Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Good morning, everyone. Welcome back to day 2 of the Laguna conference. And kicking off the transportation track today with Union Pacific, and we are very excited to have with us today Lance Fritz, Chairman, President and CEO; Jennifer Hamann, EVP and CFO; and Brad Stock, AVP from IR team. Thanks so much for joining us this morning.

Thank you, Ravi. Thanks for having us at your ninth conference, virtual this time around, we were talking about that a little bit. I do have some comments this morning. So if you'd like, please go to our website, in the investor site of our website, you'll see the slides that I'll be speaking to. Before we start, I'd like to remind everybody that I'll be making some forward looking statements. These statements are subject to risks and uncertainties so please refer to the [ UNP site ] and our SEC [Audio Gap] for additional information about our risk factors. So let's get started. If you're following the slides, we're going to Slide 3. Over the course of 2021 and continuing into the third quarter, our network has been presented with some challenges. Supply chain disruptions and mother nature have placed pressure on the network, negatively impacting our service metrics. Freight car velocity and freight car terminal dwell have been impacted by the wildfires on our Dry Canyon Bridge outage as well as mudslides and Hurricane Ida. These events also have directly impacted our Trip Plan Compliance and our service to our customers. Although we've undertaken numerous actions to help both the West Coast ports and our customers, congestion in the international intermodal supply chain continues as the shortage of labor, chassis and warehouse space limits throughput. Unfortunately, this, too, has placed pressure on our service product as we're metering our assets to stay balanced within the broader supply chain. Our service product is recovering, and I'm pleased with the progress we've made to this point, but we acknowledge there is still work to be done. Despite these challenges, the team continues to generate locomotive and workforce productivity. Train length in July was heavily impacted by the reroutes that were mandated by the bridge outage in Northern California. However, August results demonstrate the team's ability to bounce back quickly using PSR principles. This provides confidence that we will heal the network and deliver for our customers as we close out the third quarter and head into the fourth quarter. Going to Slide 4. While the demand environment remains strong, our third quarter volumes are being impacted by several macroeconomic factors. Third quarter volumes are flat versus last year. And while we're encouraged by the 15% increase in industrial, it's being offset by a 7% decline in our premium business. To put more context around our volume picture, sequentially, we've seen our volumes decline by 4% on a 7-day basis. Both volumes are up 3% versus last year. Coal leads that improvement, up 6%, driven by increased natural gas prices. Grain and grain products, however, are down 3%, and grain is down 23% due to low grain supply. However, the territories that we serve are expecting a good strong harvest. So coupled with continued heightened demand, we expect a strong fourth quarter in grain. In industrial, we've seen consistent volumes across most business lines and continued strength in markets like paper and plastics. The opening of the first new mill, steel coil mill built on our network in more than 100 years also should contribute to strong metals volume in the fourth quarter. Finally, the primary driver of our soft third quarter volumes is our premium business, both Internet -- intermodal and autos. Intermodal volumes are being impacted by the ongoing congestion within the international intermodal supply chain that I just discussed as well as tough comparisons in our parcel business as overall demand in e-commerce is a bit down compared to a year ago. The semiconductor shortage continues to have a significant impact on our autos business. In fact, the impact in the third quarter has been greater than that in the second quarter. It seems fair to say at this point that the impact is likely going to continue through the rest of this year and into next year. Turning to Slide 5. At our second quarter earnings call back in July, we laid out the guidance shown on this slide. With soft volumes in the third quarter, our risk of achieving the 7% growth target has increased. We still see a path to that goal with strong demand across many of the markets, including intermodal and grain, as well as 3.5 months left in the year. But we acknowledge it gets tougher each day if the volume picture doesn't improve relatively quickly. With our productivity target of $500 million, the operating challenges experienced throughout the year make that a steeper climb, but the team continues to produce strong productivity and remains focused on the goal. Finally, despite these headwinds and a slightly more challenging fuel price impact, we still have confidence that 200 basis points of operating ratio improvement is achievable given our ability to pull on the 3 levers of price, productivity and volume. We're looking for a strong close to 2021 as we work to overcome some of the challenges that we faced this year. Importantly, the entire Union Pacific team is laser-focused on making these targets a reality. Wrapping up on our Slide 6. Union Pacific continues to make strides toward our goal to achieve a more sustainable future. Using the United Nations sustainable -- Sustainability Development Goals as a guide, we've aligned much of our work around the 4 areas that you see on this slide. Let me talk to a couple starting with investing in our workforce. Working towards a more diverse workforce, we're taking action across multiple fronts to increase gender diversity to 11% and minority representation to 40% by 2030. We understand the key component is transparent disclosures to be held accountable to our goals, building off the enhanced sustainability report that we released in May. A few weeks ago, we released our 2018, 2019 and 2020 EEO-1 reports, and we've mapped those EEO-1 numbers to our previous disclosures. Additionally, we will continue to provide quarterly updates on our progress to our 2030 diversity representation goals. With regard to championing environmental stewardship, that 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 Progress Rail, allowing us to blend up to 20% biodiesel in our EMD locomotives. This is another key step in our goal to reduce our greenhouse gas emissions on an absolute basis by 26% by 2030. Additionally, by the end of the year, we're targeting the release of our initial climate action plan to lay out more details around how we will achieve our SBTi target while also providing measures to track our progress. These enhanced disclosures are the first of several planned improvements that we look forward to announcing over the next 6 to 12 months, all based on the TCFD and SASB frameworks. We have great momentum building within our ESG efforts and believe we must take a leadership role to build a better future. So with that, Ravi, let's get into Q&A.

