聯合太平洋集團 (UNP) 2006 Q1 法說會逐字稿

Good day, ladies and gentlemen and thank you for holding.

Welcome to the Union Pacific's first quarter earnings release conference call.

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

A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS).

As a reminder this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Jim Young - President and CEO of Union Pacific.

Thank you, Mr. Young; you may begin.

Good morning, everyone.

Welcome to our first quarter earnings conference call.

With me today to discuss the results are Rob Knight, our CFO;

Jack Koraleski, Executive Vice President of Marketing and Sales; and Dennis Duffy, Executive Vice President of Operations.

When we spoke to you back in January, we were optimistic about starting 2006 with a solid first quarter and, to date, we've delivered just that.

For the first quarter our earnings more than doubled to $1.15 per share versus last year's reported earnings of $0.48 per share.

You'll recall that a year ago our numbers included the impact of the West Coast storm which was about $0.13 per share; but even adjusting for the storm, our growth was significant.

First quarter operating income grew 93% versus 2005 to 605 million.

In fact our first quarter operating income, which is generally the slowest quarter of the year, was the second highest ever in the history of the railroad.

We have been challenged over the last several quarters converting topline growth into bottom-line results so I am most pleased with our operating ratio improvement of 6.4 points.

Operating ratio is a key efficiency measure and Rob will discuss the details in a moment.

We made great progress in the quarter but we have a long way to go to reach our long-term targets.

If you step back and look at the quarter's key drivers, it really boils down to three things.

First we moved record volume and achieved the best-ever quarterly operating revenue of 3.7 billion.

This performance highlights the strength of our franchise as total volume and revenue growth more than offset a shortfall in coal loadings.

Second, our operations did improve in the quarter allowing us to exhibit better cost control while moving record volume.

Our network management initiatives, mild winter weather and capacity investments all played a role in helping us provide better service to our customers and operate more efficiently.

And, third, while our coal volume declined 4%, the opportunity is still there going forward.

The decline was entirely in our Colorado Utah coal franchise with a 20% year-over-year tonnage decrease.

Jack will provide you with more information; but the good news are the mines are back in operation and there is upside with strong demand for Powder River Basin coal.

Overall, we again made progress with our first quarter results.

There is still a great deal of work ahead for us to achieve our full potential but we believe we are moving in the right direction.

So with that let me turn it over to Rob for the financial discussion.

Rob.

Thanks, Jim, and good morning.

Before I get started I'd like to let everyone know that our 2005 fact book is now available.

As we have in the past the book is available online under the Investor Relations page of UP's website.

I will begin today with a quick look at our income statement.

The headline here is a 93% increase in operating income generated from an 18% increase in operating revenues and a 9% increase in operating expense.

Looking at the components of our revenue growth, commodity revenue increased more than $500 million to 3.5 billion in the first quarter.

Jack will take you through the individual commodity groups.

But in total, volume grew 4% for the quarter with four groups - inter-modal, agricultural, automotive and industrial products, gaining year-over-year.

Our business mix added another point and a half of growth in the quarter due to strong ag and industrial products shipments which carry a higher average revenue per car.

Yield improvement netted six points of growth - another solid quarterly gain and fuel cost recovery added 6.4 points to the total commodity revenue growth.

Overall, it was a record quarterly revenue performance and is an indication of both our franchise strength and the strong demand environment.

Turning now to operating expenses, we will start off with salaries and benefits up 3% in the quarter to $1.1 billion.

As we discussed back in January, the drivers in this category are wage inflation, volume growth and operating efficiencies.

In the first quarter we achieved a 4% volume increase with a 2% increase in our workforce, allowing us to offset a portion of wage inflation with greater productivity.

Primary drivers in the quarter were increased volume costs with some offset for lower training expense.

We also had an increase of $4 million associated with the new stock options expensing requirements of FAS 123' and as you may recall last year we incurred $6 million in higher costs due to the West Coast storm.

Looking out to the second quarter, force level increases of about 2%, wage inflation, volume growth and stock option expense will likely push year-over-year quarterly costs up about 5%.

Quarterly fuel and utilities expense increased $150 million or 28%.

Diesel fuel prices averaged $1.87 per gallon compared to $1.45 a year ago.

In addition to higher crude prices we also experienced significant increases in refining and regional spread.

As we've discussed before, the focus here is on fuel conservation and on our fuel surcharge recovery programs.

We are doing a better job with our surcharges to mitigate the earnings impact but we are not at our objective of 100% recovery of the diesel fuel cost above our benchmark price of $0.75 per gallon.

Volume costs added 8 million to the quarter but a 2% improvement in our consumption rate saved us roughly $7 million.

Looking out to the second quarter, prices have again increased dramatically.

Today, we are currently paying close to $2.10 per gallon for diesel.

There's quite a bit of volatility in the market today, making it difficult to predict where fuel could end up.

This volatility also creates a timing issue for us as our surcharge mechanisms have roughly a two-month lag so we won't recover for April's high prices until the month of June.

And if prices remain high our recovery gets pushed out to the second half of the year.

Higher fuel prices could be a headwind to both our operating ratio and earnings improvement.

First quarter rent expense came in at $367 million, up 4% versus 2005.

This growth is consistent with our expectations for the year.

Volume costs increased due to our 4% quarterly carload growth; in addition, long-term locomotive and freight car lease expenses increased year-over-year.

Productivity gains did offset a portion of this increase in the form of better car cycle time.

Looking to the second quarter we'd expect the drivers to the volume growth with some productivity offset. (technical difficulties) Excuse us.

We've got an alarm going off here.

You might recall that a delay in deliveries last year pushed costs from the second to third quarter.

So in 2006, we would expect greater second quarter increases with expenses up about 6 to 8%.

On a full year basis, however increases are still likely to be around 5%.

Quarterly depreciation expense grew $14 million or 5% to $303 million.

Again this is in line with our expectations for the year and reflects our higher capital spending.

Materials and supplies expense increased 21% in the quarter to $164 million.

Most of the cost increases in this category can be tied to three things.

Each contributing about one-third of the higher expense.

They are higher material costs, increased maintenance activity and a cost shift between expense categories.

We moved some contract work in-house, shifting some expense from purchase services and other to this category.

For the balance of the year we would expect further double-digit increases.

Similar to the first quarter, inflation, volume and the shift in expense categories will be the drivers.

Our last expense category, purchase services and other, grew to $450 million in the quarter - a 6% increase.

One driver was the 11% growth in inter-modal volumes and the related drayage expense.

This category also includes higher state and local taxes and personal injury costs.

On the positive side this category experienced lower contract expense for equipment repairs, better freight claims experience as well as a $5 million year-over-year decrease from last year's West Coast storm comparison.

For the balance of the year we'd expect this category to be flat to up slightly as we gain further operating efficiency.

That's a quick look at our operating expenses.

Let's turn now to our operating ratio.

Jim gave you a preview of this slide in his opening comments illustrating our 6.4 point improvement in the quarter to 83.7 in '06.

This is our best quarterly operating ratio in over two years.

Although roughly a point and a half of the decline can be attributed to last year's West Coast storm, the remainder is evidence of our higher revenue and operational efficiencies.

We are converting record revenue growth into bottom-line gains.

Looking now at the full income statement, Other Income declined 50% in the quarter to $10 million.

First quarter real estate sales were lower year-over-year but we still anticipate full year Other Income in the $75 to $100 million range.

Interest expense was down $12 million in the quarter to $120 million.

Lowered quarterly debt levels drove the decline.

The one downside to higher earnings is a larger tax bill.

Income tax expense more than doubled in the quarter to $184 million; our effective tax rate was 37.2%, about a point higher than last year's rate.

Our expectation is for a 37 to 38% tax rate for the balance of the year.

First quarter net income totaled $311 million or $1.15 per share, more than double last year's $0.48 per share.

Of course as Jim mentioned, last year's results included the $0.13 per share impact from the West Coast storm.

Turning now to capital.

Dennis will provide you with the details in a minute.

In terms of the amounts our plans call for an all-in budget of 2.75 billion.

This amount is about $100 million less than last year's (technical difficulties).

Which you will recall was increased due to weather and joint line charges.

Cash capital is targeted at the 2.25 billion; and the remainder is equipment lease financing.

We remain focused on improving the overall returns of the Company as we invest for future growth and efficiencies.

Let me wrap up with a look at our balance sheet.

This slide shows our debt to cap ratios both adjusted and unadjusted for leases.

As you can see, we continue to strengthen our balance sheet as we grow our business and increase our profitability.

The bottom line, we made great progress in the first quarter and are off to a good start.

Our task going forward is to build on that and improve throughout the year.

With that let me turn it over to Jack to talk to you about our record revenue growth.

Jack, hold on a minute.

I want to apologize to everybody for the fire alarm.

I want to assure you that the fire alarm or the false alarm has nothing to do with our first quarter results here.

So what we can do here is after we are done with the pitches here if we need to go back on a couple of these slides and let Rob walk through them, please ask and we will do that.

How about it, Jack?

Okay.

Our first quarter volume increased 4% over last year, set a new record with significant increases in our inter-modal, automotive and ag products businesses leading the way.

Our strong yield enabled us to translate those volumes into all-time record revenue and average revenue per car per any quarter.

Our total revenue grew 18% as five of our six business groups posted all-time revenue records; and our inter-modal business set a new first quarter record.

We set new all-time average revenue per car records in chemicals and energy and industrial products, while our ag and inter-modal businesses set new first quarter records.

In addition to our improving yield, customer satisfaction reached a two-year high, posting its fourth consecutive quarter of improvements as our customers are seeing slow but steady progress in the health of our network.

In our ag products business, we were able to create some opportunities for our grain customers to move more freight to offset a significant shortfall that we were experiencing in our Colorado coal business.

Two of our coal mines were basically shut down for most of the quarter so we redeployed the locomotives to grain to take advantage of a very strong demand we had for feed grain.

The market drove those shipments into Gulf exports which were up over 200% in the quarter.

Domestic demand for [meals] and oils resulted in a 9% increase in volume while the ethanol market continued to expand with shipments up 22% over last year.

Although the strength in Gulf export demand cut into our Mexico volume somewhat, import beer increased 30% over first quarter last year.

In addition increased volumes of cottonseed, and meals and (indiscernible) which is the ethanol byproduct pushed our grain products 37% higher year over year.

When it was all said and done we offset a little negative mix in our ag business and the combination of yield improvement actions and fuel cost recovery resulted in a [60%] growth in average revenue per car.

Our automotive revenues were up 23% as a result of higher volumes combined with yield improvement and fuel surcharges.

Finished vehicle volume was stronger than anticipated, up 12% as heavy ground comps at year-end translated into strong demand for transportation in the first quarter.

The launch of GM's new 900 Series, the continued ramp up in production of the Ford Fusion (indiscernible), and higher import volumes for Toyota also contributed to the increase.

Our parts business increased volume 4% accompanied by an 11% improvement in average revenue per car.

So looking ahead in our automobile business, we expect that the first two quarters of 2006 are going to be the strongest in terms of finished vehicle move and we expect volumes will probably soften a little bit from that pace during the second half of the year.

Our chemical revenues climbed 14% even as volume declined 4%.

Softer than expected potash export demand and some trimming of low margin business drove a 15% decline in fertilizer volume.

Plastics were also down with fewer moves to the export market.

Those declines were partially offset by growth and petroleum products as mild weather allowed for more road construction.

With a continued focus on yield improvement, the chemicals soon delivered a 19% improvement in average revenue per car.

Despite a 4% decline in volume, a 9% improvement in average revenue per car allowed energy to grow revenue 5%.

We expected coal volumes to be the biggest growth driver in the first quarter but issues with the mines on the SPRB joint line kept that from panning out.

The good news is that the diversity of our traffic mix - combined with strong demand across the board - allowed us to shift some resources out of the coal and into other opportunities that we have in the marketplace like I mentioned before in our ag products business.

