UNP - You Got Questions? We Got (Some) Answers
June 11, 2018
Reflections on last week’s Union Pacific’s Investor Conference, or Union Pacific Answers (Some) Questions and States its Case:
UNP held its Investor Conference last week in a hotel in its HQ city of Omaha, the first in four years. It was exactly what one expected – well-attended, well-run and professional, and highlighted a deeper bench than maybe was appreciated as well as its technology capability. The conference takeaway list was not a surprise – in many ways because they had been signaling – in the Q4/Q1 earnings calls and on the analyst conference “circuit”, that they were going to increase their debt levels – and their buyback By a lot ($20B in all).
No big changes announced (aside from the anticipated buyback: They essentially reiterated their long term goals, as well – pushing the 2019 60-OR target back a year (as they has also signaled previously) and holding on to their time-indefinite “G-55/)” stretch goals. As it had been telegraphed, their shares moved little after the event, the consensus price targets were raised some 5% or so, and folks left Nebraska with a pretty good feeling….That they didn’t answer all of my questions came , really wasn’t a surprise, either; the key ones being:
How (and why) did their service levels begin a yearlong decline? To be fair, they did show that PTC “false positives” added 16% to YTD “variability events”; I hadn’t given them much credit for that because BNSF has been so breezy and positive about their PTC experience so far….Also, UP stated (elsewhere) that they were roughly 80% back to normal in terms of fluidity and recovery (the charts listed compared 2018 to 2017 – the better comparison for velocity, dwell, etc, being 2016).
How has their industry-low Capex (to revenue) levels and targets – and their expenditures compared to BNSF – impacted their service? Two major statements came out of Omaha – one, they not only reiterated their 15% target, they, in effect, doubled down – by stating, repeatedly, they would spend “15% - or less”! But they also laid claim to being the safest railroad in North America and to having won the (now-retired, officially) Harriman Award the last three years in a row….and have performed financially, of course. They 4-year average ROIC was 14.2% (but the peak, 16.2% was year one, or 2014). Also, it was noted that, despite recent congestion issues, velocity is still up some 25% since 2005. One must admit that these facts do not correspond to my “is lower capex is hurting UP” thesis, but they are also backward looking….
But they did answer their investors’ main question – capital allocation. In light of the tax cut – and anticipated performance – UP will take up their leverage targets from 1.9x (YE 2017) to ~2.7X (dependent on the economy etc) and maintain Investment Grade ratings. “What does this mean for shareholders?”, they asked – it means $20B in share repurchases plus dividends at a 40-45% payout ratio.
Union Pacific did seem more confident in its growth prospects, given its long held status as being the “best franchise in railroading” (even if they most they would declare is that said volume growth would – just - be “positive and pricing no stronger, perhaps, than “rail inflation plus”). Their HIS-provided macroeconomic forecast was supportive , and positive for GDP, IP (both up over three Target years, though with this year being the near term peak and the election year of 2020 being the three year trough) and especially housing starts (where 2020E is over a fifth higher than last year’s). Only auto production looks to be a drag. Of course this is all with a big IF given trade etc (and CEO Lance Fritz has also been a tireless defender of free trade). Highway conversion potential, new products, better use of technology all should come into play. As with a lot of rail talk these days, car-load or manifest business may be at the heart of the growth and incremental margin potential. Some marketing highlights:
Infection agenda? Industrial Products, said manifest business, has petrochemicals (the best of the best in UP’s franchise), and construction/infrastructure materials (lumber, steel, soda ash). A surprising fact from the ATA revealed in the latest AAR RTI that trucks carry 2/3 of chemicals (by revenues) so, there is huge share potential in chemicals as well as the biggest market growth story in generations.
Growth on ice: Ag competes with the BNSF, of course, but only about a fifth of its franchise is the long-haul export grain segment. But Ag is where UP is taking its calculated bet on reefer/perishable business with “Cold Connect” (they bought in their partner, RailEx and have added technology and capital - reefer cars are very expensive! - with hopes of opening new lanes in the southern regions)
Intermodal is 88% of “Premium (autos 11%) and, supported by the giant UMAX and EMP fleets, domestic is 51%. Confusion reigned in the conference when UP highlighted their Parcel/LTL growth (14% CAGR 2013-17) as a proxy for e-commerce; some took that too literally, for reasons of their own, though UP didn’t fully solve the problem by breaking out either Ecommerce within their UPS business (for example, and if that’s even possible) nor discussing in any detail their direct relationship with Amazon. On the international side, they did win the Japanese consortium (ONE) business, a good win, but still cited this as a problem area for price.