Thanks, Lance and Jennifer. That was very, very clear. I have a bunch of questions for you. Before I do that, I have to point out that for important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And also for the audience, if you have any questions for Lance or Jennifer, please submit them via webcast, and I can convey those questions to the management team. So Lance, again, very clear. Obviously, you've been doing this for a long time. I'm sure you've seen it all, but clearly, the last 18 months, the disruption you've seen kind of doesn't seem to get any easier. But clearly, you guys have been doing an amazing job of plowing through that. Again, just looking at that path forward, does it feel like you guys know exactly what you need to do? And so it's a case of blocking and tackling and so that 4Q should be much cleaner? Or do you still feel like there's a bunch of uncertainty out there?

No. 100%, it feels to me like it's all about blocking and tackling at this point. So when you go backwards, the bridge fires, the wildfires and the impact on our network in California was very significant, right? It cut down -- it severed our I-5 quarter, and we had to reroute traffic all the way to Salt Lake to get it back up to Portland and Seattle. But what that fundamentally did is it demanded more locomotives, think in the neighborhood of hundreds of more locomotives because the grades and the routing were more aggressive. And then it also demanded more manpower, more people to man our trains. So we had to shift a bunch of borrow outs, put in a bunch of power in the network. And then it also extended the times to get from L.A. to up in the Pacific Northwest and back. That used to be about a 2-day trip. And while our route was out, it turned into a 7-day trip. That increased a lot of inventory in the network. So what we've been doing since recovering the network entirely, let's say, in the first week of August has been getting the original routing back, which it has been 2 weeks after that routing was restored, but then leading off the excess inventory and putting the resource back where they need to be. That's taken a little longer than I'd like it to, but I see real good progress happening right now. We had a couple of other impacts along the way. We had some mudslides caused by monsoon rains in Arizona, New Mexico, Western Texas. Then we had Hurricane Ida, of course, be a little disruptor. I look at those, and I think those are kind of blips along the way of continuous improvement. So our weekly statistics right now are showing me that we're making good progress on car velocity, going back north of 200 as we're trying to shoot for north of 220 miles a day, getting our car terminal dwell down to that 23 hours or less. And by all measures, it looks like we're about halfway to where I want to be, but we've got plenty of work to get the other half.

Got it. It's very clear that the weather-related disruptions are transitory, and you will no doubt get past them. But obviously, when we look at the congestion issues, which is a factor that's impacted all the railroads, in fact, all supply chains, global supply chains, if you will, for the last 12 months or so, do you feel like that's more of a structural issue? What exactly is the problem? And how much of that is actually driven by pandemic factors and so will normalize when the world normalizes again? How much of that is potentially pandemic driven, but is not going to normalize? How much of that is not pandemic driven? Obviously, you guys are much closer to it than we are. If you can just unpack the causes of that and how much of the congestion issue is structural versus cyclical, that would be great.

Yes. Ravi, let me focus in on the international intermodal supply chain to unpack your question. So you start all the way over in factories, let's say, in Asia, ports in Asia, get across the Pacific, ports on the West Coast, and then we take it inland to distribution facilities somewhere east of the West Coast. So in that supply chain, for about the last year, what we've seen is we can control the middle mile. And we haven't had a lot of disruption in the middle miles of the supply chain. COVID gets at us a little bit every once a while. We -- it's been a little difficult in L.A. It turns into not having enough manpower to launch on [ time, ] on demand, but it doesn't really stop the network from operating. It basically makes us a little late, which makes us then late on the back end. But the bigger concerns have been about fundamental manpower shortages and mostly on the back end. I'd say dray drivers and warehouse labor has been a real issue, and we saw that play out. Earlier in the year, in the second quarter, when we saw demand against the West Coast ports, particularly in the Southwest, L.A. and Long Beach, turn into ships off-dock waiting to land, we upped our resources. We increased our outbound capability from those ports by about 150 to 200 boxes a day. It was about a 20%, 25% increase, maybe 30% increase. And we kept up against it. Well, we moved all those boxes into Chicago, and there was not enough capacity to take them off our ramp and get them into distribution. So we saw boxes stack up on G4. We had to open up G3 and G1 again to be available for box inventory, which is not a good thing, but it helped our customers at least maintain some level of fluidity. And that's when we took a pause. So we stopped the flow because the tail end couldn't handle it. Since that pause, the tail end has been fluid. So we're metering volume as the tail end could take it. But you see ships starting to grow again, waiting to dock on the West Coast. So the supply chain overall is not balanced out yet, and it won't balance out. Now it's not clear if the West Coast and some of the supply chain issues at dray and warehouses, how much of that is COVID, I think it's fractional, and how much is I don't need the work or I've got unemployment benefits that are perfectly adequate or whatever. I think that's a fair amount of it as well. We should see that play out over the course of the next few months, if it's unemployment benefits, and I feel pretty flushed. But if it's COVID, who knows, that's going to be all about the Delta variant.

Got it. So if it is more of the latter and, let's say, we are sitting here 6 months from now and it hasn't really improved, what's plan B? I mean is there an answer where the entire supply chain complex kind of just throws money and resources at the problem and kind of tries to attract people back? Is it automation? Obviously, that can't be done in the 6-month period. So what is the plan B?

Yes. So it strikes me when I'm talking to my customers that they are very aggressive at pursuing, making sure they're resourced properly in their warehouse and their distribution sites, and making sure that their employees are safe there so that they can keep the employment up. In the dray drivers, it's all about making sure we're training truck drivers and getting them graduated and into the seats. Now you've seen, like I've seen, wages are increasing in that area. I know the schools largely are up and running and pumping out drivers again. We've got still some issues, right? There's the clearinghouse for drug and alcohol testing that has, what, something like 60,000 drivers in it right now, and who knows, maybe a portion of them drop out forever. But I think there's the capacity to be able to handle staffing up the seats in trucks. It just takes time, right? We got to get them through school and graduated. West Coast ports, a little bit different story, right? They are dealing with the ILWU there. They have to make sure that there's a good management/labor relationship. They've got to make sure that, that workforce is healthy and can come to work. And I know periodically, they're looking at ways to automate there as well to augment what they're able to do with their labor force. I don't think it's a matter of having to throw large amounts of money and go willy-nilly at trying to fix this. I think the pathways are clear. It's blocking and tackling at this point. And I think the -- our supply chain partners are capable of that. I know the railroads.

