聯合太平洋集團 (UNP) 2004 Q2 法說會逐字稿

Good morning and welcome Union Pacific's 2nd quarter earnings release teleconference. [Operator Instructions]

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

Thank you, Maria. Good morning and thank you all for joining us at our second-quarter earnings conference call. With me today here is Ike Evans, our Vice-Chairman. Jim Young, President, and Rob Knight, our CFO. Rob will walk you through our financial details and then Jim will provide an update on our strong revenue performance and continued service recovery efforts. I will then return after their comments to give you our current thinking on the outlook for the month ahead. And then Ike will join us when we open it up to your questions.

Today we are reporting 60 cents per share compared to $1.05 per share for continuing operations a year ago. This is at the lower end of our most recent guidance range of 60 to 65 cents per share and includes about a nickel for costs associated with the San Antonio derailment which occurred last -- the last week of the quarter.

Our quarterly operating revenues topped the $3 billion mark for first time ever in the history of our railroad. And that could have been even stronger given that the unprecedented levels of demand has been experienced here. Unfortunately, however, while our service metrics has stabilized, we have not yet seen the improvement necessary to reduce costs or drive stronger revenue growth. Because of this, we were unable to convert the record revenue to the bottom line.

Rob will take you through the details of our operating expenses. But we estimate that our service issues added roughly $100 million to our expense line. In addition, a record average diesel price of $1.16 per gallon, inflated costs by over $90 million or roughly 22 cents a share. We were able to offset a portion of this increase fuel expense through our fuel surcharge program, but there is a lag in the timing of that recovery mechanism.

Now before I turn it over to Rob, I want to personally assure you that everyone in the Union Pacific management team is absolutely focused on resolving the operational issues that have temporarily limited our profitability. We know we aren't living up to the potential of this great company, but I believe we are taking the right steps to turn things around and look forward to serving additional demand of prices that will earn higher revenues for our shareholders.

Rob.

Thanks, Dick. And good morning.

As Dick just mentioned, our second-quarter earnings were greatly impacted by both our service issues as well as high diesel prices. I would like to start today with a review of both the good news and the bad news in the quarter. Our revenue performance and our operating expenses. On the revenue side, we had 5% growth to a record $3 billion for the railroad. But that revenue growth was consumed by higher operating expenses which were up 16% in the quarter. As I walk through the individual line items that make up our operating expense, I will provide some detail on the service costs.

In total, we had roughly $100 million in operating expenses that are directly attributable to our operating difficulties. These failure costs are greater than in the first quarter but as you will recall, our operation slowed throughout February and March to an average velocity of 21.9 miles per hour in the first quarter. Second-quarter velocity stabilized, but at a slower rate, 21.3 miles per hour on average for the full quarter. The entire quarter's financial results were burdened with greater operating inefficiencies as well as increased resource costs.

Before I get further into the expense detail, let me turn for a minute to the commodity revenue. Second-quarter commodity revenue reached a record $2.9 billion, up 5% year-over-year. The drivers of that growth can be broken down as follows: Volume increases and the mix of business added 3% to revenue growth. All of our commodity groups had quarterly carload growth and in fact we saw in the first quarter we set new records each month for the seven-day car loadings. Individually, Chemicals had a 6% increase and AG products was up 5%. These two groups were also the key drivers in our mix improvement with their higher average revenue per car. Fuel surcharge programs, including the fuel portion of RCAF added 1% to our revenue growth. I will talk more about our surcharge programs in a moment, but right now, we have about 80% of our total business covered by some type of a fuel recovery mechanism. Our pricing efforts added another 1% to our quarterly growth, with both AG and Industrial Products continuing to see greater than 2% price improvement. While 1% may seem a bit under whelming, this price increase is across our entire book of business. Of course for us to average 1% all end, the actual increases on the business we repriced in any given quarter must be greater than one.

Before I go through the quarterly expense detail, let me start with a brief summary of the major drivers to our cost performance. As you might recall, the second quarter of last year was one of the best operating quarters for us. Unfortunately, against this benchmark quarter, we had our service difficulties and a few other unusual items. Starting out, higher fuel prices added $93 million. Service inefficiencies and slower network velocity added a little over $75 million. This is spread across the various express lines and I will break that out as I walk you through the details of the income statement. The incremental hiring and training we are doing to backfill attrition and staff for growth added 25 million. Our service incident in San Antonio totaled roughly 22 million and other costs primarily associated with our headquarters consolidation in 2003 depreciation rate changes further contributed $40 million to the quarter.

Turning back to the individual expense lines, we will start off looking at salaries and benefits. We are up 10% in the quarter for a $96 million increase. A portion of the increase cost is due to additional employees that we hired. In the second-quarter, our average employees were up 3% or slightly over 1,500 net employees. Our cost-per-employee is up almost 7% in the quarter, largely due to service issues. For the quarter, we would estimate that incremental training added almost $25 million in expense, while items such as higher crew costs and increased recrew rates added $36 million. Another increased cost item totaling just under $6 million relates to the consolidation of employees into Omaha which you recall started in May. Although these costs will effectively lower our operating margin in 2004, the move is basically earnings neutral offsetting tax benefits.

In total, our increased expenses far outweigh the year-over-year good news that we achieved from lower protection payments and the remote-control productivity. Looking out to the last half of the year, we will continue to see some inflation in this expense line as we continue to add train and engine employees. For the full year, our average head count will be up about 1500 to 1600 employees or between 3 and 4%. Importantly, the increase in employees is entirely within the ranks of train and engine men which relate to our demand. In total for the year, we will hire and graduate 5,000 new conductors into train service. The offset to some of our hiring is an estimated 7% decrease in trainmen through expected attrition and retirements. Part of this hiring is to help us get ahead of the expected curve for next year. At year-end, roughly 1500 employees will still be in training ready for graduation in 2005 and positioning us for the anticipated demand. Continued high attrition in the years ahead will allow us to better balance crews and demand once we have our network in better working order.

Rent expense was up 21% or $64 million in the quarter with the increase driven by both service inefficiencies and volume growth. Slower velocity led to car cycle times that increased by nearly a day and a half adding $13 million in costs in addition, a higher number of short-term locomotive leases added another $7 million bringing the total service related cost increases in this category to $20 million. Increased carloads, particularly within AG products and Intermodal added $13 million in volume-related costs. The remainder of the increase -- increase is related to a variety of other items such as higher expenses of rental of maintenance of weigh equipment and timing of joint facility costs.

