Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Good morning, everybody. I'm Jason Seidl, Cowen's Senior Transportation analyst. Welcome to our 14th Annual Global Transportation and Sustainable Mobility Conference. Cowen is honored and pleased to once again have Union Pacific Corporation present. Representing Union Pacific is Jennifer Hamann, Executive Vice President and Chief Financial Officer. And I believe Bradley Stock, Head of Investor Relations, is also in the background to answer all the tough questions I'm sure Jennifer will push to him. Jennifer is going to go through a little presentation. So let me turn it over to Jennifer, and she'll take it away.

All right. Well, thank you very much, Jason, and good morning, everyone. I need to start off with some cautionary notes. The slides that are accompanying our prepared comments this morning, while shown on this video, can also be found on our investor website next to the webcast for this event. Before I start, I want to remind everybody, I will be making some forward-looking statements. 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. So we'll start off on Slide 3, which is an update of our current volumes in the third quarter. On the slide, we're showing you both the year-over-year and sequential 7-day quarterly changes as both are important. Compared to last year, third quarter volumes are flat year-over-year, led by 15% increase in industrial, offset by a 7% decline in premium. Sequentially, however, you can actually see that our volumes have declined by 4% on a 7-day basis. Although we were not expecting to see what I would call the normal seasonal patterns with a step-up from second quarter to third quarter sequentially, which is usually around 3%, third quarter volumes are more muted than what we had originally anticipated. The primary driver is our premium business, both intermodal and autos. Intermodal volumes are impacted by a couple of factors. First, congestion within the international Intermodal supply chain is affecting volumes as we are purposely matching the demand moving inland from the ports with the takeaway capacity at our Eastern gateways. At the same time, the number of ships anchored at port is growing, so overall demand remains strong. The second factor is that parcel has a tough comparison versus last year as overall demand is down compared to the e-commerce strength seen in 2020. Within autos, I think you're all very familiar with the semiconductor shortages, and those continue to impact our volumes as they're down 16% versus an easy comparison last year and sequentially, actually down 5%. So unfortunately, the negative impact of the chip shortage has actually deteriorated versus the second quarter. Our bulk business is up 2% versus last year but flat sequentially. The mix within that business team has shifted some though in the quarter as coal is up 6% year-over-year, while grain and grain products are down 2% with the grain line down 19%. Although grain volumes are down sequentially in the third quarter, we expect them to improve later this month and then carry into the fourth quarter with the strong harvest and strong export demand expected. Finally, industrial is up 15% versus 2020 and flat sequentially. We have seen consistent volumes across most business lines, especially in metals, where we see upside potential in the fourth quarter with strong market demand and business wins, including the opening the first new steel coil mill built on our network in more than 100 years. Turning to our key performance metrics. Network performance continues to feel the effect of several events. Fires in Northern California damaged our Dry Canyon Bridge and interrupted service along the I-5 corridor for more than 30 days. In order to continue serving our customers, we rerouted shipments around the bridge, adding additional costs associated with crews and locomotives. While our engineering team did a fantastic job returning the bridge to service well ahead of schedule, rebalancing our assets is taking some time. Within the international intermodal supply chain, we paused service to Global 4 in Chicago for 7 days in July to allow dray carriers and warehouses time to catch up with the inventory we were holding in the greater Chicago area. The pause had the desired effect as the backlog of boxes being staged on railcars decreased substantially, and we're again able to land trains on-demand at Global 4. While the international intermodal service product has improved since these actions were taken, we have seen increased purchase services and materials costs associated with inefficient ramp operations. Finally, last week, our Gulf Coast service was slowed by Hurricane Ida. While the human impact of Ida is significant, we're fortunate that the impact on our network was very minimal, but New Orleans is still largely without power. We have our fingers crossed for a calmer fall, needless to say. In terms [ units ] produced, locomotive and workforce productivity. We have injected locomotive resources into the network, which does add some costs, but we still plan to be flat sequentially and for the balance of the year as it relates to our workforce at around 30,000 full time equivalent employees. Train length in the quarter demonstrates the impact that the bridge outage and reroutes as prioritizing moving cars through impacted corridors impacts that train length. As fluidity improves, I would expect that you'll see train length start to grow again as it is essential to driving efficient and consistent service. Related to train length, we remain on plan to complete 20 siding projects in 2021, which is in addition to the 5 we completed in 2019 and the 36 sidings completed in 2020. To wrap things up then on Slide 6, Union Pacific continues to make strides toward our goal to achieve a more sustainable future. Using the UN Sustainability Development Goals as our guide, we've aligned much of our work around the 4 areas that are shown on this slide. Let me talk to just a couple of those with -- starting off with investing in our workforce. Working towards a more diverse workforce, we are taking action across multiple fronts to achieve our 2030 goals of female representation of 11% and minority representation of 40%. We understand the key component is transparent disclosure and to be held accountable for those goals. So building off the enhanced sustainability report that we published in May, a couple of weeks ago, we released our 2018, 2019 and 2020 EEO-1 reports. With regard to championing environmental stewardship. It will require action across a number of fronts to make real and lasting change. One action we announced a couple of weeks ago was an agreement with ProgressRail allowing us to blend up to 20% renewable diesel in our EMP locomotives. This is another key step toward our SBTi goal to reduce greenhouse gas emissions on an absolute basis by 26% in the year 2030. Additionally, by the end of the year, we are targeting the release of our initial climate action plan, which will lay out more details around how we plan to achieve that SBTi target while also providing measures to track our progress. These enhanced disclosures are the first of several planned disclosures and improvements we look forward to making over the next 6 to 12 months. We have some great momentum building within our ESG efforts and believe we must take a leadership role to build a better future. So with that, Jason, I know you've got some questions, so I'll turn it back over to you.

