聯合太平洋集團 (UNP) 2005 Q1 法說會逐字稿

Good morning ladies and gentlemen.

And welcome to the Union Pacific first quarter earnings release conference call.

At this time, all participants are in a listen-only mode. (OPERATOR INSTRUCTIONS).

It is now my pleasure to introduce your host, Mr. Dick Davidson Chairman and CEO of Union Pacific.

Thank you, Mr. Davidson.

You may begin.

Thank you.

Good morning, and thank you all for joining us for our first quarter earnings conference call.

Here with me today are Jim Young, our President, and Rob Knight, our CFO.

I will start this morning off today with a few opening remarks, and Rob will take you through the financial details; and then Jim will provide an update on our network management initiatives, as well as to discuss our commodity revenue performance.

Then I will return after their comments to give you the second quarter outlook, and then we'll open it up for your questions.

We're reporting earnings per share of $0.48 for the first quarter compared with $0.63 per share earned in the first quarter of 2004.

As we discussed with you back in March, the January West Coast storm had a major impact on our operations, reducing our operating income by roughly $55 million or $0.13 a share.

Total revenue grew by 9%, to 3.2 billion, a first quarter record and the fourth consecutive quarter that we've topped the $3 billion mark.

Contributors to the strong revenue growth are improving yields, fuel surcharge recovery efforts and the record demand for our service.

Rob and Jim will both provide additional technicolor on the revenue.

But let me say that we're pleased with our revenue growth, especially when you consider our West Coast operations were basically shut down for a couple of weeks in January.

Coming into the first quarter, we had estimated that our average diesel fuel price would be between $1.30 and a $1.35 per gallon.

Unfortunately, crude prices increased by roughly $10 per barrel between February and March, and there doesn't appear to be much relief in sight.

We paid an average of $1.45 per gallon for diesel fuel in the first quarter versus $1.02 a year ago.

The silver lining in this cloud of high fuel prices is that we've increased our ability to cover some of that increased cost.

We're still not quite there to get it all.

Operationally, our performance has improved since the beginning of the year.

The quarterly earnings were impacted by the network challenges we continue to face.

Rob will provide the break out of our higher operating costs; but this is clearly our area of focus going forward.

As we improve our network fluidity, our goal is to take out the added failure costs that we have incurred over the last year and grow our profitability.

This slide shows our seven day carloading trend.

The green line shows from January '05 to current, and the red line is '04.

We've also included '03 in the blue line for some longer term perspective.

Taking out January of 2005, when we clearly lost traffic due to the West Coast storm, we've seen growth month over month, quarter over quarter and year over year.

In fact, we've seen more than a 1,000 carload per day increase in our traffic levels compared to the first quarter of -- comparing the first quarter '05 to '03.

Taking a look at our network metrics, you will recall that in 2003, our railroad was operating at what we would consider to be normal -- more normal -- efficiency levels.

Because of this, we've included 2003 averages on the slide to give some perspective on our network performance.

I believe, and I think our customers have seen, that over the last few months, we've improved our operations.

Velocity, dwell and inventory measures have each rebounded versus a subpar performance in 2004.

The change has been gradual; but we've made progress every month this year, even in the face of the challenging January storm.

Our ability to quickly recover from the disruption out west and to move the increased volumes I just mentioned are a clear indication that our operations have stabilized.

We believe the combination of our tactical resource additions and strategic network management initiatives are beginning to pay dividends.

Clearly, we are not yet at our more fluid 2003 performance levels, so we've still got some work ahead of us before we can declare victory.

But we are gaining traction, and we're going to work hard to build on that momentum.

We'll refrain from going into too much detail on the network initiatives today and save that discussion for the May analyst meeting here in Omaha.

So 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 today by walking you through our income statement.

Operating revenue grew by 9% in the first quarter, or $259 million.

The driver of the increase was an 8% increase in commodity revenue to just over $3 billion, our strongest ever first quarter performance.

During the quarter, volume grew by less than 1%, due to the West Coast storm and having one less day in the quarter versus last year.

In addition, our mix of business, with a decrease in ag and industrial products loadings, was actually negative.

The real key to our revenue growth was increased fuel surcharge recovery and improved yields.

Fuel surcharges contributed roughly half of the growth, or about $136 million.

This strong recovery was attributable in part to the lag effect of our programs in last year's high fourth quarter diesel fuel prices, as well as our continued efforts to implement the surcharge program throughout our businesses.

Our yield initiatives added a little over 4 points to our revenue growth.

As with fuel, we're taking a very disciplined approach to our business, with the goal of improving returns.

Now turning to our operating expenses, we're clearly not where we want to be operationally, despite our velocity gains.

And although year over year we did not incur incremental failure costs, we did not see any improvement, in part due to the January storm.

We have added considerable resources into our network to drive velocity, but we aren't using those resources in the most productive fashion just yet; so there clearly is upside for us.

Looking at the individual expense lines, salary and benefit expense was up $88 million or 9% in the quarter.

Driving this change was wage inflation, coupled with a 5% increase in our workforce.

This is a reflection of last year's training and hiring program, which was really just beginning to ramp up a year ago, as well as increased track maintenance work.

In fact, our force levels were basically flat versus the fourth quarter of last year.

Year over year, our training costs were up $11 million, driven again by our hiring programs, as well as increased engineer training.

This category also saw about a 6 million increase due to the West Coast storm in the form of extra crew costs.

For the full year, we continue to hire, train and [INAUDIBLE].

We are hiring predominately to back-fill attrition; and at this point we'd estimate that our workforce could be up 1% or so for the full year.

For the second quarter, salary and benefit expense should grow more moderately as operations improve and we start lapping last year's workforce increases and higher training costs.

Rent expense was up 8% in the quarter, or $26 million.

The drivers behind the change were primarily volume increases and additional locomotive leases.

Higher intermodal loadings accounted for roughly a $5 million increase year over year; and locomotive leases, both long and short term, added another $12 million.

In the second quarter, rents will be roughly equal to first quarter expenses.

Increased productivity will likely be offset somewhat by higher locomotive lease payments associated with both our 2004 and 2005 acquisitions.

