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Union Pacific (NYSE:UNP) is set to announce its Q3 earnings on Oct. 18. The company faced a tough operating environment during the quarter which saw overall freight volumes flat or slightly down. During this earnings release, we will primarily focus on UNP’s efficiency metrics and the impact of key trends on the company’s earnings. Specifically, we will be watching UNP’s operating ratio, the impact of the US drought condition on agricultural revenues, and the impact of auto sales on automotive freight revenues.
UNP Not a Growth Story in Q3
Investors looking for growth during the quarter aren’t likely to be excited by UNP’s results. CSX Corporation (NYSE:CSX), who reported earnings yesterday, announced a decrease in revenues of 2% and Norfolk Southern (NYSE:NSC), who reports earnings next week, expects that its earnings will fall 25%.  In our opinion, the results of these competitors signal that even if UNP is able to grow, it won’t by a large amount.
Q2 Results Recap
Union Pacific reported solid results in the second quarter, posting revenues of $5.2 billion, a 7% increase, and operating income of around $1.7 billion, which was up 24% year-over-year. The big difference between operating income growth and revenue growth occurred due to a drastic improvement in the firm’s operating ratio, which improved to 67% in Q2. 
UNP Must Improve Efficiency
We think that UNP did a good job with its efficiency metrics in the second quarter. It reported a decline in operating ratio (proportion of operating costs to revenues) to 67%. The company also increased its overall network velocity by about 2%, which is key in helping it maximize the utilization of its railcars.
We think that it is imperative that UNP’s management successfully implemented strategies during the third quarter which continued the trend in improving efficiency and margins. We place a lot of value on this metric because if the company is able to improve its operating ratio, it could offset slowdowns in its freight business.
Impact of Drought Conditions?
According to the Wall Street Journal, corn and soybean production has been hit this year because around 63% of the continental US has experienced severe drought.  We expect that these drought conditions, and the resulting decrease in supply, will have a negative impact on UNP’s freight revenues since over 70% of its Q2 agricultural freight volume was made up of grain and grain products. Our concerns here were confirmed by CSX’s earnings announcement yesterday as it reported a 6% decrease in agricultural revenues due to an 8% decline in volume partially offset by an increase in revenue per unit. This is important because agricultural freight revenues made up approximately 17% of UNP’s total revenues during the second quarter.
Automotive Freight To Help Offset Other Declines
UNP’s automotive volume grew over 15% in Q2, which was the highest volume growth rate posted by any segment of the company. We expect that automotive revenues will continue to grow due to an increase in car sales, making automotive freight a key in helping the company offset declines in other segments.  In this case also, CSX’s earnings release also confirms our thesis as the company reported growth in automotive freight volume due to an increase in vehicle production.
We currently have a $122 price estimate for Union Pacific, which is approximately the same as the current market price.Notes: