Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Okay. Welcome to our next session with Union Pacific. I'm Scott Group, the transport analyst here at Wolfe. It's Wednesday, May 26 at 8:35 Eastern Time in the morning. Really happy to be joined by Jennifer Hamann, CFO, from Union Pacific. Jennifer has got a few quick comments she's going to make, and then we're going to jump right into questions. So thank you for being here, Jennifer. I pass it to you.

All right. Thanks, Scott, and good morning to you. Good morning, everyone. Before we start, I want to call attention to the fact that we do have a pitch book out on the Investor web page. That link can be found next to the event webcast. I'm going to make a few opening comments, and I will refer to some of the materials that are in the pitch book. Additionally, I need to remind everyone that I will be making some forward-looking statements today. These statements are subject to risks and uncertainties, so please refer to the UP website and SEC filings for additional information about our risk factors. A couple of weeks ago, on May 4, we conducted our virtual 2021 Investor Day. And if you were unable to join us live for that event, a replay of that can also be found on our Investor website. And we recently had, what I'll call, a highlight reel to the website that summarizes the key content, about 30 minutes. So if you haven't had a chance to participate in the full day, there's some content there that might be worth watching. As part of the Investor Day, we laid out our strategic plan framed along with 4 driving principles: serve, grow, win, together. Within the win discussion, we laid out our financial targets for 2022 through 2024, and that information can be found on the last page of the pitch book. This included putting a date on our long-term goal of getting to a 55 operating ratio, which we plan to achieve next year in 2022. Overall, I would say our discussions with the investment community post Investor Day have been very positive, although the one area where we have had some questions have been along the lines of our volume growth forecast in terms of the outlook. We said that we expect to have a 3% growth CAGR over that 2022 to 2024 time period. And while certainly there is some that would say that they have a more bullish outlook than we do, there are also some that have questioned our ability to truly achieve that level of growth. As our history would say, it's not something that we've done before. And I think the main way that folks had phrased that question is, "We heard UP talk about positive volume growth, converting more business to rail the last 10 years, what's different today?" And it is a fair question, and we understand that it's very much a show-me story, much like it was a few years ago when we announced our PSR transformation. Our Head of Marketing and Sales, Kenny Rocker, laid out what I'll call our 4-pronged attack to achieve this growth outlook, and I want to run through those 4 items with you again just real quickly this morning. First, we will continue to leverage our PSR-driven and proved service product and lower cost structure within that to win new business. We believe our enhanced service product is opening new markets to us like recyclables and allowing us to better compete in the growing electric vehicle and e-commerce space. The second piece is transforming our sales culture. As Kenny discussed, he's removed layers in the organization, he's investing in new technology tools and has changed the structure or the compensation structure of the team to help create more of a hunter mentality. And it can't really though just be marketing and sales that's oriented towards growth. It's really a cultural change for our whole company, and everyone here at UP is rallying around the need to grow our business. The third prong is advancing the customer experience, and that's where our new CIO, Rahul Jalali, is hard at work. He's meeting with customers to better understand the barriers of doing business with UP, and this also includes transforming our technology team to develop more products focused on improving that customer journey with UP. The final piece, and where I plan to make a couple more comments today, is expanding our network reach. This is where we can unleash the great strength of the UP franchise with our improved service product to reach more customers. This includes integrating deeper with supply chains to participate in new markets. For example, in the beverage markets, we're aligned with Constellation to convert more of their business to rail, and we're very excited to participate in the ever-growing seltzer market. Our Loup subsidiary continues to integrate deeper into the auto parts market given their already strong relationship with the OEMs. Recently, Loup was awarded the opportunity by Ford to move inbound auto parts for the launch of the new 2022 Bronco at the Michigan assembly plant. Expanding our network reach also includes developing new locations on UP to serve our customers. Kenny talked about our focus sites, which includes over 25 shovel-ready sites on our rail network, and one of those premier sites is Prime Pointe, a 3,000-acre industrial park just South of Dallas. Prime Pointe is strategically located next to major interstates and adjacent to our Dallas intermodal terminal, where we've been able to attract new customers. This includes a very successful Dallas to Dock plastics product that you've heard us talk about before that we developed with KTN. Finally, we also expand our network reach to the development of new service offerings. In January, we announced and launched our Twin Cities Intermodal Terminal, filling the gap in the growing market with the new intermodal service. And more recently, we announced 3 additional exciting new metrics. The first is our collaboration with Savage to construct Idaho's first intermodal rail terminal at a rail yard in Pocatello. The terminal provides match-back opportunities to use westbound empty containers to export hay and other agricultural commodities through the PNW. That terminal is expected to be operational next month in June. Second is our new global 4 grain transload facility, which is designed to further increase the competitiveness of our international intermodal market segment. Finding and developing opportunities for exports increases our overall international competitiveness and provides better economics for our customer base. This is anticipated to begin operations early in the fourth quarter, which is just in time for the fall harvest. And the new facility creates the most competitive grain export program in the Chicago marketplace. In short, we are creating a very efficient containerized supply chain. And then finally, you heard us announce at our Investor Day that we're very excited about the new Inland Empire Intermodal Terminal, positioning UP directly in the heart of this massive import distribution center. Today, there are roughly 2 million imports truck from the ports of L.A. Long Beach into the Inland Empire. And conservatively, we estimate that, that can translate into 1.5 million units of intermodal market size overall coming out of that area. We're about a month away from introducing our product brand, which is capable of producing 45,000 lifts within our West Colton yard and beginning our first intermodal presence in this region. We will continue to increase our footprint as we demonstrate our commitment to intermodal and the advantages of UP's franchise to serve these new markets. So with that said, let's open it up for your Q&A and, I guess, maybe Q&A from others.

