聯合太平洋集團 (UNP) 2011 Q3 法說會逐字稿

Greetings and welcome to the Union Pacific third-quarter 2011 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 and the slides for today's presentation are available on Union Pacific's website.

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, everyone.

Welcome to Union Pacific's third-quarter earnings conference call.

With me in Omaha today are Jack Koraleski, Executive Vice President of Marketing and Sales; Lance Fritz, Executive Vice President of Operations; and Rob Knight, our CFO.

The Union Pacific team delivered solid financial results across the board this quarter, achieving an all-time quarterly earnings record of $1.85 per share.

That is a 19% increase compared to 2010.

We also set best-ever quarterly marks in operating revenue, operating income, driving record, year-to-date free cash flow.

We are clearly delivering on the benefits of our diverse franchise.

Volumes increased in four of our six business groups.

The downside was weak international Intermodal and lower export grain.

Overall, we are pleased with these results in light of the fragile economy and operational challenges related to the severe drought in Texas.

Although we deal with weather every day, the extent and duration of the drought did impact network operations during the quarter.

Lance will provide more details on this in a few minutes.

Despite these challenges, we remain focused on delivering safe, efficient, high-quality service that generates value for our customers and translates into improved financial returns for our shareholders.

So with that, I will turn it over to Jack.

Thanks, Jim and good morning.

Let's lead off this morning with a look at customer satisfaction, which set a new third-quarter record coming in at 91.

That is up 1 point from last year and reflects a continued strong value proposition, even as our operating team battled lingering Midwest flooding and the effects of the severe drought in the South during the quarter.

Our volume increased 1% with the international Intermodal peak season weighing heavily on our growth in the third quarter, but interestingly enough, if you excluded Intermodal, our other five businesses grew 6% during the quarter, even with the softer export grain market.

Our core price improved 4.5% with each of the six groups posting gains.

Those price gains, combined with increased fuel surcharge revenue and some positive mix from the decline in Intermodal and growth in carload business, drove average revenue per car up 14%.

The end result was a 16% improvement in freight revenue to a best ever $4.8 billion.

So let me walk you through each of the six groups in a little more detail.

Our Ag products revenue grew 9% as a 12% improvement in average revenue per car more than offset a 3% decline in volume.

During third quarter last year, UP's grain exports hit their third-highest volume ever.

So against that tough comparison and with increased world production this year, exports were down 31% driving the group's overall decline in carloading.

A 7% increase in domestic feed grain shipments helped to offset at least some of the export softness.

And we also saw strength in grain products where shipments climbed 5% with solid gains in ethanol, biodiesel and meal.

Despite shaky consumer confidence and weak economic indicators, the US vehicle sales were up 6% versus last year for the quarter supporting a 10% increase in our automotive shipments.

The growth in volume, combined with a 12% improvement in average revenue per car, drove a 23% increase in revenue.

Our finished vehicle shipments increased 5% despite the lingering impact of the Japanese tsunami, but the good news going forward is that by the quarter's end, US production had returned to normal for all manufacturers setting the stage for a stronger fourth quarter.

As production increased in anticipation of improving sales, our parts shipments were up 18%.

Our Chemicals volume grew 5%, which combined with an 8% improvement in average revenue per car to produce a 14% increase in revenue.

The petroleum products business led our Chemicals growth as shipments increased 35%.

Most of that growth came from crude oil originating primarily in the Bakken and Eagle Ford shale regions; although we also saw solid growth in asphalt shipments.

Elsewhere, the solid performance that we have seen across the major Chemical segments continued in the third quarter.

The one exception was fertilizer where volumes slipped 5% because of reduced export demand.

Energy revenue grew 21% as a 13% improvement in average revenue per car combined with volume growth of 7%.

Weather, again, played a role as the impact of the Midwest flooding continued in July; however, almost all of that business was made up during the quarter, as was about 60% of the loads that we missed during the second quarter.

New business to the Wisconsin utilities, along with the new coal-fired plant coming online near Waco, Texas, produced most of the 5% increase in Southern Powder River Basin tonnage; although volume actually was up to most of our utilities year-over-year.

Colorado/Utah tonnage was up 9%, its first year-over-year quarterly growth since early 2008.

Supporting that volume growth was relatively strong international market demand and also the return to production of one of the mines that had been relocating to new reserves.

Our Industrial Products volume grew 8%, which, combined with a 15% improvement in average revenue per car, drove a 24% increase in revenue.

Metallic mineral shipments doubled as our iron ore unit train business for export to China continued to ramp up.

Drilling demand in the energy market once again drove a 39% increase in non-metallic minerals, primarily frac sand, and a 13% increase in steel.

Our Intermodal revenue grew 8% as a 15% improvement in average revenue per unit more than offset a 6% decline in volume.

The volume decrease resulted from a 12% reduction in our international Intermodal shipments, primarily the result of weak West Coast imports, but also impacted by the contract loss that we talked about in the second quarter, which cost us about 12,000 units.

The news is a little brighter in our domestic Intermodal business where volume was up 2% and strengthening through the quarter.

We set a new seven-day volume record of 29,500 units during the last week of September, topping the old record set last November by 8%.

You will recall, in the second quarter, we talked to you about MCP, our mutual commitment program, that was boosting margins, but also was holding down our domestic volume.

Well, in the third quarter, that commitment program was paying big benefits for our customers as we've had near perfect delivery on our box availability commitments.

We are proving that we can keep our commitments, effectively providing MCP customers with needed capacity and reliable service, even as our domestic business tracks 6% to 7% ahead of last year's record volume.

So as we look to the end of the year, I have to admit that I have been disappointed by the weakness in our international Intermodal peak season, but the good news is that the diversity of our franchise should continue to provide opportunities to more than offset the challenges that we face in the fourth quarter.

First of all, in terms of challenges, the better world crop production and plentiful storage available for a smaller-than-expected US corn crop shows that whole grain export shipments are still going to be soft in contrast to last year's record volumes.

We are also not expecting international Intermodal to get any stronger.

But here is where we do expect to see the offset.

September auto sales were at their highest seasonally-adjusted level since April, supporting the expectation that pent-up demand will sustain our autos momentum despite the economic headwinds.

The new Wisconsin utility business, the new plant in Texas should keep our coal volumes strong, together with improved Colorado/Utah production and lower SPRB inventories, which right now still trail what would be considered normal stockpiles by about seven days.

