聯合太平洋集團 (UNP) 2004 Q3 法說會逐字稿

At this time all participants are on a listen-only mode.

And the floor will be open for questions be a comments following the presentation.

If at any point you wish to register your question, please press star followed by one.

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 on our third-quarter earnings conference call.

With me here today is Ike Evans, our Vice Chairman, Jim Young, our Railroad President and Rob Knight our CFO.

Also present here is Jack Koraleski our Head of Marketing and Sales.

After I make a few opening remarks about the quarter Rob will take you through the financial details.

Jim will provide an update on our service recovery progress and our plans for continued improvement.

I'll return after their comments to give you the fourth quarter outlook and then Ike will join in and Jack when we open it up for your questions.

For the third quarter, we're reporting 77 cents per share versus $1.15 per share earned a year ago from continuing operations.

Our 3.1 billion in third quarter revenue marks the second consecutive quarter over the $3 billion mark and is our best total revenue performance ever as a Company.

However, the negative impact of higher fuel prices and high operating costs more than offset the revenue growth.

During the third quarter, we paid $1.25 per gallon for diesel fuel, the highest price we've ever paid by almost a dime and 35 cents per gallon more than what we were paying a year ago.

And crude oil prices have continue to climb driven higher by hurricanes, political instability and demand in China.

There weren't many crystal balls predicting oil over $50 a barrel, but that's where we are today, and we're doing our best to minimize the impact to us, one way we're doing that is by ensuring that fuel surcharges be a part of all new rate quotes and tariffs.

We're also working diligently to minimize the amount of fuel we consume with a variety of fuel conservation initiatives.

We've seen one bright spot regarding fuel with the phase in repeal of the 4.3 cent diesel fuel tax,.

As you know the industry has been opposed to this tax for several years, and we're happy that congress has finally removed its unfair burden from the railroads.

Operationally we know that we're not running an efficient railroad today.

But we believe the resource plans we are implementing will make a difference.

We did see about a half a-mile-per-hour improvement in velocity during the third quarter.

In the near term however, the cost of the added resources have outweighed the benefits of improvement.

As we restore fluidity to the network our challenge will be to improve efficiency to reduce our failure costs and be able to return to running a quality operation.

Jim will talk to you in more detail about some of our plans but let me emphasize that we will not be satisfied with simply improving velocity.

We're equally focused on improving profitability by ensuring that the failure costs that have been introduced into this system don't become institutionalized.

One fact that's been clear over this past year is that Union Pacific and for that matter the entire rail industry is experiencing unprecedented levels of demand.

We have broken monthly seven-day car loading records each of the last 13 months and we're well on our way towards extending that streak in October.

Although the current higher rate of economic growth may slow down eventually we believe that demand for our services will continue to grow over the long-term.

Aside from U.S. economic growth there are several key factors which make us believe that demand for U.S.

Rail transportation is increasing.

And some of those would be long-term growth expectations for Asian imports, very tight trucking capacity and an overstressed highway infrastructure.

When we combine these favorable dynamics with the strength of our franchise, we continue to have great enthusiasm for the future.

Now with that let me turn it over to Rob to walk you through the financials.

Rob.

Thanks, Dick, and good morning.

I'd like to start off today with a high level look at the income statement.

We had solid operating revenue growth in the quarter up 4% as Dick mentioned.

But as fuel prices escalated and we work toward operational improvement operating expenses rose 12% in the quarter and offset the revenue growth.

Before I go into the expense details let me talk about our revenue performance.

Jim will give you a little bit more technicolor on the key drivers of our business groups and talk to you about pricing efforts in a moment but let me start with a quick look at commodity revenue and average revenue per car.

The drivers behind the 4% commodity revenue growth were split pretty evenly between volume and RCAF both up 2%.

RCAF was driven by higher increased fuel surcharge revenue and better pricing up 2% and 1% respectively and remember that our 1% price increase is averaged across our entire nearly 3 billion commodity revenue base in the quarter so we were actually seeing greater pricing power on the business that we're able to reprice.

However, our business mix served to lower RCAF by about a point.

This reflects a 4% decline in ag products which has a higher average revenue per car combined with a 7% increase in intermodal units -- intermodal revenue which carries a lower average revenue per car.

Turning back to expenses, we clearly had some challenges in the quarter not the least of which came from fuel.

Before we go through the details, let me give you a brief summary of the major cost additions.

We paid an average of $1.25 per gallon in the quarter with fuel prices spiking as high as $1.50 per gallon.

The $1.25 compares to 90 cents a gallon a year ago and added $121 million in diesel fuel cost to the quarter versus last year.

Our velocity slow down and service inefficiencies added roughly 44 million to the quarter versus last year.

I'll detail these additional costs as I walk through the individual expense lines but we saw increases in almost all areas of the business due to operational challenges.

Costs for hiring and training increased by 35 million in the quarter as we continued to bring on new employees.

We graduated nearly 1500 train men and engineers in the quarter, third quarter alone.

We also completed the move into our new headquarters building adding roughly 23 million in one time move related expenses in the quarter.

While this does have a negative impact on our operating margin the move is essentially earnings neutral on a full-year basis because of incentive tax credits.

These increased third-quarter expenses totaled $223 million which drove a 6 point reduction in our operating margin.

As you'll recall we experienced about a $20 million increase in operating costs a year ago to our service challenges so when you think about the amount of added costs that we need to take out of our operations that 20 million should be included.

Looking now at the individual expense lines, salary and benefits expense was up $80 million in the quarter or 8%.

As I just mentioned training was a big piece of the increase, as were the higher service related costs that added another 32 million in expense.

In addition, 7 million of the move related costs I just mentioned show up in this expense line.

The remaining 6 million in this category reflects the impact of wage inflation, volume growth, and headcount increases.

Our hiring strategy this year has been to backfill attrition and staff adequately to meet volume demands.

