If you want a read on the U.S. economy, look at what the railroads, like Union Pacific (UNP 1.75%), are saying. Unfortunately, the stock has dipped in 2022, so is that a sign of trouble ahead? Let's look at the company's recent earnings, its outlook on the economy, and the stock's prospects in 2022.
Image source: Getty Images.
Omicron damage, but underlying prospects look excellent
If the analogy between railroads and the economy rings true, we are heading for a good year. Moreover, based on management's commentary, Union Pacific shareholders can sleep soundly knowing their company is on the right track.
The good news is as follows:
- Management believes its volume growth in 2022 could outpace industrial production growth estimates of 4.8%.
- The forecast for operating ratio (OR) is bullish for the stock.
- Commentary on the cadence of volume growth suggests many of the supply chain issues in the economy will ease in the second half.
OR is the most critical metric to follow with railroads. It's defined as operating expenses divided by revenue, so a lower number is better. It's how the railroad industry measures operating efficiency, and it's been the important number to follow in recent years as all the major listed U.S. railroads are trying to lower it by implementing precision scheduled railroading (PSR) management techniques.
In a nutshell, PSR seeks to run the same freight volumes but with fewer assets. Its practitioners follow metrics like freight car velocity (higher is better), terminal dwell (lower is better), train length (longer is better), and locomotive and workforce productivity.
Image source: Getty Images.
The following chart shows the improvement in the OR in recent years and management's target for 2022. It's a remarkable result given the impact of the COVID-19 pandemic on the economy. The achievement is all the more impressive considering that the OR increased (remember, a lower number is better) on a year-over-year basis in the fourth quarter to 57.4% mainly due to "headwind from fuel prices," according to CEO Lance Fitz on the earnings call.
In addition, some of the key metrics used to improve OR, such as freight car velocity, came under pressure due to the pandemic. According to Executive VP Eric Gehringer on the earnings call, "freight car velocity was impacted by reduced crew availability due to an increase in COVID infections and providing time off for vaccinations."
All told, it's a demonstration that Union Pacific can use PSR to reduce its OR across a range of market conditions. That's a major plus for the investment case for the stock because it means higher operating margins and profitability over time.
Data source: Union Pacific presentations.
Volume improvements
The question of how Union Pacific plans to get to an OR of 55.5% came up on the earnings call. Fritz explained it would come from three sources:
- Expected volume growth in 2022 would be leveraged (longer, more productive trains) to improve the OR.
- Productivity improvements through PSR, many of which were delayed in Q4 due to a resurgence of COVID-19 cases and mandated vaccinations.
- Increased pricing will help too.
Underpinning these arguments is the belief that volumes will improve in 2022. That's a bullish assumption for Union Pacific and the U.S. economy.
Management believes its industrial (energy, forest products, industrial chemicals & plastics, and metals & minerals) and bulk (coal & renewables, grain & grain products, fertilizer, food & refrigerated) will lead the way in the first half of 2022 with premium (automotive and intermodal) volumes taking over the growth baton in the second half.
Image source: Getty Images.
Of particular note, more robust industrial production is leading a recovery in chemicals and plastics, but forest products will slow through the year due to a year-over-year decline in housing starts. However, probably the most bullish note comes from the outlook for premium, with management expecting a rebound in automotive production due to easing the semiconductor shortage and retail inventory restocking.
What it means for investors
Since the omicron variant and government action hit Union Pacific in Q4, it's clear that risk from the ongoing pandemic is a factor. Still, underlying demand looks strong, and Union Pacific has demonstrated it can reduce the OR across various conditions. Meanwhile, management's end market outlook, formed partly by talking to its customers, is positive.
As such, Union Pacific and its current 2% dividend yield remain a valuable option for income-seeking investors. Meanwhile, Union Pacific's outlook supports the investing thesis that the second half of 2022 will see an easing of the supply chain constraints in the U.S. economy.