You will recall that 2004 adds were back end loaded and we were bringing on the 2005 locomotives in the first half of the year.

Depreciation expense climbed 15 million in the quarter, a 5% increase.

This is in line with our full year outlook and is a result of our ongoing capital programs.

Turning now to fuel expense, up $150 million, as diesel fuel prices increased over 40%.

As I mentioned, we recovered 136 million of this from our fuel surcharge programs, which equates to roughly a 70% recovery rate of the amount above our $0.75 per gallon benchmark.

Another item that helped reduce our fuel expenses was a 4% improvement in our fuel consumption rate.

This reflects our operational improvement, as well as our continued emphasis on fuel conservation.

Looking out to the full year, there continues to be a great deal of uncertainty regarding fuel prices.

Our outlook today would be for prices to stay elevated, averaging in the $1.40 to $1.50 per gallon range over the year.

Turning back to the income statement, materials and supplies expense was up 10% in the quarter, driven primarily by higher freight car and locomotive material costs and an increase in locomotive overhauls.

In the second quarter, we will likely see continued double-digit growth in this category.

Finally, we have purchase services and other down 7% in the quarter, or $31 million.

You'll remember that a year ago, we recorded a $30 million expense for the Arkansas court case.

In addition, this category benefited from a $3 million quarterly expense reduction associated with the asbestos charge we announced last December.

Offsetting some of the good news were storm-related costs of approximately $5 million in the form of contractor expenses.

For the second quarter, we would expect expenses in this category to be flat to slightly up year over year.

In total, operating expenses were up 10% in the quarter, or $260 million, with nearly 60% of the increase attributable to higher diesel fuel prices.

Despite this, operating income was flat year over year due to our strong revenue growth.

Our operating margin declined 1 point to 9.9%.

Setting aside the impact of the January storm, we believe our margins would, at a minimum, have been flat year over year, and possibly even shown some improvement.

So to finish out the income statement, other income was $20 million in the quarter, down $8 million.

That's in line with our expectations for the full year, which is somewhere in the 75 to $100 million range.

Interest expense was $132 million, down about 3 million for the quarter.

Although quarterly debt levels are slightly higher, our interest expense was actually less, due to last year's $6 million interest payment for the Arkansas case.

Income tax expense was considerable -- considerably in the quarter -- up considerably in the quarter -- to $73 million on basically flat earnings.

As you may recall, last year, our effective tax rate was 20.3%, primarily due to a one-time apportionment change which decreased our state tax liability.

This quarter's effective tax rate of 36.3% is a more normalized rate, and is closer to the 37% rate we would expect for the full year.

The end result was net income of $128 million and earnings per share of $0.48 per diluted share.

In terms of free cash flow, cash from operations was up $120 million despite the decrease in net income.

Although we prefunded a 2005 pension contribution in the fourth quarter of '04, we did have a pension contribution of $50 million in the year-ago quarter.

In addition, in 2004, we had higher compensation payments, related in part to a Union settlement.

Cash used for capital other was also higher at $620 million, a $147 million increase.

Driving this increase was higher cash capital spending, as well as the timing of equipment acquisitions.

Dividend payments were basically flat year over year.

The net result was a decrease in free cash flow of 19 million from a year ago quarter.

As you know, the seasonal nature of our revenue stream generally results in negative free cash flow in the first part of the year.

Turning now to cash capital and leasing.

This slide shows our spending trends.

The bars on the left show our cash capital as it impacts our free cash flow calculation.

For this year, we are targeting 2.1 billion in cash capital expenditures.

The bars on the right represent an estimate of the net present value of our future lease obligations under both our long term and flexible operating lease commitments.

These costs flow through our income statement over time in the form of rent expense.

In 2005, we anticipate using operating leases to finance the acquisition of 315 core locomotives, as well as our freight car additions.

Of course, this does not include the short term surge locomotives that we've taken on to improve our velocity.

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

Thanks, Rob.

And good morning, everyone.

As Dick pointed out, the base operating metrics of the railroad are showing improvement.

And if you take that down another level and look at some core productivity measures, you'll see gains as well.

Car cycle time represents freight car velocity and is a measure that our customers see in terms of car availability.

Lower cycle times are good and reflect the velocity improvement on our network.

We're better than a year ago, but still have work to do to match 2003 levels.

The key point here is we have made progress in car cycle time, in addition to handling more volume.

From an employee productivity standpoint, we began losing ground back in the second quarter 2004, when we were adding employees and our network was slowing.

Starting off 2005, our productivity was again less year over year; but that was primarily due to the West Coast storm impact.

During the first quarter of this year, we averaged around 1,850 employees in engineer and conductor training compared to about 1,650 a year ago.

We're still in a training catch up mode today, primarily with our engineers.

Looking out, a more normalized training number would be around 700 to 800 per quarter to handle attrition in volume.

So you can see, we currently have around 1,000 extra employees in training compared to our future requirements.

If you step back and look at what's driven our velocity gains, it's really two things -- The improved health of our critical resources -- that's crews, locomotives and freight cars -- and our efforts to manage the volume flows under our network.

Going forward, our emphasis will be on optimizing the transportation network through implementation of the unified plan, which I'll talk more about in a minute, improving terminal throughput using lean management and targeted capital investments and enhancing our ability to manage business flows through continued yield initiatives.

This includes working with our customers to increase load/unload capacity, reducing day of the week variability in our train flows and managing customer inventories in our network.

We've made progress in this area over the past 15 months, and we will continue to emphasize this effort as part of our overall velocity strategy.

Let me give you a quick update on the unified plan.

We completed our top level network analysis at the end of March.

Over the next few months, we'll be changing our four major components of our network operations: Autos, Manifest, Mexico and Intermodal.

Two days ago, we implemented the eastbound portion of our premium automotive plan.

This change decreases network congestion through fewer car handlings and work events, with the end result of velocity gains.

In fact, we'll see these benefits as implementation progresses, with some of our customers experiencing a 20% improvement in their Chicago transit times.

To complete the auto implementation, we'll modify westbound flows by the end of the month.

This change takes an additional four trains per day out of North Platte and creates five and a half miles of capacity on our network.