The next line item is depreciation expense, which was up 7% in the quarter to $277 million. About half of this change is associated with last year's capital spending program and the other half is to last year's second-quarter depreciation expense lowered by roughly $12 million due to the retroactive recognition of depreciation of rate changes. On a full-year basis, expense growth should still be roughly 5% in this category. Second-quarter fuel and utilities expense was up 35% or $112 million. If you look at the drivers behind the increase, the biggest component was higher diesel fuel prices. Our average price per gallon in the quarter was $1.16. Compared with 88 cents per gallon a year ago. This is the highest per gallon price we have ever paid as a company and added $93 million to our expense line. In addition a portion of that higher fuel price was driven by above-average refining spreads in the western United States where we purchase roughly 40% of our fuel. Fuel consumption rose by 14 million gallons in the quarter. A portion of this increased consumption was driven by higher volumes adding $8 million in expense. We also had higher consumption due to our service issues, more idling locomotives and use of more inefficient older models which added about $4 million in cost. On a more positive note related to fuel, we recovered 47% of our increased costs in the second quarter. We continue to include fuel surcharge provisions in all new contract negotiations and still expect to be around a 60% recovery rate for the full year.

Moving back to the income statement, materials and supplies were up $15 million or 15% in the second quarter. About $2 million of the increase is attributable to our service issues as more locomotive repairs were required on short-term leased units. As far as our core locomotive fleet is concerned, strong demand for our services also require that we perform additional locomotive overhauls to ensure reliability. These maintenance activities added $6 million in costs to the line.

Finally, purchase services and other were up 12% or $48 million. There are really several items behind the increase. Some service-related, some not. The derailment in San Antonio increased costs that we have been able to identify by roughly $22 million. Including costs for locomotive and property damage, as well as claims and other clean-up-related activity. Service-related costs including increase drayage, crew transportation, and transloading expenses totaled $14 million. Relocation expense related to the headquarters consolidation added another $7 million and other costs relating to locomotive contract repairs which again reflect the increased demand on our locomotive fleet totaled $8 million. We anticipate growth in this category to be roughly 8 to 10% in the second half of the year depending on the pace of our service recovery.

So in summary, the total effect of these increased costs is a decrease in our operating income to $359 million and an 8-point decline in our operating margin to 11.9%.

Finishing up then with a full income statement, we reported other income of $8 million in the quarter, consistent with our full-year guidance range of 50 to $100 million. Interest expense was down $19 million year-over-year due to lower total debt levels following last year's redemption of the [inaudible]. Second-quarter average debt was 8.1 billion versus 9.2 billion in the second-quarter of 2003. Income tax expense was down $84 million primarily due to lower income. Lower affected tax rate 53% versus 37% a year ago is driven by tax benefits that I mentioned earlier is associated with our corporate headquarters consolidation. Looking out to the second half of the year, our effective tax rate should be roughly 35%. A couple of points below a more normalized rate of 37% due to additional tax benefits. These figures net down to our income from continuing operations of $158 million and our reported earnings per share of 60 cents. This compares to last year's second-quarter EPS of $1.05.

Let me give you a quick update on our 2004 capital spending plans, including both cash and outsourced capital, we will spend roughly $2.25 billion this year versus a little under $2 billion last year. To break that down, we will spend just under $2 billion in cash capital, which is pretty close to last year's cash capital of about $1.94 billion. The remainder of our '04 capital is made up of long-term locomotive operating leases. Jim will talk a little bit more about the details of our locomotive acquisitions in a minute. This year's increased level of capital spend is really a function of the growth opportunities we see in our business. We are investing in the growth of the company but being very careful that an adequate rate of return will be spent on each door we spend.

A quick review of our cash flow shows our free cash flow is down $144 million year-over-year through June. If you look at the change column on the right hand side of the slide, you can see that the drivers of this difference are really cash from operations and dividends paid. Our service issues and higher fuel costs drove lower cash from operations of $104 million and dividends paid are up $38 million due to our increased quarterly dividend rate from 23 cents per share to 30 cents per share. Capital spending as shown in our cash used for capital other and noncash locomotive capital leases is basically a wash year-over-year. To date, our yearly free cash flow is negative $116 million. With our current operational challenges, we are still somewhat unsure about where our full-year cash flow will come out, but given the seasonality of our business and stronger cash flows generally experienced in the second half of the year, free cash flow is expected to be on the positive side.

Let me close today with a look at our debt-to-cap ratio on a lease-adjusted basis. As you can see we have made substantial improvement in the last three years, dropping almost 14 points. This reflects our belief in the need for a strong balance sheet and a very focused approach we have taken to reducing debt levels. Looking out to the end this year, we would expect to at least maintain, it not improve slightly over last year's marks, despite our operational challenges. We are balancing the generation consumption and uses of cash with the overall goal of improving returns and enhancing shareholder value.

With that, I will turn it over to Jim.

Thanks, Rob, and good morning, everyone.

Let's get started today with a service update and a quick review of our recovery plans. As we have discussed before, our service issues were caused by a lack of trained crew personnel in and unprecedented surge in demand. Our primary actions have been to add crews as quickly as possible, add locomotives through both short and long-term acquisition strategy. This includes the goal of turning back these locomotives as our velocity improves, manage business volumes, particularly in our capacity constrained corridors and ultimately get back to operating to plan.

The next chart illustrates our service metrics for the last year and the first half of 2004. As a recovery plans have started to gain traction, the trends we experienced through April of this year have reversed. Our operations have stabilized, and we are showing signs of improvements. Let me walk through a few more specifics.

