UP absorbs third-quarter hit

Any way you slice them, Union Pacific’s third-quarter 2016 financials aren’t good. Based on “an unstable global economy, the relatively strong U.S. dollar, and continued soft demand for consumer goods,” in the words of chief executive Lance Fritz, nearly every metric compares negatively to the prior-year quarter. Yet, “certain segments of the economy, such as grain and energy, are showing signs of life.”

UP reported 2016 third-quarter net income of $1.1 billion, or $1.36 per diluted share, compared to $1.3 billion, or $1.50 per diluted share, in third-quarter 2015, a 9% decline. Operating income totaled $2.0 billion, down 11%. Operating revenue of nearly $5.2 billion was down 7%, as volume declines and lower fuel surcharge revenue more than offset core pricing gains. Total revenue carloads declined 6%. While shipments of agricultural products grew 11%, volumes declined in the other five business groups.

In terms of revenue, Agricultural Products rose 6%, Chemicals declined 1%, Automotive fell 8%, Intermodal dipped 9%, Industrial Products dropped 13%, and Coal nose-dived 19%.

Union Pacific’s 62.1% operating ratio was unfavorable by 1.8 points compared to the quarterly record set in third-quarter 2015, but improved 3.1 points sequentially. The $1.57 per gallon average quarterly diesel fuel price in the third quarter was 13% lower than in 2015. Quarterly train speed, as reported to the Association of American Railroads, was 26.0 mph, 2% faster than the third quarter of 2015. (Editor’s note: Fewer trains on the network directly correlates with improved velocity.) The company repurchased 9 million shares at an aggregate cost of $851 million.

“Continued momentum from our productivity initiatives, as well as positive core pricing, helped partially offset the decline in total carload volumes,” said Lance Fritz. “While many of the same volume challenges have continued throughout the year, we are keeping a laser focus on our six value tracks. This strategy ensures we provide our customers with an excellent value proposition and service experience, while efficiently and safely managing our resources. The macroeconomic environment still has its challenges—an unstable global economy, the relatively strong U.S. dollar, and continued soft demand for consumer goods. However, certain segments of the economy, such as grain and energy, are showing signs of life. Closing out 2016 and heading into next year, we are optimistic about the opportunities that lie ahead. In the coming months we will continue to do what Union Pacific does best: operate a safe, efficient, and productive network while providing an excellent customer experience and delivering solid shareholder returns.”

UP “can’t see the light at the end of the pricing tunnel, yet,” said Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl. “Pricing dipped below rail inflation for the first time in recent memory and could remain there for much of 2017 as we are modeling for just 1% volume growth amid a still weak demand environment. A few end markets are showing signs of life but we are not projecting material benefits until late 2017.”

“We are downgrading UP shares to Market Perform from Outperform, largely due to a deteriorated pricing outlook and an increase in UP’s cost inflation next year,” said Seidl. “Core pricing experienced its third consecutive quarterly moderation in 3Q16, this time dipping to 1.5%, below rail inflation, following 2.0% in 2Q16 and 2.5% in 1Q16. This was due to competitive pressure and overall market demand weakness, particularly in energy and international intermodal. While UP noted that it continues to target positive pricing going forward, and we believe it is likely to continue to achieve that, we would not rule out further moderation. We believe core pricing could remain below inflationary increases, estimated to rise above 2.5% in 2017, for much of that year.

“Indeed, the factors that led to the moderation thus far this year are likely to persist going forward. On the intermodal front, weak ocean carrier conditions are set to keep the international market competitive. Longer term, we worry about minor share shifts to the East Coast as some ports (such as NY/NJ) set up for larger ships. On the domestic intermodal front, tempered overall freight demand and ample truck capacity in North America could keep the pressure on rail rates, although the truckload rate improvement in recent months is a potential bright spot. Total intermodal makes up roughly 39% of UP’s traffic, and in light of the demand weakness, we expect competition for volume from BNSF to continue to be rigorous and thus detrimental for rates.

“This also applies in some energy markets, where crude shipments are expected to stay on the decline. And while coal is being helped in the near term by higher natural gas prices, inventories remain above normal levels, and the longer-term story remains one of secular decline.”