Energy-related drilling should continue to drive growth in nonmetallic minerals and steel in our Industrial Products group.

In steel, we should also benefit from the continued recovery in the auto industry and our export iron ore should also be a growth driver for Industrial Products.

Petroleum products should again lead the way and fertilizer will rebound with seasonal demand, so we expect our Chemicals business to stay strong and the recent strength in domestic Intermodal should continue as well because retailers will be pulling inventory from West Coast distribution centers ahead of the holidays.

And I know many of you are already thinking beyond the fourth quarter and we are too.

Barring any sort of unusual or unexpected event, like a Japanese tsunami or a total US or global economic meltdown, we are thinking the slow growth trajectory that we are seeing today continues on for the foreseeable future and as we look at it, that spells real opportunity for Union Pacific.

Energy demand should remain strong and be a solid growth driver in terms of frac sand, pipe, petroleum, ethanol and biodiesel.

Strong world demand for metallic minerals and other US natural resources, like soda ash, support a strong growth outlook in those fast-growing markets for us.

Our Ag business will continue to pace with population growth, which provides a solid baseload and also allows us to take advantage of global export opportunity should they develop it.

So with that foundation and a recovering auto industry, we are delivering record results in a year where products like lumber, cement, rock and appliances are tracking anywhere from 30% to 60% below previous record volumes.

So as we think about the future, even the smallest improvement in consumer confidence and consumer spending really offers Union Pacific additional upside opportunity.

So overall, our strong value proposition, underpinned by excellent service, positions us to take advantage of the opportunities offered by our diverse franchise.

The resulting volume growth, combined with expected pricing gains, should continue to drive record revenue not only in the fourth quarter, but for the foreseeable future as well.

So with that, I will turn it over to Lance.

Thanks, Jack and good morning.

I will start with our safety performance.

In employee safety, we achieved a record third-quarter reportable personal injury rate and best-ever year-to-date results.

The continued maturation of our total safety culture, our risk identification and mitigation, and training and education efforts drove the improvement.

Our safety culture is especially important as we hire to cover attrition and volume.

In terms of rail equipment incidents or derailments, our year-to-date FRA reportable rate increased 7%, driven largely by low-cost yard and industry lead incidents.

In the third quarter, human factor and track-related incidents increased compared to the prior year.

We continue to accelerate investments in our yards and our terminals to get our exposure back on the right trendline.

Most encouraging, despite increases in rail and highway traffic during the year, our crossing accident rate improved 6% year-to-date versus 2010.

We continue to help communities address risky driver behavior and to close grade crossings.

In fact, since 2001, we have closed over 4000 at-grade crossings on the UP system in addition to educating the public about grade-crossing safety.

We remain committed to improving our safety performance on the way to operating an incident-free network.

Before getting into our service performance, I want to spend a minute on how we have managed the weather challenges you have heard us talk about.

Operations improved substantially during the third quarter in the flood-impacted areas and we are getting closer to normal business operations in that region.

Our team worked tirelessly and successfully to protect our service product through the floods.

The South was a completely different challenge this quarter.

Extreme drought in Central Texas created unstable soil conditions and when combined with record heat generated a sharp increase in slow orders.

These speed restrictions reduced capacity and velocity, requiring additional resources like crews and locomotives.

At the same time, our volume in the area grew by about 10%, putting even more pressure on the strained network.

We reacted by applying surge resources and increasing track maintenance in Texas.

Slow orders turned the corner in September and improved another 17% so far in October.

I anticipate continued improvement during the fourth quarter as we return to normal operations in Texas.

Network performance for the third quarter remained relatively strong despite these challenges demonstrating our resiliency and recoverability.

As carloads grew almost 5% from July to September, our network performance remained solid.

However, we did see about a one mile per hour impact on our quarterly velocity due to weather-related challenges.

We gained momentum in September and continue to see improvement in October.

By applying the principal of the unified plan and utilizing our surge resources, we sustained the network's service reliability and demonstrated its resiliency.

As Jack discussed, we continue to provide solid customer service at the local level.

Our industry spot-and-pull measure was 94% for the quarter, which nears the all-time record, quarterly record of 95% set in the second quarter of this year.

This is the first move and last move for a customer and it is critical to overall customer satisfaction.

This performance reflects our continued focus on the fundamentals, improving network performance, service reliability and operational efficiency.

Slide 17 illustrates some of those efficiencies.

Gross ton miles per employee were essentially flat with 2010 despite the addition of over 1000 new hires in the training pipeline and an increase in employees working on capital projects and positive train control.

Surge resources added to combat the impact of slow orders and speed restrictions that I discussed earlier also masked productivity gains during the quarter.

Those productivity gains included our work to improve train sizes.

Train lengths for our manifest and Intermodal traffic continued to increase.

The growth in Intermodal train size this quarter is particularly noteworthy considering Intermodal volumes were down 6% in the quarter compared to 2010.

And we continue to balance manpower with demand with an average of nearly 500 employees furloughed during the third quarter.

If you look at current levels, we have roughly 700 or more employees on furloughed status.

The end game is to realize the full potential of the UP franchise translated into these deliverables -- world-class safety results on the way to an incident-free network, growing the value proposition for our customers by recovering to record levels of service, continuing to generate network productivity for bottom-line results, and positioning for growth resulting from our solid service performance.

With that, I will turn it over to Rob.

Thanks, Lance and good morning.

Let's start by summarizing our third-quarter results.

Operating revenue grew 16% to a record $5.1 billion on the strength of fuel surcharge recoveries, core pricing gains and volume growth.

Operating expense totaled $3.5 billion, increasing 17%, or $516 million compared to the third quarter of 2010.

Higher fuel prices accounted for over half of the cost increase.

Operating income totaled $1.6 billion, a 13% increase and an all-time record quarter.

Other income totaled $17 million in the third quarter, $8 million lower compared to last year.

Quarterly interest expense declined 7% versus the third quarter of 2010 to $142 million, driven by lower average debt levels.

Third-quarter income tax expense increased to $549 million.

Higher pretax earnings drove this increase.

Net income totaled $904 million, increasing 16% compared to 2010.

The outstanding share balance declined 2% versus last year, reflecting our share repurchase activity.

These results drove an all-time quarterly earnings record of $1.85 per share, increasing 19% versus last year.

