Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Morning, everyone. Welcome to Deutsche Bank's 2021 Transportation Conference. My name is Amit Mehrotra, transportation and maritime shipping analyst here at Deutsche Bank. I want to sincerely thank you all for being part of our 2-day conference. Despite it being in the middle of August, we've got hundreds of investors attending -- support from the biggest and most admired freight companies. We couldn't be more pleased with the response. So thank you for joining us for the next 2 days, what I hope will be our last virtual event. Before I get started, very importantly, I want to acknowledge the hard work of Deutsche Bank's events and meetings team, specifically Heather Whitney and Donna Lichvar, who have worked many, many, many long hours, including our AV team to make this event as smooth as possible. So I want to acknowledge and sincerely thank both Heather, Donna and our AV team for all their hard work and dedication. And I can't think of a better start to our Fireside Chat series than with Union Pacific, obviously, a Class I rail, $145 billion in market value. Undeniably one of the highest quality companies in all of industrials and that too coming off a blockbuster second quarter with the 55.1 OR, 78% incremental margin. Joining us from the company is Jennifer Hamann, Executive Vice President and Chief Financial Officer; and Eric Gehringer, Executive Vice President of Operations. We also have Bradley Stock, AVP and Head of Investor Relations. Jennifer, Eric, Brad, thank you so much for joining us. We really appreciate it. I'll hand it over to you for some opening remarks, and then we'll dive right into the Q&A. So please go ahead. Thank you again.

All right. Well, thank you all, and good morning, and thanks for the warm introduction, Amit. It's a great to be with you virtually today. Although, I am very much looking forward to doing this in person very soon. I want to point a couple of things out before we get started this morning. First of all, on our Investor Relations web page, we do have an updated pitchbook out there that can be found next to the link for this webcast. We're going to reference some of the material that's in there, but it's available for you to view. And the other thing, obviously, I want to remind everybody that we will be making some forward-looking statements today. Those statements are subject to risks and uncertainties. So please refer to the UP website and SEC filings for additional information about those risk factors. I'm going to start off and just make a couple of comments, first about how we performed in the first half of 2021. It's really been a very strong year for us financially despite some challenges in the marketplace and operationally that will be discussed. But first half volumes and revenue were both up 10% through June 30, 2021. And with that, we were able to produce $235 million of net productivity. We refer to it as net because we did have some headwinds, particularly in the first quarter for weather, if you recall, the severe cold weather that we had through the Midwest and in Texas, as well as some operational costs associated with some cost of derailments that we had. But even with that, we produced 78% incremental margins in the second quarter that you referred to earlier there. Very strong incrementals as we're bringing the business back on to our network without adding costs back at 1 for 1. What that produced for us in terms of first half operating ratio of 57.5%, down 2.4 basis points from 2020 and 4.1 points from 2019, producing earnings per share of $4.72, which is a 24% increase versus 2020 and 14% up from 2019. With that also, we've had very strong cash generation and shareholder returns. 96% cash flow conversion rate. We returned $5.4 billion of cash to shareholders through the first half of the year, and that includes a 10% dividend increase in May for our second quarter dividend and repurchasing a total of 19 million shares through the first half of the year with the $2 billion accelerated share repurchase program. So again, I think very, very strong results on the basis of challenges that I know Eric is going to talk to here in a little bit. We continue to feel very good, though, about how we are making progress to become more efficient overall as a company through PSR. And with that, you can remember things like our train length, which has increased 9% year-over-year as well as the fact that all of our KPIs whilst challenged versus 2020, which is obviously a very low volume environment for us through the first half with the COVID impact, still continue to do better than the 2019 measures. If you take a look at where we're sitting here in the third quarter from a volume perspective, our volumes are currently up 2%. That's through August 11. Sequentially though, we're down 4% from second quarter and that was something that while we didn't think we were necessarily going to be down sequentially, going from second quarter to the third quarter, we are starting off a little bit softer when we did think things were going to be flattish. So perhaps a tad slower than we were originally looking at coming into the quarter, but obviously opportunities to pick that up. What we're seeing, if you look at our 3 business lines: Bulk, Industrial and Premium, right now, our Bulk is up 3% on a year-over-year basis. Sequentially, though it's flat. Really, the leader there, which is a little surprising is coal as natural gas prices have stayed high. Our coal loadings have stayed strong. So coal renewables for us during the quarter is up 6% year-over-year. On the flip side though, grain and grain products is down 1%. And if you peel that back and look at grain, specifically, it's down 9% year-over-year and sequentially down 27%. And that really relates to supply when you think about where we're at in the course of the year. You're starting to see the stocks draw down. And obviously, we had a very strong third quarter of 2020 as you started to see China buying -- the grain export's really starting to flow. So that's something I'm sure we'll have some questions about. We can talk about later. If you turn to the industrial line then, up 15% year-over-year. So that Industrial sector is looking good, but sequentially down about 1%. Energy and specialized is up 17%. Forest products were up 14%. Those are both year-over-year numbers. And metals and minerals are up 19% year-over-year. Last, I want to talk about Premium. Our Premium sector, which is, I think you all know, is our intermodal as well as our automotives, is what we report under that group. Down 5% year-over-year, sequentially down 7%, really the biggest trend areas in that auto space. We are continuing to see the impact of the chip shortage. And in fact, when you look at autos, down 16% year-over-year, sequentially down 7%, it's actually feeling a little bit worse to us in the third quarter in terms of what that chip shortage and impact is versus what it was actually in the second quarter. So continuing to have an impact there. Intermodal down 3%, sequentially down 7%. And International is up a little bit. Our truckload is pretty flat, but what we are seeing a year-over-year decline there is in that parcel sector. Again, if you think about last year, very, very strong demand with the e-commerce surge coming through COVID, we experienced still good demand, but just not kind of that surge of demand like we saw year-over-year with that tough comparison. Before I turn it over to Eric, one thing I do want to mention and talk about a little bit is ESG, obviously, something that's very important to us across that whole spectrum. One thing we put out last week is we released our 2018, 2019 and 2020 EEO-1 reports. So I want to make sure people understand that, that information is out there. We're committed to evolving our disclosures around the ESG. And we understand that it's very important for us to be transparent with our shareholders. Last thing I want to talk to about on ESG is just to remind you of some of our goals that we have out there. For 2030, should we have a goal of doubling our female representation in our workforce from 5.5% to 11%. We also want to increase the minority representation to 40% by 2030. It's currently at about 30%. And then certainly, from a fuel standpoint, we have our SBTi targets that are out there, 26% reduction of the 2018 baseline by 2030 in our Scope 1 and Scope 2 machines. So all engines going forward in terms of making sure that we're keeping the ESG perspective in front of all our employees, and we'd like to keep it in front of shareholders as well. So with that, Eric, I'll turn it over to you.