Yes. And I think at some point, the inventory has to normalize, too, because right now, you continue to have -- inventory levels are still very low. So you continue to have the surge of traffic that wants to come inland to replenish that. And so we've got to reach that normalization point as well. And that, I think, is something that will help this dynamic longer term.

Got it. That's a great point. I do want to ask you about a couple of specific end markets, maybe starting with autos and probably the end market where inventory is the greatest problem. Lance, I think you said in your opening comments that you don't think that improves before the end of this year. What are you hearing from your customers? Do you have a line of sight into a time line of improving there at all? And second, I think everyone believes quite logically that when it does come back, there's going to be this surge of inventory rebuilding. I mean do you feel like that's going to make the auto portion of your network kind of even more strained? And I'm sure you guys are planning for that. So how do we think about that in 2022?

Yes. It's very difficult to give you a decent guess to when the semiconductor shortage gets remedied. That's all about making sure that the semiconductor industry is increasing capacity in production. Part of their impact has been COVID and the COVID impacts on production, but there's a real strong increase in demand overall for units. And so that's about increasing capacity. That takes a while in that industry. I know it's underway, but it does take a while. So what we're hearing from our OEM customers is they do expect that the impacts are going to last through the rest of this year and into next [ year. ] They just don't have a good feel for how long into next year. Some of them are producing vehicles that do not have the chips necessary in them and then holding them as unshippable inventory. That will be all shipped at some point, and that looks like a great backlog for us. The underlying demand, the [ SAR ] demand feels like it's pretty good. So if there were inventory available to purchase, I think we'd be in that $16.5 million to $17 million ballpark. And I don't think anything changes as you go into next year so long as there's no big economic shock. So as soon as those units are ready to shift, we're ready to ship them. We look forward to that. Plus, Ravi, it's got a knock-on impact on our auto parts business.

And [indiscernible].

And everything.

There's a trickle-down effect on our markets for sure.

Got it. That makes sense. The next end market is coal. We've seen some good news there for an end market that has not been giving you a lot of good news over the last several years or so. I mean you've seen, obviously, nat gas prices really strong. Some of the export coal benchmark are very strong as well. How do you see that playing out through the end of the year into '22? Kind of do you think this balance is sustainable? Kind of are you adding more resources there? And do you think that can be a nice little tailwind for you?

Yes. The good news is when it comes to coal, which is strong right now, relatively speaking, the resources that need to be added are typically sets. And sometimes they come from us. A lot of times, they come from the customer. We have to make sure we have a power base and a crew base that can handle it. And the network can really handle a fair amount of loadings by just cycling in a very efficient manner. Right now, like with the rest of the network, we're about halfway back to where I [Audio Gap] our coal cycle times. And there's a line of sight for that. We got to make sure we keep the crew base healthy. And we've got the power. We've got ample power, and it needs to be positioned in a way where it stays within the coal network, and we're capable of doing that. But I think this is transitory, Ravi. This is all about $3.50 gas, give or take. I see the forward curve just like you do, and it's talking $5-plus maybe. And so that says maybe for going into next year and a fair portion of next year, coal could be pretty [indiscernible]. But in a secular sense, it's still declining. There's still a lot of pressure on removing coal as a primary source or even a meaningful source of power in the United States.

Yes. And...

Got it. And lastly -- sorry, go ahead, Jen.

Oh, I was just going to say, just a reminder, we did lose [ a ] contract coming into the year. So we won't lap that comparison until we get to the beginning of 2022. And the fact that we have adjusted many of our coal contracts to index and with natural gas, that's making our coal-fired plants more competitive in that marketplace. So there is a very direct impact there for us.

Got it. That's a very good point. Just lastly, domestic intermodal, we've spoken a lot about international intermodal. Obviously, the truck market continues to get tighter by the day. What are you seeing in terms of opportunities on truck-to-rail conversion on the domestic side? And maybe kind of a comment on specifically the pricing environment in intermodal and maybe the overall pricing environment as well.