Conductor hiring programs continue on schedule bringing in roughly 5,500 conductors by year end.

Offsetting these hires is an estimated attrition level of about 2,250 from our train and engine crew ranks during the year.

Given this we expect our average annual head count will likely be up in the 3,5 to 4% range with the increase coming entirely within the ranks of our train and engine crews.

Rent expense increased 46 million or 15% in the quarter.

The majority of the increased expense was a result of increased volume costs associated with growth and intermodal and automotive carloads.

We also paid about 5 million more in the quarter for our short term surge power and additional 5 million for locomotives we acquired via operating leases.

Looking to the fourth quarter rent expense should be up roughly 10% versus last year's fourth quarter as fewer car hire payments are offset by higher locomotive leases.

Since locomotive lease cost are increasing component of our rent expense we thought it would be helpful to see what we've done over the last years.

We look at the fleet in three components.

Our core long term locomotives which we acquire through various long-term financings.

Our flexible lease locomotives, where we have some return flexibility.

We have the option to keep these units for shorter or longer periods of time depending on need.

And thirdly, our short term peak or surge power units.

The core and flexible lease units are new locomotives.

While the surge power is generally used equipment.

You can see that over the past several years we've added roughly 400 new locomotives to our fleet annually.

Now, what's not shown is that during this time we averaged about 2 to 300 locomotive retirements annually.

So net-net we aren't necessarily increasing the fleet size but we have substantially upgraded the horsepower and reliability.

The real difference we're seeing this year is in our surge power.

Depending on velocity and demand, we commonly have some level of surge power on the property at any given time but this year with our service challenges we've had 350 peak units on hand since June.

These units have clearly added costs to our system and will be some of the first resources we turn back as we get healthier.

In addition some of you may have seen the recent announcement that we're acquiring 315 new locomotives in the first half of 2005.

A financing decision has not yet been made on these units but again that acquisition is in line with our overall fleet strategy.

Turning back to the income statement, we had depreciation expense up 4% or $11 million.

This is reflective of our ongoing capital programs and we'd anticipate a similar year-over-year increase in the fourth quarter.

I'll talk about fuel expense in a moment but let me first skip down to materials and supplies expense which is up 18 million in the quarter.

This includes an increase of about 8 million for higher material costs which relates primarily to rising steel prices and 6 million for increased locomotive overhaul.

Now back to fuel expense.

As I already mentioned fuel expenses had a significant impact on the quarter and will likely have a big impact on the fourth quarter as well.

One positive in the quarter is that after seeing increases in our fuel consumption rate during the first and second quarters, third quarter consumption was flat year-over-year.

Looking out to the fourth quarter, there's a lot of uncertainty regarding fuel prices it looks like we'll average nearly $1.50 per gallon in the month of October, so a full year number could be in the range of $1.45 to $1.55 per gallon depending on oil prices as well as spreads between crude oil and gulf coast diesel which are abnormally high today.

Given the increasingly large impact that fuel is having on our business we wanted to talk briefly about our fuel surcharge recovery programs which today cover roughly 80% of our revenue base.

Our primary mechanism is our on highway diesel fuel program.

The initial surcharge of 1.5% kicks in at $1.35 per gallon on highway diesel fuel.

That $1.35 on highway price is roughly equivalent to Union Pacific paying 75 cents per gallon per diesel which we consider to be a more normal long-term average price.

In the third quarter we recovered $90 million through surcharges which is 53% of the price increases over that 75 cent mark.

The recovery lags fuel price changes by about two months which with the spiking prices we've experienced lately is impacting our near-term recovery percentage.

Today we'd estimate that our full year recovery will be a little more than 50% versus the 60% recovery we had previously forecasted, over time as prices stabilize or fall back we'll see a stronger recovery percentage, but right now we're chasing the curve of fast rising fuel prices.

Purchase services and other expenses increased 10 million in the quarter a little better than we had previously expected.

We incurred roughly 5 million for items related to our service performance such as triage and trans load expense.

We also have higher expenses for contract locomotive repairs, state and local taxes, and our headquarter relocation but these increases were largely offset by a favorable actuarial study related to our personal injury accruals as well as insurance reimbursement.

Looking out to the fourth quarter we won't have the benefit of these favorable offsets so we'll likely return to a more normal run rate of about 15% year-over-year increase.

So in summary the net affect of our increased cost was a reduction in operating income to 418 million and a little more than a 6% decline, 6 point decline in our operating margins to 13.6.

Finishing up then with full income statements.

Other income in the third quarter was $30 million, this is double last year's third quarter amount which was reduced by a 15 million expense for the second tides redemption.

Year-to-date other income is $66 million in line with our full year estimate of 75 to a 100 million.

Interest expense was down 8 million year-over-year reflecting lower overall debt levels.

Third quarter average debt was 8.2 billion versus 8.9 million a year ago.

Income tax expense was down 53 million in the quarter, primarily due to lower income.

We continue to see some benefit from tax credits associated with our new headquarters but our overall tax rate was actually slightly higher at 36.1% versus 35.8% a year ago.

The end result for the quarter was income from continuing operations of 202 million and earnings-per-share of 77 cents.

Now that's how the third quarter shaped up.

Let's look at a couple of the full year projections.

We'll spend just under 2 billion in cash capital.

When you include the non-cash equivalent for long term locomotives and freight car leases total capital is closer to 2.250 billion.

In addition as I pointed out earlier with our locomotive fleet, we're acquiring just under 200 locomotives with flexible lease provisions.

We don't include those as capital equivalent, however,due to the potential short term nature of those leases.

Looking at our full year cash flows after dividends, we still expect to be positive for the year.

The key drivers of the year-over-year decline are service inefficiencies and fuel prices.

In addition, the dividend increase we announced last November reduces cash by 75 million.

Although our free cash flow has been impacted this year our balance sheet strength as measured by debt-to-cap ratios is largely unchanged.