Turning to our top line, we achieved 16% freight revenue growth to an all-time record of $4.8 billion.

Slide 21 provides a walk-across of the third quarter growth drivers.

Car loadings were up 1%.

We also saw a positive mix impact driven by strong growth in higher average revenue per car moves.

We achieved core pricing gains of 4.5% in the third quarter, which includes [RCAF] fuel escalators.

As you know, we calculate pricing gains as a percent of our total book of business and with the bulk of our 2011 legacy portfolio coming up for renewal in the fourth quarter, it is not a major driver of our 2011 core pricing gains.

Fuel surcharge revenue added 7 points to the top line, driven by higher fuel prices in the third quarter versus 2010 and a slight tailwind on the surcharge recovery lag.

In addition to solid core pricing gains, we saw improvements in our incremental margins this quarter.

Of course, there are many moving parts impacting this number, including revenues and costs associated with weather-related challenges.

So adjusting only for higher fuel prices, our incremental margin was 41% in the third quarter.

As we said in July, our second-quarter adjusted incremental margin of 36% would be the low mark for the year.

This still holds true even with the lower volume growth that we have seen in the back half of the year thus far.

Now let's turn to expenses.

Slide 23 summarizes our year-over-year increase in operating expense by category.

As I mentioned, higher fuel prices contributed to over half of the $516 million increase in expense.

Other year-over-year increases include inflationary costs and volume-related expenses.

We also saw additional labor increases driven by higher TE&Y training costs and drought-related expenses as Lance just described.

With that, let's spend a minute and walk through each of these categories.

Third-quarter fuel expense totaled $916 million, increasing $308 million compared to 2010.

The average diesel fuel price, which increased 42% year-over-year, was the biggest driver of the quarterly change.

The average barrel price of $90 rose 18% compared to last year.

In addition, conversion spreads, which cover the cost to convert crude oil to diesel fuel, tripled from 2010 levels to an average of $37 per barrel in the third quarter.

Although our improving fuel surcharge mechanisms enable us to recover the majority of higher fuel prices, the resulting increase in expense and revenue created a negative impact of 1.7 points on our third-quarter operating ratio versus 2010.

Fuel expense was also higher as a result of a 5% increase in gross ton miles and a 1% increase in our fuel consumption rate.

Slide 25 summarizes third-quarter expenses for compensation and benefits.

Comp and benefits expense is up 9% compared to 2010.

Over half of the increase in expense can be attributed to inflationary pressures that we have discussed with you before, including health and welfare, unemployment taxes, wage increases and pension costs.

Looking forward, our initial planning for 2012 would indicate that labor inflation should moderate somewhat from 2011 levels.

Training costs were up $17 million in the quarter as we continue to hire new employees to cover expected attrition and volume growth.

And additional crews needed to manage through the slow orders and speed restrictions in the South drove expenses up $18 million in the quarter.

Lastly, the unusually large mix shift and growth in manifest traffic this quarter drove a higher volume impact on labor expenses.

Carload growth of 1% and a gross ton mile increase of 5% resulted in a volume growth impact on expense of 2% to 2.5%.

Productivity gains of about 1.5% mostly offset this increase.

Slide 26 takes a closer look at the change in our workforce levels.

Workforce levels increased 5% in the third quarter compared to last year.

We again had more employees in the training pipeline and more individuals working on capital projects, including positive train control.

Base workforce levels also increased driven by volume growth and the impact of additional crews needed to manage through the drought-related speed restrictions in the South.

In July, we indicated that our full-year workforce would be up roughly 1500 employees depending on second-half volume levels.

Currently, we still are on track with those projections.

Now turning to other expense categories, purchase services and materials expense increased 9%, or $41 million, to $506 million.

Higher contract service expense was the biggest year-over-year driver.

Locomotive and freight car maintenance costs were also up compared to 2010.

In addition, crew lodging and transportation costs increased with the growth in volume levels and weather-related challenges.

Other expenses came in at $207 million, slightly better than our guidance of $215 million to $225 million, primarily due to lower personal injury expense.

Versus 2010, other expenses were up $29 million.

Higher property taxes and increased costs for damaged equipment and freight drove expenses up in the quarter versus 2010.

Looking at the fourth quarter, we expect the other expense category to be similar to the third-quarter results, again, assuming no unusual items.

Slide 28 summarizes third-quarter expenses for the remaining two categories.

Depreciation expense increased 10%, or $36 million to $408 million, which is in line with our previous guidance.

Increased capital spending and higher depreciation associated with hauling more gross ton miles drove the increase.

We should expect a similar rate of increase in the fourth quarter as well.

Third-quarter equipment and other rents expense totaled $293 million, essentially flat with last year.

Higher container lease and short-term freight car rental expenses were offset by lower locomotive lease expense.

Bringing revenue and expenses together, Union Pacific's operating ratio illustrates the substantial improvements in profitability that we have achieved over the last several years.

On a reported basis, our operating ratio was 69.1% for the third quarter of 2011.

Ongoing productivity efforts, core pricing gains and volume growth all contributed to this mark.

Higher fuel prices continue to put pressure on our operating ratio, creating a 1.7 point headwind in the third quarter and 2 points of headwind year-to-date compared to 2010.

However, if you adjust for fuel prices, we still expect to see real improvement this year in our core operating ratio performance versus last year's all-time record.

Union Pacific's profitability in the third quarter of 2011 also drove record free cash flow after dividends.

Growth in cash from operations more than offset increased capital spending and higher dividend payments.

Cash dividends paid in the year-to-date period of 2011 were up 39% from 2010 levels.

We continue to see the benefits of bonus depreciation, which had a more positive impact on our cash flows in 2011 than in 2010.

Union Pacific's balance sheet remains in excellent shape supporting our investment-grade credit rating.

At the end of the third quarter, the adjusted debt to cap ratio was 41.4%.

This positions us well in a wide range of economic scenarios.

Our performance is generating strong cash flow and we are returning that to our shareholders.

During the third quarter, we bought back 4.7 million shares totaling $428 million, up from the second-quarter purchases.

Year-to-date, this takes our total repurchases to over $1 billion.

Looking forward, we have nearly 32 million shares remaining under our current authorization.

When you combine our dividend payment and share repurchases this year, we have returned over $1.6 billion to our shareholders.

