Union Pacific Management Discusses Q4 2013 Results - Earnings Call Transcript

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Union Pacific (UNP) Q4 2013 Earnings Call January 23, 2014 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

Justin B. Yagerman - Deutsche Bank AG, Research Division

Allison M. Landry - Crédit Suisse AG, Research Division

Scott H. Group - Wolfe Research, LLC

Christian Wetherbee - Citigroup Inc, Research Division

Brandon R. Oglenski - Barclays Capital, Research Division

Ken Hoexter - BofA Merrill Lynch, Research Division

William J. Greene - Morgan Stanley, Research Division

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

Walter Spracklin - RBC Capital Markets, LLC, Research Division

Donald Broughton - Avondale Partners, LLC, Research Division

Justin Long - Stephens Inc., Research Division

Matthew Troy - Susquehanna Financial Group, LLLP, Research Division

Thomas Kim - Goldman Sachs Group Inc., Research Division

Cherilyn Radbourne - TD Securities Equity Research

John G. Larkin - Stifel, Nicolaus & Co., Inc., Research Division

Keith Schoonmaker - Morningstar Inc., Research Division

Jeffrey Asher Kauffman - The Buckingham Research Group Incorporated

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

Operator

Greetings. Welcome to the Union Pacific Fourth 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's now my pleasure to introduce your host, Mr. Jack Koraleski, CEO for Union Pacific. Thank you. Mr. Koraleski, you may begin.

John J. Koraleski

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

Well, as you can see, we wrapped up 2013 with another all-time record quarter. Union Pacific achieved our best-ever quarterly earnings of $2.55 per share, an increase of 16% compared to 2012. For the first time in 6 quarters, we reported overall volume growth despite significantly weaker coal shipments. It highlights the strength of our diverse franchise, the extensive network reach we have to various markets and a strong grain harvest. When combined with solid core pricing gains and our continued focus on safety, service and efficiency, we achieved a record fourth quarter operating ratio of 65%, improving more than 2 points compared to 2012.

During the quarter, we battled some extreme winter weather that challenged us on many fronts, but as we said before, running a railroad is an outdoor sport, and we successfully worked through the challenges, managing and realigning our network resources to deliver on our customer commitments.

All in, 2013 was another terrific year for Union Pacific, with our financial performance exceeding all previous milestones. It demonstrates our commitment to delivering safe, efficient, high-quality service that creates value for our customers and increased financial returns for our shareholders.

So to kick us off this morning, I'm going to turn it over to Eric Butler. Eric?

Eric L. Butler

Thanks, Jack, and good morning. In the fourth quarter, volume was up 2% compared to 2012 as the diversity of our franchise provided enough growth opportunities to offset volume declines in 2 of the groups. We had strong gains in Ag, Automotive and Industrial Products, and Intermodal also saw modest volume growth.

This good news offset continued weakness in Coal and a slight decline in Chemicals. Coal price improved 3.5%, which, combined with the benefit from positive mix, produced a 5.5% improvement in average revenue per car. Volume growth and the improved average revenue per car combined to drive freight revenue up nearly 7.5% to an all-time quarterly record of $5.3 billion.

Let's take a closer look at each of the 6 business groups. Ag Products volume grew 13%, which, combined with 5% improvement in average revenue per car, drove revenue growth up 19%. A 41% increase in grain carloadings was driven by a strong harvest as improved yields increased crop production following last year's lower drought-impacted volumes.

With more competitive crop prices and strong global demand, grain export volumes saw significant growth, up more than 90%. The strongest gains were in feed grain shipments to the PNW and Mexico and wheat exports to the Gulf. Also contributing to this growth was increased demand for domestic feed grains.

Grain products volume was up 6%, driven by a 21% increase in ethanol shipments as lower corn prices and increased gasoline consumption led refineries to replenish low ethanol inventories. Shipments of DDGs also grew 19%, driven by stronger export demand, primarily by China.

