Union Pacific on a Neutral Lane

We maintain a long-term Neutral recommendation on Union Pacific Corporation ( UNP - Analyst Report ) , one of the leading freight railroads in the U.S. The company continues to remain on its growth trajectory benefiting from its diversified business franchise and freight pricing. However, continued market weakness in Coal and Agriculture followed by economic volatilities compel our cautious stance on the stock.

We believe the company is less likely to be impacted by a downtrend in any single product, as no single commodity group constitutes of more than 20% of its business. As a result, the company will be able to retain flexibility in streamlining its portfolio, providing greater leverage to profitable segments and trimming less profitable ones.

Further, the majority of legacy contracts (mostly coal related) are expected to be re-priced and implemented in early 2013. These contracts have not been raised since 2004 compared to the company’s growth in pricing per carload, which shot up more than 70% over the same period. The company has a $350 million legacy contract, scheduled for re-pricing in early 2013, which is expected to be accretive to its operating profits.

The company continues to expect an improved operating ration ranging 65–67% by 2015 and operating margins excluding fuel to reach 50%. We believe the company has opportunities to improve yields backed by higher rate of contract re-pricings compared to its Class I peers and increased access to West Coast intermodal business and energy related markets.

However, Union Pacific expects slow recovery in the U.S. economy impacted by the ongoing Eurozone crises alongside the U.S. budget and tax policy changes. In addition, the company expects the negative impacts of corn shipments to weigh over agricultural revenue growth (estimated in a low single-digit range), offsetting the positive impacts of other products lines.

Further, it expects domestic coal to continue to be impacted by lower natural gas prices and high stockpile levels resulting in total Coal revenue decline in the range of low-to-mid teens.

In addition, Union Pacific operates in a highly capital intensive industry that requires continued infrastructure improvements and acquisition of capital assets. Union Pacific plans to make long-term investments of about 17–18% of total revenue over the next several years, supporting operating efficiencies. Although these investments are accretive over the long term, in the near term it may weigh upon margins, especially when demand trends continue to be marred by economic instabilities. Besides, the company also faces competition from other railroads like CSX Corp. ( CSX - Analyst Report ) .

Union Pacific retains a Zacks #3 Rank, implying a short-term (1-3 months) Hold rating.