Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Once again, I'm Brandon Oglenski, airline and transport analyst here at Barclays. I just want to welcome you again to our Industrial Select Conference. Next up, I'm very honored to have Union Pacific here. And joining us will be Lance Fritz, CEO and Chairman of the company; as well as Jennifer Hamann, Chief Financial Officer. And a lot of you will know and remember her because she did head up IR first. How long ago was that?

It was fairly -- IR was in 2011. So it's been a while, believe it or not, but I was there for 10 years. So it's a long run.

Well, welcome back to all the pesky analysts. So if we can queue up the audience response. Question one, do you currently own Union Pacific, overweight, market weight, underweight? [Voting]

And just by some context here, obviously, Union Pacific has gone through a lot of change recently. You guys have gone through a big operational overhaul. I know we're going to talk about that.

Yes.

And question number two, please. What's your general bias towards Union Pacific right now? Positive, negative or neutral? [Voting]

But you guys have seen tremendous change in the business and great earnings growth, great stock performance.

Yes. Great productivity is really what it's about so far.

And then question number three. In your opinion, through-cycle EPS growth for Union Pacific will be above peers, in line with peers or below peers? [Voting] I just want to say, a lot of investors here, the core holding is Union Pacific. So I know we have a whole lot to talk about.

Great. That was reflected in the answers.

Yes. Yes.

All right. Lance, I know you had a few things I think you want to open up with. So...

I do, and thank you, Brandon. So I'm going to read from a script. Before we start, I'll remind everybody that I'm making some forward-looking statements that are subject to risks and uncertainties. So I'd ask you to refer to the UP website and SEC filings for additional information about our risk factors. As I begin, I want to recognize the great work that the women and men of Union Pacific did in 2019. And then I want to provide a little insight into what we're looking at in 2020. For the full year 2019, we reported earnings per share of $8.38, which was a 6% increase over 2018. Through the implementation of Unified Plan 2020 and other initiatives, we achieved a record $590 million of productivity that drove significant cost out of our network. Those cost savings helped produce an all-time record operating ratio for us of 60.6%, which was an improvement of 2.1 percentage points from 2018. And recognizing the importance of providing strong returns for our owners, we returned $8.4 billion of cash to our shareholders in 2019 through a combination of dividends and share repurchases. These results are remarkable given the weather challenges that we faced while completely revamping our transportation plan, as Brandon mentioned. Our employees are transforming our railroad to be more reliable and more efficient. One area where our results last year were not good enough is in safety. Operating a safe railroad benefits all of our stakeholders. It benefits our employees, our customers, our shareholders and the communities that we serve. And we're going to continue to use a multifaceted approach to safety improvement. They're all grounded in identifying risks and finding ways to mitigate risk. We're committed to running a railroad that constantly improves in safety, returning all of our employees home safely after every one of their shifts. Turning to 2020. We're focused on growing our business with a service product that's more efficient, reliable and consistent. We know there are real tangible opportunities to leverage enhanced service product both in existing and new markets. On a larger scale, the plastics market will continue to be a positive for Union Pacific with our strong franchise in the South. With planned expansions continuing to come online over the next few years, we're well positioned to grow with new and existing customers. And we feel that our plastics network with its robust storage and transit and export capability separates us from our competition. In international, the international -- excuse me, in intermodal, the international market has some challenges right now, but we're actively seeking ways to grow, both in international and domestic. An example is our participation in a new Butler, Iowa intermodal terminal. It's in North Central Iowa and it provides an alternative to larger Midwest rail hubs and gives shippers a cost-competitive solution that reduces their dray truck miles. Most importantly, it allows our customers to find new rail solutions with Union Pacific, and it demonstrates our ability to adapt our service to be competitive in a constantly changing market. I'm going to wrap up with some high-level guidance for 2020. It's repetitive. We expect slightly positive volumes on a full year basis. We expect pricing gains to exceed our inflation dollars. We expect at least $500 million of productivity savings. The achievement of those goals should result in another strong step forward in our operating ratio, which we expect to be a full year number around 59%. Achieving those goals in 2020 is another step on the path towards our longer-term goal of getting in the 55% ballpark. Finally, Union Pacific is dedicated to being a positive force in building a sustainable future for everyone. While rail is already 4x or more fuel-efficient than truck, we recognize there's still more we can do. We're going to continue to reduce our carbon footprint through more efficient operations, conserving resources for ourselves, our customers and future generations. We're committed to providing value for all of our stakeholders. Thank you, Brandon.

