聯合太平洋集團 (UNP) 2006 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Union Pacific third-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.

It 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 third-quarter earnings conference call.

With me to discuss our results are Rob Knight our CFO, Jack Koraleski, Head of our Marketing and Sales Group, and Dennis Duffy, Head of Operations.

Since our analyst meeting was just a couple of weeks ago we will keep our remarks brief.

For the third quarter we're reporting another record performance with strong (technical difficulty) revenue operating income and earnings.

Union Pacific's third-quarter earnings increased 64% to $1.54 per share versus last year's adjusted earnings of $0.94 per share.

You'll recall that last year's earnings included $0.44 per share from a non-cash income tax expense reduction.

Last year's results were also impacted by the effects of Hurricane Katrina and Rita which cost us around $0.07 per share.

When Rob takes you through the details, you'll see that our quarterly earnings included an insurance settlement related to the 2005 West Coast storm as well as slightly a lower tax rate.

But even setting that aside, we still have substantial year-over-year quarterly improvements.

Third-quarter operating income grew 56% versus 2005 to a best ever $752 million.

This marks the sixth consecutive quarter of operating income growth.

Now before I turn it over to Jack, I'd like to take a minute to summarize what I see as the key highlights of the quarter.

First, the demand for our rail capacity remains strong.

Four of our six business groups increased volume compared to last year and more than offset weakness in our Industrial Products group as a result of a softer housing market.

Volume growth and yield initiatives produced our best quarterly operating revenue gaining 15% to just under $4 billion.

This growth was slightly below our plan coming into the quarter primarily driven by lower than anticipated coal volumes and a little weakness in our Industrial Products sector.

Coal's shortfall to plan was not a demand issue.

As we discussed at our Dallas analyst meeting, coal demand has never been stronger.

Joint line congestion, line production issues as well as incidents at our railroad all limited volume growth particularly in September.

Coming into the third quarter we knew we'd be challenged by the record quarterly volume; today we're about halfway through the peak season and we're managing volumes much better then we did a year ago.

As Dennis will show you in a minute, our third-quarter operating metrics were mixed with most measures other than velocity improving.

Most importantly though, we converted good topline growth into five points of improvement in our operating ratio to 81.1%.

With that, let me turn it over to Jack to walk you through our revenue results.

Thanks, Jim, and good morning.

Coming off a record-setting second quarter we entered the third quarter with pretty high expectations for volume growth.

However, instead of ramping up as third quarter usually does our volume stayed about flat with second quarter as some softness in our markets, operational challenges and our drive towards reinvestability held volume growth to 3% over last year.

Strong yield gains in our fuel surcharge drove average revenue per car up 12% to a record $1515 a car and the result was revenue growth of 15% to a record-setting $3.8 billion.

Results were strong across all six business groups and at the same time we saw customer satisfaction improve significantly over last year.

Our overall satisfaction was up 8 points to 74 for the quarter which was our highest level in almost three years reflecting customer sense of a stronger network and also better service from Union Pacific.

Let me just take you through the volume growth drivers for the quarter.

We'll start with energy.

Energy clearly led the way with volume up 7%.

Now this comparison was aided by the significant joint line repair program that was underway during the third quarter last year.

We hauled record tonnage out of the Southern Powder River Basin enabling us to overcome a slight decline in Colorado Utah lines.

Our Colorado Utah car load were hampered by mine problems and the operational challenges resulting from a pretty intensive maintenance program that we had in July.

The volume growth combined with a 10% improvement in average revenue per car resulted in revenue growth of 17%.

The challenge, the logistics, chain faces and keeping up with a demand for Western coal persisted in September.

For the most part operational and maintenance issues on the joint line and mine production problems held volumes below what was anticipated.

We had planned for about a 10% growth in SPRB tonnage in 2006.

It appears likely we're going to fall just short of that target.

Nonetheless, as Jim said, our demand is very strong and we expect energy to be the key volume driver for our growth in the fourth quarter.

Like energy, Intermodal posted their highest volume quarter ever up 5%.

The growth was driven by a 12% increase in international volume.

Our premium segment was about flat year-over-year and our domestic volumes actually declined 5% in the face of a little softness in the economy and an ample supply of trucks.

Average revenue per unit improved at all three segments driving a 14% revenue growth.

Looking ahead to the fourth quarter we expect continued strength in Intermodal particularly in the international segment as we wrap up peak season.

Now while energy in Intermodal drove our growth, our Industrial Products business saw some volume declines of about 4%.

The cooling housing market has continued to impact our lumber and panel products volume with lower production and general market uncertainty kind of fueling that softness.

The slowdown in housing starts is beginning to show up in cement, wallboard, and roofing granules and a variety of other building products.

The team's efforts to shed low margin business resulted in year-over-year declines in paper, newsprint and scrap paper but at the same time that same effort helped to drive a 15% improvement in revenue.

Also contributing to the revenue improvement was growth in construction related steel and in steel pipe and frac sand use for oil and gas drilling.

Our expectation is that we're going to continue to see a little softness in the forest products market into the beginning of next year but we also have customers in markets such as rock and cement that have a much more bullish outlook for their markets and a strong desire to shift and move even more product by rail.

Let me touch briefly on our other three business groups.

With a 19% increase in revenues our Ag products volume grew only 1%.

The growth came from ethanol which was up 51% as well as DDGs, cottonseed and soybean meal to Mexico.

Export feed grains were actually up 63% but that strength was more than offset by one of the softest wheat markets in 10 years.

Although finished vehicle shipments slowed dramatically from levels seen in the first half of the year, our volumes were actually up 1% over last year and that drove a 10% increase in revenue.

Increased auto parts shipments including the new Honda business and some tier business helped push overall Automotive volume growth to 3%.

While chemical flames were down 1%, commodity revenue improved 14% over last year.

Last year of course had some impact from the hurricanes.

The volume decline reflects the intentional shutting of some of our lower margin business as well as a 12% decrease in fertilizer volumes that has been driven by softer potash exports, the weather in the Midwest and the South which slowed fertilizer application and then we have some customers that have delayed purchases of fertilizer in hopes that lower natural gas prices would drive their product prices even lower.

These results reflect not only the strength and diversity of our franchise to help us during times of some economic softness but also our continued emphasis in driving yield improvement.

So what is the fourth quarter looking like?

It's a little different than what we've seen so far this year.

First of all its looking like the fuel surcharge will have a little bit of a lesser impact year-over-year.

With high fuel prices in the fourth quarter last year, the comparison may be more in the 1 to 2% two% range.

We will just have to wait and see how fuel prices finish off the year.

Negative mix will be a little more pronounced as we see softness in our relatively high average revenue per car business lighten the Industrial Products world, but that's going to be offset by strength in lower average revenue per car energy and Intermodal business.

We expect our volume to grow in the 3 to 4% range.

And while we have some softness, we also have areas of strength so what we need to do is to marshal our resources and at the same time stay out of Mother Nature's way.

The end result should be about a 10% improvement in fourth-quarter revenues which would drive a 15% revenue growth for the year on about a 4% volume increase.

With that I will turn it over to Dennis.

Thank you, Jack, and good morning.

I'm going to take a few minutes today to walk you around our railroad operations as well as discuss plans for the fourth quarter.

Let me start out with safety.

[Joe Santa Maria], our Vice President of Transportation, spent some time in Dallas talking with you about our key safety initiatives.

This chart illustrates our three-year safety trend for employee and rail equipment incidents.

The blue bars represent the absolute number of incidents and yellow line is the FRA reportable rate.

Comparing our year-to-year results over the past two years, we reduced our employee incidents over 20% and our reportables by more than 4%.

During that same period we've also reduced rail equipment incidents nearly 35% and reportables by almost 10%.

We are making good progress on the safety front and led by Joe and the regional vice presidents, we'd expect to see greater improvement going forward.

Turning to the operating metrics, we talked about these measures in Dallas so I won't spend a lot of time.

But each section of the quad chart illustrates our quarterly performance through 2006.

The prior two quarters are the blue bars and the third quarter is shown in yellow.

We've also added a red line to the chart showing a year-over-year comparison.

Seven-day carloadings grew 3% and terminal dwell improved by more than 7%.

Velocity although slightly better than the second quarter was down 3/10 of a mile per hour versus '05 and as we've discussed there are trade-offs between volume growth and velocity.

And I'll talk more about velocity in a moment.

But though carloads grew through 3% in the quarter, inventory was only slightly up year-over-year and as I showed you back in July, inventory control is key to creating and maintaining capacity and fluidity.

From a productivity standpoint we've also made gains.

Starting in the top left chart, the top left quartile is freight car utilization, improving 3% in the quarter.

This improvement relates directly to the unified plan in our terminal processing initiatives which are driving dwell times lower and improving asset utilization.

We've improved our train plant compliance (technical difficulty) 95% in the third quarter.

And as we discussed in Dallas, this is a key indicator of our operating reliability and execution consistency.

Another measure of service reliability is our industry spot and pull, up 6 points year-over-year to 89% indicating a more reliable product for our customers.

Our internal measures are showing improvement and as Jack discussed earlier, our customers are beginning to see it as well.

The last chart is our fuel consumption rate.

We've been making consistent gains in this area achieving a best ever rate of 1.26 gallons per thousand gross ton miles saving nearly 2 million gallons of diesel fuel in 3Q versus the same quarter last year.

So we had a solid service and productivity quarter despite some velocity challenges.

If you look at our network activity over the past three months, we did face some headwinds.

Our capital maintenance in key corridors particularly Iowa, St. Louis in the coal lines, Colorado in the PRB, along with our slow order removal and our winterization process, and Sunset interruptions in August, did reduce velocity.

On the progress side, we did add key capacity in the Sunsets;

South Texas in and around San Antonio and Houston, our Iowa East-West mainline and for the rapidly developing ethanol business.

Our manifest, auto and intermodal terminal performance continued to improve in the quarter and we had a successful launch of our peak shipping season.

Looking out to the fourth quarter, we're positioned to move record amounts of grain, coal and intermodal.

Productivity remains a key focus area for us by continuing our initiatives to remove the slow orders, drive terminal throughput with our lean projects, reduce failure cost; we will continue improving our service products for our customers and at the same time lower unit cost.

And as I started out the discussion this morning, we will be focusing on the safety and security of our employees, our customers and the public.

So with that let me turn it over to Bob.

Thanks, Dennis, and good morning.

I'll begin today with a look at our third-quarter income statement, starting at the top.

Operating revenue grew 15% in the quarter to nearly $4 billion.

We combined the strong revenue growth with an 8% increase in operating expenses to produce a record $752 million of operating income, up 56% year-over-year.

Looking more closely at the revenue growth, third-quarter commodity revenue increased $500 million or 15% to $3.8 billion, a best ever mark.

The drivers of growth were volume growth of 3% with all-time record loadings in energy in intermodal, but those record loadings with a lower average revenue per car actually offset about 1 point of growth in the form of negative business mix.

We continued our trend of quarterly price improvements netting 6 points of growth as strong gain and fuel cost recovery added about 7 points to our commodity revenue.

This is actually slightly higher than the first half of 2006 driven in part by rising fuel prices and the two-month lag associated with our fuel surcharge programs.

Let's turn now to our operating expenses starting with salary and benefits up 6% in the quarter to almost $1.2 billion.

Inflation, a larger workforce and higher volumes were the primary drivers of the increased quarterly costs.

Gross ton miles and our workforce both increased about 2% in the quarter.

And as we pointed out in the first half, we continue to add about $3 million in expense to the quarter due to the option expensing requirements of FAS 123.

Similar to the third quarter, fourth-quarter expenses are expected to increase about 6%.

The drivers of the increase will continue to be inflation, higher volume and a larger workforce.

On a full year basis, our workforce should be up around 2% or so.

Our next expense category is fuel and utilities up 22% in the quarter to $821 million.

For the third quarter, our average diesel price was a record high $2.27 per gallon roughly the midpoint of our expected range.

Although crude oil prices started dropping in late August, that reduction didn't result in lower diesel prices until September.

In fact, we paid an average of $2.37 per gallon in August versus $2.16 per gallon in September.

August was a record month topping October 2005 when prices spiked following the hurricanes.

Through our fuel surcharge programs, we offset about 89% of the record prices versus our $0.75 per gallon threshold.

Although it's not at the 100% recovery level, September's price drop did help our quarterly rate.

Looking ahead we'd expect to pay somewhere between $1.95 and $2.10 per gallon for diesel in the fourth quarter.

This compares to last year's average diesel price of $2.08 per gallon.

So we could pay a lower price year-over-year.

Interestingly that hasn't happened in four years.

Lower fuel prices combined with a two-month lag in our surcharge programs could produce an earnings tailwind in the quarter.

That does not mean that we would profit from surcharges but potentially benefit from the quarterly timing.

We chase the recovery as diesel prices rise but we catch up some when prices fall.

Overall, our 2006 recovery run rate will be about 90%.

That's an improvement over prior years but still not at our 100% recovery goal.

Our next category, equipment and other rents, increased 4% year-over-year to $371 million in the third quarter.

Higher lease expense associated with our locomotive acquisitions and other equipment leases was the primary driver of the quarterly increase.

We also experienced added volume costs related to the 3% higher carloadings offset somewhat by better freight car cycle times.

For the fourth quarter, we'd expect the lower rate of increase likely up 2 to 3%.

Although lease expense will again be higher in the quarter, ongoing cycle time improvements should offset much of this.

Turning now to materials and supplies expense, this line totaled $178 million in the quarter, a 27% increase year-over-year.

Similar to the second quarter the drivers of the increase in this category were inflation, more locomotive overhauls and the ongoing shift from purchased services due to more locomotive maintenance being done in house.

For the fourth-quarter we again expect significant year-over-year increases probably near the second and third quarter run rates.

Our last expense line item is purchased services and other, which actually declined 8% in the quarter to $389 million.

The biggest component of the year-over-year decline related to the 2005 West Coast storm insurance settlement which reduced quarterly expenses by $23 million.

We also completed a periodic actuarial study in the quarter which decreased casualty expense by $17 million as a result of lower than anticipated settlement costs.

And as I just discussed with materials and supplies, part of the year-over-year decline was attributable to the expense shift between these two categories.

Beyond the quarterly ins and outs we did have some added volume costs that were partially offset by greater operational efficiency.

Looking to the fourth quarter, year-over-year purchased services and other should be basically flat.

So that's some detail on our operating expense.

In terms of our operating ratio, we saw 5 points of improvement year-over-year to 81.1%.

Now just as I mentioned, about 1/2 point of our operating ratio improvement was attributable to the insurance settlement but that aside, we still had a solid quarterly improvement.

Looking now at the full income statement, other income was down year-over-year at $22 million.

On a full-year basis, we still expect to be in the 75 to $100 million range.

As you will recall, our fourth-quarter other income last year totaled $54 million which is more than we would expect this year.

Interest expense was down $5 million in the quarter to $119 million; lower quarterly debt levels drove this decline.

As Jim mentioned earlier, and you'll recall from last year, we were impacted by an income tax expense reduction of $118 million.

So on a year-over-year basis income tax expense increased more than $200 million.

This year's taxes were also higher due to increased earnings.

Our effective tax rate was however just under 36%, a couple points lower than anticipated.

The primary driver of this variance was lower state income tax due to an adjustment of deferred income taxes.

For the fourth-quarter we would expect a more normalized rate of 38% or so.

Third-quarter net income totaled $420 million or $1.54 per share, a 12% increase over last year's reported earnings of $1.38 per share.

But on a more apples-to-apples basis, earnings were actually up 64% versus the adjusted $0.94 per share which excludes last year's income tax expense reduction.

Turning now to our balance sheet, this slide shows our debt to cap ratio adjusted for leases.

As we've consistently demonstrated the past couple of years, we are translating our improving financial performance into a stronger balance sheet.

So that's the third-quarter results.

Let's wrap things up today with a look at our fourth quarter.

You recall that last year's fourth quarter was impacted by the Kansas washouts which reduced our coal loadings and cost of about $0.05 per share.

Today as you heard from Jack, we'd expect fourth-quarter volume growth of 3 to 4%.

There are a few demand wildcards out there but we also have upside with coal, grain and intermodal.

Although fuel surcharge should be less of a revenue driver in the quarter, total fourth-quarter commodity revenue growth is expected to be around 10%.

We would also expect to continue our trend of operating ratio improvement.

For the fourth quarter we should drive 4 to 5 points of year-over-year gain through our ongoing yield and operating initiatives.

The revenue growth and margin improvements would result in fourth-quarter earnings per share in the range of $1.50 to $1.60 per share, a 35 to 45% increase versus last year.

Although moving higher volumes with greater efficiency is the primary driver of our earnings growth, our fuel expense line could also see some relief from lower prices.

Now this helps both our customers in the form of lower fuel surcharges and ourselves since we don't collect 100% of the increased costs.

And as I just mentioned, we could also benefit from the lag effect of our fuel surcharge programs.

Assuming today's crude prices are sustained through the quarter, we'd be closer to the high side of our EPS range.

But if strong winter demand pushes crude prices up again we could see the opposite effect and our results could be at the lower end of the range.

Given our fourth-quarter expectations, our full-year outlook for commodity revenue would be close to 15%.

That would translate into roughly 5 points of operating ratio improvement and more than 60% earnings per share growth year-over-year excluding last year's tax item.

We're also targeting free cash flow after dividends to exceed $450 million, up some from our earlier expectations.

So we're taking a solid third-quarter performance and using that momentum to carry us forward into the fourth quarter and a strong finish to the year.

With that, let me turn it back over to Jim for his closing comments.

Thanks, Rob.

Let me wrap things up here today and then we'll open up to questions here.

As you heard from Jack, we're keeping an eye on the economy and any impact it might have on our Industrial Products business group now.

The announcement on housing starts here a day or two ago, we came in pretty strong so maybe there is some upside here.

The key though is even though there may be -- we've seen some weakness in Industrial Products, we clearly have upside when you look at Energy, our Ag products and our Intermodal business.

The second point, I do expect our operations to show improvement in the fourth quarter and the real key here will be converting our top-line revenue growth to a good improvement in our operating ratio for the fourth quarter.

So at this point in the quarter even though we have winter not too far away from us here, we are on track to produce another strong quarterly performance.

So with that, we will open it up for questions.

(OPERATOR INSTRUCTIONS) John Barnes of BB&T Capital Markets.

Good morning, nice quarter.

Real quick, I was asking -- this is kind of my question for the quarter I guess.

I know what the opportunity is on pricing going next year you all did a job of explaining that.

Especially on the coal and intermodal side.

But just in reviewing my notes coming out of your analyst meeting and all, where do you think the most opportunity lies commodity group-wise as we look out into '07?

What should we still be looking for?

Is it still coal and intermodal that's going to drive this pricing improvement or is there something else that kind of factors in because the comps on coal and intermodal get a little tougher next year?

Well, John, I think across the six business groups you're going to see positive price next year.

Obviously as we talked in Dallas, the three areas that have the greatest potential are going to be coal, your intermodal business and also autos.

But again, I see a positive trend for all six of the business groups.

Okay.

I think you mentioned during your meeting again I was trying to go through my notes last night, but did you all have some -- and I'm sorry if I missed this earlier on the call -- did you all have some disruption to your track during the quarter with some kind of track outages?

And could you just remind us how many days you lost on -- I think it was one of your main corridors.

And I'm sorry -- I didn't find it last night in my notes.

I apologize.

Dennis, do you want to take that one?

We did, John.

On the Sunset route, particularly during the month of August, we were out of service there had network interruptions 16 out of our 31 days there.

So that was what the reference Jack and I both made.

Hey John.

The kicker though here -- we've had a very good year weather-wise.

And compared to where we were in in 2005 we still have a few months left here.

But mother nature has been a little more kind to us this year than we saw last year.

Sure.

If you had to look at those two years, '05 being a pretty tough weather year and '06 being a pretty fair weather year, and I know you are in an outdoor sport, so which do you think is closer to the mean?

And are you nervous at all about how lucky we've been on weather so far this year?

You know, I'd hate to forecast here.

I will tell you this though.

We are in a better position to handle issues.

If you look at 2005, we were stretched on our manpower, we talked about this -- our recoverability because guess what it is going to snow again and we're going to have storms.

But we are seeing our ability to recover from these incidents much better than we were in 2005.

We just need to -- we plan for I guess just kind of a normal weather going forward here and have plans in place to deal with when we do have issues.

All right, very good.

Again, nice quarter.

Thanks for your time, guys.

Tom Wadewitz of JPMorgan.

Good morning, this is [Michael Wayans] in for Tom this morning.

With regards to coal growth -- with regards to coal, what is likely to be a larger constraint to growth, mine capacity or capacity in the PRB region?

Well right now I would look at the joint line as being at the prime driver in terms of capacity.

That is why both UP and BN are working hard to put capacity in, complete, get the maintenance programs up to speed.

But at the end of the day the whole chain, as we have said before, is going to struggle to meet the demand.

We started out this year the potential demand out of the PRB -- for PRB coal was close to 15%.

We're going to handle both UP and BN -- we'll handle record tonnage this year.

And are working real hard to get capacity in to continue to handle record tonnage next year.

All right.

And with regard to utilities inventory levels, do you have any feeling where they are or whether or not you believe they are going to push above historic levels?

Jack, do you want to take that one?

You know I think right now when you look at the Western customers that we serve you are basically looking at West, Southeast, those folks.

Inventories are at a moderate level right now.

They are not over stockpiled and they will continue to build.

And I don't know of anybody that says they are going to put on excessive amounts of coal.

Okay.

And are you seeing any change in the pricing dynamics due to looser truck capacity?

Jack?

You know, we don't really see anything right now that would cause us to change our view of the market in terms of pricing.

There is some excess truck capacity out there but there is plenty of business out there to fill any slots we have on our trains.

Okay, thanks for the time.

Randy Cousins of BMO Capital Markets.

On a consolidated basis you guys indicated that price was good for 6; fuel was good for 7.

I wonder if you could give us some granularity on the breakdown -- on energy is particular as you got average revenues per carload up 10%.

Could you give us some sense as to sort of what the breakdown of the 10% was?

How much was price?

How much was fuel and/or mix effect?

Jack, do you want to try that one?

I think if you just look at the energy line alone, you're seeing about half of that price or the average revenue per car being driven by price, half of it being fuel surcharge.

It's about 50-50.

It's pretty hard to gauge in depth right now.

There is also, you know included in that is the mix on longer haul business versus short haul business and those kinds of things.

So any time you look at average revenue per car, it's pretty hard to forecast.

Randy, and you need to be careful.

A good example when you do look at energy, it is not quite as clean in terms of how much is fuel and how much is core because in many cases you have a contract that is a certain -- reflects RCAF, it may be capped where you can only take 50% of RCAF or 75.

So it really isn't quite as clear in some of those areas in terms of split and between fuel and core price.

Because the same thing too kind of applies to sort of your intermodal.

Your average revenue is up 8 which is kind of less than your sort of combined overall sort of 6 and 7 or 13.

And I guess again if I looked at intermodal category, there is something going on there on the price side that we should be thinking about.

Or is it again a mix issue -- like how is that sort of 8% in terms of average revenue being impacted by price versus fuel?

Well, intermodal, as you may recall, has one of the highest percent of contracts that we don't really have.

We don't price to market.

And again, you've got to be careful on trying to look at the split between fuel and core pricing.

The key for me there is that one of the areas you've got the most upside if you look at current market conditions today.

Okay, final question.

Could you guys talk a little bit about labor productivity?

You know, the headcount was up but the headcount increase roughly matched your carload increase.

Could you give us some sense as to sort of -- you made productivity gains in terms of asset turns.

What about on the labor side?

What were the pluses and minuses and was there any particular pluses and minuses in the quarter and what the prospect is?

Well, if you look at -- there are a lot of different measures you can take a look at in terms of productivity.

On the labor side a common one is the gross 10 miles per employee and they were about flat when you look at it year-over-year.

Part of that is again when we lost a little bit of the volume from coal that had a negative impact on productivity.

You don't take the costs out right away.

And if you saw a sustained downturn in volume, you would adjust maybe some of your hiring.

But on a month-to-month kind of basis, you don't -- we just don't see a fluctuation there.

I do expect our productivity in fourth quarter to improve when you look at our numbers here.

And then for the four year again, we have moved it in the right direction.

Rob, do you want to --?

Yes, Randy, I would just add that additionally in our headcount number you are seeing some hiring that we are doing in anticipation of stronger growth going forward too.

So we're getting a jump start in terms of hiring for our future needs.

So when we are looking to 2007, we should be looking for 3% labor productivity growth?

Is that kind of a reasonable number?

Randy, what I've looked at and we've asked our team out here the minimum is to offset inflation.

That's your starting point.

Okay.

And then I'll sneak one last one.

Is there any more insurance settlements coming?

Rob?

No, there isn't.

Okay, thank you.

Ken Hoexter of Merrill Lynch.

Great.

A simple one.

On the industrial side, yield is up in the high teens and volume is slowing.

I just want to hear some commentary on the sustainability of that as if we get a moderating slowing economy or if you get more and more I guess truckload competition from the freeing up of some capacity there.

Any thoughts on that?

Well, we're going to be smart about our pricing and understand what's happening in the markets.

But as I said in Dallas, let's not confuse, the goal here is financial return.

It's a combination of price; that's a combination of productivity; that's a combination of turning the asset.

Included in some of that softness there is we did walk away from some business because it just didn't -- we didn't even see long-term the capability to get it to where we needed to on the return on investment numbers.

The economy again turns down here.

One of the things we have to balance is when you think about a downturn in Industrial Products how much more coal do I handle?

Or grain?

We look across all of our business groups.

So we'll be smart about it.

Jack, do you want to add anything?

No, I'd say we are seeing somewhat of a moderate industrial products economic softness right now and we're weathering that pretty well.

I don't see us changing strategy or deployment.

But I will tell you, -- we'll leave it at this though -- the industrial products group still has upside to get to their targeted returns.

Okay, great.

I love hearing the return focus.

On the El Paso storms, I think John asked before just about the storms.

Did I miss something?

Did you quantify the impact of any of the service outages?

No, we didn't.

Can you?

I think at the end of the day, it cost us a little bit of volume.

You know the cost numbers -- I don't think there is really probably a lot there.

It's just again your throughput and volume we probably lost some there.

All right.

I guess we saw a reacceleration on the yield side, right?

Just a little bit but acceleration from second quarter after it looked like we had peaked.

Jim, should we relate that more to timing of contract exploration?

And I know you had said like a 7% of contracts, if I remember the numbers right, are going to hit for the first time in '07.

Is there anything sizable coming up in the fourth quarter or anything else causing this reacceleration on the yield side?

No, I don't think so.

You might get a little bit of mix in the numbers but I don't see anything any major changes here in fourth quarter or next year.

Ken, I think if you look at the yield compared to the second quarter you see it to be about flattish.

Great job.

Thanks a lot.

John Larkin of Stifel Nicolaus.

Good morning, gentlemen.

I just wanted to get a refresher on the Colorado Utah coal volume, it was down 1% in the quarter.

I got the impression that you may see a rebound in that next year.

Any change in your thinking there?

Jack, do you want to take that?

No, I think you know in Colorado Utah, John, this year we've been plagued by a number of mine issues.

We started out the year with heat problems and roof cave ins and those kinds of things.

And then we had some pretty intensive maintenance on our [Moffett] sub where we haul a lot of that coal.

I think those things will clam down and provided that the mine issues are under control, we should see good growth next year in our Colorado Utah business.

Okay.

Second question on the paper and newsprint that evidently you are shedding.

Are you completed with that demarketing effort there or is there more to come?

Jack?

For the most part I think that is pretty clear that those efforts are done although the year-over-year impact of that will still impact the business that we had in the fourth quarter, for instance.

Do you think that is moving to another rail carrier?

Is it moving to intermodal or is it moving over the road now?

You know, it's probably a combination the majority, but I think is moving to truck.

There's probably some moving to rail as well.

Okay, thanks.

On the steel demand which has been strong for you and at least one of the Eastern carriers, how long do you think that's going to hold up?

Is that an area that could see some softening with softening in housing construction and the auto sector?

you know, the things that are really hot for us right now are construction steel and then all of the steel associated with pipe.

I commented on the oil drilling but also the steel used for windmills and things like that for electric generation.

So those kinds of things are all very good for us.

And the housing side of it and the automobile side of it will kind of ebb and flow with what's happening.

We're hoping with the boost in housing starts last month that that will be kind of a short-lived issue for us and we will have a pretty good year.

On chemicals which were down 1% I think on the volume side, I would have expected maybe a little better comparison given Rita.

Didn't Rita have a pretty negative impact during September last year?

Yes, it did.

But we're seeing -- the fertilizer business for us is a big deal.

And seeing the export potash markets a little soft but also seeing the delay in application both in the Midwest and in the South.

Basically what will happen -- typically what would happen is you'd see that demand move.

It looks to us like its persisting to the point now where it is going to show itself as a very strong spring fertilizer season and less effective in the fall.

John, you'll see -- I mean the hurricane impact really came in fourth quarter.

You know Hurricane Rita was in the last week of September.

So you will see any carryover where we had -- in October in terms of the overall numbers.

Okay, that is helpful.

And then just one last one on the financial side.

Operating lease adjusted debt to total cap is now down to around 41% I think you said.

Is there a plan to level that off at about that level and then perhaps increase your share repurchase program or perhaps your capital expenditure program or do think you are going to take that leverage ratio down lower?

Well, John, as you know we did announce that we are going to bump up our capital next year in terms of key growth corridors and capacity.

We also said in Dallas that even with the increased capital we're going to generate to generate decent free cash flow next year.

My goal here is to put us in the position that I've got the cash and then we'll work with our Board in terms of what are the other ways we return that to shareholders.

All right.

That is all I had.

Thank you very much.

Scott Flower of Banc of America Securities.

Good morning, all.

Just a couple of quick questions and forgive me if you touched upon this.

I was a little late on the call.

Is -- and maybe this is for Jack.

Could you give us some sense of -- and I know you talked about fuel recovery -- but if you think about your book of business as the total number of contracts or however you may look at it in that way, what percentage is covered by your fuel surcharge and/or what percentage is covered by RCAF now?

You know, we have about 90% of our business that has some form of fuel recovery.

And that just coincides very nicely with our 90% recovery.

So the balances left in some of those legacy contracts that we're working over time to change.

But even some of those legacy contracts have some fuel recovery provisions and then that at the time we did them, (technical difficulty) we weren't thinking they would ever come to fruition.

But in the rapid increase in fuel prices they certainly have.

And is that split or more skewed more toward your fuel surcharge versus RCAF?

Is RCAF a smaller component of that 90%?

RCAF is a smaller component of the 90%.

Okay.

And then the other question maybe more conceptual and obviously you still probably have some room to run on your value proposition and obviously focus on returns.

But when you think about your pricing and what is going on in the intermodal markets, is there any sense that you get that pricing in general for the rail industry may be a lagging indicator?

And how you might think about that going forward is trying to manage your book of business, get returns?

But as you said, Jim, be smart about it?

I'm not sure certain if I understand your question, Scott.

We are going to keep our eye on the economy.

We do watch our market share.

We understand our book of business at a very detailed level where the returns are.

And -- you understand your competitive position in terms of where we want to put new products in the market.

So it is not quite clear to me what your concern would be.

It's a very -- we've got a very focused effort here at again looking at returns on really each book of -- on our book a business here so -- what am I missing?

Not to dwell on it but just to try to frame it, it seems as if rail pricing picked up after truck pricing on the way up.

You've got a lot of momentum.

There is a spread, oil prices have moved.

It would seem as if that your pricing momentum will continue until -- the question is could you push too far in price because you can get it now but if you then look at it in a year's time or so do you wish you may have not have made that last incremental push?

Not to say you still don't have lots of pricing?

It would seem like your pricing levels might lag what's going on versus what you might see in the volume side on a six- or nine-month lag basis.

Where we do -- Jack had the question earlier about -- you know I think we probably have lost some business on the highway in terms of where prices are at.

Part of it we know if you get a little bit of a surplus in truck capacity, truckers are very aggressive, they are going to price to cash flow if they have to.

What we have to be smart about though is sticking long term here.

We're looking at our balance in terms of how much should be tied up in contracts.

We know each of our businesses -- you can respond with tariff pricing within -- fairly quickly.

So if you saw a real falloff in a sector here, we have the capability to respond.

What's important to me though and I'll tell you here we've got a lot of failure cost in our network here in terms of operations.

I'm willing to loose some business if the return isn't there and I believe we have the opportunity to again -- to improve our velocity and take some cost off.

No, that's good.

Thank you.

Edward Wolfe of Bear Stearns.

Just quickly a little verification on your 6 to 7% yield guidance.

You talked about assuming flattening or down fuel.

But can you talk a little bit about what your assumptions are for base yields?

Are those firm?

Are they just coming in a little bit?

Are those still rising?

Are you talking about fourth quarter, Ed?

Yes.

Ed, our guidance on your reference to the 6% yield and 7% fuel recovery was the third quarter.

For the fourth quarter we gave guidance of 3 to 4% volume and all-in about 10% plus or minus on the all-in revenue.

So the implied for rates are what as you see that percentage?

What are you implying -- what is your baseline for fuel I guess?

Fuel baseline price is between $1.95 and $2.10.

That would imply that the fuel recovery component is 2%-ish.

Okay.

Can you talk a little bit about -- just refresh us on the incentive comp?

What your incentive comps in third quarter was versus a year ago and what the year-ago fourth-quarter incentive comp looked like?

You are going to catch me on this one because I don't really know the detailed here in terms of the individual quarters.

I will just remind you that our program, the bonus program is based on operating income and velocity for the year.

And the long-term program is based on return on invested capital.

It is up I'm sure a little bit from where we were a year ago because it coincides with as you have financial success you're going to have a greater potential for a bonus.

I missed Jack's presentation because I was on another call.

But I did see that Peabody lowered their growth production by 7 million next year and I don't know how much of that is all where it is.

How confident are you in -- the demand is certainly there on the coal side that the production is going to be there?

Well, as I said on our call here, the railroads are putting a significant amount of resources in in terms of capacity and ramp up the ability to handle more volume.

I've met individually with all the CEOs and they are committed to increases going forward here.

We'll have to look at it.

I haven't seen that in terms of exactly what the specifics are.

But the demand is out there.

And at least in our discussions with the producers they have very specific plans on increasing their production.

Okay.

Jim, one last question.

We've done a couple of incoming calls in the last day about talks with the unions and that maybe those haven't been going so well the last couple of days.

Can you give us a sense of where you are with the talks, what the timing till you think we will get a contract might be?

You know, I wish I could tell you when the timing of the contract but the issues are going to be wages, health care and then some work rules in terms of looking at productivity.

The discussions are ongoing.

It's an iterative process here and the goal for me is let's keep talking here.

But I don't see anything out until maybe sometime next year.

When you think about productivity, what kinds of things should we think about?

There are different things in terms of work rules that you look at.

We did say, and I said that in Dallas that single person crew is off the table for this round.

But it's really a total package.

You look at the individual railroads, you can look at the ability maybe in terms of some contracting out kinds of issues.

But we still have a pretty good upside when you look at the some of the work rules that are out there that limit productivity.

Thanks a lot for the time.

John Kartsonas of Citigroup.

I guess a question more on the long-term and you've talked in the past about your target on the operating ratio in the mid 70s.

When you think about that is the assumption more on the volume side I guess on the revenue side or more on the assumption that you will be able to control better costs?

I mean how do you think about this target in the long term?

You know it is obviously a combination of all three.

We've got upside on pricing as we've said when you look at our legacy contracts and demand.

The investment we're putting in in terms of growth capacity will drive some volume.

As you may recall, we bumped our volume growth numbers up when we thought long-term we had been around the 2% range.

We now think we can be in that 3 to 4% range that drives operating ratio.

And we've got a huge opportunity on the cost side in terms of efficiency.

All three of them are going to play a major role in terms of us really driving that operating ratio down.

Is this [assumption] related to the fact -- to your expansion projects and their returns there?

How sensitive is this relating to the volume growth I guess?

I don't know.

It's not clear to me what the total number is on operating ratio.

If the volume would slow down, as we have said, I can slow down the capacity expansion.

We will be smart about it here.

We've got a very intense focus on our efficiency in productivity.

Again I said the minimum is we have to offset inflation going forward.

The capacity expansion actually not only does it help volume but in some cases it's going to accelerate velocity and take failure cost out.

So I don't know offhand what the actual proportion is because you can run models with a lot of different sensitivities.

But all three of them are going to drive that operating ratio down.

Okay, thank you very much.

Thank you.

There are no further questions at this time.

I'd like to turn the floor back over to management for any closing remarks.

Thank you everyone.

We look forward to talking to you here in another three months.

And do expect right now a good fourth quarter.

So thank you for participating today.

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

You may disconnect your lines at this time.

Thank you for your participation.