Union Pacific's (UNP) CEO John Koraleski on Q2 2014 Results - Earnings Call Transcript

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Union Pacific (UNP) Q2 2014 Earnings Call July 24, 2014 8:45 AM ET


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

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

Lance M. Fritz - President of Union Pacific Railroad Company and Chief Operating Officer of Union Pacific Railroad Company

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


William J. Greene - Morgan Stanley, Research Division

Scott H. Group - Wolfe Research, LLC

Robert H. Salmon - Deutsche Bank AG, Research Division

Kenneth Scott Hoexter - BofA Merrill Lynch, Research Division

Allison M. Landry - Crédit Suisse AG, Research Division

Christian Wetherbee - Citigroup Inc, Research Division

Walter Spracklin - RBC Capital Markets, LLC, Research Division

Jeffrey Asher Kauffman - The Buckingham Research Group Incorporated

Brandon R. Oglenski - Barclays Capital, Research Division

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

John G. Larkin - Stifel, Nicolaus & Company, Incorporated, Research Division

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

Justin Long - Stephens Inc., Research Division

Thomas Kim - Goldman Sachs Group Inc., Research Division

Keith Schoonmaker - Morningstar Inc., Research Division

Cleo Zagrean - Macquarie Research

Cherilyn Radbourne - TD Securities Equity Research

Patrick Tyler Brown - Raymond James & Associates, Inc., Research Division

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


Greetings. Welcome to the Union Pacific Second Quarter 2014 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, and welcome to Union Pacific Second Quarter Earnings Conference Call. With me here today in Omaha are Eric Butler, our Executive Vice President of Marketing and Sales; Lance Fritz, President and Chief Operating Officer; and Rob Knight, our Chief Financial Officer.

This morning, we're pleased to report that Union Pacific achieved second quarter earnings of $1.43 per share, an increase of 21% compared to the second quarter of 2013 and another quarterly record. Total volumes were up 8%, and the increases were nearly across-the-board. We saw growth in 5 of our 6 business groups, with particular strength in Agricultural Products, Intermodal and Industrial Product shipments.

We were pleased to see strong volume growth, which, combined with solid core pricing, drove more than 2-point improvement in our operating ratio to a record 63.5% for the quarter.

On the operating side, Mother Nature did finally release her winter grip, but we experienced numerous washouts, flooding and mudslides, which caused disruptions to our network during the quarter. In this environment, increasing velocity and fluidity has been a challenge, but we continue to be focused on safely improving network efficiency and service for our customers.

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

Eric L. Butler

Thanks, Jack. Good morning. In the second quarter, volume was up 8% compared to 2013 as solid demand across our franchise led to volume gains in 5 of our 6 business groups. We had strong gains in Agricultural Products, Intermodal and Industrial Products, and we also saw strength in Automotive and Coal. In Chemicals, declines in crude oil volume were mostly offset by gains in other commodities. Core price improved around 2.5%, which was partially offset by mix that produced a 1.5% improvement in average revenue per car. Our volume growth and improved average revenue per car combined to drive freight revenue up 10%, which set an all-time quarterly record of nearly $5.7 billion.

Let's take a closer look at each of the 6 business groups. Ag Products led our growth again this quarter. Volume grew 16%, which, combined with the 2% improvement in average revenue per car, drove revenue growth up 19%. Strong grain demand continued this quarter, with carloads up 43%.

Last year, you may remember that we experienced a tight U.S. corn supply and improved world production, which led to lower exports and reductions in domestic demand for livestock feeding.

The strength in U.S. supply and lower commodity prices this quarter drove strong demand for export feed grain. Domestic feed grain demand was also strong across most of our franchise. The one soft spot within grain was wheat, where the smaller hard red winter wheat crop led to a slight decline in overall wheat shipments.

