As I mentioned the other day in discussing CSX's (NYSE:CSX) earnings, good companies show their qualities when times get a little tougher. With that in mind, there's little to suggest that Union Pacific (NYSE:UNP) ought to be dethroned as the best railroad at the moment. While the company's pricing and operating expense control is laudable, it's worth asking how much of a premium investors should pay for a best-in-class operator facing some near-term macroeconomic challenges.

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Solid Third Quarter Results in a Tough Environment
Between the monthly traffic reports from the American Association of Railroads and the earnings warning from Norfolk Southern (NYSE:NSC), it was hardly surprising that Union Pacific saw some operating challenges this quarter. Even still, the company basically delivered the goods once again. Revenue rose almost 5%, as the company offset a slight decline in carloads (down less than 1%) with better yields. Overall revenue growth was quite a bit better than at CSX, and Union Pacific also saw its intermodal business grow another 8% (and it makes up about 20% of freight revenue). Union Pacific also did quite well with its expenses. Average cost per employee declined 2%, while the company's fuel consumption declined at a faster rate than traffic (down 4%). As a result, the company posted a 250 basis point improvement in operating margin and 13% operating income growth.

Familiar Trends in Traffic
There weren't many surprises in Union Pacific's traffic numbers. Like CSX, and the industry in general, coal continues to be especially weak - down about 12% in carloads this quarter. Union Pacific has done a pretty good job of offsetting this with strong pricing, so coal revenue only declined 5% for the quarter. Elsewhere, auto traffic remains strong, as does carload volume for chemicals (which for Union Pacific was helped by a near-doubling of petroleum traffic from the Bakken). "Industrial" carload growth was a little light at negative 2%, while overall ex-coal traffic was up more than 3%.

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Management isn't looking for a huge recovery in the fourth quarter, either. It sounds like volume will be flat to down slightly, though ongoing strength in price realizations should offset some of that. What's more, if you listen to the guidance offered by large banks like U.S. Bancorp (NYSE:USB) this quarter, you'll hear talk of slowing loan growth in the fourth quarter as businesses pull back on concerns regarding the election and upcoming "fiscal cliff." Perhaps the biggest question is whether Union Pacific can maintain such strong operating ratios - management guided to a sub-70 number for the fourth quarter (as the inverse of operating margin, lower is better), and this is probably the largest unknown for near-term performance.

How Much Better Can It Get?
Union Pacific has done a good job of improving its financial performance over the past few years, as the company has benefited from the expiration of unfavorable long-term contracts, improved equipment, and ongoing improvements in performance metrics. The question is how much is left in the tank. I don't think cheap gasoline/diesel is coming back, and if it does it will come with a major caveat (namely, I believe fuel prices are only heading meaningfully lower if economic activity slows).

Consequently, the cost-based shift from truckload carriers like Swift (NYSE:SWFT) and Werner (Nasdaq:WERN) (or, more specifically, even smaller and less efficient national operators) is unlikely to change. Likewise, I still believe there's room for intermodal growth at the rails, but I'm not sure if Union Pacific will benefit as much as Eastern rails such as CSX and Norfolk Southern.

Therefore, at the risk of underestimating or underappreciating management, Union Pacific looks more like a volume story. If the economy strengthens (and if trade with Asia picks back up), traffic should improve and so should revenue and profits. A rebound in coal demand would be welcome, but I don't expect it and investors should realize that Bakken rail volume will eventually be replaced by pipelines.

The Bottom Line
If Union Pacific gets the same long-term industry-wide average multiple of seven times next year's EBITDA, fair value is more or less bang in line with today's price. Give the company a half-point premium and the target moves to the low $130s, while a full point premium (eight times) pushes the target into the low $140s. Given Union Pacific's demonstrated strength and its unique pure-play on Western traffic (as Burlington Northern is part of Berkshire Hathaway (NYSE:BRK.A, BRK.B)), I wouldn't quibble with a half-point premium, but even a full extra point doesn't really make the shares cheap. As a result, I'd probably look elsewhere in transportation for a stock to buy today, but if rails sell off again I'd revisit this name.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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