For an employee standpoint, we continue to have three main areas of focus: Hire and train conductors, promote experienced conductors to engineers as the new hires graduate into train service, reduce recrew rates through increased velocity, increase surge capacity to handle volume spikes and provide flexibility to deal with incidents like weather or derailments. We have significantly strengthened our crew base with the addition of nearly 2300 conductors in the first half of this year, although when you consider attrition and retirement, the net add on T & Y right now is about 900. We also expect to add another large group of graduates coming in train service in the 3rd quarter. We still have some work to do with engineers, but we are really looking for improved health in the second half and are also positioning ourselves for 2005. Our goal is to get ahead of the hiring curve and stay there. Our locomotive plans have also increased slightly from April with the addition of 125 locomotives. We will start receiving these units in August to help out with the peak season. In addition, to help improve our overall velocity, this added power should enable us to turn back some of the older less-efficient short-term lease power we have today. To give you a metric here, these lease units, the older ones are 15% to 20% less efficient of the new locomotive when you consider fuel efficiency and maintenance. We are taking a more aggressive approach to managing our volume growth in the second half. In our July customer letter, we outlined specific plans to allow us to more efficiently manage volume on our system. We are seeing unprecedented level of demand and taking immediate action to improve fluidity on our network

This all boils down to a few key objectives. Aggressively price to market, meter our business based on financial returns and optimized through put in constrained corridors. This includes working with our customers to enhance efficiencies both at the point of loading and the point of unloading. And examples would be expanded weekend operations or larger block shipments. All of this is focused on enhancing velocity and improving equipment utilization. At the end of the day,this chart illustrates what our network inefficiencies or quality failures have met to our company and our customers. Nearly 14% of our revenues were spent on qualities failures in the first half. If you analyze that, it is about 1.5 billion. And we have demonstrated -- as we have demonstrated before, quality failures are directly linked to customer satisfaction. Obviously we have substantial opportunity for improvement.

Despite our service issues, second-quarter business levels were record-breaking, with revenue up 5% on a 2% increase in carloads. It was also a best-ever quarter for average revenue per car. Looking at the bars on the left-hand side which show our revenue performance, let me highlight the four areas where we had the greatest growth. Chemicals, Industrial Products, AG, and Intermodal. Our chemical revenue was up 9% in the quarter, totaling 439. This was our highest quarterly revenue since the third quarter of 1997 nearly seven years ago. Plastic, soda ash, liquid and dry chemicals all had strong growth as a result of overall improved economic demand and increased China consumption. Industrial Products had a best-ever quarterly revenue. Growth in this group was broad based carloads up and in most segments and aggressive pricing actions adding further growth. AG products also had a record quarter. Shipment of corn and feed grain to the Pacific Northwest and wheat exports to the Gulf were the key growth drivers. In addition import beer shipments from Mexico were up more than 50% compared to a year ago. Intermodal had its best second-quarter revenue despite leaving some demand on the table with strong International loading and improved overall pricing and fuel surcharge escalators on our domestic business which helped drive further growth. One thing that jumps out at you is the decline in energy revenues. Although we had record continue tonnage, demand was solid, a mix to shorter-haul business coupled with the slow start in April due a derailment resulted in a disappointing quarter. Looking out to the last half of the year, we see strong business volumes continuing, particularly in the areas of Industrial Products, Chemicals and Intermodal. We are already handling record International and Intermodal volumes and could see elongated peaks with the same ships running with 95+%. As you know the ILWU has experienced a labor shortage that has slowed the unloading process and could be somewhat of a challenge for the rest of the year.

Let me turn to pricing for a minute. Rob walked you through the revenue break impact on pricing efforts in the second quarter. As he mentioned we are limited in the short term by the amount of business we have under contract. We are seeing, however, in the 30% to 40% of our business revenues that we can act on in the air, price increases averaging 2% to 3% excluding fuel surcharges. In addition to price increases, we are also taking actions that we believe will be beneficial in the long term. We are moving to shorter duration contracts with volume caps. We are instituting more tariff based pricing to give us greater price flexibility and simplicity and an example is the our Cole circulator, it raises the overall price to protect invest-ability. It adds a full fuel surcharge and encourages shorter duration commitments. The overall impact of these actions we are taking to enhance the returns of our business. As I mentioned this is essential to protect the reinvest-ability and to increase shareholder value.

Looking to the rest of 2004, I am confident in our ability to increase velocity and improve our overall service performance. Peak service volumes can certainly challenge this effort, but our service recovery plan should still enable us to improve. And as our operations improve, we will return running to our operating plan which will help further increase velocity and reduce failure cost. These operational improvements will help us leverage the growth opportunities we see ahead. The chart on the right illustrates that our monthly seven-day average carloads during the first half of 2004 topped a previous month's best for any year, and despite the limits we placed on certain areas of our business growth, we expect record loadings to continue for the balance of the year. We also continue to see a good pricing environment going forward, and we are committed to pricing for higher returns.

Before I close today, I would like to comment on safety. It is at the top of everything we do at the Railroad, and we won't be satisfied until we can report we have no injuries, no derailments, and no crossing incidents. Looking at the charts, you will see that over the last three years, we have made significant progress in every category. Even with the challenges we face this year with our service issues and new hiring and training efforts, we have still approved and will continue to do so. We are committed to safety, and it is a priority for everyone.

With that, I will turn it back to Dick.

Thanks, Jim.

I just would like to reiterate the last comment you made on safety. We at the U. P. are absolutely committed to running a safe railroad and we work hard every day to make each day's operations safe.

As we look to the second half of the year, our velocity and service performance will be critical drivers behind our financial performance. We have got to run the Railroad faster to improve asset utilization and operate more efficiently. We are in a position, however, where demand has been offsetting our aggressive efforts to hire and train new people. So as Jim discussed, we are taking steps to manage business volumes and more effectively manage peak season operations. These actions aren't intended to reduce our overall business, but to control the growth and improve traffic flows. During the second half of the year, we anticipate that volumes should still exceed last year's record levels and that our full-year commodity revenue growth will still be in the 4% to 6% range.

Looking more specifically at the third quarter, we expect revenue to grow by roughly 4%, which recognizes that we do have some metering efforts in place and that fuel prices will remain historically high. The combination of operational challenges and high diesel prices will continue to hinder our ability to translate increased revenues into increased levels of net income. As a result, our current expectations are for earnings per share between 75 and 85 cents compared to $1.15 per share that we reported from continuing operations a year ago. While this is a wide range, it reflects the uncertainties associated with our recovery process, as well as the price of fuel. If our operations are slow to improve and if fuel prices stay at today's high levels, we will likely be at the lower end of the range. But to the extent we see improvement in service or fuel costs, we should move up toward the higher end of our earnings estimate. As you know, you can follow the progress of our metrics through our weekly reports to the AAR.