Awesome. Thank you, Jennifer. I'm going to start with some questions, but if anyone else has any, definitely feel free to type those in, and we'll get to them. So let's start with an update on second quarter, and then we'll get into some of the longer-term things. So volumes are tracking up 27%, 28% quarter to date. I guess, how are volumes doing relative to the plan? What segments are doing better than you thought? What segments, if any, are doing worse than you thought?

Yes. So intermodal and grain are both staying very strong. They really have been the 2 stalwarts that we've seen growth starting late in 2020. Those have stayed strong. Intermodal, we will expect it to stay strong. I would say grain is staying strong for a period where you would typically see it start to tail off a little bit, but staying strong right now. If you stay on the bulk side, fertilizer is also staying strong. This is a period that where we typically see that. And then on the industrial side, certainly, lumber, very high demand for lumber, paperboard products as you think about the e-commerce connection. And then also, I would say, we're seeing the chemicals and plastics business has largely recovered from some of the outages that they experienced back in February, March time frame related to the storms down in Texas. Offsetting some of that, obviously, is the automotive piece. We really thought, by this time, we would be seeing a little bit more resolution to that chip shortage than what we're experiencing, and I would say that's now pushing some of that actually into third quarter. And even with that, there's still not great line of sight to, what I'll call, full resolution of the chip shortage. And then our rock business is a little weaker right now than we might have expected. But all in, our volumes, you referenced the plus 27%, 28% year-over-year, these year-over-year comparisons, obviously, are a little funky given what happened last year with COVID. Probably more relevant, we're up 7% sequentially off of the first quarter that we know our volumes were impacted by the weather. So it feels like we're tracking about where we thought we would overall. Some puts and takes in there, but with kind of a wash overall.

And at this point, knowing what you know, how are you feeling about the full year volume guidance of 6%? Do you see potential upside, potential downside?

Yes. I think we feel good about that. We started the year saying 4% to 6%. We bumped that up to saying, no, we think we're just going to be closer to the 6% range as we were continuing to see the opportunity for grain to stay strong, in particular. We feel pretty good about that. And I think I should remind everyone, within that, we do have 2 points of headwind, 1 point from coal on a year-over-year basis and 1 point from energy markets, so think frac sand and crude. So you call that a net 6% volume growth of what it would be kind of a gross 8% if you didn't have those 2 headwinds.

