Demand for U.S. rail shipments is linked to the overall state of the American economy, where things are slowly looking up. The country's leading railroad company, Union Pacific (UNP 2.14%), leveraged this growth and reported record earnings last year. But a downturn in the coal and crude oil business has reversed the situation in the last two quarters. Management has confessed it is in no position to beat or match last year's performance in 2015. Union Pacific badly needs an alternate business plan to turn things around. Let's assess the company's growth prospects under the current scenario.
Coal and crude oil playing major spoilsports
Coal demand has fallen in the U.S. because utility companies have come to prefer natural gas for electricity generation. In April, for the first time ever, natural gas had more market share than coal in the U.S. electric power-generation market. In the second quarter, coal accounted for 32% of total electricity generation in the country, down from 39% a year ago. Experts feel the shift is not just a reaction to soft natural gas prices but a more permanent change in preference.
Union Pacific's coal revenue declined 31% to $679 million in the second quarter on 26% lower volumes and 7% lower average revenue per car. But what's unnerving is that rival Burlington Northern Santa Fe (BNSF) reported just a 1% volume drop for the same time period.
Falling crude oil shipments pose another big challenge for Union Pacific. Global oversupply and low prices have stalled shale oil production in the U.S. and the number of rigs has halved from 2014 peak levels. This lowered the company's crude oil shipments 29% in the second quarter.
Though Union Pacific has a diverse business mix, most of its other segments are also witnessing soft market conditions and could not cushion the coal and crude oil impact. The net result was that total freight revenue took a 10% hit in the second quarter.
Union Pacific is cutting jobs
The company talked about adding 1,000 new jobs during July 2014, but this year, it's laying off workers due to falling freight volumes. In the first six months, it has made 1,200 temporary layoffs, mostly in the ranks of train and cargo handlers. Over the coming months, it will cut several hundred more management jobs across the country. It's also sent 900 locomotives into "storage" in the first half of the year to match resources with demand.
Where Union Pacific still has an edge
The U.S. economy expanded 3.7% in the second quarter, and more economic activities could bring new growth opportunities for the company. With more than $2 billion in cash and a debt equity ratio of less than 1, Union Pacific has ample liquidity to pursue any new strategy. It remains profitable and operationally sound -- having earned $1.2 billion in the second quarter against BNSF's $963 million. Its operating ratio of 64.1% in the second quarter was better than BNSF's 66.3%. Operating ratio is a key metric for railroad companies as it measures operating costs as a proportion of operating revenue -- the lower the ratio, the better the company's profit potential.
Union Pacific owns one of the largest tracks in the country, spread across 32,400 miles with access to major trade centers. It's working hard on speed and safety, and has improved its performance on both counts in the second quarter.
Finally, the railroad has an advantage over BNSF in its Mexico operations as it serves all six Mexican gateways, while the latter serves five. Mexico is the second-largest exporter to the U.S. and an auto manufacturing hub, which makes it a lucrative growth avenue for logistics companies. Last year, Union Pacific's Mexico business expanded 8% and accounted for 10% of total shipment volumes.
Union Pacific is a Fortune 500 company. Between 2010 and 2014, it's grown its operating revenue at a CAGR of 9% and net income at 16.8%. It's unlikely the current business downturn will spoil its growth prospects for good. But it's imperative for the railroad major to find a way out of the coal and crude oil dilemma and deploy its resources into more rewarding businesses if it wants to please its investors.