Coal is….coal. UP sensibly forecasts a slow declining glide path, from 30% energy share (remember, down from 50% only a decade back) to the high 20s. the 27% under this Business Unit that isn’t coal – renewables, LNG, sand – all have dynamic, uncertain but certainly brighter futures for the railroad; CBR from the CP ought to offer a medium term lift as well.
Two Segments cut across the B/U platforms to offer opportunity, as well:
Mexico – where UP is a major player (to the border and with KCSM and their 26%-owned FXE, across it) and which contributes some 12% of the revenue with a higher growth weight, offers potential in the areas we have become familiar with in analyzing (and, recently, visiting, KSU): autos, IM, refined products. In addition, they see Mexican produce and export coal as possible growth prospects. Unlike their partner and rival, KSU, they offered little specific quantifiable numbers. Of course, this area carries the highest political risk, and UP also put in “rule of law & security” as negatives (which is either pessimistic – can’t it only get better? – or blunt). For itself, Mexico is of course very thankful that it isn’t in the G-7….
Hungry like the Wolf? LOUP – UP combined 4 existing 3PL-like units (UPDS, Insight, Streamline, and “Ship Cards Now”) into a new unit with the name of “LOUP”, French for wolf (but that’s neither here nor there). LOUP cuts across car-load and IM to drive new business to the railway, with big exposure to the auto supply chain and to both retail and wholesale IM.
Technology was highlighted and intertwined with Operations: To give the Street credit where its due, technology makes up a growing amount of the inquiry level these days (and this was true in Omaha as well). I have to give Union Pacific credit here - not only did UP give a prominent position to CIO Lynden Tennison but highlighted the connections with and within Operations. So Up gave ‘em (and, to be truthful, me) what they wanted….UP Technologies is a big business - it has a “design not buy” mentality, and with 1500 professionals including 800 software engineers, it has the muscle to do so. PTC productivity was covered by the VP/Network Planning & Operations, Tom Haley; meanwhile the straight technology section of the Conference covered track sensors and engineering/MoW productivity. Missing, to my mind, was the customer-facing, marketing/ease of doing business/visibility aspects (again, to be fair, LOUP covers some, but not all of this). Also, the highlighting of UPT’s cost-efficiency very likely appealed to the listening audience , but to me the fact that UP spends just over 1% of their revenues on IT (which appears to be about ¼ of “all organizations” according to Gartner – but no industry comparisons) is more a cause of concern than congratulations, though likely it’s just an irrelevant consultant factoid. Certainly, as Lance Fritz stated, there is “more appetite” for spending in tech at UP> Operationally, technology is the driver behind initiatives we saw highlighted, such as “Blend & Balance” (network productivity) and fuel conservation. Behind a lot of it was using PTC “as a platform to build on” (thereby adding UP to the growing chorus of next-gen PTC advocates, seeing operational and thus marketing gains in velocity and capacity among other good things).
Some other chestnuts from Nebraska:
In facing questions about hump vs. flat-switching yards, UP declared that its new $550mm Brazos (NM) humpyard will be the most efficient on its network
Questions concerning other aspects of PSR were plentiful, in public and off-line – and UP refreshingly said, in essence, that of course they look at successes at CSX (and others) and would incorporate onto their network when and where appropriate….
It was terrific to see the new Regional VP of the West have some great face time – Cindy Sanborn! - who expressed her positive impressions of western railroading (and its similarities rather than structural differences with the east)
UP stated that the east-west port market share game is over; hopefully eventually some folks will hear that….
In summary – Union Pacific’s Investor Conference was a worthy event. It wasn’t revolutionary nor was it revelation-ary – but then, “back in the day”, meeting with management was de rigueur, and regular - not only reserved for revolutions. UP was upbeat and confident. Of course, you can look at the glass from either perspective – does low capex mean low expectations or prudent management? Only time will tell. For sure, I would have liked to see more numbers (though not guidance), and less OR talk. But UP management did state that ROIC was more important than OR, and the looking at capex as a “percent of revenues” was a means, not an end (and that should growth appear to be more robust, so would self-investment spend). I was impressed with the team and the bench-strength we saw, and I left Omaha (and with my time to reflect) yes, with remaining questions but a greater sense that UP isn’t becoming an outlier – a low-growth cash machine in a declining environment. Again, time will tell. As for some of those competitive questions….If only BNSF could still talk!
Anthony B. Hatch