Okay. And now let's talk about mix and yields. Yields have been negative for you guys for the last 4 quarters. Should we expect yields to inflect positive this quarter? And then maybe if you can get a little bit more granular and talk about yield trends, excluding fuel, if that has the potential to be positive as well this quarter.

Yes. So to your point, Scott, we are seeing a positive inflection relative to mix. We expected to see that really in the second quarter. Intermodal continues to be a headwind. We're not getting the benefit that we thought we would have gotten from some of the automotive traffic, not as much, still up year-over-year, but maybe not quite as much of a positive kicker there. But with the grain staying strong, that's obviously a strong mix element for us. So that's looking good. So we feel good about having that positive mix inflation -- or mix inflection, setting aside price in fuel. And then later, those things go on, certainly, year-over-year, seeing higher fuel prices, higher fuel surcharge revenue as well.

Okay. And what about underlying pricing trends? Clearly, a very tight truck market. Truck rates are up a lot. Are you -- are your same-store -- I know you don't necessarily talk about same-store pricing, but as you think about underlying pricing trends, are you seeing those accelerate as well throughout the year? Or is that potentially more of a '22 opportunity? How should we think about base pricing?

Yes. I mean, I think you're familiar with it, Scott. So we -- if you look at our full portfolio of the business, about 45% is under multiyear contracts. We've got about 25% that is under tariffs, so think short-term pricing. And then another 30% of the business is basically 1-year type of deals, and that's where a good chunk of that domestic intermodal business lines is in that segment. I think you heard Kenny talk about the fact, as we were going through the domestic intermodal repricing, not only where we've seen new business plans, which we're very excited about, but also seeing strong pricing. That will start kicking in, in, call it, the third and fourth quarters. And so you do see some momentum as you were just indicating that pushes into 2022. But certainly, I think the trends are positive as we move through 2021.

Okay. Great. Let's talk about operating ratio now. The guidance for the year now is basically 200 basis points of OR improvement. Are we still confident in getting to that level? I think -- I mean, to get there, you basically need to get to a 55, plus or minus, in the second quarter. Are we thinking about that right? Just thoughts overall on the operating ratio and the guidance for this year.

Yes. I mean, obviously, I'm not going to comment on second quarter operating ratios. But mathematically, you're obviously hitting it. We started the year a little slower than we would have otherwise thought, 60.1% operating ratio, impacted by weather and fuel. But we not only said we were still good with our overall guidance range. We, again, kind of like volumes pushed it to the top end, so 200 basis points of improvement. And so just mathematically, to get there, we've got to have some strong quarters post Q1 to do that, and we still feel confident in that, yes.

Okay. Great. So let's now shift to some of the longer-term things. So you mentioned it in your prepared comments. There certainly are questions about you haven't grown volumes in a decade, right? Can you do 3% volume growth? I guess, are there any -- you mentioned some things like export hay or something. Are there any big or lumpy pieces that you have visibility to that give you confidence in that 3%? Or is it more of just a renewed focus on growth, some renewed incentives on the sales team and, hopefully, just a more cooperative macro environment?

Scott, it's really all of the above. I mean, there are some lumpier pieces as we look ahead to some business that we're going to compete more off the highways that we think can be some significant wins for us. But a lot of that is -- you hear the term frequently in the rail industry, pick and shovel work. Some of it is just providing a platform for our customers to grow. As you know, many of our customers don't ship all of their goods with us, and many are not doing that because of our historic inability to be fully reliable for them. So they've had to hedge their bets, if you will, in terms of our service product, even though they know we're the more economic option there. And as we're getting more reliable with our service product, as we're working to knock down some of those customer barriers and understanding better where their pain points are, that's enabling us to win a larger share of their portfolio. So it's all of those things that you mentioned. And we see some things like the renewable diesel market. I didn't mention that earlier, but that's a new market that's coming online that we absolutely see good line of sight to. We're partnering with a number of different companies. I think during the Investor Day, we mentioned Phillips 66 is one. It's got a new refining facility in California. And the nice thing about renewable diesel is, I call it, the mini ethanol because we don't anticipate the market is going to get as big as ethanol, but it has that same dynamic in terms of we're going to be taking product in and product out. And so that's right in our sweet spot.