Okay. Lance, I really appreciate that. And this might not be a fair characterization for the history of Union Pacific. But the industry at large, especially in the U.S., the U.S. rail industry, we used to look at Canadian National and say, "Well, they have the best margins, best returns." And Justin Lane was just talking about that up on stage here. But they have a simple network up in Canada and socialized health care costs, you name it. U.S. carriers shouldn't be expected to replicate that. But today, I think you guys might have actually beat them on the OR last year. You've actually hired Jim Vena, their former Chief Operating Officer. He's now your Chief Operating Officer. So I guess what changed in the past decade where there was this realization now that railroads can be run more efficient, there's more opportunity?

Yes. Brandon, I wouldn't say that we thought there was a block from running efficiently and well, and ultimately, being the best in the industry. We followed a model for years that shaved off 2,500 basis points from our operating ratio. So we look backwards at that and think that was a very effective model for what we were trying to accomplish. In a nutshell, what that model did was it broke our business into really more discrete networks and then commingled those networks into our transportation plan. So for instance, you go back 3 or 4 or 5 years, 40% or 45% of our business might be in a manifest train. That's where different commodities, different freight cars ride 1 train. And the rest of the business was broken out into unique unit train segments. That might be rock, ethanol, grain, international intermodal, domestic intermodal, on and on and on. You fast forward to today, and after treading water for a little bit with that model at about 62.5% or 63% operating ratio, we figured there's a better way for us to run the railroad. We're going to have to do something differently. What was happening is coal was going away, so there was becoming much less opportunity to have these large, efficient unit train networks, and it was putting pressure on us to try to find a different way to run the network and get efficiency and more like consistent reliability out of it. And that's why we switched to the Unified Plan 2020, which is PSR. And at its guts, what we fundamentally did was we commingled a lot of those unit train networks into a manifest train. And then we grew those manifest trains and stopped touching cars. If they didn't need to be touched, we didn't need to do the work. And that took a lot of work out of the network. It took train starts out of the network. And it improved the reliability of the service product. So today versus 4 years ago, true train starts are probably down by about 1/3. That's a dramatic number. Local service is probably flat, maybe a little higher here, a little lower there. And yard work is probably down by about 20%. So that's how you get a much more consistent, reliable service product that's simplified, and that's how you take $590 million out of the network last year even as our volume dropped pretty dramatically.

Well, I don't want to be too near-term focused, but obviously, we have some potential disruption in China situation. Have you guys heard anything from your customer base on expectations for volumes, for port planning, for your intermodal network? Is this significant or do we just not know yet?

We don't know, and it could be significant. Think about it this way. The Lunar New Year occurred and everything shuts down for Lunar New Year. There was a mandated additional week of shutdown in the Chinese economy. That all by itself is 1/13th of the quarter, right? I mean that's a dramatic impact all by itself. And then from all of the conversations I've had with our customers, regardless of the industry they're in, their workforces, if they have plants in China, have not fully returned as of the end of last week. They're anticipating coming back over time to full strength, but there's still a fair number of people working from home or being encouraged to work from home.

So how do you plan for this then? Obviously, it's going to have a volume impact, and you guys are guiding to margin improvement again this year. Could that impact that outlook at all?

