聯合太平洋集團 (UNP) 2003 Q3 法說會逐字稿

Good morning and welcome to the Union Pacific third quarter earnings release teleconference.

At this time all participants are on a listen-only mode and the floor will be open for questions and comments following the presentation.

If at any point you wish to register your question pleases press one, four.

At this time it is my pleasure to turn the floor over to your host, Mr. Dick Davidson.

Sir, the floor is yours.

Good morning.

Thank you all for joining our quarterly earnings conference call.

With me this morning are Jim Young our CFO and Ike Evans, President of the Railroads.

Since we spoke to most of you a few weeks ago today's remarks will be fairly brief.

Jim will take you through the financials followed by Ike to discuss the Railroads third quarter, and I will provide some fourth quarter guidance and take your questions.

We entered the third quarter somewhat cautiously watching for signs of an economic pick up and hopeful the diesel prices would fall.

From an economy standpoint it is pretty much status quo going into the third quarter, the volumes did start to pick up and hit near record level by the end of September.

Diesel fuel hit both ends of the spectrum with nearly a 5-dollar per barrel price range during the quarter.

Against that backdrop with earned $1.21 per share in the third quarter compared to $1.63 a year ago.

That's not an apples to apples comparison.

Last year's earnings included 44 cents from the Utah Transit Authority land sale as a tax settlement.

In the first half of the year fuel continued to be a drain on earnings, adding nearly $50 million to our third quarter expense.

We also incurred another $15 million in expense to redeem the second $500 million trant as a convertible secured securities.

On the plus side record revenues totaled nearly $3 billion with a 4% increase year over year.

Our revenue growth was aided by positive pricing, fuel surcharges, R.C.A.F increases and our overall business mix.

But the strength of UPs revenue diversity was also evidence of the strong demand in three of our six business group, A.G. product, energy and industrial products.

Since 1987 Union Pacific has been dedicated to the principles of quality and being a quality company.

We truly believe that providing quality service costs less and history has proven time and again that our customers benefit from a quality approach as well.

Unfortunately our recent service performance has not been that of a quality company.

So while we turned in a record quarter it could have and should have been even better, both on the revenue and the cost side.

Although on a year over year basis we saw a reduction in our [inaudible] year costs third quarter results offset some of that progress as expenses increased in a number of areas due to service failures.

Both Jim and I will address these issues in more detail but let me assure you that we are totally focused on turning around this negative trends in our operations.

We will rely on our quality roots to guide our tackle plans for short term solutions as well as our long-term operating strategy.

With our focus on the reduction and elimination of errors that allows us to improve our service and enhance customer satisfaction.

We have done both in the past for many years and we are going to do it again in the future.

In total, the third quarter came in about as we expected.

Some problems operationally but otherwise a solid profitable quarter.

As I mentioned earlier we were pleased to report an all time record revenue level.

We saw very strong volumes from wheat harvest and the summer coal burn was good as well and we had good strength in the industrial products area.

We continue to cultivate new and profitable business relationships which is our customers such as United Parcel Service and we are proud of our ability to just not think but also operate outside the box.

A strength that we are beginning to leverage.

Overnight had another great quarter of revenue and operating income growth.

As you know we announced the IPO of overnight in August.

During the quarter it was still a part of the Union Pacific family and we were very happy for them to be there.

So now let me turn it over to Jim for a review of the financials.

Jim?

Thanks, Dick, and good morning everyone.

We'll start the financial review with the corporation third quarter income statement.

I want you to note since we announced the overnight IPO in August their earnings are now recorded separately as discontinued operations.

Operating income from continuing operations totalled $592 million for the third quarter of this year, down about 4% to a year ago.

I will cover the details here in a minute.

Other income of $15 million, that's down $145 million to a year ago.

You may remember last year we closed the property sale to the Utah Transit Authority for $141 million this year our results also include $15 million of expense for the early redemption of the second trench of our tides.

You recall we have now redeemed two-thirds of the outsiding tides.

Interest expense saved $17 million year over year as a result of lower debt levels, and rates our average debt levels are down $700 million compared to the same a year ago.

Our tax rate came in at 35.8, that's down an couple points to a year ago.

It's driven primarily by overall lower pre-tax income which is down about $155 million.

Overnite results as reflected in discontinued operations reported $17 million of net income this year.

I want you to note that a year ago the net income numbers include $34 million of net for a one time tax settlement.

That bring us down to a net income of $317 million or $1.21 a share.

You should note that the average diluted share outstanding for the quarter total 265 million shares, that's down 4% from a years ago.

Really illustrates the benefit of redeeming two-thirds of our tides.

Next slide, Dick showed you a slide earlier that compared 2002 to 2003 but let me break it down a little more for you.