So let me start with an update on the recovery of the system. So as a reminder, back at the end of June is when we had our bridge, that is in Northern California, damaged, 1,300 feet long, 160 feet tall. Our initial estimate was that it was going to take us the better part of 60 to 62 days to be able to cover that bridge from the wildfire damage. And in reality, there were a lot of innovation and exceptional planning. We actually got it done by 32 days. So we got it done 30 full days faster than we expected. So that line is open. Now during that same outage, we also faced an outage east of there, about 100 miles in our [ Canyon ] subdivision. The impact was less from the perspective it didn't take us as long that we made the repair, but it still impacts the fluidity of the system. Again, the team answered the call and in a matter of about 11 days got it back in service. So it's a testament first to the fact that the operations that we use to firefight in conjunction with federal entities and state entities, they're the top notch. They are the heroes of the Union Pacific in what they do day in and day out to mitigate any damage. The recovery effort, again, world-class engineering team, world-class logistics team here, very proud of the entire team. Now it doesn't get us through it. That just got us our lines back open, which again, both are open. So now as we continue recovering in the system, it's a focus on getting the inventory -- beginning to process through that inventory in a very financially responsible way. All the lessons of PSR, they continue to apply. There's nothing about our recovery that forces us into some other playbook. It forces us even just deeper into our PSR playbook. That means very, very responsible with, yes, you're going to add locomotives, but you add them in very, very strategically, where you know that you can improve velocity. And you take crews from one location in the east and you move them to the west so that you can provide additional crews to improve that sort of [indiscernible]. Everybody here is focused on ensuring that we can get the system ramped back up. It is not something that takes days, it does take weeks. But that's because we do it very intentionally. I'll give you an update on the calls of our operations on the intermodal side [ of L.A. ] So you'll remember during the second quarter earnings discussion, I mentioned that as a result of the congestion that it [ built off of L.A., ] you saw the Union Pacific doing a number of different activities to help the customer base as well as the overall supply chain, when I talked about opening G3 as an inland storage, talked about the additional cost and resources that we put on -- the list goes on and on. We've made multiple intentional efforts that have really driven improvements to be able to help the supply chain. At the same time, after 4.5 months of doing that and the congestion outside of Chicago from the L.A. ports, we had to stop and pause our operation. We told you back then that we were going to pause that for 7 days, and that's exactly what we did. We accomplished 99% of exactly what we wanted to do, which was to be able to draw down that inventory, get it into the terminal, give our customers an opportunity to be able to [ dray ] that off and get it to the big BCOs. So a very exceptional execution of that effort. Now I will point out, we have, as of this morning, 32 ships that are off-dock. So we continue to work with our customers, trying to get as far west in the process as we can to understand those shipments, where they need to go, priorities and then, of course, working with the dock operators on how do we plan our resources as they plan their resources to be able to get the most we can have done. And then on the back end, obviously our marketing and sales team works very closely with our customers, specifically BCOs, and helping to understand dray capacity, how we can optimize that. In fact, I think I'll talk a little bit about them in some of the questions and answers related to intermodal excellence. Moving over to crews. I mentioned this one in the beginning here because it seems to be a topic that has come up a lot on the second quarter calls. As we sit here today with Union Pacific, we're not concerned about our [ purchase ]. We have approximately 400 that are still in furlough status. We're still having a [ recall rate ] at 68% to 72%, which is not where it was a year ago. But keep in mind, these are people that have been furloughed for anywhere between 18 and 24 months. So they still get back on average 70%. That's a very positive indicator that we can continue to draw on that resource as we need it. We do have the better part of 600 people that are in some portion of our training pipeline. So we still have them in the wings, that we'll be bringing on as we need to get backfill for attrition. You've seen our headcount numbers, whether it was the numbers that were just put out recently or whether it was our second quarter. You saw we hit historical best in our workforce productivity. So although I talk about 600 people being in the pipeline, we will continue to be very judicious on how we think about resourcing our boards and keeping that very lean to what we need and not more than what we need. Finally, just talking about our current operating metrics. As I walk you through the recovery, I don't want to leave anyone with the impression that, again, this is fixed in a matter of days. The entire team is focused on it. I see every single day consistent, continuous improvement, whether you look at our inventory count, whether you look at our train's count, where you look at even the total number of trains. We're working those all back down to our historical best, and I expect nothing less than that.