Looking ahead, we believe that many of the fundamentals of the railroad industry are undergoing real change. We have talked to you about the changes we are seeing in the demographics of our work force and their implications for our work force management process. We are seeing changes in economic trends and perhaps most critically, we are seeing changes in the long-term demand for transportation capacity with a growing shift toward rail. Over the past months, we have clearly been focused on improving our service performance and our operating efficiency, and we remain convinced we are taking the right steps to achieve that goal. As we work through that effort, however, we are looking at the way we want to run our business for the long term. We are looking for ways to work smarter and to take better advantage of this changing industry environment.

It all starts with quality, and Ike is taking the lead in reinvigorating our quality program. He and his team are using industrial engineering techniques such as lean management to find ways to make our key processes more efficient and more effective. You have also heard Jim talk this morning about our plans to better manage demand by optimizing capacity, improving pricing, and working with our customers to enhance service efficiencies. These efforts will extend to all levels of the organization in our drive to make this company stronger and more profitable. Taken together, they are all focused on improving yield and driving stronger returns to the bottom line. The value of our premiere rail franchise has never been clearer and we are intensely focused on translating that value into opportunity in the years to come for our customers, our employees, and our shareholders. So with that, we will be glad to open it up for questions here

Thank you. The floor is now open for questions.

Our first question is coming from Ken Hoexter with Merrill Lynch.

Hi, good morning. I wanted to talk a bit about the pricing. I mean obviously -- if you could also comment on the "The Wall Street Journal" article this morning. It seems like if you go back to the Southern Pacific merger, there was an opportunity there where -- I believe you talked about before where you had to give some rebates or some things like that. Is there any of that going on now? Could that occur if things don't get better? It seems like we have seen velocity kind of level off but not start that rebound yet. And if you can talk about that and also in that conversation, the amount of pricing that is fixed in contracts and when they roll over and the opportunity to raise pricing additionally further. Thanks.

Ken, let me discuss a few of those things that you mentioned, "The Wall Street Journal" article, I think you know my comment there would be to look at the penultimate paragraph where customers did recognize and stated so that our service was improving. And as far as the comparison with the '97-'98 situation, there is no similarity here today at all. And as far as customer claims, if we have contracts in place that provide for some sort of a guaranteed service, we clearly will honor those contracts, but other than that, that's -- you know, that's all that we intend to recognize. And as far as our velocity goes, if look back at the metrics over the last three months, you see incremental improvement not as rapidly as we would like to see obviously, but our train speeds are improving. In fact today out on the western part of our railroad where we saw the most difficulties late last year and early this year, our train speeds are up to -- between 17 and 18 miles per hour from where the low point we were down around 15 earlier in the year. So we are seeing nice improvement, particularly out west. And we hope that continues. We think our strategy is starting to work. Pricing -- Jim, do you want to talk about pricing?

Well, Ken, as I mentioned here, in any given year right now, 30% to 40% of our business comes up for pricing. We have been very aggressive there. You know, we are separating in front of our customers here today and I am spending a lot of time with them. You know, we are making some commitments here in terms of resources. Whether you are talking track capacity or locomotives. And, you know, we are going to get the returns up, and that means that we've got to get the pricing up in the business here, but, again, about 30% to 40% was up this year. Year and we are getting 2 to 3% overall in that business.

And then Jim or Rob, I don't know if you mentioned this going through the locomotive counts. Any pulling forward with that, back half of the year for locomotive, you had the target 740/750 and you mentioned, I think it was 30 per quarter were coming on in the peak season. Are you pulling that forward faster?

Well, this is Jim. I will answer that. In total you just -- you look at the chart and you've got over 700 locomotives on there. Just about over 400 are new. Some of it is pull-ahead in terms of, as I said, we have got 125 that will start up in August, and will require over balance of the year. I think as we look ahead to next year, if this demand stays strong, in any given year we have 200 to 250 that fall simply from retirement. We have not retired many this year because the demand is so high. So I think it is early to say these are all pull-ahead. We will clearly have a locomotive program next year. A lot of it depends on growth. The way I would look at that chart, though, remember the short-term lease locomotives are the ones that were we are really using here to plug kind of the slowdown in velocity. They are very inefficient and costs us money. And as we get our velocity up, that's -- we will return those -- those locomotives back to the market.

Great, thanks.

Thank you. Our next question is coming from John Barnes with Credit Suisse First Boston.

Hey, good morning, guys.

Good morning, John.

Let's see. In taking a look at your strategy and especially, you know, on some of the volume caps in quarters, I guess, that you put in place. What is your expectation on what that impact -- you know, what that strategy could do to your market share. I mean, are you expecting to give some up here? Or -- would you even mind giving up some here I mean in trying to better the quality of the freights you are handling.

That is sort of a complicated question. What we are trying to do with the traffic that we're metering is increase the fluidity of the Railroad, and if it works right, hopefully, which we think it will, it is going to allow us to be more fluid and take on more traffic, and, you know, in preparation for the peak season is -- is what we are at. We -- you know, we -- at this point, we are not -- and I have said this many times, we are really not focused on profit share or market share all that much. We are more focused on profitability. And what we are trying to do is free up the Railroad.

Okay. In terms of talking about price, I mean, I guess this is a little bit of what Ken was getting at, but, you know, it just seems to me you are getting price right now but ultimately if service doesn't improve noticeably, customers are going to begin to balk at accepting additional increases. Do you believe that is the case? Or do you believe capacity is tight enough that shippers are willing to absorb, you know, the pricing increases, you know, even if service kind of bottoms here and doesn't get noticeably better during peak shipping season.

Well -- Jim, do you want to answer that?

Well, John, service is going to improve. At the end of the day here when you look at the failure costs -- you know -- we have got great pricing opportunities. We are being aggressive when we can be. We are in front of customers in terms of talking through the returns and customers are interested in the long term here for our business. Are we going to be here for them. We are get our velocity up. Cost us $100 million this quarter. We have a lot of incentives there obviously to move forward with improving service.