Before I turn it over to Jim I'd like to make a brief comment on asbestos.

We've engaged an actuary to perform a study on unasserted asbestos claims.

The study is currently in progress and we'd expect recorded charge for unasserted asbestos claims sometime in the fourth quarter when the study is complete.

We will make an announcement regarding the adjustment at the appropriate time.

Importantly we believe we are adequately accrued for asserted claims and we do not expect to see a change in future cash flows.

With that I'll turn it over to Jim.

Thanks, Rob and good morning, everyone.

I'd like to start off today with an update on our service.

If you look at the chart, the red line shows the steady climb in volumes versus our velocity in the blue line.

You'll see that May was a point of inflection for us as we're able to stop the downward trend and start to move our velocity up.

Even in the face of record volume.

We have stepped back some in October due to the combined impact of strong volumes and a few critical service interruptions and I don't see us making significant improvement in our velocity until we get through the peak season which is around the end of November.

I do see some other positives in our performance though as our manifest business is moving with fewer terminal delays and our intermodal network is staying current during peak season, we're also recovering more quickly from service incidents which is a real positive given that winter weather is not far away.

If you look at the key drivers behind our velocity improvement plan to the first nine months of the year, we've taken on 216 new locomotives, 315 short term surge power units and we still have another 175 new locomotives to be delivered by the end of the year.

We've also graduated nearly 3400 new train men and 400 engineers so we're much healthier from a train men perspective, but we'll be tight for engineers through the end of the year.

And we're working to better manage our network by controlling volume flows focusing on improving overall yields and redesigning processes to create capacity.

While the network management piece has always been an important part of our operations, the stakes are today are even higher given the substantial demand for rail services that we are seeing and the stress capacity state of the overall transportation infrastructure in the United States.

The key to this strategy is to be much more proactive rather than reactive when it comes to managing volume flows on our network.

Being able to manage a network more practically is really a great opportunity for us and it involves four basic steps.

First is an overall redesign of our transportation plan with the goal of reducing car handlings.

Second manage train and car flows to optimize terminal efficiency, this includes both looking at our operating plans as well as a rigorous industrial engineering approach to minimize capacity constraints and improve processes.

Third continue our focus on alliance initiatives.

Although you've heard us talk about this over the past several years and we've made good strides in this area there's more work to do.

Given that we interchange over 40% of our business with another carrier this work is vital to improve performance and finally, work with our customers to improve through put.

This includes 24 by 7 operations as well as a significant focus on increasing load/unloading capabilities.

Good example of this is our south Texas rock network partnering with our customers to build longer trains and increase load/unload capacity we're moving more rock with fewer cars in service, a win for everyone.

Before I close out the discussion on operations let me spend a minute here on safety, safety is the number one emphasis with our new employees and it's an important part of UPs extensive training program.

As we move great volume this year I'm pleased to report that through September both our lost work day cases and our reported derailments are down 5% year-over-year unfortunately our crossing incidents have risen by about 11% a trend that's been experienced by the entire industry.

There does not appear to be anything systemic about the increase other than more rail and highway traffic, but we're revisiting all of our prevention programs to ensure we're doing all we can so that gives you some perspective on how we're progressing operationally as well as our direction in the future.

Now, let me turn to our revenue performance.

Third quarter revenues were up 4% total but given the levels of demand that we're seeing it could have been stronger with better service.

Looking at the individual commodity groups industrial products had another great quarter.

Six of the groups 13 market segments had double-digit growth with steel revenue up nearly 20% and lumber revenue up 12%.

Our chemicals business benefited from broad-based demand for silt, ash, fertilizer, liquid, dry chemicals, and plastics, one of the drivers here is the spread now between crude oil and natural gas.

As you know, U.S. producers base their production feed stock in natural gas while international is based on crude oil, what we're seeing is our U.S. producers are more competitive and are able now to compete better in the U.S. Market.

Intermodal revenues were up 7% in the quarter on a 4% total volume increase which included a 9% jump in international volumes.

As I mentioned, our operations stayed current with this strong demand.

Automotive revenues increased as manufacturers delivered less of the 2004 model year plus began 2005 roll-outs.

Real wild car will be what we see coming up here in the fourth quarter.

Moving to energy we worked during the quarter to increase velocity in our network enabling us to move record tonnage out of both the southern Potter river basin in Colorado, Utah despite this revenues were flat year-over-year due primarily to contract losses.

As we've talked before these tough comparisons will lap at the beginning of next year and you should see volumes improve.

And finally ag products revenue was down for the first time in 10 quarters reflecting lower whole grain movements as shippers waited for better pricing in the fall harvest.

Let's take a look here at our business outlook for the fourth quarter the outlook is strong demand to continue in most areas of the business.

We see the growth in the industrial economy continuing which should drive continued strength in chemicals and industrial products.

A wild card for us in the quarter is ag products, the harvest is in full swing and it's certainly going to be one for the record books but grain shipments are somewhat uncertain.

It may be more of a 2005 event than in the fourth quarter.

An area of concern in the quarter is automotive.

North American car and truck production dipped 4.5% in September and the big three manufacturers have all announced fourth quarter production cuts.

I'd like to transition for just a minute here and talk about pricing.

When we look at the market place today there are some continuing trends that are changing the railroad pricing environment.

As Rob mentioned our price yield in the quarter was about 1%.

The average price increase in business that we could take action, however, was much, much stronger and, in fact, today we're seeing our strongest pricing environment ever.

Our pricing strategy is really pretty straightforward.

First, price to the level that supports reinvestability.

We're seeing strong demand for services, but we will not increase our growth capital dollars without higher returns.

Second, accrue the mix between short term and long term pricing tools the goal here is to understand our spot and base customers to better identify peaks and valleys of the business and finally expand the use of fuel surcharges to neutralize the volatility of fuel prices.

Rob talked to you about this -- our programs here and the successes but this is a real change for our industry.

So let me sum it up.