I'll just wrap up then, reminding everyone about our full year 2021 guidance that's out there. And what you were over-reiterating today, 7% volume growth in total, $500 million of productivity, pricing gains in excess of inflation dollars, 200 basis points of operating ratio improvement for the year. So from a 58.5% to 56.5%, around there is what we're targeting. And then also on the cash side, if you recall in the second quarter, we upped our forecast in terms of share repurchases as a result of our strong free cash flow. We're going to be repurchasing about 7 billion shares -- $7 billion worth of shares. So with that, I think we're ready to turn it back for your questions.

Great. Well, thanks, Jennifer. Thanks, Eric. Really appreciate that update. And by the way, we have a lot of people dialed in here. If you want to ask a question, please raise your hand, virtually. I'll bring you in for a question. I'll get started. Jennifer, just on that last point, I'm a little bit surprised that you guys are reiterating your 7% volume growth forecast for this year. I know it was just recently raised, but I think based on your own comments, the third quarter is a bit disappointing from a volume perspective. Just talk about what gives you confidence in being able to see a pretty significant reacceleration in the fourth quarter, which is what you need to hit that number, and off of even more difficult comps in the fourth quarter. Maybe we'll start there. RTMs are also up a lot relative to carloads. So maybe you can kind of layer in some mix comments as well. But let's start on the volume side, and what gives you confidence on that 7% volume growth based on how third quarter is shaping up?

