聯合太平洋集團 (UNP) 2006 Q2 法說會逐字稿

Good morning, ladies and gentlemen.

Thank you for holding.

Welcome to the Union Pacific second quarter 2006 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.

Is now my pleasure to introduce your host, Mr. Jim Young, President and Chief Executive Officer of Union Pacific.

Thank you.

Mr. Young, you may begin.

Good morning, everyone.

Welcome to our second quarter earnings conference call.

Joining me today are Rob Knight, our CFO, Jack Koraleski, Executive Vice President of Marketing and Sales, and Dennis Duffy, Executive Vice President of Operations.

Today we are reporting another record quarter, driven by solid yield improvement, volume growth, and operational productivity.

Second quarter earnings increased 64% to $1.44 per share, versus last year's reported earnings of $0.88 per share.

Of course, last year's earnings were impacted by the incidents in the southern Powder River Basin joint line, but even with that, our earnings growth was significant.

Second quarter operating income grew 53% versus 2005 to $717 million.

Our best ever operating income in the history of the railroad.

Reaching this milestone so early in the year is a clear indication that the demand environment remains very strong, and we are moving volumes more efficiently.

If you step back and look at the second quarter, a couple of areas really drove our record performance.

Customer demand for our rail capacity produced record volumes across our system.

For the first time ever, we moved over 200,000 car loads in a seven-day period.

We combined strong demand with solid yield gains, producing 17% revenue growth to a record $3.9 billion.

In 2004, we topped the $3 billion quarterly revenue mark for the first time ever.

Now just two years later, we are closing in on the $4 billion threshold.

The accomplishment I'm most pleased with in the quarter is that we converted strong demand and yield into bottom line results.

To better employ an equipment productivity, which Dennis Duffy will talk you through more in a minute, we handled record volume growth more efficiently.

Our second quarter operating ratio improved 4.3 points to 81.7%.

Our best performance in more than two years.

And as Rob will discuss, that improvement came in the face of record fuel prices.

We are very encouraged by the progress we made in the second quarter, but there is still substantial work ahead.

We are moving it in the right direction.

With that, let me turn it over to Rob to take you through the financials.

Thanks, Jim, good morning.

I will begin today with a look at our second quarter income statement, which shows we combined a 17% increase in operating revenue, with an 11% increase in operating expense, to achieve quarterly operating income of $717 million, a best ever quarter by nearly $100 million.

If we look more closely at the components of our revenue growth, second quarter commodity revenue increased $546 million, or 17%, to more than $3.7 billion.

Jack will walk you through the details in a minute, but the growth drivers were pretty evenly divided between volume gains, yield improvement, and increased fuel surcharge revenue.

Volume grew 5% in the quarter setting all-time records, with four groups gaining year-over-year.

Ag, Autos, Energy and Intermodal.

Our mix of business offset some of this growth ,as a large portion of the increased quarterly car load volume came from our lowest average revenue per car businesses, specifically Energy and Intermodal.

We continued our trend of quarterly yield improvements netting 6.5 points of growth.

Very strong again.

And fuel cost recovery added nearly 6 points to our total commodity revenue growth.

This is actually a little less than the first quarter, driven in part by the two-month lag associated with our fuel cost recovery mechanisms.

In total, second quarter commodity revenue was a best ever, topping our first quarter by nearly $200 million.

Looking now at the individual expense lines, we will start with salaries and benefits which were up 6% in the quarter to $1.1 billion.

We handled 5% more volume with only a 2% increase in our work force, an indication of greater employee productivity, which Dennis will talk in more detail about in a moment.

Inflation, volume costs, and larger work force were the primary drivers of the year-over-year increase, with some offset for lower training costs.

As we saw in the first quarter, the option expensing requirements of FAS-123 added a little more than $3 million of expense in the quarter.

For the third quarter, we will likely see a year-over-year increase similar to the second quarter.

Drivers will be inflation, volume costs, and option expense.

We should offset some of this cost pressure with employee productivity.

In anticipation of continued record business levels, we do however expect that our force levels will increase.

On a full year basis, it's likely our work force will be up around 2.5%, driven by strong volume growth.

Next is fuel and utilities up 33% in the second quarter to $794 million.

Back in April at our first quarter call, we were paying around $2.10 per gallon.

Unfortunately prices moved up from there, averaging $2.15 per gallon for the entire second quarter.

Although we are doing a better job mitigating the impact of high fuel prices through our surcharge programs, we are still not at a 100% recovery level.

When prices rise during the quarter, we achieve a lower recovery rate versus expense paid, because of the two-month lag in our fuel surcharge mechanisms.

In the first quarter of 2006 we recovered slightly more than 90% of the increased fuel cost of over $0.75.

But in the second quarter because of the lag our recovery fell to about 80%, costing us roughly $0.13 per share versus our first quarter recovery rate.

In fact, the third quarter could be shaping up like the second quarter, where we chased higher fuel prices.

Crude oil prices have spiked to record levels, pushing our spot diesel fuel price as high as $2.40 per gallon.

Prices have moderated some here lately, and we are currently at about the middle of the $2.20 to $2.40 per gallon range, that we are estimating for the third quarter.

But we know that there is a lot of volatility in the market today.

Given this, our recovery rate over the balance of 2006 could be kept below the 90% level that we had previously been expecting.

Again, 100% is our goal, and we are not there yet.

Looking now at equipment and other rents, up 9% in the second quarter to $371 million.

The key factors in this category are increased volume costs, locomotive rent, and other equipment leases, offset somewhat by better asset utilization.

As I mentioned in April, we had some timing differences in our 2005 locomotive deliveries that created a headwind for us this year.

On a full year basis, we still expect this expense to increase about 5% or so.

Moving into the peak season, we are focused on improving our asset utilization, to help us mitigate some of the cost pressures on this line.

I will close out our discussion of operating expense by looking at materials and supplies, and purchased services and other.

You really need to view these two categories together this quarter, because there is some activity between them.