We'll start implementing the manifest plan in May.

The rest of the operational changes are scheduled for completion in the second and third quarters, with continued refinement throughout the year.

This timeline is slightly elongated from our original estimate, but we're still targeting full implementation prior to peak season.

Really, this will be an ongoing process for us as we continue to match demand and capacity constraints.

Let me give you an example of a specific project that incorporates demand management, lean and unified plan, all brought together to improve our productivity and velocity.

The Sunset Corridor, which spans roughly 760 miles from Los Angeles to El Paso, has been a real challenge for us.

When we merged with the SP, it was a little over 20% double tracked, and we were averaging about 32 trains per day across that line.

Since merger, we've added another 13% of double track but increased throughput the number of trains by nearly 50%.

We also know that the actual demand for trains moving on that line could be up as much as 20% higher.

To improve velocity in this quarter, we formed a special project team was tasked with four things -- Meter volume and throughput on the Sunset at an optimum 44 to 46 trains per day through a combination of demand management, as well as summary routes over our South Central Corridor; reduce the daily variability in train volumes; increase terminal processing rates in Phoenix, Tucson and El Paso using lean; and achieve a sustained velocity.

Let's take a look at the results of those efforts.

Today, we have steady train volume throughput across the Sunset at our targeted volume.

At that optimum train flow, our velocity has improved 15% since the last half of 2004.

In addition, our customers have benefited from a more than 40% reduction in freight car dwell time in Phoenix.

What's important to know is that much of this progress was made in the face of the West Coast storm interruption, which caused us to reroute trains back over the Sunset.

In addition, our annual track maintenance program on the Corridor was in full production by the end of February; so this has been a real success story.

Now long term, we do have ongoing capital needs on the Sunset with our double track project; but we can add those miles incrementally as growth investment is supported by improving financial returns.

Turning to our revenue growth, it was a strong quarter for us, especially when you consider the January storm.

Volumes were up about 1%, but our run rate was probably closer to 2% without the storm.

Looking at it by commodity, energy had a record quarter, both in terms of revenue, up 14%, and operations, running a record average of 36 trains per day out of the southern Powder River Basin.

Our outlook is for continued strength, based on overall demand for western coal.

Industrial and agricultural products are both great examples of yield management.

The January storm had an impact on these groups, and we also know we left business on the table.

Our focus here is on improving our network and at the same time increasing returns.

In particular, with industrial products, a strong construction market continues to drive revenue growth in such areas as lumber, stone and steel.

In fact, in the month of April, orders for center beam flatcars used to haul lumber are continuing at very strong levels.

So our second quarter outlook in this group would be for another strong performance.

And while ag products saw a fall off in Gulf wheat exports during the first quarter, our ethanol volumes increased by 13%, and we saw good demand for our refrigerator box cars in our Express Lane service.

Growth should continue in the second quarter, especially as service improvements drive greater car availability.

Our chemicals business continued the growth trend it started last year, with a 2% volume growth and 6% yield improvement.

Strong demand for fertilizer, liquid petroleum gas and soda ash contributed to this growth.

Looking forward, we see continued strength in the movement of fertilizers and soda ash, but there could be some weakness in plastics if auto production stays soft.

Intermodal revenue was up 3% on a 1% volume growth.

This group felt the biggest impact from the West Coast storm, with revenues down nearly 3% in January but up over 5% for February and March.

Our international volumes ran strong in the quarter, up 14%.

As we talked back in January, we still expect continued intermodal growth, driven by Asian imports and consumer demand.

Automotive was the only group that didn't run ahead of last year, which isn't surprising considering the slowdown in new car sales and extended plant shutdowns.

We had previously expected auto revenue growth between 2 and 4% this year; but that's probably not realistic given what we've see in the industry today.

For the second quarter, we will likely be slightly down year over year.

So let's wrap it up here in terms of our outlook.

Overall, we have a pretty positive outlook for the remainder of the year.

We will spend some time in our May analyst meeting discussing more detail, but here are a few of the thoughts.

We see demand for our services continuing, although autos will likely be softer, and there's some question mark with regard to plastics.

As we implement our network management initiatives, we expect operational efficiency to improve, which means we should convert more topline revenue into bottom line results.

Economists are not predicting energy prices to abate in 2005, so we will focus on our fuel recovery program and be aware of the potential broader economic fallout.

While our business today is very strong, we are watching the economy closely for any signs of softness.

The upcoming peak season is both an opportunity and a challenge.

Today, we're much healthier with our resources and better positioned to handle the peak; and when August rolls around, we'll be even more prepared with our continued locomotive and employee additions, as well as implementation of the unified plan.

Finally, we would expect our overall financial returns to improve, which is absolutely necessary to support additional capital investments.

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

Okay, thanks, Jim.

I would echo your comment regarding operational efficiency.

We're absolutely committed to running a quality railroad, which will permit us to leverage the revenue growth into better bottom line results.

Looking in particular at how we see the second quarter shaping up, we would expect to report earnings per share for the second quarter in the range of $0.75 to $0.85.

The drivers behind this estimate are revenue growth in the 10 to 11% range, with fuel surcharge recovery and improving yields driving the majority of the growth.

Although volume should grow 1 or 2 percentage points in the quarter, we'll continue to be selective regarding the business that we permit to come on to our network in order to facilitate further operational improvement.

Today, our spot diesel fuel prices are averaging $1.70 per gallon, due to unusually high regional spreads in some areas of our operations.

We do expect that to come down, however; and for the second quarter, we are forecasting an average diesel fuel price between $1.55 and $1.65 per gallon.

This compares to $1.16 per gallon that we paid in the second quarter of '04.

Assuming less fuel price volatility in the quarter, we would expect to offset much of the added expense through fuel surcharge recoveries.

We would also expect to see margin improvement in the quarter as we look to translate more of our strong revenue growth into bottom line earnings.

At this point, our full year expectations have not changed much; although we would anticipate revenue growth of 6 to 8%, slightly above our original 5 to 7% projection, with some further upside possible if demand stays strong.

We've also increased our forecast for crude oil from 40 to $45 a barrel to closer to $50 a barrel.

