The deterioration in the economy's vital signs implies the U.S. economy is headed for recession. U.S. rail traffic and intermodal units fell 8.1% Y/Y for the month of October. Through the first 44 weeks of the year, combined U.S. rail traffic and intermodal units fell 4.4% Y/Y. This implies business activity is in decline. It does not bode well for rail operators like Union Pacific (UNP). The company reported Q3 revenue of $5.5 billion, down 7% Y/Y. Carloads fell 8% while average selling price ("ASP") increased 1%.
Revenue for every product category experienced a revenue decline. Agricultural revenue fell 1% on a 2% decline in volume and low single digit decline in ASP. The segment was hurt by reduced grain exports and weakness in potash. Demand could pick up by the first half of 2020. The U.S. and China agreed to a limited trade deal calling for China to increase purchases of certain agricultural products. Agricultural represented 22% of Union Pacific's Q3 revenue and could be a catalyst over the next few quarters.
Energy revenue fell 20% on a 15% decline in carloads and 6% decline in ASP. Sand carloads were down 45%, while coal and coke volume also fell by double digits. E&P in the oil patch has stagnated and may not pick up unless OPEC engages in more supply cuts. Industrial revenue fell 1% on a 2% increase in carloads and 3% fall in ASP. The segment saw strong demand for construction-related products, offset by reduced lumber and paper shipments. Premium revenue fell 9% on a double-digit decline in carloads. UNP experienced weak intermodal demand; the situation may not abate unless tariff uncertainty eases.
Union Pacific's carloads fell 8% Y/Y, which was worse than the total railroad industry. Carloads for the Energy and Premium segments fell by double digits. Energy represented 18% of total carloads and could continue to deteriorate given the uncertain outlook for shale. Premium represented 47% of total carloads; this segment's outlook remains uncertain as long as the trade war with China lingers on. Outside of the Agricultural segment, Union Pacific's volume could remain dismal for the near future.
Railroads had feasted on price hikes in the past. Growth in ASP dissipated a bit for Union Pacific, only increasing 1%. It was not nearly enough to offset the decline in carloads. ASP only grew for two of the four product categories. However, the Premium segment represented 47% of total carloads and its ASP grew 2%. At the end of the day, Union Pacific is losing pricing power in Energy and Industrial. The days when price hikes masked the decline in carloads appear over.
Cost Cuts Continue
In 2017, CSX (CSX) engaged in cost cuts to lower its expense ratio. Union Pacific has recently followed suit, though its cost take-outs have been more gradual. In Q3, its operating expenses of $3.2 billion were down 10% Y/Y and declined more than revenue. The company lowered its operating expense ratio to 59%, down 300 basis points versus the year-earlier period. CSX, Canadian Pacific (CP), and Canadian National (CNI) consistently deliver operating ratios sub-60%. Union Pacific can now consider itself one of the most-efficient railroads in the market.
Compensation and benefits expense of $1.1 billion declined 10% Y/Y via headcount reductions. Purchased services fell 9% on reductions in repair costs and contract services. Fuel costs fell another 24% as the decline in rail traffic resulted in less fuel consumption. As a result, EBITDA of $2.8 billion fell 1% Y/Y. This was much less than the 7% decline in revenue. EBITDA margin was 51%, up 300 basis points versus the year-earlier period. I expect more cost take-outs over the next few quarters. The ability to cut costs without sacrificing service levels will likely drive the narrative for UNP.
UNP Is Overvalued
UNP bulls are excited over solid earnings in the face of revenue declines, yet the stock is overvalued. The company has an enterprise value of $147 billion and trades at 13.6x run-rate EBITDA (nine months EBITDA annualized). UNP has benefited from the melt up in stocks. In my opinion, the valuation is too robust for a cyclical name experiencing falling carloads.
UNP is up 16% Y/Y, yet the stock remains overvalued. Sell UNP.
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Disclosure: I am/we are short CSX. 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.