Union Pacific CEO Goes Off the Rails Chasing Profits

Opinion by Thomas Black. (Source: Bloomberg.com 10/20/2022)

By Thomas Black

October 20, 2022 at 1:19 PM PDT

Union Pacific Corp. is doubling down on its goal of boosting its operating profit margin to 45%, about 5 percentage points from where it’s running so far this year. Rising profit margins are usually a good thing; they keep investors happy and provide cash to reinvest in the business.

But when a company’s service is admittedly poor and customers and the industry regulator are complaining loudly about its business practices, it’s probably not the best time for that company to trumpet its power to drive profits to records.

This is what is happening at Union Pacific after Chief Executive Officer Lance Fritz reiterated his pursuit of an operating ratio, which is just the inverse of an operating margin, of 55% during an analyst call on Thursday to discuss the railroad’s third-quarter earnings. Any shippers who were listening to the webcast may have had to pick their jaws up off the floor because they also saw that Union Pacific reported that it managed to deliver only 58% of their carloads on time.

Winner by a Wide Margin

Railroads boast the highest profit margins on the S&P Transportation Index

“We do believe that 55 is achievable. We don’t think it sacrifices the service product,” Fritz said on the call. “It was a target we put out for this year. We thought it was quite achievable this year, and then a whole lot of stuff happened that made it difficult.”

If Union Pacific were an airline, consumer complaints would be too boisterous for the regulator to ignore, and flyers would be looking for another carrier. The airline would most likely be scrambling to spend extra to make sure pilots and planes were available to improve service.

Railroads, though, usually have only one main competitor and count on many captive customers. It’s expensive to move chemicals, metal, coal, grain and other goods by truck. Often, rail is the only sustainable option. And if Union Pacific is the only railroad that has tracks near a factory, that plant owner has little to no leverage to push back on price and poor service.

That allows railroads, not just Union Pacific, to focus more on profit than service. This means that even though Union Pacific can’t get a railcar on time to a customer’s freight yard about half the time, the railroad will continue to raise prices. Union Pacific has been clear that it will keep its prices above its own inflation rate, which is expected to run about 5% this year.

Railroads often argue that they require much higher profit margins than trucking companies or airlines because they must invest heavily in their networks. There was a period when railroads had to invest heavily to reverse decades of neglect before deregulation in 1980 saved the industry. That era is over, and capital expenditures as a percentage of revenue have been trending down for several years. Now, those profits are mostly returned to shareholders. Union Pacific spent $7.9 billion on share buybacks and dividends in the first nine months of this year.

The bottom line is that railroads talk a lot about improving service but rarely do. Something always gums things up — floods destroy tracks, wildfires burn down a bridge, a train derails on a main line, an ice storm shuts down Chicago or Dallas. The service will always suffer, even if profits don’t.

This year the service decline was self-inflicted. Fritz acknowledged that the railroad had too few employees and even had to turn away business because of the lack of train crews.

“We ran the network tight,” Fritz said. “We got into trouble on our crew availability, and we’re digging out of that.”

Union Pacific said it’s solving the worker shortage problem by hiring 1,408 employees. The Omaha, Nebraska-based carrier will also have to pay its workers more as the railroads collectively seek to conclude a labor deal with 12 unions that still has the potential to devolve into an industrywide strike. Under the deal brokered by the Biden administration through a Presidential Emergency Board, or PEB, Union Pacific would have needed to pay workers $114 million in bonuses and wage increases going back to July 1 during the third quarter. It’s clear it will be the shippers who end up footing the bill for those higher wages and other rising costs.

“We’re fighting against pretty significant inflation. You see it in the PEB, but it’s across the board on our services and inputs,” Fritz said on the call. “We’re going to have to overcome that with price and we anticipate we will — we’re confident we will.”

That’s a lot of confidence amid a slowdown in freight, which trucking companies including Knight Swift Transportation Holdings are calling out. Trucking spot rates dropped by a third last week compared with those a year earlier, according to KeyBanc Capital Markets. Inventories are bloated and parcel demand is flagging, indicating that consumer demand is weakening.

If Union Pacific can ram through price increases even as trucking prices decline, it might catch the attention of the Surface Transportation Board, the independent agency that regulates railroads. Railroads often point to long-haul trucking as their rivals when shippers argue the rail industry lacks competition. Although there are six large railroads in North America, in reality there are only two competitors each in three large regions in the US and Canada. Union Pacific, for example, competes mostly with BSNF Railway Co. in the western US.

Besides price, the other two main levers Union Pacific can pull to boost profit margins are improving efficiency and increasing volume. Union Pacific lowered its target for volume gains this year to 3% from 5%. While the railroad isn’t giving forecasts yet for 2023, it does see some volume tailwinds, such as more movements of coal, autos and construction materials for highways and other infrastructure.

The efficiency gains are where customers get nervous. Union Pacific has over the last few years reduced employees, closed switching yards and parked locomotives. It also works hard to build longer and longer trains, which in the third quarter reached 9,483 feet in length, or almost 2 miles. These productivity strategies can erode service, and shippers are at the mercy of how hard Union Pacific is willing to pull that efficiency lever.

Perhaps shippers wouldn’t balk on price increases so much if the service were great. They know from experience not to count on that happening. Fritz should be as tenacious about improving Union Pacific’s on-time performance as he is on driving up profit margins.