Okay. And you mentioned this year about a combined 2-point headwind from coal and energy. How do you think about those 2 markets going forward in terms of the headwind that they may present to the overall volume growth?

Yes. We think the coal market is going to continue to present about 0.5 point headwind over that period. So again, we're talking about a 3% CAGR in terms of our growth at 2022 to 2024 period. That's net. On a gross basis, we'd be calling at 3.5, about 4, what's likely to continue to have in the coal markets as that business is just in secular decline. Energy is maybe going to be more lumpy, and so I wouldn't say that we're necessarily forecasting a big headwind from there. As you know, much of that business has already moved away from us. It's a much, much smaller part of our portfolio today. Is there a chance for maybe some spikes in there depending on what happens in the energy markets going forward? Maybe, but I would say that's not factored into our thinking today.

Okay. And then you talk about expanding the network reach. CSX announced recently an acquisition of a trucking company. Is that something that could potentially make sense for UP?

Potentially. We were aware of the quality distribution opportunity. It wasn't something that necessarily fits within our network maybe perhaps as well as it might for CSX, but we're certainly open to looking at things that can drive more business to the rollout. We've got the capacity, as you've heard us talk before, both with PSR and the fact that it has enabled us to be much more efficient with our assets. When you think about our locomotives, certainly, we have track and terminal capacity, as we become more efficient in those areas. And then kind of couple that, unfortunately, with what's happened with business volumes, either as a result of pandemic or cold wave, some of the secular shifts, we're poised for growth. And so to the extent that there might be an opportunity out there, we would certainly look at it. Nothing on the horizon today, but we will certainly look at those things.

Okay. Now I -- your long-term guidance that you laid out still implies continued operating ratio improvement. How do you balance the desire to keep improving margins with the desire to grow and wanting to give good service? I mean, how do you accomplish both? And do you feel like we need to start adding more meaningful resources back in terms of either people or equipment or CapEx in order to actually get the service where we want it to be and get the growth?

The short answer is no. I mean, we feel fine from a resource standpoint. We saw employees furloughed today that we had the ability to call back. We obviously have equipment that's still parked today. So we have the resources and the capacity we need to invest in an inhibitor to the service product. What we're having some issues in our service today really is related to what's going on in the supply chain logistics, mostly in that intermodal sector, where capacity is just very, very tight, you still have some congestion on the West Coast ports. And as we have really ramped up and increased resources to try to get those boxes off the ports, that's now creating some issues when you then look towards the Eastern part of our network because there's not always the available chassis then to take those international boxes or the domestic boxes off of our ramp. So it's just a supply chain imbalance that's going on right now, where we're seeing some service issues, but it's improving. We're working with our customers very closely. Eric and his team are doing a great job of really focusing on turning those assets as much as they can and being very diligent in that asset utilization. And we are continuing to invest for growth, too. As you know, our capital spend is less today on an absolute dollar amount basis, but we've become much more efficient with our capital investments. So we're getting productivity there as well as on the OE side, and so we're stretching those capital dollars. And even within the $2.9 billion of capital that we're spending today in 2021, there is capital that's in there for growth. So -- and it has been. Obviously, we're not spending what I would we consider to be kind of barebones capital. So we don't see it as an either/or proposition. We very much see it as an and. We have not reached a point in our business where we are making a trade-off between efficiency and growth. We believe we can grow efficiently, and that still is very much our focus. So we have a very good reason to believe and intention to do that.