In the fourth quarter we will add to our resource base with a graduation of little over 1500 new conductors. 350 engineers and 179 locomotives to the fleet.

These resource additions are gaining traction and we've seen some recovery in the face of record revenue.

As I mentioned earlier though, our network has strengthened but volume is still a challenge for us and it will be tough to make substantial velocity gains until we're through peak season.

As we work toward recovery our goal is to switch to an execution mode which effectively means blend to the plan, reduce our quality cost failures, and significantly improve customer service through greater reliability.

With that I'll turn back over to Dick.

Okay.

Thanks, Jim.

Let me reiterate your comments about improving reliability.

It's absolutely critical that we provide our customers with consistent quality service.

Over the next several months our immediate focus will continue to be on improving operations in the face of record volumes.

As we look towards the fourth quarter we would estimate our earnings-per-share should be in the 65 to 75 cent range, while that might seem like a wide range we continue to see many variabilities and uncertainties that could affect our financial performance.

First and foremost is the price of diesel fuel.

The last couple of days we have paid up to $1.55 per gallon which is almost double the 89 cents per gallon that we paid in last year's fourth quarter.

That price increase alone would subtract 25 to 30 cents off our earnings net of the fuel surcharges and based on today's prices would place us at the low end of that earnings range.

If fuel prices moderate somewhat, there may be some upside.

But if prices rise above the $1.55 per gallon it would certainly push us below the 65 cent per share.

Another variable affecting our earnings is our service performance.

As we improve our velocity we have more revenue opportunities, and can refocus our efforts as Jim discussed on efficiency but our first priority has got to be improvement so efficiency gains will lag an increase in velocity.

Finally, in this earnings range we are assuming revenue growth of about 5%, there's certainly revenue upside as our operations improve, but, again, we will continue to be cautious and try not to take on too much too soon.

As Jim opened out longer term, we're working to make continuous improvement to both our customer service and our profitability.

Our belief is based in part on our ability to improve processes and efficiency but also on the changing transportation market.

To support that change and the associated growth, the transportation industry and the rails in particular need a strong infrastructure.

That's why as an industry we have invested billions of dollars to maintain and expand our track, terminals, and facilities.

But investments alone won't guarantee success, and future investments have to be accompanied by higher returns.

Success also requires teamwork and cooperation.

As we work with our customers on our service issues, they have consistently asked what they can do to help.

Those efforts have been greatly appreciated but they must continue beyond today and extend in the long term partnerships that can benefit both parties.

And we must continue to work with our alliance partners to make our service seamless to the customer.

As an industry our focus on returns is right minded and is the ultimate answer to providing additional infrastructure investments that will support the growth and vitality of our economy.

All of us at the Union Pacific understand the tremendous opportunities that we have as a Company to grow profitably and improve our returns.

And we're all working together to satisfy our key stakeholders, our customers our employees and our owners or our share shoulders.

With that we'd be glad to open it up for questions.

Thank you.

The floor is now open for questions.

You may register your question by pressing star followed by one on your touchtone telephone at this time.

If at any point your question has been answered, you may remove yourself from queue by pressing the pound key.

We do ask all participants to please utilize the handset for optimum sound quality.

Our first question is coming from John Barnes with Credit Suisse First Boston.

Please pose your question

Hey.

Good morning, guys.

Good morning, John.

Dick, could you talk a little bit about the hiring that you've done?

The numbers are pretty impressive.

But, are you beginning to run into any issues with the ability to recruit enough people to replace to keep up with attrition or to get ahead of it and then secondly, in terms of, you know, we've heard a number of people talking about just that the training facilities and that type of thing are exhausted.

I mean, that they're just, you know, there's not enough training facilities to pump all these people through at one time.

Is that leading to some of the you know the limitations on the service improvement at least in the near term?

John, let me say this.

The recruiting hasn't been easy by any stretch of the imagination.

I think you probably heard us say before that we have to interview about 10 people to get 1 acceptable candidate.

And it may even be more than when you go to a place like southern California but generally speaking after we get through that process, as laborious as it is we've as it been getting very high quality people and the training has placed somewhat of a limitation on us because part of the training is not just classroom but it's on-the-job training.

We place our employees, our new employees with experienced people to understudy them as part of the training program and there is a limitation on how many people you can assign out there.

But having said all that, as Jim said, we've made huge progress on getting our train men ranks fully staffed.

We had to go through that before we could start training engineers.

So we now are really stepping up the pace on engineer training.

And, you know, it's going well.

A year ago if you would have asked me I would have not thought that it would have been the end of 2004 before we got fully staffed up, but that's about where we find ourselves.

I am happy to say though we are getting very good people.

And if you went beyond just train and enginemen and looked at hiring mechanics and other types of engineering employees and that sort of thing, I think our total hiring this year is going to be well over 6,000 people so it's just been unprecedented in my career that we've had to bring on that many people in one year.

Okay.

Secondly, in terms of the fuel surcharge, I mean, you know, I think the numbers, the trend lines at least encouraging on the recoupment of the higher fuel cost but your experience thus far with this on highway diesel fuel index and that type of thing, has it given you enough comfort that maybe you start to think about, you know, still pursuing abandoning the fuel component of the RCAF or something like that and trying to go to more of a fuel surcharge mechanism across your entire book of business or is this new fuel surcharge mechanism somewhat limited in the commodity that it can be implemented on?

I'll let Jim have that one.

Hey, John, RCAF is what it is.

It looks at actual costs through the industry.

What we're doing in terms of new business and where opportunities come up is getting away from RCAF and we are putting in this specific fuel recovery mechanism in areas that historically would have used RCAF.

We think it is a good model.

It's much more current and that's our direction where we want to go over time here.

Okay.

Last question and then I'll give it over.