Dividend growth and opportunistic share repurchases continue to be key components of our balanced approach to cash allocation for the long-term benefit of our shareholders.

Looking ahead, we see continued opportunities to grow and improve our profitability.

As Jack discussed, we are focused on continued year-over-year volume growth in the fourth quarter.

Of course, this assumes that the economy cooperates.

We remain committed to achieving real pricing gains driven by the increased value of our service, market demand and added benefit of competing for and repricing our legacy business.

We believe that continued revenue growth and our ongoing productivity efforts should produce record earnings in 2011 allowing us to reward our shareholders with even greater returns.

So with that, let me turn it back over to Jim.

Thanks, Rob.

Now before we open up to questions, I wanted to provide a quick update on the national labor negotiations.

As you know, the United Transportation Union, which is the industry's largest union, ratified a new contract earlier this year.

We think the agreement is fair and equitable to both parties.

The remaining unions were released from mediation, which led to the creation of the Presidential Emergency Board.

The PEB is scheduled to submit their recommendations by November 7.

In the meantime, the industry remains committed to achieving a negotiated settlement that reflects the patterns of the UTU agreement.

Our employees are critical to the success of this Company.

We currently enjoy good working relationships and we expect that to continue as we move forward through the negotiation process there.

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

(Operator Instructions).

Bill Greene, Morgan Stanley.

Yes, hi, good morning.

Hey, Jim, so if we are looking at this -- if it weren't for fuel and the weather stuff, you had an OR below 68% and I realize the third quarter is typically your best, but I have got to think that this kind of performance gives you a much greater conviction in your ability to hit the long-term goals, regardless of kind of how the macro plays out.

Is that sort of fair?

I think that is very fair.

So we have got a big legacy reprice next year.

How does Union Pacific sort of think about updating that long-term guidance then?

Is it -- do you have to get there and then you will address it or --?

We can sort of see these trends.

It is a big year next year.

Well, Bill, to me, the real wild card is where do we think the economy is going.

If you get some upside in the economy, obviously, we have a greater potential going forward here.

We will stick with our current guidance.

We have said 65% to 67% OR and see how things go.

But we are feeling pretty good about the markets, the pricing we are able to get for the value we are providing and then efficiency.

No, it makes sense.

And then just on pricing, fourth-quarter pricing, we have been flat all year.

Given that the legacy is way at the end of the quarter, is that safe to say for 4.5% that there shouldn't be a big step-up or we will actually see the legacy in the fourth quarter?

Not in fourth quarter.

You will see the impact of legacies in next year.

Okay.

So the acceleration comes next year.

All right, thanks for the time.

Peter Nesvold, Jefferies & Co.

Good morning, guys.

Call volumes were unusually strong in the context of the other Class 1s for the quarter, particularly Burlington.

I was just curious if there is any thoughts on the outperformance.

I mean was it just kind of where the relative flooding was geographically and you just kind of got the long straw?

Or was it some kind of marketshare gains or anything else that sort of impacted the flows during the quarter?

Peter, the prime difference there was flooding.

Clearly, BN got hit much harder than we did.

Look at their announcement they had on their capital, that gives you an indication of what kind of hit they had.

There wasn't much in terms of share shift at all.

Okay, great.

And then the follow-up, with the reprice coming up at the end of fourth quarter, any perspective on how volume-dependent the potential for yields are as you negotiate that or as that new contract goes into effect?

Thank you.

Well, again, the legacy deals that we have negotiated and are currently still negotiating will carry over into -- really you will see the impact in 2012.

I mean the big spreads in some of these, obviously, are you look at what happened here with our falloff in Intermodal versus the other groups this year, but we have got very good opportunity next year.

But you don't feel disadvantaged at all going into that process, the fact that volumes are much -- I mean the volume growth has really slowed here in the last three years or so?

No, these are long-term propositions when you look at them.

We are making -- you are making deals that are many years out.

So the assessment is won on what is the value proposition that the UP franchise can offer.

Great.

Thank you.

Chris Ceraso, Credit Suisse Group.

Thanks, good morning.

Just a couple of quick ones.

First, on the wage and benefit front, can you give us a feel for what kind of inflation you are looking at over the term of the next contract?

Rob, go ahead.

We are not going to get into the specifics on the contract, Chris.

But one thing just to comment on, the overall inflation on the comp and benefits line, we said it is about 5.5% this year.

We expect that to moderate as we head into 2012, somewhere more in the call it 4%-ish range rather than the 5.5%.

Chris, I mean the UTU deal, if you look at it, it is 17% over 5.5 years.

So you can kind of get a feel there in terms of the math.

The real key is healthcare costs, which is, if you look at our contract, what was put on the tail of the contract, there is very little in there in terms of work rules where we see the biggest opportunity long term as, again, as most businesses in America are struggling with is rising healthcare costs.

Okay.

And then just one on your Automotive business.

Can you give us an idea of how much of your auto franchise is with the Japanese OEMs?

Jack?

We have about 30% with the domestic big three -- about 70% with GM, Ford, Chrysler and then about 30% with everybody else.

Okay, thank you.

Tom Wadewitz, JPMorgan.

Good morning, it's Michael [Wines] in for Tom.

Congratulations on a great quarter.

I guess to start with, on coal, could you give us the actual stockpile levels?

You said it was down seven days year-over-year and that you guys had made up 60% of what you had lost in the second quarter and is that expected to -- is the remainder expected to be made up in the fourth?

Jack.

We'll probably make up the rest of that in the fourth quarter, I would expect.

And the other thing, Michael, I don't have the exact numbers in terms of 59 days versus 52 days, those kinds of deals, but there is a seven-day differential.

I would expect, as you look at those numbers, that is the Powder River Basin stockpile situation.

I would expect those tend to probably be more reflective of what is happening with the BN customers given that they were more severely impacted.

But we should still see fairly solid coal volumes here in the fourth quarter.

Okay, great.

And for the second question, related to headcount, you had said that you are still expecting the 1500 increase year-over-year.

Is that an end-of-quarter fourth-quarter number?

Average fourth-quarter number?

Yes, it is.

(multiple speakers)

End of quarter, but fourth-quarter projections.

So that kind of implies a slight decline from third quarter.

Is that related to Texas?

It is a slight decline, but it is just based on our projection of where volumes -- well, basically just what volumes have done here in the back half of the year.

