For UP, a challenging second quarter

UP Chairman, President and CEO Lance Fritz

Written by  William C. Vantuono, Editor-in-Chief, RailwayAge Magazine

"Revenue declines in six traffic groups were a key contributing factor in Union Pacific’s second-quarter financials, for which the railroad reported diluted earnings per share of $1.17, a 15% decline from the prior-year quarter; operating income of $1.66 billion, down 15%; and an operating ratio of 65.2%, up 1.1 points.
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Operating revenue of $4.77 billion was down 12% in second-quarter 2016 compared to 2015. Business volumes, as measured by total revenue carloads, declined 11%. Volume declines in coal, intermodal, industrial products, chemicals, and automotive more than offset growth in agricultural products. Revenue per carload was down 2%, as a 4% decline in fuel surcharges more than offset a 2% core price increase.

Quarterly freight revenue decreased 13% compared to 2015, as volume declines and lower fuel surcharge revenue more than offset core pricing gains. Agricultural Products dipped 3%; chemicals dropped 5%; Automotive fell 13%; Industrial Products fell 14%; Intermodal dropped 16%; and Coal nosedived 27%.

On the cost side, UP’s $1.45 per gallon average quarterly diesel fuel price in second-quarter 2016 was 27% lower than second-quarter 2015. In addition, quarterly train speed, as reported to the Association of American Railroads, was 26.6 mph, 8% faster than 2015, though the velocity increase is almost entirely attributable to fewer trains in operation and, hence, more capacity and improved network fluidity. UP also repurchased 7 million shares in the quarter 2016 at an aggregate cost of $602 million.

“While the second quarter was again challenging from a volume perspective, we continued focusing on initiatives that are squarely in our control, such as being productive with our resources, providing our customers with excellent service, and improving our safety performance,” said UP Chairman, President and CEO Lance Fritz.

Looking ahead, Fritz said that “a soft global economy, the negative impact of the strong U.S. dollar on exports, and relatively weak demand for consumer goods will continue to pressure volumes through the second half of the year. However, we see potential bright spots in certain segments of our business if key economic drivers continue to strengthen as they have in recent weeks. Beyond the impact of the current macro environment, we are implementing a strategy that will make us a stronger company for the future. In the months and years ahead we will continue to create competitive advantages for our customers, enhanced safety and satisfaction for our employees, strength in our communities, and solid returns for our shareholders.”

Wall Street responded to UP’s financial report with a “mildly negative reaction to the results,” said Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl. “We view this as a unique buying opportunity, as it appears largely attributable to further moderation in price, which we believe will begin to improve in 2H16. Potential near-term drivers include agricultural products, coal, construction products, and domestic intermodal. Longer term, free cash flow should begin to increase as UP’s capex needs moderate.”

UP’s results were largely in line with Cowen and Wall Street consensus estimated. The 2Q16 EPS of $1.17 topped Cowen’s $1.15 expectation and met the consensus of $1.17. The 15% operating income decline was fairly close to Cowen’s and street expectations of $1.67 billion and $1.70 billion, respectively. UP’s 12% revenue drop, to $4.77 billion, was largely in line with Cowen’s and consensus estimates. The OR’s deterioration by 110 basis points year-over-year to 65.2% was 50 bps worse than Copen’s assumption and 80 bps worse than the implied consensus OR.

“UP’s 2% core pricing result represented a deterioration from 2.5% in 1Q16, which in turn was below the 3.5% achieved in 4Q15, which had a half percentage point of legacy business,” Seidl noted. “We believe the pricing pressure is attributable to three main factors: 1) Ample capacity across freight modes. 2) Ocean shippers taking advantage of low rates to take freight further on water, with more East Coast-bound freight going directly to Eastern ports. 3) Aggressive pricing by BNSF.

“We believe the price moderation was the key culprit behind the mildly negative reaction to the results. We view the stock weakness as a unique buying opportunity for long-term investors as we believe pricing will begin to rebound in 2H16. Indeed, UP noted recent tightening in freight capacity, which is consistent with the takeaways from our private trucking call, in which participants noted improved volumes in June and July and a rise in spot truckload rates.

“Other potential bright spots include agricultural products, coal, construction products, and domestic intermodal. On the Ag front, a combination of high levels of grain in storage, a strong expected crop in the U.S. this season, and weak crops in South America could drive the shipment of domestic and export grain. On the coal front, we are modeling for a material sequential rise in traffic, as coal burn in June was outsized vs. May, and much of the coal produced in UP-served regions is now in the money at current natural gas prices. Construction products, according to our channel checks, remain strong and should continue to drive demand for the shipment of lumber and aggregates. Finally, domestic intermodal should benefit from what appears to be a gradual recovery in truckload rates.”