Over the last five years, the railroad sector's stellar performance has largely come about due to the wide-scale adoption of precision scheduled railroading (PSR) management techniques. However, the question now is whether the outperformance versus the stock market can continue for stocks like Union Pacific (UNP -1.78%). Let's look at the puts and takes behind the debate.

Precision scheduled railroading

For those readers unaware of PSR, it's a set of management principles pioneered by legendary railway man Hunter Harrison. Adopted by all the leading listed North American railroads, PSR emphasizes running fixed schedules at fixed points on a network. This is opposed to the traditional hub-and-spoke model. One key difference is that PSR practitioners are willing to adjust the freight price to fill routes, while the hub-and-spoke model tends to result in freight cars sitting idle in hubs while they wait to be attached to trains.

A freight train.

Image source: Getty Images.

The name of the game in PSR is running the same freight by using fewer assets. Railroads practicing PSR use a host of metrics (train speed, terminal dwell, trip plan compliance) to measure performance improvement with the ultimate aim to reduce the operating ratio (OR). Since the OR is simply operating expenses divided by revenue, a lower OR implies a higher operating profit margin. As you can see below, margins across the sector have expanded. That's great news for long-term investors because it means the long-term earnings potential is now higher.

UNP Operating Margin (TTM) Chart

Data by YCharts. TTM = trailing 12 months.

What about Union Pacific?

Digging into the details of Union Pacific's first quarter and the outlook given on its investor day presentation, it's clear that the railroad expects to make significant progress on its OR in the coming years. There are two points to highlight:

  • Management guided investors toward the high-end of its full-year 2021 OR guidance, despite facing significant OR headwinds in the first quarter.
  • The guidance on the investor day presentation calls for the OR to fall from an adjusted rate of 58.5% in 2020 to 55% in 2022.

Operating ratio guidance for 2021

On a headline basis, Union Pacific did not have an excellent first quarter in terms of OR. In fact, the first-quarter 2021 OR increased (remember a lower number is better) to 60.1% from a rate of 59% in the first quarter of 2020. The reason? It comes down to a combination of headwinds from lousy weather and an increase in fuel prices -- both factors that won't necessarily repeat. In fact, without these headwinds, the OR would have fallen to 57.5% in the quarter. That's a decrease of 150 basis points, with 100 basis points equaling 1%.

However, what caught the eye was CFO Jennifer Hamann outlining on the earnings call that "guidance around full-year pricing, productivity, and operating-ratio improvement in the range of 150 to 200 basis points all remain intact," and "we will likely be closer to the 200 than the 150." That would be an excellent result considering the headwinds experienced in the first quarter.

A railway hub.

Image source: Getty Images.

Medium-term guidance

Turning to the investor day presentation on May 4, management outlined expectations to hit an "industry leading operating ratio" of 55% by 2022. That figure means an operating margin of 45%, and Wall Street analysts have wasted no time penciling in a consensus for a 44.7% operating margin in 2022 and 45.3% in 2023.

Furthermore, the transportation stock's earnings are expected to drop down into free cash flow (FCF) generation of $6.5 billion in 2022 and $7 billion in 2023. Based on the current market cap of $147 billion, Union Pacific would trade at 22.6 times its FCF in 2022 and 21 times FCF in 2023.

Is Union Pacific stock a buy?

All told, the stock is probably not a buy for most investors. The valuation looks like it's fully up with events, and it's worth noting that Union Pacific's 2021 OR guidance received the boost of a better end-market environment. For example, management expects volume growth of 6% in 2021, compared to a previous estimate of 4% to 6%. Moreover, there's no guarantee that Union Pacific will reduce its OR beyond 2022, meaning that its earnings could end up on a low-single-digit growth trajectory in line with economic growth in general.

On the other hand, the stock's 2% dividend yield and the solidity of its end markets mean it will continue to attract risk-averse investors looking for a decent place to park some cash. As such, the stock remains attractive for a certain type of investor.