Food and refrigerated shipments were down 4%. Gains in import beer were offset by declines in sugar volumes, following an unusually strong fourth quarter last year and a continued sugar surplus that reduced imports from Mexico.

Automotive volume grew 10%, which, combined with a 7% improvement in average revenue per car, produced a 17% increase in revenue. The same trends that supported growth throughout the year, replacement demand, low interest rates and favorable financing, continued through the fourth quarter. Aided by moderating fuel prices, demand for pickup trucks and sport utility vehicles gained momentum, and the growth rate of the automotive industry outpaced that of the overall economy.

UP finished vehicle shipments grew 7% as sales continued to grow, with the seasonably adjusted annual sales rate reaching $15.9 million in the fourth quarter, the highest quarterly level in 6 years.

Parts volume increased 13%, while pricing gains and the previously announced Pacer network logistics management arrangement increased average revenue per car. We now lapped that arrangement on a year-over-year basis, so we won't see its positive ARC contribution going forward.

Chemicals revenue grew by 3% as a 3% increase in average revenue per car more than offset a 1% decline in volume. Industrial chemicals volume was up 6%, driven by strength in end user markets such as housing and automotive. Increased demand in new business led to a 7% increase in petroleum products and LPG shipments.

Dampening the good news was a 22% decline in crude oil volume compared to the fourth quarter of last year. And increased supply of crude at the Gulf Coast reduced Gulf prices, which led to a decline in shipments from West Texas and Oklahoma. In addition, the discount of Louisiana Light Sweet to Brent displaced some of the Bakken crude shipments away from Texas and Louisiana.

Coal revenue declined 1%. Fourth quarter volume was down 10%, which was mostly offset by a 10% improvement in average revenue per car. You can see from the chart of weekly carloadings that unseasonably early snow impacted shipments from the Southern Powder River Basin in October, with the tonnage down 12% for the fourth quarter. River infrastructure projects and low water levels on the Ohio River curtailed barge traffic at St. Louis, which also reduced shipments. Also contributing to the decline were inventory management initiatives by select utilities and the continued impact of a contract lost from the beginning of the year. Despite growth in West Coast exports, Colorado/Utah tonnage declined 10% based on soft domestic demand and mine production issues.

Providing some good news, tonnage from other coal-producing regions increased 10% from a relatively small base, driven by gains from Southern Wyoming and other regions.

In Industrial Products, a 9% increase in volume and a 5% increase in average revenue per car produced revenue growth of 14%. Nonmetallic minerals volume was up 28% as continued growth in shale-related drilling, mainly in the Eagle Ford and Permian Basins, increased frac sand shipments by 36%.

Metals volume was up 11%, driven by China-bound iron ore shipments through ports in California and Mexico. We also saw growth in pipe shipments with increased pipeline and drilling activity related to shale energy. Growth in housing and home improvements continued to increase the demand for lumber, with shipments up 6%.

Intermodal revenue was flat in the fourth quarter. Lower fuel surcharge revenue and unfavorable mix led to a 2% decline in average revenue per unit, which offset volume growth of 2%. Our International Intermodal volumes declined 1%, driven by continued market share shifts within the ocean carrier industry and increased port transloading activity. We also saw a greater flow of revenue empty move for international container repositioning, which impacted the overall traffic mix for the quarter. Volume fared better for Domestic Intermodal, where continued success converting highway business to rail drove volume up 5%.

I'll close with a look at how we see our business shaping up for 2014. Our current outlook is for the economy to continue its slow improvement. A diverse franchise provides access to a number of markets with potential growth opportunities. The new crops should provide opportunity for Ag in the first half of the year, with anticipated growth in both domestic and export grain markets. Food and refrigerated is expected to see modest growth.

Automotive manufacturers expect sales growth to continue, and Global Insight has raised its full year light vehicle sales estimate to 16 million vehicles. This should be good news for our finished vehicles and auto parts business.

Crude oil spreads, a growing Gulf crude supply and increased pipeline activity are expected to have a continued impact on our crude-by-rail volumes. Most other chemicals markets should remain solid.

