, you can see our elevated sense of urgency and focus and determine when our headline quote for the quarter, when we just generated record EPS, is ‘and it could have been better.'" Fritz noted that UP recorded $65 million in what it said were inefficiency costs, or excess recovery costs, and it included such things as overtime and inefficient use of crew resources that the company is working to fix.
"All of that is addressable, and when we remove that we would have had a much more attractive second quarter," Fritz said. He added that he's confident that productivity initiatives that are underway will allow UP to reach a goal of a 60 operating ratio by 2020.
Questioning headcount levels
Another analyst pointed to the "precision railroading" strategy of CSX, a complex system that pushes for lower labor inputs and a reduction in hump yards, among other features. CSX touted a lower headcount in its quarterly earnings. Union Pacific reported a slightly lower headcount compared to 2017, but a higher gross ton miles per employee, up about 4 percent from the second quarter of 2017.
Fritz was borderline defiant in answering that question. He said headcount is being propped up by aggressive hiring of trainees who will replace older employees exiting the work force, and that the imbalance will work itself out later this year. He said there had been some significant productivity enhancements that had been implemented, such as reducing the low horsepower fleet.
But Fritz also pushed back against the idea that OR is the overwhelming metric upon which to judge performance. "The frustrating this is not that there isn't activity on good ideas to generate more productivity," Fritz said, citing several other ongoing initiatives. "We really value our service product to our customers and first and foremost, we are going to give them an excellent product. In the end, we have a strong franchise that will generate winning in the marketplace. I'm not saying we need to add crews over and above volume. We are saying we need to get the crews right so we can get the service product right, and that is happening as we speak."
Later, Fritz returned to the same theme that it isn't just OR. "We care about a number of measures, whether we're running our business well, generating higher operating income and cash from operations, and how we reward our shareholders," he said. "We had a pretty damn good half in that measure."
Stock slides after call
The positive statements didn't resonate with investors. At approximately 1 p.m. Eastern time, UP stock was down $2.51 to $138.74, a drop of about 1.8 percent on a day when broader markets were trading lower by about 0.4 percent. One analyst quoted by Bloomberg called the results "decidedly negative."
The other area where several analysts questioned the UP performance was on pricing. UP reported an 8 percent increase in freight revenue, but only a 2 percent increase in core pricing, in a time when all signs point to increases on the road and on the rails between 5-10 percent or more. UP provides less information on pricing than many other transportation carriers, and analysts were mostly unsuccessful in prying out further data on the call. CFO Robert Knight said the company is "feeling pretty good about the environment" and if UP is able to achieve higher prices going forward, "that will show up in the yield calculations."
The core pricing includes coal and international intermodal, which Knight said "continues to be a challenge." He added that if those are put aside, core pricing would be up 3 percent, which would still be on the low side in this market.
Elizabeth Whited, the company's chief marketing officer, said UP is "encouraged by what we have seen in the truck markets. ELDs have definitely had an impact on capacity, and it is a good opportunity to price into that." Her remarks focused on domestic intermodal, as opposed to the more challenging international intermodal that is providing "headwinds."
While reiterating the company's policy not to project pricing trends, she noted two specific areas where UP had been able to take market share from trucks. First, pipelines for drilling previously had been mostly moved on trucks, she said, because it had been a short haul business, but UP has been able to convert some of that to train traffic. "There are a number of other examples, but that is one of the best I can give you," she said. But she then cited moving fresh and frozen produce, as well as lumber. "That's another one where trucks had penetrated in some areas and we're now seeing people returning to rail," Whited said.
Still, various switches will be one-off victories that won't fundamentally change the underlying business, where coal, chemicals, automobiles and grains will always make up the biggest areas of product movement. The possibilities for picking off demand from trucks "tend not to be home runs, so you would have to pile a bunch of them to move the needle," Whited said. "The team is actively working on that all the time."
Another area where performance lagged was in network velocity. Velocity was 24.7 mph, down from 25.4 in the second quarter of 2017, and 24.8 in the first quarter of 2018. However, the collapsed tunnel was cited as a contributor to the slow speed of the second quarter. Terminal dwell time was 29.5 hours, up from 28.3 hours in the second quarter of 2017.
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