A year ago third quarter EPS was $1.63 per share, of that 12 cents was from the tax estimate related overnight, six cents from overnight operations.

We also had 32 cents from the Utah Transit lands sale.

This nets down to $1.13 per diluted share which is comparable to the $1.15 per diluted share we earned this quarter from continuing operation.

In total we reported $1.21 which would include the sick cents from Overnite.

Talk about other income for a minute. we reported $15 million in the third quarter, that's a little more than expected due primarily to real estate sales coming in a little stronger than we anticipated.

Partially offsetting real estate was $15 million in tides early redemption cost, $5 million of that is for the 1% premium, $10 million for unamortized fees.

Fourth quarter outlook, you'll remember we had another large real estate sale last year where $73 million to the Santa Clara Valley Transit Authority.

Our current outlook is for other income to be in the range of $30 to $40 million pre-tax, a little above earlier expectations but we've got several small real estate transactions that are in the hopper.

There's a chance we could do even a little bit better than this but it really will depend on closing some cheap deals here in December.

Slide four, Ike will provide a little more detail on the revenue side of the railroad I want to talk about the average revenue per car.

You look at average revenue per car it was up over 3% it was the best ever for any quarter.

In fact we had three of our business groups, egg products up 5%, inter mobil up 3%, industrial up 4%, that's an all time best for ARC.

Now ARC is obviously not pure price here if you look at the three components here, fuel surcharge accounted for about $10 of the increase in, a, that's a little less than 1% that includes the fuel surcharge plus the RCF component.

Price excluding fuel was up about 1 percent, that's consistent with what we have seen all year and what we believe we will see going forward.

Then favorable mix added about $17 per car.

Fuel inner mobil containers, longer haul corn, and coal and then higher tons per units for coal.

Just note R.C.F component index in the third quarter was up 6.6%.

Right now the outlook for fourth quarter R.C.

F is to be up about 1.7%.

Take a minute to look at review of operations at the railroad.

Again, we have the impact of the accounting adjustment, FAS 143.

We recognize in the first quarter.

We show both the reported change which matches the financials as well as the year over year change when you adjust the 2003 numbers to exclude FAS 143.

Look at salaries and benefits, we reported a 6% increase, however if you adjust for FAS 143 which gives you really the apples to apples comparison labor costs were up about 3% on a 3% increase in gross ton miles.

You also note that our total employee counts came in about 46,400, that's down 3% to a year ago, as Dick mentioned this is a little bit lower than what we wanted in particular when you look at gross ton miles or volumes up about 3%.

Rent expense, good news story down about 3 percent, higher off-line receipts, a little bit favorable mix and little bit lower rates offset a slight increase in our car cycle times.

Look at fuel and utilities, it was up $53 million or 19%.

Fuel prices are a big driver, paid 90 cents a gallon this year versus 75 cents a gallon a year ago.

We do, however, continue to improve our consumption rate.

In fact third quarter this year was our best ever consumption rate for fuel, improved about 2%.

I'll talk a little bit more about fourth quarter fuel here in a minute.

Purchase services and other, up 21%.

Again we have seen this all year, it's a litany of things, higher state and local taxes, locomotives maintenance contracts, insurance, rates associated with Intermodal, this should be a little bit lower in the fourth quarter of this year.

Put it all together we had at the railroad 4% increase in revenue, 6% increase in cost which drove our operating income down around 4 percent, the operating margin did decrease from a years ago by about 1.7 points.

It's primarily driven by higher energy costs.

Take a minute here to look at fuel.

The chart shows our average price per gallon paid by quarter both last year and this year.

We paid about 81 cents in fourth quarter a year ago and our outlook is between 85 and 90 cents for the fourth quarter this year.

We did take advantage of a small window in September when prices fell to hedge an additional 17% over fourth quarter fuel.

So we now have hedged 24% of our fourth quarter fuel at 81 cents per gallon.

We also put in place collars for about 7% of fourth quarter fuel.

Those collars have a floor of 81 and a cap of 91 cents.

Spot fuel right now is running about 92 cents in the fourth quarter.

A total for the year, we will likely see fuel prices that are about 20 cents higher year over year costing us an additional $250 million.

Again we are doing a better job on cost recovery.

Right now it looks like our fuel surcharge programs will recover about 40% of our fuel.

Obviously we still as would our customers like to see overall lower energy prices.

We have nothing hedged at this point for 2004.

We have put in some collars in terms of first quarter, we've collared about 11% of our fuel, between 81 and 91cents and then the remaining of the year we have about 7% collared at 77 to 86 cents.

The futures market on next years fuel right now throughout 85 cents.