Okay. So when I look at -- so on the labor side, do you think -- you've been sort of flattish recently on headcount trends. Do you think that, that continues into the back half of the year? And then comp per employee, though, was up a lot, 10% or so in the first quarter. Any thoughts on how we should think about that cost item going forward?

Sure. So to the headcount question first, I appreciate you said this. So we do think that our headcount is going to be relatively flattish through the course of 2021, that we're going to be able to absorb the volume growth with the current headcount base. Maybe some fluctuations here and there, but, by and large, pretty flat. We feel quite comfortable with that 6% volume growth range. Now if things surge for them, you see more volumes, you might see us out a little bit, but certainly would not be the one-for-one from a workforce productivity standpoint. We'd still see very, very good results. In terms of the comp per employee, you're right, first quarter was up. Some of that was weather-related. But going back to the third quarter of last year is we're running our crews a little more tightly. You are seeing a little higher comp per employee, and we do think that's the appropriate decision to make for our company, and both sustain a good service product and have crews available to run the trains. One thing to remind you, though, just in terms of second quarter, and then you'll see this a little bit in the third quarter as well is kind of on that year-over-year comp, last year, through the pandemic, we did take some action where we reduced management agreement salaries. And we mentioned during the April earnings release, that's about a 2% expense headwind for us here in the second quarter year-over-year. And most of that is going to be in that comp benefits line.

Okay. So something similar in the second quarter, what we saw in the first quarter on comp per employee.

Yes. I mean, it's going to stay elevated. Q1 was weather. Q2, you're going to see more from that year-over-year related impact.

Okay. I want to ask about the balance sheet now. So yesterday, you guys announced an accelerated share repurchase program. In the context of CN saying that they're going to go to 4.5x debt to EBITDA and still be investment grade, I've got to think that there's, if you wanted to, some opportunity to increase the leverage all the way to 3x. I would probably think over 3x and still say strongly investment grade. What's -- maybe just talk about the conversations with the rating agencies and if there's a limiting factor from them that prevents you from going to that level of leverage?

Yes. I mean, first of all, and you're right. So a week ago, we did a debt offering, raised a little more debt, very favorable rate. Rate environment continues to be supportive, and then we deployed a big chunk of that -- most of that to an ASR yesterday. So we are continuing to execute on what you've seen us do, what we've talked to do in terms of using that balance sheet capacity and deployment for the benefit of our shareholders. We don't have plans to significantly increase our leverage. The catalyst, when you referenced CN, they're stopping their share repurchases because they're going out, and they're acquiring something. They're putting forward a model and saying, "I'm going to pay that back down in a fairly short order," and that's allowing them to keep a fairly decent credit rating with that. But it's going to be a wait-and-see approach, certainly, I'm sure for the rating agencies. So it's a little different when you're talking about raising your capitalization for share repurchases, but we are very much in an active dialogue with them. They see the very strong cash generation that we have, but we are very much committed to that strong investment-grade credit rating and don't really have any plans to change that dramatically going forward.

Just so I understand, are the rating agencies signaling that you couldn't go to 3x or 3x plus and maintain your investment-grade ratings?

Well, if we went to 3x plus, certainly, S&P would probably take a look at us, and we're closer to the rating from a Moody's perspective. And so I wouldn't be surprised if they would take some actions if we were to do that. I mean, that is not what we are targeting today, and we don't think it's in the best interest. We feel like we're fairly well optimized today with where we're at.

Okay. So I want to talk about the M&A environment for a little bit to the extent that you've got some thoughts here. So now at least, it seems like for now, we know it's a CN-KCS combination. We'll see if that gets voting trust approval. How do you think about the competitive threats of that potential combination? And specifically, how do you think about the cross-border auto business with U.S., Mexico?

