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Operating Ratio Improvement Aids Railroads: An Analysis

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It is no secret that the transportation sector had a very tough time last year, thanks to the COVID-19 outbreak. Railroads, being one of the most important corners of this widely-diversified sector, were no exception. The coronavirus crippled the shipment of goods not only across the United States but also globally, thereby hurting railroads as overall volumes were reduced drastically.

Due to depressed volumes, freight revenues, which constitute the bulk of total revenues, took a hit. Evidently, at Union Pacific Corporation (UNP - Free Report) , currently carrying a Zacks Rank #3 (Hold), operating revenues declined 10% in 2020 mainly due to a 10% reduction in freight revenues. Even though freight revenues have been improving in the current year with the gradual recovery of the economy, the same lags the pre-coronavirus levels.

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At Union Pacific, even though the second-quarter 2021 freight revenues improved 29% year over year, the same was below the second-quarter 2019 actuals. The spread of the Delta-variant in the United States is a dampener and is threatening to derail the economic recovery. This is a setback to the recovery in freight revenues. Consequently, due to the Delta variant-induced supply-chain woes, shipment volumes declined 4.2% and 3.1% month over month in June and July, respectively. Also, per data released by the Association of American Railroads, U.S. rail traffic (including carloads and intermodal units) dipped 3.1% year over year for the week ended Sep 18. Disruptions caused by Hurricane Ida are a further headwind to the recovering freight scene.

Despite the challenging scenario pertaining to revenues, railroads in the country are witnessing improvement with respect to the operating ratio (operating expenses as a percentage of revenues), a key measure of profitability for stocks in the railroad industry. The lesser the operating ratio the better as it implies that more cash is available to a company to reward its shareholders through dividends/buybacks. A lower value of the operating ratio is in fact a pat on the back for management of a railroad operator.

Cost Cuts Buoy Operating Ratio

In a bid to lower costs and drive the bottom line, railroads like Union Pacific, Norfolk Southern Corporation (NSC - Free Report) , CSX Corporation (CSX - Free Report) , Kansas City Southern (KSU - Free Report) and Canadian Pacific Railway Limited (CP - Free Report) adopted the precision scheduled railroading (PSR) model, which aims to improve efficiencies by streamlining operations. Evidently, at Kansas City Southern, PSR initiatives had earlier contributed directly to the 2020 operating expense savings of $96 million.

Mainly owing to the actions to improve the cost structure, operating ratio has been bettering at most railroads. At Union Pacific, the operating ratio improved to 57.5% in first-half 2021 from 59.9% in the first six months of 2020. At Norfolk Southern, the operating ratio improved to 59.9% in the first six months of 2021 from 66.8% in the comparable period of 2020.

Rosy Views on Operating Ratio

While revenues in the September quarter are likely to be hit by the Delta strain and the Hurricane Ida-related woes, low costs are likely to lead to further improvement in the operating ratio for railroads. With revenues likely to increase after the third quarter as the freight scene picks up again following ramped-up vaccinations, which should limit the spread of the Delta mutant, operating ratios of various railroads should continue to improve.

Adding to the sunny scenario pertaining to this key metric, costs are likely to remain low owing to the adoption of the PSR model by railroads. Norfolk Southern expects the operating ratio for 2021 to improve in the band of 400-440 basis points from the 2020 reading. Union Pacific expects its 2021 operating ratio to improve roughly 200 basis points to 56.5% from the year-ago reported figure.