I think most of us, too, John, feel there is a basic change here in the railroad business. I mean, we are looking at huge growth in imports over the West Cost. trucks clearly can't handle it. The railroads are -- the Railroads are the solution here. Not just UP, but all railroads -- the economy is strong. We have got great demand for our service, and you know our customers, along with us, are looking for us to grow and be profitable and reinvest in the business and it's a scenario really that is far different than anything I have seen in my career. It's -- it's -- you know, I -- I wish we were participating at a better level than we are right now, but the future really does look great.

Okay. Yesterday one of the companies was talking about, you know, peak shipping season and normally by now we are beginning to see a bit of an ocean backlog developing on West Coast ports. They indicated that they haven't quite seen it yet that the backlog seems to be developing a little bit slower than they would have expected. Are you seeing similar trends? Jim, your comments seem to indicate that maybe you all are starting to see it a little faster.

I think we would say we thought we saw maybe an early start to imports maybe even last month. Today we, Union Pacific, is absolutely current on moving Intermodal traffic out of Southern California with the exception that there is a slow movement of containers from on dock not due to the railroads but due to a shortage of longshoremen. In fact, our information this morning was that there were eight ships anchored in the ocean that weren't able to dock because of slow unloading of ships, but we at this point, at least, we are positioned to move the business out on a current basis and our Intermodal terminals inland are current. So in volumes, International volumes are running higher through the second quarter in July than they were during peak last year. So, you know, business is very strong, and quite honestly we keep hearing about how strong peaks is going to be at least on the International side and I do think there will be some increase, but I believe we are limited somewhat because most of the ships are pretty well filled up already today.

Okay. Last question and I will turn it over. You know, the last two years in November, y'all have been very good about raising the dividend and giving back some to the shareholder, you know strong free cash flow. This year with that free cash flow being a little bit more uncertain, you know, I guess, one potential dividend increase. Can you comment on that? Is it likely you will even ask for one? And then secondly, is there anything that puts the current dividend in jeopardy?

Well, John, I can't -- you know at this point I can't imagine what would put the current dividend in jeopardy, but we have committed that we are going to look at the dividend policy every November and we will look at it again this year and I wouldn't want to speculate beyond that.

Okay, thanks for your time, guys

Thank you. Our next question could coming from Scott Flower from Smith Barney.

Good morning, all.

Hi.

I guess a couple of broader questions and then I had maybe a couple of very quick follow-ups for Rob. I guess on a broader basis from what I'm thinking that your business and what I heard from you today is that you hold your own during the run-up to peak season. Maybe you have made progress here in July because some of the auto plant shutdowns, but you'll try to hold your own with the incremental resources, but once you get past peak is where you make more of your progress, i.e. once you get some of the seasonal subsiding in demand, you will make more headway. Is that a short version of what I heard today?

No, I don't think so. I didn't mean to convey that. We are going to work our tails off to make continuous improvement every day here regardless of peak. And you are right, the automobile business has slowed down somewhat, although not as much as we would have thought, because there was quite a little bit inventory build-up still to be moved so we have been moving a lot of finished automobiles even during the shutdown period, but it is everybody's goal at Union Pacific to make continuous improvement every day. We go to bed thinking about it and we wake up thinking about it --

but is it -- is it fair to say, Dick, that you will make a lot more progress in October and November once you past the absolute venus a seasonal event-- you are adding a lot of resources but make more headway as we look toward early fourth quarter.

I don't know if that is an unreasonable assumption because clearly as you get out in November and December we do normally see a tail-off in business somewhat.

Okay. And the other broader question and this will be for yourself, Jim, or Ike, has -- what's happened in terms of surface transportation capacity and obviously the demand for your services and then also just the pressures on the operations, changed at all the way -- I think some of it has -- versus your truck conversion -- strategy. Not that you don't want any truck conversion, but that you are gonna be a lot more selective and at much different yields than you might have thought a year or two ago?

Scott, this is Jim. As I mentioned here when you look at our demand management, you really are taking a hard look at the returns in the business. You look at corridors. You know, the highway, though is a huge market. Lots of opportunity. We have been able to get very good pricing for the products we have offered there. I don't see much change from that strategy. Some of the things we are looking at, though, is where we -- you also combine this -- particularly and look at constrained corridors with what are the demands. Two sides when you look at a customer, the pricing upside and then there is the efficiency. So I don't really see any major change there other than we are being even more aggressive in pricing when you look at the markets.

Great. Great. And then I guess -- one other question as we look forward, and I know that, Jim, you gave some color on this. And you don't have a precise number because you won't know until probably like toward the end of the year, but I guess what I would say -- if I look forward Cap Ex in '05, it might not be unreasonable to think that you will be at about the same level as you were this year or do you think it will necessarily be lower. I mean obviously it defends on where the economy is blah-blah-blah, but is it likely that we will see a 2, 2 kind of number as we look at Cap Ex for '05.

I think it is too early to speculate here, Scott. We really haven't gotten that far in our budgeting process, but as we said forever, $2 billion is not an unreasonable number to use for planning purposes. If demands stays really strong and we are successful in getting our yields up and demands there we obviously, we want to be able accommodate high revenue growth. It's just an analysis process that we will have to go through with really a lot of focus on returns.

All right. And then one quick financial housekeeping item. Maybe Rob can help me with. On the tax benefit from the headquarters relocation and obviously letting your effective tax rate be somewhat lower, will that continue into '05, or should we consider for planning purposes to use a 37% or so tax rate for '05.

For '05 use a 37 assumption.

Okay, thank you very much.

Thank you, Scott

Thank you. Our next question is coming from Tom Wadewitz with Bear Stearns.

Good morning, everybody.

Good morning, Tom.

I have got a couple of questions for you. I wanted to start with the allocation program. I know it is a little difficult to quantify, but if you look at the different corridors, what you are trying to achieve with that, can you give me any kind of range of the volume -- the magnitude of volumes that you are trying to keep -- keep out the system? Is this -- if you didn't have the program. If could you handle the volumes would that be another 2 percentage point of growth. Any sense you can give me of the magnitude of those metering programs.

Jim, do you want to handle that question?

You know, Tom, really you have to look at, are you -- it's ultimately what the demand is that's out there. And what we have done is we've targeted corridors that we think we can get the best and quickest impact on velocity. As that velocity comes back, we will bring that volume back. You said could you have another couple of points of revenue growth. You know as strong as demand is, when you look across our numbers here, I don't think that's -- that's unusual. We look out to -- to the future here again. Demand, the economy continues to be strong. It is one of those that we've got to kind of cap the peak here a little bit. We said even with the metering we are doing, we gonna have record loadings the rest of the year.

