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.

Forex Broker Guide: Using the right broker is essential when competing in today's forex marketplace.

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%.

SEE: The 8 Most Volatile Sectors

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.

Related Articles
  1. Stock Analysis

    8 Solid Utility Stocks for a Bear Market

    If you're seeking modest appreciation, generous dividend payments and resiliency, consider these eight utility stocks.
  2. Stock Analysis

    Why Phillips 66 (PSX) is a Solid Long-Term Bet

    Here's why Phillips 66 will likely remain one of the world’s largest and most profitable companies for a long time to come.
  3. Investing

    Major Companies That Lose Money On Shipping

    We look at some of the big companies in the home delivery business that have high shipping costs and how they mitigate this.
  4. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  5. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  6. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  7. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  8. Mutual Funds & ETFs

    Top 4 Transportation Mutual Funds

    Discover the top-rated mutual funds in the transportation industry, and understand how investors can position these funds in their asset allocation.
  9. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  10. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!