Sure. Well, as you know, Mexico is an important part of our business, important part of our franchise. Today, we do, call it, 10% of our volumes are in and out of Mexico, and that's pretty evenly split between FXE and KCSM. And so as we look at any potential merger, you heard Lance talk about this, one of the things that we're very focused on is ensuring that we have a quality South of the border in terms of how we're treated because, today, if you think about a business that's moving on the KCSM and then interchanging with us, our customers are doing that because they see a better service product, a better rack structure with us to their end serve markets. And we want to make sure that they still have that ability to make that choice going forward. So that's the important point for us. We love competition. We think we've got a great franchise. We think we've got the best rack structures going in and out, consider that North and South and then the further reach, whether you're going West or East. So we feel very comfortable with our ability to compete as long as it's a level playing field.

So it's basically about preserving gateways and things like that.

Yes.

Okay. And you guys have been, I think, very clear that you don't think it's sort of the right time for broader, full-scale consolidation in the industry. What could possibly change that view for you guys?

Well, I mean, I think if you roll things out far enough, if you get into a space where autonomous trucks are more prevalent, you think about that, and if, for some reason, we're not allowed to operate autonomous trains at that point, and even if we are, that might be something that could change the competitive dynamic enough. I mean, competition is changing in our space, and that's something that we think the STB is ultimately going to have to look at beyond just the rail competition side of things is that broader competition space and how we can be allowed to compete more freely. That would be one thing, but I'd be speculating if I try to go much beyond that.

Basically, it's the status -- the current status quo has to change in terms of the competitive dynamic or the regulatory dynamics. Something would have to change.

I would say so, yes, Scott. I mean, we all feel very good. I think about the service product, the respective railroads we're providing today, as almost everybody who's implemented PSR and are operating in that like mindset, I think we are providing for our customers a more seamless product. Technology can honestly play a role there as well, giving them more end-to-end visibility. And so those are things that we're working on and still have opportunities to accrue on. But it really ultimately comes down to what that customer need is. The industry is healthy today. We're investing for growth. You hear all of us talking about wanting to grow with our customers, so that's a very positive dynamic.

You mentioned the FXE as an interchange partner. Is there an interest? Or is there an opportunity to potentially increase the stake there or acquire the full asset?

That's, again, not something that we're considering today. We have a 26% ownership in FXE, as you know. We've had that stake for, gosh, a long time since the late '90s. So it's an investment that we feel very good about. We've got a great working relationship. Germán and his team, Fernando, they're doing an excellent job in running the railroad down there and feel very good about working with them.

Okay. And then lastly, you mentioned earlier just automated trains. And maybe just give us an update on the potential for 1-person trains and if that's a realistic outcome this labor cycle and when that could be.

Well, certainly, it's something that we have on the table and are very serious about pursuing. As you know, kind of at the forefront of kicking off this latest round of negotiations, one of the things that the rails did was actually take, what I call, some of the unprecedented step of suing one of our unions to even have the right to negotiate for crew consist or crew size. We won that. It's being appealed now. But even during that period now, we are still being able to negotiate for it. COVID really slowed things down last year, made it very difficult to advance any of the negotiations, but it is something that's front and center for us. How that's ultimately going to play out still remains to be seen. We're really looking for flexibility there in terms of some trains, it may always make sense because of the work and the profile of that train to have 2 people in the cab, but there may be other trains that we can be just as safe and efficient with, with only one person in the cab, and it's probably not going to be truly a one-for-one trade-off. If we get that flexibility, we may need to be putting people on the ground, and that can actually be a positive from a labor perspective because it can be more of a regular scheduled position to cover trains going through a certain territory. So we think there's a lot of advantages to it, not just for ourselves as a company, but as the labor force looks at it and our ability to further grow and be efficient. But it's something that we need to continue talking with the unions about, but we're focused on doing it.

Okay. We've got to wrap there. Thank you so much, Jennifer. This was great. Really appreciate it.

All right. Well, thank you, Scott, very much. Have a good rest of your day.

We're going to get going in about 2 minutes with our next fireside chat with CSX. Thanks again, Jennifer. Appreciate it.

Thanks, Scott. Take care.