Yes. I mean, again, it's probably really too soon to say, Brandon. But we thought that the second half of the year would be the stronger part of our year from a volume standpoint, and certainly, you know how our margins work through the year, too. First quarter usually is tougher with a harsher operating environment, less volume, and then that improves through the year. What this may mean is that you see kind of that trough period extend like it is going to extend at least for a little bit, but maybe there's going to be a sharper spike when you get into the second -- maybe the second half of the second quarter into the third quarter as the goods return. Inventories are certainly being drawn down right now. And so that's going to create some pull in the system that really hasn't been there for much of last year and may ultimately turn out to be a pretty good thing for us, but it may push some of the timing of things to the back half of the year even more so than we originally thought.

And the inventory situations coming from your customer base. That's an ongoing issue right now then?

Right. Right. I mean you've got one example. We were just in meeting yesterday, and there's the auto manufacturers. They're relying on China for a fair number of their parts and they're having to use airfreight to get some of those parts over. And so that's -- those are parts that maybe sometimes move by rail, maybe sometimes don't just move by truck. But if you get that disruption in the supply chain, there's going to be some need to restock.

Okay. And I guess we've been pretty positive on you guys for a long time, but...

Good.

Relative to Canadian National, now Canadian Pacific, Canada as a whole has seen a lot more rail traffic growth in the past decade. Union Pacific, obviously, you have your challenges in coal book. I'd like to hear more about that because it's down quite a bit this year. But despite that, you haven't seen a lot of volume growth on your network. I think if we go back 10 or even 15 years, it's pretty much at the same level. It's obviously much different mix today. Is this just an issue that you're playing a losing hand with the Port of LA, Long Beach, and you don't have the infrastructure like they do up north? Or is there more to this?

No. I would say that is certainly not part of the issue. The issue of essentially no growth and it's factually no growth over, call it, 15 years is all about what you outlined, which is coal going away. That's real. If you look back to even 10 years ago, we're shipping probably 1/3 of the coal we ship then. That's a big, big deal. I mean that, in and of itself, is tens of thousands of carloads a week. And there's other puts and takes. We've been very judicious in price and making sure that we're asking for a rate that reflects value and is a reinvestable number. If you go backwards, our margins weren't quite as strong as they are right now. So what was reinvestable back then looks different than what's reinvestable today. All of those had an impact on us having a difficult time to grow the top line. That doesn't mean that there weren't commodities growing, right? And over time, grain has grown for us. Over time, food and beverage has grown for us. Over time, plastics, industrial chemicals, fill in the blank. But the broad book hasn't -- ethanol has been a strong engine over a long period of time. As you stand now and you look into the future, I think my expectation is we are poised for more growth. You mentioned, are the South Coast ports on the west disadvantaged in some way to, let's say, Prince Rupert or Vancouver? The answer is not at all. They're still the largest port facility in the United States and on the West Coast by far. The problem is the service product through them -- and I don't mean how much time it takes for the freight to hit the dock and get to a customer. I mean the transparency of the service product, satisfying the needs of a box owner, an international shipper with how much time that box is on the ground at the port, how visible it is. All of that needs to be improved. And we're working very hard with both Port of L.A. and the Port of Long Beach to get that done. I look at that and I think that's all opportunity. I look at Prince Rupert, and I think that's opportunity. That's business that had been in the South, went up to the North. Maybe it wants to stay there, maybe it doesn't. There's other opportunity that's very much obvious to us. Domestic wholesale intermodal is an area that just continues to have lots of growth opportunity. All the industry along the Gulf Coast is opportunity to us. There's this numbers of different markets that we look at and think are in good shape.

Yes. I mean even within the auto space, I mean that's an area that's grown for us when you think about finished vehicles and auto parts, but parts is still an area where we're underpenetrated. We've got great relationships with the OEMs. But when you look at the amount of their parts that they ship via truck versus rail, they still are predominant truck users. We know we can save them money. We know we can be a reliable partner for them. And so as we're rolling out PSR, that's helping us penetrate those markets as well.