You know, I hate to use the word "demarket" but, you know, with some of the quotas and that type of thing that you've put on and some of the business that and again I don't like to use the word "abandon" but you tell me a better word some of the business that you've kind of pushed off the railroad to make sure you can handle the influx and maybe some better service, how concerned are you about permanent damage to customer relations out there or are you in a situation where there's not a lot of alternatives so the shipper kind of has to accept these are the conditions we have to operate in and things sooner or later will get better?

John, let me take a shot at that and then I might ask Jack Koraleski to comment.

Almost universally when we've met with our customers, of course the few customers that have been demarketed I guess if you want to use that word obviously don't like to hear it but our -- generally speaking, the tone of all of our meetings is from our customers's point of view, we need you guys, we want to work with you and find a way to make you successful so you can handle our business and be there for us.

And it's really, it's been quite heart-warming.

Jack?

Yeah.

I think, John, that overall we are being very careful and very sensitive to minimize any impact that we've had on our customer base as a result of having to take some business off the railroad but we have explained to them that in some cases that has been necessary for us to be able to get our feet back on the ground and get running again.

And we're looking very carefully at those relationships.

We're looking very carefully as Jim said on the reinvestability of the business and in some cases there is some business that just doesn't fit on our franchise and we have been moving some of that business off the railroad.

Okay.

Thanks for your time, guys.

Thank you.

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

Please pose your question.

Good morning, gentlemen.

I've got a couple here.

Your intermodal revenues are up 4% not too bad but not near where your rivals are at the moment.

How much of that freight do you think that they got to be one back once your service levels start to improve to where you think they should be?

Jim, do you want to?

Jason, the -- you know, the big part of this, obviously some has moved over to the other side here but a big piece of this we think has gone on highway here, and, you know, we still see good demand, even with our service numbers where they're at today our real question in our business is as we look at our whole network, we look at the total demand on all of our products is what's the right balance.

Should intermodal be twice that growth rate.

You the coal -- you look at our industrial products businesses so there's clearly, we improve the service, there's clearly very good demand out there.

It is really a function of how fast we want to grow that market.

Okay.

Also, kind of a related question.

Pricing is up 1%.

That's obviously probably not where you want it to be.

How much has the -- I guess your service challenge impacted you on your ability to increase pricing?

Jim, do you want to keep going?

Well, you know, clearly service and price are linked.

When you look at it, I -- the market's very strong today.

We're working with our customers in terms of, you know, where we're putting price in, where we believe the service numbers are going.

You know, how much it's hard to tell how it's all interrelated.

We are taking a very hard look at, you know, the reinvestability of the business in terms of what we look at here.

I'm in front of a lot of our customers, and I'll tell you while they're not happy, no customer I think is ever happy with a price increase, their real interest to me is are you going to be here for me six months, three years and five years from now and we work very closely with them and I do believe as we continue to improve our service up we even have greater price opportunity going forward.

Okay.

Thanks, Jim.

Two quick questions actually for Rob.

Rob, you mentioned when you were reviewing your purchase services and expenses that there was a favorable actuarial adjustment could you elaborate on that a little bit.

We look at our personal injury accrual on a regular basis and our trend and our base case has improved.

Our rate has improved and we made the corresponding adjustment.

How much did you make for the quarter?

Yeah, I mean, I don't want to get into a specific number on that.

But it's just in that overall improvement number.

Okay.

Also, you were talking about the asbestos claims for the fourth quarter and for us to expect a charge but then the next sentence you said that you felt your accruals were fine so I'm wondering why if your accruals are fine why you expect to take a charge?

What we're looking at here is taking a look at an actuarial study that we'll look at on asserted claims.

Today we are adequately accrued for claims that have been asserted.

Gotcha.

Okay.

Thanks so much, gentleman.

Thank you.

Our next question is causing from Scott Flower with Smith Barney.

Yeah.

Good morning, all.

Morning, Scott.

I wonder if you could help me with I guess a few things.

I know you all have tried to help us in terms of talking about 1% price and understanding only part of the book of business is open.

Could you give us some rough framework, if you think about what the marginal rates are doing on those pieces of business that are open, I know it may vary widely but are we talking 3 to 4%, are we talking 6, are we talking 2?

I'm just trying to get a sense of -- because, obviously you're making a point that the average is not what's going on with the margin, I'm just trying to get a sense of what's going on with marginal pricing.

Sure, Jim.

Scott, we've said historically when you look at it you have about 40% of your business that comes up in a given year that you can put on the table in terms of pricing.

The market's very strong, much, much higher than what we've seen before.

I honestly don't think it does a lot of good here, you know, to get into that, you know, in this forum here.

What we're really looking at, the markets there we're going to take -- do what's right and work with our customers here to make certain they look at, you know, the overall value of rail service right now.

Is it -- just one follow-up on that.

Is it fair to say that this is a normal year in terms of that 40% of business rolling over?

That's right.

Although, you know, over time here, and we've talked about, our goal here is to really take a look at how much your mix you want tied up long term versus short term and really try to balance even business fluctuation and demand here but 40% is a good number to look at here in the near term.

Okay.

And then just a couple other quick questions.

Know that you may not have nailed this down, but I'm just trying to get a sense.

As we look toward next year on requirements for cap spending and I know Rob talked about 315 locos in the first half.

Is it fair to say that the all in CapEx number will stay in about the range it was this year i.e. is it including long term operating leases or capital equivalents that were talked about on Q2.

That wouldn't be a bad benchmark to use, Scott.

Okay.

And then just two other quick questions.

I wonder if and maybe this is a question for Jack -- give us some sense of why you think the ag markets as we look toward next year will firm and get better?

I mean, everything that seems to be said from the USDA would suggest that exports in the U.S. may be down despite what may be a decent crop and I'm just trying to get a sense as you look at the ag markets and I know that they can be all over the map why do you have some optimism relative to things breaking loose next year versus fourth quarter?

You know, basically, Scott, that's with our customers are telling us.

