Union Pacific: Will Face Retail Destocking, Sluggish Industrial End Markets for Much of 2023

Since roughly 2018, all the rails have confronted the push to implement precision scheduled railroading, if they hadn’t already. Shareholders have demanded it, motivated by PSR’s initial success at Canadian National and Canadian Pacific. Union Pacific UNP is no exception, launching its own PSR efforts in late 2018. UP’s operating ratio (expenses/revenue) was in a better position than other railroads when its rollout started, but PSR has proved to be the surest path to greater network efficiency and higher incremental margins.

UP’s initial margin success came a few decades after partial deregulation in 1980, as it eliminated unprofitable routes and boosted efficiency during industry consolidation. When carloads slid 16% in 2009, UP nimbly cut costs faster than sales declined, then steadily improved its operating ratio from 2010 to 2015. Even an 18% coal carload decline in 2015 couldn’t keep UP from reaching record margins, though another painful 20% coal decline in 2016 constrained improvement. The next major step up in profitability occurred between 2019 and 2021 as UP implemented PSR and reached a record annual OR of 57.2% in 2021.

Despite margin setbacks in 2022 linked to labor-related network headwinds and painful wage inflation from the new union contact, PSR has generally yielded more efficient use of locomotive assets and labor. We expect UP and its peers to grapple with wage hikes, sluggish retailer restocking, and easing industrial production in 2023 but look for OR gains to resume in the years ahead as the firm recovers fluidity and refines its PSR playbook. Our fair value estimate bakes in a midcycle OR 56.5%-57.0%.

UP still has meaningful exposure to coal. Despite coal’s volume bounce in 2022, it will face secular declines longer term because of stringent environmental regulation. This factor is baked into our model assumptions. Of note, UP’s mix of intermodal freight has increased over the past decade. While intermodal is currently grappling with retail sector destocking, we consider it to be a key long-term growth driver for most Class-I railroads due to its potential cost savings for shippers and secular constraints on truckload capacity.