And I just want to hit the negative real quick on coal. So I don't even know how much volumes are down this year, but it's pretty bad at the moment. Is this just a function of where natural gas prices are and this is accelerating the pace of decay? Or how do we think about it?

Yes. We think the -- what you're seeing right now is all about natural gas below $2. Once you're in that ballpark, only the most efficient coal electricity-generating units are fired up. And there's precious few of them left today. So I think you're seeing absolute baseload right now in terms of coal loadings. I don't think it necessarily snaps back and grows dramatically if natural gas goes to $3 or $3.50. And I also don't necessarily expect that to happen. United States is a low-cost natural gas producer and it's probably going to be that for quite some time.

Okay. On deposit side, though, you do have a much better margin profile and return profile than you did a decade ago. I mean did that change your process in approaching growth markets or the way you price the business?

So let's start with -- the pricing philosophy doesn't change, which is we're going to price for the value we represent in the supply chain, understanding the competitive environment, and we're going to make sure that we earn a return that we consider attractive from that. What changing the playing field from a margin perspective does is it changes the calculus. It doesn't change the equation. It changes the calculus in the equation. So markets that used to look marginal to us might not look marginal today. The other thing that is occurring is the service product is fundamentally more consistent, reliable, virtually across all KPIs. And our commercial team is working closely with our operating team to understand how can that new machine satisfy the needs of their customers that maybe we used to not be able to satisfy. Or the answer used to be we can't do that because it doesn't fit the network. And today, it fits the network. In my prepared comments, I mentioned this start-up intermodal ramp in North Central Iowa. That doesn't sound like much. But what it is, it's an area of the country that's populated pretty densely with distribution centers. In the old day, that product used to have to go to Chicago and dray back for about $1,000 or $1,200 a truckload. We would have never developed that in an intermodal product 4 or 5 years ago because we would have looked at it and thought, well, we better build density for us to run an intermodal train there and you can't do that. You're not going to build $150 worth of daily or every other day density there right out of the shoe. Well, our new business model where we're commingling our traffic much more, we use an existing intermodal ride that goes from Southwest United States to Council Bluffs. And then we use existing manifest rides that take it to interchange with a short line in Mason City. And it's going to generate tens of thousands of loads that we would have either maybe gotten some part of into Chicago or maybe not.

Well, and Jennifer, on the cost side, you guys are guiding to $500 million of productivity, like Lance mentioned, but also an improved margin even with what is a pretty challenging volume environment right now at least. What are some of the things on the productivity side that give you that confidence?

Well, we really continue to look across the spectrum of opportunities to be able to save cost for us. Labor continues to be the number one area. We continue to work to become more efficient with our labor force. Train starts -- I think, Lance mentioned train starts. When you take train starts out of the network by running longer trains, that's the savings of multiple crews depending on how long that train is moving. So that's something -- we've reduced our mechanical forces pretty dramatically. When you look at what we've done in terms of shrinking the locomotive fleet using fewer cars, where we can increase the number of carloadings we get for a given freight car, that's productivity not just in terms of that car asset but also in the labor assets that it takes to maintain that. We're looking at ways to be more efficient with our engineering. That's an area where we've done some work. You typically maybe think of those forces on the capital side, but it also has operating expense implications as well. Fuel efficiency is another area where we know we have opportunity. When we're running longer, denser trains, we think there is an opportunity. We're also investing in energy management systems. If you think of Trip Optimizer or LEADER, that's technology that we're in the process of deploying, working with our crews for them to adapt to that more. And we think that there are savings there. Car rents, operating expense, it goes -- it really runs the gamut of things. And just kind of going back to your question about the pricing environment, those cost savings have an implication for our customers as well. Not only are we driving reliability to them, which has a value, but when you think about -- I think it's 60% to 70% of our carloads are moving in private car, private equipment today. Assuming you need fewer car assets, that's the savings for our customers as well. So that's another reason why we think we can continue to drive value to them in the form of very good margin business.