Quick look at Overnite, as we discussed when the IPO prices at overnight they still reported our earnings for the quarter.

We need to go back one slide here, please.

There we go.

Overnight at I mentioned in the IPO process good performance operating revenues up 8%, operating income up 13% and improvement in their operating ratio, we are still at registration and the road show is in process so we really can't say much else.

Last slide will take a look at cash and give you our full year projection.

On the left side of the chart shows cash flow from operations and the other side free cash flow dividends.

Right now we are looking at about $2.5 billion cash from operations this is up over 10% to about $250 million from last year.

Free cash flow which we look at after the payment of dividends is on target to come in over $500 million for the year.

This includes the pull ahead of 46 locomotives which we will pay with cash for $84 million from next year as part of our strategy to improve service.

Ike will cover that in a little more detail here in a minute.

I also wanted to note, you may have, I hope you've seen we did get our ratings upgrade from Moody's.

We were moved from a Baa3 to Baa2.

We are real pleased with that.

I should also point out that our free cash flow out look excludes any of the proceeds for Overnite.

These proceeds would be in addition to these numbers.

That completes the financial review.

We will now turn it over to Ike.

Thanks, Jim and good morning.

As Dick mentioned third quarter revenue was the best ever so I will start by summarizing our revenue performance.

Agriculture products was core leader both in car loading and revenue.

Wheat revenue was up 45% and Ethanol revenue increased nearly 70% to $12 million.

Our express lane business which as you know is a key highway conversion program for us continues to grow approximately with almost a 10% revenue growth on a 6% increase in volume.

Industrial products extended its strength of seven consecutive quarters of year over year revenue growth with its best ever quarterly performance.

This team of the 16 product lines experienced growth was double-digit gains at lumber, scrap, metallic minerals, waste and government shipments.

Energy had another great quarter as well as setting new records for revenue for quarterly revenue and trains per day out of the southern basin.

Productivity gains also continued as total tons hauled, tons per train, tons per car and cars per train all hit new benchmark levels.

Our chemicals business has flat revenue despite continued high feed stock prices and weak demands and while plastic volumes were down nearly 7% in the quarter price increases resulted in plastics revenue growth of almost 1%.

Intermodal is another good pricing story for us, flat revenue on a 3% decline in volume.

This reflects our ability to replace international business with higher margin premium moves.

You'll also see a little bit of the ILW effect from last year where we experienced normally high volumes in advance of the block outside.

Finally our automotive groups revenue was down 3% on a 2% decline in volume.

The key driver of course was lower automotive production.

There is also a silver lining here.

We are leveraging our auto network to convert truckloads into rail car loads into auto parts volume grew 13% while revenue was up more than 16%.

In total the modal revenues grew almost 4% in the quarter our strongest growth of the year.

Each quarter we talk with you about productivity and as you know it's the key efficiency measure at our company.

In the third quarter we saw a 3% increase in gross ton miles and an all time quarterly best and in fact August was our single best month ever and we moved at this rate with the 3% fewer employees.

We did incur some additional failure costs by running a little short on crews in the third quarter.

We missed that sweet spot between labor expense and quality cost, resulting in some additional short term expenses.

We are correcting this and remain committed to do our goal of achieving at least 5% productivity year over year.

Speaking of employment levels, we have historically hired 1,000 to 2,000 people every year to partially offset our attrition.

This year you will see a similar trends.

Total hirings should be about two thousands but our average year end head counter should still be down around 2%.

Next year we anticipate an attrition loss of roughly 2500 to 3500 employees.

Depending on our volume growth and productivity we expect to higher another 2,000 to 3,000 employees.

This next slides shows a few of our service metrics comparing the third quarter of 2002 to this year's measures.

Clearly we are not happy with our recent performance and we've taken steps to get thing back in shape.

Long-term hiring efforts I just mentioned are one part of that plan.

We have also simplified train service transfers for all employees initiated efforts to higher experienced employees from other railroads on a short-term basis temporarily reassigned selected employees to field operations and shifted R.C L. trainers back into train service to provide immediate relief in key areas.

We've also pulled ahead to purchase 46 A.C. locomotives from 2004 to further boost our efforts.

Importantly these changes are already producing positive results.

Unfortunately network inefficiency has also impacted our customer satisfaction index.

During the third quarter customer satisfaction slipped below our record-setting first half performance as did our service delivery index.

We realize that our recent service levels have not met our customers or our own expectations.

Everyone is focused on improving our services in a save expeditious manner.

On the topic of safety this is an area that I am proud to say has continued to improve.

We believe running a safe railroad is the foundation for overall operational success so even one accident or injury is one too many.

We still have work to do but we are focused and we are making progress.

