聯合太平洋集團 (UNP) 2008 Q2 法說會逐字稿

Welcome to the Union Pacific Corporation's second quarter earnings conference call, held at 8:45am Eastern Time on July 24, 2008 in Omaha, Nebraska.

This presentation many accompany materials, containing statements about future expectations or results of the Corporation that are 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 limitations, expectations, projections, estimates, and similar statements regarding the Corporation and its operations of 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 of these statements or information provided in this presentation or the accompanying materials.

More detailed information regarding forward-looking information on such risks and uncertainties are contained in the materials that accompany this presentation and in the filings made by the Corporation with the Securities and Exchange Commission, which are available from the SEC at www.SEC.gov, and on the Corporation's website.

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

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

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

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

Greetings, ladies and gentlemen, and welcome to the Union Pacific second quarter earnings release conference call.

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

A brief question-and-answer session will follow the following presentation.

(OPERATOR INSTRUCTIONS.) 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.

Welcome to Union Pacific's second quarter earnings call.

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

I'm pleased to announced today, Union Pacific overcame the challenges of widespread flooding in the Midwest, record high diesel fuel prices, and a soft economy to post second quarter earnings of $1.02 per share, a 24% increase over 2007.

Quarterly operating income was a record $931 million in the quarter; it's up 18%.

Looking at the drivers of our quarterly performance, the discussion has to start with fuel.

Fuel became UP's largest expense category in the second quarter as prices increased more than 60% compared to a year ago.

Rob will talk to you more about the flooding impact on our financials, but it did reduce quarterly earnings by about $0.05.

Our dedicated employees quickly restored service to customers, as we overcame the challenges associated with operating a 32,000-mile factory without a roof.

UP's franchise diversity is a great strength and we demonstrated that again in the second quarter.

Americans are spending more to fill their gas tanks, leaving fewer dollars available to purchase consumer goods.

In fact, the conference board's June consumer confidence index reached its lowest level since February 1992.

The effect of less confidence in the economy and reduced discretionary income is reflected in our lower quarterly loadings in automotive, industrial products, and intermodal.

The offset to consumer weakness is strong demand for our bulk commodities.

Driven by growth in coal, grain and fertilizer, our agricultural, chemicals and energy groups each posted positive volumes in the quarter.

And growth in those areas was pacing even stronger before flooding impacted our Midwest operations.

In fact, in April and May, total car loadings were running about flat to a year ago before finishing the quarter down 3%.

But we clearly lost some of our upside in the month of June.

Despite lower volume, our second quarter operating revenue was the best ever, $4.6 billion.

Strong pricing and increased fuel cost recoveries, both contributed to the gain.

Operationally, we had a strong quarter.

Dennis will talk you through a few of the key metrics, but we hit best-evers in a number of areas, despite the flooding challenge.

That operational fluidity, not only contributed to good cost efficiency in the quarter, but also drove record customer satisfaction.

Overall, we turned in a solid second quarter performance, despite a number of obstacles and we're looking forward to further profitability gains in the quarters ahead.

Now, let me turn it over to Jack to discuss our second quarter revenue.

Jack?

Thanks, Jim, and good morning.

Our second quarter freight revenue increased 13% to a record $4.3 billion, even though continued economic softness and severe flooding held our volumes 3% below a year ago.

The revenue growth was driven by improved average revenue per car for each of our six commodity groups.

Four of the six businesses posted their best ever revenue.

Intermodal came close, they had a second quarter record.

Only the automotive business failed to set a new record, as our revenues in that business were down 9%.

At the same time, customer satisfaction again showed year-over-year improvement.

Last month's Midwest flooding, along with the flooding in the Powder River Basin in late May, clearly effected our second quarter volume with the greatest impact in our coal business.

Overall, our volume was tracking flat to last year through April and May; would likely have come a lot closer to finishing there had it not been for the flood.

We estimate that the flood cost us around 40,000 loads, but the good news is we think we can probably recover some of that as we go through the second half of the year.

Three groups, our auto business, intermodal and industrial products, saw volumes decline for the quarter.

Our automotive volume fell 20% with the American Axle strike driving about two-thirds of that decline and the balance resulting from decreased production by the big four auto manufacturers.

The economic softness also showed up in our industrial products results, where volumes were down 1%.

The drop in West Coast port volumes is keeping our intermodal business sluggish, but most of that volume decline was driven by some competitive losses and the impact of the flood-related embargo.

The biggest volume offset was an 11% improvement in ag products, helped by continued strong grain markets.

There's also plenty of demand out there for coal, where volume was up 2% despite the floods.

Our chemical car loadings grew 1%, as the strength in our fertilizer business offset the impact of economic softness in other segments, such as liquid and dry and our domestic plastics business.

This morning what I would like to do is take you just a little more intently on ag products, energy, and our industrial products business, talk a little bit about the highlights we had there in our second quarter.

Turning to ag products once again, ag products posted the largest revenue gain with an 11% growth in volumes, combining with a 16% improvement in average revenue per car to drive a 29% increase in revenue.

As in the first quarter, worldwide demand for grain and a weak US dollar created a strong export market for feed grains and wheat.

Both saw volumes grow significantly in all three export markets, the Pacific Northwest, the Gulf and Mexico.