On a per gallon basis, this is roughly $1.40 to $1.50 per gallon.

However, this is still a very volatile number, so we will update you as the year progresses.

Importantly, with the first quarter behind us, we would anticipate earnings improvement going forward through the remainder of '05.

Of course, underlying all of these estimates is our expectation for increased operating efficiency.

Although we will always have challenges that temporarily slow our recovery, we are encouraged by the progress that we've made so far this year.

We also look forward to further gains as we rollout the unified plan and continue utilizing lean management techniques.

Our focus on improvement will benefit our customers, our employees and our shareholders as we restore fluidity to our network and increase our profitability.

So with that, we would be glad to take your questions.

Dan?

(OPERATOR INSTRUCTIONS).

Our first question is coming from Jason Seidl of Credit Suisse First Boston.

Please proceed with your question.

Dick, Jim, guys, how's everyone today?

Good.

Thank you.

A couple of quick questions here.

One, I apologize if I missed this, but could you break out what pricing was in the quarter if we exclude fuel surcharge gains?

Yes, I think Rob addressed that.

Rob, do you want to --?

Yes, it was on the slide.

Excluding fuel, our yield was up 4.3% for the quarter.

Okay, and that's excluding any sort of just general commodity mix changes or anything else?

Yes, mix and volume resulted in a negative 1%.

Okay, so that was against you.

Okay.

In regards to the fuel surcharge, you guys said you recovered about 70%.

Going forward, where do think you can take that number?

You know, we continuously improve that as we have every opportunity to strengthen the fuel surcharge recovery in our deals, and I think that based on the numbers that we're looking at for the year on fuel, we would expect that to be at around the 75% range.

But our long-term goal is clearly to get to 100% recovery.

Long term.

Yes, this year will be in the 75, but ultimately we want to get to 100%.

Okay, fair enough.

Also, when we look at your operational matrix in your slide, you've used 2003 sort of as a comparison point.

I guess at what point do you think you could start meeting the 2003 levels, and is that the point we you start trying to take on additional business?

Well, let me address that, Jason.

In some areas, and if you look at the graphs that we showed, we're approaching 2003 levels now; as an example, with terminal dwell, we have really seen the fluidity of our terminals improve.

We still have substantial room for improvement in velocity and a little bit of improvement left to get our freight car inventory down where we would like to see it; but it's -- our freight car inventory is also shown a huge improvement.

You can see here we're within a few thousand cars of being back at 2003 levels.

So you know, I'm not going to give you a specific date when we're going to surpass it on all three measurements, but what we look for here is continuous improvement.

Okay.

And in terms of -- you know, is that sort of the inflection point do you think of starting to allow more business to come on to the network instead of being --?

Well, that's a -- you know, we're going to be very selective about additional volume coming onto the railroad.

You know, kind of the test is going to be is everything reinvestable, does it justify our valuable capacity here?

Because in many corridors, as we have said, we are pushing capacity.

And if we continue to grow volumes on those corridors it's going to have to justify investment.

So it's going to be -- we don't look for strong volume growth.

We will look for continuous improvement of 1 or 2% or so, but we're not anticipating huge volume growth.

Okay, fair enough, guys.

I'll let somebody else have at it.

Thanks.

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

Please proceed with your question.

Great.

Thanks.

I guess this is probably for Rob, but is it -- did you get about 2.1 billion in cash Cap Ex, and then about what, 700 million in operating leases coming on for, what, about 2.8 billion of new capital coming into the system?

That's right.

Okay, so that's about two and half times depreciation.

I guess what I'm trying to figure out is -- you know, because I thought the big spending program after SP was going to be kind of in the late 90’s, and then maybe '01, '02; it looks like it's ramping up again.

And the other railroads are spending kind of the mid teens in terms of revenue on Cap Ex, and you're up now to 21%.

Can you kind of give us a thought on when does this start to go down, or does it start to go down?

You know, Jim, what we're looking at here is we're going to be smart about the cash capital investments here, and if the returns are there, the business strength is there -- you know, we will make the smart decision here.

So -- I mean, if Jim or Dick --

Let me remind you, too, Jim, you mentioned '01 and '02 being kind of the peak year.

The fact of the matter is, in '01 and '02, we actually cut capital back, because if you remember, we were kind of in the midst of a business downturn, so we tightened things up considerably.

Our peak spending years were, if I remember right, '98 and '99, when we were really going strong, we were building a locomotive fleet and that sort of thing.

You know, going forward, nobody's crystal ball is perfect, but I would expect our locomotive acquisitions to slow down, because we have added a lot of horse power and we've got a very young, modern locomotive fleet.

And then from there, we'll just have to see how strong the business demand is and what cash flow looks like and what makes sensible investments for us.

Okay, okay.

If I could switch gears for a minute, on the Powder River Basin we’re finally seeing after a long time, the commodity price at the mine really start to move up quite a bit.

And I think the utilities are realizing the value relative to the price increase we've seen out east.

To what extent is your Circular 111 and 112 – to what extent are you capturing that amount of increase?

We're seeing in some cases longer term contracts going up 20, 30% for the actual, you know, coal.

Jim, you want to --?

Well, Jim, you know, right now, our Circ 111, we've got about 15% of our business when you look to next year under -- in that excess (ph) southern Powder River Basin under that new pricing and document.

You mean in '06 or '05?

Through '06.

You know, you look ahead here -- that's this point in time here.

But there are more contracts coming up over the next, you know, year and half that, you know, will come under that circular.

So what's under the circular presumably, could float up and we could see it moving up like a commodity price?

That's our intent.

Okay, and one last question here.

The Cap Ex numbers here, do they include any major expansion in Southern California?

And then could you give us an update on -- given all the congestion and demand in that market, what your thoughts are on the need for new capacity?

There are some significant dollars this year, Jim, being invested in capacity expansion.

They are facilities such as Wilmer in Dallas, a new intermodal and automotive terminal in Salt Lake City; and of course, an additional 50 miles of double tracking on the Sunset Corridor.

We're also spending some capital dollars, a fairly healthy amount, on the East/West line between Omaha and Chicago for signal improvement on that antiquated system that was in place over there, plus some additional trackage to facilitate volume growth.