Here's a look at how the mine and rail issues impacted first quarter volume.

The chart shows the sorts of missed volume for Colorado, Utah and the southern Powder River Basin.

For example in Colorado Utah, the entire shortfall of 21% was attributable to problems in two of our Colorado mines that significantly impacted loading.

One mine suffered a roof collapse and another encountered persistent heat and gas problems.

Now while these problems originated late last year the impact continued through most of the first quarter; and the result was a 2.2 million ton shortfall versus last year in this business segment.

The good news is both mines are now back in full operation.

In the Powder River Basin, tonnage was slightly ahead of the first quarter record we set last year.

Unfortunately, we missed the 140 trains because of operational problems at the mines and 114 misses due to joint line issues and rail operations.

So our performance for the quarter could have been much, much better.

What this data reinforces is that there's just very little slack in the Powder River basin supply chain.

And if a trainload is missed, whether it's because of a rail or a mine or a utility issue,, it's almost impossible for us to make it up.

That's why we're actively working with the BNSF, the mines and the utilities on a number of initiatives to ensure that we take advantage of every available train slot.

In addition we're continuing our capital investment as Dennis will show you because we're confident, with the progress we're making, the returns on our coal business will certainly justify those investments.

So we're off to a little slower start than what we had expected but the demand is still there; and we think we can still achieve a 10% growth in our coal business for the full year and we're doing everything we can to move that coal.

A 20% improvement in the industrial (technical difficulty) per car coupled with a moderate increase in volume resulted in a 23% growth in revenue.

Stone, sand, and gravel volumes grew 8% as increased train sizes and cycle time improvements allowed us to capitalize on the strong rock demand in Texas, Arkansas, and Louisiana.

In addition the mild weather especially in January drove year-over-year growth in our lumber, cement and steel businesses.

Average revenues per car improvement was driven by continued movement of prices to market levels and the opportunity to mix up substituting higher margin business in place of business that would not allow us to reinvest in the future.

Our largest volume growth for the quarter was in inter-modal which was up 11% with strong demand in all three segments - international domestic and premium.

All three segments also saw double-digit average revenue per car improvement.

The year-over-year comparison was helped somewhat by the flooding that occurred in the first quarter of 2005.

We are making good progress in our inter-modal business; the balance in our network between L.A. and the East has improved from 66% to 74% resulting in reducing empty positioning moves, improving asset utilization and lowering their costs.

In light of a relatively high proportion of legacy contracts in our inter-modal business, we're pleased with the progress we're making in yield improvement as well.

It was a great quarter in terms of transporting strong demand and to yield and revenue growth and we are equally pleased with the improvement that we saw in our customer satisfaction.

Customer satisfaction index increased to 70 with the highest level that we had seen in two years.

To help put that in perspective our seven-day car loadings were up 7000 cars per week.

So we are encouraged that the satisfaction improvements we're seeing reflect the customer's sense of the stronger network.

Clearly these satisfaction scores aren't at an acceptable level and we are focused on driving further improvement in our performance to better meet customer requirements.

Dennis is going to take you through these things, the things that we're doing that we believe will help continue to drive improvement in customer satisfaction.

But before he does let me just wrap up with one more slide on the commodity outlook.

For the second quarter we are looking for commodity revenue growth of 14 to 15% with about 3% coming from volume gains and the balance from continued yield improvement in fuel recovery.

The chart on the left shows the core price improvement for the first quarter was 6%, reflecting a continued strong market demand.

A key part of our second quarter revenue plan will be double-digit coal loading growth.

Now you'll recall May of last year was when the joint line issues surfaced so the year-over-year comparison is a little easier.

However the 2006 joint line repair program began on April 3rd; and although we don't expect a significant impact on loadings that repair work does add variability to an already complex operation.

On a full year basis, we have updated the revenue outlook we gave you back in January.

We now expect our revenue growth to be in excess of 12%.

So with that I'll turn it over to Dennis.

Thanks, Jack, and good morning.

Today I will spend a few minutes discussing our first quarter operating performance and provide some additional Technicolor on our 2006 capital budget and share a few of our second quarter and full year initiatives.

Let me start out with a safety update.

This chart shows the three-year safety trend for personal injuries and rail equipment incidents which are primarily derailments.

As you can see we have shown improvement in both of these measures over the last couple of years.

The bars on the left show our employee incident rate improving 7% versus last year and nearly 19% over the two-year period.

On a reportable basis 2006 rates were slightly higher than 2005.

We have maintained a rate, however, that is well below the 2005 industry average of nearly 2.3.

The chart on the right shows rail equipment incidents over the last three years.

In both measures total incidents and reportables, we have seen year-over-year improvement.

Our strategy is zero tolerance and we work in all facets - employee, customer and public safety - to drive performance improvement.

Turning to service.

The story for the quarter is really volume leverage.

You have heard both GM and Rob talk about it.

This chart illustrates its impact.

On a weekly basis we handle nearly 4% more volume.

Our velocity increased 2/10 of a mile per hour over the same period.

It illustrates that we have created capacity through our network initiatives; and we are generating more throughput across the systems.

In addition to the velocity we have improved service consistency, which I will talk about more in a moment.

Our daily focus remains velocity improvement; driving greater asset utilization; and increasing our capacity.

Let me update you on a couple of the initiatives.

One of our goals has been to simplify our network by reducing car handlings and in route work events.

The major initiative is the unified plan.

We actually just passed the one-year mark since we began making some of our network adjustments.

So comparing the first quarters of '05 and '06 really shows that the before and after impact of the unified plan.

A 12% reduction in the rate of car handlings or switches at intermediate terminals and a 16% reduction in the rate of in route work events.

Over the next several weeks we will be concentrating our unified plan efforts in the Southern and Western regions where we have our greatest pieces of industrial business plus our Mexican gateways.

The unified plan benefit can also be seen in other productivity measures.