Overall, feed grain exports grew 71% in the quarter and wheat exports were up 47%.

While narrowed margins and tight credit are stressing the ethanol market, our ethanol markets continued to grow quite well.

Our ethanol shipments were up 25% in the second quarter and we saw a 14% increase in DDGs.

For the second half of the year, the majority of the flood-related damage occurred in eastern Iowa and southern Illinois, which are not significant UP grain origins, so we're really not expecting to see a big impact on our grain volumes for the rest of the year.

In fact, with worldwide demand for grain, for meat and poultry, and the growth in our produce rail express trains, we expect our ag business is going to show continued strength throughout the second half of the year.

Energy became our first business to top $900 million in revenue for a quarter, as our revenue grew 21%, driven by a 19% improvement in average revenue per car and a 2% volume growth.

Although both major segments of this market, the southern Powder River Basin and our Colorado-Utah zones set productivity records for tons per train, weather-related disruptions resulted in the somewhat modest growth against last year's volumes which incidentally, were also impacted by some severe weather.

Southern Powder River Basin volume grew 4%.

May loadings were hindered by mine flooding late in the month and June volumes, of course, were impacted by the Midwest flooding that curtailed shipments to the East, as well as in Iowa and around St.

Louis.

The chart shows you, however, that in July, we pretty much put that disruption behind us and were running strong.

Production issues, utility outages, and the St.

Louis floods led to a 3% decline in Colorado-Utah tonnage.

Looking ahead to the rest of the year, Colorado-Utah looks like it's going to be up 3% for the year and we're still shooting for 5% growth out of the SPRB.

With continued strong demand, the real wild card for us is going to be the ability of the tight supply chain to have some opportunity to make up some of the loads that were missed as a result of the flooding here in the second quarter.

A 10% improvement in average revenue per car enabled industrial products to grow revenue 9% to almost $900 million, even as volume declined 1%.

With weak demand resulting from the ongoing slump in the housing market leading to mill closures, our lumber shipments declined even further in the second quarter, falling 25% below last year.

The impact of a weak construction market also showed up in our cement business, combining with the rain in the Midwest to drive volumes down about 11%.

But industrial products is our most diverse business group, and there was some good news that helped offset some of the overall volume declines.

For instance, our steel shipments increased 20%, as the weak dollar limited steel imports, creating a stronger domestic market and inventory replenishment across the United States.

The worldwide demand for scrap and finished steel caused scrap prices to double since the end of last year and drove a 17% increase in our ferrous scrap volume.

Favorable weather in Texas combined with pent-up demand from the first quarter weather issues drove a 6% increase in rock shipments.

As we discussed in Chicago, our wind energy business is expanding by leaps and bounds.

We're continuing the conversion to unit trains.

We had two new unit train movements to wind-powered components, starting up late in the quarter.

One moving from Mexico to the Pacific Northwest and another set from California to Texas.

Over the second half of 2008, we're looking to wind, along with opportunities in other energy-related markets, like frac sand and pipe, and continued strong demand in steel to help us offset the soft housing-related markets, which are showing at this point in time, virtually no recovery.

As we look to the rest of 2008, we're expecting that our strongest businesses will be those that led the way through the first half, namely ag products and energy.

Chemicals, which is run slightly ahead of last year so far, should stay solid for us.

As I highlighted earlier, industrial products is a mixed bag, but we think there's potentially enough upside opportunity to offset the continued weakness in lumber and other markets.

Domestic, intermodal and our automotive parts won't be big growth drivers over the next year, but they should hold their own with volumes pretty much unchanged from 2007.

That leaves us with automotive vehicles and international intermodal.

At this point in time, we really don't see anything that's going to jump start vehicle volumes.

GM's announcement last week was only the most recent reminder of the troubles in the automotive sector, as they deal with both a soft economy and changing consumer preferences.

In international intermodal, West Coast imports have been down, the soft economy looks like we're going to have a fairly mild peak season.

If you put it all together, we expect overall volume in the third quarter's probably going to be down in the 1% to 2% range versus last year.

For the full year, looks like we'll be down around 1%, reflecting a relatively soft first half and our expectation that the economic doldrums are probably going to continue through the second half.

But as we did in the first half, we will offset the volume softness with price.

We'll wrap up the year with a core price improvement in that 5% to 6% range, and that should continue to drive top line growth through the end of the year.

With that, I'll turn it over to Dennis for the operations update.

Thank you, Jack, and good morning.

For the operating team, the second quarter was a study in contrast.

We've made significant progress in April and May to improve the efficiency and reliability of the network, only to have Mother Nature set us back with the Midwest flooding in June.

Despite these challenges, we continue to operate a safer network in the quarter, in particular, with [great] crossing incidents and derailments.

Productivity was the real story line for us in the quarter, as we made strong gains in virtually every category.

Employee productivity, as measured by gross ton miles per employee, improved to 3% in the quarter.

Through freight train starts were down 4%.

And yard and local starts declined 5% year-over-year, with only a 1% decline in gross ton miles.

Another important driver of our operating performance in the second quarter was our network resiliency.