All told, I think those kind of numbers would add up to somewhere around $300 million.

Okay, but you’re not doing anything on dock or at the extra port to expand capacity?

Not really.

You know, our thought there is just to -- with the augmentation of our manpower and locomotive fleet, is to move the stuff out of there on a current basis.

Okay, great.

Thanks, guys.

Appreciate it.

Thank you, Jim.

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

Please proceed with your question.

Good morning.

I have two different questions for you.

The first one is along lines, again, of capacity.

I think you had mentioned that the capital investment translates to about 50 miles of double track this year on the Sunset line, and I was wondering if you could provide some perspective in terms of historically on the whole system, how much double track work do you do in a typical year?

Is it -- you know, is it 50 or is it 20?

And then also, looking forward, given the projections for continued double digit growth into the port, if you're going to handle growth with your existing customers in intermodal, how much do you need to add the next, say, three, four years in terms of double track on the Sunset line?

Well, you know, quite honestly, I'm kind of the historian of the Company here, I guess, since I've been around here for 45 years.

Double tracking is a fairly new phenomenon.

In fact, most of my career we were retiring trackage instead of adding.

But in the second half of the '90s, I guess primarily driven by growth in coal coming out of the Powder River Basin, we started double tracking and triple of tracking, and in one case, quadrupled tracking, across Nebraska and Kansas and of course, then when we brought the Chicago Northwestern, there was about, if I remember, 45 or 50 miles of single track on the CNW that we double tracked.

So it's really -- it's been a phenomenon that -- with the just reverse retirements and started adding capacity here in the second half of the '90s.

Right now, you know, we're probably looking at 50, 60 miles a year unless we see a real strong economic motivation to grow faster than that.

So we're -- it's a relatively long-term project to get the entire Sunset route double tracked.

But we will see incremental improvement with each segment that we put in.

In fact, we're seeing it today.

I think we've cut in about 30 miles already this year, and it really is making a nice improvement in our fluidity, along with the attention we're paying to it with our industrial engineering group.

Hey, Tom, this is Jim.

You know, when you think about capacity, as Dick said, it's not just double track, it’s signal systems.

For example, between Chicago and Omaha, we're upgrading our signal systems.

That generates capacity; it’s upgrading the track -- existing track -- to where you're taking out slower orders and track defects you get your velocity up.

All of that generates throughput for us.

And I'm with Dick, the other thing -- I mean, obviously, you can ramp this up or down depending on what your view is in terms of the economy and returns.

And that's one nice thing about the railroad business, is you can kind of spend it by the inch as the -- as demand drives it.

Right, okay.

Great.

One more question, then.

On the pricing side, I think historically maybe the biggest customers were the toughest to deal with in terms of, you know, avoiding prices going down too much or even trying to get rates up.

Can you give me a sense maybe over the last six months how you've seen the bigger contracts roll over?

And also, if you look at what you might have repriced in the first quarter, how much are you asking for it now or how much are you getting versus what you would have been getting a year ago?

Jim, you want to take that?

Hey, Tom.

Yes, it obviously varies by market, customer, where the returns are today; but I will tell you, you know, across the board, we're taking a very hard look at the returns, whether it's a small or large customer.

And you know, in many cases, we are seeing prices go up.

Now, we are working with our customers here in terms of a lot of the discussions we have are walking through the logic on where are the financial returns, how do we support their growth long term.

Many of our customers are interested, are we going to be there for them three years, five years from now.

And that's -- so we really do sit down and go through kind of the value proposition here.

But you know, we've got contracts out there, and we're taking a look at all of them.

But again across the board, I'm looking at returns and in many cases, the pricing is going up.

Do you think that pricing number -- Rob mentioned something like 4% yield -- can that accelerate further or should we think of that staying around 4% the next couple quarters -- or how should we look at that?

You know, Tom, it's hard to kind of predict here.

Right now, the market's very high; and when you look at truck rates that are out there, particularly look back first quarter, you know, very significant increases.

We'll just take a look at, you know, what the demand continues to be.

And then again, more importantly to me, is where are the returns?

And some of these quarters that were looking at, where we are faced with investment going forward, if we can't get the pricing up in that particular movement or corridor, you know, we're not going to put the capital into the ground.

Okay, great.

Thank you for the time.

Thank you, sir.

Our next question is coming from Scott Flower of Smith Barney Citigroup.

Please proceed with your question.

Yes, good morning, all.

Hi, Scott.

Hey, just a couple of questions.

I noticed in your revenue guidance, obviously in first quarter and second quarter, you're running and have been running at 9, and you're obviously talking second quarter 10 to 11; but yet for the year, you've got obviously a lower average, and I'm wondering is that presuming a slowdown in second half?

Are you seeing some things in the customer base that you're just trying to be cautious and conservative?

I'm just wondering why the drop off relative to, obviously, if you look at first quarter and then near term guidance for second quarter, you know, you're close to double digit levels.

And obviously, as we look for the full year, that would imply the second half would be demonstrably softer in revenue growth than the first half.

I'm just trying to understand that.

Scott, maybe I will let Rob and Jim both take a crack at that.

Scott, this is Rob.

Our fourth quarter comps, keep in mind, as you know are tougher, but we don't see any -- we're not predicting any particular slowdown here.

So hopefully, as we said, 6 to 8, and yes, there could be some upside to that.

We hope it would be strong.

Jim, do have anything to add?

That's the right answer -- there could be upside.

And then a couple of other things.

Dick, can you tell us how much total is left of the Sunset route to double track?

I know that as you mentioned, it is a long-term project and you've been talking about clipping along at 50 miles a year, plus or minus, depending on the returns and depending on demand.

But give us a sense of the totality of what's left of the project there?

It's just under 800 miles in length and just over a third of it is double track today, so whatever the math is there.

Okay.

And then just a color question.

And I know that you all had alluded to this, but I guess I need to get a little color.

Not assuming that the economy tanks, but that with oil prices where they are and interest rates gradually rising, and at some point economics works and the relative demand shows some moderation, how are you expecting to be able to manage that -- i.e., you've got to be tactical if demand is there to handle it as you turn the operation.