We're working very closely with our customers, the USDA, the National Feed and Grain Group and trying to do our very best job that we can of assessing where we think this movement is going to play, and what everything looks like is we're going to see initial movements, a very small piece of that might be some export but most of it's going to be positioning the harvest into storage, and that they would expect that pricing environment and things could ease up here in the first quarter and we should see stronger movements in the first quarter of '05.

Got it and then one last one and I'll let someone else have it.

I know you've all said demand is staying quite good.

But I'm just curious if you peer beneath the detail, obviously you get a lot of granularity, are you seeing anything among your industrial customers or otherwise that would suggest that $50 plus oil prices are starting to at the margin have an effect i.e. this may have a bigger impact as you look toward '05 but if you peer beneath the surface is there anything there that gives you some concern the demand will moderate out six months from what you're seeing today?

Well, we obviously, Scott, worry about it every day but I will say this.

Our book of business at this point is still quite strong.

Now, whether, you know, how much it's impacting the automotive manufacturers is a little hard to nail down.

But on the list of things we worry about, high energy prices is certainly right up at the top.

But our industrial products business and our chemicals business, you know, the things that are pretty tightly aligned with the economy right now are just very robust.

Thank you.

Thank you, Scott.

Thank you.

And our next question is coming from Tom Wadewitz with Bear Stearns.

Please pose your question.

Yes.

Good morning.

Hi, Tom.

I want to focus on a couple of things on the capacity side.

One of the questions we have is at what point do you begin to see leverage in this model again so if the volume growth does persist and if you get a chance for that to perhaps improve next year do you begin to see some operating leverage and what's required to do that?

So if you have any thoughts in terms of the timing of when you might see that leverage, when you might see some of these short term leased locomotives be returned and see that cost follows it and also along those lines if this year crews and locomotives were the capacity constraint, let's say you address that, are there still some looming constraints that may hold you back in '05?

So that's a number of questions but, maybe if you could help me out with that.

Tom, let me say this we identified several constraints this year.

You may recall, the Sunset route was identified as a constraint.

The north/south route between Chicago and Mexico and Texas, one segment of it in southern Missouri, was identified as a constraint.

And then we also identified the area between Omaha and Chicago when the former CNNW route a constraint and we have put in place capital spending programs to address those.

Now those are long term.

They're not going to be fixed in one year so they will remain constraints for a while.

The rest of our -- although lessening as each year goes by.

The rest of our railroad will benefit greatly and so will those three segments as well as we improve the velocity of the railroad.

But probably until you become an old man we will be debottlenecking somewhere every year because, you know, that's a good situation where you've got business growth and we can expand capacity substantially by taking out bottlenecks here and there.

Jim, do you want to --

Tom, I think a key here as we work with our customers on identifying flows and we look at at as Dick mentioned a few of the areas that are constrained is really be very proactive and smart about how you manage that volume.

We have areas in the railroad that are not constrained today so that the whole strategy is to make certain when you look at the network you factor your volume.

You factor your price strategies in that give you the best opportunity to lever the whole network.

Okay.

If you look at some of the rails that have seen pretty good operating leverage this year, I think one of the things, you know, clearly locomotives and crew is an issue but that they've addressed -- but it also seems that they've had available capacity on the track side and terminal.

Do you think that the constraints you mentioned would limit your leverage, your operating leverage in 2004 or is that not something we should be concerned with.

You mean 2005?

Excuse me, 2005, yeah.

Well, I'll tell you that growth on the Sunset route is -- will be constrained.

There's no question about that.

Now, as far as the old CNNW route going into -- the former CNNW route going into Chicago, I think that we have room for growth there and new employees will help that.

I think we're going to have our constraint on the north/south line that I mentioned through southern Missouri rectified in the not too distant future but, we'll just have to monitor traffic flow very carefully here.

We want to be able to accommodate growth.

However, we have got to get the returns in place where it's going to support, you know, those investments.

Now we're going to do a lot through getting our velocity up and focusing on process improvement, the quality way to look at things through quality processes and procedures.

But I don't think that you'd want to say we've got unconstrained growth opportunities here.

We're going to be careful about adding back volume.

Okay.

Just on the short-term lease locomotives, Jim or Dick, do you have any sense of when we'd start to see that number, I forget what it is, 350 or something like that really start to fall down because it sounds like that's kind of inefficient locomotives that you'd like to get rid of.

Well, you're right about that.

I would hope that by the end of the year we'd be looking at shipping some of them home.

Okay, great.

Thank you for the time.

Thank you.

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

Please pose your question.

Great, good morning.

On the -- we've heard a little bit of clogging going on at the ports and most of it seems to to be from labor but some of it also seems to be rail service.

You know, a little while ago when you did the customer meetings you talked about different regions where you were having congestion like down in Houston and the Pacific Northwest.

Can you give us an update any regions where you're seeing particular clogging, I think some the port guys have said that UP has had some clogging particularly lately going on within Chicago and over by the ports.

Can you kind of clarify any any of that?

You know that's -- the rumors of our demise are greatly exaggerate there.

We've actually stayed current in southern California.

A couple months I guess, it's been a long time since we've been behind there.

Now, Chicago's pretty well subscribed.

But our new intermodal terminal out at Rochelle has helped that situation a great deal.

So no, if there's a constraint at the ports, it's I think inaccurate to say it's the railroads.

It's more accurate to say it's the ability of the ports to unload the ships I believe.

Now, as far as the areas of congestion around the railroad, at one time we had identified the Pacific Northwest and the Houston area as our major problems and I'm happy to say that's changed a great deal.

In fact, our service on the I-5 corridor which you know we've been focusing on on for a couple of years now has really come back strongly, and we're once again giving very good service there.

Not quite as good as we'd want it to be but very good.

The operations in Houston while I suspect if you had asked our customers there they'd say it's not what they'd like it to be yet but we've seen huge improvement.

