Union Pacific freight revenue gains in 1Q

Union Pacific Corporation reported 2018 net income in the first quarter of $1.3 billion, and a first-quarter record $1.68 per diluted share, compared to about $1.1 billion, or $1.32 per diluted share, in the same quarter a year ago.

Operating income totaled $1.9 billion, up 8% for the Omaha-based company. The operating ratio of 64.6% improved 0.6 points, even as higher fuel prices negatively impacted the operating ratio by about 0.2 points. The $2.13 per gallon average quarterly diesel fuel price was 22% higher than a year ago.

“Our solid first-quarter results were a direct reflection of the tremendous effort put forth by our entire workforce, and had it not been for some network congestion it would have been even better,” said Lance Fritz, Union Pacific Chairman, President and CEO. “I am encouraged by the work we are doing to quickly regain superior levels of service and efficiency.”

Operating revenue of $5.5 billion gained 7% year-on-year. Volumes, as measured by total revenue carloads, increased 2% as increases in energy, industrial products and premium shipments more than offset a decline in agricultural products.

Freight revenue improved 7% on volume growth, increased fuel surcharge revenue, core pricing gains and positive mix.

Train speed, as reported to the Association of American Railroads, was 24.8 mph, off 4% from first quarter 2017.

The company repurchased 9.3 million shares in the first quarter 2018 at an aggregate cost of $1.2 billion.

Among specific categories, shipments of agricultural products was flat; Industrial gained 6%; Premium was up 7%, and energy products increased 15%.

“We are pleased with the improvement we have seen in recent weeks and are confident in the plan we have in place to continue building on the progress already made,” Fritz said. “With the economy favoring a number of our market segments, we are well- positioned to benefit from another year of positive volume growth and solid core pricing gains.”

In a note to investors, following a sharp sell-off after UP’s earnings announcement, Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl wrote:

“UN reported 1Q18 EPS of $1.68, up approximately 28% year-over-year and above our and consensus estimates of $1.62 and $1.66, respectively. Operating income grew 8% to $1.94 billion, also beating our and Street expectations of $1.80 billion and $1.89 billion, respectively. Revenue increased 7% to $5.47 billion, above our and consensus forecasts of $5.27 billion and $5.39 billion, respectively. The operating ratio was 110 basis points better than our estimate and 40 bps better than consensus.

“The earnings beat occurred despite cost headwinds associated with the ramping of resources to accommodate stronger-than-anticipated demand in certain regions. The 7% top line growth (versus our 3% estimate) was driven by a 2% rise in volume, a 3% increase in fuel surcharges, a slight mix tailwind, and 2% core pricing. This pricing result represented an acceleration from the 1.75% achieved in 4Q17. Excluding the negative impact of coal and international intermodal, core pricing was 2.75%, which is largely in line with 4Q17 and above UP’s rail cost inflation forecasts of just under 2%.

“Management noted that it is still confident in achieving an OR improvement this year, but the room for error is a little smaller given the resource ramping required to accommodate rising freight demand. We are now modeling for an 80 bps OR improvement this year to 62.3%, compared to our prior estimate of 62.1%. The company also noted that it may be difficult to achieve a 60.0% OR in 2019 but implied that an OR just above 60.0% is still achievable. This is still consistent with management’s prior target of achieving ‘60.0%, plus or minus.’ Additionally, consensus was at 61.4%, and we were at 60.4% at the time of the earnings call. So given that expectations were already for the company not to achieve a 60.0% OR next year and given an OR just above 60.0% would still be consistent with the company’s prior target, we thought the initial sharp decline in the stock was not fully warranted. The stock recovered some of its initial market losses, closing down just under 3%.

“UP, which has historically maintained a somewhat more conservative balance sheet than its Class I counterparts, noted on the call with analysts that the benefits of tax reform could justify increasing leverage without jeopardizing the company’s investment grade rating. The company currently has an adjusted debt/EBITDA ratio of approximately 1.9x, and we believe its comfort level could allow it to go just over 2.0x, which would be largely in line with Norfolk Southern and still well below CSX, which is at around 2.6x. We estimate that this could result in $0.25-0.30 per share accretion to UP’s annual earnings.

“We are fine-tuning our 2018 EPS estimate to $7.80, from $7.70, in order to reflect the $0.06/share 1Q18 beat to our estimate; a slightly lower tax rate of 24.5% (mid-range of the company’s new guidance), compared to our prior assumption of 25%; and more robust freight demand. These three factors more than offset the increase in our OR estimate to 62.3%, from 62.1% previously. Our new 2019 EPS estimate is $8.80, compared to $8.75 previously. This is as our new OR of 60.9% (60.4% previously) is more than offset by the aforementioned lower tax rate assumption and improved freight demand. We believe the additional resources (people and power) added to the company’s network will begin to yield positive results and note that [logistics provider] Hub Group stated that it is seeing better rail performance in early 2Q out west on its recent earnings call.

“Our new price target is $140 (from $139) and is based on the same 18x multiple and our new 2018 EPS estimate. We remain on the sidelines but note that further share weakness could cause us to reexamine our investment opinion.”