Turning to Coal. The previously mentioned legacy contract loss will impact volumes, but low inventory levels and increased exports should help offset this. Volume growth for the year will depend on weather conditions, economic activity and natural gas prices.

Industrial Products should continue to benefit from shale-related activity, with increased drilling supporting growth in frac sand and pipe shipments. Housing starts are projected to exceed 1 million units for the first time since 2007, which is expected to demand -- drive demand for lumber shipments. Increases in commercial construction are expected to support growth in rock, metals and other highway-related markets.

Highway conversion should continue to drive growth in Domestic Intermodal. International Intermodal may be challenged in the first quarter by a difficult comparison to 2013, but an improving economy and strengthening housing market should keep International Intermodal ahead of last year.

For the full year, our strong value proposition and diverse franchise will, again, support business development efforts across our broad portfolio of business. Across the groups, we'll continue to develop opportunities in Mexico, where our unparalleled ability to link Mexico's economic growth with U.S. origins and destinations is the strength of our franchise. Assuming the economy cooperates, we expect to deliver profitable revenue growth yet again in 2014, driven by modest volume and core pricing gains.

And with that, I'll turn it over to Lance.

Lance M. Fritz

Thanks, Eric, and good morning. I'll start with our safety results. The 2013 reportable personal injury rate was up slightly from our all-time record performance in 2012. Not shown is the number of severe injuries, which declined to a new record low. We focus our attention on risk and severity because these injuries have the greatest human and financial impact. Our goal is for every employee to return home safely after every shift, and we will get there using a robust safety strategy that includes the Courage to Care, Total Safety Culture and risk identification and mitigation.

Moving to rail equipment incidents or derailments. Our full year reportable rate finished up 1% versus 2012. We continue to make progress on human factor incidents through enhanced skills training and root cause resolutions. In addition, we continue to invest in capital to harden our infrastructure and leveraging advanced technologies to find and fix track and equipment defects.

In public safety, our grade-crossing incident rate improved 7% versus 2012, a result of our efforts to improve or close high-risk crossings and to reinforce public awareness. Most encouraging was the 17% improvement on our southern region, which has a higher grade-crossing density than our overall network.

While our reportable rate in both employee and rail equipment safety increased slightly during 2013, the absolute number of incidents, which includes incidents that do not meet the regulatory reportable threshold, declined in both categories.

Our safety strategy helps keep our network strong and resilient, particularly in the face of recent winter weather challenges. Recall that in October, a winter blizzard in Wyoming severely impacted shipments out of the Powder River Basin. In early December, we were hit with the most severe winter weather interruption in the past 7 years. The storm covered 2/3 of our network and generated a 33% increase in the number of days with major service interruptions during the quarter. As a result, average train speed declined 3% in the fourth quarter compared to 2012 but remained within a solid service range. These weather interruptions also drove a decline in our Service Delivery Index. The metric, which gauges how well we are meeting overall customer commitments, also reflects the tighter service commitments we introduced last year. We continued to provide outstanding local service to our customers with a fourth quarter record 95.5% Industry Spot & Pull, which measures the delivery or pulling of a car to or from a customer. Overall, our network remains well positioned to handle volume growth.

Moving on to network productivity. We continue to leverage existing resources as grain train lengths set a new best-ever quarterly record, while automotive and manifest train lengths set new best-ever fourth quarter records. Intermodal train size dropped, reflecting an increase in new service offerings. We expect these new trains to grow as we convert business from the highway. Other efficiencies included a 2% improvement in locomotive productivity, as measured by gross ton miles per horsepower day, in spite of a 2 to 2.5 point headwind due to the mix shift from lower coal shipments to higher manifest shipments. The improvement reflects a long-term trend of increasing locomotive reliability, as well as effective utilization plans.