Thank you, Jennifer, for that great update. I just want to remind our listeners here, you can go and put a question in the chat room, I'll see it. Alternatively, you could email me at [email protected], I'll try to get to everything. Jennifer, I want to start a little bit with the macro sort of demand front. It's shifting around a bit. You've covered some of it since the second quarter, automotive curtailments, Delta variant issues, fires, hurricanes, it seems like everything has been going on in -- since the second quarter here. What are your sort of current views on growing volumes sort of in different sectors for the remainder of the year as well as how many of these issues are going to jump into next year and maybe beyond? Because we've heard from some of the automotive manufacturers that this chip shortage can last till 2022.

Yes. I mean as I think you know, Jason, we have, I think -- and unfortunately, erroneously kind of kept saying the chip shortage is ending. We're thinking that we're getting better. And then unfortunately, it just continues to get worse. So I think you're probably right. I think that is something that's going to be with us here for most of 2021 and linger into 2022. Inventories on dealer lots are very low. I think the demand is strong. We know the consumer is very healthy from a monetary standpoint. So feel good about the fact that once that shortage resolves itself that there should be strong demand. We know that the auto manufacturers, in many cases, have continued to manufacture the automobiles and are just staging them around the plants, ready to have the chips installed and then we'll be ready to ship them. So it truly is some pent-up demand there that at some point is going to break through. We just don't have good visibility to when that is. I'd say similar on the Intermodal side of the world, with the backup building again on the West Coast ports and the demand that seems to be there. As I mentioned, we're purposely matching what we're taking off the ports to what people can haul away at our Eastern gateways. And as a result, you're seeing some of the ships build up again. And that's in part because we're metering, but it's also because warehouses, dray labor around the ports is in short supply as well. And I think a lot of those warehouses don't have a lot of capacity either. So it's those things that are having an impact, and it feels like they're going to linger into 2022. That doesn't seem like there's going to be a quick fix to any of them. So demand from those things, I think, remains strong and looks good. As I mentioned, we do have a lull right now in some of our grain volumes, but we look for that to pick back up as the harvest season starts. I know there's drought in a number of areas. Canada, in particular, I think, has been pretty hard hit. And while it's a little dry in our served territory, it's really not been too bad. And we've gotten some late rains that should help the crop and help that harvest. So looking forward to that. And the industrial side is really looking quite good, and we have some further opportunities to grow. So I'd say, overall, at a macro view, demand looks pretty good. From that standpoint, it looks like it's got some good tail going into 2022. Some of the issues, though, with the chips, with intermodal is limiting how some of those volumes are flowing through into our network right now. And so that's probably holding our volumes down a little bit artificially, but we look to work through that.