What we are trying to do -- I used to have a boss that would say we need to slow down so we can hurry up. And it is sort of what we are trying to do here is where we have the most constraints is make the thing more fluid so we can get greater through put. It sounds like kind of a contradiction in terms, but it is what we are trying to accomplish so we can deal with the -- with the peak effectively.

Okay. I know you try to do this in kind of a measured way so you don't have disportionet impact on a given customer, but that having been said, I think there are some areas perhaps certain customers are really getting hurt by this program. Do you think that the business you turn away today can actually come back to the railroad in 2005? Or in some of these actions are you actually going to turn business away that won't come back and how do you avoid doing that?

I think the correct answer there is that if we provide adequate service at acceptable price levels and a good business decision for the customer, they are going to make the good business decision.

Okay. I mean, do you think that takes a bit of time, maybe 2006 business which comes back or --

No, not at all. I would -- I don't want to predict anything with a great degree of accuracy here. I've tried to avoid doing that.. But it would -- you know, its my fondest expectation or hope that in some cases we will be able to start metering business back in as the year goes along here as we get resources in place. We -- you -- it is really heart warming dealing with our customers. They -- they are working with us. They want us to succeed. They want us to make adequate returns to reinvest in the property. They really need the Railroads and wants us to be successful.

Okay. And one -- one more on the pricing side, it seems like this is really the best opportunity in memory for the Railroads to take up pricing. It sounds you are obviously focused on that but sounds like you are probably a little bit limited at the present time given some of the service issues. What do you think price could be if it is up 2 or 3% this year, whatever the number is. Can that overall be 4, 5% next year. Where do you think you can go with this, you know, if you get the service back up to your standards?

I hope we didn't express that or convey that thought here, because we sure didn't mean to. We have a constraint. It's more the nature of the contracts that are in place that have to be up for renewal and roll over. That's -- Jim, don't you think? That may be the only constraint.

Tom, again, as I said earlier you have just your absolute limit in your ability to touch business in a given year. We said 30% to 40%. We are working with the customers. We know we are not satisfying their needs or their demands or meeting the needs, but at the end of the day we are pricing to market. You know I look them in the eye and I talk to them about that and we -- again, we take a look at what kind of capital is required to handle the business, and I will tell you, you know, they -- while they are not happy today, they really do need this as part of their business going forward.

Okay. One -- just one last one if I can toss this in. You are doing a lot with resources which helps a lot -- which helps out near term. How do you avoid the risk of adding too many people on locomotives now and if the economy rolls over a little bit you are in an over staffed position. Or is that something so far from where you are now you don't even think about it?

Quite honestly, the risk is minimal. We have so many short-term leased locomotives today, 350 or so so and older locomotives that should have been retired if business were to slow down which by the way we don't see. It is very strong and think we will have a record 3rd quarter and probably second-half volume-wise, we can quickly adjust our locomotive fleet and get rid of the least-efficient units on a short-term basis. And as far as over staffing, as far as conductors and engineers go, with the attrition rates that we are seeing, we can quickly bring head count back in the line. And also we don't want to do is -- we would if we had to. We can furlough people because the new hires we hire are not guaranteed employment or guaranteed salaries. So, you know, I worked all through college for the Railroad as a brakeman and was furloughed half or two-thirds the time. So it is not a new concept in the industry. Do you have the right to furlough.

Tom, we still do expect to turn back some of these short-term leases this year as the operations improve.

Right. Okay, great, thank you very much for the time.

Thank you.

Thank you. Our next question is coming from Jordan Alger from Deutsche Bank.

Hi, morning. Just curious. Roughly how much velocity improvement would you need or is built in to that 3rd quarter forecast, and then attached to that is, what is the velocity level you would peg as railroad yourselves, let's say, running at a smooth fashion with the leverage could drop down to the bottom.

We -- we just look for continuous improvement as far as -- I mean we don't -- I am not going to shoot Duffy if he is not running 20 miles per hour by the end of the 3rd quarter. We look for continuous improvement every day. And under the AAR measure, train speed, I guess, what are we, 20, 24, 25 miles per hour would be a fluid operation for us.

Thank you.

Thank you. Our next question is coming from Greg Burns with JP Morgan.

Hi, guys. Just two quick questions. On -- Dick, on the comment about customer revenue coming back. I guess we are all assuming that services significantly improve going into '05, but guess my question is, isn't some of the business that is leaving the Railroad sort of being signed up on contracts and might that be sticky and certainly, you know, a different industry, but certainly it took UPS a fair amount of time to recover some of the business it lost to Fed Ex. In other words, why are you so optimistic that it will come back relatively quickly?

Well, you are right. Some of the business that goes away could be committed for a longer period of time under contract, but what we've found through experience is that time goes along. If we are giving the kind of service the customer is looking for and the prices that will give him an advantage compared to some other form of transportation, they will choose the right business decision.

Got you. Got you. And on the Cap Ex, just to clarify in my mind, I may have missed it, but the 15% increases. Part of that Cap Ex, including the growth capital, sort of a catch-up from Cap Ex sort of you wish you would spend in '03 in hindsight or pure forward-looking growth. I guess where I am getting is given your outlook, could we see another 15% jump given the growth we are seeing from '04. Is this a catch-up or you going to continue to grow the Cap Ex this way.

Probably too early to speculate on that. I don't look for out-of-control growth at all here. At the end of the day the business climate and the demand are and our improving returns will have a lot to do with it because we do want to grow with our economy and take care of our customers, assuming that we can do it at improved returns. So -- it's just too early to speculate about where we will be next year. We have always said that $2 billion is a good planning number to use and then we will just keep you posted as our plans develop.

Greg, I would just add to that, that the increase in '04 compared to '03 is not so much catch-up as it growth -- growth capital improvements.

The only catch-up we have, as we stated a number of times, we are -- we are spending a little additional money on strengthening our infrastructure with an accelerated cross tie replacement program and strong maintenance away focus to strengthen our railroad.

I guess that's very helpful. Just to clarify. I mean, if you can turn back the clock knowing what you know about how strong '04 was, would you had spent more money in '03.

