Union Pacific Corporation (NYSE:UNP) is among the leading railroad networks in the U.S. Its stock price has appreciated by around 25% in 2013. One of the key factors driving the continuous increase in the company’s stock price has been an improvement in its profitability. Union Pacific’s operating ratio has fallen sharply from 87.5% in 2004 to 67.8% in 2012, and it further targets a sub-65% operating ratio by 2017. UNP’s operating ratio declined from 68.7% in H1 2012 to 67.4% in H1 2013.
We believe this trend of profitability expansion will continue at Union Pacific, and hence, we have forecast its EBITDA margin to rise from 44.4% in 2012 to 47.7% in 2017, and over 49% by 2020. In this article, we outline some of the key factors that have driven this margin expansion and why they are expected to persist in the future.
We encourage our readers to modify our estimates and see the impact on the company’s valuation. A scenario where Union Pacific’s EBITDA margin stays at the present level till the end of our forecast period, represents around 10% downside to our price estimate for the company’s stock.
Solid Pricing Gains
Core pricing gains is the main factor that has driven margin expansion at Union Pacific, and railroads generally target long-term 4-5% annual price increases, or higher than railroad cost inflation.
Union Pacific achieved core pricing gains of more than 4.5% each year during the period 2007-2012. During the first two quarters of 2013, core pricing gains of around 4% were recorded. We believe the company will be able to maintain this pricing power in the future as well due to its existing contract structure and favorable market dynamics. We believe new business contracts and renegotiation in contracts will help in profitability expansion in the future.
Fuel Recovery Provisions
Since fuel expenses account for a large proportion of railroad operating expenses, Union Pacific has put in place fuel surcharge programs to mitigate the impact of fuel price increases. Through these programs, it derives additional revenue when the fuel costs are elevated to recover a portion of the increased fuel costs. The company has added new fuel recovery provisions in its renegotiated contracts in the past which drove higher revenue from these programs. UNP’s operating revenue included fuel surcharge revenue of $2.6 billion, $2.2 billion and $1.2 billion in 2012, 2011 and 2010, respectively. We expect these fuel surcharge revenues to help in margin expansion in the future as well.
Efficiency In Operations and Cost Reductions
|Gross ton-miles (GTMs) (millions)||1,037,500||1,020,370||959,280|
|Employees (average)||48, 329||48,242||45,928|
|GTMs (millions) per employee||21.47||21.15||20.89|
|Customer satisfaction index||Not available||83||93|
|Fuel consumption rate (Gal per 000 GTM)||1.33||1.204||1.131|
|Average train speed (miles per hour)||21.4||23.5||26.5|
|Average terminal dwell time (hours)||30.5||24.9||26.2|
|Average rail car inventory (thousands)||Not available||300.7||269.1|
Most of the above mentioned measures recorded improvement during the period from 2004 to 2012, due to increased efficiency and leaner operations. A decline in gross ton miles was followed with reduction in employee count, thereby resulting in cost savings. Increased fuel efficiency has also contributed to cost savings. Improvement in customer satisfaction index and average train speed shows greater value is being provided to customers, further supporting Union Pacific’s pricing power. We expect these efficiency gains to continue at the company.
If you think there are any other reasons that have contributed to UNP’s margin improvement during the period, feel free to post your comment.
Our $165 price estimate for Union Pacific, represents a near 7% upside to the current market price.