Let's jump to the West Coast ports because if we go back, and you know I've done many state of report calls with the head of the port of L.A. as well as the heavy -- other ports across the country. The beginning of the year looked terrible, and then they sort of were digging out of it. And it looked like we were going to start sort of seeing the light at the end at the proverbial tunnel. And now it's reversed itself, right? And actually, if you look at the numbers, it's gotten worse than we were at the beginning of the year. What's your view of this situation to get this much worse after they were digging out? And sort of what type of financial impact has that had on you? In other words, as we get out of this, what sort of [indiscernible] for UNP?

Yes. So as I mentioned, I mean, it is -- from a volume standpoint, we are purposely matching the volumes with what can be taken off of our ramps. And so that is having a governor, if you will, in terms of our revenue in the international intermodal space. Some of that is probably, I'll call it, deferred or delayed because it still wants to move inland and it's going to wait and just be a little bit longer in terms of transit time and supply chain. Some of that, though, is moving into warehouses, when it can, when they can find the dray capacity, can find the warehouse capacity. And then when it comes out in that form, it may or may not move on us. It may move by truck at that point. It may move on other IMCs. And it could still move on us, but it becomes a bit more of a jump ball once it goes into that warehouse around the ports and gets break bulked and comes back out again. So that's kind of how we see that happening. I mentioned when you're having to touch containers multiple times in a ramp, which is some of what had to happen here is we have not had chassis on the international side to be able to land the boxes, that increases your cost from a standpoint of having multiple touches. And then to the extent before we were -- did the shutdown in July, we were holding trains out on line of road waiting for available capacity to bring those trains in, so that added some cost to us as well. Net-net, I don't have a number to give you. But I think the revenue piece is the more significant of those 2 pieces, and some of that is deferred and some of that probably is lost.

Do you think the situation got worse in part because some people were shipping early ahead of peak season? Or is that not the case?

I suppose that's possible. I do know inventory, retail sales. If you look at some of the retail sales to inventory ratios, inventories are still pretty low. You still go to different stores around the country, and they don't have the stock that they usually have. And it's odd things that are still missing. But we've all encountered that. You go to your neighborhood Target, Walmart, Costco, whatever, and they don't have something that's like -- it's just the supply chain shortages and that inventory is still pretty low overall, I would say.

Okay. Let's switch to pricing a little bit here. You've always been above cost inflation for many years now. However, rail cost inflation is on the rise. Obviously, the railroads had the benefit of pricing the product in a very tight supply chain environment. That said, where do you think rail cost inflation is going to be by the end of the year? And will UP and some of your other fellow railroads be able to match that?

Yes. So for 2021, we said that our rail cost inflation is going to be about 2.25%. Our long-term view that we gave at our Analyst Day back in May was 2.25%. And while that maybe sounds a little bit low compared to some of the inflation numbers you see talked about today, if you look back historically, call it over the last 5 years, our inflation was more like 1.5% to maybe 2%. So we have seen it move up some, particularly in some of the materials. So that really impacts a lot of our capital goods and our capital projects when you think about rail, ties, ballast, some of the services and construction around that. So that's why that -- those productivity efforts that we have going on in our engineering space are critical. Certainly, wage inflation is a component there as well. As you know, we're going through our labor negotiations right now with all of our unions. So that's certainly part of the conversation there. But we haven't given a specific target for 2022. We're still working through the plan. In fact, in pretty early days of working through the 2022 plan. But it is a higher inflation market out there, and that means we have to go out. And Kenny and the team need to get more price because we do need to be able to cover those inflation costs and absolutely have every intent of covering our inflation costs with our pricing actions.

It seems like it's a good market to go out and get pricing based on what I've seen throughout the supply chain. Would you concur with those assessments?

Yes. I mean certainly, there are parts of the supply chain that are very tight right now. Truck capacity remains tight. And so that's an area where certainly we have that dynamic. Strong demand in other parts of our industrial space, which is very beneficial. Other markets, maybe not quite so strong. But from a broader macro view, demand in the rail space is good.

Perfect. Let's talk about the regulatory front for a moment. Obviously, I think the pendulum has been shifting over the past couple of years in favor of the shippers. There's been a lot of talk about reciprocal switching and bottlenecks. What's the financial exposure for UNP when you look at reciprocal switching, when you look at bottlenecks? And is there anything the industry and UNP can do going forward to limit any of these potential regulatory impacts?