Looking ahead to the fourth quarter, let me give you a few thoughts on what we see as the strength and weaknesses.

Intermodal will have an easier comparisons versus last year as a result of the ILW lock out.

In addition international shipping peak is later this year and we are seeing more of this volume in the fourth quarter than we traditionally would.

Gold should be another strong positive in the quarter for us as demands continues to be strong in our service territories.

The grain harvest is well underway and demand remains solid.

This could taper off later in the quarter and we would still look for good year over year improvements.

Industrial products continues its winning ways, winning business from trucks and moving the lumber, scrap and rock that our customers are demanding.

On the negative side, high energy prices continue to challenge our chemical customers and demands really hasn't strengthened all that much.

We really don't see any upside with finished vehicles as the demands remains soft.

Overall, though, we look for another quarter of solid revenue growth.

As we progress through the fourth quarter and into next year we are improving operationally and we will continue to improve.

We are focused on the operating challenges we face and have the necessary plans in place to resolve these issues.

An unmatched franchise, a diverse customer base and dedicated employees comprise the great foundation upon which this company is built.

It's from this firm base that we will leverage our collective time and talents to make Union Pacific one of this Nations's best companies.

Dick?

Thank you.

We certainly have great potential in the fourth quarter.

At our analyst meeting a few weeks ago Jim walked through an outline of our expectations for the quarter which included many of those same themes.

In general, we are pretty bullish about the fourth quarter.

As Ike mentioned revenue could have solid growth again this quarter due in part to last year's ILWU port disruption but also aided by strong grain and coal demand.

Although volumes in October are running a little behind September's pace we are cautiously optimistic we are seeing more broad-based growth and economic conditions that are improving.

We would also expect our operations to get stronger during the quarter, enabling us to enter 2004 with a balance fluid system that's positioned for new growth and new business.

On the expense side, well likely see a moderation in the added quarterly fuel expense.

The fuel prices are still volatile and will come in above the 81 cents per gallon average we paid the fourth quarter last year.

We will ends 2003 with strong free cash in excess of $500 million for the year and the Overnite IPO should be completed shortly.

The road show is in progress now and we would expect the transaction to close in the next week or so adding even more cash to our books and giving us great financial flexibility.

In fact our financial strength was recognized by Moody's, as Jim said, earlier this week with an upgrade in our debt rating.

We are pleased with that announcements and are committed to maintaining a strong balance sheet.

Comparing last year's fourth quarter earnings to this year's outlook is a little bit complicated with all the changes year over year.

Last year we reported $1.41 which included 3 cents from Overnite.

With also had 16 cents from a land sale at the Santa Clara Valley Transportation Authority and 15 cents from tax adjustments.

So from an adjusted base we would expect to exceed last year's fourth quarter by a dime or so with some upside potential depending on fuel prices.

As we move through the fourth quarter and look ahead to '04 we can't help to be excited about the future of this company.

We are committed to our quality process and believe that we are making the right decisions to make this a fine company and a great company.

We have the franchise, the people and products to deliver high quality service for our customers and generate above average returns for our shareholders.

So we thank you for listening to us today and with that we'd be glad to take your questions.

Thank you.

The floor is now open for questions.

You may register your question by pressing one, four on your touch-tone telephone at this time.

Your first question is coming from John Barnes of Deutsche Banc.

Please go ahead with your question.

Good morning, guys.

Jim, just as clarification for everybody, Overnite will show up as a discontinued operation for next quarter and then starting first quarter of '04 it kind of falls off?

Correct.

Okay.

In terms of the fuel surcharge, 30 percent, 40% recovery that you are seeing, can you remind us again what percentage of your business is covered, I'm not talking about the, a half, I'm talking about pure Union Pacific implemented fuel surcharge and what is your opportunity for, what's the total recovery amount we should see?

Or potentially see?

John there's two measures.

You have a lot of contracts where you can kick in $31 a barrel, I look to look at pure coverage right now.

We believe longer term released the next couple years at 40 to 50% recovery is about the right number, the number of contracts or businesses that's covered is probably up in the 60, 70% range overall.

But that's not highly relevant to me.

It is what is the actual recovery rate.

Okay.

Dick, one question for you on couldn't question in the railroad as a whole we asked this question, it's fallen off the radar screen but it seems to have reappeared here recently, the downturn in the economy certainly held alleviate a lot of bottlenecks in the system.

You were farther along there were still bottlenecks in the system and lower volumes help.

As we see this ramp up in the economy, which signs to be gaining some momentum, are you worried at all that step wide and I am talking about all the northern American railroads could run into some congestion problems again or do you have issues we have seen in recent weeks are isolated to the companies just facing the same things you are, higher attrition has cut into train crews and that type of things?