We might have spent a little more, yeah. Unfortunately, our -- looking forward is not quite as effective as 20/20 hindsight. As you may remember we went into '03 with a very, very soft economy and managing things pretty tightly.

Right. Thanks a lot, guys

Thank you, our next question is coming from John Larkin with Legg Mason.

Yes, good morning, everyone. Dick was suggesting a few minutes ago that he thought maybe the railroad business had entered a new era here where there was going to be a fair amount of traffic shifting back from the trucks to the rails. I was wondering if we could maybe look out into you know '05 and beyond and talk a little bit about how Union Pacific is going to kind of permanently deal with that kind of a secular pattern in terms of something other than just adding more locomotives and adding more train crews. Seems to me a fair number of bottlenecks that need to be eliminated. Can you give us a little more color on those. Talk a little bit about, perhaps, what can be done in terms of maybe tweaking the operating plan some to eliminate potential problems in the future at increased traffic levels and maybe even talk about what can be done with a labor agreement to perhaps get some more productivity.

Well, there is really -- quite frankly there's -- there is a jillion and one things going on in the business to take advantage of technology and do work processes. I would reiterate a few of the things that we have talked about in the past. One is the sunset corridor, enhancing capacity there. As you know we have got about a 50-mile double-tracking project going on this year there. Enhancing capacity on the old Chicago Northwestern line between Omaha and Chicago. We are improving the signal system so we can handle greater through-put. Eliminating little bottleneck in southern Missouri so that we can enhance through put on our North-South route, and then we are seeing immensely, stronger demand for Colorado and Utah coal of late, even though we have been loading record volumes there. We are not -- we are still not meeting demand so we have started a major capital project in Denver. I think we have committed about $43 million to remove our bottleneck there and support the growth of that very high quality, highly desirable coal, and, you know, you can just go on and on and on where modernizing our engineering equipment so that we can maintain and repair our track quicker and more cheaply. Higher technology, higher quality locomotives. Ike Evans' focus here on lean processes, lean manufacturing techniques so we can get more through put through our terminals and I will say and I think I have mentioned this before, but that our initial cut on this is just dramatic. At one of our Intermodal terminals in Chicago we call Global II, we started off using McKenzie working with Ike in the operating guys there, and where we had recognized an upward limit of 800 to 850 lifts a day. That's now over 1200 lifts a day and they think they can ultimately get to 1600 lifts a day or double what we were doing originally. That is just one terminal out of dozens across the railroad, not just Intermodal terminals but also our electronic classification yards and flat switching yards and diesel shops and car shops and you just name it. So Ike has got three years left work and he is going to be fully occupied ringing the last ounce of opportunity out of those facilities. So quite honestly, just a zillion things -- we are putting in a new dispatching system. We are modernizing our train dispatching systems. We can talk a long time about that.

There is one other thing. You know, we are -- we recognize where the business -- there are cycles in the business. So we are going to be cautious when we look to next year. I mean, for example, how long do we look at China's growth which obviously had an impact. What will happen with grain markets where, you know, the first time in many years that we have had strength in grain. We do have the capability, though, to scale back capital spending if we see the demand fall off and as Dick said our resources. So we -- although our assumption right now as you look at the economy. Even though the forecasts are getting a little bit softer, they are still very strong. That's very helpful. Thank you very much.

Thank you, our next question is coming from James Valentine with Morgan Stanley.

Good morning.

Good morning, Jim.

Can you quantify how much the customer reimbursement payments were in the second quarter just so we can model that out for; hopefully next year it won't be there and do we expect those to, I guess, go up or down in the second half of the year or stay relatively flat.

I -- it was a very insignificant amount, Jim wouldn't show up on your radar screen in your model.

Okay, okay. Second question is, any track maintenance right now being deferred. Obviously slows a bit more and come back and thinking about in terms of modeling purposes.

That is a very astute question. We have had to rearrange the timing of some of the maintenance. It is not going to be deferred for long. We are just looking for a more opportune time to get it done. We are still looking at record tie installations this year of nearly 5 million ties in the track and very strong rail program and grinding program, but we have -- in a -- in a couple of cases, we have rearranged the timing of when we are going to get it done.

Is that more likely like an '05 event?

No, no, something we were going to plow ahead with this year, but when -- when business slows down a little bit --

nothing major, Jim.

Okay.

No, the end product of our -- of our effort, we are still going to have a banner year as far as our maintenance programs go.

Okay, good, good. Another question here. I sense that the concept of one-man crews may be a topic of discussion for this round of labor negotiations at least between -- I think one railroad and one union. And let's just assume that even if labor ultimately accepted the idea, and I think, you know, we all know that is probably a long shot and will take years to get, but should we then assume that we would first need to get positive train control and I guess the line of questioning is, how long do you think something like positive train control would take to implement because I believe UP has been doing a reasonable amount of work on that and I thought there was a prerequisite before you go to one-man crews.

We have been a leader in research on positive train control. We started a joint effort with the Burlington Northern, gosh, back in the early '90s. Technology still not proven, but I wouldn't make that assumption. We have got train control signals on fairly substantial part of our railroad today. You know good technology with automatic train stop and that sort of thing. I think you are right that it will be an item of negotiation and sometimes those things do take a little while.

Yeah, okay.

Do you see that differently, Ike?

No. That's exactly right.

And my last question -- and I don't mean this in a confrontational way, but I am trying to understand in terms of ways to avoid the -- or things that could be done to avoid the kind of problems we have with congestion that which we have now -- we had with southern Pacific and CNW. Trying to understand if there is anything done behind scenes that you are not going to bullet point in a slide presentation, but being done behind the scenes to maybe better connect the kind of front-line tactical management with the senior more strategic longer-term management to avoid these kind of problems in the future.

Jim, that is not a confrontational question at all, it is a good one, and we have asked ourselves that a number of times, and that's one of the things that we are really focusing on is learning from our challenges, and making things better and that's -- Ike, do you want to talk about what you are doing? He is relooking at all of our quality processes to make sure we come out of this better and stronger.