Grain products volume was up 8%, led by 15% increase in ethanol shipments. We had a best-ever quarter for ethanol shipments, driven by favorable producer margins, higher gasoline demand and lower ethanol inventories, and DDG shipments grew 33%, driven by strong export shipments to Mexico. Food and refrigerated shipments were up 3% for the quarter. Import beer volume was up over 20%, partially offset by declines in rice exports and lower produce in frozen food shipments.

Automotive revenue was up 2% in the second quarter on a 6% increase in volume. Average revenue per car was down 4%, driven primarily by the previously reported change in the way we handle per diem revenue and also by mix. Finished vehicles shipments were up 5% this quarter. North American Automotive production continue to be strong, up 4% versus the fourth -- the same quarter in 2013. Also, the sales rebound that started in March continue to gain strength as the second quarter progressed.

On the Parts side, volume increased 8%, driven again by strong production demand and over-the-road conversions.

Chemicals revenue was up 3% for the quarter, with a 4% average revenue per car improvement, partially offset by a 1% volume decline. Industrial Chemicals volume was up 7%, driven by demand in a variety of markets, such as shale-related drilling; inventory replenishment of de-icing materials after a strong winter demand; and increased demand for chemicals used in nylon production.

Fertilizer shipments were up 2% for the quarter. Strong export potash demand, coupled with the delayed spring planting season in the U.S., drove the increase. And crude oil volume declined 24% compared to the second quarter of last year, with price spreads, again, negatively impacting Bakken volume.

Our coal revenue increased 1% on a 1% increase in volume and a/1% improvement in average revenue per car. Southern Powder River Basin tonnage was down 2% as demand from lower inventories and higher natural gas prices partially offset our previously reported legacy contract loss. Volume was also impacted by network fluidity challenges.

Colorado/Utah coal tonnage was up 11%, benefiting from increased demand in the western part of our network, and we continue to see strength from other coal-producing regions where tonnage was up 12% for the quarter.

In our Industrial Products business, a 12% increase in volume combined with a 3% improvement in average revenue per car to produce 16% revenue growth. Nonmetallic minerals led to growth in IT, again, with volume up 21% for the quarter. Frac sand used in shale-related drilling drove the increase with shipments up more than 25% versus last year. Our lumber shipments were up 17% in the quarter. We were encouraged to see improvement in the housing markets driving continued lumber demand.

Finally, construction products shipments were up 15% as demand for aggregates and cement continue to be strong, particularly in Texas and California.

Turning to Intermodal. Revenue was up 16% in the second quarter, driven by a 12% increase in volume and 3% improvement in average revenue per unit. Domestic Intermodal volume was up 12% in the quarter. New premium services and continued highway conversions contributed to our volume gains.

Our international Intermodal volumes were up 13%. Imports to West Coast ports rebounded in the second quarter after declining earlier in the year. We believe some portion of the strength in the second quarter can be attributed to cargo owners advancing shipments ahead of the July expiration of the ILWU contract. So it is possible that some of our traditional peak international demand has already moved.

Let's take a look at how we see our business shaping up for the second half of 2014. In Ag Products, strength from last year's crop is carrying into the third quarter, and early signs point to another good crop year later this year. If we have another good crop year, we should have a strong second half in grain, but remember that our comp gets much more difficult in the fourth quarter. We also see continued demand for ethanol. The current forecast for ethanol production is 14.1 billion gallons for the year, which would be a record for the U.S.

We expect Automotive production and sales to continue to be strong in the second half of 2014, which will drive both finished vehicle and auto parts demand. Most of our Chemicals market should continue to remain solid throughout 2014, though we think crude oil spreads will continue to be a headwind.

Low inventory levels and higher natural gas prices will drive demand for coal in the third quarter. As always, weather conditions this summer will also influence demand. We will be better positioned to meet demand as our operational efficiencies improve.

In our Industrial Products business, frac sand will continue to benefit from shale-related activity. We think the strength in construction products will also continue, particularly in Texas and California. And we are cautiously optimistic that the housing market will strengthen in the second half of the year, driving our lumber shipments.

