Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Okay. Good morning. I'm very pleased this morning to have Union Pacific with us. We have the CEO, Lance Fritz; and Brad Stock from Investor Relations. Lance, I'm going to turn it over to you. I know you had a few comments, and then we can dive right to the Q&A.

Yes. Great. Thank you, Allison, and thank you very much for hosting us this morning. I do have a few comments that we're going to go through. Brad will handle the slides for me. You'll see the slides accompanying my comments on this video chat. But they're also available, they can be found on our investor website next to the webcast for this event. And before we start, I want to remind everybody that I'm going to be making some forward-looking statements. Those statements are subject to risks and uncertainties. So please refer to our website and SEC filings for additional information about our risks. So let's get started on Slide 3. Our fourth quarter volumes have remained pretty steady through the quarter, around 160,000 weekly loads, which was on-pace with what we expected when we finished the third quarter. With Thanksgiving last week and Christmas and New Year is coming up, we do expect to see the normal sequential seasonal impact to our volumes this month. Fourth quarter volumes are currently up about 3% year-over-year as we continue to see growth in the premium sector and improving sequential volumes in both bulk and industrial products. Looking a little deeper to each business team, premium is currently up 10% versus fourth quarter 2019. That's driven by growth in our Intermodal business, which is up 14%. Intermodal volumes continue to be led by e-commerce or parcel and inventory restocking that's spurred by the holiday shopping season. Automotive volumes are only down 2% quarter-to-date, and that shows a slow industry recovery on their part. Our bulk business is flat as coal continues to be a headwind, down around 17% quarter to date. However, that's been mostly offset by grain exports. That's grain and grain products, are up 18%. Finally, our industrial business was down 6%, demonstrating some sequential improvement. While Energy markets remained challenged, with crude and sand down 40% and 25%, respectively. A strong housing market is driving our forest products line up 10%. Let's go to Slide 4. We continue to make improvements across nearly all of our operating metrics, striking the right balance between service and efficiency. In the fourth quarter, locomotive and workforce productivity have improved sequentially from the third quarter as we see those resources being used more efficiently. That productivity has been driven by -- in-part by continued improvement in train length with November's number up to over 9,000 or 9,200 feet. This improvement is especially impressive given that sequential volumes were essentially flat. Finally, and most importantly, we continue to provide our customers with an enhanced service product. Manifest service remains fluid and on time, while our Intermodal services recovered strong as evidenced by the 82% on-time performance so far in the fourth quarter. Turning to Slide 5. By transforming our operating model, we're providing our customers with a more reliable and consistent service product and also reducing our overall cost structure. This combination is opening up new markets and opportunities for us to secure new business. While the uneven nature of the volumes this year has clouded the impact of our business wins, they are now starting to become more evident. As we've mentioned before, we've secured new car loadings across a number of our business lines in grain, tomato paste, sweeteners, pipe, domestic intermodal and international intermodal, just to name a few. We're also bringing new products to market as well. We've recently announced the opening of the Union Pacific Twin Cities Intermodal Terminal, featuring domestic intermodal service between the twin cities in Los Angeles. This new alternative will give regional shippers and receivers fast, direct and reliable Intermodal service to key markets. Our marketing and sales organization is excited about the products that they're selling, and these wins only increased our optimism for the long-term potential of our franchise. Going to Slide 6. At Union Pacific, we recognize the importance of delivering value for all of our stakeholders. The United Nations has adopted 17 Sustainability Development Goals, with a target date of completion by 23rd. While Union Pacific has a role to play in all 17, we're focusing on just 7. I want to quickly highlight some goals that we've set for ourselves to make a difference. At Union Pacific, we're taking aggressive steps to remove barriers for women in our traditionally male-dominated industry. Today, women make up approximately 5.6% of our workforce. But by 2030, we have a goal to double that to 11%. Additionally, we recently set a goal for 40% minority representation in Union Pacific by 23rd. That's an 11 percentage point increase from today. We believe our company's performance is improved in strengthened with a diverse and inclusive workforce. Speaking of the great Union workforce, we recently announced that we're providing monetary recognition to our agreement professionals in the form of a $1,000 bonus in December, which adds around $37 million to our compensation and benefits line for the fourth quarter. Our great Union employees have been on the front lines of the pandemic, providing an essential service to the country. Quite literally, these employees have kept the country moving when we needed it most. They went above and beyond to take great care of our customers. So this recognition is incredibly well-deserved. Finally, in March, we announced our intention to set science-based targets to help us further reduce our emissions. We're in the final stages of verification of our proposed target, and we anticipate publishing it in the very near future. That's an important step toward a more sustainable future. Let's go to Slide 7. Two months into the quarter, our thoughts on the fourth quarter and full year 2020 remain unchanged from what we discussed at our third quarter earnings call. Volumes have played out pretty much consistent with our expectations heading into the quarter. So we still expect fourth quarter volumes to be up low single digits, with full year volumes down 7% or so, while our full year expectation for productivity is to exceed $700 million, and our long-standing guidance on pricing remains unchanged. We expect the total dollars generated from our pricing actions to exceed rail inflation costs. And while fuel prices have risen a little since October, our expectations for volume, price and productivity should produce a record 2020 operating ratio. We expect a full year operating ratio to improve by roughly 1 percentage point and start with a 5. Longer term, our guidance of capital expenditures of less than 15% of revenue, a dividend payout ratio of between 40% and 45% of earnings, and ultimately, a 55% operating ratio remain intact. So with that, Allison, I will turn it back to you. We can get into Q&A.