Separately materials and supplies grew 39% to $178 million, while purchased services and other declined 7% to $415 million.

Together, however, the categories increased 4%, or $21 million, which is a more normalized view of these expense categories.

As we discussed back in the first quarter, materials and supplies are seeing a double digit inflation, due to material cost increases, and a higher level of maintenance work.

Specifically, higher material prices particularly for wheel sets added roughly $18 million to this category.

And we supplied materials for 104 locomotive overhauls for the second quarter versus only 39 a year ago.

Another driver is the continued expense shift from purchased services, due to more locomotive maintenance currently being done in-house instead of using contract services.

We also had more reimbursable car program work, and lower year-over-year joint facility costs this quarter, contributing to the purchased services decline.

Costs increased in the quarter for personal injury, crew transportation, and lodging, as well as drayage.

For the second half of 2006.

We anticipate the shift between these two expense categories to continue, as well as ongoing inflationary pressures in the materials and supplies lines.

Although not to the extent we experienced this quarter.

Third quarter materials and supplies expenses will likely be 25 to 30% from last year.

On a year-over-year basis, purchased service and other should be flat to slightly up in the third quarter.

That's a quick break down on our operating expense.

Let's move on to the operating ratio, where we achieved 4.3 points of improvement year-over-year to an operating ratio of 81.7%.

This continues our trend of quarterly improvement driven by yield gains and better operating efficiency.

Similar to surcharge recovery, our operating ratio was impacted by the spiking fuel prices.

In fact, if you adjusted our operating ratio, removing both fuel surcharge revenue and costs above our $0.75 threshold, it could have been closer to 77% operating ratio.

That would approach our best ever levels for this Company.

Looking now at the full income statement, other income was flat year-over-year at $29 million.

We still anticipate it to come in between $75 million and $100 million on a full year basis, but it's more back end loaded into the fourth quarter.

Interest expense was down $8 million in the quarter to $121 million, lower quarterly debt levels drove this decline.

Second quarter income tax expense grew by 100 million, to $236 million, driven by increased earnings and higher tax rate.

Our effective tax rate of 37.7% was almost a point above last year's rate, and we would expect this to continue for the balance of the year.

Second quarter net income totalled $390 million, or $1.44 per share.

A 64% increase over last year's $0.88 per share.

Of course, as Jim mentioned, we estimated that the impact of the southern Powder River Basin joint line incidents, cost us about $0.09 per share last year in the second quarter.

Turning now to capital, our all-in 2006 capital budget now stands at $2.8 billion.

Up about $50 million from our original budget.

This additional amount will be funded by cash, bringing total cash capital to $2.3 billion for the year, and the remainder is equipment lease financing.

As we announced with BNSF back in May, we have agreed to add 40-miles of third and fourth main line capacity on the joint lines, we are also planning to complete some additional grading work on the Sunset corridor before the end of the year.

We are announcing plans today to invest $90 million for an Intermodal facility in San Antonio, furthering our support of business growth in this region, particularly the new Toyota plant.

This project does not add incremental capital for 2006, but will be included in our 2007 budget.

We are investing for the future growth and efficiency of our Company, while remaining focused while improving overall share holder returns.

If you look at cash generation through the first six months of 2006, you will see we have grown our cash from operations to more than $1.2 billion.

The real driver of this growth is nearly doubling our net income.

Importantly, we have seen solid growth through the first half of the year, with expectations for that to accelerate in the last half.

Let me close out today with a quick look at our balance sheet.

This slide shows our debt to cap ratio adjusted for leases, as we grow our business and increase profitability, we are continuing to improve our balance sheet.

Overall we had a very solid second quarter handling record volume, managing our costs, and producing strong earnings growth.

The key financial takeaways are record demand is translating into yield growth, cash generated by operations of the Company is strong and growing, and our financial returns are improving.

Let me turn it over to Jack to talk about our record commodity revenue performance.

Thanks and good morning, everybody.

As Rob said, our second quarter volume was an all-time record.

What was pretty interesting for us was we broke our all-time record for the monthly average seven-day car loadings in May, and then we topped that again in June.

So that's the first time that record has been set outside of our peak season.

Our volume increased 5% over last year, while strong yield gains and our fuel surcharge drove average revenue per car up about 11%.

So over last year's to a record $14,090 a car.

The result was revenue growth of 17% to $3.7 billion, which also set a new quarterly record.

Results were strong across the board for each of our six business groups posting all-time records, for both average revenue per car and revenue.

We are also pleased that our customers are seeing a stronger network, and reflecting that in improved customer satisfaction ratings year-over-year.

Even as we handled 10,000 more cars per week.

Now let me spend a couple minutes highlighting the groups that experienced the largest growth in the second quarter.

Energy led the way posting their highest quarterly volume ever.

Our volume was up 9%, and as Jim mentioned, that comparison was helped somewhat by the problems with the joint line that surfaced in the spring of 2005.

We hauled record tonnage out of the southern Powder River Basin, enabling us to overcome a 7% decline in the Colorado/Utah volumes.

Our Colorado/Utah haulings were improved from the first quarter, but still below what we had expected.

Turned out that the mines had experienced shutdowns that impacted our first quarter volumes, weren't able to ramp up as quickly as we had hoped.

All-in, the record volume combines with a 6% improvement in average revenue per car, drove revenue growth of 16%.

Energy demand remains very strong and is still expected to be the key driver of our growth in the second half of 2006, and with this incredible demand for western coal, the entire logistics chain is still challenged to keep up.

For us to hit our year-over-year 10% targeted SPRB volume growth, we are doing everything we can to work with the BNSF, the mines, and the utilities on a number of initiatives, to insure that we can take advantage of every available train slot, as well as continuing our capacity investments.

Our intermodal volume grew 7% with our international business running way ahead of last year's peak levels.

While we didn't set a new all-time record for the quarter, we came within 800 containers of doing so.

Our premium business grew, and our domestic volumes were down slightly, due to lane closures, and a modest softening of west coast demand.

