Union Pacific (NYSE:UNP) is set to announce its Q4 2012 earnings Thursday, January 24. Of all the railroads in our coverage portfolio, Union Pacific was the best performer in the third quarter due to strong pricing gains and an improvement in margins. Since global economic growth has remained slow during the fourth quarter, we will again be closely watching these two metrics during this quarter’s earnings announcement. As volumes stay flat or decline, Union Pacific can only drive growth via an increase in prices or improvement in margins.
Q3 Results Recap
Union Pacific posted solid Q3 2012 results. It posted revenue growth of 5% during the quarter while CSX Corporation (NYSE:CSX) and Norfolk Southern (NYSE:NSC) reported revenue declines. Additionally, the company’s operating income grew 13%, primarily due to a 2.5 percentage point decrease in its operating ratio, which fell to 67%.  Each of these metrics was a quarterly record for the company, and we will be looking closely at how they stack up in the fourth quarter earnings release.
Improving Efficiency Will Improve Margins
Along with growing its revenue base, Union Pacific did a good job in the third quarter when it came to reducing its operating ratio (proportion of operating costs to revenues) to 67%. The company improved its average train speed 6% year-over-year in the third quarter, and also decreased its terminal dwell time by 1%. We think these are encouraging trends and will be closely watching these figures because they will likely be indicators of UNP’s margin trends.
The reason our main focus will be on the company’s margins is because they are important to our price estimate for the company. At present we forecast that Union Pacific’s EBITDA margins will increase slightly to around 44% by 2019. However, if margins start to fall and hit around 40% by the end of our forecast period, there would be 10% downside to our price estimate for Union Pacific.
Pricing Power Key as Volumes Growth Slow
Global GDP growth remained low in Q4 2012 and is expected to stay low in 2013. This means that freight volumes aren’t likely to rise too fast since they are generally correlated with trade levels and growth. This is why as freight volume growth remains muted, it is important that Union Pacific be able to increase prices to drive growth, like it did in the third quarter. UNP increased the average revenue per car of coal freight by 9% even as freight volumes declined 12% and overall freight revenues increased by 4% despite a fall in volumes. This demonstrates the importance of pricing power in driving growth.
During the Q4 earnings announcement we will be closely watching Union Pacific’s overall freight prices. If the company is successful in increasing them again during the quarter, it will likely be the best performing railroad in our coverage universe.
We currently have a $122 price estimate for Union Pacific, which is approximately the same as the current market price.Notes: