Union Pacific Management Discusses Q3 2013 Results - Earnings Call Transcript

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Union Pacific (UNP) Q3 2013 Earnings Call October 17, 2013 8:45 AM ET

Executives

John J. Koraleski - Chief Executive Officer, President, Director, Chief Executive Officer of Union Pacific Railroad Company and President of Union Pacific Railroad Company

Eric L. Butler - Executive Vice President of Marketing and Sales for Railroad

Lance M. Fritz - Executive Vice President of Operations - Union Pacific Railroad Company

Robert M. Knight - Chief Financial Officer and Executive Vice President of Finance

Analysts

Thomas R. Wadewitz - JP Morgan Chase & Co, Research Division

Allison M. Landry - Crédit Suisse AG, Research Division

Scott H. Group - Wolfe Research, LLC

Ken Hoexter - BofA Merrill Lynch, Research Division

Justin B. Yagerman - Deutsche Bank AG, Research Division

Christian Wetherbee - Citigroup Inc, Research Division

Brandon R. Oglenski - Barclays Capital, Research Division

William J. Greene - Morgan Stanley, Research Division

Walter Spracklin - RBC Capital Markets, LLC, Research Division

David Vernon - Sanford C. Bernstein & Co., LLC., Research Division

Anthony P. Gallo - Wells Fargo Securities, LLC, Research Division

Justin Long - Stephens Inc., Research Division

Cherilyn Radbourne - TD Securities Equity Research

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

Jason H. Seidl - Cowen and Company, LLC, Research Division

Keith Schoonmaker - Morningstar Inc., Research Division

Jeffrey Asher Kauffman - The Buckingham Research Group Incorporated

Donald Broughton - Avondale Partners, LLC, Research Division

Operator

Greetings. Welcome to the Union Pacific Third Quarter 2013 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded and the slides for today's presentation are available on Union Pacific's website. It is now my pleasure to introduce your host, Mr. Jack Koraleski, CEO for Union Pacific. Thank you, Mr. Koraleski, you may now begin.

John J. Koraleski

Thanks, Rob, and good morning, everybody. Welcome to Union Pacific's Third Quarter Earnings Conference Call. With me today here in Omaha are Rob Knight, our Chief Financial Officer; Eric Butler, our Executive Vice President of Marketing and Sales; and Lance Fritz, our Executive Vice President of Operations.

This morning, we're pleased to announce that Union Pacific achieved an all-time record financial results this quarter. We generated best-ever quarterly earnings of $2.48 per share, an increase of 13% compared to the third quarter of 2012. The quarter was not without its challenges, including headwinds in coal and grain volumes and severe flooding in Colorado that caused network disruptions and shipment delays. But at the end of the day, that's all part of running a railroad.

We managed our network efficiently, overcoming these challenges and continued to benefit from the strength of our diverse franchise. When combined with real core pricing and productivity gains, we more than offset the flat volumes to generate a new, best-ever quarterly operating ratio of 64.8%.

We feel very good about our accomplishments this quarter. We're leveraging our capital investments to strengthen the UP franchise and further enhance our value proposition in the marketplace. We remain focused on delivering safe, efficient, high-quality service that generates value for our customers and increased financial returns for our shareholders.

So with that, let's get started this morning. I'll turn it over to Eric.

Eric L. Butler

Thanks, Jack, and good morning. In the third quarter, the value and diversity of our franchise allowed volume to finish flat compared to last year despite volume declines in 3 of the business groups. Industrial Products, Automotive and Chemicals led the way with growth. Offsetting that good news were declines in Intermodal, Ag and Coal. Core pricing gains of 3.5%, which, combined with a modest benefit from positive mix, produced a 5% improvement in average revenue per car. The combination of flat volume and improved average revenue per car pushed freight revenue to a record $5.2 billion.

Let's take a closer look at each of the 6 business groups. Ag Products revenue declined 2% with third quarter volume down 4% and a 2% improvement in average revenue per car. Grain carloadings continued to reflect the impact of last year's drought with third quarter volume down 9%. Domestic feed grain shipments declined as tight U.S. corn supply led to reductions in livestock feeding and increased reliance on local feed crops. Export feed grains also declined with improved world supply and the higher U.S. prices. Partially offsetting these declines was an increase in weak Gulf exports, primarily destined to Brazil. Grain products volume was up 3%, driven by an 11% increase in ethanol shipments as the discounts to gasoline led refineries to replenish low ethanol inventories. Declines in import beer and barley led to a 4% decrease in food and refrigerated volume.

Automotive volume grew 8%, which, combined with the 9% improvement in average revenue per car, produced a 17% increase in revenue. Growth rates in auto production and sales remained strong in the third quarter, driven by pent-up demand to replace aging vehicles. Even so, the average age of vehicles on the road continued to increase, reaching 11.4 years, with customers replacing them with new models offering improved technology and fuel efficiency. UP finished vehicles shipments grew 5%, and sales continued to grow with seasonally adjusted annual sales rate reaching $15.7 million in the third quarter, the highest quarterly level in 5 years. Parts volume increased 12% while pricing gains in the previously announced Pacer network logistics management arrangement increased average revenue per car.

Turning now to Coal. You can see from the chart of weekly carloadings that volumes picked up from the second quarter as expected but tracked 7% below last year. Core pricing gains and favorable mix led to a 10% improvement in average revenue per car and produced a 2% increase in revenue. Tonnage from the Southern Powder River Basin decreased 8% as mild summer weather led to a 3% reduction in year-over-year electricity generation in UP-served territories. Also contributing to the decline was the continued impact of a contract loss from the beginning of the year. Colorado/Utah tonnage declined 17% as soft domestic demand and mine production issues offset growth in West Coast exports. Also hampering loadings in the third quarter was the September Colorado floods. Providing some good news, tonnage from other coal-producing regions increased 19% from a relatively small base, driven by gains from Southern Wyoming and Illinois loadings.

Before we move on, note this slide shows a steep decline early in the fourth quarter as volumes were impacted by nearly 3 feet of unseasonably early snow in the Powder River Basin during the first week in October. This has impacted volumes through the first half of the month, but we expect the majority of shipments be made up throughout the remainder of the fourth quarter.

In Industrial Products, a 9% increase in volume and 2% improvement in average revenue per car, despite unfavorable mix, produced revenue growth of 11%. Nonmetallic minerals volume was up 21% as continued growth in shale-related drilling increased frac sand shipments by 27%. Our construction-related volumes grew 11%, driven by an 11% improvement in rock shipments with increased construction activity, mostly in the Texas and California markets, which also contributed to 12% growth in cement volume. Metals volume was up 8% as pipeline projects picked up following a slow start to the year. We also saw an increase in export iron ore shipments with the resolution of mine production issues that limited shipments last year. Growth in housing and home improvements continued to increase the demand for lumber, with shipments up 6%. Although the housing market continue to strengthen, lumber's growth eased early in the third quarter as falling lumber prices and excess inventory slowed lumber shipments. Offsetting some of the strength in other Industrial Products market was a 4% decline in government and waste volume. As in previous quarters, reduced government funding, limited military shipments and delays to extending the federal production tax credit led to a decline in win moves.

Intermodal revenue was flat as a 2% increase in average revenue per unit offset a 1% decline in volume. With the economic recovery continuing its slow pace, retailers proceeded cautiously in the third quarter. Our international Intermodal volumes declined 5% due to market share shifts within the ocean carrier industry and increased port transloading activity. Continued success converting highway business to rail drove 4% growth in domestic Intermodal.

Chemicals revenue grew 5%, reflecting a 3% increase in volume and a 2% increase in average revenue per car. Industrial Chemicals volume was up 9%, driven by strength in end-user markets such as housing and automotive. Increased demand in new business led to a 10% increase in petroleum products volume. Dampening the good news was a 5% decline in crude oil volume compared to the third quarter of last year, although crude oil shipments to St. James, Louisiana, continued to grow compared to 2012.

Before we move on to our outlook for the fourth quarter, I'd like to give a brief update on our Crude-by-Rail business, which accounts for about 40% of our shale-related volume and about 2% of our overall volume. As we said, we've been expecting our 2013 crude oil volumes to increase at a moderate pace year-over-year, though not with the dramatic ramp-up seen in the year before, particularly given the lack of significant destination capacity expansion this year. As you can see in the blue portion of the bar chart, so far this year, we've seen the benefit of very steady demand into St. James, Louisiana, which continued to be a premier rail destination. Additional opportunities have come from other areas, such as West Texas and Oklahoma, and these volumes, in particular, has been somewhat more volatile as the domestic crude oil market continues to evolve and reflect the dynamics inherent in the commodity marketplace.

As you know, pricing spreads are one of the influences on traffic flows as producers look to maximize netbacks. With the narrowing of the WTI discount to Brent, we've seen a resulting volume decrease into areas with readily available pipeline access, primarily Texas and Oklahoma, which also have been impacted by increased pipeline capacity. We've also seen a small decline in shipments from the Bakken to Texas as tighter spreads have made it more attractive to ship Bakken crude oil to the East, where new facilities have increased crude-by-rail capacity.

Going forward, we expect the economics of crude oil spreads to continue to be a driver of traffic flows, particularly in areas such as Texas. Other markets, such as Canadian crude, should provide new opportunities as Crude-by-Rail continues to evolve. Meanwhile, our franchise strength in the South will continue to provide a solid foundation to our business, giving customers attractive access to important Gulf destinations.

While crude oil volumes will always be subject to the ups and downs of market spreads, we believe the long-term fundamentals of Crude-by-Rail remain attractive. Increasing crude production, limited pipeline infrastructure and the flexibility rail provides will enable us to leverage our value proposition and develop new unique opportunities ahead.

Let me close with what we see for the fourth quarter. Our current outlook is for the economy to continue its slow improvement, although there is uncertainty in the marketplace. No matter what the economy does, we'll continue to focus on strengthening our value proposition, attracting new customers and supporting our existing customers as they work to grow their business. Given that, here's what we see across our business for the next few months, both the challenges and the opportunities.

With the effects of last year's drought behind us, an improved fall harvest is expected to provide opportunity for Ag growth. Global, Insight raised their full year light vehicle sales estimate to 15.5 million vehicles, which is good news for our Automotive business. Crude oil spreads will continue to impact our Crude-by-Rail volumes but strength in other Chemicals markets is expected to drive the solid performance we've seen throughout the year. With the challenges previously mentioned in our Coal business, we now expect full year volumes to be down in the high single-digit range, which includes the lost contract of about 5% of our Coal volumes. Industrial Products should continue to benefit from shale-related growth with increased drilling activity that supports frac sand and pipeline projects. An improving housing market is expected to drive demand for lumber shipments, and growth in construction is expected to support increases in rock, metals and other related markets. International Intermodal volume is expected to be down slightly compared to last year, while highway conversions will continue to drive domestic Intermodal growth.

For the full year, our strong value proposition and diverse franchise will again support business development opportunities across our broad portfolio of business. Assuming the economy does not slow down, we're well on track to deliver profitable revenue growth again this year.

With that, I'll turn it over to Lance.

Lance M. Fritz

Thank you, Eric, and good morning. Starting with safety, year-to-date results nearly matched our 2012 record results on the strength of a record-low third quarter reportable personal injury rate. I expect our total safety culture, risk identification and mitigation process and robust training programs to drive continued improvement as we go forward. Our ultimate focus is making sure every one of our 50,000 employees returns home safely at the end of each day.

Rail equipment incidents or derailments improved 3% year-to-date versus 2012. This is a direct reflection of the investments we've made to harden our infrastructure and to leverage advanced defect detection technology, which, combined, have reduced track and equipment-induced derailments. We are also making progress on human factor incidents through enhanced skills training and root cause resolutions.

Moving to public safety, our year-to-date grade-crossing incident rate improved 7% versus 2012, reflecting our continued focus on improving or closing high-risk crossings and reinforcing public awareness. We achieved year-over-year improvement in 5 of the last 6 months, including a record third quarter rate. Our focus on grade-crossing risk in the South has generated an 18% year-to-date improvement in that region.

Our safety strategy helps keep our network strong and resilient. And as a result, our network remains fluid and is operating at very efficient levels. Velocity in the third quarter improved 1% compared to 2012 and improved 2% sequentially from the second quarter, despite flooding that severed numerous corridors in Colorado. We rerouted traffic and developed contingency plans during the event to support our affected customers and rapidly restored service on the lines that were washed out.

Our agility in the face of these outages prevented any year-over-year deterioration in our Service Delivery Index. The measure, which gauges how well we are meeting overall customer commitments, improved sequentially from the second quarter and would've improved year-over-year if not for tighter service commitments to our customers. We continued to provide outstanding local service to our customers with a best-ever 96% Industry Spot & Pull, which measures the delivery or pulling of a car to or from a customer.

Infrastructure investments and process efficiencies have improved our ability to recover after incidents, reducing their impact on the network. We continue to invest in capacity across our network, most notably in the South, where volumes are growing, across our diverse portfolio. Overall, our network remains well positioned to handle volume growth.

Moving on to network productivity. Slow order miles declined 38% to a best-ever third quarter level. As a result, our network is in excellent shape, reflecting the investment in replacement capital that has hardened our infrastructure and reduced service failures. We continue to identify and realize efficiencies that contributed to our record 64.8% operating ratio this quarter. Locomotive productivity, as defined by gross ton miles per horsepower day, improved 1%. Network planning and improved locomotive reliability drove this improvement in spite of a 2.5- to 3-percentage-point headwind associated with the mix shift from lower coal shipments and higher manifest shipments.

During the quarter, we continued to reposition resources to align with the traffic mix trend of growing southern region and manifest volumes, which require additional manpower versus the average of the network. The chart on the lower right demonstrates our ability to leverage growing manifest volumes through UP's extensive terminal infrastructure. We switched 1.5% more cars while keeping yard and local employee days flat. This resulted in an all-time quarterly record in terminal productivity. The improvement was particularly evident in our southern region where car switch per employee day was up 3%. These results reflect employee engagement, which is an important part of our operating strategy. Our employees are bringing their expertise to bear on improving safety, service and efficiency by standardizing work and reducing variability.

To recap, our operating performance in the third quarter was solid, improving nicely from second quarter levels. We remain vigilant in our commitment to operate a safer and more efficient railroad for the benefit of our employees, customers, the public and shareholders. We've demonstrated the ability to successfully flex network resources in response to dynamic market shifts and unexpected events, including weather.

As I touched on last quarter, we've successfully completed a number of significant capital track programs, both on the replacement and capacity side. Overall, these projects were completed with minimal network disruptions and resulted in measurable enhancements to our franchise. We will continue to make smart capital investments that generate attractive returns and that keep the network fluid and safe. With strong network fundamentals, we are well positioned for future growth while enhancing UP's value proposition.

With that, I'll turn it over to Rob.

Robert M. Knight

Thanks, Lance, and good morning. Let's start with a recap of our third quarter results. Operating revenue grew 4% to an all-time quarterly record of nearly $5.6 billion, driven mainly by solid core pricing gains. Operating expense totaled $3.6 billion, increasing 1.5%. Operating income grew 10% to $1.96 billion, also hitting a best-ever quarterly mark.

Below the line, other income totaled $28 million, basically flat with 2012. For the full year, we would expect other income to be in the $110 million to $120 million range, barring any unusual adjustments. Interest expense of $138 million was up 1% from last year. However, it includes about $7 million of net onetime costs associated with our recent debt exchange. Income tax expense increased to $701 million, driven by higher pretax earnings. Net income grew 10% versus 2012, while the outstanding share balance declined 2% as a result of our continued share repurchase activity. These results combined to produce a best-ever quarterly earnings of $2.48 per share, up 13% versus 2012.

Turning to our top line. Freight revenue grew 4.6% to more than $5.2 billion, driven by solid core pricing gains of 3.5% and favorable mix of a little more than a point. A decline in lower average revenue per car Intermodal shipments, combined with freight revenue impact from the Pacer arrangement, drove the positive mix. But these items were partially offset by double-digit growth in rock shipments, which typically move less than 200 miles, and a decline in longer haul grain moves.

Moving on to the expense side. Slide 21 provides a summary of our compensation and benefits expense, which was up 1% compared to 2012. Inflationary pressures and higher training costs drove the increase, largely offset by productivity gains. Workforce levels increased 1% in the quarter. About half of the increase was driven by more individuals in the training pipeline and the other half was due to capital projects, including positive train control activity. When you think ahead to the fourth quarter, remember that we saw the benefit of a onetime $20 million payroll tax refund that is reflected in last year's fourth quarter comp and benefits expense.

Turning to the next slide. Fuel expense totaled $866 million, decreasing 2% versus 2012, primarily driven by lower average diesel fuel price. In addition, gross ton miles declined 2% due to lower coal and grain shipments. This mix impact also contributed to the 1% increase in our fuel consumption rate compared to 2012.

Moving on to our other expense categories. Purchased services and materials expense increased 8% to $588 million due to higher locomotive and freight car contract repair expenses and joint facility maintenance expense. And we're incurring logistics management fees associated with the 2012 Pacer agreement, which are recouped in our Automotive freight revenue line. Depreciation expense was $447 million, basically flat compared to last year. The impact of increased capital spending in recent years was offset by a new equipment rate study that went into effect at the beginning of this year.

Looking at the full year, we expect depreciation to be up about 1% versus 2012, slightly lower than our previous projections. However, for 2014, full year depreciation expense should increase at a more normalized rate, more likely in the 5% to 7% range.

Slide 24 summarizes the remaining 2 expense categories. Equipment and other rents expense totaled $309 million, up 3% compared to 2012. Increased container expenses associated with the Pacer contract and growth in Automotive shipments drove higher freight car rental expense. Other expenses came in at $205 million, up $5 million versus last year. Higher property taxes and freight damage costs drove expenses up compared to 2012. A moderate reduction in personal injury expense and effective cost-control measures partially offset these increases. For the fourth quarter, we would expect that other expense line to be more in the neighborhood of $215 million, excluding any unusual items.

Turning to our operating ratio performance. We achieved an all-time best operating ratio of 64.8% this quarter, improving 1.8 points compared to last year. Our performance highlights the positive impact of solid core pricing gains and network efficiencies despite flat volumes. Through the first 9 months of this year, we generated an operating ratio of 66.5%, improving 1.5 points from 2012, clearly illustrating the strength and value proposition of the Union Pacific franchise.

Union Pacific's record year-to-date earnings drove strong cash from operations of nearly $4.9 billion, up 12% compared to 2012. Free cash flow of $1.3 billion reflects the growing profitability of the franchise and includes a 13% increase in cash dividend payments versus 2012. Our balance sheet remained strong, supporting our investment-grade credit rating. At quarter end, our adjusted debt-to-cap ratio was roughly 39%, which includes the impact of adding over $450 million to our balance sheet debt since year-end 2012.

Opportunistic share repurchases continue to play an important role in our balanced approach to cash allocation. In the third quarter, we bought back nearly 3.7 million shares, totaling $575 million. Year-to-date, we've purchased more than 9.6 million shares, totaling over $1.4 billion, already matching our full year spend from last year. Looking ahead, we have around 5.4 million shares remaining under our current authorization program, which expires March 31, 2014.

So that's a recap of our third quarter results. As we move through the rest of the year, we're mindful of the economic uncertainty in the marketplace. For the fourth quarter, we expect to see modest volume growth, mainly driven by improved grain shipments. Assuming the economy doesn't slow down for the rest of the year, we would also expect to see continued growth in other market sectors. Given the flat volumes in the third quarter, it's unlikely that our full year volumes will be positive even with our modest growth assumptions in the fourth quarter. However, we will have to see how the rest of the year plays out. In addition, we should see solid core pricing gains roughly similar to the third quarter results. All in, the fourth quarter should round out another record financial year for Union Pacific.

Now let's take a preliminary look at next year, realizing that it's still very early. From where we sit today, we're expecting modest volume growth if the economy continues along a slow growth trajectory. We think there will be some markets that will be stronger than others. We should see strength in grain shipments. And if the economy holds, there should be positive growth in other business sectors. Mexico-related traffic should also generate volume gains for us next year.

Our Coal business is a little more difficult to predict, but we can tell you that we retained and renewed roughly 50% of next year's $100 million legacy business. The lost legacy business, which is currently not moving at re-investable levels, will create about a 2% headwind on our Coal volumes in 2014. But as always, weather and the economy will be the driving factors for our Coal business next year. Although 2014 is a legacy-light year, we'll continue to generate real core pricing gains. However, we don't expect to match 2013's levels, which, as you know, include about 1.5 of legacy repricing that won't repeat next year. In addition, inflation-related escalators are expected to be lower next year, including those used to calculate the A-lift cost escalator.

At the end of the day, our fundamental strategy and focus on pricing for returns has not changed. While we won't see a legacy benefit next year and inflation escalators are expected to be modestly lower, pricing on the rest of our business in 2014 remains strong. When you add it all up, we expect to achieve core pricing above inflation next year. Overall, we're forecasting another record financial year in 2014, if the economy cooperates. In addition to our pricing initiatives, ongoing productivity gains and volume leverage opportunities should help drive continued margin improvement.

We feel very good about our outlook going forward. The fundamentals are strong, supported by a diverse franchise that allows us to pursue new, attractive market opportunities. We'll continue to move the ball forward, focusing on improved returns to support capital investments that will strengthen and enhance our network, create value for our customers and drive increased returns for our shareholders.

With that, I'll turn it back to Jack.

John J. Koraleski

Okay. Thanks, Rob. Well, as Eric mentioned, we've had a bit of a tough start here to the fourth quarter with the early blizzard slowing Coal volumes out of the Powder River Basin. But the good news is there's still a lot of quarter ahead of us. And as we did in the third quarter, we'll manage through the obstacles to ensure our customer commitments are met and our network is protected. More broadly, we continue to monitor the economic landscape and the ongoing saga in Washington.

But supported by our diverse franchise, we remain agile and well positioned for economic recovery. The 50,000 men and women of Union Pacific stand ready to leverage the opportunities while navigating through the challenges. We'll continue focusing on re-investable pricing, attracting new, profitable growth opportunities and running a safe, efficient and reliable network that generates greater value for both our customers and shareholders going forward.

So with that, let's open up the line for questions.

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