Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

[Audio Gap] Barclays transportation and airlines analyst. Just want to welcome you to the first session of our 39th Annual Barclays Industrial Select Conference in sunny Miami Beach. So very glad to be back in person and getting back home after 2 years of the pandemic.

Amen.

And to kick it off, I'm very excited to host Mr. Lance Fritz and Jennifer Hamann from Union Pacific, I think, North America's largest railroad. And also, we're going to talk a lot here about the various businesses and obviously, their longer-term trends towards better margins, better cash flow. But it's been a great story thus far. So I don't know, Lance, did you want to kick it off with a few remarks?

I do but I'm not going to look at them. We're just going to make this up. First off, we're going to say some things that are forward-looking. And please, if you want to know more about the risks or forward-looking statements, take a look at our website or our SEC filings. So it's important to know that first. Second, let's talk a little bit about the business before we get into it. The year is starting out pretty well. From a safety perspective, it's looking good. Our service product has improved from the back half of last year, where we were struggling with crew availability mostly because of COVID. That's looking like it's repairing. The marker I pay most attention to is car velocity. That was a 208-mile a day number in January. So that's repairing. That's about 7-plus miles away from where we want it to be at this point given the mix of products. We've done a lot in the ESG front over the last half year. I'm sure you've seen that. We've got our Building a Sustainable Future 2030 report out. We put out our Climate Action Plan, and we just recently released our human capital report. So they're very consumable. And if you open up those reports and take a look at them, you'll get a very good sense for what we're doing about greenhouse gas emissions, what we're doing about our human talent and then also what we're doing in terms of broader governance. Is there anything else you want to touch on?

You want to talk about volumes?

Yes.

Volumes are good. Through February 18, I think we're up 5% now, and that's after a relatively slow start where we were treading water a little bit, down year-over-year. Mostly, it looks like the comps for the rest of the quarter are going to be pretty easy. We had Winter Storm Uri last year that essentially shut down the Gulf Coast. That, of course, doesn't appear to be being repeated this year, which is welcome. And inside that volume number, coal's very strong. That's because year-over-year natural gas prices are very high. And then we've won a bit of new business. We've onboarded Knight-Swift. That's been helpful in the domestic intermodal side. The automotive chip shortage looks like it's starting to recover a bit. We're seeing that in auto parts first. We won other business or opened up new facilities, whether it's plastics manufacturers, steel manufacturers. So across the book, it's looking pretty good.

Okay. Yes. Thanks, guys. Well -- and just a little note here on the conference. You'll see a QR code in front of you. We do have audience response questions. So if you scan that with your phone -- unlike years past where we just had a thing where you could vote, here, you're going to vote on your phone. There's just 6 questions. We ask that you participate for each company, if you can. Just asking questions about do you own Union Pacific? What's your general bias towards Union Pacific? In your opinion, through-cycle EPS for Union Pacific will be? Number four, in your opinion, what should Union Pacific do with excess cash? Number five, in your opinion, which PE should UNP trade at? And number six, what is the most significant investment risk for UNP? So this will be not just for UNP but every company you sit through on a fireside chat. And hopefully, we can get the responses at the end here.

Yes. That would be fabulous.

And for those in the webcast, I think there's a way to vote as well. And one more, if you want to ask a question, you can obviously just raise your hand and we'll get to your question right away or you can type it into the webcast there and we can read it up here, I believe.

So guys, it sounds like even with maybe the sluggish start of January and February, volumes are trending at positive territory, giving you a pretty good feeling about 2022, isn't it?

It is. And our guidance remains firm and intact. We said we would grow better than industrial production this year. We came into the year thinking industrial production would be about 4.8%, somewhere north of 4.5%. We don't see anything that changes our opinion.

Okay. And then maybe a longer-term question around growth. I think if I go back in my model, you guys peaked around activity like in 2004, 2005 from a GTM, RTM perspective and those are just unit measures. But obviously, your mix of coal has come down a lot in that time frame, but we've also seen greater growth at some of the other railroads that serve the West Coast ports. So what is changing that you believe Union Pacific can now really partake in some of those opportunities?

Yes. So we've changed a number of things. First and foremost is the service product has been transformed, right, our PSR implementation. Two things for us that made us a much more reliable and consistent service product for our customers and a better one if you measure it on the basis of car miles per day, which is the ultimate "What are we doing for a customer?" measure. The second thing it did is fundamentally changed our cost structure, where cost structure is much lower than it was 4 years ago. You take those 2 things together and it means we can be more competitive in the marketplace. So we talked about this over the course of the last handful of years. It's opened up markets to us that before didn't look attractive because we couldn't get a good margin out of them. And the service product is now creating more believers, both amongst our existing customer base and opening up more of their book as well as new customers and bringing them into the market with us. And it's slow going. I mean we've talked about this before, that converting somebody that is truck-centric to using rail sounds pretty simple. We have to do a lot of work to make ourselves easier to do business with. We're investing heavily in that. And then we've also got to hold their hand because most transportation management systems do not embed carload or even intermodal as an effective option in their decision-making for their transportation needs.

