There is much chatter on Tuesday about operating ratios at Union Pacific (UNP) as it pursues its Unified Plan 2020 under the leadership of newly named COO Jim Vena.
Shares have popped almost 9% even into late afternoon hours, on the hope that he can trim the companies operating ratio and keep profits for shareholders.
But, given the industry specificity of operating ratios, a quick run through of the task ahead is in line.
An Introduction to Operating Ratios
Luckily, this is one of the simpler formulas in all of finance.
All that operating ratios are for railway companies like Union Pacific, Norfolk Southern (NSC) , and even the Berkshire Hathaway-owned (BRK.A) Burlington Northern Santa Fe are all a measure of how much of the company's revenue go to operating expenses.
So, for example, Union Pacific generated revenue of $5.93 billion in its last reported quarter, while incurring expenses of $3.66 billion. That works out to an operation ratio of 61.7.
For reference, that is firmly in the middle of peers like Canadian National Railway (CNI) , Canadian Pacific Railway (CP) , and Norfolk Southern, CSX Corporation (CSX) , and Kansas City Southern (KSU) .
The difference is that Union Pacific is twice as large, by market cap, than Canadian National Railway and nearly three times as big as Norfolk Southern. The company is also neck and neck with BNSF in terms of the largest revenue driver among railways in North America, meaning that each point off of its operating ratio means huge profits.
The problem with driving that type of revenue is the amount of track it runs on and the freight costs associated with achieving that revenue number. According to its filings, the company operates 8,500 railcars across 32,100 miles of track in 23 different states. The only larger railroad in terms of scope is the aforementioned BNSF.
To achieve the company's stated goal of a 55% operating ratio, the company would need to reduce costs significantly and real its ratio in by almost six percentage points or alternatively boom profits without increasing costs at all.
Such a task would is a tall order in an environment wherein fuel costs are increasing and delivery volume depends on industries like coal, fracking, and automotive.
The Man for the Job?
The idea of doing either in a utility business so tied to business cycles is no easy task, but it is not without precedent. In fact, the man stepping in at UNP as chief operating officer, Jim Vena is a protégé of a man who set the industry's bar for such moves.
The master of Precision Railway Scheduling (PSR) and longtime Canadian National Railway, Canadian Pacific Railway and CSX CEO Hunter Harrison helped reel in CSX's operating ratio its from 67% to 64.8% in 2017 alone.
Analysts have so far been confident that he can move things rapidly as his mentor did.
"We believe that Jim Vena could be instrumental in helping UNP push forward with its Unified Plan 2020, which aims principally to improve operational efficiency through the implementation of PSR," BMO Capital Markets analyst Fadi Chamoun commented. "Operational improvements could materialize faster under Vena's leadership as he brings to bear his extensive experience in PSR."
Vena is aided by the fact that the company has already begun to cut its work force and streamline its fleet of rail cars, giving him somewhat of a head start.
Given UNP's lion share of railroad revenue, if he can drive operating ratios down as his mentor did, shareholders could enjoy some serious value creation.
For reference, in the year that Harrison cut operating expenses to trim CSX's operating ratio by over 2 points, over 60% was returned to shareholders and was only diminished at all by his untimely death in December of that year.
When looking at that chart, UNP's big jump makes much more sense.