John, that's a very far reaching question and I must tell you I would be a lot more comfortable with you asking the other railroads about their own situations than me offering insight on their situation.

I can talk about the Union Pacific.

You know, you shouldn't have any thought in your mind that we are at capacity as far as the physical structure of our railroad.

We have a focused effort now for five, six years on removing bottlenecks that's something we go through every year and take out the areas where are capacity is most constricted and it's been very successful.

That's how we won a lot of this premium business.

Our problem, pure and simple, just like we said in St. Louis, is we are really tight on employees, we are playing it coast to close to the invest going into the years until we see the whites of their eyes and we've seen it and business is growing and we are remediating that as quick as we can and we also had a big maintenance effort as you heard us say where we are going to install nearly 4.5 million ties, probably a 30% bigger program than we ever had in our history.

We had a strong de-bottlenecking effort than we had in years and that's what we look at how can we make the railroad more fluid as we get our employees hired and our locomotive sweet enlarged a little bit when the gun is clocked and running we will come out of the chute bucking and jumping hereby the end of this quarter.

Thanks.

Thank you.

Next question is coming from Scott Flower of Smith Barney.

Please go ahead with your question.

Good morning, all.

Just a couple of quick questions.

One of the, I know your meeting in St. Louis as well as today you talked about the steps you are talking taking to try to resolve the issues.

Where are we in that process should we expect that by the end of this quarter or even the end of October we will be more to a system you will find acceptable and related to that is this in terms of the customer service delivery index, will the customer index take a couple of quarters to bounce back how does that affect the customers and where is the impact greatest, was it among your industrial merchandise customer as opposed to Intermodal and perhaps the coal services?

Let me say this.

I will let Ike talk about the customer satisfaction index as far as our hiring and getting people into position so far this month we placed a couple hundred I guess train service employees out there and the pipeline as far as training goes is really setting up nicely but the big graduation class is going to come in November and early December.

That's also coincides with the additional 46 locomotives we are pulling ahead.

We will get them in November.

So it's not going to be an overnight thing where we get the railroad as good as we like but we should see day by day improvement throughout this fourth quarter.

I would expect by the first of the year we are going to be at normal levels and improving.

I can, you want to.

The only thing I would add is service is locations specific.

It's not across our network.

It's location specific and it's been about four locations and we are as Dick said addressing it and clearly are already on the mend.

I agree with the time frame that Dick outlined.

On the customer satisfaction index we are finding it's got about a thirty-day lag to it so I don't see that over a longer period of time.

I think a period of 30 days is about the right and as we talk our premium service and that in areas like that have been unaffected at all by that.

So it's been scattered but it's been location specific.

So it's not across the network as far as the customer concerns as well.

I know that LA has been one area but can you give me a sense of where the other major areas may be, in the Gulf Coast or where else on the network might they be?

Primarily on the West Coast, Scott.

Two other quick questions.

One is relative to cap ex, I know thank you talked about pulling forward and obviously that's about 100 million incremental to this is are this year's cap ex, two questions off of that should we expect about 2 billion of cap ex this year and what, do we see an equal drop next year or do we see a further pull ahead in '05 to '04 and next year's numbers will stay at $2 billion.

We always guide people to a figure on about a $2 billion capital program going forward and that hasn't changed.

This year's program will still be under $2 billion even with the additional locomotives, I think about a little over 1,000,000,009.

With haven't finalized next year's plans 1.9 billion.

With don't see a big locomotive pull ahead for '04.

As you're aware we had a strong locomotive purchase program for the last five, six years.

I think we acquired something over 3,000 new locomotives in the last four, five, six years.

Consequently we've got the most modern, up today to date technologically advanced locomotive fleet in America and we will always be in the market year after year after year keeping that fleet strong.

Okay.

One last quick question, I guess this would be for Jim, it's really more information a administrative, on the tax rate what should we use going forward is the 358, you described the reasons for that, that has some implications or catch up from earlier parts of the quarter that was a cumulative effect from the prior three quarters and looking forward what should we be using as a run rate tax rate for you all?

You know, Scott I would say between 37 and 38.

You can split it down the middle would be a good playing number.

Did any of the 358 be related to the prior quarters, because of the income level for the year, some of the Delta from 358 to that sort of run rate you just described related to 1 and 2Q.

I think if you look at the full year number here we are going to come out a little bit over probably 37 or so.

Okay.

Great.

Thanks very much.

Our next question is coming from Thomas Wadewitz of Bear Stearns.

Good morning, everybody.

I have two questions for you.

These may be primarily for Jim.

As we look at the comp and benefit sides it seems you had two different factors you are doing good with the head count reduction year over year in the third quarter.