And certainly, we're incenting the marketing and sales teams differently, really making them hunters. We want them to go out and win new business. And so I think that certainly played a role. ESG ultimately, I think, is going to be good news story for Union Pacific in terms of attracting new business to our railroad. I think that's very much a positive. And PSR has helped create capacity for us as well, which is going to make us less capital intensive as we grow. We've sold locomotives stored. We have yards that we've idled. The siding extension investments that we've made help us be more productive, but it's also going to give us capacity to grow.

Okay. I also view it maybe -- and you can correct me if I'm wrong. But from the outside looking in, maybe Union Pacific was a little bit more risk averse in the past than now. Like you have this lower cost structure. Are you able to address greater markets that maybe before you weren't really incentivized to pursue?

Yes, Brandon. I think it shows up in a lot of ways, but I don't think you're wrong. We have been fairly conservative, and you could label that risk averse, company for years and decades. And through the transformation of railroad, we've adopted a more front-foot-forward posture towards risk, and it shows up in a lot of different ways. We'll try new things operationally or from a marketing perspective. And they're well thought out but they're experiments. And if they don't work, it's okay. We'll fail them fast and move on and learn from them. Historically, we probably would have done a lot more analysis to make sure that for sure that experiment was going to work. And a fair amount of the time, we'd spend so much time doing that, that you'd lose the opportunity.

And again, 2 great examples of that are the pop-up intermodal terminals that we talked about last year. One we're making full scale this year is Twin Cities intermodal terminal; and then the one in Inland Empire, the West Colton, which we have plans to scale up. But to Lance's point, our normal approach would have been really analyze it and say, "Okay, I've got to put $100 million investment into something before I started it." With Twin Cities, I think, we spent $30,000 maybe, moved a few things around and cleared a lot and open it up as an intermodal terminal, testing the market, working on the service product and now we have the conviction to make the full-scale investment.

And you talked about some changes you made on the sales and marketing side. Is there a different incentive structure now? Or...

Absolutely, yes. One of the things we did -- and a growth mindset is broader than just the commercial team. The whole company has to be postured towards trying to figure out the jobs that the customers need to get done and then doing it better than anybody else. So the company's mindset has shifted towards that. But inside of that, we took a little over half of the commercial team, the ones that are really customer focused, and we've changed them from salary plus bonus to salary plus, essentially, commission. And the commission is built in 2 ways. You got to do the activity that's going to generate business development and growth, and you have to deliver business development and growth. And Jennifer reminds me every time I talk about that, that it's predicated on marginal improvement, that is margin not just top line sales.

Okay. I think a big topic that people saw pretty visually over the holidays was the disruption in the L.A. ports and some of the pictures we saw in your tracks. Can you talk to, though maybe more broadly, the impacts we've had across the global supply chain? Where are the pain points right now? Or are things beginning to open up? I think you spoke about velocity being up. Is it where you want it to be?

Yes. So let's talk about that a little bit. Let me clear the images that you saw. If you go back any time prior to the pandemic, breaking into an intermodal container on a railroad was a crime of opportunity that would happen if you happen to stop a train in an area where -- that might be prone to have somebody do that. It would take a while and then somebody would see the opportunity and take advantage of it. So spotty and it was kind of all over the network, concentrated in areas where there were population centers. What's happened in L.A. is very different. That is organized crime. Now you've got criminal activity that actively tries to stop the train and position things like trucks and cars so that you pop open containers really quickly and it's quite organized. One person pops open the containers, there's a group of people that go through the boxes looking for what might be valuable, and then there's a different group of people who are like the logistics machine that take it from track to truck or car. We've done a number of things to both raise that to the attention of the authorities in the local area as well as get on it. So right now, there's in the neighborhood of 4 dozen UP police augmented by LAPDs, some California Highway Patrol, even some customers that are providing temporary off-duty police to help that are concentrated in the L.A. Basin to be a deterrent. We're spending money to secure the property. We're building concrete walls with concertina wire. We're creating fencing that's difficult to break through. And we've added technology. So we've got infrared cameras that are monitored to deter activity as it's occurring. So that's all had a nice impact, right? So we're starting to -- we've got a grip on what needs to happen, and it's starting to show progress. We're nowhere near where we need to be, and one of the big lifts was trying to get the local DA to prosecute the crimes because, in today's world, there's a thought that crime -- property crimes are not the thing you want to go after. They're clogging jails with people who are not criminals. That's just not the case here. This is organized crime and needs to be stopped. Okay. So let's set that aside. From the standpoint of larger supply chain, supply chains are still not good. I think if you talk to any large manufacturer or retailer, they would tell you they still struggle to get what they want when they want it at the price they originally had a commitment to receive them. And our perspective is that's still very much around labor, truck labor and warehouse labor and just labor throughout the supply chain. Our labor situation is improving, and it feels like we're within a couple of months of being absolutely on top of it. And you can see that in our service product. Absent hiccups caused by winter weather here and there, it's continuing to improve. But I don't think that's true across the networks. And so there's still more that has to be done to get people into the labor force and get them into the jobs.