Sure. Well, I mean, we are still hopeful for forecasting as are a lot of the OEMs when the chip shortage is going to get resolved. And when you look at that, that's really having a significant impact on our weekly carloadings. You could say it's anywhere from, call it, 3,000 to maybe 4,000 carloads a week, both on auto parts and finished vehicles side, that that's impacting our carloads. So we're, call it, [ 1 57, 1 58 ] -- at the best of [ 1 61 ] just in one product line. We also know that there is good demand out there on the intermodal side of the world. The international intermodal air preference to the ships. If we can get the supply chain moving, we can get some of that dray capacity, helping keep the ramps fluid, that would certainly help them. So we definitely see the opportunity there to get to that 7%. And it's across a variety of things and so then as work speeds up, we're able to take cars and place them with customers more fluidly, more on demand. The opportunity and the demand is there. I have every confidence in the world that Eric and team are going to continue to heal the network. Again, it's not an overnight kind thing, but over the next few weeks, we're certainly seeing improvement, and that positions us well going into the fourth quarter. We also see the grain harvest. In our [ shared ] territory, it's looking pretty good. And so we think there's that opportunity as well. We will obviously keep you updated, but that's our thinking. And then overall, in terms of why we think still reach that 7%, it's -- it will take some improvement certainly from the levels that we're at today. If you want to talk about mix, then I think that was the second half of your question. When I look at mix for the third quarter, there's some headwinds there certainly. Auto is a part of that. To have autos down year-over-year is pretty significant when you think about where we were last year in 2020, just kind of coming out of the shutdowns and, and the other manufacturers were still struggling to get workers back in place. And so that's a pretty significant headwind for us on the mix perspective. We also have the grain now. That's a mixed headwind. And then just love to talk about mix within mix. And so if you think about the intermodal sector, with parcel being down year-over-year, that's a bit of a mix headwind. So mix is probably going to be stressed a little bit here for sure in the third quarter, but we'll see if we can get, again, autos and grain turn back around here in the fourth quarter. That should look a lot better.

Yes. And you obviously have this incremental margin framework now, I think 65% to 70%-ish running better than in the first half. It looks like, obviously, the third quarter, it's just going to be really difficult to -- you're obviously going to see year-on-year growth. You might see some sequential revenue decline. Talk about kind of the fixed cost deleveraging that's going to occur sequentially. Is there anything you could do? I know in the second quarter of last year, there were a lot of proactive things you did to kind of limit or mute that decremental margin. What can you do now and just what's the right calibration on how to think about incrementals given that mix headwind in the third quarter?

Yes. Well, just a couple of things there. So our long-term incremental guidance is mid- to high 60s from 2020 to 2024. What we said, we expected to have 78% incremental margins in the second quarter. Our expectations for the back half of 2021 is that we'll average in the ballpark between third and fourth quarter. It's going to be a little stressed, perhaps. But we still think we have opportunity to do that. And it is all really volume-related. You've seen our headcount numbers, we're staying very close there. We're continuing to get solid productivity as the network pulls back up, and we're able to get that velocity back up, and the inventory should -- we're looking for strong performance.

Yes. And I guess I would say that just looking across the rail sector, in general, I would say that the volume has been disappointing across the board. And there's obviously a lot of supply constraints. I'm trying to parse through maybe what's in your control, what's out of your control. I don't really know if it matters at the end of the day, it is what it is. But if I look at the UP's volumes, you guys are running below where you were in 2019. You're running 4%, 5% below year-to-date where you were in 2019. It's just the circuity of the network, just that upside down at the moment. The supply constraint is really limiting your ability, the equipment shortages, the chassis shortage is making you guys meet your volumes. What's going on really that's limiting, because obviously demand remains robust, and it's well above 2019 levels.

Well, I mean, you've said a lot of those things. We'll start with autos. Again, that's the chip shortage. So there's just not the auto's [ shipping aspects ], both our finished vehicle line and it affects the parts. So you've got that piece of it. On the grain side, we would say it's a supply issue that we're seeing right now here in the third quarter. We expect that though to resolve itself. So I wouldn't put that on anything network or capacity-related, other than the supply of the crop. If you go to intermodal, then dray capacity is still an issue. That's very much just an issue on international side, in particular, to a lesser extent on the domestic side. I'd say the domestic issue really there is more the chassis in terms of shortages relative to the chassis. When you think about other parts of our network like lumber for example, and Eric will [indiscernible] I know there's an example I was just looking at the other day when we had the bridge outage, where there was the carload coming down in I-5 that would normally have taken what, 5 days and because of the reroutes...

Yes. So if you think that the reroutes normally have a transit time from, say, Southern California, Northern California up to Portland or back, you normally have like 2, 2.5 days and with the reroutes, it may take anywhere between 4 and 5 additional things on top of it. So reroutes certainly had the impact. And that's why we see the inventory that we have as far as our car count grow because we still want to be able to infuse those resources, knowing that we want to be able to turn those cars at the expected times, thanks to our customers. But when you're rerouting 7 days, what used to be 2, you're going to have some sluggishness that's built in.

Yes. And that's going to impact your [indiscernible] too. Your ability to reload that car you basically cut in half and maybe buy a little bit more than that in some cases.