Perfect. Well, thank you, Lance. Maybe if we could start with the current -- the quarter-to-date trends. I know you mentioned that sort of overall that the sort of low single-digit growth is pretty much along with your expectations. But are there any commodity types that have performed better or worse than expected? And then as you think towards 2021, could you outline what you think are some positive catalysts for growth going forward?

Yes. So mostly, the aggregate volume, as you mentioned, has played out about like we expected. E-commerce has been surprisingly strong as sales have grown, and inventory has shrunk. And that's also created this restocking that's going on, and that's been a little bit of a surprise. I'm looking forward to seeing that extend into next year. So the consumer has continued to be relatively strong and that, to me, is somewhat surprising in that they're overcoming all of the negative headwinds of news and job loss that we've seen through this pandemic-driven recession. In the industrial sector, industrial product -- our industrial markets are largely recovering, but they're recovering more slowly than the consumer-driven sectors. We've seen some really good volumes driven by export grain. So the grain and grain products world is pretty strong and healthy. Lumber in the housing market looks pretty good. Plastics are recovering pretty nicely. But some of the core products in industrial chemicals. Steel is okay. Building and construction material is okay, but we're looking forward to that continuing to recover as we look into 2020.

When you think about Intermodal that's been obviously a source of growth recently, how much do you think is being driven by inventory restocking? How much further room does that have to go based on some of your conversations with customers? And then are you starting also, given tight truckload capacity, are you seeing highway conversions also drive through that domestic piece?

Yes. Allison, it's really hard to bring apart and tease out what's being driven precisely by restocking versus consumer buying behaviors versus, maybe tighter truck capacity because of capacity coming out entering the year and through the recession. All 3 are generating really strong domestic enrolled businesses for us. Part of that also is being driven by international Intermodal hitting the docks on the West Coast, being transloaded into domestic boxes and turning into domestic business for us coming out of the L.A. Basin. When we talk to our customers, they recognize all that's occurring, and they seem to indicate that it's probably going to bleed over into 2021. Nobody is quite sure how long it lasts, but you can still see in the inventory sales ratios that there's room to improve inventory and match up with the sales volumes that are occurring. Notwithstanding, we all saw the statistics from the Thanksgiving weekend that said, food traffic wasn't very strong. As a matter of fact, we can read anywhere from up by 1/3 to 1/2. But e-commerce was very strong. And so consumers are still out there buying.

Okay. And then maybe just wanted to turn to merchandise though. I think in the past several quarters, you guys have talked about historically, there haven't been opportunities for you guys to bid on business, but you walked away from that volume because it didn't meet your return threshold. But now undergoing PSR implementation and the changes in train design and service, it seems like that's a bigger focus. So could you help us sort of think about, number one, I guess, a framework for maybe sizing that overall opportunity? And have you been able to sort of chip away at gaining some of that volume, and potentially, it be a meaningful sort of needle mover, I guess, from the volume pipeline in 2021 or should we think about this more as like to do and after that?