Typically, we reduce headcount late in the fourth quarter for seasonal purposes.

Some of your capital projects.

Right, okay.

Just wanted to clarify that.

Thank you very much for the time.

Chris Wetherbee, Citigroup.

Great, thanks.

Good morning, guys.

Rob, you mentioned the incremental margins and the ability to kind of get a little bit of an acceleration potentially.

Do you need to see the legacy contracts start to roll through or is this the type of progress that you might be able to make in 4Q, assuming that you don't necessarily get hit with another type of weather interruption?

It is kind of all of the above, but, again, reminder for the fourth quarter alone, we don't expect to get much additional uptick yield from the legacy.

That is mostly going to carry over into 2012.

So as we look in the fourth quarter, it is going to be volume, productivity, ongoing pricing initiatives that are underway.

And just again, a reminder, for us to hit our long-term guidance of that 65% to 67% full-year operating ratio by 2015, that implies, on an annualized basis as we look forward, that we will be in that incremental margin neighborhood of about 50%.

Okay.

And that is taking into consideration the legacy repricing as we look forward.

Sure.

No, that's helpful.

When you think about furloughs, you take a look at the average number, then what you ended the quarter with.

Obviously, it picked up a little bit while volumes were starting to accelerate.

How do you think about that number for the fourth quarter?

I am just trying to get a sense of what is driving the furloughs.

Is it just timing issues or is there something else behind it?

Lance, do you want to deal with furloughs?

When you think about the fourth quarter and furloughs, what is going to happen is, as peak season starts bleeding off, typically on the TE&Y side, our furloughs will increase.

And likewise, as we start getting frozen out of some parts of the network from a maintenance away and capital project perspective, we start furloughing also on the maintenance away side.

And Chris, the big driver here, I mean the surprise to us was one on international Intermodal.

And if you look across our regions, North, South and West, the biggest round of furloughs was out West simply because there was very -- really no decrease in the international business this year.

Okay, no, that's helpful.

One final quick one, Jim, from a process perspective.

We get the PEB recommendations at the beginning of November.

What is the process after that?

What do we think about the timeline going forward after recommendations come in?

Well, you have got really another 30-day cooling off.

I mean the key date is around December 7 in terms of when the potential would be there for some actionable parties.

So as we've said, November 7 is the date that the PEB recommendations come out and both parties have to take a look at those recommendations and negotiate from there.

Great.

Thanks for the time, guys.

I appreciate it.

Ken Hoexter, Merrill Lynch.

Great, good morning.

Lance, that was a great overview on the handling of the drought and kind of goes back to the middle of the 2000s when you kind of sat there going through El Paso and Phoenix when you had problems, but it is great to see how smooth things bounce back now.

But when you think about the equipment status, you kind of gave the employee furloughs.

Can you talk about the equipment side?

What have you done on the locomotives parked there?

What do you need to do in terms of CapEx?

It sounded like you added a bunch of locomotives.

What do you need to do now to get that back reset to ongoing operations?

Sure.

So on the locomotives side, as the South continues to come back to normal, you will see us being able to bleed off some of that locomotive count, put those back in storage.

We are at about 600 units right now and as the South gets normal and as volumes from the peak season start dropping off, you will see that storage number grow.

The reason why we are buying locomotives next year isn't just a volume story.

We have got locomotives in the capital budget next year for a number of reasons.

We get a pretty decent return off of them driven by fuel efficiency, the fact that they are DPU-enabled and that helps us on the train size, productivity side of the story.

And then I think we have talked to you before about Tier 4 requirements, another federal mandate that takes effect in 2015 and purchasing locomotives now is a little bit of a hedge against the fact that the manufacturers of locomotives do not have yet purchasable locomotives that meets those 2015 guidelines.

So there is a little bit of a risk hedge in that purchase as well.

And also can you talk about how the progress -- I guess maybe, Rob, also on the progress of the UMAX domestic network.

What have you done in terms of containers and how has that progressed with CSX since you've rolled that out?

Jack.

We are having great success with UMAX.

We are feeling good about it.

Like I said, our domestic Intermodal volumes right now -- last year, we actually hit a record in terms of domestic Intermodal during kind of the second phase of peak season.

So if you think about peak season in terms of international phase goes first and then domestic, so now we are in the domestic side, we are 6% to 7% stronger than we were a year ago.

And it looks like that is going to probably continue on at least for the next several weeks.

So we have made some great product offerings with the CSX.

We have been running really well in terms of our on-time delivery despite things like the floods and some of those kinds of things.

So we are well-positioned.

Yes, we have got good programs with both, NS and CSX.

There are no domestic containers stored today on the UP side.

I think the other thing you want to keep in mind on demand here, the sales inventory ratios are still very, very tight.

And as you see in the domestic trucking sector, capacity is pretty tight.

So it will be interesting to see how the rest of this year plays out given tight inventories.

And we are pretty balanced in terms of the number of containers that we have in both programs, so it is a nice opportunity for us.

So Jack, how should we read that though?

If you said that the domestic -- obviously, nothing in storage and we have moved into the second part of peak and you are seeing that used, but yet the international remains so weak because of the short and brief peak season, is that just still all truck conversion that is still going on out West or how do you read the differential?

That is a really good question because when you look at what is happening, inventory levels -- if you look at inventory to sales ratios, you are not really seeing any improvement.

They are still historically low.

So you are seeing a lot of product that is moving distribution centers to stores, a lot of what I would describe as more like spot purchases of retails and we are seeing a lot of truck conversion in that process.

So that has been a very strong growth arm for us in terms of that highway conversion.

Great.

Thanks for the time.

Gary Chase, Barclays Capital.

Good morning, everybody.

I wanted to see if I could ask a couple of Jack on the export side.

First, I saw recently that Russia was not a formal ban like last time, but limiting some of the exports.

I wondered what your thoughts were on that, if it was factored into your thought process about volume declines, continued volume declines in the grain export business in the fourth quarter.

Yes, Gary, we are looking -- last year we had a record fourth quarter.

We had all kinds of good things happening.

We had the Russian drought; we had the Ukraine banning the export of their grain and other problems around the world.

The whole situation has turned around differently for us now, so Russia is very strong in terms of their production capability.

We have tough comps.

So we are actually expecting that we are going to see somewhere in the neighborhood of like a 5% to 6% decline in our export grain movements in the fourth quarter.

