Please ensure Javascript is enabled for purposes of website accessibility

Union Pacific Struggles to Lift Productivity

By Asit Sharma - May 9, 2018 at 7:07PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Management of the sprawling railroad has been forced to scale back productivity achievement timelines. Here's why this unnerves investors.

And with respect to our targeted 60% operating ratio, plus or minus, on a full year basis by 2019, we have clearly lost some time given the current service challenges that we are experiencing. And it is now unlikely that we will achieve that target next year. We are still committed to achieving a 60% operating ratio, just not likely next year and ultimately, [committed to] a 55% operating ratio.

--Union Pacific CEO Lance Fritz

With these words, Union Pacific (UNP 0.91%) chief Lance Fritz shifted the conversation during the company's first-quarter earnings conference call with analysts on April 26, from a discussion on a relatively successful quarter to a prolonged question-and-answer session addressing analysts' concerns over the railroad's productivity. 

Shareholders seconded analysts' caution, as Union Pacific's stock dropped 3% on the earnings-day trading session. Shares have seen muted action since, though they've recovered to a pre-earnings level of roughly $137 per share.

It's not surprising that the productivity forecast revision affected Union Pacific's share price, as the operating ratio is perhaps the most commonly used yardstick to measure productivity in the railroad industry. This metric divides operating expenses by revenue, effectively revealing the percentage of operating costs attached to each dollar of revenue. A lower operating ratio indicates higher productivity. 

3D rendered illustration of a curving line of colorful freight cars.

Image source: Getty Images.

In the first quarter of 2018, Union Pacific's operating ratio declined by just 60 basis points, to 64.6%. The organization's productivity stasis (and the backtracking from long-term targets) stems from current service problems, which are most acute in the southern part of its network.

Last year, Union Pacific's southern region grew congested, partially from the relatively attractive problem of volume growth, and also due to the complexity of implementing positive train control (PTC), as mandated by Congress.

So far in 2018, congestion in the South remains, and according to management, it's been exacerbated by record manifest volume. Manifest train volume denotes trains of mixed car types, carrying assorted cargoes and commodities, which are assembled at multiple points. This is in contrast to unit volume, in which a train is typically assembled at a single point, carries a uniform commodity, and routes to a single destination.

During Union Pacific's earnings conference call, Fritz explained that its congestion issues were best solved by over-resourcing. Specifically, this means putting additional locomotives into service and activating more crews, which should ease constraints on the network and decrease the average dwell time of cars.

If you happened to have worked in a manufacturing environment, the approach of throwing resources at a bottleneck may sound familiar. Union Pacific is pulling cars out of storage and hiring more TE&Y (train, engine, and yard) employees to ensure a steady flow of rail traffic.

Of course, in the short term, this actually weakens the operating ratio, as the company has to pony up additional dollars to unclog its lines, from the higher TE&Y spend to incurring expenses such as temporary locomotive leasing.

As for a longer-term solution, Union Pacific is opening the Brazos classification yard in Robertson, Texas in 2020. A classification yard is a facility for sorting and switching cars onto separate tracks. Union Pacific began construction on Brazos Yard in January 2018, and when completed, the location will have the capability to switch 1,300 cars a day. Brazos Yard's $550 million price tag represents the largest investment in a single facility in Union Pacific's history, and management believes the state-of-the-art project will help significantly improve network fluidity within its southern region.

Why shareholders fret about a single yardstick

Maybe the slight pall cast over Union Pacific stock from focusing on the operating ratio seems overdone. But the metric is vital in the rail industry since railroads face a high burden of fixed costs, most prominently in the form of labor and benefits, but also from fuel and continuous rail maintenance. And since rail revenue growth is often directly a function of the broader U.S. and global economies, investors prize a railroad's ability to squeeze higher profits from each revenue dollar, regardless of the external environment.

It also hasn't helped that competitor CSX Corporation (CSX 0.78%) just reported a massive year-over-year jump of nearly 6 percentage points in its operating ratio, from 69.4% to 63.7%, in the first quarter of 2018. I recently described how a more aggressive approach to operations appears to be fueling CSX's productivity. And yet it should be acknowledged that CSX isn't facing a congestion event like Union Pacific's.

It must be frustrating for Union Pacific leadership to delay the 60% operating ratio target by at least a year, while one of its competitors wows investors with accelerated efficiency. Year to date, CSX stock has gained almost 12%, while the UNP ticker, though still positive, has gained just over 3%.

Nonetheless, the company has reiterated its commitment to a longer-term operating ratio goal of 55%, as indicated by Fritz at the outset of this article. During the April 26 earnings call, executives also emphasized that the operating ratio shouldn't become the sole source of investor focus. Fritz reminded analysts that management watches a number of operational and financial metrics to improve the business, and pointed to return on invested capital, or ROIC, as an equally substantive measure.

Investors may want to take slight issue with this otherwise reasonable comment. Over the long run, given a relatively static capital base, increased after-tax profit is the lever that sends ROIC higher. And beyond one-time events like the recent U.S. tax legislation (which lowered Union Pacific's tax rate and thus boosted net income), both the operating ratio and ROIC benefit when a company lifts its top line while effecting operational improvement.

Simply put, improving ROIC demands much of the same work as trimming the operating ratio. Whichever metric management chooses to focus on, investors want higher productivity out of Union Pacific in the coming quarters.

  

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Union Pacific Corporation Stock Quote
Union Pacific Corporation
UNP
$215.52 (0.91%) $1.94
CSX Corporation Stock Quote
CSX Corporation
CSX
$31.18 (0.78%) $0.24

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
330%
 
S&P 500 Returns
115%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/23/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.