2. Thesis
UNP’s structural advantage can help it achieve industry best margin
The Operating Ratio (O.R. = 1- EBIT margin) target of 55 given by UNP had stunned the Street, as this was a feat achieved nearly by only CNI having decades of PSR experience. UNP’s O.R. target, in our view, is not high considering its structural advantages of a long length of haul (LOH), easier geographic footprint and high exposure to merchandise traffic. A longer LOH should provide an advantage to move heavier cargos over longer distances driving better-fixed cost absorption. UNP’s LOH is second only to BNSF and CP. Still adjusted on a length of haul basis it had the most inefficient cost structure with a cost/RTM of ~$3.11. This also makes it a prime beneficiary of PSR. Imagine if UNP is successful in implementing PSR like the Canadian rails and bring its cost/RTM below the trendline. Not only a 55 O.R., but a successful PSR implementation could also bring its O.R. to even ~50.
UNP’s Path to 55 O.R. (base case) and 50 O.R. (bull case)
UNP is making substantial progress by rationalizing yards and improving efficiency. Productivity gains are exceeding targets. Average dwell time (hours) have declined by 27% since 2018. Dwell time (lower the better) is the time a train stands idle between stops to load/unload the freight. Train lengths have increased by 24% since 2018. Longer trains increase locomotive productivity, reduce train starts and train crews, and improve fuel efficiency. Trip plan compliance (percentage of cars on time) have improved between 75-82% from 67% in 2018. High trip plan compliance is important for more time-sensitive intermodal freight, including e-commerce related parcels (think Amazon, Walmart). Velocity (the higher the better) has increased by 15%. Imagine if UNP is successful in implementing PSR like the Canadian rails. Increased train length and density should drive outsized labour and fuel productivity.
Improvement in employee productivity is a hallmark of PSR. In a typical PSR implementation, compensation (GTM/employee) and fuel (fuel/GTM) are the largest buckets in terms of cost takeout. Both employee cost and fuel being at higher-end present enough cost takeout opportunity for UNP.
Combining this with the ‘greatest capital allocation policy’ in the company’s history by leveraging cheap credit (2.9x net debt/EBITDA) and buying back stocks worth $ 20 bn (15% of market cap) is expected to reward equity shareholders. Unlike CSX, which implemented PSR in a short time (creating service disruptions), UNP is implementing PSR in stages with a target O.R. of 60 by 2020 and 55 without giving any timeline. Our estimate suggests a base case and a bull case upside of 40-60% by only giving the benefit of O.R. improvement to a depressed 2019 number.
Our approach does not give importance to the earnings in the next quarter/year. We will continue riding the train until the capital allocation policy is intact. A risk towards opportunity coast of capital remains if it takes longer. Also, while Warren Buffet went all-in in BNSF, it was because BRK generates a high amount of cash every year which it needs to invest that may not be the case for individuals with limited capital.
However, to communicate the drivers of growth in the form of multiples, UNP trades at a PE of 22 x 2021 estimates. Two reasons – one the earnings are dressed (PE looks high) and second, PSR players trades at a premium (see below) justify a high multiple.