My sense is maybe that doesn't look quite as good as you have more crews coming in you have the per worker number which is up 9.8% year over year.

I'm assuming a fair bit of that is over time.

Your overall comp and benefits performance, does it tend to get better or worse as you get the network more fluid but you have higher crew count?

Can you give me this directionally how I should look at that?

Tom, that's whereas the network slows down you will see failure costs show up on the labor line.

A lot of our crews are, both time and primarily mileage but also time, for example for example recrew rates will come in there there's one odd factor that's driving that cost up.

Remember labor protection cost, we have about $20 million of labor protection cost recorded on that line this year that was going against a reserve last year.

So you have a little bit of apples to oranges there.

The mix actually also comes into play.

A lot of the fail out or reduction in jobs have come in really the back office areas and as you know our T. N.Y., the average wages per T. N. Y. employers are the highest in our business.

There's also a little bit of a mix here.

Bottom line going forward you improve the very well loft we will velocity we will see that improve.

The unit cost will continue to come down.

Jim, can you give me any senses for next year, the net would work gets more fluid you have the different factors play out the way you expect.

What's the right run rate for inflation on a per worker basis, is it three, 4% for next year?

Inflation rate we are planning just pure inflation is probably in the four, 4.5% range with benefits.

That doesn't count productivity and you have to also be careful what you do with volume when you look at that line.

Okay.

Good and then one last question for you.

CSX came out kind of late last night and had a change in their accounting for asbestos.

I wonder if you could refresh for us how you account for that?

I think their best change is they are looking forward and now trying to have a reserve for the future liability.

Is that something you do now looking forward or is it just with already filed claims?

No, Tom, in fact I think CP and Union Pacific both we look at just a case-by-case basis here.

As we've said here consistently we feel we are in good shape in terms of our accruals.

I didn't say the exact detail on the CSX deal, but overall our accruals and the way we approach it today is we feel in good shape.

But there's no sense that since others have moved that way you would consider that?

It's not something you are looking at.

You never say never on something like that but our auditors are comfortable when we attempt to look forward.

It's pretty uncertain when you look at that world particularly with changes and discussions up in Washington.

Great.

Thank you very much.

Thank you.

Your next question is coming from [Jennifer Ritter] of Lehman Brothers.

Good morning.

Hoping you could give a little more explanation and I apologize if I missed it on the tax adjustments, real estate and tax adjustment on your fourth quarter earnings out look?

Jennifer, are you talking about a year ago?

Actually now it makes sense.

I thought you were saying it was going to happen in the fourth quarter.

But I see that it makes sense.

Okay.

Thanks.

Thank you, that's the best kind of a question.

One of those mornings.

Thank you.

Your this question is coming from Ken Hoexter of Merrill Lynch.

Please go ahead.

Hi, good morning.

Jim just real quick on the follow up there, you said four to 4.5% inflation per worker including benefits.

Does that include any impacts from any pension, increased pension expense or anything else or is that just an all in kind of four to 4.5% increase there?

You know, the pension expense would only hit on what we call nonagreement employees but that would include all in.

Okay. great.

Secondly, Dick mentioned at the end in his review there, I think you said volumes in October were running a little bit behind September pace but still the economy is building.

Is that because of the certain sectors that you are seeing increase now or where would, where is that confidence coming from?

Well, we are seeing very strong growth in the industrial products area as we talked about when should be a good accounts receivable been engineer of things to come, things like lumber or housing, construction, stone and sands and gravel, cement for highways and buildings and offices, scrap for steel.

Most areas of industrial products, in fact, I think all but one line item that we of the 18 we measure is very positive.

While automotive is down a little bit we are comparing against record levels so auto sales, while they are not as strong as the manufacturers or us either one would like, are still excellent.

Our ag business is very strong, our energy business is very strong.

One area of real disappointment is chemicals because of the high stock feed cost.

No question about it is retarding kept chemical production, but it feels to us like business has got a stronger tone to it.

Sounds great.

Just a final question, perhaps it goes to Ike or anyone on coal contracts obviously we heard a lot of back and forth of contracts that are being win and lost against Burlington northern.

Can you talk a little bit about kind of your pricing strategy with respect to continual rollover of contracts and talk about if you have any more large contracts coming up for expiration in the next quarter or so?

Let me start and Ike will add a lot of tech color to this.

Our game plan is pure and simple.

With look at every deal that comes down the road and we bid it based on our all in cost, capital requirement, whatever else goes into it to meet an acceptable profitability standard for us.

As I said many, many times coal was the second more profitable commodity we handle.

That's our strategy pure and simple.

Ike, I'm not sure about the contract expirations and renewal.

We are in pretty good shape as we look forward into '04.