Well, Jason, you've covered the industry for a long time. Really, ever since deregulation, there have been periods where the STB and others have been looking to increase regulation on us. And really, kind of first and foremost, our best answer to regulation is our service product and our investment in our network. And so that's what we're obviously very focused on is providing a great reliable service product for our customers. When I think about and read some of the things, obviously, that are out there in terms of the executive order relative to regulation, one of the things that I think is maybe missing or not being like fully considered is that you also have the administration saying that climate is a top priority for them. And we are -- the rail industry is very environmentally friendly. And we can play a great role going forward in contributing to reducing carbon emissions for our shippers. Yet you have this talk of wanting to limit our ability to compete naturally, compete effectively, and we think there's a very competitive dynamic that's in the market today. And we invest in our own infrastructure. We're not relying on taxpayer dollars. We actually are substantial tax payers. And so we see, I guess, some disconnects if you think about it in terms of what one part of the government is saying and what the other part is saying. We'd like to kind of a whole-of-government approach to recognize that we're a very positive contributor to the U.S. economy, to labor, when you think about strong, good paying union positions and then the carbon side. So that's our argument against some of the calls for increased regulation. That -- and it's a very competitive market. We compete heavily against one another, and we compete heavily against other modes of transportation, truck. And when you think about where we're looking to grow long term, where most of the industry is looking to grow long term, it's intermodal. And that's a truck competitive market. So we'll just continue to provide the best service product that we can. I can't give you any size to any potential reregulation. It really depends on what might happen. But from our view, it's a very competitive, healthy industry today. And increased regulation could be detrimental on a number of fronts beyond rail space but to the economy and to the climate.

You brought up an interesting point. You talked about intermodal and how important that is for the rail industry to grow and I wholeheartedly agree. What are some of the things that you're doing now or maybe need to do in the future to continue to grow that product with your shippers? What -- in other words, what can Union Pacific do increase sort of the supply chain visibility of the intermodal product?

Yes. Well, there's, I think, a number of things that we can do there, Jason. One of the things is increased visibility. You heard us talk about some of the work that we have underway with Jon Panzer and his intermodal excellence team. We talked about that at our Analyst Day. Because we recognize for us to be able to grow in that space as aggressively as we want to and plan to, we're going to have to make a different experience for our customers. We need to improve the reliability of our service. We need to improve the predictability of the service and provide more accurate lead times to our customers so that they can engage their dray drivers and make that a more predictable experience in terms of when that box is actually going to be available for the driver to pick up. So some of that involves better visibility to where the trains are at, better visibility to the container, adding more machine learning, artificial intelligence in terms of that predictability around boxes being available. And then even just that driver experience of when the driver comes on for our ramps, how quickly they're able to come through the gate, find their load and exit. We know that when the drivers are getting their assignments or taking their assignments in the course of the day, they're making some of those selections based on how many loads can I get? And is it, a, if I go to a Union Pacific ramp, I know that I can get in and out quickly, and I can make a couple of more loads or moves today versus if I go to another ramp and it's maybe a slower, less fluid experience. So I think those things are important and just getting better visibility. We are looking at different ways through APIs to give more control and visibility to our customers directly.

Let's jump to my last question, and then I'll turn it over to the audience. I figure we only got one question from the meeting here. The KSU saga has been interesting, to say the least. What, if any, impacts do you think a completed transaction will have on UNP? And could this lead to further consolidation in the industry?

Yes. So in terms of the last point first, from a further consolidation point. I mean, again, you look at the executive order, if you look at some of the commentary that's come out of Service Transportation Board, I would say that neither of those is very welcoming in terms of further consolidation in the industry. It seems like there's certainly a sentiment that there has been enough consolidation. And while this one small piece may makes sense as it's end-to-end, that they aren't looking forward to further consolidation. So -- and just building on top of that with the CP transaction, if that's the transaction that goes through, that's under the older rules versus the new rules. So at the end of the day, we may -- we wouldn't still know what it means to enhance competition. That still remains a bit of a black box in terms of what's being looked for there. We're not afraid of competition. We like competition. And so moving to the transaction itself, we compete for that business today that we would now compete for against a combined CP-KCS. Our concern, and you've heard us say this before, is that we want to be treated equitably south of the border. We want to make sure that our customers have the same opportunities and selections today, I should say, going forward that they have today. To size it, about 11% of our business moves North-South. That's split pretty equally between the Kansas City Southern and the FXE where we have a 26% stake. So we look forward to competing. We know that we have a favorable route structure when you come north of the border. That's why a lot of that business tends to exchange from KCSM to UP today. That won't change. It would go from an interchange service to single-line service with a merger. But we think we can compete effectively at that as long as we can be guaranteed that we're treated equitably south of the border.