Our two big switching yards there are handling traffic on a pretty current basis and our to and from industry and we watch this very closely among our many Industrial customers and chemical customers down there, is actually quite good not as good as we want it yet, but it's approaching levels of a year ago.

And as far as switching our customers when they want switched and giving them the cars they want at the right time and pulling the cars as they release at the right time so that situation has changed a great deal.

In fact, I think you could probably go across our entire railroad and not encounter much congestion everywhere.

We're just not moving as fast as we'd like to move.

Our velocity is still slow and once in a while like on that sunset route, if we have a signal failure or a train gets a draw bar or, you know, we have some kind of a blip, we can have some congestion build up pretty rapidly but normally it's been running just pretty doggone well, we just got to get the velocity back up.

Great and I think, just as a different subject here.

I think in Rob's presentation he talked a bit about programs on fuel surcharges covering about 80% of revenues.

I just want to dig into this a little bit further.

I know there were a couple questions earlier but average revenue per carload I think overall was up 2%.

Is that a mix of 1% pure increase and 1% fuel surcharge increase or I just want to try to understand how much of your revenues are covered with the fuel surcharges and why we're not seeing kind of better coverage I guess relative to what we've heard from some of the other rails so far.

On the average revenue per car computation about 2% for the quarter was fuel, 1% price and then we had a negative 1% mix in there that I mentioned.

On the fuel surcharge, just to elaborate, roughly 80% of our revenue has some type of a fuel recovery mechanism or another and for the quarter, we recovered about 50% of the increased fuel costs above that more normalized 75 cent price that I mentioned and that takes into consideration the fact that there is about a two-month lag on recovery.

So, you know, we're chasing the curve here in that 50% number so it will continue to improve.

Rob, if we see fuel then climb up to, say, $70, or even if it stays flat at these levels because if there's a lag and if they're staying at these flat levels should you then at some point not see the impact of fuel increases on the business.

You would still see an impact in your example but we'd be he recovering an ever increasing rate of that differential.

I mean it's still that higher priced fuel, because we're only recovering -- we are recovering 50 to 60% of that delta so that rising price of fuel both the price of fuel and the cost to us would be rising at the same time our recovery rate is but net-net there would still be an increase to the cost base.

Okay.

Helpful, thank you.

Thank you.

Our next question is coming from James Valentine with Morgan Stanley.

Great.

Thank you, good morning.

Rob, could you review your slide on purchase service and other and just review how the PI and insurance were offset by I think you said moving expense I missed that and I think it's kind of important we understand when accrual rates are changing and I just want to get my hands around that.

Jim, let me -- I didn't quite catch your entire --

The PI and insurance you said, we had a benefit meaning it went down and I thought you said it was almost entirely offset by I think moving expense going up.

But you didn't quantify either one and I'm not sure I got that right.

Yeah.

If you want I got another question I'll just move on.

I'm going to look at my slide.

Okay great.

Maybe we can move on to yield.

I'm not sure if this is Jack or John.

But we were a little surprised to see chemical yields only go up 1.3% when fuel surcharge alone should have probably driven it up 2 to 3% and then we saw a report yesterday 8% growth in their chemical yields and they don't have much of a fuel surcharge.

So I guess what I'm trying to understand is when we're modeling out that chemical 1.3% yield increase should we look at the third quarter as having something unusual.

Was there any kind of either lower pricing for the customers or rebates or anything that's probably going to be in hindsight a one-time in nature?

Jack, would you like to --

There's a number of factors that would influence those numbers, Jim.

Part of it is mix.

Also part of it is that still we have a large piece of our chemical business that's tied up with RCAF increases where we really don't have the flexibility at this point in time.

There's one issue too that I'd point out.

Some of the strong growth was in plastics and a lot of it moved to sit facilities rather than long haul so the mix was a real drag there as far as the yield goes.

Do you understand that, Jim?

Oh, yeah, yeah, I understand.

There's a lot of -- we had a very substantial volume of plastic growth but it was very, very short haul going into sit facility so any kind of deferred revenue at some point that's going to become long haul.

Okay.

How much of this business could turn over, what portion of your business could turn over let's say in the next year where you could change the RCAF to some other mechanism.

Is it like 50, 70% is it a big piece?

Jack?

I think overall, Jim, if you -- if I think back through our book of business we've got about 56% of our business tied up in long term contracts.

I would say that maybe 25% of that business will come up for rebid next year.

Okay.

Good, good.

If I could move on to a labor question.

Your labor inflation on a per employee basis was up only 2.3% which was very impressive.

Low by industry standards and given that I presume you're paying more overtime cost and we also see just general wage and benefit in inflation going up for the railroad industry at 4 or 5%.

I'm trying to figure out was that increase of only 2.3%, was that -- was there something going on that maybe a reversal of any kind of incentive accrual or other one time offset that we should look to continue into the fourth quarter into the next year or is that 2.3% the new run rate?

Well, it's probably too optimistic to say that's a permanent run rate but I think your analysis that overtime was up is -- does have something to do with lowering the inflation somewhat.

Jim, there's nothing unusual in there.

You know, when we look long term labor costs, I think that's 3 plus percentage rate is probably you know, what you need to expect.

Okay.

If I can just move on to one other question regarding contracts, that you put out circular 111 in March, I'm just trying to get my hands around the success so far.

How many large coal contracts have rolled over since then, that was to say a million tons or more since you debuted that back in March?

Jack?

Very small number, Jim.

Okay.

And of that small number do you feel confident circular 111 is working.

We've had some success with circular 11 we feel very good it and we're optimistic that -- we have no intention of changing our course.

Last question, and this is for Jim.

Jim, you said you won't invest growth capital until your returns get better and UP spending I guess 2.25 billion this year on CapEx.

I'm just trying to make sure I get clarity around that and is this to suggest that that is kind of the maintenance CapEx number that that's how much we need to spend before we think about growth?

Well, part of the number this year is, you know, dealing with growth.