We face a number of weather-related disruptions on our Northern region beginning in late May, but unlike the mudslide in Oregon, these outages hit us right in the heart of the railroad, the Red X, which is the densest part of the network.

And in fact, at its worst, our Central Corridor was closed for ten days.

Fortunately, we came into this flooding situation with a very fluid network.

In the second quarter we experienced a total of 54 network interruption days, nine more than last year.

Now, some of you might expected a bigger difference, but you'll recall that we had flooding last year around the Kansas City area and in Texas.

Our recovery from the flooding was much faster this year than last, in part from the continuous improvement principles we applied and from lessons learned.

We took an innovative approach, establishing a coordinated redesign of the transportation plan that allowed us to maximize the efficiency of alternate routes.

We utilized the permitting process to control the flow of business onto our network.

This allowed us to isolate the impact of the flooding to the Northern region.

Our engineering team did a great job of prepositioning resources, so we could immediately start work to reopen the lines after the water receded.

This involved rescheduling some of our work gangs, giving us extra resources in affected areas, while reducing the maintenance impact on other parts of our network.

In addition, the investments that we made over the last couple of years to harden our rail infrastructure, and add capacity and surge resources, greatly improved the resiliency of our network.

The end result of these efforts can be seen in the chart at the bottom left, where we improved our quarterly velocity by over 1 mile-per-hour versus last year.

And if you look at our velocity on a weekly basis, you can see more clearly the improvements we've made.

We had a nice pickup in velocity through the quarter, averaging 23.5 miles per hour in the month of May, our best monthly velocity in five years.

Importantly, since we've moved beyond the major flooding issues, velocity has rebounded quickly and we're running at nearly 24 miles-per-hour today.

Our other key operating metrics, inventory and terminal dwell, both improved in a challenging environment.

We are translating greater network fluidity into better operating efficiency and service reliability as shown by the charts on the right.

Freight car utilization, which measures the days between originated car loads, was a second quarter best at 9.5 days.

As we've improved our system velocity, recrew rates also improved, declining more than 2 points year-over-year.

To put this in perspective, 1 point of improvement saves us over 100 train and engine employees.

Jack shared with you the high marks that our customers are giving us on their satisfaction surveys.

Internally, we are also setting new records as our service delivery index, which we use to measure customer service commitments, improved nearly 10% versus last year and set a monthly record in May.

Across the board, we are improving operationally.

We're consistently executing our transportation plan, which is driving greater overall efficiency and reliability.

Looking to the back half of '08, the operating team will continue to execute on the principles that have driven the improvements year-to-date.

Safety remains our priority and we'll continue with implementing total safety culture across the railroad.

Summer is the peak maintenance season for our railroad.

Our challenge is to accomplish these major programs and continue to achieve the necessary throughput to improve service.

We expect continued productivity from our structured approach to asset utilization and cost control; and customers will see greater service reliability across all of our business segments.

With that, I'll turn it over to Rob for the numbers.

Thanks, Dennis, and good morning.

Let's start off with a quick look at our income statement.

Second quarter operating revenue was $4.6 billion, a 13% increase year-over-year.

Operating expenses increased 12% in the quarter, driven entirely by higher fuel costs.

In fact, second quarter operating expenses excluding fuel actually declined 1%, or $28 million.

Although we did benefit in the quarter from a $12 million casualty expense reduction, that was more than offset by roughly $23 million of higher costs associated with the final cleanup of the Oregon mudslide.

The Midwest flooding also added costs to the quarter of a little more than $10 million, but we were able to offset the majority of these through fewer train starts and less fuel consumption.

This cost performance highlights our improved operating efficiency, and it's even more remarkable when you consider the operating challenges that we faced during the quarter.

The net result of our operations was 18% growth in operating income to a second quarter best, $931 million.

Looking at the drivers of our freight revenue growth, we reported a 13% increase, or $496 million to $4.3 billion.

Freight revenue would likely have been about $45 million higher in the quarter, but was impacted by the Midwest flooding, primarily from fewer coal loadings.

Increased fuel cost recovery, driven by higher fuel prices, was the largest contributor to our 13% freight revenue increase.

Pricing also continued strong for us, as we achieved roughly 6 points of core price improvement in the quarter.

Our mix of business was also a positive.

In particular, the business group with the highest average revenue-per-car, agriculture, grew volumes 11% in the second quarter.

Turning now to expenses, compensation and benefit expense declined 4% year-over-year to $1.1 billion.

We offset general salary and benefit inflation through greater overall workforce productivity, as we moved 1% less gross ton miles, with 4% fewer employees.

Training costs were also lower versus last year, as the continuing trend of lower volumes requires us to backfill less attrition.

For the remainder of the year, our work force levels will be aligned with anticipated volume and productivity.

Costs per employee will likely increase, however, as the nationally negotiated wage increase of 4% went into effect on July 1.

As Jim mentioned, increased fuel expense was a key driver in the quarter, totaling a record $1.2 billion, driven by a 64% increase in average diesel fuel prices for the quarter.

This expense category increased more than $400 million versus last year.

Although our various fuel cost recovery mechanisms helped offset these rising fuel prices, the effects to our profitability cannot be overstated.

In fact, in the second quarter alone, we estimate that higher locomotive fuel costs over $0.75 per gallon threshold, net of our various fuel cost recovery mechanisms, reduced operating income by almost $200 million.