It translates directly to our improved to our improvement in terminal drill time which decreased by half an hour in the first quarter of '05 versus '06 and while that decrease may seem small it results into less car higher expense, saving us nearly $9 million annually.

The reduced dwell time drive improves car cycle that Rob mentioned.

We continue to make solid improvements in this measure shortening the cycle, reducing congestion and creating additional capacities.

Rob also mentioned we continue to move more freight and burn less fuel.

Our first quarter sheet rate was the best ever first quarter allowing us to move a 2% increase and goes 10 miles with virtually no increase in fuel consumption.

This slide shows you a few different ways of measuring deployed productivity by (indiscernible) mile, carloads or freight train miles per employee.

We are not satisfied with where we stand today on productivity but we are seeing signs of improvement.

Particularly in two of the measures.

As we worked through our training bubble over the last couple of years and moved employees into productive service, those new employees have given as the capacity to grow and we'll continue to focus our efforts on driving additional productivity, particularly in these areas.

Bottom line is our velocity increases we will see continued improvement in these areas.

As Jack showed you, our customers are telling us that service is improving.

Two measures that we look at internally to gauge our customer service are car connection performance and industry slot spots and pull.

Our connections which improved two points in the quarter measures the percent of time outbound cars make their scheduled departure objectives.

An increase in this measure correlates to more consistent service and on-time arrivals.

In the 3 spot in full which jumped 10 points in the quarter measures of timeliness of our customer pickups and deliveries, this gain can be attributed at least in part to the roll out of our customer inventory management system or CIMS.

Through better management of our terminal workload and inventory on hand. we are delivering a more reliable service product to our customers.

In January, I shared some of our high level capital projects for 2006.

Taking a more granular look at the work plan for this year it breaks down as follows.

We will spend roughly 1.5 billion for track maintenance - that is slightly more than the work we did in 2005.

Our capacity spending will total nearly 305 million.

A portion of this will go to additional mainline staff capacity such as another 52 miles of double track on the Sunset corridor, 18 miles of triple track in the Southern Powder River Basin with the BNSF and in an additional mainline through North Platte to accommodate run-through business such as coal.

Other capacity projects include new sightings and extensions as well as signal system enhancements to help drive velocity and productivity.

An additional $180 million is being spent on commercial facilities.

This includes such items as support track in the Midwest for our ongoing growing ethanol business as well as inter-modal and automotive facility upgrades.

We will also acquire 200 new high horsepower locomotives and roughly 2700 freight cars for both replacement of older equipment and business growth.

We are off to a good start on our 2006 capital plan, completing several projects in the first quarter.

I will just highlight a couple.

Our Sunset Corridor double track work is progressing nicely.

We've already completed 20 miles and we are on track to complete another 22 miles by August.

In mid-February we completed our bypass project in Marysville, Kansas.

This was a multiyear project and moved our double mainline out of downtown, added six passing tracks and closed 11 grade crossings.

We are improving public safety and enabling a speed increase for our roughly 70 trains per day from 20 to 50 mph.

We're continuing to make infrastructure enhancements at San Antonio in anticipation of the new Toyota plant opening this fall.

And we also realize solid productivity with our maintenance capital taking advantage of the warm weather in California, Arizona and even the Midwest.

In the second quarter and for the balance of the year our capital programs will continue to positively influence our operating improvement initiatives.

Looking ahead to the remainder of '06, we remain focused on our core disciplines.

Operating a safe railroad, simplifying operations, increasing productivity across our critical resources, and investing a critical part of our network for efficiency and capacity.

The end result will be further network simplification, reduced car handlings, and overall service improvements for our customers.

With that let me turn it back to Jim.

Thanks Dennis.

Let me close here with an outlook on the rest of the year.

As Jack had mentioned, our second quarter revenue outlook is growth of about 14 to 15%.

About three points of that growth should come from volume; the rest from yield.

The real key here will be our coal business obviously going forward here.

The strong operating revenue growth should combine with continued improvement in our operations, which should drive a three-point improvement in our operating ratio year-over-year.

All in, we would expect our second quarter to be in the range of $1.20 to $1.30 per share.

That's an increase of 36 to 48%.

Obviously the major wild-card in this estimate is the price of diesel fuel.

While we have substantially improved our fuel surcharge recovery over the past several years, rise in crude oil prices can still impact our operating ratio in earnings especially in the short-term.

For the full year, we expect revenue growth to be at least 12%.

Now when you think about a full year (indiscernible) outlook given we had an 18% growth in first quarter, we are predicting 14 to 15% in second quarter.

That equates to a lower growth rate in the second half of the year.

Our outlook here for volume and yield continues to be very strong.

That slow growth rate really falls in what we will see in the growth rate for fuel surcharge recovery.

You'll recall last year we had a very strong run-up in our fuel surcharge recovery in second half.

We obviously won't see that kind of run-up here in the second half this year.

The strong revenue growth for the year should combine with better operating efficiency to produce a 4 point improvement in the full year operating ratio; and and earnings basis, this translates into a range of $5.00 to $5.20 per share and we are also raising (technical difficulties) of free cash flow after dividends to the 350 to 400 million range.

So, to wrap it up we are off to a good start in 2006, but have a lot of year ahead of us.

We are being somewhat cautious in our overall outlook but we continue to see solid demand which should support future volume and yield growth.

Our challenge is to handle the growth more efficiently.

We have a long way to go before we are satisfied with our service velocity and financial returns; but we are confident in our plans for improvement.

With that let me open it up to questions.

(OPERATOR INSTRUCTIONS) Jason Seidl with Credit Suisse.

Good morning, everybody.

Impressive results for the quarter.

I was wondering if you could -- you teased out on the OR a little bit in terms of what the West Coast washouts did last year and sort of the gains this year.

In some of the slides when you give your productivity improvements could you tease out the West Coast from that as well and let us know where you stand?

Well let me start here.

On the operating ratio the storms last year cost us about 1.5 points.

And on the operating income I think we said it was about $50 million of operating income, kind of split evenly between revenue and operating cost.

It's tough in terms of looking at the overall productivity numbers.