We efficiently handled the volume growth across each region of our network, effectively utilizing our workforce. We leveraged growing manifest volumes within UP's existing terminal infrastructure, as reflected by an improvement in car switch per employee day. The improvement was particularly evident in our southern region, where car switch per employee day increased 5%. These productivity gains were generated by our men and women in the field as they leveraged their expertise to improve safety, service and efficiency using the UP Way.

Moving on to our capital investments. We invested nearly $3.6 billion in our network during 2013, with more than $2.1 billion in replacement capital to harden our infrastructure and improve the safety and resiliency of the network. At the end of the year, over 99% of our network was free of slow orders. Spending for service growth and productivity totaled around $1 billion, driven by investments in capacity, commercial facilities and equipment. Major projects included are $400 million investment in our Santa Teresa, New Mexico facility and more than $200 million of capacity work in the South to support our diverse and growing book of business in that region. In addition, we invested another $420 million in Positive Train Control during the year, bringing our cumulative PTC investment to $1.2 billion of our estimated $2 billion projected spend. Although it's unlikely the industry will meet the 2015 deadline, we're making a good-faith effort to do so and are working closely with regulators as we implement this new technology.

For 2014, our plan will likely exceed last year's spending. We'll continue to make capacity investments in our southern region while also advancing capacity projects across other parts of our network. Although some buckets will fluctuate year-over-year, our core investment thesis will not, which is to maintain a safe, strong and resilient network and invest in service growth and productivity projects that meet our aggressive return thresholds.

So in summary, we finished 2013 on a solid note despite the winter weather challenges. As we move through 2014, our focus, above all, will be the safety of our employees and the communities in which we operate. We'll take advantage of growth opportunities by leveraging our network resources. We'll look to make productivity improvements in all areas, utilizing resources more efficiently and investing capital productively. As a result, we'll provide customers with a value proposition that supports growth with high levels of service. We call that moving our business up into the right. All combined, it translates into increased returns for our shareholders.

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 fourth quarter results. Operating revenue grew 7% to an all-time quarterly record of more than $5.6 billion, driven mainly by solid core pricing gains and volume growth.

Operating expense totaled nearly $3.7 billion, increasing 4%. Operating income grew 14% to nearly $2 billion, also hitting a best-ever quarterly mark. Below the line, other income totaled $37 million, down $6 million compared to 2012. Interest expense of $127 million was down slightly compared to the previous year. Income tax expense increased to $709 million, driven by higher pretax earnings and a higher effective tax rate. Net income grew 13% versus 2012, while the outstanding share balance declined 2% as a result of our continued share repurchase activity. These results combined to produce best-ever quarterly earnings of $2.55 per share, up 16% versus 2012.

Turning to our top line. Freight revenue grew 7.5% to a quarterly record of $5.3 billion, driven by solid core pricing gains of about 3.5%, which included a little over 1 point of legacy repricing. Volume growth of 2% and favorable mix of a couple of points also contributed to the improvement. Growth in longer-haul grain moves and a 5% increase in higher average revenue per car manifest shipments drove the positive mix. These items were partially offset by growth in lower average revenue per unit Intermodal shipments.

Slide 21 provides more detail on our core pricing trends in 2013. For the year, our core pricing gains ranged between 3.5% and 4%. Lost opportunity due to lower coal volumes totaled about 0.5 point for the full year. This slide also shows the quarterly rail inflation escalator, excluding fuel, on a year-over-year basis. As you can see, it drifted into negative territory in the second half of 2013, creating a slight pricing headwind on a portion of our business, which is tied to the escalator. Over the past 5 years, the cost escalator has averaged about 3%, but as we've discussed, we expect 2014 inflation to moderate, negatively impacting our pricing gains but also tempering operating expense increases.

As we've said previously, the more significant impact on our 2014 pricing will be the lack of about 1.5 points of legacy pricing benefit that we saw last year. That said, we remain committed to our strategy of pricing for reinvestability. It's supported by the value we create for our customers and is required to generate the returns needed for continued investment in our franchise.