Can we talk about maybe a more positive aspect of the -- sorry, which is obviously yield and pricing. Yield obviously turned nicely positive in the second quarter. I think more than half of that was fuel surcharge driven. You're seeing 3-ish percent kind of price/mix benefit last quarter. How should we think about yields offsetting some of the volume headwind? Do you think yields can be up sequentially? Obviously, you'll have some of the benefit of the fuel surcharge, but maybe the mix is a little bit more challenged. Talk about mix trends sequentially from 2Q to 3Q.

Yes. I mean, certainly, to your point, the fuel on a year-over-year basis is going to continue to help us. Sequentially, it probably help us a little bit as you continue to see fuel prices go up just a little bit. And obviously, we have the 2-month lag. So that pushes a little of that forward from quarter-to-quarter. So some benefit there. Certainly, the pricing environment, it continues to be favorable. I mean capacity is tight in a number of areas, particularly that domestic intermodal piece, and we have good ability we go through kind of an annual pricing cycle with that in some of those prices from a domestic intermodal standpoint, those kick in, in third and fourth quarter. So we still see good opportunities. Obviously, still very confident in our ability to price above inflation, and we'll look for that to -- I would say, should be able to improve somewhat sequentially. I'm not looking for a large step change, but I think we can continue to see improvements.

So even with the mix challenges sequentially, do you think yields -- overall yields can actually move up a little bit sequentially from the second quarter?

I did say marginally, yes.

Yes. And I guess on the pricing side, Jennifer, I just wanted to follow up on that. The majority of your contracts, small majority, 55% or so, kind of renew every year or there's some spot tariff business. That's obviously an interesting opportunity given where truckload capacity is today. I think you guys obviously stopped disclosing core pricing. The whole industry has not talked about pricing in a while, at least disclose pricing. When can we have that be a more meaningful -- see a more meaningful impact on yields? You talked about third or fourth quarter. Is that when we really start to see the inflection? Or is this more of a 2022 story?

Well, it has a lot to do with pricing and it has a lot to do with the ability to bring that business on. And as we were just talking, you have some constraints on that on the chassis side of the world. We actually still have containers I don't remember the exact number, maybe 2,000 or so containers, that we don't have pulled out stacks right now because there aren't the chassis associated with them. And so while we're getting good price in that market, we're not moving as much volume against that as you like. And I think as you recall, Amit, the way that we calculate price, and even though we don't state it when we show the waterfall with the revenue, we're still using that same methodology. We're not using a same-store sales kind of methodology and giving ourselves credit if I put a 10% price in the market. We didn't move anything. I got it with the freight to get that price. So the volume of it is maybe what's holding that back a little bit.

Yes. And then we've seen in the past that core pricing number when you guys did disclose it, in some really tight markets, it was above 4% in a particular period. Do you see that type of opportunity in terms of core pricing gains over the next 12 to 18 months? Just talk about kind of the level of pricing opportunity relative to past cycles?

Yes. I mean I'm not going to you obviously any numbers on that, but it is a positive pricing environment right now. And as we look out into 2022, it looks like it's going to stay in positive territory. There's nothing -- there's no indicator or any way that we're seeing on the horizon that would say that there's going to be a big influx of capacity -- truck capacity into the marketplace in early 2022. The shortages along the lines when you hear about recruiting for truck drivers and it's back-to-school season, how people are talking about recruiting bus drivers. So there is just a workplace shortage that is impacting that. And while it has a very positive impact on price, it will also have constraints to volume to a certain extent.

And is the pricing opportunity kind of what gives you confidence in that 56.5 OR target for this year? I'm just trying to understand, obviously, there's some risks, I would say, to the volume forecast. Now hopefully, in the fourth quarter, you get some acceleration. But is the pricing kind of a nice offset that gives you confidence that, hey, listen, if loan growth is 5% or 6% for the full year, you're still going to be able to hit that productivity number in that operating ratio.

Yes, I mean I'm not just swinging my hat on a [indiscernible] our ability to get price to drive the operating ratio. I have, as I mentioned, every confidence in the work that Eric and his team are doing. They're doing the right things. They're still driving productivity, even in the face of some of these operational challenges. And so as they continue to drive that, as they continue to drive the network fluidity, it's all 3 levers that are going to get us to that 56.5 target, which is volume, price and productivity. So it's not one or the other. It's all 3 that we're going to push to get there.