What the message I'm delivering and what we look at in the Company right now is you've got a very good, you have the best time we've seen in history in terms of price opportunity in the industry.

We know going forward, I don't see that changing substantially given what's going on in the overall transportation infrastructure so my message again working with our customers who are very interested in, are we going to be there for their growth is one, I've got to do something on pricing.

It's a pretty simple equation for us, and, you know, part of what I'm doing right now, I mean we're trying to get healthy.

There's -- you look at the capital we've pulled ahead here, you look at the locomotives that are coming through are looking next year but to me it's a long term strategy that we're looking at.

Okay.

But that 2.25 is probably the number for '05 or somewhere in that ball park.

I think something around there.

And Rob did you have a thought on the --

Hold that slide up I think you can probably see it there, I think if I understand your question, contained in that number for the quarter was about 25 million of good news items.

So if you looked at more of a run rate you could look at more of a $415 million plus or minus kind of run rate.

That's very good.

Great, thank you,.

Yeah.

Thank you.

Our next question is coming from Jordan Alliger with Deutsche Bank.

Yeah, hi.

Hi.

Just a question on the fuel surcharge realizing that you're getting more effective with it, I think you had mentioned that, you know, the way it's implemented relative to the DOE prices is you have sort of that effective two month lag.

Is there any thought at some point about doing more like maybe the truckers do in terms of sort of having a week to week rebalancing, if you will?

Jim?

You know, I think Rob's comment is when you look at the two month lag that covers a lot of our different mechanisms that are out there today.

The unhighway program that used today it's about a 30-day lag.

You know, you could consider going to weekly, but I'm not quite certain from a customer perspective and administratively when you look at trying to change all the rates that makes sense so I'll be very comfortable if I can get this thing to a 30-day lag for most of our business.

Okay.

And then just out of curiosity I think you had mentioned that there was $90 million of recovery in the third quarter relative to that normalized price.

Do you happen to know offhand what it was sort of a year ago?

Around 30ish.

Tell you one other thing, we should point out that although there's a lag going up, there's a lag coming down too so it balances.

I'm assuming it does come down again at some point in the future.

That's why it's 30 days makes a lot of sense from a customer perspective as well as our own.

Okay.

And then just finally, I'm pretty certain I know the answer but the fuel surcharge revenue, that's in your commodity revenue numbers basically tax on to that, the $90 million?

Yes.

Okay.

Thank you.

Thank you.

And our final question is coming from Hasan Malik with J.P. Morgan.

Hi, guys.

Here for Greg Burns.

Just on the coal, yields are flat, is that just because there's not been much contracts rolling over or is pricing actually coming down on that front?

Jack?

When you look at what's happened to us on the coal front, it's the loss of a couple of large contracts this year to the competition.

And overall we really had no major changes other than that this year.

We're running with the RCAF and we basically have started kind of an upward turn in terms of our pricing and our energy markets.

Great.

In terms of '05 tax rate, what should we be thinking?

36ish.

All right, thanks.

Okay.

Well, thank you all very much.

Oh, wait, do we have another one?

Okay.

Two more.

Two more.

Yes, sir.

Our next question is coming from Randy Cousins with BMO Nesbitt Burns, please pose your question.

Jim, I wonder if you could speak to the ability to improve efficiencies during the winter months.

Railroading and winter don't generally make for a happy combination.

Given the stresses on your system should we be taking a pretty conservative view in terms of progress in Q1 versus Q4?

You know, we have weather every year.

It all depends on how tough it will be.

But, I'll tell you going into this year, we are healthier with crews.

So when we do have an incident and we saw this last year, you know, we had, you know, some terrible ice storms out in Kansas that really put us down for quite some time.

Part of it we just burned all of our crews so we're feeling healthier going in.

We're not 100% healthy here and, in fact, we're taking a look at our winter operating plan that you have every year.

It's really a wild card.

We're preparing for a tough winter.

That's the way we're aligning our resources and, you know, we do feel better about our capability going in, and we'll see how it goes.

And Rob, I guess one question for you, just in terms of thinking about Q1 and Q2 of next year, the fuel issue, it's obviously a huge issue right now.

In terms of sort of comps when we sort of look at Q1 versus '05 versus Q1 of '04.

Given what you've done in terms of fuel adjustments, assuming fuel prices stayed where they are, how much of a drag are we going to see on a net basis on the fuel side in Q1 and Q2?

Well, I mean, it clearly will have an impact on us if they stay at this kind of level at the same time, our recovery percentage continues to increase as Jack and the marketing team renew contracts and encourage that number up.

I can't give you a specific number but your point is valid.

That if those numbers, fuel prices stay high then it'll have a negative impact on first and second quarter.

Randy, I think if your question is do fuel cost prices stay the same in fourth quarter -- first quarter as they are in fourth quarter, you know, it shouldn't have a major hit because our fuel recovery mechanisms are going to be catching up.

Catching up.

Catching up so again, I think that was your question if they stayed where they are today.

So the degree of damage from fuel, in other words, you're going to get -- when looking an at Q1 versus Q1 of last year on this fuel side question what you're saying is really we should sort of not worry as much about sort of a huge, huge negative variance.

Q1 over Q1 you would see an increase, I think what Jim was responding to was right and that's if you were looking at Q4 versus Q1 but Q1 versus Q1 you'd see that increase.

Yeah.

I guess the issue I'm wondering about is that in terms of sort of forecasting for -- when you bring it back down to it.

For forecasting for 2005 purposes, I wonder if we should take a more conservative view for Q1 and Q2 and then an acceleration in Q3, Q4.

I guess really what it's coming down to, a big acceleration in Q3, Q4.

Well, I don't think we'd want to encourage any kind of a quantum leap here or anything but what we would be looking for and what we're striving for is continuous improvement.

Okay.

Thank you.

Thank you.

If that wraps it up why we'll be visiting with you here in 90 days.

Thank you.

Thank you.

This does conclude today's teleconference.

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