Operating approximately 8,000 locomotives over 32,000 miles in 23 states, Union Pacific (UNP 0.23%) has the reach and flexibility to capitalize on several opportunities. Changes in 2018 have put the company on a one-way trip to efficiency following a successful logistics model -- a model that will be important to its ongoing success.
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Efficiency at its best
Union Pacific announced a plan in 2018 to streamline operations, lower costs, and increase profit margins. It was named the Unified Plan 2020, and it implemented precision scheduled railroading (PSR) into Union Pacific's operations. Prior to PSR, Union Pacific used a "hub and spoke" system, which involved allowing cars to enter a yard to be shuffled onto different trains. This system was terribly inefficient, requiring multiple redirects before a car reached its destination.
PSR incentivizes longer trains, shorter terminal waiting times per car, and faster shipment speeds. Used successfully by CSX Corporation (CSX 0.59%), Canadian National Railway (CNI 0.70%), and Canadian Pacific Railway Limited (CP 1.03%), PSR has been proven to lower costs by increasing efficiency. To measure PSR performance, the operating ratio (OR) is used, which determines optimal cost efficiency by dividing operating expenses from revenue. The lower the operating ratio, the more efficient the company.
If an operating ratio is 60, then the company is making $0.40 for every $0.60 spent. Union Pacific set a goal of an operating ratio below 60 to be reached at the beginning of 2020 – which looks to be on target. Union Pacific announced an operating ratio of 59.6 in the impressive second quarter of 2019, a decrease of 3.4 points from the second quarter in 2018.
Slow and steady
For the remainder of 2019, Union Pacific expects sand, coal, and housing to have a negative impact on shipment volumes from a mix of trade tensions, economic slowdown, and lower demand from individual segments. Standout shipments in the second quarter included plastics and petroleum products, increasing 6% and 30% respectively year over year from the recent quarter -- assisting in the 12% increase in earnings per share from $1.98 to $2.22 year over year.
Plastics growth is expected to continue. The United States is the second-largest plastics and rubber manufacturer, accounting for 23% of global production in 2018 -- China taking 48%. Mordor Intelligence released a forecast estimating a 5.19% compound annual growth rate (CAGR) in plastics manufacturing from 2019 to 2024, showing a steady increase in global demand -- with an expected market value of $104.32 billion in 2024. In addition, demand for petroleum and liquid petroleum gases (LPG) products are expected to remain consistent within the United States over the long term. OPEC expects a 0.6% CAGR into 2024.
Union Pacific had a decrease in overall energy-transportation revenue of 13% during the second quarter as coal demand slowed within the United States. Petroleum, LPG, and renewables grew 30% within the energy segment, however, only accounted for 22% of revenue within the energy segment. As Union Pacific experiences a decrease in coal shipment volume, there are expectations to fill the lost volume with plastic shipments.
A growing dividend
Income investors rely on steady returns with an increasing and secure dividend -- Union Pacific has both, paying a 2.49% dividend yield with a five-year CAGR of 15.64%. CSX, in comparison, is paying a yield of 1.44% and a five-year CAGR of 2.27%.
Long-term debt of $22.42 billion is a concern, but Union Pacific delivered $3.9 billion from operating activities in the second quarter -- $5.17 billion in free cash flow in the trailing 12 months. In addition, Union Pacific repurchased 3.7 million shares in the second quarter, totaling a repurchase of $3.629 billion in 2019 -- strengthening shareholder value.
All aboard
The total number of carloads volume is expected to move higher in 2020 assuming trade tensions settle. Lance Fritz, the CEO of Union Pacific, stated in July that it is important for the U.S. to come to an agreement on the United States-Mexico-Canada Agreement in addition to settling trade tensions with China, Europe, and Japan. Fritz notes that if trade tensions lighten, there is continued opportunity economically -- which should improve Union Pacific's performance into 2020. Operating on north and south corridors, Union Pacific has access to both Mexico and Canada, serving all six gateways to Mexico in addition to interchange traffic with the Canadian rail systems.
Keeping an eye on operating ratio, overall shipment volume, and train lengths will be important, as each is a driver of efficiency and the bottom line. Income investors wanting to invest in a company with strong financials and a growing dividend will feel confident knowing Union Pacific is strong in both areas.
