聯合太平洋集團 (UNP) 2007 Q2 法說會逐字稿

Thank you for accessing the Union Pacific conference call for July 19, 2007.

This presentation deals with statements about future expectations for results for the corporation but not statements of historical fact.

These statements are or will be forward-looking statements as defined by the federal securities laws and generally include without limitation, expectations, projections, estimates and similar statements regarding the corporation and its operations and financial performance, customer demand and economic conditions.

Forward-looking statements should not be read as a guarantee of future performance and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in the statement.

The corporation assumes no duty to update any statements or information provided in this presentation or the accompanying materials.

For detailed information regarding forward-looking information and such risks and uncertainties are contained in the materials accompanying this presentation, and the filings made by the corporation with the Securities and Exchange Commission, which are available from SEC at www.sec.gov, and on the corporation's web site.

In addition, during the course of the presentation the corporation may refer to certain non-GAAP measures.

Management believes these measures provide an alternate presentation of results that more accurately reflect ongoing operations.

These measures should be considered in addition to, not as a substitute for the reported GAAP results.

Please refer to our web site for a reconciliation of these measures to GAAP.

Greetings, ladies and gentlemen and welcome to the Union Pacific second quarter 2007 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, Chairman and CEO for Union Pacific.

Thank you, Mr.

Young.

You may begin.

Good morning, everybody.

I apologize, we are a little bit late here, we've had some communication problems here, but I think we are set right now.

I want to welcome you all to our second quarter earnings conference call.

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

Second quarter earnings totaled $1.65 per share.

That's up 15% versus last year's $1.44 per share.

Strong pricing gains and continued operational improvement enabled us to convert a 3% increase in operating revenue into solid earnings growth.

Although our second quarter results demonstrate our solid earnings momentum, we really lost our upside with greater than expected economic softness and weather challenges.

The impact of the economy can be seen in our Industrial Products business which was off 10% year-over-year and our automotive loadings down nearly 2%.

The slow down in the housing industry, declining sales by the domestic Big Three domestic auto manufacturers, as well as softness in Texas and Oklahoma construction markets all played a role.

The weather was also a factor in our coal loadings, which finished the quarter down 4%.

Jack will talk more about our outlook for coal in a minute, but flooding at the mines and in the Midwest clearly impacted our coal business.

The key takeaway for the quarter, however, was our ability to improve our operating ratio in the face of lighter volumes and weather challenges.

Now before I turn it over to Jack, I want to take a minute to illustrate the overall impact of our efficiency gains.

In addition to our yield improvements, increased network fluidity and faster asset turns have produced both a steadily improving operating ratio and consistently better customer satisfaction ratings.

We are committed to continuing this trend in the quarters ahead, driving efficiency and service to deliver greater profitability.

So with that, let me turn it over to Jack to talk about our revenue performance and outlook.

Jack?

Thanks, Jim, and good morning.

On the strength of a 7% improvement in average revenue per car to a new record of $1,589, second quarter revenue grew 3% to just under $3.9 billion.

That's our best quarterly revenue ever even though volume ran 3% below last year's second quarter.

Our Chemical business set an all-time revenue record, up 8% and Ag Products, Energy, and Intermodal established new second quarter bests.

Our Automotive revenue was flat with last year and Industrial Products saw revenue decline slightly.

At the same time, as Jim said, customer satisfaction continued its year-over-year improvement trend.

With the quarterly volume down, I thought what we'd do is take a look at how that played out across the groups and then drill down on our Industrial Products, Energy and Intermodal businesses.

We continue to see strength in Chemicals where volume grew 2%.

Our other five businesses all saw some volume decline.

Heavy rains and flooding impacted not only our Energy business, but also our Industrial Products line as wet weather in Texas held back crushed stone volumes.

We continue to see some market softness, especially in the housing and construction-related markets within Industrial Products.

Declines in production by domestic auto manufacturers more than offset the growth we saw in our parts business.

And for the first time in 13 quarters, our domestic Intermodal grew faster than our international business, as heavy pre-shipping in the second quarter last year combined with the slower economy this year to drive international volume down 1%.

With low barge rates and good river navigation, Gulf exports of feed grains declined, while a strong local feed crop lowered exports to Mexico.

Overall, our feed grain exports were down 27%.

But there was some good news in Ag Products where ethanol and DDG showed substantial growth, up 26% and 60% respectively.

As I mentioned, Chemicals was the lone bright spot with a particularly strong showing from liquid and dry chemicals.

In addition, record corn planting continues to support growth in fertilizer volumes and we saw our plastics and soda ash business increase over last year, as well.

Our Industrial Products volume declined 10% with weather and economic softness impacting most of our lines of business.

A continued focus on yield improvement drove a 9% improvement in average revenue per car holding revenue to just a slight decline.

Wet weather in Texas delayed some expansion projects, and a variety of customer issues all impacted our crushed stone volumes, which were down 15%.

Continued weakness in the housing market drove an 18% decline in lumber, and the soft economy also resulted in slight declines in our steel, ferrous, scrap, and cement segments.

Counter to that downward trend, growth in frac, sand and barite to support the natural gap drilling market produced a 4% increase in non-metallic minerals volume.

With the May unsold housing inventory reaching the highest level since 1992, significant near-term recovery in the lumber market seems unlikely, so we are hoping to see some stronger volumes in steel, rock and non-metallic minerals to offset some of the economic softness in the second half of the year.

Although demand remains strong, coal loadings were down 4% with yield gains providing an offset that drove a 4% improvement in revenue.

I have mentioned the supply chain challenges that we all face in keeping up with the demand for Western coal.

Unfortunately, that played out again in the second quarter.

Severe weather and continuing mine production issues were key drivers of a 2-million-ton decline in Southern Powder River Basin tonnage.