Okay.

Then I wonder too if the iron ore exports that you were referring to were higher rated business than what you might see in the rest of the industrial book, because pricing there looked solid.

And there are some who are wondering if maybe some of the exports to China of iron ore will cool off a little bit looking forward.

You know, our book of business for export iron ore is priced well.

We are very comfortable with our profitability and the reinvestability of that business, but that is also true of our other business in our Industrial Products world.

Have you got some pretty good visibility on those exports for the fourth quarter?

Yes, we think it is going to continue to be strong.

We are going to continue to move -- it is always kind of one of those deals where you have to watch China very carefully because they consume, I think, about half of the world trade in iron ore today.

So should they decide to change course here relatively quickly, we have seen how that can happen.

But right now, we are looking for a solid fourth quarter.

Gary, you know, the other thing to keep in mind while we have got some of our international markets so pretty hot right now as Jack mentioned, you have -- within the Industrial Products group on the domestic side, we have markets that are still 30%, 40%, 50%, 60% below where they were in the peak.

Anything related to construction is 40%, 50% below.

So while we have got some markets that are hot that could cool off a little bit, you have got others that are barely alive I guess is maybe the best description.

Okay, guys.

Thanks very much.

Scott Group, Wolfe Trahan.

Thanks, good morning, guys.

So with the upcoming legacy opportunities, I am wondering how much of that business is already locked in with new contracts.

I guess I'M trying to understand if there is a rough percent of the business you feel confident that you're going to keep?

Jack, do you want to take that one?

You know, we are making good progress on all of our legacy negotiations as it stands right now, and we are very comfortable with that we are working hard to retain all of that business.

Hey, Scott, you know at the end of the day we have lost some of our business when you look at repricing these legacy deals.

I mean we are competing with the other guys and in some cases, we have lost some of the business.

And the key is we are setting some minimum returns that we look at and if we can't get it, I am willing to walk.

So in the cases in the past where you have lost a legacy deal, obviously, there is a volume and a revenue hit, but does there tend to be much of an operating income loss from losing a legacy deal?

Well, short term, anytime you take out a pretty good chunk of revenue, we can't get cost out fast enough, so you do take some pressure in your operating income.

On the other hand though, we can redeploy some assets.

If you think about locomotives, some of the -- our track capacity is pretty generic when you look at the way products move.

We also are able to take advantage -- we have a continuing attrition on the workforce side.

We are going to lose about 4000 employees a year for the foreseeable future.

So you can fairly quickly adjust your workforce, but I have got to tell you, the first quarter you lose that revenue, it usually has a negative impact on the bottom line.

I guess I was just thinking that these are probably lower margin if any margin business.

Well, they are clearly -- and some of these, we are losing money in every carload we handle from a long-term variable cost perspective.

So I mean that is why the sense of urgency and why it is so important that we have got to get these margins up in this business.

So you are right.

In that context longer term, it isn't quite as big of a hit, but it is still a little bit of a hit.

Great, that's helpful.

Just second question, as you prepare for continued slow growth, if that is what happens, what should that mean for headcount next year?

I am wondering when you expect the headcount growth and the volume growth to come more in line.

Is that an early 2012 event or not till late 2012?

Well, long term, what we would expect to see is -- again, let's assume you have got positive growth year-over-year, you will see headcount increase, but not at the same rate.

We got ourselves caught a little bit this year that we have a lot of people in hiring.

The international Intermodal was much -- came in negative, so we got caught a little bit with surplus resources.

But, again, long term, you won't see the same kind of growth, volume and headcount.

And Jim, I mean the other thing that is going to normalize is the delta, just the pure delta in the training pipeline, which we have talked about several quarters and the pure delta in the capital headcount.

Now keep in mind, we are also hiring for PTC right now that doesn't have anything to do with volume.

So you've got to separate out a little bit.

Now, at the end of the day, we have got to recover that cost in the business.

There is no excuses, but where you look at kind of the pure volume-related numbers, we should continue to see productivity every year.

When do you think we normalize?

I think you are going to see that probably fourth quarter or first quarter next year.

A little bit better comps on our labor and our force levels.

Great.

All right, thanks so much for the time, guys.

I appreciate it.

John Larkin, Stifel Nicolaus.

Good morning, gentlemen.

Thanks for taking my question.

There has been a lot of talk about natural gas substitution at power plants in the East and also the impact of the new EPA regulations that are going into effect next year.

Is there any risk to your coal business next year or the year after from these two sources?

Jack.

Yes, John, there is always some risk to that because of the grid and how it plays.

Most of our utilities -- our utilities are fairly modern productive.

So in the overall distribution of things, we don't have that many that we see as potentially shutting down.

But any time that any new utility is being constructed or things like that, certainly with natural gas hanging in there in the $3 to $4 range, it is a pretty attractive alternative to building a coal plant.

But I think we are going to be okay next year in our coal business.

Thank you.

And then just on the NIT League's proposed reciprocal switching idea that is now sitting before the STB, do you think that gets any traction at all even as a test case?

We will have to see.

I mean we, obviously, have made our comments in terms of -- I mean it is access.

You can call it whatever you want to and I think we have been consistent in our message that anytime you introduce some kind of artificial competition, which it is, there can be a consequence in our growth in capital.

So we will see what happens in terms of ultimately what comes out of the STB.

Thank you.

Justin Yagerman, Deutsche Bank.

Hey, good morning, guys.

I was curious just an update given the backtrack in volume growth that we have seen here.

Where do you feel you are right now with the network capacity and given the operating leverage you guys were able to generate in the quarter even with low volumes?

I'm curious what a nice uptick in volumes would look like and how you would be able to handle that.

Lance.

Sure.

We feel very good about the amount of capacity we have gotten in fixed infrastructure.

Once again, our peak carloading month was north of 200,000 7-day carloads.

Now as we have continued to invest in the right areas in the network, we have substantially improved the service product that we have in comparison to what we delivered during that 200,000 plus month.

But as we look forward, with the capital program that we have got in place or planned for and the way that the network is operating, we feel very good about the amount of capacity that we have got in fixed assets right now.

Are we talking 10 to 15, 15 to 20 in terms of being able to handle additional room?