By consuming 19 million fewer gallons of diesel fuel in the quarter, we somewhat mitigated the impact of higher prices.

Consumption was lower as a result of moving 1% fewer gross ton miles year-over-year, as well as our ongoing efforts to conserve fuel.

The operating department's conservation initiatives, as well as the increased use of newer, more fuel-efficient locomotives, have enabled us to consistently improve our quarterly consumption rate.

In particular, our June consumption was very favorable year-over-year and better than anticipated.

A portion of this variance can be attributed to our business mix, but the Midwest flooding and the associated reduction in train starts was also a factor.

Another fuel headwind for us is the increased cost of gasoline and diesel fuel to our work and fleet equipment.

This added $12 million to our second quarter expense.

We are committed to improving our fuel cost recovery and reducing the negative impact of fuel on our profitability, but until we reprice all of our legacy contracts, we are exposed to rising fuel prices.

Moving to purchase services and materials expense.

This expense line increased $16 million, or 3% in the quarter.

Cleanup and restoration costs associated with the Oregon mudslide and the June flooding, as well as higher contract costs, were the primary drivers of this increase.

Crude transportation costs were also higher in the quarter as a result of increased fuel costs.

On Slide 24, we show both depreciation and equipment expenses.

Depreciation expense increased 6% in the quarter to $346 million.

This increase is driven entirely by higher capital spending.

Second quarter equipment and other rents declined 5% to $338 million, a $16 million savings year-over-year.

Better asset utilization and fewer shipments of finished vehicles and industrial products, both contributed to a reduction in car hire expense.

In addition, lower lease expenses for freight cars, containers and equipment were partially offset by other rental increases.

Our last expense group is other, which declined $3 million in the quarter to $199 million.

The primary driver of the decrease was a semi-annual actuarial study we completed in the quarter, which reduced casualty expenses by $12 million year-over-year.

Our continued safety improvements and lower estimated settlement costs are reflected in the lower expense.

Offsetting a portion of this decline were increased utility costs and higher state and local taxes.

You'll recall that in 2007, we conducted actuarial studies in the first and third quarters, which in 2008 will be completed in the second and fourth quarters.

And in the third quarter of last year, we recorded a $47 million casualty expense reduction.

Although we will see ongoing benefits from our improved safety performance, last year's quarterly reduction will clearly impact the year-over-year comparison.

The next slide shows our second quarter operating ratio.

We improved our operating ratio by nearly a point in the quarter to 79.6%, our lowest second quarter mark since 2002.

Of course back then, we were only paying $0.72 per gallon for diesel versus this year's average price of $3.60 per gallon.

You can see the impact of higher fuel prices, adding about 4.6 points to the operating ratio.

This further illustrates the substantial headwind we face from the more than $400 million run-up in quarterly fuel expense.

The ongoing strength of our base business, driven by strong pricing gains, improved operating efficiency, and the casualty expense reduction, more than offset those added costs to drive 5.5 points of operating ratio improvement in the quarter.

This operating ratio improvement is actually understated a little when you take into consideration the weather events we experienced in the quarter, both this year and last year.

You might remember that in 2007, we experienced flooding on our network that reduced our earnings by about $0.05 per share post split.

This year, we had the impact from both the Oregon mudslide and the Midwest flooding, which all together cost us closer to $0.08 in the quarter.

We are pleased by this quarterly performance as we continue to set the bar higher with regard to our profitability.

In particular, we know we have a tough comparison going into the third quarter.

Turning now to the full income statement.

Second quarter other income was $17 million less than the quarter at only $19 million.

Less interest income and a year-over-year decline in gains from real estate sales contributed to this decrease.

For the full year, we still expect other income to be in the range of $75 million to $100 million.

Interest expense increased 7% in the quarter to $128 million, as a result of higher average debt levels.

Income tax expense increased 13% versus last year, or $34 million.

Higher pretax income was the driver of the increase, with some offset from a lower tax rate.

The effective tax rate in the second quarter of 2008 was 35.4%.

This reduction is a result of federal tax audits and state law changes, which increased earnings by $18 million after tax.

Through the first half of 2008, our effective tax rate is 35.5%.

For the second half of the year, we would expect a more normalized rate of around 38%.

Net income was a second quarter best of $531 million, a 19% increase.

Earnings per share grew 24% to $1.02 per share.

Of course the per-share amounts reflect the two-for-one stock split that we completed at the end of May.

Similar to the first quarter, our earnings per share growth is outpacing the rate of our net income as a result of our share repurchase program.

On a fully diluted basis, our weighted average shares outstanding declined 4% in the quarter.

During the second quarter, we repurchased 6.3 million shares of UP common stock at a total cost of a little more than $480 million.

Since starting our repurchase program in January of 2007, we have bought back just over 38 million shares, returning more than $2.3 billion to shareholders.

Turning now to slide 29 and our balance sheet, our adjusted debt-to-cap ratio is up year-over-year to the mid-40s, with about $12.5 billion of total debt obligations at the end of June.

This puts us solidly in the middle of the investment grade credit range, which provides us with good access to the capital markets at a reasonable cost.