Yes, that's a great question, Allison. So let's unpack it in a couple of different ways. First is our pricing strategy is unchanged, right? Every piece of business that we bid on and look to receive is got to stand on its own 2 feet from a return perspective. So pricing discipline has not changed. To your point, what has changed is our cost profile. Our cost basis has fundamentally shifted and dropped because of our implementation of PSR and the unified plan. And that gives us more opportunity to bid on more markets or opportunities. So that is real, and we're seeing that come to fruition. In terms of securing business, it's great to be in the current marketplace because trucks are tight and demand for domestic intermodal is very strong. So that gives us great opportunity, both on the pricing side as well as on the securing new business side. And we're seeing that across the board happening. But there are real headwinds as we look into next year, and it's hard to determine just exactly when they're going to abate or how stiff they're going to be. Our energy book, whether it's coal or frac sand or petroleum, continues to be pretty challenged. And that's -- those are pretty substantial drops year-over-year. In the industrial marketplace, while I'm optimistic looking into next year that our industrial markets are going to improve and get back to a pasture of growth. They haven't done that across the board yet. And those are very important markets for us when it comes to mix. So as we look into next year, Allison, I would say the opportunity for truck conversion is enormous, right? It's effectively almost a limitless marketplace. Now there's a lot that we have to do to make ourselves look much easier to do business with for the customers that aren't currently using us. We've got an opportunity to grow with customers that are using us, and it's fantastic. But there's much more opportunity in markets where we have somebody using us and many others that don't. And the ones that don't, we have to help them see how easy it can be to do business with us, what the value proposition is and get them converted. That's all about the customer experience.

Okay. Maybe turning to sort of operations and network. Could you walk through where you think you are as far as the structural changes that have been made in the network or further rationalization? Then if we could maybe talk about the transition from Vena to Gehringer? And basically, just sort of want to understand maybe how the transition is coming [indiscernible] . So if you could maybe give us a key message for this transition and what you were going to communicate to investors?

Yes. So there's a couple of key points in response to that. First is that PSR is here to stay. It's built -- or we're building into our DNA into our culture. I'd say there's still work to be done there, but I have 0 fear about backslide, right? Its deep enough now to where the ideas for improvement are coming from the ground up. They're coming from our front-line and our mid-level management team and the craft professionals doing the work because they understand what we're trying to accomplish. Now there's more work to be done there, right? It's -- we're nowhere near perfect in terms of our cultural stance towards continuous improvement through PSR. But the fact that it's -- that the way we're going to run the business and the fact that new ideas for improvement are coming from the field is fantastic, that's exactly what we want to see. In terms of the maturity of our PSR implementation, again, we're somewhere in the middle of the -- I wouldn't -- I would hesitate to even say we're in the middle of implementation. PSR is evergreen for us. So we're exceptionally proud. I'm exceptionally proud of what we've accomplished in the last 2.25 years or so, right? We've fundamentally redesigned the network. We've taken a lot of touches out of our network. There's about 1/3 fewer train starts for the same type of volume. There's about 1/4 to 1/3 fewer touches of a car for the same volume of Manifest business. And we're doing much more efficient work when it comes to building and maintaining our route. I was just visiting a tie gang in Texas. And year-over-year, they've reduced their cost to install a wooden tie by about 25%. And they were rewarded by being able to get more work done and basically pulling forward some tie program for next year. I see that all over the railroad. So we're building and maintaining at better cost and our overall cost structure is down and our service product is up. That's an evergreen process. And we have plenty more opportunity there as well. There's stuff that's already in flight. We've talked about Chicago and the Intermodal product there. We've talked about Houston and the separation of our Intermodal and Manifest products there. We're looking at L.A. Basin, and there's probably going to be some work done there. And then there's still work to be done on line, right, between L.A. and Chicago, L.A. and Dallas and Treeport, L.A. and Houston as well as Chicago and the Pacific Northwest. So all that's underway. Now let's turn to the transition between Jim and Eric. Comparing the two, they are different personalities, for sure. You'll see that, Allison, I think you've already started to see that in how they present themselves. It's just different people. But the most important things, they are very similar. They're very competitive. They absolutely want to win. They don't take nonsense, that is accountability is a big, big deal. You can't hide from Jim behind latitudes and saying things are all right, just like you can't hide from Eric on the same topic. And they're absolutely driven to continue to take risks and look for ways to do better. And so in the most important ways from my perspective in running our operation, that's why Eric has been tapped to replace Jim.

