It's been an extremely eventful year for the railroads, but they look to have emerged from it with their investment cases strengthened. That's certainly true for West Coast railroad Union Pacific (NYSE:UNP). Let's take a look at what happened and whether the railroad stock is a buy for 2021.

Two questions going into 2021

There are two key questions to focus on regarding railroads and Union Pacific right now:

  • Railroads are the lifeblood of the industrial economy, so how are Union Pacific's end markets recovering from the shock of the COVID-19 pandemic in 2020?
  • How did the pandemic impact efforts to structurally increase profitability in 2020?

Answering both of these questions leads to positive views on Union Pacific as it enters 2021. In other words, there's reason to believe revenue and operating margin will improve in 2021, and that's usually good news for stocks.

A freight train rounding a curve in a desert landscape

Image source: Getty Images.

Revenue improvement?

The first question is easier to deal with, as there's clear evidence of improvement in carload traffic overall and in the more economically sensitive intermodal traffic.

US Carloads Rail Traffic Chart

Data by YCharts

Moreover, the latest data from the Association of American Railroads shows total traffic up 2.5% year over year in the week ending Dec 19. and total intermodal unit traffic up 10.3%. 

In this context, it's reasonable to expect the relative improvement in Union Pacific's freight revenue in the third quarter to carry through into the fourth quarter as well. Although the third-quarter freight revenue growth figure doesn't look that impressive, it actually represents a 16% increase from the second quarter of 2020. That's a very favorable number compared to the 2% fall in sequential revenue from the second to third quarter in 2019.

Union Pacific

Q3 2020

Q2 2020

Q1 2020

Q4 2019

Q3 2019

Freight revenue YOY growth

(11%)

(24%)

(3%)

(10%)

(7%)

Data source: Union Pacific presentations. YOY = year over year. 

Operating margin improvement?

All the major listed railroads have adopted something called precision scheduled railroading (PSR) in order to decrease their operating ratio, or OR. For reference, OR is simply operating expenses divided by revenue, so a lower number is better. Obviously, a lower OR means a higher profit margin.

In a nutshell, PSR is a set of management principles aimed at running the same volumes by using fewer assets. At the heart of it lies the principle of running trains on fixed schedules between two fixed points on a line. This is opposed to the traditional hub-and-spoke model that railroads used to operate.

PSR practitioners measure improvements in terms of a host of metrics, such as dwell (the amount of time a car spends at a certain location), train speed, train length, trip plan compliance (percentage of carloads on time), and workforce productivity (daily car miles per full-time employee). The idea is that improvement in these metrics will result in a lowering of the OR.

In general, railroads have made great progress on lowering their ORs and they continued to do so in the first quarter of 2020. However, the shock to the system created by the sudden cessation of economic activity in the second quarter put a lot of pressure on railroads' OR, leading to fears that the railroads are only capable of reducing the OR when they have strong revenue growth.

That said, the reality is that Union Pacific did reduce its OR in the third quarter even with declining revenue. In addition, management is guiding toward a sub-60% OR for the full-year -- an excellent result under the circumstances.

Union Pacific metrics.

Data source: Union Pacific presentations.

Finally, turning back to the key metrics that go together to produce a lower OR, it's clear that there's across-the-board improvement in place despite a very difficult operating environment. Union Pacific is running longer trains faster, and with less terminal dwell. Management continues to aim for a 55% OR over time. 

Union Pacific

Year-to-Date

YOY comparison

Average terminal dwell

22.8 hours

10% improvement

Train speed

25.8 mph

4% improvement

Freight car velocity (daily miles per car)

217 dmpd

7% improvement

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

920 daily miles per FTE

8% improvement

Intermodal car trip plan compliance (% cars on time)

81%

Improvement from 72%

Train length 

8,676 ft

14% improvement

Data source: Union Pacific presentations. YOY = year over year.

Is Union Pacific a buy?

The railroad looks like it's headed for a combination of revenue growth and margin expansion in 2021 and beyond. Given its near-2% dividend and the stability in its market position and importance to the economy, the stock will suit retirees and dividend-seeking investors. It has a combination of a decent yield and good underlying growth prospects. That might be enough for investors looking for a secure income rather than holding money in the bank at current interest rates.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.