But what things can you do -- obviously, the easiest example is on the short term lease locos drop out.

But I'm just trying to understand if things for whatever reason as we go towards late third quarter start to decelerate more quickly than what's evident now, what things can you do to drop resource costs out at that juncture?

Well, as you know, our workforce is a variable cost; we clearly could tighten things there, Scott.

Also, if volume softened a little bit, I would look for failure costs to drop out more quickly as well.

As an example, our recrew rate is just way too high right now, and if volume softens a little, I would look for that to improve to dramatically.

As you say, we still have some high cost, short-term leases locomotives running in the fleet that would come out more quickly.

Freight car cost should shrink, and we ought to see improving cycle times on our freight cars, and -- you know, it would be the same thing that you've seen over the years where we would be able to take costs down.

Okay.

And then I guess the last question for me, and I'll let someone else have at it, is I know that you all have set the time line in June to discuss about the unified plan, and I know that you're tailoring it uniquely to properties, looked at it.

But obviously, when you looked at some other folks that have rearranged their networks, they haven't been able to really turn it quite as quickly, and this is seemingly a more compressed time scale, and you obviously have a very complex and intricate network.

Could you maybe give us some color or flavor for why you feel good about the time scale of implementation and getting everything done prior to peak?

Obviously, you've looked at this carefully.

But I'm just trying to understand that a little better.

Scott, let me take a crack at it, and then Jim can correct what I say.

One, we've had the benefit of benchmarking all the other railroads that have gone through this exercise, so you know we're shameless about trying to copy good things other people do.

So we've had that knowledge.

Plus, actually, we have started -- and some things were started actually ahead of the second quarter, like some of our terminals, we rebalanced the workload and have already started seeing the benefits from that.

Now, I don't think that Jim intended to imply, nor would I be so bold, as to say we're going to have everything straightened out once the unified plan is in place; but it is going to make a dramatic difference, I believe, and we'll see a more accelerated stair step improvement would be my hope here.

But you know, we've got really smart people working on this.

We've got absolute buy in from all of our managers all over the whole railroad.

We've got them all together and going through the plans and they've all -- if they didn't agree with it, they expressed their concern and we've worked back and forth, and we now have something 100% of our people are engaged in, and we’re going with it.

I mean, Jim, do you --?

Sure.

Scott, you know, I think when you look at the Sunset Corridor, it gave us some confidence that if you approach this right it does work.

That was really kind of a mini test lab, I guess, to say, do all these concepts where we're talking about unified plan, good industrial engineering, which is lean in the terminals, flow management working with customers, it works.

We've got a phased approach.

You know, I look at this as, you don't just turn a light switch on, you start, you implement, you adjust as you go forward, but you're always cycling.

I mean, this is -- one of the things we're learning here is with capacity being tight -- and there are not going to be any quick solutions to capacity in this industry here in the near term -- we're going to continue, really every year, fine-tuning this plan.

You know, Jim, that reminds me.

When I got that question about added capacity in southern California, I failed to mention the most important thing here.

As we've gone through the lean process in our intermodal terminals -- you may remember, we talked about the process that we went through in Chicago back a year ago or so with McKinsey (ph) helping us.

We have taken that philosophy to all of our intermodal terminals across the railroad today, including Southern California, and I think that just in round numbers, we have increased throughput through our intermodal facilities by 30% with just process improvement.

Very little capital.

So I mean, it's absolutely a heartwarming story.

It is -- it's just -- the results have been huge for us, and that gives sense a new benchmark that as we continue to refine our industrial engineering techniques, that we would expect to get even additional throughput.

So that's the most important thing I failed to mention this morning, and thank God it doesn't always take capital dollars; process improvement can make a huge difference.

Great, thank you.

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

Please proceed with your question.

Good morning.

Hi, Jordan.

Hey.

Can you guys talk a little bit on the pricing side, specifically on the intermodal, which, you know, normally I guess it just tracks lower than the other commodity segments; but just wondering, because it did seem a little less than we would have thought.

Jim, do you want to --?

Okay, Jordan, you know, there are a couple of different things driving the intermodal if you look at it.

We had your revenue per unit up 2% which was the lowest out of all the groups.

Two things, mix hurt us there.

We had a falloff in terms of our premium and domestic, which tends to carry a higher revenue per unit; and that's a function at the end of the day of our service.

And to some extent, pricing; but as our service numbers improve in velocity that favorable mix will come back.

But also this is an area that's got, you know, a high proportion of longer-term contracts that our pricing capability has been limited.

And that's a business that the returns absolutely have to increase going forward, and as these contracts roll off, we're going to price these things to market.

Is contract anything more or less this year, would you say, or is it normal, you know, 20% or how do you characterize it?

Yes -- overall it's around 20% for all of our business in terms of how our contracts roll off.

This one here has a little bit longer time line when you look at it, and -- but again, we're working with our customers in terms of looking at how we can together get pricing up; and you know, as these contracts come off, we'll -- we've got to get the returns up here.

And if you think about the Sunset Corridor, where you're facing -- that's a premium corridor, it's got a high degree of intermodal business -- and for us to look at any substantive kind of growth investment there, these returns have to go up in the intermodal business.

And just as a just final question, sort of take a picture, with the investments that you guys are making, what's the sort of longer-term type of volume growth you're generally looking at in your network, given, you know, the investments that you're making?

Do you have an update on that?

And I know this year it's sort of 1 to 2%.

But, you know, longer term, based on the infrastructure investments, what are you looking for?

You know, I think it's a function of, again, right now we look at maybe 2 to 3% long term; that might be the best mix when you look at capital.

It's a function of how much capacity you want to put in this business.

We will get the most out of assets with things like lean and unified plan before we put a dollar in; but the real key is, how much growth do you want to put in the business in terms of capital?

And I tell you, there's a very direct correlation between that and volume growth.

But right now for us, we kind of think that optimum is maybe 2 to 3% on volume.

The returns will drive it.

If the returns are strong enough we will be glad to invest for it.

Our next question is coming from Randy Cousins of BMO Nesbitt Burns.

Please proceed with your question.

Good morning.

I wonder if you guys could address the whole productivity issue.

I quite like the slide with your GTM’s per employee and cycle times.

You've talked in the past about failure costs.

Could you quantify the failure costs in Q1 and then how you expect those failure costs to come down over the balance of this year?

Yes, I'll take that.

This is Jim.

You know, first quarter is around $50 million when you look at kind of the failure costs out there -- that excludes training.

So, you know, again, it's a big number.

We've said, you know, a mile an hour is worth about a $100 million of operating income to us, and a lot of that is failure costs.

So it -- again, that productivity slide we have in there on gross to miles per employee -- just a reminder, we've got about 1000 extra employees in training right now, primarily in engineers -- we're going to be at our healthiest in engineers by the middle of the year, so the normal run rate that will fall out, so we've got a lot of opportunity here on the failure cost side.

So Jim, in terms of this 50 million in the first quarter, would you expect to have that sort of number down to 0 by the end of the year?

You know, Randy, you know, my expectations are is we are going to see continuous improvement through the year here, and we'll see how things go.

I do expect, as I said, our productivity numbers will continue to improve each quarter.

Okay.

My second question has to do with the Powder River Basin.

Your capacity constrained across the network, and you had good volume growth in Q2.

How was your capacity situation coming out of the PRB, and what do the coal mines say to you in terms of the volume expectations for the balance of the year?

Let me address that question.

As we said -- well, first off, let me clarify something.

We don't have full capacity over the entire railroad -- just certain segments of it.

Other segments have additional capacity and room to grow.

As you know, we've invested quite heavily in the Power River Basin.

The entire route now is double tracked, or portions of it are triple tracked, and even the joint line, the 100 miles that is jointly served by Burlington and Union Pacific, there's been a huge amount of investment going into that line.

It's all double tracked and quite a bit of it's triple tracked, and we're adding more this year -- the Burlington is adding more this year -- they operate the line.

Quite frankly, we have had more capacity in the first quarter to haul additional coal out of there than the coal chain, delivery chain, has been able to satisfy.

And when I say that, in the chain, you've got the producers, which are the mines and the PRB; you've got the railroad, and then you've got the consumers, which are the utilities.

And my guess, and this is just kind of a Kentucky windage guess, is we could have easily handled another 30, 40, 50 trainloads of coal out of the PRB, except for the fact that one of the portions of the chain broke down and didn't quite maximize the opportunity.

So we had the capacity to handle it.

But for one reason or another, it wasn't loaded.

Now, going forward, I would tell you that as far as accessing the Powder River Basin and having the main line capacity, we're in pretty good shape.

As that business grows, though, there will have to be a little bit of incremental improvement in processing at our inspection and fuelling points, but we can -- I mean, we've got a plan laid out how to do that, we can do it cost effectively, and, you know, we're looking at that as one of our continuing growth areas for us.

But Dick, in terms of sort of like a expectation for volume growth in the coal franchise out over the balance of the year, what kind of numbers should we kind of be modeling, then?

What are the coal companies saying to you in terms of volume that they expect to move?

You know, I think they're all pretty bullish about demand for coal saying strong and good production.

I think today that, you know, with the high natural gas prices, there's no utility that I know is burning any natural gas if they can avoid it.

They all want coal.

So the kind of growth rate we saw Q2 -- or Q1, excuse me -- we should extrapolate kind of going forward?

That’s roughly correct, yes.

Yes, that's pretty accurate, I think.

Okay, thank you.

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

Please proceed with your question.

Good morning.

Jim, I just wanted to follow-up on a couple of the employee hirings that you were talking about in your presentation.

You'd talked about -- I think you said you were looking for it to be about up 1% for the year.

Can you talk about the rate of retirees that are going -- I think you kind of alluded to this during your presentation -- that you're trying to play catch-up and you still have some extras in training.

Can you talk about what that path is going to be?

Because I'm trying to understand the gross ton miles per employee, why that decreased so much.

Was that more a factor of the velocity staying down, or is that on the employee side?

Well, the decrease was two things.

One, it was -- we were losing volume and two, we significantly bumped up our training numbers.

In fact, if you go back to '04, we trained almost 6,000 employees in the [INAUDIBLE], and that was a combination of new hires, conductors and then also engineers.

This year, that number, when we finish up '05, will be about 35, 3600.

So the number of people in training is going to be reduced; and then '06, when you really look at it, you're talking that number is going to be down around 1000 from there.

So normal -- in the train and engine crew area, attrition is going to probably be in the 2000, 2,000 plus range, and so you would expect that's kind of the hiring number I have in T&Y (ph).

That doesn't count volume that's out there; but again, a big piece has been the significant increase in training here in '04 and first half of '05.

So the attrition has slowed from what you were seeing in '04?

Well, no.

You know, the attrition overall is going to be -- when you look at our whole -- you step back at UP in total, you know, our attrition rate is going to be in that 5 to 6% range going forward here that, you know, we've got to deal with.

And we're going to deal with it in several ways.

One, we want to stay ahead of it in the key areas; but two, we've got to improve productivity where we can get -- you know, where we target areas that through technology or efficiency the challenge in this industry is going to be one -- which is difference from where you're going backwards -- is how do you deal with attrition going forward?

We've got a very old workforce that in the next four or five years, our hiring will stay pretty strong.

Right.

But is the attrition now kind of past that peak level, or is this something that's kind of smoothing out on a --?

You know, when you look backwards from where we were, you had attrition in terms of retirements, we had volume that surprised us, and we were behind the curve, when you look at it; and so we had to do a significant amount of hiring and training to get caught up and get healthy.

By the middle of this year, we're going to be in very good shape in terms of being caught up; so going forward, though, again, you're going to have a new level of people in training -- all the railroads will in terms when they look back in the last 8, 9 years because had -- honestly, you had a surplus of employees, and with that rate, the number of people in training is going to be much lower for UP than where we were here the last year and a half.

We will be 50% less than we were last year on a normalized run rate.

Ken, this s Rob.

In the last half this number, should be positive at around 2 percentage.

Very helpful.

And then just on the unified plan, I think you said you were just starting now the auto plan.

Did I catch that correct?

Yes, two days ago we started implementation.