We think strong demand will continue in Domestic Intermodal as highway conversions and new product offerings drive growth. International Intermodal should benefit from an improving economy, though volumes in the third quarter could moderate because of the advanced shipments we saw in the second quarter.

The economy got off to a slow start this year, but it is showing signs of the modest strengthening we expected. Our strong value proposition and diverse franchise will again support business development efforts across the broad portfolio of business. If the economy cooperates, we expect a strong second half of the year.

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

Lance M. Fritz

Thanks, Eric, and good morning. Starting with our safety performance, we set first half records in 2 of our 3 major reportable metrics and improved in all 3 year-over-year. Our first half reportable personal injury rate of 1.01 set a first half record and improved 6% versus 2013. The team's commitment to risk reduction in Courage to Care and the Total Safety Culture overcame a challenging operating environment.

In terms of rail equipment incidents or derailments, our reportable rate improved 4% to 2.95 and also set a first half record. Continued investments in our infrastructure and advanced defect detection technology drove a reduction in track and equipment-induced derailments.

We also made progress on human factor incidents through enhanced skills training and root cause resolutions.

In public safety, our grade-crossing incident rate improved slightly versus 2013. To make continued progress, we are focused on improving or closing high-risk crossings, as well as reinforcing public awareness through our use of targeted safety campaigns.

In summary, the team has made terrific progress towards getting every one of our 47,000-plus employees home safely at the end of each day despite adverse weather conditions and the risk that comes with a stressed network.

Moving on to network performance. In April, we discussed the impact the polar vortex had on first quarter operations. Starting the second quarter, we generated sequential performance improvement while growing volumes. By late May, we felt we were well-positioned to continue to make incremental advancement.

Unfortunately, flooding severed a number of key quarters in June, including our east-west mainline, impacting our ability to generate the improvement we anticipated. The episodic weather events were compounded by an increase in track maintenance work and interchange fluidity issues. And as Jack noted earlier, while we were pleased to see increased demand, the network was challenged to absorb the stronger volumes while performing at sub-optimal levels. Fortunately, we were able to use our unique franchise to mitigate some of the impact. We adjusted transportation plans to use alternate switching yards and gateways and moved resources to where they were most needed. Using surge resources, we've increased our active locomotive fleet by more than 800 units and our total TE&Y workforce by around 800 since last fall, and we have more resources on the way. We've roughly doubled our TE&Y hiring plan from our original expectations and now plan to hire 3,200 TE&Y employees for the full year to cover both attrition and growth. In addition, we've added $150 million to this year's capital plan, which now includes a total of 229 new locomotives.

Our service performance fell short during the second quarter, which is reflected in the metrics we report each week to the AAR. Second quarter velocity was down 7% and freight car dwell up 12% when compared to 2013. The interruptions and subsequent limits on network capacity also drove a decline in our Service Delivery Index, a measure which gauges how well we are meeting overall customer commitments.

On a more positive note, we were able to maintain local service within a reasonable range, registering a 93.9% Industry Spot & Pull. This metric, which reflects the tighter service commitments we introduced this year, measures whether a car is delivered to or pulled from a customer's facility on time.

In addition to surge resources, infrastructure investments have also improved our resiliency. The team is working very hard to handle our customers' growing volumes while restoring the service they expect from us, and I am confident we are well-positioned to do so.

Speaking of demand, as Eric noted, the volume trends we saw earlier in the year were largely sustained in the second quarter, with volume growth in each region of our network. We realized productivity with a volume growth despite the headwinds we faced during the quarter. So while we incurred some incremental costs associated with the congested network, we handled 8% volume growth with a 5% increase in regional TE&Y workforce. Productivity improved from an increase in average train lengths in all major categories and from T-Plan adjustments that reduced online work events. Our dedicated craft professionals and managers generated these results using the 5 key drivers to make a difference in safety and productivity and in serving our customers.

