Insights From Union Pacific's Second Quarter

| About: Union Pacific (UNP)

Summary

Studying UNP's results allows you to form an economic worldview.

Latest results met expectations, but were still terrible.

Conditions are challenging in most end markets, and investors will have to be very patient.

Union Pacific (NYSE:UNP) is a great stock to follow because it can provide a lot of insight about the health of the US and global economies. By studying the company's quarterly results you can form a comprehensive worldview that you can use as a starting point to generate investment ideas. UNP's latest quarter didn't have any surprises. Revenues fell 11.6% but were in line with expectations, and EPS met estimates. This article will touch on the driving forces behind each segment so that you can get a better idea of where things might be headed.

Agriculture Products:

This segment transports grains and other agriculture products to processors, animal feeders and ethanol producers. The Ag products segment was the only commodity group to generate positive volume growth (2%) in Q2, but revenues declined 4% due to lower pricing. Grain volume increased 10% due to harvest delays in South America and strong demand from Mexico. We are optimistic on the outlook for Ag shipments. Meat consumption around the world is on the rise, and farmers have more cattle to feed. Low Ag commodity prices (a result of record harvests in 2015) should continue to fuel volume growth, and we expect the carryover effects from bad weather in Argentina and Brazil (leading to a crop shortage in corn and soybeans in Latin America) to persist through 2016. Ethanol volumes were flat in the latest quarter, and we don't see as much room for upside given slowing vehicle demand and pressures to cap ethanol blends in fuel.

Automotive:

This segment transports finished vehicles and parts to distribution centers and OEMs. Revenues declined 13% due to a 2% decrease in volume and an 11% decrease in pricing, which was the result of an unfavorable product mix. An increasing portion of auto parts in the mix (volumes grew 9%) reflects slowing consumer demand for new cars (finished vehicle shipments decreased 10%). After six consecutive years of rapid growth we fear the US auto cycle is nearing a peak. Auto sales fell 6% in May, the biggest monthly drop in almost six years. There isn't much new demand left, and a bunch of used cars have hit the market, leading to lower prices and making new vehicles less competitive. We suspect used cars will take share from new vehicles, particularly in the millennial demographic that is struggling to overcome student loans and poor job prospects.

Chemicals:

This segment transports industrial chemicals, plastics, fertilizer, crude oil, and refined products. Revenues fell 5%, with volumes down 3% and pricing down 2%. If it weren't for crude oil (volumes down 46%), industrial chemicals shipments would have been positive. But this is not a sign of end market strength. LPG has risen in popularity because it is cleaner than other fuels and can be used in a wide variety of end markets. But the recent uptick in volumes does not reflect strong end market demand. Refiners have taken advantage of cheap crude prices to produce more refined products, but a significant portion of the capacity has gone unsold. Inventories are at record highs, and we think this will prevent oil prices from recovering in the next year. Plastics volumes fell 5%, which reflects a slowdown in global consumption, as polyethylene is used for packaging in a broad spectrum of consumer goods. Fertilizer shipments fell 6%, a result of soft demand from domestic agriculture markets. Low crop yields (a result of the food commodity glut) continue to weigh on farmer incomes, and we expect crop production to stay muted in the near term.

Coal:

This segment transports coal and petroleum coke to power companies and industrial facilities. Revenues fell 27%, driven by a 21% decrease in volumes, a product of low natural gas prices and high inventories. With the US government shifting the domestic market off coal, this segment relies on export demand for much of its volumes, and the strong dollar continues to be a headwind. We are bearish on the long-term outlook for coal shipments, due to slowing industrial activity worldwide and a transition to cleaner-burning fuels. Unless the prices of substitute energy sources rise considerably, we don't see much hope for coal.

Industrial Products:

This segment transports construction products, minerals, consumer goods, metals, lumber, paper, and other products. Revenues declined 14%, led by an 11% drop in volumes. Weakness in the oil sector and production cuts from E&P firms continue to drag on performance: minerals volumes fell 43% and metals shipments fell 11%. Given our forecast that oil prices won't rise far above current levels, we expect low drilling activity to continue to be a headwind for metals and minerals over the next year. We also worry that if production levels do increase, the bulk of it will come from frackers, who have shorter lead times compared to deep water producers, and can respond more quickly to changes in oil prices. This will mute demand for metals and minerals, and also keep oil prices from rising very high. Construction volumes declined 4%, largely due to floods, which delayed construction activity. But as long as interest rates stay where they are we expect housing to continue to show strength, which should boost lumber and rock volumes throughout the year.

Intermodal:

This segment involves the transportation of import and export containers. Revenues fell 16% on a 14% drop in volumes. Despite a strong dollar (which boosts demand for imports), domestic volumes fell 6%, which reflects a slowdown in consumer spending. International shipments fell 22% as a weak global trade activity and excess capacity in the shipping sector. In the commodity boom years, container shippers loaded up on debt to expand their fleets. But now that demand has slowed the industry is over-supplied with vessels. This has driven down shipping rates and created financial troubles for a host of companies. We expect slowing emerging market growth will continue to make life difficult for the shipping industry, and that the intermodal business will struggle well into 2017.

Conclusion:

You can learn a lot about the global economy just by reading one of UNP's earnings reports. Q2 revealed that the problems impacting the majority of UNP's end markets are not about to dissipate. The US and global economies are very sluggish and we don't see any sings that things are about to improve. Weak end market demand will continue to weigh on volumes, and the company will struggle for pricing so long as commodity prices stay low. Investors will have to be patient with UNP.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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