Okay. Well, I think we're all looking forward to getting some exposure to him. Next, obviously, I want to focus a little bit on the OR. Do you think it's fair to say that as you've made all these structural changes and cost improvements and service improvements over the last couple of years, although volumes have been down, do you -- when I think about volumes likely being up next year, hopefully, right? Do you sort of get outside leverage because you're sort of fully realizing more of that productivity as volumes and intensity builds in the network? Is that the right way to think about it in terms of the OR or margin improvement framework for 2021?

Certainly, Allison, I'd prefer to try to improve our margins, whether it's ROIC or operating ratio or operating margin in an environment where volumes are growing than when where they're shrinking. We've done a hell of a job looking backwards, taking 1 point -- almost $3 billion in productivity from the railroad in the last couple of years in a declining market. I'm very much looking forward to next year, hopefully, we see growth. And if we see growth, it does provide us an opportunity to drop some attractive incremental margins to the bottom line. I got to remind us that we're entering next year with some mixed headwinds, and I can't wish those away. They're real, but we've made margin improvement across the spectrum of product, whether it's our Intermodal product or our bulk product or our industrial product. And so growth in any is better than the margins that we saw a year ago or 2 or 3 ago. But again, the mix of that business will dictate just how attractive the incremental margins are and just how much margin improvement we can make.

Okay. That makes sense. Maybe just sort of the longer-term OR, you've had the 55% target there for a while. [indiscernible] given where you are today because is that still the right sort of longer-term goal? Do you think you can go below that ultimately? And do you think that the UP network had certain advantages, whereby it can get the lowest OR in the industry, like the [indiscernible] customer mix? Could you walk through that and sort of what your current thoughts are?

Yes. Allison, we are laser-focused on achieving that 55%. It's been a long-term target for us, and we're more confident now than ever in being able to achieve it. There's a certain possibility to be better than that. Our overall desire, our overall drive is to be the best in the industry. We think we should be the safest, most consistent, reliable service product and most efficient provider of service in the railroad industry. Then we have a franchise that supports that. I have a team that supports that. And I think we have a game plan that supports that. So once we achieve 55%, who knows what happens. The other thing I know is that we've got to grow. I'm looking at the way our service product is. I'm looking at our cost structure. And we have got to translate that into growth. And growth is going to have to be a more important part of our 3-legged stool of growth, productivity and price to achieve margin improvement. And very confident, all of the above is going to happen over the course of the next 2-, 3-, 4-plus years.

Okay. Maybe just pivoting to growth. We saw earlier this week, CSX acquiring the Pan Am, I'd say, not a direct impact. [indiscernible] more roughly or strategically [indiscernible] for the UP network, would that be sort of additive and, maybe sort of on the flip side of that, do you think you can achieve the synergies by collaborating with your short line partners as opposed to doing M&A.? So just maybe your broader thoughts on that. And what's required, I mean, of course, on-time service and reliability and tracing and tracking or what the shippers are saying is the most important. But maybe the sort of longer-term catalysts to continue to grow. What are some factors like short line acquisitions or collaboration that can really sustain that growth longer term?