That is a good question as Dick said, Jim. We are looking at our business processes from strategy. All the way to execution. In trying to do a better job. We've always done it, but we're trying to do a better job of -- of understanding and then putting contingency -- understanding the risk and the contingency of those disconnects between those various processes. And it's -- it's even really more challenging because the environment is changing. Where we are going to have demand, so we want to make sure we have got the right business mix that will produce the maximum profit, you know, as we go forward. So I am -- we are working hard on this one, and we are going to come out of this a much stronger and better company where we really are able to take advantage of this great franchise that we have.

Great, great, sounds like it is good to have some focus on that. Thanks so much.

Thank you, Jim

Our next question is coming from Jason Seidel with Avondale Partners.

Morning, gentlemen. Most of my questions have been answered. But one quick one, can you quantify what pricing would have been if not for the service failures that you have had in the quarter. Would it be 2% instead of just 1% across the board?

We tried to get at that. Jim, do you want to take another cut.

You know, where we had the opportunity to price -- in other words, it was contract renewals that came up we averaged 2% to 3% in that corridor. You know, it keeps coming up about the service issue. I can tell you we -- while -- while we are working with our customers on our service issue, we are pricing long term here. If the market is in that range, that's what we are going after. So that gives you a feel in terms of about 30% to 40%. We were able to average -- really pretty close to 3%.

Our biggest constraint has been timing of contract rolling over. Not the -- not -- not the service issue. It has been the timing of contract renewals.

Some of the -- some of the freight that you had to push off the railroad, was that freight that would have been up for price increases? Or is there -- is that tough to figure out?

Well, let me say this, some of the business that we have metered and exited in some cases was kind of at the lower end of the scale, so we probably averaged up.

You averaged up? Okay, fair enough. Thank you, guys

Thank you, our next question is coming from Donald Ryan with AG Edwards.

Good morning, gentlemen.

Good morning.

I would like to go back real quick if we could and hope we haven't beaten it to death, but this whole tie issue, right-of-way maintenance. I know you accelerated Cap Ex on -- on capacity-related issues, but I have been talking to people who are supplying you with ties and I am getting ongoing consistent reports of delayed maintenance there. If you intend to put 5 million ties in place this year, I mean I understand delaying it because -- it is right-of-way maintenance, you can delay it for a short period of time. When do you intend to put them in later this year? You have got the fall surge coming. Are you going to put all these ties in in December? I am a little confused as to how that works out.

Maybe I didn't a-- didn't address that clearly enough. We have been going gang busters all year with tie installation and rail renewals. We have shifted priorities in a couple of cases from one line to another, but it -- it hasn't been deferred at all. We are going -- we are going gang busters with our program. It won't be quite 5 million ties. I think it comes in at 4.8, 4.9, something like that and last year 4.6, 4.7 so we've had a strong tie program for a number of years, but quite frankly, it will take several more years to get this railroad where we need it -- where I want it to be, where we've got a -- you know, no deferred ties anywhere.

Nobody would ever accuse you guys of having a poorly maintained infrastructure. And I -- I -- and perhaps I am not talking to all of your tie suppliers, but the ones I have talked to said that -- said that they have been told since pretty much the beginning of the year that you were going to delay because of service issues. So maybe you have just changed ties suppliers, but that begs the question, why not retard some of the right-of-way maintenance in order to get your maintenance guys out of your right-of-way?

Well, as I said, we're -- where the -- where it helped our service short term we did get them out of the road, but we didn't stop putting them in. We just went somewhere else. And we will come back to those points when --

when you can.

When it lightens up a little bit.

So you didn't really retire -- Cap Ex was not retarded this year so far at all or won't be for the full year by any right-of-way maintenance?

Not at all. What maybe our tie suppliers -- I don't know -- maybe they thought we were even going to take more ties than the 4.8 or 4.9 million. Maybe that's what they are referring to. I don't know. But we have got a dynamite program this year.

Like I said, I don't talk to all of them. And it could be just somebody in purchasing switching from one to another. That could explain it, but like I said, that was the report we had been getting. But -- okay --

I think they would be very happy.

I am sorry.

I would think the tie suppliers would be very happy.

Well, that's true industry-wide. So you -- you continue to Cap Ex. You are confident -- if you are confident as you say you are about eventually being able to get your service levels back. You have got free cash sufficient to continue what is an increasingly aggressive Cap Ex program, free cash sufficient to pay down debt, why aren't you repurchasing shares on a very aggressive basis?

Well, our free cash has suffered this year. We have made no bones about that. We had originally predicted $500 million and then took guidance away.

Right

So we still think we are going to be positive you about it has been greatly reduced.

Why not target what you think you will regenerate toward share repurchase if you are really that confident about --

Well, you know, at the end of the day, it is going to get down -- you have got lots of ways of returning your success to shareholders. So it's got to be a balance between share repurchase, dividend increases and reinvesting in our business. If -- if growth is as strong as we hope it is going to be, and we get our returns up, we want to be able to invest in the business of take advantage of those returns. It is a balancing act, and we will look at the uses of our capital.

Sure. All right. Well, unfortunately, the highly ironic part is if your returns really begin to improve, then repurchasing of stocks will no longer be the multiple of book it is today.

Yeah. Well, we are looking forward to the day we can start looking at those three possibilities again. Right now we are really just focused on getting the Railroad running right.

Fair enough. I will let someone else ask

Thank you, our final question is coming from Reno Bianci with Citigroup.

Yes, good morning, everyone. I think I didn't catch it or maybe I didn't pay close enough attention, but I was wondering, you focus a lot about the impact of the inefficiency on cost. I didn't hear anything and any quantification of the amount of revenue that you think you lost to competition both with railroads, mostly BNI, and trucking during the quarter.

We didn't try to quantify it.

Okay.

Quite honestly. You know there are some, certainly, and it is probably a pretty good number, but we haven't tried to quantify it.

You don't have the tool to do it? You don't want to tell it to us? I am sorry, not trying to be pushy here, but trying to understand it, what you normally do in these kind of practices.

You know we -- when you look at our -- our six business groups, you know really probably in five of the six we know there is some demand up there. It is always hard to read, but we have got a manager network here and we have got to have the right kind of returns in pricing and as we said we left some business on the table. How much, it is tough to say. Really a function of how -- how healthy we could have been and how much loss was there.

Okay, fair enough, thank you.

Thank you. Gentlemen, there are no further questions at this time.

Okay. Thank you very much. And we will be talking with you again in three months.

Thank you, this does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day.