Next year we expect to see an up contribution and up price as well as on the coal side.

The other thing on your first question, Ken, is we have the opportunity for truck conversion and even in softer markets we still have the opportunity to do that and that's really where our focus is on the truck conversion side and we are making great progress there in all of our commodities groups that are applicable.

Thanks a lot.

Your next question is coming from Gary Yablon with Credit Suisse First Boston.

Hi, guys.

I want to focus my question on the cost side of the house if I could.

Jim, getting back to the issue of inflation you talked four, 4.5% or so just on a per head basis.

Can you tell me a little bit how things look on the productivity side, let's say for '04 and '05, how much can you offset that how confident do you feel, so on, if we can touch on that?

Gary we set our target as a minimum 5% productivity.

That assumes you've got a decent economy, we are handling volume that you do lever nicely that is our goal if you look at over time we've succeeded in that obviously mergers have helped, but we look at 5% as the number.

Again, volume will be a big driver of that in terms of leveraging the volume on the unit cost basis.

I want to make sure I am reading the five right.

Does the five mean that the labor cost in dollars in a modest unit environment, the labor cost in dollars would be flat?

What you look at, there's three components.

You have your core inflation, you have productivity and you have volume.

The latter two could be related but you can also get productivity by reducing failure costs, by technology deployment, capital investment will generate returns.

You would not see the labor line, that would imply that you have a pure no increase in labor.

I don't see it that way.

If you have three plus percent volume growth next year you would see some increase in labor costs.

But again overall unit costs would be driven down.

I'm not going to give you the exact numbers.

You can do the math in ranges but that's how we would see it.

Okay.

Fair enough.

Okay.

Purchase services and other expenses were up pretty sharply in the quarter.

I know you talked about them being a bit higher.

Where is that going in the future, is that a number you're okay with or are there some of the inefficiencies that crept into the system in that particular line item?

It's been up all year as I look at next year obviously we will not see this kind of an increase.

This year was really unusual.

You will see a little bit, for example, Intermodal as that picks up you will see that cost goes up a little bit, you have state and local property taxes.

A lot of the states have some challenges.

You are going to see those costs come under pressure.

But, you know, we've seen a double-digit increase this year when you look at that line item it will be single digits next year.

Okay.

And I guess this one is for Dick, maybe for Dick and Jim, the earnings guidance, I want to make sure I am not reading too much or not enough into this, the earnings guidance in Q4 assumes at least relative to my model a bigger real estate component than we had expected but it's about the same earnings number.

Is there something about the core operations of the railroad that you feel a little less comfortable about or is this just in the spirit of being cautious on guidance?

We are being cautious but also if you remember Dick mentioned fuel prices.

If you look at the number we have been all over the place higher and we did get some hedge in but I tell you our fuel prices have been anywhere from 81 cents to $1.05 and that volatility is pretty tough to predict.

It has come back down.

I think the spot today is in the mid 90s price so you really do need to look at fuel price.

Again, depending on where the economy goes here, we are seeing some strength but we have seen all quarter here one of the things we mentioned we see very strong strength toward the end of the quarter, you turn around start out a new quarter, in fact what we saw in October we got a pretty good fall off.

A lot of our customers are managing their inventories pretty tight so we are being cautious here.

Is October normally a better month than September?

They are both strong, actually, comparable.

Okay.

And August is strong.

You have a three-month period there where you have strong business normally in all three months.

All right.

Thanks a lot.

Your next question is coming from James Valentine of Morgan Stanley.

Please go ahead with your question.

Good morning.

Two questions, first this might be for Ike, maybe you mentioned this, but I missed it.

In terms of trying to quantify the congestion cost you did a really good job of trying to compute failure costs and I suspect that includes overnight [INAUDIBLE] rates and so forth, when we try to look at the third quarter of next year presuming it would be running much more back to norm, how much we could take out in terms of costs and where they would come from?

Jim, we didn't spend an awful lot of time trying to get this to the third decimal point or anything, but I think safely $15 or $20 million.

And some utilization.

Locomotive, straight cars, the whole gamut asset utilization was about as good as we would have liked to have seen.

And the second question and I hate to circle back to this issue of coal but it is arguably without a doubt its the number one question from clients over and over again.

The question is not will you keep coal profitable and among the top one or two or three commodities, but you say it's the second most profitable commodity why don't make it the most profitable commodity?

Knowing that utilities are fairly inelastic with their demand here, they are going to have to buy this coal and you see figures that western coal could go up four, $5,000 a ton, why is there not motivation to say we can generate more shareholder value by taking the pricing up, why wouldn't that be the direction?

I would love for coal to be most profitable, but unfortunately market set prices, Jim and I think Dick did a good job and how we look at these major contracts when they come you up.