Yes. The domestic intermodal market is still a good, strong market to be competing in. There's plenty of opportunity to convert from truck to rail. Some of that's getting retarded because of these supply chain disruptions we've talked about. It's causing, in one sense, our truck partners and some of our beneficial cargo owners to look to rail as a solution because they're having a hard time finding truck. In another sense, they can be a little panicked in terms of getting their inventory into their stores and in extending that last mile a little further out. So they -- as soon as the box is available to them, trying to get it into their warehouse distribution network. So it's a little bit odd. We're seeing impacts in both directions. Pricing environment is sound. It's a great environment to be competing in. And the fundamental driver, which is consumers buying stuff as opposed to services, that seems to keep going. And consumers seem to be pretty flushed right now, and they seem to be buying things, which is good.

Got it. Maybe shifting gears a bit away from the top line towards the bottom line. Again, you've been very clear about the risks to the top line guidance by the end of the year for factors outside of your control. But we look at the factors within your control, again, really impressed that you're able to hit your productivity targets and your OR improvement target for the year. Can you just give us a little more color there on how do you get productivity in an environment like this? It seems like an environment that's not conducive to productivity at all. Maybe some of the risks around that number as well. And also kind of over the next several weeks, kind of what are some of the benchmarks you're looking at to make sure that you are on track to hit those targets at the end of the year?

So let's use the benchmarks first, and then we'll go backwards into how do we [Audio Gap] this environment. So the benchmarks are the ones we publish, and I'd pay close attention on this, the ones we pay close attention at the highest level. We need car velocity to continue to improve. And the endgame there is somewhere north of 220 miles a day is a great number. That's a very fluid network. We need our locomotive productivity and workforce productivity to keep growing. And that locomotive number, we like it when it's in that 1 40 number, and we love to be north of 1,000 with our workforce. We want to see that Trip Plan Compliance continue to grow and recover. We'd love to see it on the manifest auto side. We'd like that in the mid-70s. And on the intermodal premium side, we see that north of mid-80s. We need to continue to take strong steps in the right direction there. So pay attention to those, the published statistics are the ones to watch. Okay. In terms of how we get productivity, it's really straightforward. We can overwhelm an environment like we're in right now where there's some headwinds, there are some problems with mother nature causing us to do unproductive things in our network. We can overwhelm that with fundamental T Plan design and sticking with PSR principles, right? We've fundamentally designed out of the network work that doesn't need to be done. We're moving as balanced a network as we can, and we keep looking for opportunity there. We're really relentless when it comes to locomotive utilization and inventory. We peaked out at inventory on the overall network probably 3 weeks ago. And we've been just relentless at moving it down. We've taken about half the inventory that needs to come out of the network out, and we've got about half yet to go. Now that can show up in the very early term as, "I don't have a car to give my customer on time who's asking for an empty to low." And that causes real problems. But the promise is, "Well, you let us go for about 2, 3, 4 weeks and there's enough fluidity in the network where I can give you those cars real time as you need them." But if I just allow inventory to do that, we get gummed up and it becomes really, really hard to take the next step in terms of efficient and reliable service. So it really boils down to the fundamental playbook of PSR. It's embedded in how we look at our network. And the cool thing about it is we've released -- we've made empty a bunch of capacity around the network. And when we get into a jackpot situation, it gives us the opportunity to use it for our customer base prudently, but in a way that helps. That's like opening up G3 to store boxes for some of our customers.

Got it. Just to remind the audience, please submit your questions via the webcast. I can literally see hundreds of people on the webcast. So surely, someone has a question out there. But maybe switching gears a little bit and talking about ESG, which is obviously a huge focus area for you guys. I was particularly struck at your Analyst Day a few months ago where you said, I think, literally, your #1 driver of growth in the coming years is going to be kind of convincing shippers that you guys have a much better ESG footprint than trucking does and kind of driving that conversion. How have the conversations gone? And how -- what percentage of your customers kind of have that as a top 3 or even top priority in picking their transportation provider? And kind of -- how do you think that drives incremental conversion? Like is that something that you're looking at in the back half of this decade? Or is that something that happens in the next 3 years?