Moving on to the expense side. Slide 22 provides a summary of our compensation and benefits expense, which increased 7% compared to 2012. Inflationary pressures, volume-related expenses and a mix shift to more manifest traffic drove the increase. In addition, higher overtime and re-crew expenses, driven by severe winter weather, masked overall productivity gains. You also need to take into account the $20 million payroll tax refund included in our 2012 fourth quarter results. Excluding this onetime item, our comp and benefit expense was up about 4.5%.

Workforce levels were flat for the quarter as we leveraged a 2% volume increase with a 1% increase in TE&Y employees. Fewer capital employees offset the TE&Y workforce increase.

As we look at 2014, we expect our comp and benefits expense to grow. However, the extent will be driven by volume levels and business mix. The good news story is our continued productivity initiatives that will help mitigate these increases. In addition, we'll continue to see labor inflation this year, but it will likely moderate to below the 2% mark.

Turning to the next slide. Fuel expense totaled $905 million, decreasing 2% versus 2012, driven by a lower average diesel fuel price. On the flip side, gross ton miles increased 2% in the wake of strong grain shipments, while our fuel consumption rate increased 1% compared to 2012.

Moving on to our other expense categories. Purchased services and materials expense increased 10% to $585 million due to higher locomotive and freight car repair expenses and an increase in joint facility maintenance expense. And we continued to incur management fees associated with the 2012 Pacer agreement, which are recouped in our Automotive freight revenue line. And as Eric mentioned, we've now lapped that contract on a year-over-year basis, so we won't see that variance going forward.

Depreciation expense was $458 million, up 1% compared to 2012. The impact of increased capital spending in recent years was mostly offset by an equipment rate study that went into effect in 2013. For 2014, we expect depreciation expense to increase at a more normalized rate, likely in the 6% to 7% range. This range includes about $80 million of depreciation expense associated with Positive Train Control capital investments. I'll talk more about PTC in a minute.

Slide 25 summarizes the remaining 2 expense categories. Equipment and other rents expense totaled $311 million, up 3% compared to 2012. Increased container expenses associated with the Pacer contract and growth in Agricultural and Automotive shipments mainly drove higher freight car rental expense. Other expenses came in at $188 million, up $6 million versus last year. Higher property taxes and freight and equipment damage costs drove expenses up compared to 2012. A reduction in personnel injury expense and effective cost control measures partially offset these increases. For 2014, we expect the Other expense line to increase between 5% and 10% for the full year, excluding any unusual items.

Turning to our operating ratio performance. Our focus on pricing the business right and moving it efficiently continues to pay off. We achieved a record fourth quarter operating ratio of 65%, improving 2.1 points compared to 2012.

On a full year basis, we also made tremendous strides by generating a best-ever operating ratio of 66.1%. It clearly illustrates the strength and value proposition of the Union Pacific franchise. We've talked about our focus on continued core pricing and productivity gains and leveraging what we see as modest volume growth over our planning horizon.

On the cost side, it's a matter of effectively managing inflationary pressures in addition to other cost hurdles that we have every year. For example, operating taxes that we pay will continue to increase as our profitability grows. Depreciation expense is another item that will continue to increase, assuming a growing capital spend. And as we've discussed, depreciation and other operating expenses will be driven higher by shorter-life Positive Train Control assets and maintenance costs as we move further into that project.

Despite these obstacles, we feel very good about our prospects of now achieving our sub-65% operating ratio before 2017. Exactly how much sooner before 2017 will depend on the usual drivers: economic growth, fuel prices, inflationary hurdles, just to name a few. That said, we're equally focused on cash generation and improving our overall financial returns.

Slide 27 provides a summary of our 2013 earnings with a full year income statement. I'll walk through a few of the highlights from our record-setting year. Operating revenue grew more than $1 billion to an all-time record of nearly $22 billion. Operating income also set a new best-ever mark of $7.4 billion, topping 2012 's record by 10%. And net income of $4.4 billion and earnings of $9.42 per share also set new full year records.