Clearly we had the impact last year.

On the other hand okay, the way coal really didn't flow as well.

It had really a kind of negative impact this year.

So I think it's all those as I said, earlier, the unified plant, mild weather this year really all helped.

I guess what I'm trying to get at, if you said that like a half an hour improvement terminal dwells about $9 million on an annual basis, but if I just think about it conceptually, I would imagine that you probably were almost on par with last year given the washup.

So there is a little bit of room to grow there the remainder of the year in terminal [dwell] time.

Actually you're not hearing -- I hope you don't hear from this team here that we are doing a high five over our productivity right now.

We are -- we've made I would call it some progress with 4% increase in volume but there's clearly a significant amount of upside here going forward.

Fair enough.

If we look out on the inter-modal segment, given where fuel is now, are you seeing an increased demand from a lot of customers given the spread between pure truckload and fuel just gone up due to the fuel surcharge recovers?

You know right now, international demand is very strong and the premium and domestic markets are a little softer but it's really just the seasonal demand kind of situation you see in the first quarter of every year.

Now I'm going to say that on one hand; on the other hand they are both a little stronger than what we had thought they were going to be.

So yes, we are probably seeing some impact of the higher fuel prices but it's not pushing us to any extreme.

I'll give one more here and I will turn it over to somebody else.

If we look at your fuel surcharge recovery rate, you say it's improved but you think they're going to get better.

Could you give us some numbers behind that and I apologize if I missed it.

In terms of what percentage?

What we've always said is we are not at our objective of recovering 100% of the run-off in fuel.

We've made progress on that year-over-year we are still not where we want to be but we are subsidizing the customers less this year than we did last year.

We didn't give the exact percent but we made progress; and in our total revenue growth just over six points of that revenue growth was attributable this quarter to the fuel surcharge recoveries.

Thanks for the time, everyone.

Ken Hoexter of Merrill Lynch.

Good morning.

Just want to talk to you about the salaries and benefits.

Obviously showing up a bit better improvement than we anticipated.

It's a very solid cost control.

Is that something you've got specific initiatives or is it just an offshoot from the unified plan?

I just want to kind of understand what is sustainable on an annual basis when we start looking at these ongoing improvements?

I think there are a lot of things that apply here.

Productivity, your unified plan, a lot of the industrial engineering work we're doing in the terminals, a reduction in some of the training bubble that Dennis had mentioned where we are getting caught up.

All are really contributing to that.

I don't -- going forward here I still believe that 3 to 5% productivity is very real for us when you look at going forward here.

So there's no time frame on that kind of productivity.

You can see that for a couple more years?

No time frame.

My goals -- I'm -- we're going to have productivity this year and continue it going forward.

Secondly, the capacity issues.

You talked about adding capacity in the PRB.

How about the mainline surrounding it?

Are there any congestion issues once you actually leave the ERP for the work around it?

Ken, in the past we talked to you about three corridors that we focus on really to increase our capacity.

Obviously the Sunset, you know what we are doing down there, continuing to add double track.

The Central Corridor which would be basically from Granger, Wyoming through to Chicago and onto Kansas City.

We are working on that.

We've had a four-year progress or project there to add signal capacity and additional capacity.

I mentioned to you the additional mainline in and around North Platte.

We continue to improve our infrastructure in there to increase velocity and throughput there.

And then the north-south route where we are working on our terminal infrastructure - primarily Houston, Dallas-Fort Worth and San Antonio.

So those are the three key areas that we are focusing on from a capacity perspective.

Just a real quick one.

In the quarter, wondering (indiscernible) announced that they've leased containers from you?

Do you have anything left to lease out?

Or is this a full commitment program?

We have a healthy fleet of VMP boxes that we have retained.

Those are just some one-off deals that we thought were appropriate.

Did you want to give numbers around

You know it wasn't all that much.

Thanks a lot.

James Valentine of Morgan Stanley.

Thank you.

Great quarter.

Can I just ask about the guidance here in the, sequentially if I go back a few years ago before we had fuel inflation you would see about a 30% step up from your first to second quarters.

And if we did that this year, we made about $1.50.

If we take out let's say a dime or $50 million in fuel inflation sequentially, we would be at $1.40.

And I'm just trying to understand are you being just incredibly cautious here or is there something else out there that you see beyond fuel that is starting to creep back into the cost structure?

I think most of it goes into kind of your outlook here on fuel.

It's very tough.

You look at where the numbers have been moving here quickly.

There's a lag.

There is a minimum 60-day lag in our fuel recovery so I -- and I did say we were being cautious.

But that really kind of is an outlook for the whole year here.

So a lot of things have to go right here.

I mean we are -- our outlook on coal.

We should have a strong quarter but as Jack said, you know you've got maintenance work going on.

We saw about half of the misses as Jack had mentioned go back to the mines points.

So I think there's upside there; but a lot of things have to click for us.

Can I just ask Rob, you may have given this, what is your fuel assumption for the second quarter and full year guidance?

We didn't give that, Jim.

Really when we gave the guidance we take into consideration that fuel is very volatile here and if fuel stays where it is today, that gives us a headwind on our earnings and our operating ratios.

If it moderates, that puts us probably at the higher end of that guidance.

If it goes above where it is today, then that puts pressure on us and puts us (indiscernible) .

Did you say you are paying $2.10 a gallon right now?

Currently we are paying $2.10 as we speak.

And that means as of like today or yesterday that (MULTIPLE SPEAKERS)

Last few days.

Right.

Great.

One other question I have and maybe, Denny, you want to think about this or help us with this.

Relates to the whole schedule railroad program and what I've been starting to witness now or over the years is that would schedule railroad when they get implemented can take kind of 18, 24 months before they really start to kick in and generating earnings leverage and we saw that at Canadian National.

We saw that at Norfolk Southern.

Now here, this quarter we are starting to see this in CSX.

You guys are about, I guess while you said a year into your program, can you give us some kind of feel if you are starting to see I guess I'll call it a step function into that acceleration we've seen from other carriers, where it really starts to kick in and everything falls into place?