Average revenue per unit improved in all 3 segments, and combined with a strong volume to drive our 16% revenue growth.

Just like Energy, we expect Intermodal to also be a big driver of our growth in the second half.

In our Automotive business, finished vehicle shipments continue to show surprising strength.

Our Automotive revenue was up 18%, as a result of all-time record volume combined with yield improvement and surcharges.

Finished vehicle volumes grew 9% from last year.

We saw a 25% increase in Ford shipments, primarily driven by the production of their Fusion, Milan, and Zephyr products at Hermosillo.

Chrysler volume growth was 19% resulting from increased production at Belvedere which now produces their Caliber and Compass crossover vehicles, and we also saw Toyota and GM volumes grow, 8% and 2% respectively.

Our parts volumes increased 2%, primarily due to new business from tier suppliers and Honda.

Looking ahead we are still expecting that the Automotive business is going to slow a little in the second half, given the very strong production that we saw thus far this year.

Of course, that's always contingent upon automobile sales, and if they start really gaining momentum, that could change as well.

Let me touch briefly on the highlights of our other three business groups.

Our Agricultural products grew 5%, driven by a 44% increase ethanol, and DDGs and Cotton seed, both of which grew in excess of 70%.

Our domestic feed grain business was up 14%, but that was largely offset by declines in wheat and export feed.

Chemicals volumes were flat year-over-year as strong asphalt shipments for road construction, were offset by soft export demand for pot ash, and the loss of some of our lower margin business.

Shedding low margin business was also part of the story for our Industrial Products business, where volume was down 3%.

We saw the lumber and panel products market slow as housing starts were off 4% in May, and 11% in June, and mortgage rates hit a four-year high.

The good news in Industrial Products is continued strength in the commercial construction demand, especially for steel, aggregate, cement, and pipe.

All three saw significant yield improvement that produced record revenue, and looking ahead to the second half, we are still expecting flat volume growth, but continued yield grains will drive significant revenue growth.

Our customer satisfaction index continued to show significant improvement year-over-year.

So far in July our results are in the low to mid-70s, and we see that improvement as confirmation that customers recognize the stronger network, brought about by our unified plan and our other operating initiatives.

At the same time, we know we need to leverage those initiatives to drive further improvement in our performance, to better meet our customer's requirements.

Dennis will take you through the things that we are doing, and how we believe those will continue to drive our improvement, but before he does, let me just do a quick wrap-up from the commodity outlook perspective.

For the third quarter, we are looking for commodity revenue growth of 17%, similar to what we have seen over the first half.

About 5% of that will be driven by volume, and the balance will be from continued yield improvement and fuel recovery.

On a full year basis we are still looking for revenue growth in the 16 to 17% range.

With that I will turn it over to Dennis.

Thank you, Jack.

Good morning.

Today I'm going to walk you through how the railroad handled that record volume discussed this morning.

I will begin with a safety update, because it is the primary responsibility for all of us at Union Pacific.

This chart illustrates our three year safety trends for both employee and rail equipment incidents, or derailments.

The blue bars show the incident rate and yellow line is the FRA reportable rate.

As you can see, we made progress in both areas, comparing the first six months of 2004 to 2006, we see an 18% decrease in employee incidents shown on the left, and a 17% decrease in rail equipment incidents, shown on the right.

Now our employee reportable rate is up slightly versus 2005.

But overall incidents are improved, and that's our primary area of focus.

So our continued emphasis on safe operations is working, and the gains we have made are significant, especially when you consider that 30% of our train and engine employees are new over this period.

In the second quarter, we moved nearly 10,000 more car loads per week, a 5% year-over-year increase.

While we were able to hold the line on block via 21.2 miles per hour.

We were able to offset the higher volume with tight inventory controls, and our quality improvement initiatives, as well as capacity additions.

We believe in the future we can achieve velocity gain in a high volume environment, through this combination of quality initiatives and capital investment.

Inventory control is key to creating capacity and fluidity in the network.

Since 2003 second quarter car loadings have grown 8%.

But our inventory levels relative to those car loads, have actually declined over that same period.

For the second quarter, we generated 7.7 car loads for each car in inventory.

More car loads relative to inventory keeps the network fluid, and capable of handling these higher volumes, and it improves asset productivity.

The productivity improvement is also evident in several key asset classes.

On the employee front, we are reporting quarterly improvement up nearly 3% year-over-year, as we leverage volume growth against a more balanced work force.

In terms of our infrastructure we are achieving roughly 4% more throughput versus 2005.

These efficiency gain are further illustrated by our freight car utilization, attaining its best level in three years.

We are creating this space on our network through better asset turns, and reducing the need for 3600 equivalent cars between 2005 and '06.

And as we have consistently demonstrated over the past 18 months or so, we are becoming more fuel efficient.

Our consumption rate of 1.27 is a second best quarter, saving us 5.5 million gallons of fuel versus 2005.

A key initiative aimed at both productivity and service is the unified plan, as we discussed previously, which as you can see is simplifying the network through fewer car handlings, and en route work events.

This is a specially significant considering that roughly 35% of our business runs in manifest service.

Also, we are operating a third more point to point trains, with no intermediate work events.

Through our unified plan efforts and our customer inventory management system, we have improved our industry switching performance by 7 points.

This is a critical customer interface, and is a key indicator of service reliability in the car load area.

Most recently, we concentrated our unified plan efforts in the complex southern region, and specifically we rebalanced the terminals in the important Gulf Coast region, and developed more point to point trains on the Sunset corridor, and to and from Mexico.

In support of our unified plan, we have recently realigned our network operating management, reducing interregional handoffs by 25%, and further simplifying operations.

At the end of the day, we are translating our network management efforts into greater operational productivity, and service reliability across all the networks.

Manifests, bulk, and premium.

You heard Jack talk about the tremendous demand we have experienced for southern Powder River Basin coal.

On the operating side of the house, that demand has challenged us to become more and more efficient and reliable.

In the second quarter, we increased our average trains per day by nearly 4, and we also increased the tone hauled per train set by more than 4%, as we hauled nearly 118 tons per car, and over 15,000-tons per train.

Both of which are best ever quarterly measures.

We have also improved our service reliability, as measured by the coal cycle performance, which is running over 92% in 2006.

Despite these gains, we know we are not meeting all the coal demand.

The rails, mines and utilities must continue to work together to maximize output, and we intend to do our part.

We are also improving service and efficiency for our Intermodal customers.

For example, our Sunset corridor which handles roughly 45% of our Intermodal volume, is running faster and more reliably.

On the common corridor between Los Angeles and El Paso, our initiatives have increased throughput by more than 10%.

The charts on the right show our service delivery performance between Los Angeles and Memphis, comparing the 2005 peak shown by the blue line, and spring 2006 shown by the yellow line.

Over that period we shortened the transit times by 5 to 6%, and tightened the delivery span for both our premium and standard Intermodal service products.

The unified plan efforts I just discussed, and targeted capital improvements especially in the L.A. basin and on our Sunset corridor, have contributed to this improved fluidity and service.

Looking more closely at our capital programs, we continue to make solid progress in the second quarter.

Across the South and West, we cut over 11 miles on our Sunset corridor, I just mentioned. 31 more miles, that's 31 miles year-to-date that we have cut over, and are targeting 11 more miles by mid-August, and we completed a lead track, a significant lead track on an extension at our east L.A.

Intermodal facility, allowing us direct access to the yard, without disrupting main line operations.

In the Mid-West we cut over 19 additional miles of [third] main line along with BNSF in the southern Powder River Basin.

We made progress on our centralized traffic control, our signal project across Iowa, completing 30 miles of the 60 miles scheduled in '06.

In San Antonio we began work on our terminal improvement project, that will increase our capacity and fluidity, that will support the new Toyota plant, Mexico business, and our local San Antonio customers.

And as Rob mentioned, we are adding a San Antonio Intermodal facility, increasing capacity by over 100,000 trailers and containers annually by the year 2008.

So let me wrap up today with just a few highlights about the second half of the year.

As you heard from Jack, record volume is going to be the name of the game for the rest of the year.

Our resource plan is designed to peak in August, receiving our full compliment of road locomotives, and ensuring that our train crew ranks are trained and ready.

We will continue to improve productivity through our network management initiatives, such as the rollout of Sims projects, and the unified plan, and working to reduce our failure costs and improve reliability of our service product, and we will achieve these goals while focusing on safety of our employees, our customers, and the public.

With that, let me turn it back to Jim.

Okay, thanks, Dennis.

Let's wrap up our earnings discussion with a look at the balance of 2006.

We expect the record volume strength we saw in the first half of the year to continue through the upcoming peak season.

As Jack mentioned, we anticipate third quarter commodity revenue growing to be pretty consistent with what we experienced in the first six months of 2006, up around 17%.

Permanent growth is expected in all of our business teams with the strongest growth in Ag products, Energy, and Intermodal.

We expect to move record volume more efficiently, driving a 4 to 5 point improvement in our year-over-year operating ratio.

We expect third quarter earnings per share in the range of $1.40 to $1.50 per share.

This target range may seem somewhat at odds with our strong revenue forecast, but spiking fuel prices can put downward pressure on our quarterly earnings, as we saw in the second quarter.

In addition, third quarter other income will likely be less year-over-year.

In comparing our outlook to last year, you may recall that the third quarter of 2005 included a $0.44 per share gain from a non-cash income tax expense reduction.

So on an apples-to-apples basis, we would expect third quarter earnings growth of 50 to 60%, versus $0.94 per share last year.

Looking at the full year, we are again raising our estimates for revenue growth, operating ratio improvement, earnings, and free cash flow after dividends.

Our first half performance came in stronger than expected, giving us confidence that we should finish 2006 with a great deal of momentum.

Our current full year expectations call for money to revenue growth in the 16 to 17% range.

At the start of the year we targeted operating ratio improvement to be around 2.5 to 3 points.

Today we are increasing our expectation to be more than 4 points.

Earnings per share growing in excess of 60% in the $5.50 to $5.60 per share range, and free cash flow after dividends nearly doubling to around $450 million.

The biggest challenge ahead for us will be to continue to make progress on our operating initiatives, productivity and service reliability, in the face of record volume growth.

Now, looking beyond 2006, we believe that today's environment of strong demand, yield improvement and operating gains will continue.

The optimism was based on a strong demand forecast with several critical drivers including, the ongoing expansion of international trade flowing across the West coast ports.

Continued truck capacity constraints caused by driver shortages and highway congestion.

The potential for sustained high fuel prices which favor rail as a highly fuel efficient transportation option.

Growing demand for coal powered electrical generation, especially when you consider high natural gas prices, and the shift toward low sulfur western coal, and increasing traffic moving up and down the NAFTA trade corridor.

All the signs point to growth.

Obviously, we will keep an eye on the economy, but we expect these long term opportunities to translate into strong growth in revenue, earnings, and financial returns.

In order to maximize this great potential, we are considering an increase to our capital investment for growth.

One of the best examples of this is our Sunset corridor.

As most of you know we have been working to double track this important Intermodal route between Los Angeles and El Paso.

By the end of 2006, we expect to have half of this 760 mile route double tracked.

The current timetable calls for the remainder to be completed over a seven to eight year period.

We believe it's time to take a serious look at accelerating our Sunset double track project.

Over the next few months we will be requesting bids for accelerating this work, with completion dates ranging from three to five years.

We have more analysis to do, and we will have to see how the bids come back, but we believe the returns in this corridor will be improving significantly over the next several years, and we want to make sure our capacity will be ready to handle this opportunity.

Other segments of our business such as Coal and Ag products also have strong demand forecast, and expected financial returns that support the case for growth.

The capacity investments we are considering would not only accelerate growth across the overall network, but would also improve operating efficiency, and service for all of our customers.

So, as we begin our planning for 2007, we will be making some decisions about how to best allocate our growing cash.

Looking back over the past five years, we have committed our cash to capital programs, debt reduction, and dividends.

We invested over $9.5 billion of capital into our network.

Took nearly $2.5 billion of debt off the books, and increased our dividend by 50%.

Looking ahead, our recent financial performance and strong outlook give us increasing confidence, that our cash from operations will grow significantly next year.

We would allocate this cash toward multiple uses.

Our plans are still very preliminary.

But our current thinking is that 2007 capital spending could be about 15% above 2006, which would put it around $3.2 billion.

We believe this level of investment would be fully supported by the growing strength in our cash flows and financial returns.

It would create long term value for our shareholders, by enabling us to accelerate the tremendous growth opportunities we have just discussed.

Even with higher capital spending, we expect to generate substantial free cash flow next year, and as the year progresses, we would be in a position to consider additional ways of rewarding shareholders, such as dividends and share repurchase.

Although our outlook is bullish, we will be cautious in our approach.

We were not building the church for Easter Sunday.

As we have been telling our customers we want to work with them to meet their needs over the long term, but can only invest for growth where financial returns warrant.

We will closely monitor our performance, and if demand lets up, or returns slip, we will adjust our plans accordingly.

Bottom line, we believe these investments represent a great opportunity.

They will enable us to provide better service for our customers, and create significant value for our shareholders, with increasing returns on invested capital.

With that, let me open it up to your questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Jason Seidl of Credit Suisse.

Please proceed with your question.

Morning, gentlemen.

Morning, Jason.

Impressive results this quarter.

Got a few quick ones for you.

You mentioned that despite the real strong growth that you guys posted in coal volumes, that you were still hampered a little bit by weakness in Colorado.

Could you give us an update on where those lagging mines are right now, in terms of their operations?

You know, Jason, the two biggest problems that we had, one was a mine had a roof cave in.

Another one was a gas situation.

Those things have started to come back.

They didn't come back as quickly.

The mine operation, the roof situation has been rectified, and they are back into production right now.

The gas and the heat problems have cleared, but certainly like right at the moment, we have a mine that's experiencing some problems with some of their track infrastructure.

And when you have all pieces of the supply chain operating at full capacity, even small bumps can have an impact.

We were watching that pretty closely.

For the most part Colorado/Utah is back online.

Could you expand upon a comment you made there was a little bit of softening of west coast business, where I think it was the Intermodal product.

I think it was our domestic intermodal off the West coast.

You know, what we think is really happening there, Jason, we have had a number of customers that have stopped transloading from international containers into domestic containers.

What's happening if you looked at our results in the second quarter, we saw very strong international business, and we saw the domestic business soften somewhat, and I think what's happened is a lot of that business just shifted into international boxes and persisted.

I have a follow-up question and then I will get into the queue again.

On the potential 15% increase in your capital plan.

Are we looking for some of the same split between cash capital and operating leases?

And then also how much of this could be predicated around if you guys, if the railroad industry gets their 25% tax credit that's been talked about.

I think it's a little early to determine the exact split between cash capital and operating leases.

Although I would say the majority of it probably would fall on the cash capital side here.

In regards to the investment tax credit that's discussed in Washington.

Even when we look at the level of increase we have right now, I still don't think it will be enough when you look at demand over the long term.

And to me, the investment tax credit proposal is one that really helps address to me a serious capacity issue this country has in transportation infrastructure.

I think there is more out there.

We could do more.

But for me the focus we will look at is the returns.

And unless those returns hold, we won't spend it.

Fair enough.

Thanks, gentlemen.

Our next question is coming from Tom Wadewitz of J.P. Morgan.

Good morning.

Congratulations on the strong results.

I have a couple different questions.

On the first one, you saw some at least versus what I expected, the cost side performance was pretty strong, and that was despite velocity, and dwell time, which didn't show a lot of improvement.

Is that the type of profile that we should look for, and I guess the offset to that, is that you are handling that strong growth?

Or would you think that perhaps we see some velocity improvement later this year, or in '07, that would drive even further pace of cost improvement?

Dennis you want to handle that one?

Obviously our target is never anything less than continuous improvement in both of those key metrics and velocity as well.

And we expect to drive the operation that way.

I would think our expectation internally here, is that we will improve as I said, velocity, end dwell, in the face of those volumes.

We have to get better and have a lot of network management initiatives and then continuous improvement initiatives to make that happen.

That's where we expect to be.

And so if we see that start to come through, and we have good visibility at least on the AAR metrics, would that then imply even better cost side performance than you showed in the second quarter?

Certainly if efficiency is associated with velocity and reduced well.

Okay.

And second question for you on this increase in spending you are considering, how much of that do you think is just catching up to have really the level of track capacity and terminal capacity that you would like to have for today's volumes, and how much of that do you think is really putting new capacity in the ground to handle future volumes?

Well, Tom, you know I would love to have the Sunset corridor double tracked today given the volume.

When you look at that time in that context, you could say we are behind the curve.

To me at the end here you really look at a couple of groups, Coal and Intermodal, we know what the demand there is, and we aren't handling it all.

What's also very important here is the financial returns in the business look very good going forward.

Whether you want to look backwards, and say what we should have done.

That's probably not relevant to me.

What is important here is what do we see going forward here in terms of the opportunities.

Okay.

Any thought on or update on where you are at with the book of business, and repricing with respect to next year, how much you will touch next year, and how far underpriced that might be?

You want to take that one?

You know, at the end of this year, Tom, we will have about 32% of our business that we have not been able to take to market.

Next year is a little bit of a light year for us.

I think about 7% of that is going to come up for renewal.

We also have a continuing opportunity to reprice the other business, the 68% that we will have already touched.

So we still have some upside opportunities there.

Do you think pricing and yields might be as good next year then as this year?

Or is that hard to say?

The opportunities there.

And it's again what is your assumption of the economy, demand, will think it will still be pretty good.

We also had the opportunity with improved service in terms of pricing.

We know working with our customers, part of my commitment in front of a customer when we look at our price increases, they want to know how we will handle their growth, and how we will improve their service.

I will tell you, they are willing to pay for that.

Thanks for the time.

Okay.

Next question comes from Jordan Alliger of Deutsche Banc.

Hi Jordan.

Good morning.

Just sort of a curiosity question.

You continue to have solid volumes and given folks' concerns, or what have you regarding where the economy is, I'm wondering is it your sense it is more a function of economic strength, or the better service and potentially pent up demand for rails, that's driving the business on your network right now?

The economy is relatively strong.

Jack talked softness in lumber and maybe a little bit on our fertilizer moves.

I think a lot of this though is pent up demand for rail when you look at it.

Again, being in front of our customers here, even with the pricing we have done they still want to have a serious discussion about long term commitment to rail, and how they move more of their business on rails.

Another question roughly in the same vein, but on price.

If things did slow a little bit out there, and as you noted for Forest Products maybe with the housing impact, there has been some slowing, is it your sense though, that you would have an upward bias to the price on the areas that might be more economically sensitive.

I'm not talking actually talking coal and agriculture, which is sort of separate, but the industrial and chemical type of areas.

Can you still exert an upward bias to price if things do slow in those areas in the coming quarters?

Jordan, we will be smart about what happens with the economy when we look at it regularly.

But I will tell you unless we have minimum return guidelines set for our business, I'm not willing to go backwards here.

If we kick up the capital spend here, we have a long way to go to drive the return up.

You have a major recession or something we will be smart here, but I have an upward bias on pricing, let's put it that way.

Let's put it that way.

Next question coming from Scott Flower from Banc of America Securities.

Please proceed with your question.

Good morning, Scott.

Just a couple of quick questions on the roughly $400 million of incremental CapEx for next year that you are contemplating.

I know it's not a done deal.

Is that primarily going into the Intermodal and Coal business. like either Sunset route which is largely Intermodal, and then incremental capacity expansions for the Coal business.

Is that right?

Or where else is the incremental money being spent, or could be spent.

There are really three categories we look at.

You have the track infrastructure which is the Sunset corridor.

You look at your Coal network, which would be up in our central corridor.

But you also look at our terminal facilities.

Those three, which are all infrastructure is really where that investment will go.

We have to get the whole network up and moving and handling the volume.

It's among those three groups.

A question for Jack and I want to get a little color, is obviously on the average revenue for a car which is a proxy for what's going on for fuel surcharge and pricing, Coal and Intermodal were up less.

Is that a function of the contractual durations of those businesses, as well as perhaps in the Coal business the fuel surcharge may lag a little bit, because there's more ARCAP, or help me understand a little bit.

Because obviously on a revenue per car basis, year-over-year change, those were below your average, and I want to get more color on that.

You are right.

Those are two of the groups where we have the greatest proportion of our legacy contracts still in effect.

Then the last question I had was, maybe for Dennis.

Are you completely implemented on the unified plan on the Gulf Coast, or are you still in process there?

That's a very intricate area, and I'm just curious where you are in the process of the unified plan there.

Are you still halfway done?

All the way done?

Are you fine tuning?

I want to get a sense of an update where you are with that.

We basically completed our first pass through the Gulf Coast, Scott.

We still have work to do.

Our intent is to finish that work up, and then come back, and we are in the second phase now of implementing what we call the enterprise edition, where we will be able to further integrate into Jack's forecast, and do a better job of planning and looking at our key plan, and going to seasonal key plans.

Then the third phase we will also go back to is our to and from industry piece.

Our Customer inventory management piece.

We have a lot of work to do there yet in the Gulf Coast.

So we still, we are still optimistic here.

We have work to do here but we are pleased in the direction we were going.

What's the rough timing on those incremental phases?

Is that by year end?

A year out?

I don't have any sense of timing.

We expect to get all of our major terminals, all of our 13 major terminals that report on the AAR through the terminal review process here by the end of this year.

Let me also tell you, Scott, you will continue to hear about the unified plan.

It's an Evergreen process.

That's something we will incorporate here as an ongoing initiative for us.

It's the way we will do business.

While in these initial phases, you will continually hear about this ever forward.

Great.

Thank you.

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

Please proceed with your question.

Nice quarter.

Good morning.

On the CapEx, do you think there is any money there for additional equipment?

Or is it likely just on infrastructure.

The incremental that you are talking about in '07?

A little bit for locomotives.

It will be volume related here.

Very good.

Second along those lines, you talk about how you would love to have the Sunset corridor double tracked already, are there any other facilities you wish were in place today.

Obviously the third and fourth lines up in the Powder River Basin.

But the San Antonio Intermodal facility, is that something you would fast track, or are the other things will kind of go your normal rollout of additional facilities?

An important pice of this thing, Houston, the L.A.

Basin all come into play.

St. Louis, you look for coal.

That's really all part of this here.

And because again, the philosophy here is we will build a highway but we need the landing spots, too.

It's really a balanced approach at the way we want to look at the network.

Okay.

And then in talking about service I know velocity and dwell time, are the statistics we get and everybody kind of gets focused on.

But I'm curious.

What other, Burlington talked about the number of miles per train per day, and that type of thing.

What other metrics are you looking at, that maybe are better gauges for the success of the unified plan and the improvement, or are you comfortable with the velocity and dwell time arguments?

Those are two high level measures.

There are many other measures we look at like our to/from industry.

To me equipment cycle time is absolutely critical.

When we look at the amount of we invested.

We have the the highest inventory of any of the railroads.

And we are really pushing here to look at, and you can say car miles per day.

Contribution per car day, those kind of measures are all focused on asset utilization.

One other piece is the consistency of service.

You take off these tails here on your service, which is very important to customers, of course they would like a much higher velocity, but they also want to have much more predictability in the delivery of our goods here.

Duff, you want to add anything else?

Okay.

And then -- that does it for me.

Nice quarter, guys.

Thanks for your time.

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

Please proceed with your question.

I just want to understand again on the capital projects, when you double track the sunset corridor how much capacity is created?

Two times, less because you already have the sidings.

Ultimately how much capacity you create, and what impact that has on your ability to continue to get this pricing leverage.

When the Sunset is completed you would double the capacity out there, and again you want the track structure, but you also want the terminals to be in sync with what you are doing over the road.

Another piece on the capacity on not only volume but efficiency is real important here in service.

You get, you not only can handle more volume, but we can handle it much more efficiently.

So Jim, it's doubled despite the fact that you add the sidings as you go, which keeps your capacity, so the day that you complete the double tracking, you have double the capacity, or saying you double it versus what you had when you started the whole process?

We are running about 50 trains a day right now, we've doubled that, but keep in mind as you turn it over, we don't have to wait to double track the corridor to have the benefits, as we are turning over capacity today during the year, you see the benefits.

Okay.

And then coming back to the velocity question.

What is the biggest constraint there?

Is it just this track issue on improving velocity?

Yes, on a long term basis, that's absolutely the truth.

You have to have the capacity to be able to do that.

Having said that, there are opportunities to create velocity, like managing our inventory very tightly.

Focusing on our locomotive productivity.

Working on our throughput through all of our lean initiatives and our unified plan.

At the end of the day, you have to have capacity to be able to run the railroad.

When you talk about a 2x type thing, we will not only have a room for growth, but as Jim said, taking out those failure costs and realizing those efficiencies is equally important.

What's happening right now is we have progression of by plan, lean, a lot of our customer initiatives, it's being backfilled with higher volume, which to me is a great problem, as we said, we have peaked over 200,000 cars in a seven-day run rate.

At the end of the day if you said you would run volume off here, we would see our velocity improve, but in our business here, the long term success is we have a sure ability to really grow the business and handle it very efficiently.

Great point, we are definitely seeing that with your back half volume estimate increases.

Then last question, Rob, can you talk about your locomotive additions for '06 and '07?

On that, does the potential shift of the accounting change of perhaps moving lease accounting on the balance sheet.

Does that dictate any of your thoughts on how you are going to finance those?

No, it doesn't.

We haven't finalized the number for '07 on the locomotives.

The number on '06 is 200 locomotives.

As Jim mentioned, we would anticipate that part of the increased capital spending is for the higher growth.

We will need additional locomotives next year.

We will finalize those numbers but no impact on the accounting change.

Sorry, just thought of another question, so I will ask one more.

On the pricing side, I just want to come back to a question from before, you still see the same pure pricing increases.

You said a few contracts roll up in '07 than did in '06.

Can you maintain this level of pure pricing increase in your head as we go into the back half of the year, and into '07?

You want to answer that one?

Again, it will depend on what the market looks like, and the economy stays with us.

Our plan is we will have fairly strong pricing through the balance of this year, and our initial thought at 2007, is that the pricing environment still looks like there is some upside for us.

Great.

Thanks for the time.

Okay.

Our next question is coming from Edward Wolfe of Bear, Stearns.

Thanks, good morning.

I would like to expand some of your comments on the purchase services and others.

It was so improved and you talked about some of that swapping of with materials and supplies.

But even if you add them together they look like they are improved.

Can you talk a little bit about what's going on there on the purchase services and others line?

Yes.

Purchase services and other as you point out was improved, but as I said about $29 million in the quarter versus the previous year.

What's going on there is some miscellaneous items.

We had some joint facility, favorable versus the previous year.

Some contract maintenance that was down.

Again as I pointed out, you need to look at those two categories together because there was shift between materials and supplies and purchased services.

And overall when you combine them they were up a combined 4%, which I think is a better way of looking at the business.

And materials and supplies was up as I pointed out, because of increased freight car materials, other materials, locomotive maintenance, et cetera, were the primary drivers within that category .

If we look at the 2 up almost 4%, is that the way we should look at them going forward, or there is anything one-time here, where it goes up a little faster with volume?

That's about right. 4%, 4 or 5 range.

Somebody asked the question about coal yields, and you talked about Coal and Intermodal are the long-term contracts.

But if I just look at the year-over-year and second quarter here at 6.3% for Energy versus 9.3% in first quarter, there is just something quirky in the first quarter comparison, or how do I think about that?

I think what you are seeing is probably what's happening more in the second quarter because of the problems we had last year with the Powder River Basin.

It makes the second quarter comparisons look a little easier.

I'm seeing the yields though decelerated in second versus first.

So year-over-year yields as I'm looking at it, are up 6.3% for Coal, whereas in first quarter they were up 9.3.

I that I that's Colorado.

That's probably what's happened to us with the Colorado/Utah business.

Mix issue.

I wouldn't read declining yields as a second or first as a trend.

No, not at all.

I read you on that.

Can you talk a little bit -- you made a lot of comments on the Agriculture side.

You mentioned something on the Potash on the Chemical side.

We had some wheat and corn harvest that are below a year ago, and I'm guessing that we will start to see some of that in the shipments out a couple quarters from now.

Can you talk to that?

The jury its still out on the current corn harvest, and how the drought is going to impact that.

There was good carry over.

We see our corn business as being pretty strong.

We don't see quite the same thing with wheat.

We think that wheat has softened the harvest was kind of a non-event for us this year.

We think that will persist.

The corn markets is ripe, some of those kinds of other commodities look pretty good.

How should we think about Ag volumes overall as we go out through the rest of year.

Up 4.7 as you report them.

How do we think about that through the rest of the year, flattening out?

If I were to look at Ag volumes year-over-year, I think they will be down a little bit.

From what they were in the first half, but I still think they will be up year-over-year.

So, decelerated but not down.

And Rob one question on the cash flow, the $450 million of free cash guidance implies a big change.

In the first half of the year so far, you have used $150 million of cash prior to dividends and haven't generated any.

Where is the turn going to come?

It is not like you have precapitalized or anything here too much.

There was timing issues in the first half.

Timing of pension payments, fuel inventory, accounts payable.

Typical patterns that we would see in any particular year.

Okay, so we will start to see that in the third quarter.

As we always do.

Thanks a lot for the time.

Thanks.

Next question comes from Randy Cousins of BMO Capital Markets.

Good morning.

I wonder if you guys could comment on your guidance is on commodity revenue growth is 17%.

Could you comment on how you see your other revenue growing.

Will it be in-line with the commodity revenue growth, or do you see it accelerating or decelerating on a relative basis?

Rob, you want to handle that one.

Our guidance on the other income is in the 75 to $100 million range.

As I pointed out on the other income, yes, excuse me, I was addressing other income, other revenue is not quite as much of a growth, Randy.

So modeling purposes, should we just if we budget this out, in the quarter you did $181 million worth of it.

By my calculations of other revenue are non-commodity revenue.

Is that like a run rate to use for Q3, Q4?

Or should we be linking it to the incremental revenue growth that you're getting?

How should we think about that?

Look at the second quarter run rate would be a better way of looking at it.

I want to come back to this materials and purchases thing, because year-over-year Mother Nature conspired against you guys pretty tough last year.

So year-over-year comparisons are tough.

And I'm thinking sort of as a benchmark quarter to quarter, and I noticed that your combination of purchased services plus materials and supplies in Q1 was I think 614.

And in Q2 it was 593, with higher volumes and higher revenues.

For modeling purchases should we think of that 590 to 600 as kind of like a go forward run rate, or how sensitive is line item really to the volume growth you are getting?

I would look at it as the 4 combined, 4 or 5% run rate kind of number.

When you look at them combined.

I said on the third quarter our guidance for the materials and supplies alone would be about 25 to 30% up from last year.

Okay.

I look at purchased services, on the other hand, being about flat.

So when you guys think about the sensitivity of these two particular the two line items to volumes, would you say it's more of a inflation kind of cost item?

Or is it a volume based cost item?

Mostly inflation.

A little bit of volume, but mostly inflation.

Okay.

And then my third question has to do with sort of relative pricing momentum.

You got three product categories that are running at 17, 18 ARC growth, and sort of two product categories, Energy and Intermodal dragging themselves.

Can you give us some sense as to how much of this relative differential is due to efficiency of fuel recovery?

And do you see any sort of risk to sort of revenue growth, or for some of the higher ARC type units, if they change the formula by which you calculate the fuel surcharges?

The biggest difference you see there is the businesses where we have a large portion of business tied up in historical contracts, as opposed to the fuel surcharge itself.

Part of those contract limitations prevent us from applying a fuel surcharge.

So it's really kind of a combination effect on that business.

I don't see anything there, other than those contractual legacy issues.

And in terms of if the formulas for calculating fuel surcharges are changed to be sort of a mileage base or unit base, as opposed to a revenue base, do you see that impacting your business in any material way shape or form?

No, I don't see that actually doing that.

The jury is still out in terms of mileage base, in terms of how that works or doesn't work.

And we are watching, we were taking a very careful look at our fuel surcharge as to how we might reconstitute that if we need to.

At this point in time that will not impact our business.

Thanks very much.

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

Please proceed with your question.

Great quarter.

Kind of an esoteric question.

The USDA is reporting that there has been a 32% drop in cross border grain shipments between the U.S. and Mexico, and I thought given your interest in your Mexican property down there, maybe you can give us a little light.

Our Mexico grain business is actually up.

I don't have the exact number with me right at the moment.

But we have not seen significant dropoff at all.

In fact, a big portion in our increase in Mexico business has been grain.

What was our total volume up for Mexico this year?

We were up 13,000 units, and of that, grain was about 3700 units of that.

We were up 13,000 units, 7%.

Grain to Mexico was up 11%.

So we are not seeing it right now, Don.

Due to time constraints, our last question today will come from Gary Chase of Lehman Brothers.

Two quick questions, one for Jack and kind of referencing back to another question you were answering.

The industrial ARC gains continue to be very strong.

You mentioned in your commentary the shedding of some of your lower margin business.

How far through that process are we, and should we think of that as one of the dominant contributors to those gains?

Or is it mostly core pricing that's driving that continued strength?

It is primarily core pricing.

When we look at it, Gary, we are still looking at some of the business that may not be at market levels, so we still have some upside on those.

But clearly there are some markets, some of that business segment that basically when you look at the economics of handling it versus other alternatives of transportation, it made better sense for that business to be someplace else.

Rob, I apologize.

I didn't have time to do quite all the calculations I wanted to.

When you said the fuel impact in the quarter was $0.13.

What was the base line you were referring against?

Was that relative to the first quarter recovery rate?

Relative to full recovery, steady state, absent the timing issues.

How should we interpret the $0.13?

And just a quick follow-up to that, is the thought process, as far as the guidance goes, that fuel prices will kind of stabilize at third quarter levels?

Rise like the forward markets are projecting.

What's baked into the guidance on that level?

My $0.13 comment was relative to the first quarter.

As I mentioned, because of the two-month lag in our recovery mechanisms in the second quarter, our recovery rate above our threshold price was about 80%.

It was off from the first quarter again, because we were chasing that rising price.

The guidance number that we gave contemplates fuel anywhere from $2.20 to $2.40 a gallon kind of range.

It's anybody's best guess in terms what it will do.

That would suggest that it either stays at the current high levels, or maybe a little bit of moderating, and we will have to see.

Okay.

So if fuel were to go up, there might be a little head wind.

That's correct.

Absolutely true.

Sorry, in the first quarter, the 92% was more than just where, you got a little bit of timing benefit in the first quarter, did you not?

That's correct.

Thank for clarifying.

Thanks, guys.

All right.

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

I would like to turn the floor back over to management for closing comments.

Thank you, everyone.

That concludes our second quarter review here.

As I hope you heard, we are feeling pretty good about our results, but a lot of work ahead of us, and look forward to seeing you here with our third quarter review.

Thanks.

Ladies and gentlemen, this does conclude today's teleconference, you may disconnect your lines at this time.

Thank you for your participation.