Justin, it's very dependent on where that growth occurs and how quickly it comes on, but in terms of any reasonable estimate of what we think is going to be happening as we look forward, we are very well-situated to be able to continue to provide excellent service and handle the growth.

Great.

And just a follow-up question, was curious, you called out on the Chemical side the great growth that you guys are seeing off a small base in terms of crude opportunity in the Bakken and Eagle shales.

Can you give us some sense of what kind of indications you are getting?

I am assuming unit train business, pretty profitable stuff.

Where is the growth there for that business and how long of a ramp do we have in front of us for that?

Jack.

Overall, Justin, I think the growth potential for the business is excellent.

I mean the primary play we are seeing right now is Bakken, but Eagle Ford is just starting to come in on our railroad.

And so you're right.

It is positioned well from a profitability point of view.

Rail actually provides some great flexibility for those customers that basically doesn't tie them into a single destination on a pipeline.

So even as pipelines get built and developed, we continue to think that, for the foreseeable future, rail is going to have a play in this marketplace and it is going to be a solid growth opportunity for Union Pacific.

How does the profitability of that business compare to coal unit trains?

It depends on contract to contract, but it is solid profitable.

It meets our reinvestable criteria and we are very happy with it.

Great, thanks so much, guys.

Cherilyn Radbourne, TD Newcrest.

Thanks very much and good morning.

As we sit here with sort of an uncertain economic outlook, I wondered if you could just talk about the cost levers that you could pull in the event that volumes came in lower than expected and just comment on the extent to which it is more difficult to adjust to a small volume decline versus the kind of big declines we saw during the financial crisis.

Well, if you look back at the last -- I think a good model to look at what happened when we had, in 2008, early 2009, when you had a falloff in business.

Now that was pretty substantial if you recall.

I think second quarter of '09, we were down almost 20%, 25% on volume.

We have the opportunity, as I said earlier, that we are losing about 4000 employees a year through attrition.

What happens, and even in a small falloff in volume, we will try to take advantage of where we can that attrition.

If that means we don't -- we slow down hiring, which is what we have done here on the Western part of our region, we can try to respond as quickly as possible.

When it gets into locomotives and capacity, things like that, obviously, in the short term, you are not going to be able to do much, other than put some in storage.

But, again, a short-term blip either down or up, you are not going to get as much response.

The question is, if you see this thing turning down here and you start looking two, three, four or five quarters, you will see us being able to take more advantage at taking costs out.

And what indicators are you guys relying on to assess the business at this stage?

Well, we start with our customers' perspective.

We are very close to our customers, trying to understand where they are making investments, where they are putting capacity in.

There are long leadtimes on that.

And so far, it is still very strong when we look in several of these groups here.

At the end of the day though, we look every morning at what were loadings yesterday and pretty intense running the business daily and if we see things turn off sharply, we will respond.

You try to be as proactive as you can, but nobody has perfect vision to the future here.

Thank you.

That is all my questions.

David Vernon, Bernstein Research.

Hi, could we maybe talk a little bit about the domestic Intermodal yield management efforts, kind of what kind of business is actually leaving the network and how that pricing discussion is going and what's kind of the runway that you look at on that Intermodal repricing?

Jack.

Any business that you see right now leaving the network is being replaced on a fairly strong basis by truck conversions.

So for instance, if you just think about our little streamline subsidiary did 80,000 moves last year, it is growing 20%.

84% of that business in the third quarter is coming off the highway.

So highway conversion is more than making up for anything that we lose for us in terms of our yield diversion and we are particularly seeing that now in the third quarter.

Originally, in the early part of the year, we were having a little bit of a startup issue with our MCP program just because it was something new and different and the idea of making a commitment was something that some customers weren't all that excited about.

But I think what they are seeing right now is we are doing such a great job of that and they are already starting to talk about signing up for next year and giving us some strong indications with our service performance and the way we are meeting our commitments, it will be a solid path forward for us.

So we are actually feeling quite good about that.

So does that mean that the full 6% year-over-year decline was international import/export then?

Yes, actually --.

Or it was actually a little worse.

Then there was the domestic offset then?

When you see our third-quarter results -- if you looked into our third-quarter results, our international business was down 12%.

Our domestic business was up 2%, but that 2% is a weak start to the quarter that built to a relatively strong end to the quarter.

So the 2% isn't really -- like I said, right now, we are running 6%, 7%, 8% better than a year ago.

Okay, great.

Thank you.

Walter Spracklin, RBC.

Thanks very much.

Good morning, everyone.

So my first question here is just for Lance, perhaps on your train size, it is trending very nicely here ticking up each year.

Can you talk to us a bit about what you see average train lengths being ultimately once you reequip your fleet with your current targets, both on manifest I guess and to put it into context Intermodal train lengths as well?

And touch a little bit on DP and what percentage of your fleet is currently equipped DP compared to where your current targets are for a percentage of your fleet equipped with distributed power?

First on train sizes, the short answer is we have got plenty of opportunity to keep growing.

I think that Intermodal number this quarter was something like 170 plus.

Depending on the Intermodal lane, that can easily reach 200, 250 and we have probably got some lanes where it could go north of 250.

So we have got plenty of upside there.

On the manifest side of the world, we have got upside from the high 80s number that we are recording right now.

And when it comes to DPU strategy, every incremental road unit that we are purchasing at this point forward is DPU-equipped and all of our current DPU locomotives are fully utilized.

I want to say somewhere in the 60% ballpark of our traffic right now is DPUed and that is just going to grow as we look forward.

And in terms of the total percentage of road fleet that is DPUed, I can't answer that off the top of my head, but it is a fair portion.

It is a pretty substantial portion.

Walter, keep something in mind here though.

We could significantly drive train size up if we sacrifice service.

The challenge that the operating team has is to run as efficient train size as they can, but meet aggressive service targets.

So that is the balance you have to wrestle with here.

I am telling you service pays off big time.

We are seeing that in the market when we are redoing these deals and the value that is there.

So we have got to always keep both of those in mind, train size and the service commitment.

And that is an interesting -- that is an interesting point in terms of that being the bottleneck.

Your infrastructure is not the bottleneck, your sightings are long enough now to handle 200 to 250 car length trains.

Is that a fair statement?

No, we still have opportunities on capital, particularly you look down in the South that we are struggling with today, that we can improve the productivity and efficiency there.

Lance, do you want to add anymore?

Sure.