Or do you think that is probably still late this year or even a 2007 event?

I would expect to see certainly continuous improvement and I think there is that [step level] opportunities to be made here.

Volume creates opportunities for us in terms of creating additional bypass trains, which we are trying to build and reduce our work event.

So I think the expectation would be obviously continuous improvement and in certain locations and certain quarters and volume level.

Lot to play with that.

But we will continue to drive productivity and continuous improvement.

You'll see it in our terminals and our velocity and all of our metrics.

Thanks so much.

Tom Wadewitz of J.P. Morgan.

Good morning and strong quarter; nice quarter.

Let's see.

Two questions for you - one on capacity, one on pricing.

It seems like you are making a lot of good investments, smart investments in capacity.

You are probably -- you know you are behind a bit.

At the same time you've got some pent-up demand in a couple of business units.

Is there a point where you think you actually catch up in terms of the pace of investments you're making?

Or is it more likely that, if we still have good demand in the coal inter-modals, you don't see necessarily an inflection point where you've got the capacity added and you really get that strong improvement fluidity?

You know there is some catch-ups you're doing here but I will also tell you when you look at the demand right now, you know, we've got some great opportunities out here.

The key for me at the end of the day is our ability to continue to improve the returns where we have got a lot of business opportunities out here when you go forward.

It's not clear to me whether all of those businesses are going to meet the kind of financial return we want; and I'm not going to invest in that line of business if it doesn't get there.

So you know I don't -- if you are asking the the question are we going to fall off to $2.2 billion of capital or two, three real quick I just don't see it right now.

And the economy will play a role here in terms of the man but we are seeing pretty significant demand here across most of our business lines.

So put another way, given the demand you see you invested a pace to keep things relatively tight.

And that probably provide (technical difficulties) support on the pricing story as opposed to really kind of massively investing to get ahead of things?

There is no quick fix here in terms of capacity.

I think in the whole rail network that that is going to magically develop excess capacity here.

I think, again, one of the nice things about railroad investment you can kind of put it in an inch at a time and you look at our investment in the Sunset quarter.

Dennis has got a goal of 50 miles this year.

We turn 20 miles over top rations in first quarter and we really can meet it.

Then on the pricing side, there continues to be upside versus our expectations at what you're going to get on yield and price in general.

Is it possible that when you look to '07 you can sustain kind of a all in price number which is 5, 6, 7%?

Excluding fuel surcharge but just looking at affected price across the portfolio.

You think that's possible?

Or do you think that it's -- would be likely to have the pace of price fall off meaningfully in '07?

You know I think, again, it is going to be a function of how long and sustainable you believe the demand is, the economy.

Although I really do believe there is a structural shift here in demand in our business here.

We are going to be aggressive.

We have got a long ways to go when you look at it in terms of getting this business to where you can look at it's (indiscernible) and earn your cost of capital and I also have several businesses that (technical difficulties) really are a long ways off of reinvest ability.

So we (technical difficulties) -- gressive.

I'm not going to confirm the numbers for next year but right now pricing is pretty strong.

Thank you for the time.

Edward Wolfe of Bear Stearns.

Good morning.

Can you take us a little through the coal?

When did the two Colorado mines open up again?

In mid to late March is when they opened up again.

Both of them at about the same time?

Yes.

Pretty much.

And when you look at 10% volume for the year, how do we think about that as we go out sequentially?

I'm guessing some of that is back-ended, given the heavy maintenance and the comps get easier later on, but how should we look at that kind of quarter-over-quarter as we go out?

As you recall second quarter is when the Powder River Basin joint line last year really struggled.

And in fact, I think, for the second quarter we averaged about what was it 31, 32 trains off to PRB.

We are running 35 or so right now. 35. 36.

So you are going to have -- you should see a strong increase this year and in fact if you looked at the PRB challenges last year they went all away through I think September, October.

So you are going to see the stronger growth right now starting here, really, in May through probably September.

And again though, you know, there is a challenge out here with the whole logistics chain.

And we are working very hard with the mines, our customers the (indiscernible) to make certain we get every train stop we can off the -- out of the Basin.

So we should be about 10% this quarter is what you're saying to get to 10% for the year?

That's right.

And Jack you mentioned potash export, potash being soft.

Can you talk a little bit about what you are seeing in trends there?

And how much of that is negotiating price versus real softness that you see sustaining?

You know at this point in time, Ed, we are kind of looking at it that you've got kind of a lull right now.

There is some probably pricing negotiations going on in the potash markets themselves.

The exports, the Chinese markets haven't been quite so strong.

But we actually think that over the course of the year we might have a shot of getting that back.

In other words, recovery?

Yes.

Okay and when do you get a sense for that?

Is it a month from now, two months from now?

I wish I knew the answer to that question.

But I would say, yes, over the next month to two months we should probably have a much better read on what is happening and whether it is going to be a sustained softness or whether things are going to perk up here.

And, Jim, just one thought on fuel.

We are starting to seek a little bit more publicity as fuel gets higher at the pump for everybody.

And the STV holding hearings and all those kinds of things.

Is there any thought of UP of changing the way you collect your surcharge?

You know, Ed, we -- if you think about the surcharge, how it originally went in.

That was based on a lot of conversations with customers.

They wanted to keep it ticket simple.

Ability to manage it.

It followed -- if you really looked kind of a lot of the traditional fuel surcharge methodologies.

The key point for me we are not at 100%.

Our goal is to be 100%.

No more than that.

We will always take a look at what makes most sense going forward here.

I think when fuel surcharges went in most people believed it was kind of a one off deal.

You had a blip in crude; it would come back down and we would go from there.

And obviously I don't think anybody believed crude is going back to the $26 barrel we had when we put that fuel surcharge in so -- or is the base.

So we will take a look at it going forward.

Right now I don't have any plans to change it.

Thanks a lot for the time.

Jordan Alliger of Deutsche Bank.

Good morning.

What stood out to me was - and you talked about this a little - is that your fuel consumption, your gallons were basically flat even with the volume increase of 4%.