Let me close today with a look at the third quarter and the second half of 2008.

Similar to the drivers of the first half of the year, the key factors in the second half will be volume and fuel.

Jack talked to you about our expectations that third quarter volumes could be in the 1% to 2% lower year-over-year range.

From a fuel standpoint, our outlook assumes $4 per gallon for diesel fuel in the quarter.

That equates to roughly $135 per barrel for crude oil.

At that price, third quarter fuel expense would increase roughly $550 million year-over-year, assuming a flat fuel consumption rate.

The good news is that in the face of lower volume and a huge cost hurdle, we still expect solid earnings growth.

We would look for third quarter earnings to be in the range between $1.10 and $1.20 per share, or 10% to 20% growth.

Put some perspective around this, if third quarter car loads are down 1% and crude is near $135 per barrel with reasonable refining spreads, our quarterly earnings could be toward the high end of the range.

But if car load volume is weaker and we see fuel prices increase, that could bring earnings closer to the lower end of the range.

We are also updating our full-year outlook.

We now expect volume to be down around 1% for the full year.

This reflects the tougher than expected start to the year, with volumes already off 1% through the first half.

We are also increasing our earnings range to $4 to $4.20 per share for the full year, or growth of 16% to 21%.

This is above our previous range and is consistent with our stronger year-to-date earnings, as well as our expectation for continued earnings growth.

Our focus on improvement will allow us to drive more of our strong top-line growth into greater profitability for our shareholders.

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

Thanks, Rob.

As we look ahead to the second half of the year, we'll continue to face challenges from higher fuel prices and a softer economy.

We remain committed, however, to driving productivity improvements throughout the organization, while providing a safe, reliable service product to our customers.

The end result of these efforts will be a record financial performance for Union Pacific and greater financial returns for our shareholders.

With that, we've got time to take a few of your questions.

Thank you.

(OPERATOR INSTRUCTIONS.) Our first question this morning will be coming from the line of John Larkin with Stifel Nicolaus.

Please go ahead with your question, sir.

Good morning, everybody.

Good morning, John.

I had a question regarding the tremendous unit revenue performance in both the ag and the energy business segments, both up in the high teens.

I was wondering if you could comment a little bit on how much of that was price?

How much was fuel surcharge?

How much might have been the use of larger cars on average?

And how much might have been a change in the length of haul?

Jack, do you want to try a shot at that one?

In the energy business, John, we did have some repricing of a couple of our legacy deals.

And so the price component of that number was stronger than what we saw overall for the average for the quarter.

And in the ag business, quite honestly, it's just the strength of the market that's allowed us to go in.

Whereas typically, we might take one or two price increases over the course of a year, we've been able to do three or four.

Our core pricing in both of those segments has been at the higher end of our business groups.

John, the other thing I would remind you, that you have a real spread there on the ag and energy.

Energy, obviously we've got a big book of our legacy contracts.

While we had a nice increase on the average revenue per unit, it really doesn't reflect what the market is right now.

It's much higher than what we had in the second quarter.

Okay.

Also had a question regarding the cleanup expenses with natural disasters, such as the Oregon mudslide and the flooding in the Midwest.

Seem to recall that a couple of your other US railroads, in the face of other disasters, have had insurance recoveries on cleanup and rebuilding expenses.

Is that something that applies in these cases?

Well, the Iowa floods, we don't see that being something that we would cover in insurance.

The Oregon mudslide is one that we do have some coverage on.

At the end of the day, though, you still -- you may recover insurance, but you pay it back over the long-term.

Got it.

That's all I had.

Thank you very much.

Thanks, John.

Thank you.

Our next question is coming from the line of Tom Wadewitz with JP Morgan.

Please proceed with your question, sir.

Let's see, the -- I think the thing that really stands out the most in the quarter to me seems to be the cost improvement, the operating performance, despite the headwinds in June.

Where -- how much of the benefit of that improvement really came in on the cost side?

If you look at head count reduction and rent.

Or was a lot of that held back by the flood impact?

And I guess, is it -- as we look forward, do we say, okay, you're going to continue to improve and maybe the cost improvement stays at a similar pace?

Or is there some further acceleration that -- clearly you have a lot of momentum on the operating side, so wanted to get some thoughts on that.

Well, Tom, I think the best slide -- velocity before and after.

If you look at it, we had a dramatic fall-off.

We were running strong right before the flood that's out here, and then we've recovered.

That's not by accident.

That's by plan, in terms of how we're running our network today.

We still have, I think substantial opportunity for productivity improvement going forward here.

The rate that you've seen, while it was dampened somewhat by the floods and weather, we're going to continue.

We've said long-term that our productivity opportunities, we said at a minimum, we want to offset inflation.

Dennis, do you want to add to that?

The only thing I would add to it, Tom, we tried to show you at our previous analyst sessions that we have a very structured approach to cost reduction and asset utilization.

You are starting to see some significant payoffs from our efforts on unified plans, simplifying our network and running a much more disciplined operation.

We expect that to continue.

If I look at -- on equipment rents, you were improved about 130 basis points year-over-year, if you look at it as a percent of revenue.

Then the head count was down 4%.

That type of pace probably can continue for a few more quarters and might even accelerate a touch if you don't have more weather events.

Is that a fair way to look at it?

Well, I would be careful about just expanding it out.

A great win there is we are reducing our lease locomotive fleet, the short-term lease locomotives, which is directly related to our velocity improvement.

We'll end the year with fewer locomotives when you look at it.

As we've said to you before, part of those additions and those assets looking backwards was our challenges we had with velocity.

But we've got good opportunities going forward.

Rob, do you want to add something?

One comment, Tom, just remember last year's third quarter was a very good performance period.

While we'll continue to make improvements, you've got the headwind of a difficult comp in the third quarter.

The other point I would make to your earlier comment, is on the fuel consumption.

As we pointed out, the fuel consumption in June was a result of the some mix issues, and the weather was extraordinarily good.

I wouldn't anticipate that that run rate would continue.

We'll continue to make improvements, but that particular run rate clearly helped us on the fuel consumption side in the second quarter.

Okay, and what -- it seems like improvement in velocity is a good indicator at the present time of some improvement in your cost side performance.

Where do you think velocity may ultimately go to?

Is this realistic to look back to '02 and say, you get to those levels> Or you think there's a sense maybe going into next year, you could even exceed those type of levels?

Tom, we're going to continue to improve our velocity.

Now, part of this will -- part of this in my mind is what's the market willing to pay for the service piece?

There are two equations of velocities, which are reducing assets, improving the returns.

The other piece, in fact my head of marketing actually missed the slide, so I'll have to bail him out here on the customer satisfaction slide.

But if you look at it, we had a customer satisfaction for the quarter of 83, the best since merger.

There's great value there from the customer base as we turn their assets and provide great service.

I don't have a number -- we don't have a number out here that says what's the ultimate velocity.

What we're focused on is every year improving our asset utilization and our speed.

Okay, and then I guess last one and I'll pass it along to someone else.

Legacy contracts, you commented that coal got a bit of a boost from some legacy repricing in second quarter.

Is there more -- I guess your contracts are second half loaded.

Can we see further acceleration even in effective pricing on some of the lines in second half as more of those legacy deals are repriced this year?

You'll see the carry-over effect of things we've done so far, Tom.

Really from this point forward, the bulk of them are going to be year-end expirations.

We don't really have many coming up here in the third and fourth quarter.

Okay, great.

Well, congratulations on the strong results.

(multiple speakers) The other boost that we got in the energy business was also in some of our export coal opportunities.

We have a new move of export coal that's moving down to Mexico.

We've also started moving some coal off the West Coast to Asia.

Both of those helped us as well from a pricing perspective in the quarter.

Okay, great.

Thank you.

Thank you.

Our next question is coming from the line of William Greene with Morgan Stanley.

Please go ahead with your question, sir.

Hey, Jim, maybe I could just follow up with one comment you just made here at the end.

The service improvements, should we think about that as being able to extend the period when you can sustain this 5% to 6% core pricing?

Or could it actually mean that contracts you've already repriced have even more upside so we can think of maybe even growing that core price?

I think it's both there.

It really is.

We've said it consistently.

There's a market price for obviously the service you're providing today.

But we clearly are seeing some very good opportunities where we are really entering new markets, providing new service products.

I think the value of railroads really are showing through right now with our customer base.

I see upside on both sides.

Okay.

You mentioned that you expect coal to be strong.

Do you have a sense for where your stock piles are?

Is this something where you're just going to make up the flooding?

Or do we actually have more pent-up demand there?

Stock piles at the moment are declining, but that's really not unusual for this time of the year.

This is the heavy season burn.

You would expect that -- I don't know that we would say they are declining at an alarming rate.

They are seasonally acting the way we think.

We think we will have stockpile replenishment as well as some upside opportunities selectively for some export business.

Then we've got some of the recovery stuff that's out there.

I think there's three things that are going to contribute to a strong second half with coal.

Okay, then just last question.

At the analyst day, you mentioned that you had seen lumber shipments seem no longer to deteriorate sequentially.

Are you seeing any signs that things are getting better in that world?

Or was that just sort of a fluke?

I'll answer that one.

I don't think -- we're down, what, 25% on the quarter.

That's on top -- we're down almost 50% from where we were in the peak.

I don't see anything out there on the housing side that says there's a recovery in the near term.

We're -- our planning cycle next year says it's still going to be pretty tough.

Now, we're fortunate to have a good mix of business.

You look at steel, was up, what, 15% or so, 17%.

Stone, some of that's related to highway construction was up.

But I don't see anything in the near term that's going to drive our lumber business back up.

Okay.

Thanks for your help.

Thank you.

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

Please go ahead.

Good morning.

Just on the oil side, now that we've seen a bit of a pull-back, you were talking about what if it goes up and the impact to earnings.

Since we've seen a $20 pullback, I'm just wondering, do you see any of that domestic intermodal that, Jack, you were talking about might be good in the second half?

Do you see any of that maybe potentially going back to the truck?

Or do you think you keep winning even at these high lofty levels?

Ken, I really think that the domestic intermodal will stay fairly strong for us over the -- even if it pulls back $20.

I think we're going to see a sustained demand.

There are some good initiatives that we have in the marketplace.

We've got some great service product.

And our service is getting better and better all the time.

One of the cool things we're seeing happen right now is that the service gap between truck and rail, as our service improves and this highway congestion gets worse, we're closing that gap.

We've got a lot of very strong products particularly on the Southeast, on the Sunset Corridor, and places like that.

We will continue to make in-roads even as fuel prices creep back down.

I think wild card in the domestic -- two things.

One, obviously the economy, but there's a second one here is, what is happening with excess truck capacity today.

We know it's been shrinking in terms of -- you look at equipment being sold overseas.

We actually have seen some areas that have -- we saw some shortages in terms of equipment.

I think there are -- obviously fuel's, energy costs are a big deal to the truckers, but there are other factors that have to play out here.

Okay.

Just two quick technical questions, if I can.

In the annual targets, are you using the $1.02?

Or are you excluding the tax gain in that full-year target?

Rob?

We're using the $1.02.

Okay.

And then same for -- what it last quarter, you also had the tax gain?

Yes.

We are including that.

Okay, thanks.

And then on the fuel, Rob, do you use WTI or diesel in your surcharge rates?

We have several different surcharge, but very little of it is WTI.

DOE is the predominant driver.

Okay.

And then I think, Rob, I forgot who mentioned it earlier, but intermodal was driven by competitive losses.

I think maybe Jack mentioned that.

Can you talk about the scale of what on the international side is being lost?

Is it going all East, or is it being lost to other carriers out West?

Ken, we lost some business to rail in terms of the contract.

That's -- it wasn't really shifting to the East.

Okay, and then the pricing mix in that high teens performance this quarter, great 16% yield.

I think -- can you simplify that?

What percent was pure price?

Pure price is up about 6%.

So at the top end of that 5% range?

Right.

Okay, and then last question I have is just as you look on the 4% increase in costs, the employee costs, the new contract that Rob talked about.

Just wondering, what -- are there anything specific that you need to do in order to offset the immediate increase in this quarter?

Or is that going to be something you just keep the ongoing productivity to gradually offset that?

Could we see -- is that why you're being cautious on the third quarter, because the scale of that employee cost increase?

You're going to have the pressure, as Rob mentioned, but we need to continue to focus on our productivity, reducing recrews.

We've talked about that before.

Our recrew rates while we had a good improvement year-over-year.

We're still running 8% or 8.5%, 8% or 9%.

We've got to keep focused on the productivity piece.

Great.

Thanks so much for the time.

Great job.

Okay, Ken.

Thank you.

Our next question is coming from the line of David Lambert with Goldman Sachs.

Please go ahead with your question, sir.

Good morning, gentlemen.

Good morning, David.

One question, because weather's been such a hot topic.

I figure I might as well ask it.

I guess it's now tropical storm, Dolly, is that having any effect on you folks in Texas?

Not a major impact at all.

You made some comments about your international intermodal business in the second half of the year, talking about a mild peak season.

Wondering if you could provide more color.

Were you speaking specific to UNT?

Or are those comments based on your outlook for the US economy?

Does that have to relate to the fact that you lost those contracts?

I'm just trying to understand what led you to think that the peak season would be mild.

Was it overall?

Or more customer-specific?

Well, we're speaking to UMP, but it really starts with where do you think consumer spending is going to go.

Of course, part of peak is getting ready for Christmas.

Our auto producers, which also are part of peak, is they are producing new models.

We don't expect that to be as strong this year.

It is unique to UP, but it also reflects what's happening in the overall economy.

We will have a peak.

It just simply -- it may be only a hill this time instead of a mountain.

Fair enough.

And then last question, you talked about truck-to-rail conversions.

Can you talk about length of haul?

I understand you have some new service offerings that are helping you win, but that is also -- what's the typical length of haul on that?

Are they shorter in duration?

Are they longer?

Is there any difference whatsoever?

It's typically long-haul business.

West Coast to the Southeast, Northern California, business heading to the East.

Are you seeing anything on north-south moves in the Midwest, shorter distances or not yet?

Not particularly strong.

Thank you very much.

Okay.

Thank you.

Our next question will be coming from the line of Ed Wolfe with Wolfe Research.

Go ahead with your question, sir.

Hey, thanks.

Good morning, guys.

Good morning, Ed.

What happened in the last two and a half weeks that allows you to print such a strong number at the end of the quarter?

You still talked about $0.05 of impact from the West Coast.

What really happened at the end of the quarter that was so positive and can you talk about that relative to how July's begun?

Well, Ed, we ended up with just a much stronger finish to the quarter.

It was -- when we gave our guidance, the fuel impact -- or the weather impact came in pretty close to what we got.

But we saw a pretty strong bump in the quarter at the end of the quarter.

And right now, it's -- if you take autos out of the equation, we're -- we had shown you what's happening with coal running over 37 trains a day out of Caribbean coal.

It's staying a little bit stronger.

But it doesn't take much when you look at -- our productivity came in a little bit better.

Then fuel, fuel consumption came in better.

Okay.

Jack talked before about ag going through PRB and Gulf.

Can you give a sense on the export grain side the mix of volume or revenue in terms of how that splits up?

Jackson?

Right now, the markets are favoring some of the Pacific Northwest shipments, We're seeing product move from the Midwest up to the PNW.

We're seeing uniform strength, whether it's moving Gulf, PNW or Mexico, right at the moment.

Typically for us, the PN W would be one of the weaker markets, but it's pretty strong right now.

All three, all three outlets for our international grain feeds are doing quite well.

But in terms of the size of each one, where are they right now?

I don't have the specifics on that, Ed.

Relative to each other then?

Pardon me?

Relative, are they fairly even at this point?

But just relative to where more volume's flowing?

You're going to have more volume -- would be flowing Gulf and Mexico than you would to the PNW.

That would be the smallest of the three for us.

And the Gulf and Mexico, where is that mostly moving to?

Part of it -- in terms of the final destination?

Yes.

Asian markets.

Do you have concerns at all at the end of the year, based on what we're hearing from Australia in terms of after two years of drought, it feels like they are going to have some very strong planting?

I think where that's going to impact us is the wheat markets.

If you look at last year's wheat crop around the world, the US had the bumper crop.

Everything else was relatively soft, so the Australian wheat crop and others are going to bounce back.

That says we're going to basically probably diminish some of the strength in wheat sometime around the fourth quarter.

But I think we'll still have plenty of market demand for our product and that shouldn't be an issue.

Another place where we've seen some pretty strong exports is also to Europe, and Italy in particular, for our wheat products.

We think some of that's going to roll back a little bit here in the fourth quarter, but it's not going to be Draconian by any stretch of the imagination.

We'll still have solid market demand for our grain products.

In your forecast, you have a little bit less wheat, but made up in other areas basically?

Yes.

Corn's going to be okay, despite kind of the concerns right now.

In our served territory, our corn crop should be good.

You always have the normal crop risk that you have to worry about, early frost, those kinds of things.

Some of the lost acreage got transplanted into soybeans.

Again, the soybean market should be strong.

The acreage is looking good.

The corn crop itself, the quality of the crop, we were concerned that the quality of the crop was going to be weak.

But it's actually -- the latest projections, it's back up to 150-bushels an acre, so it should be good.

Okay, and just shifting here, Jack, to coal and export coal.

You talked about Mexico and West Coast.

Can you talk a little bit about what the size of that export coal product is currently and what the capacity is to expand that over the next couple years?

Yes.

This year in total, Ed, we'll probably do about 4 million tons of export.

Probably a 1 million to 1.25 million of that is going to be off the West Coast, going to steel producers in the Asian rim countries.

Probably 0.5 million tons down to Mexico.

Then the balance is going to move to the river and head off to Europe, Spain and other places.

That's the run that there is right now.

There's actually more capacity out there from the port perspective and the rail perspective than there is right now at least, on the mine side of things.

If in fact we could get greater production out of Colorado-Utah, I think we would have some greater upside potential.

In the first quarter, I mentioned that our export potential was somewhere in the neighborhood of 8 million tons alone, just off the West Coast.

My team now would say new interest -- new contacts would say that export market is probably somewhere in the 15 million-ton range, in terms of what the potential is.

We don't know how many of those will come to fruition, but we're feeling actually pretty good.

We spent a lot of time working with ports.

We think there is some port potential capacity out there that's unused that we have the opportunity.

I think our biggest concern right now or our biggest opportunity is if we can get more production out of the mines.

What's your best guess as to when the mines can get you more production?

They are working hard at it.

It's pretty hard to determine --

Is it quarters or years away?

I would say it's quarters to -- I would say next year.

I think over the time period, I think you're 12 to 18 months away.

(multiple speakers)

The question, though, is long-term.

When does Australia come back into the market.

I think again, they are talking about a couple years.

PRB could be of interest as -- moving export.

I think, again, we've -- export coal has seen cycles and this is one of the positive ones here.

I think if it's sustainable, you'll see the supply chain response.

The other thing we're seeing on just the fill-back phenomenon of the eastern Appalachian coal going international, because we've got a lot more interest now from Eastern utilities wanting to bring in PRB coal.

Typically, what they are trying to do is blend it so they don't have to make major modifications to their boilers; but there's far more interest in trying to make those movements happen now as well.

And is that magnifying itself, or manifesting itself in terms of test burns or requests for tests?

Where are you in that process?

Yes.

It's a combination of test burns.

It's not only -- on any railroad that has a test burn, whether it's us or whether it's our competition, the contracts when they come up for opportunistic bidding, will be a free flow for all of us.

Okay.

What do you think of timing is of that?

And then I just have one quick one, and I'll let someone else have it.

You could actually see some of that come to fruition in 2009.

Okay, just the last one.

You talked about the split between 6% pricing.

What's the other 9% or so, how did that split between fuel and mix, give or take?

Up 2 points maybe mix, Ed.

Thanks.

Thank you very much for the time.

That's helpful.

Thank you.

Ladies and gentlemen, we've reached the end of our allotted time for questions.

I would like to turn the floor back over to Mr.

Jim Young for closing comments.

Well, we want to thank everybody for being on the call this morning.

I hope you see we've got some great upside going forward here, and look forward to talking to you again here in our third quarter call.

Thank you.

Ladies and gentlemen, this concludes today's teleconference.

You may disconnect your lines at this time.

Thank you for your participation.