One of those 5 key drivers is capital effectiveness. We increased our targeted 2014 capital spend back in May to around $4.1 billion. Roughly $2.4 billion of that is replacement capital, with most of that to renew our track infrastructure. We are on target for the year as roughly half of that program work is now complete. Spending for service growth and productivity will total around $1.2 billion. Capacity commercial facilities and equipment are the primary drivers.

This year's forecasted new capacity includes 56 miles of double track on the Sunset Route and another 300 million or so on the southern region. The investments in the South add critical capacity and fluidity to a historically constrained part of our network. We are also accelerating investments to support growing volumes in our north/south corridors. We're purchasing 229 locomotives, more than 400 freight cars, as well as 5,000 domestic containers.

Spending on Positive Train Control will total about $450 million for the year. All of these projects positively impact safety, whether they support replacement, service or growth. And the growth capital projects must meet aggressive return thresholds in order to be funded.

To wrap up, our first order of business is to safely improve network performance while serving customer demand. We are working hard to provide customers with a value proposition that supports growth with high level of service. As I mentioned in April, our recovery is partly dependent on interchange fluidity, so we continue to work with our connecting railroads to improve performance at key gateways. We expect to generate record safety results on our way towards an incident-free environment. Our investments in surge resources and network capacity have proved invaluable as we handle network challenges, service interruptions and increased demand. Our focus on reducing variability in the network has never been more important to generating sequential improvement.

Ultimately, safety and service will drive our ability to leverage unit growth to generate solid productivity, all of which creates value for our customers and 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 second quarter results. Operating revenue grew 10% to an all-time record of more than $6 billion, driven by strong volume growth and solid core pricing. Operating expenses totaled just over $3.8 billion, increasing 6% over last year.

Although operating challenges in our recovery efforts did increase costs during the quarter, our operating income still grew 17% to a record $2.2 billion.

Below the line, other income totaled $22 million, down 4% from 2013. Interest expense of $138 million was up 4% compared to the previous year, primarily driven by increased debt issuance during the first half of 2014. Income tax expense increased to $789 million, driven primarily by higher pretax earnings.

Net income grew 17% versus 2013, while the outstanding share balance declined 3% as a result of our continued share repurchase activity.

These results combined to produce best-ever quarterly earnings of $1.43 per share, up 21% versus last year.

Turning now to our top line. Freight revenue grew 10% to a quarterly record of just under $5.7 billion. This was driven primarily by volume growth of 8% and core pricing gains of just under 2.5%. Business mix was about 0.5% unfavorable as the positive mix impact in grain and frac sand volume was more than offset by the increase in Intermodal and shorter haul aggregate and cement shipments during the quarter.

Other revenue increased 12% in the quarter. Primary drivers included subsidiary-related volume growth, as well as the change in the way we handle per diem revenue on auto parts containers, which Eric just mentioned.

Slide 22 provides more detail on our core pricing trends in 2014. As we pointed out on our first quarter call, 2014 is a legacy light year, so we are not seeing the 0.5 of legacy benefit, which we achieved in 2013. Even without this legacy tailwind, our core pricing gain for the quarter was just under 2.5%. This was up slightly from the first quarter and also continue to exceed inflation, which remains low as we expected. We remain committed to a strategy of pricing to market at reinvestable levels that are above inflation. This enables us to earn the returns necessary for continued investment in our franchise.

Moving on to the expense side. Slide 23 provides a summary of our compensation and benefits expense, which increased 5% versus 2013. Higher volumes and inflation were the primary drivers of the increase, along with some increased costs associated with running a less than optimal network. Looking at our total workforce levels, our employee count was up 1% when compared to 2013. However, the reduction in the number of employees associated with capital projects helped to offset some of the increase in non-capital-related workforce levels. If you exclude capital-related employees, our workforce was actually up approximately 2.5%, with just over half of this increase coming into TE&Y.

For the full year in total, we plan to hire about 5,000 people to cover growth and expected attrition of just under 4,000. This total includes the TE&Y hiring, which Lance mentioned earlier. Over the long run, as we hire and train new employees for growth and attrition, we expect to see our workforce levels increase with volume, but not at the same rate. Lastly, we still expect labor inflation to come in under 2% for the full year.