The weather impacts included the carryover effect of the late March snowstorm that we talked about last April.

Heavy rains in early May and again in June caused track washouts in the Midwest and flooded the coal pits at the mines which disrupted production of the coal supply chain.

Similar disruptions across the supply chain have impacted our trains per day so far in July.

The decline in SBRB was partially offset by at 4% growth in our Colorado/Utah tonnage.

We expect to see Colorado/Utah volumes soften some in the second half as declines in Eastern coal prices have curtailed some spot moves out of that market.

Strong demand, including moves to Mid-America's new Council Bluffs plant will drive growth in Powder River Basin tonnage, but with the slow start to the year we now anticipate only about a 2% growth in coal for the full year.

In Intermodal, our domestic volume grew 2% on the strength of our new service offerings.

In May, we initiated our Blue Streak service via Shreveport in conjunction with the NS, the best service in the L.A.

to Atlanta market, and as customers watched our performance we've seen volume grow 30% year-over-year.

New auto parts service over Salem created the opportunity for new business growth in our Chicago/Laredo corridor.

And with our on-time performance in the I-5 corridor at 90% year-to-date, we're seeing truckload shippers shift from highway to rail which helped driver a 3% increase in volume.

Growth in the domestic market was offset by a 1% decline in our international business.

Peak season pre-shipping that drove record volumes in the second quarter last year did not materialize this year.

Hopefully, that means a more normal peak-season shipping pattern this fall.

In addition, the softer economy had retailers working off inventories built up over 2006 and early 2007.

With overall Intermodal volume flat, the 4% improvement in average revenue per car netted revenue growth of about 3%.

With continuing service improvements, some strengthening of the economy, and a more normal peak season we expect to see our overall volume in Intermodal grow in the second half of the year.

For us, the best proof of statement of our improved service is what our customers say.

So it is gratifying to see that our customer satisfaction scores continue to improve.

Our customer satisfaction index climbed to 80 in the second quarter, which is the first time we have been at 80 or better for a quarter since the second quarter of 2003.

Looking ahead to the third quarter, we should see stronger volumes than the second quarter.

While we expect our Industrial Products markets to pace below last year, stronger Intermodal business driven by a more normal peak season and continued solid demand for Energy and Chemicals should keep overall volume from falling below year ago levels.

We are keeping our eye on that corn crop, which with a little luck could push Ag Products into that growth driver group for the fourth quarter, as well.

With a stronger second half, we expect to see volume flat to slightly down for the full year and with continued yield gains producing revenue growth around 5%.

With that, I will turn it over to Dennis.

Thank you, Jack.

Good morning.

We will start off this morning with a safety update where we continue to make good progress, improving safety for all of UP stakeholders, employees, customers, communities and our shareholders.

This chart shows our six-year trends in the three key areas of safety.

The employee safety numbers are 14% better than last year, and 48% improved from 2001.

We are also seeing improved results from our grade crossing safety initiatives.

In recent years, the entire industry has seen an increase in crossing incidents, as well as a result of more vehicle and train traffic.

Through our targeted efforts to raise public awareness, first half 2007 incident rates are the lowest they have been since 2003 and 12% better than last year.

Finally, rail equipment safety, or derailments, improved 16% from last year, and 27% since 2001.

What is particularly encouraging about these results is that we have achieved them in the face of some difficult weather challenges.

In total, our network was impacted by some type of weather outage 45 of the 91 days in the second quarter.

These interruptions were centered primarily in the Midwest and Texas, impacting several critical corridors and gateways.

We finished the second quarter and began the third with more flood outages on the routes south of Kansas City.

These lines handle 45 to 50 trains per day.

We rerouted nearly 300 trains while restoring those lines with some impact to car loadings and velocity.

Throughout these interruptions, however, our network has been very resilient.

We rebounded quickly from the interruptions in early May and already have things back to normal from the late June and early July outages.

You should continue to see our service metrics improve over the next couple weeks or so.

Despite these challenges, our second quarter service metrics showed solid improvement year-over-year.

We increased velocity and asset turns to deliver better service to our customers.

Quarterly velocity increased nearly 2% to 21.6 miles per hour, while terminal dwell improved by nearly three hours, or more than 10%, our best quarter ever.

We also increased fluidity on our network, reducing inventory by 14,000 cars, a 4% improvement.

Lighter car load volumes are clearly part of this decline, but we are utilizing the Customer Inventory Management System, CIMS, our terminal improvement projects, the unified plan, and lean initiatives to continually improve network operations.

These actions all help control costs as well as improve service.

We also made quarterly gains in our freight car utilization, taking a half a day out of the cycle time between originated carloads.

This is nearly a 5% improvement year-over-year and our best second quarter utilization since 2003.

I talked to you in April about the progress we're making in improving train size.

This slide illustrates our network approach to improvement, starting with process and ending with capital investments.

In the second quarter, with total carloads down 3%, we reduced train starts by 7%.

We have driven P&L, profit and loss, responsibility down to the local managers thus promoting better business decisions based on unit cost.

For example, managers today can see all the unit costs associated with running their business, not only labor costs but asset costs for locomotives and freight cars, as well as risks related to safety.

In the area of process and technology, we continue to find better designs through our unified plan initiatives.

Distributed power technology is also helping us achieve train productivity results.

And in fact, a couple weeks ago we ran an Intermodal train with 552 containers, our longest ever across our Sunset route to evaluate the economic trade-offs.

Throughout our efforts we are always mindful of working the steps in the hierarchy; process, organization, technology, and then put iron in the ground or capital as a last resort.

As both Jim and Jack showed you earlier, better efficiency translates into better service for our customers.

We are particularly pleased with the reception we received from our latest Blue Streak product running from Los Angeles to Atlanta in less than four days.

In partnership with the Norfolk Southern and the Meridian Speedway, our premium customers have seen a 12-hour reduction in transit time over this new route.

This is a very truck-competitive product that has run 100% on time since inception, a great start considering some of the weather obstacles which also affected Texas.

Our network performance initiatives, as well as the capital investment on the Sunset Corridor, are delivering these results.

A quick mid-year update on our capital investment plan.

We have constructed 15 miles of double track on the Sunset so far this year, as well as adding terminal capacity in several key locations.

We expect to add 57 total miles by year end, as well as begin grading on the next 100 miles of double track construction.

In the Powder River Basin coal network, UP and BNSF will complete 46 miles of third and fourth main track by the end of the year on the Joint Line.

Across Nebraska and Iowa, we are continuing centralized traffic control installation which we will complete in early 2008.

Our annual maintenance program is in full swing.

This year's program is complete on the Sunset Corridor.

By September, we will have all of the tunnels cleared for double stacks on the I-5 corridor between L.A.

and Portland.

Our primary maintenance focus now is currently in the Central Corridor.

We have received 210 of our 300 road locomotives ordered for 2007 with the remaining 90 to be delivered by September.

The new locomotive power is more fuel efficient and certainly more reliable.

In the current environment of lighter volumes, we are actively retiring older, higher cost units as well as turning back extra leased power.

When you look at the remainder of 2007, the network is resilient and we're ready to handle additional volumes.

Along with the locomotive situation we have a strong workforce positioned for peak season.

In fact, we have roughly 650 employees furloughed today.

So we have access to a trained labor pool when the business does come back.

Productivity is expected to continue improving with several network and local initiatives intended to drive efficiencies and lower unit costs.

Finally, our total safety culture and zero tolerance approach are laying the foundation for continued improvement in all aspects of safety.

With that, I will turn it over to Rob to discuss the financials.

Thanks, Dennis, and good morning.

Let me start out today with a summary of our income statement.

Operating revenue grew 3% in the second quarter, to more than $4 billion.

This is a best ever mark for the Company, and the first time we have crossed the $4 billion mark for a quarter.

Operating expenses increased 2%, or $53 million, driving operating income growth of 10% to a second quarter best, $787 million.

Driving operating revenue growth was a $123 million increase in second quarter commodity revenue, up 3% to nearly $3.9 billion, a best ever quarterly mark.

We continued our trend of commodity revenue growth despite a 3% decline in volume.

Higher yields demonstrated by a 7% increase in our average revenue per car drove the gains.

As you know, we converted roughly 15% of our revenue base between mileage-based surcharge mechanism in late April.

With the change, we rebased our on-highway diesel fuel surcharge entry point from $1.35 to $2.30 per gallon, reflecting our belief that fuel prices will remain at higher levels going forward.

We intend to convert business to this new program as contracts expire, a process that will likely take several years.

Until then, however, we will be working with different surcharge mechanisms that have different entry points.

So unlike our prior quarters where we have broken out various commodity revenue drivers year-over-year comparisons are not meaningful.

Turning now to the individual expense lines, we have salaries and benefits up 2% in the quarter to $1.2 billion.

Our quarterly workforce level was 1% lower year-over-year against a 3% volume decline.

Year-over-year inflation increases were partially offset by lower training costs, cost per crew and volume savings.

Looking out to the remainder of 2007, we would expect to make further productivity gains.

Depending on volumes, second-half workforce levels could see declines similar to what we experienced in the second quarter.

Second quarter fuel and utilities expense declined $28 million in the quarter, or 4% to $766 million.

Although our quarterly diesel fuel price increased $0.02 per gallon year-over-year, we consumed 14 million fewer gallons of diesel fuel as we moved less freight.

Our quarterly consumption rate was basically flat year-over-year as weather issues impacted our conservation efforts.

In addition, higher gasoline and utility costs added $4 million to this category versus last year.

Looking out to the third quarter, we are currently paying about $2.33 per gallon for diesel so we could see quarterly diesel fuel prices above last year's record price of $2.27 per gallon.

Crude oil prices declined over $70 per barrel in recent weeks.

We've also experienced increases in refining spreads in parts of our network due to the flooding, particularly in Kansas.

Equipment and other risks were basically flat year over year, down $1 million to $370 million in the second quarter.

Equipment and other rents were basically flat year-over-year, down $1 million to $370 million in the second quarter.

Equipment expenses came in lower than forecasted, largely due to volume declines.

Although car cycle times improved, this was offset by weather-related delays and increased locomotive lease payments.

Materials and supplies expense increased 4% in the quarter to $186 million.

Increases in this category were driven by higher material costs, as well as the cost of maintaining a larger locomotive fleet.

The next expense category is purchased services and other, up 8% in the quarter to $447 million.

Second quarter casualty expenses declined roughly $12 million-year over year.

Continued improvement in our safety performance, as well as a favorable comparison versus last year, drove the change.

Offsetting this improvement were higher costs associated with contract fees, increased crew transportation and lodging expenses related to weather and higher state and local taxes.

In addition, last year's expenses were impacted favorably by a one-time item and a reimbursable car program work.

Looking out to the third quarter, this expense line will experience some headwinds.

You'll recall that in last year's third quarter, we had a couple of good news items in this category.

We received a $23 million insurance settlement and recorded a $17 million reduction in casualty expense as a result of a periodic actuarial study.

Although we expect improved casualty costs as a result of our safety efforts, the insurance settlement was a one-time item last year.

Let's turn now to our operating ratio, comparing our second quarter performance over the last four years.

We achieved 1.2 points in improvement in the quarter to 80.5%, our best second quarter operating ratio in four years.

Pricing improvements and better operating efficiency are driving consistent profitability gains with more to come in the quarters ahead.

Looking at the full income statement, other income grew $7 million to $36 million for the second quarter.

For the first six months of 2007, other income totals $51 million, consistent with our expectations to be around $75 million to $100 million on a full year basis.

Second quarter interest expense was flat year-over-year at $120 million while income tax expense grew 9% to $257 million.

Although increased pre-tax earnings drove taxes higher, this was partially offset by various state and federal income tax adjustments which resulted in a lower effective tax rate of 36.6% in 2007 versus 37.7% a year ago.

Although we are still assuming a 38% effective tax rate for the full year, our third quarter tax rate could be 40% or so.

The primary driver of this one-time increase is an expected tax law change in the state of Illinois.

Second quarter net income totaled $446 million, or $1.65 per share, a 15% increase over last year's $1.44 per share.

All in, it was a good second quarter for us, especially when you consider that the flooding took an estimated $0.10 per share out of our earnings.

One last item I would like to update you on for the quarter is our share repurchase program.

In the second quarter, we purchased more than 3.6 million shares of UP common stock at an average price of $116.40 per share.

In total, we have completed 28% of our 20-million-share program, returning more than $625 million to our share through the first six months of 2007.

Looking ahead to the rest of 2007, we expect third quarter earnings to increase 10% to 15% over last year's earnings of $1.54 per share.

As you've heard discussed this morning, the quarter has gotten off to a slow start as a result of the Kansas washouts, but strong demand for coal, Intermodal peak season increases and improved efficiency should enable us to generate solid earnings growth.

For the full year, we are updating the volume and revenue guidance that we provided in the second quarter.

We now expect full year volumes will range between down 1% to flat while revenue should be up about 5% or so.

So although we don't expect the second half of 2007 to be as robust as we originally did, we still believe the last six months of 2007 will be stronger than the first six months, particularly from our coal and Intermodal business.

Despite lowering the volume estimates, we are maintaining our full year operating ratio, earnings and return targets.

This demonstrates our commitment to improvement as well as confidence in our ability to improve overall profitability in a lighter volume environment.

Let me turn it back over to Jim for some closing comments.

Thanks, Rob, we will wrap up here.

If you look back at the first six months of 2007, we produced strong earnings and solid margin improvement despite a slow economy.

I just reiterate here, when you look ahead, we see a number of factors driving our performance in the second half of the year.

As Jack just described for you, we have solid opportunities for stronger growth in the second half than what we have seen so far this year.

It really boils down to three things.

Our coal demand remains strong, although there is some question about mine production capability.

We do expect to see a more normal Intermodal peak season and our Ag Products business could clearly benefit from what is expected to be a record corn harvest.

Beyond these areas, we still see the economy as a wild card for the balance of the year.

In fact, we are not expecting much of a change from our Industrial Products business, and we are not sure we have seen the bottom of this market here.

While we have largely mitigated the impact of fuel on our earnings, spiking prices can have a negative quarterly impact in the short term.

So to sum it up, over the next six months we expect continued improvement in safety and productivity, as well as increased revenue yields on the business.

This will drive strong financial results for Union Pacific in the second half of the year.

So with that, let's open it up for your questions.

Thank you.

Ladies and gentlemen, we will now be conducting a question-and-answer session.

(operator instructions) Our first question is from Ken Hoexter with Merrill Lynch.

Please state your question.

Great.

Good morning, great job on the operations side, and particularly on improving service.

Can you quantify the weather costs for you in the quarter?

Is there a way to look at it in that perspective?

It is primarily on the revenue side, you look at, we said about $0.10 per share, and clearly right on coal.

When you look at our coal revenue, it is probably in the 70%, 80% of the total shortfall.

On that, in quarters past you have talked about what pure pricing has been.

Can you talk about that in terms of the 7% pricing gains you posted for the quarter?

We said around the 6% to 7% range is what that core price number is.

Okay, so same as we have seen recently.

I just want to come back to the Intermodal side.

Jim, you kept saying that you expect a normal peak season.

Are there any indications from shippers that you expect some sort of pickup as we move into August?

I'll let Jack.

Yes, Ken, if you look at what our customers are telling us, they're saying what happened last year in May there were some substantial increases in the steamship pricing so a lot of people tried to pre-ship.

That didn't happen this year.

What they are telling us to expect is probably a more normal pattern for peak season shipping.

We would expect, we are starting to see a little bit of ramp-up now, but as you move into August and then through November you should see -- we are expecting to see a pretty good pickup.

And we are seeing our volumes in Intermodal up from a year ago, stronger than what we have seen here in the first half.

Is it a more normal pattern for a peak season or is it a building strength as inventory as you noted have gotten de-stocked a bit?

Well, I'm not quite certain what normal peak means anymore.

We do expect the business volumes, though, obviously, to pick up and peak in that September/October time line.

You combine that with the potential what could happen on the Ag Products there with the harvest here.

Again, we do see things being maybe a little more normal when you compare it back over a long-term trend.

Great.

Any other driver for the other income gains, were there particular real-estate sales or anything?

Very small items in there, Ken.

Okay, great.

Thanks a lot for the time.

Thanks, Ken.

Thank you.

The next question is from Tom Wadewitz with JPMorgan.

Please state your question.

Yes, good morning.

Morning, Tom.

Let's see, I wanted to ask you a little bit on pricing on a specific line item, the coal yield accelerated quite a bit in the second quarter, up almost 9% year-over-year.

I think it was around 4% (inaudible) --

Tom, you faded out here.

Let me try that again.

Is this better?

That is better.

Okay, sorry about that.

The coal yields accelerated in the second quarter, I think it was close to 9% versus 4% in first quarter, and I was wondering if that is something, is that a contract repricing that bumps that up, and is that something that continues going forward or is it one-time noise in the quarter and you go back to the first quarter pace going forward?

Jack, do you want to take that one?

Yes, if you look at what happened to us in the second quarter, Tom, we had a much stronger performance in Colorado/Utah, than we did.

So part of it is mix and part of it is just repricing of some contracts that occurred last year and early in this year.

But, Tom, coal continues to be one of the commodity lines, when you look at the six business groups that still has the biggest piece of its business that has not been repriced to market.

So it is not unreasonable to say that type of yield growth in the second quarter might continue?

The only question I have about that, Tom, is that we are seeing the Colorado/Utah, the spot markets which tend to be some of the higher-priced business.

We are starting to see that kind of fall off for us because Eastern coal availability, Eastern stockpiles, that is the target market for some of that coal.

That has kind of cooled that market a little bit, so we are kind of expecting Colorado/Utah to not be quite as strong for us in the third and fourth quarter.

Okay.

Fair enough.

On the cost side, Jim, if you can just maybe give a, or Dennis, give a sense of how much of the cost, the fluidity improvement you're seeing in the railroad is really coming through on the cost line?

The comment on 7% reduction in train starts is pretty impressive.

I guess if I look at the reduction in headcount, it would seem that if you kept that 7% reduction in train starts going, you could see a bigger reduction in headcount, and I'm wondering if you can give a sense on how we should think about that cost side going forward, how the progress is, and maybe also if there is somewhat of a lagging effect to the numbers like that train start reduction?

Tom, as we said, we took those 7% down and we lost about two to three points of that in the translation down to the bottom line with all the noise we had going on in the quarter with the floods and everything else.

So that is a point of reference that we think we ought to be able to take that back and turn that into the bottom line and reduce the headcount even further.

Hey, Tom, there's another factor that plays in here too.

As you know, you don't turn labor on and off automatically.

We have 650, 700 Team 1 employees furloughed today.

Again, the question is, what is your view of the future here in terms of demand?

We can absorb that pretty quickly here.

We also put a program in place this year, instead of our traditional approach where we furloughed employees and they are gone, and there is no compensation to retain them.

We put a program called Alternative Work, which we're covering 100% of their benefits and guaranteeing about nine days of employment.

The goal there is to bridge -- again, we are still seeing a lot of attrition in our workforce, but also to bridge to when the demand picks up here.

We have to be a little careful in the short term.

If this thing prolongs in terms of the downturn, you'll see those employment numbers fall.

We have slowed down our hiring in terms of where we are right now, but we still want to make certain we are ready to handle some increase in the business here over the balance of the year.

Okay, great.

One last quick one.

I know you said the weather impacts primarily revenue, but is there an expense line item that gets hurt a little bit on some of the flooding issues that might look a little bit better if we finally get some kind of alleviation from the weather issues that you faced?

Rob?

Yes, Tom, where you saw some of those expenses occur on the expense side of the impact, where our consumption rate on fuel was impacted.

We have higher limo and re-crew related expenses, so kind of spread across the board.

All of those line items that are, in fact, the labor, hotels stays, limos, fuel consumption would be the main categories.

Okay, great.

Thank you for the time.

The next question is from William Greene with Morgan Stanley.

Please state your question.

Yes, hi.

I'm wondering, do you have in your second quarter results any impact from the labor contracts being ratified and put in place?

No, Bill, we are fully crewed for what we see as the settlements here, so we are in good shape.

Okay, and then when we look at the OR improvements, they slowed a bit here from what has been the case for the last few quarters.

So is that really all whether or is some of that maybe that it's getting a little bit harder to get some of these efficiencies on the cost side?

Does it all have to come from revenue going forward?

No, I'll tell you, weather was the big deal on it for us this quarter.

As I said at the start of the year, we have substantial upside on the productivity piece.

The weather impacted us both on revenue and some on the cost side here.

You are going to continue to see it improve.

I think I had mentioned to you last -- in our first quarter earnings, we thought we'd break the 80 operating ratio -- not that anybody is doing any celebrating over that, but it did cost us when you look at the weather here in the second quarter.

Okay, and then can you just talk about your views on leverage these days, where you are in terms of returning capital?

Well, as we said when we started the year, we felt we had our balance sheet in good shape.

Service metrics are moving right and financial performance is improving.

We initiated the program in terms of our share repurchase, if you look at it 20% of the program work, we're ahead of where we thought we would be at this point here, we will lever up some, when you look at it.

We do have some room here.

If your question is am I willing to go less than investment grade it's not.

I think in this industry with the capital intensity that we have, we need to make certain we keep some flexibility.

But again, this is the year here that we've really focused on accelerating returns for shareholders.

I think we have a lot of upside going forward.

Thanks.

The next question is from Ed Wolfe with Bear Stearns.

Please state your question.

Thanks.

Good morning, guys.

I know you said there are different inputs with the fuel now, but can you do the best you can to directionally talk about mix versus price versus fuel in the yields that you reported?

Ed, what are you looking for here?

At the end of the day, if you look at the core price, if you sort through and try to put it in an apples-to-apples comparison issue as you can get, the core price numbers are about 6% to 7%.

Is the way to look at it though with mix adjusted yield around 6.5% that fuel is pretty flat and mix was pretty flat?

That is probably fair.

That is not a bad assessment.

Okay.

Can you talk a little bit about which contracts year-to-date have repriced, what percentage of the total book that hadn't repriced yet since 2004, and what you are getting on those average long-term contracts?

Well, we know at an end of the year we are going to still have outstanding, about what, 25% of our contracts we haven't touched.

But, Jack?

We pretty much -- the big deals that we had for this year are pretty much behind us now.

They have been repriced to reinvestable levels, to market levels.

We are pretty comfortable with how that plan has come together.

Is that number for this year, is it 7%, 8%, something like that?

It was -- oh, I am sorry, it was about 7% of the business, each contract varies, and typically the first-year increases are somewhat higher than that.

What is a typical average year right now?

I know it is a real rough kind of number, but is it that 5, 6 kind of number?

On each individual contract it is an entire different spread, Ed.

But overall right now our pricing in the second quarter is about the same as we saw in the first quarter.

We are sticking with our 6% to 7% level.

Ed, I think we need to be careful about getting into a lot of detail on the pricing side here.

The market is very strong.

To move your core price 6% to 7%, it shows to me when you think of the total book of business, the spread between what we are repricing and market is pretty strong right now.

I don't see anything out there on the horizon right now that says it is going to weaken a little bit.

We expect second-half numbers to be pretty good for us.

Switching gears, can you talk with labor contracts starting to come up and get ratified, how should we think about some extra costs from labor either this quarter or going out that might result from these contracts?

You won't see any extra costs.

We have accrued really where we have seen the settlements come in.

If you want to look to the future, you are talking about 2008, 2009, probably inflation is about 4% to 4.5% on labor rates.

That is great.

That is helpful.

You talked a little bit about the Blue Streak business, the L.A.

to Atlanta.

Can you give an update on the state of the Meridian Speedway?

What is it like right now?

When did you start going over it and where do you see it a year or two years from now in terms of capacity and speed?

Dennis?

As you are aware, Ed, the KCS and NS are in the midst of rebuilding that.

They have done significant tie work and are doing some additional rail work now.

In fact, that is still in progress.

We still think between the two of us there is substantial upside still in the transit times in there, even though we are doing extremely well now with that fourth afternoon delivery.

Going forward a year, we will be looking at adding westbound service here later this year, and still continuing to tighten down the transit parameters around that, which both of us believe are still available.

Can you talk a little bit about when this started up, if you are fully ramped up right now, and what the revenue opportunity is?

It started on May 21st.

We are into this about two months now.

It has been gradually growing.

Jack, if you want to comment on the --

Yes, we've seen about a 30% increase in volume.

Customer receptivity has been very good.

Lots of people have seen the performance, they see it improving and are talking to us about business opportunities, and we will monitor it carefully in terms of additional service and train starts and certainly working hand in glove with NS and KCS in terms of when we can do that.

Ed, I think the key on this, any product we put in the market is to prove it to the market.

You don't automatically, day one, when you put it in, have customers flock to it.

You have got to show consistency.

It is a huge market when you look at the potential out here.

As Dennis said, we are 100% on-time in this market and that starts to show up with building confidence with our customers.

Directionally, is it a $10 million product right now, a $50 million product?

Where do you see the potential?

I will tell you.

I think it is very, very strong.

To me, $100+ million would not be unreasonable when you look out here with the full potential.

Where are you now?

Probably somewhere in the neighborhood in that market, we're probably around $30 million.

Okay.

Thanks a lot, guys, for all the time.

The next question is from John Barnes with BB&T Capital Markets.

Please state your question.

Hey, good morning, guys.

Hi, John.

Jim, given your comments on your outlook for the back half lf in terms of carloads and balanced with some of the issues you had with flooding and that type of thing, where does your CapEx outlook look for the balance of the year?

You reign in any of the expansion products in, or are you having to divert money over to repair work?

Can you give us an idea of what your outlook is now and even extrapolating that out into 2008?

Can you give us an idea of what you're looking to in terms of CapEx magnitude in 2008?

John, we are sticking with 3.2 right now.

We have to be careful in making long-term decisions based on a couple quarters of weakness.

Double tracking the Sunset is a long-term investment for us.

I don't really see anything this year that we are going to cut back on.

We have already committed locomotive deliveries.

That's a big piece of it.

We have about 200 of 300 ordered.

This year, I would continue to use the 3.2.

Next year we will take a look at it.

I can tell you one item that it is pretty clear we are not going to -- we will cut back on our locomotive acquisitions next year.

As our velocity picks up, our utilization improves, we are not going to need the kind of locomotive buy we have had this year.

Cut it in half?

Cut it two-thirds?

John, I am still looking at it.

The wild card is tell me where you think the economy is going to be.

(laughter) I think you know better than I.

The other question on employees.

In terms of your full time equivalents being down, two questions along those lines.

One, when do you think you get over the worst of the current attrition?

And, two, as you look at your employee base, can you divide that up into rail employees and non-rail employees in terms of are you seeing greater levels of attrition with your actual rail employees that are out on the rail running the locomotives or what have you?

John, I don't see -- I don't see any fall off in attrition rate here in the next five years.

It is easily in that 3,500 to 4,000 range.

When you looked across our work force here, it is pretty consistent across most the groups, whether you're talking about your train and engine service, your engineering, your maintenance away folks, our marketing department.

We see pretty consistent attrition.

As I've said earlier, that is an opportunity for us in terms of ensuring we get the maximum productivity here.

My intention is not to replace all those jobs long-term and make certain we figure out how we improve our productivity.

And then rail versus non-rail?

All of my employees are rail employees when you look at it here.

If you are talking about train and engine service, your mechanical folks, repairing locomotives, or your people who are repairing track, that's 80 plus percent of our employees, employee base.

But again, every one of these categories, we are seeing the same type of attrition rates going forward.

Okay, and then last question along those lines, I hear what you're saying in terms of not replacing all those employees, but the forecast for the rails handling more and more of the freight handled in this country, it is pretty robust.

At some juncture does this attrition cut into your ability to continue to improve productivity?

Does it become as bad an issue as the turnover and driver shortage in the trucking industry?

John, there are two things you need to think about.

We will staff for growth.

When you look at the potential demand you have not only the capital we're putting in to handle that growth, but having the resources to handle it.

What I want to do is make certain that that growth is a productivity opportunity for us, that we can handle more business on a per employee basis, you'll see that productivity go up.

If our business, if you look at volumes growing 4% or 5% per year going forward here, which will be very high, although there are estimates, when you look at some of the studies, I would I expect our employment would be up.

But the productivity piece would clearly be improved per employee.

Okay, very good.

Hey, nice quarter, thanks for your time.

Thanks, John.

The next question is from [Nick Lamont with Halcyon.] Please state your question.

Yes, good morning.

Congratulations on a great quarter.

Just one question.

I know you wouldn't want to speculate on the press reports of the last couple days but wondering whether you might consider an MLP structure for the railway assets?

I will tell you, Nick, 10 years ago I had somebody sit in my office wanting to do a [REIT].

It didn't make sense then.

It doesn't make sense now, when you look at it.

There are a lot of issues when you look at reversionary property, there are tax issues when you look at the way the industry is taxed, and it just doesn't make sense.

Okay, thank you.

Okay, Nick.

The next question is from Jason Seidl with Credit Suisse.

Please state your question.

Hi, guys.

Most of mine has been covered.

Quick question, if you could look at some of your performance measures which were pretty much all up despite the weather conditions you had, how much better would they have looked in terms of your velocity, it was up almost 2%, your terminal dwell which was down about 10.5%?

Duff, do you want to take a shot at that one?

Well, Jason, when you look at it, like we said before, where we had a 7% reduction in our crew starts, and we had to give up two or three points of that, that is certainly one area.

We did not like our labor situation in terms of the multiple crews that we had to use and forfeit some of that opportunity to take that to the bottom line.

Certainly, we could have done better in our velocity.

I think our terminal dwell for the quarter was an excellent performance.

The 24/7 level was very solid.

So I think our upside opportunities is to take our train start reductions down to the bottom line, and continue to increase our velocity and lower those variable costs.

At the same time, we are totally focused on taking our unit costs down for every unit we handle.

I'd use that number that we talked about in terms of potential reduction in our crew starts there as some kind of a barometer of what we could have achieved.

Jason, I think one of the keys here is we will have more floods and storms, that is the nature of our business here.

But we clearly, our recoverability is substantially better from where we were before a couple, three years ago.

That is what is most important here.

Okay.

If I could just visit the tax thing for one moment, is it fair to say that basically what you gained a little bit this quarter you will just give back next quarter?

Rob?

Yes, that is the way the math will basically work out, Jason.

There are different issues, as you know, but we expect in the third quarter, as I said, a 40% or so effective tax rate.

We came in a couple points better in the second quarter.

That is probably about the way the math works out.

Fantastic.

Thanks, guys.

Thanks, Jason.

The next question is from [William Peck with ING.] Please go ahead with your question.

Thanks for taking my call.

Can you take a couple moments and talk about your capital structure?

We talked a little bit in previous questions here about adding some leverage, focusing on the shareholder this year, you mentioned that you would seek to maintain investment grade ratings.

But in light of that, can you give us an idea of what your ultimate capital structure is, what you are looking to target?

I'm not asking you to comment on any of the rumors that have been out there as far as private equity and LBOs, and so forth, but in light of that, that has caused so much volatility in the markets lately that it would be nice to have you guys comment on, and in light of that how are you going to run your balance sheet and what your target is going to be?

Well, Bill, at an end of the day here we are looking to maintain a solid investment grade, you look at some of those leverage ratios, your debt cap probably up in the mid 40s or so.

But what is most important here is that we really accelerate the returns and the cash generation.

That gives us obviously much more flexibility in terms of how aggressive we are going forward.

I am not willing to take the Company below investment grade level on the table.

Running the business and generating the cash is the most important.

Our shareholders will see a very nice benefit from that.

Thank you.

The next question is from Scott Flower with Banc of America Securities.

Please state your question.

Yes, good morning, all.

Just a couple of questions, maybe the first couple will be for Dennis.

You talked about dropping out leased locomotives and obviously with some of the power coming on, how many leased locos do you have?

Is it really more just a peaking effect?

I would have thought a lot of the leased locos wouldn't have been necessary in this environment, particularly as they have a pretty strong locomotive program on the CapEx side.

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

Well, Scott, we were sourced for a different volume level as you saw.

We are going to take the opportunity to take those out.

We had an original plan.

I will tell you that we have exceeded that.

We will take out at least another 100 out and then we have another tranche we figure to take out in the first quarter of 2008.

That will take care of all of those.

In addition to that, we will accelerate, as Jim said, the older, more costly locomotives.

We will retire those.

We have exceeded our plan there by 100.

There is at least 200 more that we will take out versus plan that we originally had going into the year.

How many leased locos did you start the year with so we have a baseline?

250 or so.

I think it was around 250 or so.

Okay, and then maybe this is just more sort of the different elements you all have talked to us about in terms of using engines in terms of driving productivity with local initiatives and network initiatives, are these the same things you talked about in broad, lean, internal processes and unified plan, or are there other sort of additional incremental things that are more tactical that you are doing?

There are more tactical things, particularly in and around our terminals that we are focusing on.

I mentioned the operating income statement a couple times now that we have taken down to the local work units.

So we have initiatives around those in terms of lowering our unit costs, reducing the amount of switching that we are doing from a labor perspective and continuing to take our overall cost structure down.

Okay, and then, just a couple quick ones for Jack.

I know you talked about in an earlier question, the percentage that you repriced, what business lines were those primarily in?

Was it Energy, or was it Energy and some other things where you had 7% that you repriced this year?

I'm just trying to get a sense of that.

We had some Intermodal contracts, we had some Automotive contracts and we had some Chemical contracts.

Okay.

And Energy?

Is Energy also in there, or no?

We did.

They were towards the end of last year.

A couple contracts, 2008 is actually kind of a big year for us in terms of the Energy play.

Okay, and then the other quick question is, in the last several quarters your mix actually has been a negative impact to revenue growth.

Is that consistent with what you saw this quarter or has that flipped somewhat?

If I look over the last several quarters the mix has been sort of a negative 1% to 2% to revenue.

Did that flatten out somewhat this quarter or was it still a drag?

Scott, are you talking about, for example, reduction in your Industrial Products business that has some of your highest revenue per unit?

When you say mix, I am not clear on what you mean?

No, I mean traffic mix.

You always sort of looked at it in terms of the different parts and pieces of business are growing, or a mix effect as to what impact you have on revenues.

I'm just trying to get a sense, if you look at the past several quarters mix has been a drag as you get to total revenues versus my sense is that you said that was a bit flatter now.

If you looked at second quarter, Scott, I think our Intermodal and our coal business volumes were low.

We saw our Chemical business relatively strong compared to the rest of the book of business.

So when it all kind of played out, I think mix improved to the point where it was about flat.

Okay.

I appreciate that.

Thank you very much.

Thanks, Scott.

Our next question is from Randy Cousins with BMO Capital Markets.

Please state your question.

Good morning.

I guess, Dennis, I'm going to start off with you.

The great thing about your network is some places were not affected by the weather.

Have you looked at the areas that were not weather affected and did a same-store sales type of process, what did you see in terms of train speed improvements and dwell time improvements in those portions of your system where you could say there was no weather effect?

Because clearly when we are looking at these consolidated numbers there is a huge negative working through them that's masking the real improvements?

Yes, Randy.

We saw significant contributions in the South, primarily in Texas, even though the main lines were impacted.

Our terminals operated very efficiently.

They are operating at some of their best all-time levels, and in the West we saw a nice contribution in most of our terminals out there.

One of the things we did complement that is we tried to get the majority of our capital work done, tie replacement, rail, those kinds of things in the South and on the West.

So it did mitigate some of the contributions that they would normally have made.

Now we have them pretty well, as I said -- the Sunset is completely done.

The South is primarily done with their major work and we are focusing on the Central Corridor.

We are working looking for some positive contributions from them, the South and West primarily, in the second half of the year while we finish up the work here in the North.

We are optimistic on our performance numbers.

Another way to come at this, if you look at this from a consolidated basis and you hadn't had the weather effect, or conversely, how much do you think the weather effect adversely affected dwell times, train speeds and some of the other performance metrics?

I tried to answer that previously and obviously I didn't do a very good job.

We gave back two points out of those seven points on our train start reductions, our crew start reductions.

That is primarily over the road.

Our terminals operated pretty well.

You saw the increase, or the reduction of three hours, about 10%.

That is substantial.

Our upside that we gave away from the weather was on the velocity side.

Believe me, we intend to get that back.

Okay.

My next question is for Rob and has to do with the cash flow statement.

I'm looking at the deferred tax line, and just for modeling purposes, Rob, should we be using 20% as the cash tax accrual, or the GAAP accrual for taxes as kind of the deferred tax line item in terms of your cash flow?

Randy, as I actually previously said earlier in the year, for this year on a cash tax basis we are recommending you're looking at a 20% to 25% cash tax rate.

Okay, and just with reference to the run rate on other income it looks like you are $50 million already through the first half, looks like you are going to be closer to the 100 than the 75, is that a fair way to come at this?

Randy, that category can be lumpy so we're still saying in the 75 to 100 range.

It is not linear necessarily.

Okay.

Then the last question has to do with -- there is news in Canada suggesting that CP Rail will be taken out by a financial player.

You guys have a minority interest in a Mexican railroad, you have a long-term historic relationship with Canadian Pacific.

Would you view, or does the Union Pacific give any consideration to entering into a more activist type of ownership interest with one of the Canadian railroads?

Randy, we have said consistently we don't believe consolidation makes sense in our industry at this point.

We will keep our eye on what is happening with the industry, if a private equity comes into the CP, my interest will be their ability to work with us to grow, again, can they put the capital in and provide the service?

Right now, I don't see consolidation making any sense at this point.

Okay, great.

Thanks a lot.

All right, Randy.

We have time for one more question, and our final question comes from Amy Young with Calyon.

Please state your question.

Hi, this is Amy Young from Calyon Securities in for Sal Vitale.

I am just looking at the business segments.

Can you go over the yields for Ag and Industrials?

It was growing at mid double-digits.

I was looking at it and it is decelerating.

Can you comment on what you are looking at for the second half of 2007 and 2008?

Jack?

If you look at where they are today, you have to put into perspective what happened in the network.

It was Ag, Chem, and what was the third one, Amy?

I'm sorry.

Just Ag and Industrials, actually.

Ag and Industrials?

I think we are going to continue to see strong performance in both Ag and Industrials.

We are certainly watching industrials in terms of the overall market play.

Most of our pricing is pretty well locked in for the year right now, or scheduled and we really don't see much change to that.

You're going to continue to see fairly good yield performance in both Ag and Industrial.

Amy, and if you look long term, the question you are looking at, the longer term, the trends, obviously, those are the two business groups that we had the ability to price more immediate to market.

You had some ability to really reflect the market change much more quickly years ago.

We just need to watch what is happening in those markets going forward.

Okay.

Thank you.

Okay, Amy.

I will turn the call back over to management for closing comments.

Thank you, everyone, for being on the call today.

We feel had a good quarter, but we did lose some upside here.

You will see continued success in this Company over the next six months.

Thanks for attending today.

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

You may disconnect your lines at this time.

Thank you for your participation.