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Why Union Pacific’s 4Q16 Margins Might Be Its Achilles’s Heel

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Jan. 13 2017, Updated 4:35 p.m. ET

Union Pacific’s 4Q16 operating margins

Analysts surveyed by Reuters are projecting an operating margin of 37.0% for Union Pacific (UNP) in 4Q16. That reflects a slight improvement of 20 basis points over its 4Q15 margins. Analysts also expect a marginal improvement in UNP’s margins over the next four quarters. Let’s see why.

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Why UNP may not deliver on operating margins

In UNP’s 3Q16 conference call, management clearly stated that the company had no improvement in its operating margin. That could end up to be its Achilles’s heel. The company has a long-term ambition, however, of increasing its operating margin to 40.0% on a yearly basis by 2019. The sheer scale and size of Union Pacific’s operations don’t allow it to quickly react to a falling volumes scenario.

UNP’s efforts to run longer trains may not immediately result in a boost in its operating margin. The present environment also offers less of a chance for core pricing growth, which results in higher margins. So what remains for UNP is to shift its focus to improving productivity.

In view of enhancing efficiency, UNP started a “G55 +0” initiative in the fall of 2015. “G55” represents attaining a 55.0% operating ratio, and “0” represents zero injuries. Under this initiative, UNP has kick-started more than 45 efficiency improvement projects focused mainly on engineering, fuel, support, and frontline areas.

As of November 25, 2016, UNP had ~2,700 trains as well as some engines and yard employees in furlough state. In addition, the company had around 1,600 locomotives in storage. Improving operating margins remains the biggest challenge for Union Pacific.

Peer group margin situation

This year is expected to bring about a turnaround for the railroad industry. However, if the volume situation doesn’t improve, UNP and its US peers such as Kansas City Southern (KSU), Norfolk Southern (NSC), and CSX (CSX) will have to focus more on the cost front. In that case, there could be a tectonic shift of focus for railroads, from top-line growth to bottom-line improvement.

Major US railroads make up 5.9% of the portfolio holdings of the iShares US Industrials (IYJ).

In the next part of this series, we’ll see what analysts have recommended for Union Pacific and its peers.

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