Now, we've been working on this thing since fourth quarter in terms of doing the network design and the high level analysis.

So auto plan started two days ago, should be done here by the end of this month; and as I said, manifest plan starts first of May.

Can you describe when you say you've launched the plan, what is exactly changing that we can see on a kind of operational basis?

You're actually changing train operations, how they operate the corridors, where they do switching in the network.

Work events (ph) on line.

Processing through the terminals.

Our goal here is to take out a very substantial portion of the work done on line and to rebalance the workload for all of our terminals.

Essentially -- well, as an example, on this automotive network, as Jim said, it will take 5 miles of freight cars of North Platte, Nebraska electronic [INAUDIBLE] yard, which is just huge; it’s enormous and there are other examples like that where we should see the work demand at our major terminals substantially reduced.

In fact, I think it wouldn't be out of line to expect a 3, 4, 5% efficiency improvement in our terminals, and essentially, it's getting free capacity by better planning.

So Dick, I guess at the end of the day is this something we see directly into velocity and terminal dwell or is this something that's just more on the overall service metric?

It will reduce terminal dwell and it should improve network velocity; both of those items should look -- should show nice improvements.

Appreciate that.

I just wanted to clarify the direct relation.

Yes, and we'll talk about that more, too, when we have our analyst meeting next month.

Great, thanks a lot.

Our next question is coming from [Brandon Elliott] of [Freed & Associates].

Please proceed with your question.

Good morning, gentlemen.

Just a quick question, and maybe we have to handle this offline, but the fuel effect -- you know, if I look at the fuel and utility side for the quarter, is most of that, you know, basically 150 million increase fuel?

And if so, how does the fuel recovery offset?

I think you said 75% offset, but if I look at the percentage on the revenue growth side, those numbers don't seem to match.

Can you help walk me through what fuel cost you in the quarter?

Yes, quarter over quarter, as I had indicated, the fuel cost line was up 150 million and our fuel recovery was up 136 million, so we recovered 136 of that 150 in the quarter --

Okay.

-- versus last year.

And what's the effect -- what effect has the raising of your fuel or your diesel assumptions going forward have on how you're thinking?

Is that straight line like that as well?

For the year at our higher expectation of fuel prices, we recover -- the way we look at it is how much are we recovering above the $0.75 benchmark rate that we look at?

And we would expect for the year -- and it's a jagged, because, you know, it doesn't actually generally work out to be straight line, so it can be jagged.

But generally speaking, we would expect to be about 75% recovery above the $0.75 benchmark -- which is -- is that clear?

Yes, perfect.

Thanks.

Great quarter, guys.

Thank you.

Our next question is coming from John Barnes of the BB&T Capital Markets.

Please proceed with your question.

Good morning, guys.

Real quickly, going back to the headcount for just a moment.

Are you doing anything with your retiring employees to entice them to stick around a little bit longer, or are you looking at hiring some of them back part time -- you know, they're a retired status, but can you hire them back in a part time situation to handle some of your needs in the near term?

John, we did all that a year ago when we were in such desperate need of folks.

We offered them an inducement to stay on longer, and a number of them did; but we also -- and we also went through our workforce to see how many of them would like to come back to work and work for us a little bit.

I just kind of assumed that in retirement you'd get tired of watching soap operas and be happy to come back to work.

But I think we only found one soul that wanted to return from retirement and come back to work for us.

So, you know, a lot of them are nice enough to stay on -- they're all gone today and you know, we're not trying to utilize that alternative any longer.

Okay, all right.

And then secondly, as you've gone through the process of putting some of the embargoes in place, or -- you know, and I hate to use the word demarket -- but kind of, you know, exit some businesses, maybe not fully but at least partially -- have you learned anything about, you know, the customer base you had, and you know, has that spurred you on to say, okay, hey, this is an area we want to completely exit -- it just is not good business for us, you know, it was a difficult divorce, but now that we're on of it we want to be completely out of it -- or have you found, you know, that you really want to get back into everything you were doing?

The answer is, we don't; but Jim, do want to elaborate on that?

You know, John, we're learning quite a bit here, particularly in the manifest network.

And generally when we look at the individual markets and the margins -- and in particular, particularly what happens with capacity consumption the way we operate and a particular customer operates -- we've been working with our customers in terms of reducing the backlog of inventories.

You know, for example we saw cases where a customer might have a 5 car spot, and yet we had 75 cars backed up in the network and yards waiting to get in there; and we've had to be very aggressive in that in terms of ensuring that both the railroad and our customer optimize that networks in there.

In some cases, there is some business that at the end of the day, if the returns don't get to where we see it's the minimum for reinvestment, you know, we will probably -- we'll work with our customers in terms of options -- but at the end of the day, it may not move in the railroad.

Okay.

And then, is any of that being negatively impacted by the whole common carrier concept?

I mean, are you getting pushed back or, you know, veiled threats from customers saying, hey, you know, you can't abandon me like this -- you have to serve us?

In most cases, I think it's been deregulated business.

Okay.

All right.

And then lastly, outside of the Sunset Corridor, is it any other areas of the railroad that you're currently involved in an aggressive double track effort?

We -- John, it's not a double track effort, but we are aggressively pursuing some additional track capacity, but mainly signal enhancements.

It was a -- started out to be a three year project -- it'll actually be about a three and half year project, I guess, now between Omaha and Chicago.

That was really a -- they had a signal system there, but it was really antiquated and it wasn't conducive to maximizing traffic flow, so we've got an aggressive program going there Omaha to Chicago.

This would be the second year of the program, and we've seen great results from it.

About another -- it would be '06, or mid '07, that program will be done.

But that's it.

We're doing a little bit of work on the north-south route between Chicago and Texas and Mexico.

But the main thrust is the Sunset line and its former Chicago Northwestern between Omaha and Chicago.

Guys, thanks for your time.

Thank you.

Why don't we just take a couple more here, and -- is that it?

Well, very good.

We thank you for being with us this morning and we look forward to seeing you at our meeting in Omaha next month.

Thank you.

Ladies and gentlemen, this does conclude today's teleconference.

You may disconnect your lines at this time.

Thank you for your participation.