I'm just curious if you could talk a little bit more about that and how you are doing that and how that might look after the future?

Sure.

I'm going to have Dennis take that one.

It's a multifaceted approach to it.

Obviously what we've done a lot with our simulator training on our engineers and that is really starting to pay dividends for us.

Obviously our new locomotives that we purchased over the last few years are very efficient and have delivered us a substantial savings there.

We -- our put had new technology on all of our locomotives.

The automatic start stop that allows us to take advantage of idling time.

Our fuel conservation policies that we have with our shutdowns.

And then the other thing that we have our employees started an initiative called Fuel Masters where they actually incent and compete with each other on good train handling and have just done an excellent job.

And it's saved us literally millions of gallons a month by their good train handling and their great fuel conservation.

So it's a multifaceted approach which we are very serious about and continue to reinforce at all levels of our Company.

So generally would you say the pattern, even with increased volumes, could -- I mean, obviously, it will depend on what fuel cost per gallon does (technical difficulties) being equal sort of the general trend where gallons increase less than the volume should persist?

I think within a reasonable range.

We are -- again, our focus is fuel conservation efficiency.

How business mix comes into play clearly can have an impact and so you have to be careful about kind of making it linear off of the first quarter.

But my expectation every year is we are going to see better fuel efficiency.

Just a quick follow-up on the coal side of things.

I guess just I'm sort of wondering, I know a few months ago before the coal production issues in Colorado, the thought was that coal demand could be up like 12 to 15%.

And now it's looking at 10% and coal, obviously, is a critical commodity to you guys.

I am just wondering - I know we talked about fuel expense and the wildcard to earnings.

I'm wondering on the coal volume side, how much can that play or not play in to the second quarter and full year earnings outlook you are relative to sort of that 10% bogey?

Our outlook on volume and demand are two different things here.

The demand is higher right now when you look at the total demand for PRB.

In fact, I think the numbers when you look backwards here are up near 15% year-over-year in terms of tonnage.

The real question is the ability of the supply chain to deliver that kind of demand.

So we, right now our outlook is what we think we can deliver.

But I don't see demand falling off right now.

It is going to continue and, again, I think that's why it's so important for us to focus on the whole logistics chain.

Our capital investments we are making.

Because I don't see that falling off in the near-term.

So the 10% though.

Just to make sure, that is what you expect to be able to deliver?

That's right.

Thank you very much.

Gary Chase of Lehman Brothers.

Good morning.

I admire your tenacity in reporting your results through the fire alarm there.

Just a quick question.

You've held coal out as something that's critical for the quarter.

Obviously, you face your share of challenges along those lines.

This quarter you had the flexibility to offset that elsewhere in the network.

In the event that you run into difficulties again in the second quarter, do you think you have the operational flexibility and the demand to do what you did this time and offset that impact elsewhere?

Yes, I believe we do.

You know we are -- you look across the six business groups that we have, there's good demand really across most of them right now.

We do have some ability if production has fallen off on the mines that we can shift some resources.

Grain is an example.

Where you can put locomotives and so I don't -- you know, I want to handle the coal at the end of the day.

That's our goal is handle the coal and we meet our other commitments here to our other customers but we do have some flexibility on looking at mix.

But we should read that as you'll have an ability to offset some of that if -- for whatever reason?

Right now, I'd say yes.

Great.

Thanks a lot.

Rick Paterson of UBS.

Good morning.

Jim, I would just like to get your latest thinking on the price of (technical difficulty) you are going to be doing this for years and by the time you get it done it's probably time to triple track it.

Any interest in dramatically accelerating the program?

As you know, we are 50 miles (indiscernible) put you on about an eight-year curve to finish it and with demand, you are right.

You will be at capacity that is done.

But what supports me right now is looking at the financial returns in the inter-modal business.

That will drive any decisions to accelerate spending on that line.

And I tell you every time we cut it it looks like demand is going to stay very strong.

But we've got to work in the financial returns side.

I don't -- you know (indiscernible) assessing where we get the best capacity expansion here.

We have got to protect our network.

Double tracking Sunset, you have to look at the double networks here and demands on coal, landing spots etc.

So we are sticking to our guns here in terms of what we've got our outlook for capital this year and (technical difficulties) how things go when we put our plan together for '07.

And speaking with inter-modal, the (technical difficulties) 400 with a little bit of upside.

Are you still committed to maintain those boxes in-house?

Yes we are.

Thank you.

Randy Cousins of BMO Nesbitt Burns.

Good morning.

With reference to slides 12 and 13, Rob, wonder if you could give us a little bit more clarity in terms of this stuff that you've brought back into the firm and the context for the guidance you are giving for the balance of the year?

In other words, how much of the guidance as in accounting is a swing in terms of allocation between the materials and supplies and purchase services?

About a third of that increase was a result of our decision to move locomotive overhauls that we had previously been contracting outside work to do in their different locomotives, etc.

But for various good reasons we moved those overhauls into our in-house and, really, what that does is move it from purchased services expense category to our materials and supplies.

So if we were to rip out that reallocation, in terms of starting to think about Purchase Services and Other, it's actual organic escalation rate in terms of sort of cost would be what?

And the same thing on material supplies, again, stripping out this reallocation issue?

That was in the guidance I gave.

That's been taken into consideration, Randy.

Rob, but I'm just trying to think from our perspective in terms of sort of trying to understand underlying cost increases, both in Purchase Services and the material supplies.

What would you say is sort of the organic rate of cost increase independent of this reallocation issue?

Rough numbers, material supplies.

More like a 15 percent-ish rather than a 21 percent-ish.

That includes, there are several components there that includes increased locomotive overhauls which you can attribute to volume and larger fleet going forward.

Obviously you have core inflation going on in some of these categories here.

So you know when you say organic it's not quite clear to me what you mean there.

Because that also includes volume in some of these categories.

I was thinking about more in the context of both that sort of volume and sort of the inflation component because you give highlighted inflation as kind of one of the issues for materials and supplies.

Yes, again, I would say about a 15% kind of number instead of the 21 issue you saw here.

And then for purchase services, the kind of base rate increase would be what?

Excluding this reallocation issue.

Would have been roughly 8 percent-ish.

Great.

Thank you.

And the other thing I wanted to get into was just the issue of the fuel lag.

Can you give us in terms of your surcharge, can you give us some sense as to sort of how we should model up a lag, so if we got higher fuel costs today then we had sort of on average for the first quarter through the fourth and that is going to cost some squeeze in Q2, how does that reverse itself in Q3?

Can you give us kind of some sort of sensitivity measure that we could use?

That's kind of a tough one.

I guess a rough rule of thumb may be that you've got almost a two-thirds lag and you'd think second quarter a run-up in fuel.

(MULTIPLE SPEAKERS)

An April price increase in fuel, our April cost will determine what our June surcharge is.

So any run-up that you see in May or June will actually -- the recovery for that is moved into July and August.

So let's assume for argument's sake that you've got $100 million worth of fuel price increase; and you've got a 70% recovery rate.

That is $70 million worth of increase.

That kind of two-thirds of it falls under the following quarter.

Is that a way to think about this?

It's a two-month lag to implement the (MULTIPLE SPEAKERS).

That's not out of line.

Great.

And then the last thing just (indiscernible) I want to get some sense of sort of what you guys actually think the real underlying organic demand is for your business?

Because obviously you are constrained on network capabilities, on [positions] that you have to deal with in terms of sort of returns in certain businesses, but if the pricing was right and the system was there, the availability of the system was there.

What do you actually think is the underlying growth and demand for your book -- for services from Union Pacific?

That's a tough one.

It's more than what we are handling right now and, again, we are trying to be selective.

We are trying to look at returns.

We are looking at what makes most sense in the network.

We are working with customers on improving throughput.

But I will tell you right now it's -- you know there are very few of my customers -- they all want to give us more business and we -- again I felt good about first quarter.

We had 4% increase in volume and did a pretty good job of handling it.

I'm concerned long-term.

You know the question becomes you've got interest rates up, you've got fuel over $70 a barrel.

You know we will hit another cycle at some point, but you know I think it's, again, a function of what we can officially handle.

We are not adding capacity fast enough that will guarantee 100% of the -- we are going to handle 100% of volume and we won't do that.

We've got to really look at the returns and what business makes more sense.

Could you say, just shooting from the hip, that real underlying demand is actually probably 2 or 3% higher than you are actually capable of accommodating?

I don't think that's unreasonable.

Great.

Thank you.

Jon Kress of European Investors.

Unit three obviously is regulated.

You hear a lot of noise about your customers complaining about the increases in the fuel charge and the regulators listen to the customers, I guess.

What is your, what is the risk here and what is your strategy, with respect to dealing with the regulators and providing the customers with something other than lower prices basically that would make them basically happy?

I mean, can you -- is there other service elements or capital spending that you could do to sort of switch the heat from prices to service performance?

I spend a lot of time in front of our customers.

You are never going to find a customer that is happy with the price increase.

You can understand that; but I will tell you if every one of them that are concerned about, are we going to be there for the growth and are we putting capacity in to handle the business.

The fuel surcharge, I think that will eventually be worked through.

To me, it's kind of a secondary issue.

The fact of the matter is, with all the talk of re-regulation, the current business model is working.

We have got the highest single capital spend in the industry in many, many years.

We've started to see some real capacity going to ground for growth and you know we've already you had the regulated model.

And we know what happened there.

You would see capital investment - in my mind - dry up very quickly.

So service, we need to improve.

I commit to that with our customers and in fact, you know one of my commitments is if they put price in, if I get price I get the returns up, I'm committed to service and I'm also committed to capacity growth.

So the strategy in my mind is working with each customer and helping them understand what we need to do to continue to be successful in the industry.

I think we would agree with that but do you think that the regulators see it that way?

Or the regulator?

You know, the question is what is the regulated solution?

Where is the capacity and capital investment going to come from?

It's not going to come from the shareholders at Union Pacific when you look at re-regulating this industry.

So that the question is does it come from private industry or does it come from the government?

I don't see that -- the latter as the solution.

What do the think is the most -- this is the last question.

What do you think would be the most important investment that the industry could make to improve service?

What would have the biggest bang for the buck?

Not that Union Pacific would make but that the union industry as a whole would make or its parts?

The solution for service really covers a lot of different areas, but track infrastructure, track capacity - whether you're talking terminal - you are talking your mainlines is really the key.

And those are the highways out there that we have to build and maintain and to me that's where you get the biggest bang for the buck.

It's not the only solution, though.

We cannot buy our way or spend our way out of the challenges here.

We have got to look at working with our customers, unified plan, working with customers to work more than Monday through Friday.

Load.

Unload.

Really taking a hard look at really the whole processes here.

Thank you.

Due to time constraints our last question today will be coming from Scott Flower of Golden State Research.

Good morning.

A couple of quick questions.

I know, Jack, you've mentioned -- are you making any progress on some of the customers be it in inter-modal or automotive or as we may have legacy contracts that stretch out for several years working in advance of those deadlines to work with those customers to perhaps avoid a step function later?

In other words working with them to say, real world prices are here and your prices are dramatically below market?

Just wondering have you had any success in that kind of dialogue?

Depending on the situation, the customer, the economics of the deal and where we are, we have worked with customers and we are working with customers on some of those deals and (technical difficulties)

-- other operating line and I'm assuming the timing issue on working capital; otherwise I'm just wondering what that was because it was a big enough number to be meaningful?

If you look at other, I guess net in terms of your operating cash flows?

What is that?

You are exactly right.

It is timing and it's pension, it's inventory payments.

You know for the full year, we were expecting that other category to be, the change to be in the $50 to $100 million range rather than what you saw.

You mean in terms of the deficit.

Yes.

Thank you very much.

Thank you, everyone, for being on the call this morning.

We will see you here in about three months.

Thanks.

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