Turning to the next slide. Fuel expense totaled $923 million, up 7% when compared to 2013, driven primarily by higher gross ton-miles associated with increased volumes. Compared to the second quarter of last year, our fuel consumption rate improved 1%, while our average fuel price was flat at $3.10 per gallon.

Moving on to our other expense categories. Purchased services and materials expense increased 9% to $636 million due to volume-related subsidiary contract expenses, higher locomotive and freight car material costs and crew transportation and lodging expenses. Depreciation expense was $470 million, up 7% compared to 2013, consistent with our 7% to 8% full year guidance.

Slide 26 summarizes the remaining 2 expense categories. Equipment and other rents expense totaled $316 million, which was up 5% when compared to 2013. Higher freight car rental expense was partially offset by lower freight car and container lease costs, resulting from the exercise of purchase options on some of our leased equipment.

Other expenses came in at $228 million, up $9 million versus last year. Year-over-year improvement in our freight damage costs and environmental expense was more than offset by increases in our property tax expense. For 2014, we still 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. Pricing the business at reinvestable levels and strong demand continues to drive our results. We achieved a quarterly record operating ratio of 63.5%, improving more than 2 points when compared to 2013. Through the first half of the year, we have achieved a 65.2% operating ratio, an improvement of 2.2 points over last year. We also remain committed to achieving strong cash generation and improving overall financial returns.

Turning now to our cash flow. Record first-half earnings resulted in cash from operations of over $3.2 billion. This is roughly flat with 2013, reflecting primarily the headwind this year in bonus depreciation and the timing of cash tax payments. Capital invested totaled $2.2 billion year-to-date. This includes about $260 million for the buyout of the financed lease on our headquarters building, which was put in place back in 2004 and is in addition to this year's $4.1 billion capital plan. In addition, we returned $776 million in dividend payments to our shareholders.

Taking a look at the balance sheet, we increased our adjusted debt by approximately $1.1 billion since the first of the year, bringing our adjusted debt balance to $13.9 billion at quarter end. This takes our adjusted debt-to-cap ratio to 39.4%, up from 37.6% at year end 2013.

We continue to work towards our targets of an adjusted debt-to-cap ratio of approximately 40% and adjusted debt-to-EBITDA ratio of about 1.5.

Opportunistic share repurchases continue to play an important role in our balanced approach to cash allocation. As you may recall, our new repurchase authorization of up to 120 million shares post-split over 4-year time period went into effect January 1 of this year.

Since the first of the year, we've bought back 16 million shares totaling about $1.5 billion. This brings our cumulative share repurchases since 2007 to 228 million shares. When you combine dividend payments with our share repurchases, we returned over $2.2 billion to our shareholders in the first half of this year alone. These combined payments represented a 51% increase over 2013, again demonstrating our continued commitment to increasing shareholder value.

So that's a recap of the second quarter results. As we look to the remainder of the year, continued strength in the economy, solid core pricing at reinvestable levels above inflation and improvement in network performance will help us achieve margin improvement, record financial results and strong returns for our shareholders.

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

John J. Koraleski

Okay. Thanks, Rob. As we move into the second half of the year, our network velocity and fluidity are improving, which will better position us to serve the strong demand we're currently seeing in the marketplace. With our increased capital budget of $4.1 billion, we are committed to invest in the resources necessary to run a safe, efficient, reliable railroad, which supports our value proposition for our customers, and we're optimistic about the second half of the year. As always, we are closely monitoring the economic landscape, along with the major drivers across all of our business segments, including the potential impact that weather could have on grain and coal.

As the economy gradually continues to improve, the power of our diverse franchise is providing business growth opportunities in all of our commodity groups. The men and women of Union Pacific are committed to safely improving our network performance, allowing us to provide customers with the excellent service they deserve while rewarding our shareholders with increasing returns.

So with that, we're going to open up the line for your questions.

Earnings Call Part 2:

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