Chugging To The Top: Union Pacific’s Earnings Finally Outperform (NYSE:UNP)

Union Pacific Q1 Earnings

Jim Vena, Union Pacific’s CEO, is nailing it. We are finally seeing Union Pacific (NYSE:UNP) report stronger earnings and overperforming the industry, instead of being the laggard. Union Pacific’s earnings showed the company’s strength amidst a soft freight environment and Union Pacific’s shares jumped up over 4% as the press release was available. In this article, I will walk you through the report, showing why I now see it appropriate to rate UNP as a buy.

SA readers may know I have been extremely meticulous with Union Pacific, as I was rather disappointed with increasing inefficiency while the company was taking on more and more debt to fund its generous buybacks. However, while shareholders did enjoy a nice ride up, the company’s fleet and network were not being maintained and renewed adequately. As a result, Union Pacific’s buybacks repurchased shares of a business with slowly deteriorating assets, making me wonder whether the company was going off track or not. Then interest rates spiked up and this happy playbook came to an end: buybacks were paused to protect the balance sheet.

Eight months ago, Jim Vena was appointed as the new CEO of the company to fix these exact issues and make Union Pacific a true industry leader.

Union Pacific’s Turnaround Seems Beginning

First of all, a new way of running the business can be seen in how the quarterly result presentation is now built. We finally see something unique in the industry, something I have long wanted to see railroads report.

Union Pacific reports its freight revenue excluding the fuel surcharge, which is then added as a separate item. This is of utmost importance to assess the operations of a railroad. Indeed, fuel surcharges greatly impact total revenues by either increasing or reducing them. Since railroads don’t release the exact amount earned through these programs in their quarterly reports (we usually find more information in the annual reports), it is harder to understand if a railroad is gaining volume and if it is flexing its pricing power.

Union Pacific makes this much easier now and this proves to me that Mr. Vena wants to be crystal clear about the improvements he is executing in Union Pacific’s operations.

So, right off the bat, we see that Union Pacific did report total revenues down 1% YoY to $5.62 billion instead of $5.66 billion. Yet, freight revenue actually increased by 4% YoY if we excluded the fuel surcharge. This means the price/mix was favorable for Union Pacific.

Operating expenses moderated and were down 3% YoY. In particular, Union Pacific’s management stressed that the company has reduced its active fleet by parking around 500 locomotives around its network. This has the double advantage of smoother operations and reduced costs. Moreover, it helps the company’s fuel efficiency because older locomotives are stopped, while newer ones keep running.

The consequence on the operating ratio were meaningful: an improvement of 140 bps, from 62.1% down to 60.7%. If Union Pacific keeps walking down this road, we should soon see it report an OR below 60%, which would probably foster renewed excitement for the stock.

Union Pacific’s net income increased 1% YoY thanks to a 3% improvement in operating income. As a result, UNP’s earnings per share increased by $0.02 to $2.69 without the help of any share reduction. Considering that in Q1 2023, there was a $0.14 per share real estate gain, as Union Pacific disclosed during its last earnings call, we see that Union Pacific is making great strides toward enhanced profitability.

Union Pacific’s Volumes

Union Pacific reports its freight revenues under three main segments: bulk (grain, fertilizers, food, and coal); industrial (petrochemicals, metals, minerals, forest products, energy); and premium (automotive and intermodal).

Bulk delivered a revenue decline of 4% to $1.82 billion, though volume was down 5%. This means the average revenue per car (ARC) was up 1% YoY to $3,787. However, bulk was greatly affected by coal, whose carloads were down 18% and caused a 23% decline in revenues to $388 million from $505 million a year ago. Nonetheless, the overall segment held up fairly well, thanks to the nice 8% increase in fertilizers and food products. These two segments have a much higher ARC than coal: $4,271 for the former and a staggering $6,231 for the latter. Coal hovers around $2,200.

So, if we adjust for coal, even though the freight environment is currently soft, Union Pacific would have delivered an increase in volumes of almost 2%. This is part of the outperformance we were expecting.

Coal is projected to be weak for the whole year because inventories are rising and natural gas is back to low and affordable prices.

Let’s look at the other two segments.

Industrial’s performance pleased investors and may confirm that a manufacturing rebound is on its way. In fact, petroleum grew 11%, both in freight and in volume. Petrochemicals’ volume was up 4% YoY and revenue did even better with a 7% increase. This means Union Pacific had pricing power here. Rock (metals and minerals) volumes, on the other hand, were soft and were down 10%, though freight revenues declined only 4%. Union Pacific’s management said that it expects “the rock market to be challenged to exceed last year’s record volume”.

Premium, contrary to the name’s meaning, is the segment with the lowest ARC of the three: only $1,792. Here, automotive keeps on performing well, with volumes and revenues up 4%, thanks to some wins Union Pacific had with Volkswagen and General Motors. But I expect automotive to moderate throughout the year as dealers’ inventories replenish and demand softens due to high interest rates. Intermodal volumes were positive in the quarter. This alone is great news. In particular, intermodal was driven by strong international West Coast demand, partially because of traffic shift away from the Panama Canal. However, domestic intermodal proved soft and this goes along with the lower-than-expected GDP print that just came out.

Union Pacific’s Balance Sheet

Union Pacific had to improve its balance sheet, lowering its debt/EBITDA ratio. We see that in the past three months, the cash balance decreased by $130 million. At the same time, Union Pacific paid back $1.36 billion of LT debt, over twice as much YoY. In addition, it issued only $400 million of new debt compared to $1.2 billion issued in the same quarter of last year.

Thanks to LT debt repayment of $1.3 billion during the quarter, Union Pacific’s adj. debt/EBITDA ratio is now below the 3x threshold, at 2.9x, confirming the A-rating on its balance sheet.

However, properties didn’t increase much, meaning we are still not in an enhancement cycle.

Union Pacific’s Free Cash Flow

Union Pacific reported operating cash of $2.12 billion, which equals to a cash flow conversion of 81%. These results laid the foundation for the strong FCF generation Union Pacific reported: $525 million vs. $240 million.

This made the company confident enough to disclose that, starting Q2 2024, the company will resume repurchasing its shares. We don’t know how much Union Pacific will spend. But, given the reported FCF, we could expect UNP to report a few hundred million worth of repurchases. This goes along with a dividend yield of 2.24%, which is a good start.

Union Pacific’s Outlook

Union Pacific’s outlook expects the company’s profitability to gain momentum while volumes are seen more or less flat YoY. What will move the needle between growth and decline will be international intermodal. In fact, bulk is seen as more or less flat, while industrial is expected to improve gradually throughout the year. Premium, excluding international intermodal, should be flat as automotive and domestic international offset one another.

Union Pacific’s Valuation

We have to give credit where credit is due. If Union Pacific starts growing once again, we will soon see it receiving a much higher grade compared to the D+ it is currently being given by SA’s Quant Ratings.

The company trades at a 20.8 fwd PE, below the current earnings multiple of the S&P 500, which is around 23.5 at the time of writing. Moreover, Union Pacific trades at a fwd FCF yield of 4.2%, which positions the stock as an interesting pick.

Since I see several signs hinting that Union Pacific’s turnaround may be on its way, we are before a stock that could generate substantial returns in the next few years during Mr. Vena’s tenure.

As a result, I upgraded my UNP’s rating from hold to buy, considering the stock much safer now than it has been in the recent past.