Yes. Ravi, so I'd start by saying it feels to us like our investing community is slightly ahead of the overall customer marketplace in terms of emphasizing ESG as a critical business component. We understand it. We've been emphasizing it for a while, and we're accelerating ourselves down the path. If you break out our marketplace, there are some aspects of the market like [Audio Gap] industry, plastics, some of the larger retailers, large sophisticated beneficial cargo owners where ESG is almost like table stakes. And to the extent that you can help them achieve their Scope 1, Scope 2, Scope 3 greenhouse gas emission goals, they really want to understand that and know that. We have a tool where every customer that uses us can know immediately how many trucks they took off the highway and how much greenhouse gas emissions they are saving by using us. Little things like that just help ring the bell and remind them. But I would say in terms of becoming a substantial growth generator in and of itself, we're a little ways away from that. In terms of being an important aspect of the overall decision, there's a fair amount of our marketplace that uses that right now, but there's still a pretty large part that doesn't. And I think that will change and shift over time. And in your time frame, 2, 3 years, I think by the end of our 3-year planning horizon, it's going to be much more emphasized by our customer mix.

Yes. We're starting to see it show up on RFPs more and more, more as, I'll say, a question mark kind of a yes, no versus I'm going to make a decision based on it kind of thing. So to Lance's point, I think that is evolving and as more of our customers are getting the same questions we are getting, quite frankly, from investors. You're seeing that move down through their organization. So we do see that as an opportunity. I kind of consider us the easy button for shippers, especially ones that are using us already, but they're splitting their loads [ between rail and ] truck. Just take that truck piece, shift it over to us, and you've automatically made a very positive impact on your carbon footprint.

Got it. So the good news is that my appeal for questions has opened the floodgates a little bit. So I'm going to toss a couple your way in the few minutes we have left. The first one is, how much of a factor is mix, which is coal versus intermodal? How much of it -- how much of the -- is that a factor in being able to hit the 200 basis points in margin expansion for the full year?

Yes. So mix always cuts both ways, right? We're seeing good news, like you said, on the coal front. Intermodal being down actually is a positive to mix, but you also have the premium down, and you have grain gap. And so those are 2 pretty big negatives when you think about automotive, finished vehicles and then grain, offset by some of the growth in coal. And then the industrial products line, too. I mean, in general, with industrial products up 15%, that's our highest -- our group in total. And so that's a benefit. So net-net, I think it's holding us, and it's helping us. I wouldn't say it's a huge tailwind for us. We would look for, hopefully, a little bit of mix improvement as we move into the fourth quarter as we should see parcel come back. That's the best part of that premium on the intermodal side as well as the grain [indiscernible] side.

Jennifer, remind us, weren't we negative mix in the first quarter, a bit less so in the second? So it would be nice if we could get some positive tailwind.

Yes. Our yields looked positive and [Audio Gap] look for them to stay positive [indiscernible] through the back half.

Got it. Next is, any concern on pricing and STB's recent comments pinning that on the rail companies to solve that equation?

Yes. Our concern at the STB, Ravi, is about ill-advised reregulation of the industry. We've done a great job over the last 40 years getting to a place where we can reinvest in ourselves, where we provide a very stable service product. It's a better service product than it was at any point in past history, and that's fantastic. We generate a good attractive return for our customers on a historic cost basis. Of course, your investors know that on a replacement cost basis, we still got plenty of room to run. So no, I'm not terribly worried about price control specifically. I'm broadly worried about overall regulation.

Got it. With that, I'm getting the wind-up signal here. So Lance and Jennifer, thank you so much for the comments. Again, thanks so much for being here, and we will chat soon on the earnings call.

Thanks for hosting, Ravi.

Thank you, Ravi.

Thank you. This does conclude the presentation.