Okay. Perfect. Let me go to some of the questions we have in here. One of the first question, I'm going to read here. What are puts and takes into the second half operating ratio given weaker sequential volumes, lower train length and adding equipment to the network?

Yes. I mean all of those things challenge -- what we're experiencing today challenges our ability to get to 7% volume growth. That challenges our ability to hit the 200 basis points of operating ratio improvement. We still believe we have line of sight and the ability to achieve both. Part of that is we do have -- even though we're challenged, we are still generating positive productivity. The pricing environment that we've talked about a little bit earlier is favorable. And so those are positive dynamics. But we still have also 4 months of the year to play out. And so we're looking to see a strong close to the year. As we continue to get further distance between us and some of the temporary issues that we've encountered, as we're able to spool our network back up, that gives us some greater fluidity, gives us the ability to move more business. While we were originally hoping that the chip shortage was going to resolve itself, that's probably going to remain and maybe our biggest headwind as I move into the second half of the year.

So would it be fair to say that you're not changing guidance. There's still a chance that you can get there. It's just going to be a little bit harder than it was when you initially put it on with you?

No, that's well said, Jason. I mean we absolutely still have a path to achieve those things, but it is a little bit higher-risk profile. And it's going to be a little bit harder here in the last 4 months of the year than what we would have thought sitting here, call it, 1.5 months ago in July when we were giving our second quarter earnings release.

Okay. Let's go to the next questions. With climate change and weather creating service disruptions, what steps is UNP taking to harden infrastructure to reduce outages?

Sure. So we're doing a number of things, actually. One of the things that we have done for a while is we work very closely with the National Weather Service and some other weather companies to help get good visibility when there are storms approaching, when something is happening. So contemporaneous with severe weather that we can make adjustments to how we're running our train schedules. So that's one thing. That's kind of the day-to-day piece. But we also look back through history and look at hydrology reports, look at where we have historically had issues... [Audio Gap] and go through and range it on an annual [ basis ], in the track hire that, in places, if we raise the track a few feet, it's above the areas where it's typically flooded. We're also very diligent about making sure that our culverts are cleared out so that one of the things that doesn't happen is if you have some sort of a flash water event that the problem isn't on us in terms of having a culvert that's not cleaned, and just going through kind of systematically around the railroad and taking that approach to looking at where are the high-risk areas and then what can we do to mitigate the risk in those areas.

No. It's definitely an interesting question from one of the clients there because we just had obviously major flooding events in the tri-state area. And even right behind me, Jersey Transit was underwater in several locations. The next question, what percentage of intermodal volumes are e-commerce/parcel? And how much of a year-over-year headwind is that right now? I know you brought it up a little bit before.

Yes. So on the e-commerce side, we've not ever broken that out. It's part of our domestic intermodal segment. If you look at our intermodal business in total, it's not quite 50-50, international and domestic, but that's fairly close. And I think we've said that the parcel business, Brad, is down double digits right now. Is that fair to say? Yes.

Okay. You brought up Mexico and your interchange partners. You own a portion of Ferromex now. Would you ever consider trying to increase your ownership stake?

Yes. So we do own 26% of the Ferromex, and we've had that stake since the late 1990s. It was part of the concession purchase. Just a little bit of history. We originally bought 13%. And then one of the other partners exited a few years later. And we picked up their share to take it to 26%. It's been a great investment for us. It's been a great partnership with the FXE. We don't have any immediate plans to change that. We continue to develop the relationship and work very closely with one another. I never say never to anything, but there's no immediate plans to change that relationship.

Perfect. Well, Jennifer, that's all the questions I have, and that's all the questions we have from the clients. I want to thank yourself, Brad in the background there and the rest of the people at Union Pacific for taking the time today to speak to us. Jennifer, be well.

Yes, you too, Jason. Thanks very much.

Thank you. Please join us in about 10 minutes for a hub group.