The latest results from west coast railroad Union Pacific (NYSE:UNP) didn't bring any major near-term surprises, and the stock remains a decent option for income-seeking investors looking for a place to park some cash. However, the question with the railroads is always whether there is any catalyst for an improvement in long-term earnings. Fortunately, the answer to that question is yes, and here's why.

Operating ratio

Let's start with the most obvious factor, namely Union Pacific's attempts to lower its operating expenses compared to its revenue. The operating ratio (OR) is a key metric in the railroad industry. It's simply operating expenses divided by revenue, so a lower number is better.

A freight train.

Image source: Getty Images.

The key development in the listed Class 1 U.S. railroads in recent years is how they have been lowering the OR through extensive application of precision scheduled railroading (PSR) management techniques. In a nutshell, PSR is a set of principles designed to run the same number of carloads with fewer assets.  As 2020 began, all the listed railroads looked set for an improvement in the OR, but the COVID-19 pandemic upended those assumptions.

Union Pacific's OR in 2019 was 60.6%, and the plan was to decrease it to around 59% in 2020, with an ultimate aim of 55% over time. Unfortunately, the severe volume declines caused by the pandemic (Union Pacific's carload volume declined by 20% in the second quarter) put severe pressure on the OR, since railroads have a lot of fixed costs. It was no surprise to see the OR rise to 61% in the second quarter, compared with 59.6% in the same quarter last year. In a similar vein, Kansas City Southern's (NYSE:KSU) adjusted OR also increased to 65.2%, compared to 63.7% in the same period last year.

However, the key point is that Union Pacific managed to improve all the key performance metrics that the railroads are using to measure PSR improvements. As such, it suggests that the transportation stock can continue to improve its OR when volume comes back in line with a post-COVID-19 recovery. Moreover, investors have reason to be positive over the matter because Kansas City Southern reported similar improvements in its PSR-related metrics in its second quarter. 

Union Pacific

Q2 2020

Trend

Freight car terminal dwell (hours)

21.6 hours

16% improvement

Train speed (miles per hour)

26.9 mph

10% improvement

Freight car velocity (daily miles per car)

225 dmpc

11% improvement

Workforce productivity (daily car miles per full-time employee)

868 daily miles per FTE

Flat

Data source: Union Pacific presentations.

All told, the underlying metrics appear to be improving. That bodes well for OR reductions in the future, meaning earnings improvements ahead.

End market growth

In addition to the possibility of margin improvement through lowering the OR, the transportation stock has some opportunities to improve long-term revenue growth too:

  • Reshoring would lead to pick-up in industrial activity in the U.S. and ultimately in railroad volumes.
  • Union Pacific's management believes it's well-positioned to grab market share from trucking due to recent business wins and an improvement in service levels generated by PSR initiatives.

Both subjects came up on the earnings call. Regarding reshoring/nearshoring, Union Pacific's CEO Lance Fritz said: "It's early innings, so I can't really point to any substantial investment that's occurred at this point in time in terms of executing on that. But I do know there's planning in place."

Turning to the issue of winning market share from trucking in the intermodal market, VP of sales and marketing Kenny Rocker said: "E-commerce strength is likely to continue and volumes will be bolstered by recent business wins." Rocker went on to argue: "We feel good about the wins that we've made that we know will show up here in the near term. And it's broadly across the intermodal network."

A railroad hub with trains on several tracks

PSR initiatives help to reduce the number of hubs a railroad needs to use. Image source: Getty Images.

One example of how PSR is improving service levels comes from Union Pacific's improving trip plan compliance (the percentage of cars on time) -- something that will encourage companies to use rail rather than trucking.

Looking ahead

All told, it's clearly going to be a difficult year for Union Pacific, but the underlying trend of improving PSR metrics suggests that management's aim of getting to an OR of 55% is well founded. Meanwhile, the supply chain difficulties created by the pandemic and the trade war imply that more companies will look at reshoring, and PSR-induced service improvement levels suggest that rail can win share from trucking.