At the end of the day determines where we are going to be there and it's not any more complicated than that.

The market I hear you but it's, if we look BM they are going to renew customer retention programs it sounds like a price war, I guess they just lost an ANP contract for '05 and they said they are going to go out and sell it that sounds to me that they are going to try to get the business back.

Is there any reason why we shouldn't be at least mildly concerned that pricing is will continuing to decline or decline even faster into '05, '06?

I don't think it would be appropriate for us to comment on BM's pricing policy.

We just know how we do our own.

I can tell you our contribution levels for energy for next year will be up over last this year.

We will be more profitable next year on our energy business than we were this year.

That's really the bottom line.

What do you bring to the bottom line?

We have good productivity and Dick is right, we really can't appropriately answer what the BM is doing.

We have to answer what we are going to do.

Thanks, appreciate it.

Thank you.

Your next question is coming from [Gregory Burns] of J. P. Morgan.

Please go ahead with your question.

Just a quick question what the near term coal outlook?

You sound positive and I was wondering if that was a view in inventory levels or a view in we think they are or whether the comps are easy, what's driving your near near term outlook in that category?

The answer is that overall we are seeing the slope of the line is moved up.

Its at times a little saw tooth but we are seeing some strength in most of our businesses as Dick outlined.

The ones that are weak are chemicals because of high feed stocks and autos are, although very, very good are coming off of very, very difficult comparison and we expect to is sea solid energy as well.

Just following up on the question about coal being higher contribution next year, is that an all in contribution including capital costs, sort of return on capital allocated coal will be higher next year?

Yes.

Okay.

Actually, you know, one thing we ought to point out there is that the capital cost to do coal is going to be a declining issue for us going forward.

If you are not familiar with it Greg because you just started following the railroads here recently but we had enormous costs early on building up capacity into the powder river basin and as of the end of this year our coal line is running from northwest Nebraska up to the joint territory will be 100% double track CPC railroad concrete ties and we'll have enough capacity there now to take us well into the future.

We can accommodate a lot of growth with very little incremental capital.

That's really a good news for us.

We have a great property now connecting us with the joint track in Wyoming.

If we looked at those as single business cap ex will continue to fall below depreciation in that business line essentially?

I don't think about things in those terms.

Just on a straightforward basis it will take less capital investment to grow the business.

Great.

Thanks a lot.

Thank you.

Your next question is coming from Donald Broughton of A.G. Edwards.

Good morning.

I'd like to take a little bit more of a macro situation with the dollar a full 20% less than it was a year ago, I am looking at your numbers in ag and I am wondering number how much of any of the commodity groups is being driven by improved export demand because our commodities look better in the world market?

It has helped us a little bit has been the dollar, U.S. dollar versus the Canadian dollar and it made U.S. lumber more competitive than Canadian.

But I think, at this point in time, however over a longer period of time there can be more implications but at this time in time, that's what we would see.

Was your question grain?

I thought grain was up as well as looking through the other groups wondering whether or not there were others.

Oh.

Thank you.

Your next question is coming from from [Fritz Voncarp of Sage Asset Management].

Please go ahead.

Good morning.

Just quickly you talked about the capital program vis-a-vis the locomotives.

Can you talk about the capital program vis-a-vis cars of various types?

Thank you.

Well, not really.

We haven't finalized our capital program for '04 yet so it would probably be inappropriate to jump off into that.

This year our capital spending for freight cars was relatively modest, do you remember,?

50 million or so.

And most of that would be for these new refrigerated boxcars we are acquiring.

We had 500 of those in this years capital program, I believe.

It will be in that range or more next year but we haven't finalized it.

Thank you.

Thank you.

Our last question is coming from Stephen Simmons of Flippin.

Please go ahead.

Just a follow up on a previous question.

If you can't comment on congestion, you need locomotives to remove some of the congestion.

What about the excess rail car supply off the tracks, say years ago versus today, can you just give some color as to how much of that excess supply has been a move back on to the tracks?

Very little.

As of this morning if I remember right we had about 316,000 cars on line and last year at this time we were about 312,000 so it's very little.

So given the increases you are seeing in commodity grain, coal, I guess your comments about spending will be probably flat next year, maybe it's up a little bit compared to this year for cars?

Here's the situation on freight cars.

We've got to get our forecast put together first and see what -- how our car supply meets us with, I wouldn't be surprised at all if we increased spending a bit, but it's just premature right now.

We are just not that far yet.

Okay.

Great.

Thanks.

Thank you.

This does conclude today's teleconference.

You may disconnect your lines at this time and have a wonderful day.

Thank you.

Thank you Maria.

Not a problem, sir.

Have a great day.