Overall, one of the key measures for our performance is the cash that we generate. In 2013, cash from operations increased to $6.8 billion, up 11% compared to 2012. After $3.5 billion in cash capital investments and $1.3 billion of dividend payments, our free cash flow totaled nearly $2.1 billion, being the first rail to surpass the $2 billion mark in our industry's history.

Taking a closer look at 2014, we will not see the benefit of bonus depreciation. In fact, we'll see a headwind to free cash flow of about $400 million due to tax payments associated with prior year programs. However, we don't expect this to impact our cash allocation strategy or our ability to grow shareholder returns.

Slide 29 shows our 2013 all-in capital investment of $3.6 billion. It's a bit higher than our cash capital due to capital leasing activity and other noncash capital items. In 2014, we expect to increase our capital spending from 2013's levels, pending final approval from our Board of Directors in February. The chart on the right reflects our achievements in generating returns on these investments. Return on invested capital was a record 14.7% in 2013, up 0.7 point from 2012. If you calculate it on a replacement basis, our return shrinks to about half that number. Returns must continue to improve to support asset replacement costs and investments required to achieve our safety, service and growth initiatives.

Beyond funding our capital commitments, our record profitability and strong cash generation have enabled us to grow shareholder returns. After increasing our quarterly dividend per share 15% in 2012, we raised it an additional 14.5% last year. For 2013, we achieved a payout ratio of 31.5%, up from 30% in 2012. We're making good progress in moving up within our targeted payout range of 30% to 35%.

In addition, we continue to make opportunistic share repurchases, which play an important role in our balanced approach in cash allocation. In the fourth quarter, we bought back more than 4.9 million shares totaling $786 million. Full year purchases topped more than 14.5 million shares totaling over $2.2 billion, up 50% from 2012. Our new repurchase authorization of up to 60 million shares over a 4-year time period went into effect January 1 of this year. Combining dividend payments and share repurchases, we returned over $3.5 billion to our shareholders in 2013. It represents a 36% increase over 2012, clearly demonstrating our commitment to increasing shareholder value.

Our balance sheet remains strong, supporting our ongoing commitment to a solid investment-grade credit rating. Continued growth in earnings and cash flow has improved our 2013 year-end debt-to-cap ratio to roughly 38% and our debt-to-EBITDA to just under 1.4x, even with the addition of nearly $600 million of balance sheet debt since last year. As we've said, these metrics are a little lower than where we believe they need to be. We are targeting about 1.5x and around a 40% for year-end 2014, which is closer to the low 40s target range that we've previously discussed. Our $1 billion debt issuance earlier this month was a good step in that direction.

So that's a recap of our fourth quarter and full year results. As we focus on 2014, we're projecting another record financial year if the economy cooperates. In addition to our pricing initiatives and ongoing productivity gains, volume leverage opportunities should also help drive continued margin improvement. And as Eric just highlighted, we have growth opportunities across a variety of market sectors that should drive modest volume growth for the full year. First quarter volumes also are expected to be on the positive side of the ledger, driven by continued strong growth in grain shipments, cross-border traffic with Mexico and various other industrial-related moves.

Our Coal business is a little more difficult to predict. The lost legacy business creates 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 this year.

We feel very good about our outlook as we move forward. Our 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.

So with that, I'll turn it back to Jack.

John J. Koraleski

Thanks, Rob. So as we look at 2014, we see the economy is slowly strengthening. We're well positioned for economic growth and are confident in our ability to deliver on our customers' growing transportation needs. Excellent service is key to our future success. It supports our pricing initiatives and improves network and asset utilization. It also demonstrates the power of our value proposition to new customers that are looking for viable transportation alternatives.

Our capital investment strategy will be another key part of UP's success going forward. We are making investments today, building the capacity that we need for tomorrow. Longer term, we remain bullish on our future prospects. We'll continue our unrelenting focus on both safety and service to our customers. We strongly believe in the power and the potential of the Union Pacific franchise to drive even greater financial performance and shareholder returns in the years to come.

So with that, let's open it up to your questions.

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