Yes. So Allison, if we think about growth strategically in 3 wins, you hit them all. The first is operational excellence, supporting more carload growth onto the railroad, whether that's boxes or literal freight cars. That has to be business that fits the network, but we have to do the pick and shovel that includes customer experience and it includes that heavy-dose technology, which we haven't talked about yet this morning, and I'm very excited that we've hired Rahul Jalali from Walmart to help us build that ecosystem, that platform that enables customers to see us as easier to do business with and a natural partner in their supply chains. So that's pillar #1. Pillar #2 is doing more for our customers than we do today. That also have a -- has a heavy dose of technology. We have a loop subsidiary, and it largely provides broad services when and if different the customers ask. We're going to turn that around and look for opportunities to provide services and grow into the supply chains of our customers. That's a lot of product development and maybe inorganic as well. And then the third way is to grow our geographic footprint. And to your point, we do that right now through doing things like focused sites. That's where we create industrial sites like master-planned communities, where the property is owned, there's a lot of front work done. There's some fundamental infrastructure built-in, and then we could have a customer go from greenfield to producing in a matter of 12 to 18 months. We make it very easy to customers -- for customers to do that. So that's one way of increasing our geographic footprint. Another way is through acquisition. And while we look at our short lines as very effective partners, there may be opportunity for those short lines to become part of the UP family. And as those opportunities come up, if they make sense to us and we can do the work better, whether more efficiently, safer, with a better service product, fantastic. But right now, our short line partners largely have been very good partners in business development and growth.

Maybe a touch on technology that was going to be my next question. I mean, obviously, all the rails are focusing different things like the automated inspection portals and tracing for customers or predictive maintenance, locomotive technology. What are some of the things that UP is focusing on specifically? And how might that drive incremental productivity gains going forward?

Yes. Fantastic. So let's talk about a handful of things in the technology sphere. One is being more efficient with our assets and with our craft professionals. So we use tools right now what is called UP Vision. It's basically a visualization tool, an exception management tool and soon to be a decision support tool for all of our operating team to use. And it's quite granular, and it gives them a lot of good visibility into how long has it taken them under a process of car. How long has it taken them to process power? Where are the gaps? What are they doing versus their goal? What are they doing versus what they could be? So there's tools like that, internally developed and launched. We also have tools for our customers that help them have a better experience. That's our use of APIs. We're leading in that. We've got about 2 to 3 dozen right now available and developing more every day. That's where a customer can reach into our system, grab the data that makes sense to them, put it inside their system, turn it into decision-making tools for them without anybody touching. And our architecture under NetControl, which is a completed enterprise system for us, just recently rewritten, enables that very easily. So we're pretty happy about that. We've got CADx, which is a multiyear computer-aided dispatch system that replaces our current. And incorporated into it is a train optimization tool that will improve train flows across our network. And then we've also gotten some tools that we use for our sales force to be more effective. That's a suite of sales force and pros for pricing and tableau for decision-making, it also includes some tools for our customer base like UPGo to make train drivers more efficient on our ramps, be able to find their parking spots and then pick up spots like that or you are next, where local services known down to you being the next customer to receive service by your local people or knock up your derails and open your gates, we're coming. All those form a suite of an ecosystem, a platform for us to look really attractive to the customer base and be able to do our business efficiently.

Okay. I think we're getting close to the end. But I did want to touch on your sort of initial thoughts on CapEx for 2021. And then if you could touch on capital allocation, any sort of change in strategy in terms of buybacks versus dividends?

Yes. So Allison, you know, we build our capital program from bottoms-up, and we also take a look from top-down. We've recently, over the last few years, have said, we expect the outcome to be less than 15% of revenue, and it's plain and true. And PSR is only making some of that pressure down, not up. Now, we still have opportunity to invest in the network for productivity or for service or for growth. And we still have to put near $2 billion, $1.9 billion, give or take, into the network for reliability just to maintain it. But the need for incremental capacity is really largely off the table unless it's a rifle shot here or there for a very specific return. So that less than 15% still feels pretty darn good to us. And in terms of allocating our cash flow, our job, my job, first and foremost, is to increase operating income so that we generate more cash. And then what we do with that cash, the railroad gets the first dollar. And then we split the rest between a dividend policy that's between 40% and 45% of earnings and share buybacks. And we have plenty of investors, I'm sure, on this call, who want either or both. Then there's a fair amount of our investment community that can't invest in Union Pacific unless we are providing some kind of routine income. So we're going to continue to do that as we look forward. Right now, we've said 2.7x debt to cap is about where we want to land. We're above that. We've got to work ourselves back down toward that. And we're comfortable there.

All right. Lance, thank you so much. Brad, thank you as well. Have a great day. It was a great conversation. Take care.

Thank you. We'll see you, Allison.