Yes, it's just very dependent again on the quarter and the specific route you are talking about.

Although, again, our current capital plan long term and near term takes that into account where we anticipate growth is going to be happening and we have got a solid capital plan to enable continued productivity and service improvements.

Okay, that's great.

Second question here is just sort of a minor one.

Jack, would you be able to quantify for us the percentage of your book that is currently legacy, how much you think of that is going to get repriced in the fourth quarter of 2011 and the estimated lift?

You have talked about a 100 basis point opportunity in average core pricing lift.

Is that still the case?

I'm trying to look at my chart here.

Walter, you have stumped us here.

Go ahead, Rob.

I would refer you back to the slide that you have seen us present in the past, we didn't have it in our deck today, that shows the breakout of legacy by year.

In 2012, as a reminder, we said there is about $300 million worth of business up for renegotiation in our legacy book in 2012 and we break it out in multiple years beyond that.

But we haven't provided specific guidance in terms of what the uplift will be other than, if you look backwards, we have said we have gotten about 2 points of yield annually from the benefit of repricing legacy.

We haven't given guidance as to what that uplift is going to be going forward.

Okay.

And if I remember correctly, I think 2011 was the bulk -- was the biggest year out of the next three or four years.

Yes, 2011 was about $750 million, which was the back-end loaded comments that we have made.

Right.

Okay.

That is all my questions.

Thanks very much.

Matt Troy, Susquehanna Financial.

Thanks.

The export coal story has primarily been one dominated by the Eastern rails.

We have recently seen some concerns about cooling export demand, which I think any sane person would expect off this year's peak.

But we continue to think it is a multi-secular -- multiyear secular run.

You have got a couple of terminals that have been announced or proposed on the West Coast.

I am just wondering -- Gateway Pacific, (inaudible), Port of Morrow, St.

Helens, Grays Harbor, Coos Bay.

Which projects have you been approached about or are you in discussions with and when do you see them potentially coming to fruition so you guys can move some export coal off the West Coast?

Jack.

Matt, we are interested particularly in the ones up in the Longview, Washington area, the one -- I think it is called Alhambra Energy, the Australian company.

That one has some real opportunity for us and virtually any of the ones that we can access, we are also looking at some Gulf Coast opportunities and even some possibilities moving down to Mexico.

So I think the big question for us, particularly on the West Coast and the domestic US marketplace, is whether or not those construction projects will actually take place and whether the EPA and the environmentalists and things -- I mean they have put a lot of roadblocks up in terms of getting those projects approved and under construction.

So that is the thing we are watching most right at the moment.

Got it.

Second question, which will be my last question, would be just on exports again.

Obviously, imports were disappointing this peak season.

I was thinking more up in the export side.

You have seen some fairly robust numbers out of the Port of LA.

I think in the last three months, up north of 20% in terms of full box exports out of LA.

Are you seeing any of that business and could you just maybe clarify, if you are, what is it that you are moving to port that is going the other way?

We are moving the iron ore business, we are moving a lot of export soda ash, export fertilizers and then in the boxes themselves, we are seeing everything from DDGs to grain.

There has been some proposals -- well, scrap paper is also a big item.

There has been some proposals for commodities even like iron ore as a potential to go back.

Just about anything that will fit in a box and that is reasonably possible are things that a lot of the companies are looking at to take advantage of that excess capacity.

So fair to say that it's a lot of different businesses and a lot of active discussions at present?

Absolutely.

All right.

Thanks for the time.

Jason Seidl, Dahlman Rose.

Good morning, everyone.

Two quick questions.

In terms of maybe not legacy business left to be repriced, but what percent of your book of business was repriced say from December 2008 through maybe the first quarter of 2009?

When you look at it, there is 60% or 70% of our business -- no, there is about 60% of our business that either moves under tariff or moves in one-year letter quotes, so all of that gets repriced every year.

And then on an ongoing basis when you look at our multiyear contracts, this year is a little bit of a larger group than what we have seen, but the number just right off the top of my head is something in the past 12 months is going to be somewhere in the neighborhood of $2.5 billion, $2.6 billion.

$2.6 billion.

Okay, thanks.

That's good color.

And that would include both the legacy and the non-legacy.

Okay.

Fantastic.

When I am looking at, obviously, your domestic utility business, the question was asked if any of the regulations actually could hurt you.

I am going to ask it the other way.

Can any of them actually help you because, obviously, the CSPR regulations, they have changed a little bit over time, but we have been hearing that some of the utility buyers might have held off a little bit of buying some thermal.

Do you think they could actually start changing the bases they purchase from going forward?

It could.

It could be a positive for us.

It just depends on how quickly the evolution takes place and what is planned.

One of the things we are seeing right now is actually kind of the side benefit of some of those regulations is the potential for moving either limestone or trona as a scrubbing agent to help meet some of those.

So when faced with kind of a long-term decision, the quickest and most immediate thing might be to just put in a quick scrubbing solution that doesn't cost quite as much like the trona manufacturers offer to the utilities and that turns out to be a nice piece of business for us.

Okay, thank you for the time as always.

Jeff Kauffman, Sterne Agee.

Hi, it's actually [Conchetta Nebretti] in for Jeff.

Just had a question, if you could talk about some of the changes that you are seeing at the ports of call on the West Coast and if you are seeing a net benefit from increased containers being dropped off in Oakland versus Los Angeles and Long Beach.

Jack.

We are not really seeing any major shifts or changes actually.

And probably this isn't a good time for us to really see a lot of those because there is plenty of capacity everywhere, volume levels are below what they were a year ago in the third quarter.

So we are not seeing any dramatic shift taking place.

And then one more question.

Of the 7% increase in derailments per train miles, how much of that was related to weather and the heat and the drought?

Lance.

Yes, some was related to the heat and the drought in Texas, clearly.

A lot of very low value train derailments track caused in yards and terminals and so there was a little bit of an impact there as well.

Thanks so much.

That is all I had.

Thank you.

There are no further questions at this time.

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

Jim Young for closing comments.

Well, thank you, everybody, for joining us this morning.

I hope one of the things you recognized -- I think this quarter really reinforces the value of the diversity of the UP network and we had some surprises on some of the areas on volumes, but, once again, the diversity paid out for us.

So we look forward to talking to you again with our fourth-quarter earnings.

This concludes today's teleconference.

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Thank you for your participation.