And how important is it -- it seems like, historically, volumes come up coming out of a recession and it looks like, visually, rail service comes down. Historically, that's been a correlation. It seems to be maybe a different driver this time but similar outcomes. Should customers expect maybe more consistent rail outcomes in the future when we get out of the pandemic?

Yes. I can't speak for other railroads and how their machine operates. I can speak for us. Empirically, volume does not take us down. If you look backwards, our service product was getting better in 2020 when the recession hit and volumes went to 25% down to 30% down, which opens up that railroads can do anything you want. Our service product continued to improve when volumes grew back to the 155,000 carloads from 120,000 carloads. So the network is fluid enough to where we don't have to rely solely on volume. Now there will be spots in the network where, like in Houston, if we get an overwhelming demand and there's limited capacity to serve the Gulf Coast chemical franchise, if we don't have enough warning of that so that we can spend the capital where we need to debottleneck, you could see us bog down a little bit. But that's not -- we're not seeing that happening right now.

Okay. And are there any audience questions? And folks in the back, are there any on the webcast? I don't know, is there on the iPad?

I was going to say it might be there.

Yes. Let me get this to you, Brandon.

All right. It's like we do have a couple. You have the industry's best franchise so should you have the industry's best OR and best volume growth?

I know where that came from.

I submitted that. No, we -- and we've said that at our Investor Day in May we guide into the 55% operating ratio as the long-held goal. We're going to get to 55.5% this year. We said we're not going to give guidance beyond that but we talked about incrementals kind of implicit in that math as we look to improve. We know none of the other railroads are standing still. Everybody is trying to make those improvements. But because of our franchise, our book of business, the efficiency opportunities we believe we have ahead of us, we absolutely believe we should have the best.

And we were the best last year.

Yes.

And is OR the metric we should be focused on? Or is it return on invested capital?

We focus on both but focus is probably not the right answer. The right answer is we focus on what's necessary to run the business so that we could grow because that's going to be a long-term value generator. And value is generated by cash and by operating income which generates cash. Now inside of that, the equation is going to say that, that should generate good operating ratio and good return on invested capital if we're prudent with capital.

Yes. And that's why we were talking also about incremental margins. If you go forward and you're looking at growth, that's going to tell you not only how much we're growing, how profitable the businesses that we're bringing on but then also how efficiently we handle it. And then the cash conversion is another metric. So there's a whole different -- a number of things that you can look at. And if we're doing our business right, all of those are going to be looking very good.

I do want to talk about the commercial side with some of the intermodal ones. But I guess while we're talking about capital, I think you also guided to CapEx less than 15% of revenue. But is it still relevant to look at CapEx relative to revenue when margins have gone up so much? Is that the right way to approach it? And I guess a 2-part question. Because if we look historically, the Canadian rails to the north have fundamentally driven more volume growth than most of the rest of the industry but they've also spent closer to 18% to 20% on that metric. So...

So a couple of things I would say. It's an easy shorthand -- that's not necessarily what we manage to, but it's an easy shorthand to communicate how the spending is trending. So you're right, as margins include improved fuel surcharge, it impacts your revenue quite a bit from year-to-year. So -- but it's a shorthand for us to use. It's not how we run the business. In terms of growth though, again, going back to my comments about PSR. We've created capacity, and that's capacity that we can grow into. Now the great news story will be fill that up, and we're out in the market buying new locomotives beyond battery electric, doing some of those things. In my mind, that's a very positive sign because that says we've grown beyond the capacity we created and we're moving forward. So we'll spend what we need to spend to support the growth of the business. That's where our first dollar goes.

Exactly. Let me emphasize that. So when we plan capital for the business, dollar 1 goes to what's necessary to both maintain the robust infrastructure that we have and debottleneck or create growth opportunity or improve safety where we can. And then after that, we have a very specific dividend policy that we will adhere to. And then after that, if there's not a compelling investment to make somewhere else, we'll give it back to the shareholders.

Okay. And obviously, there's been a lot of activity on the M&A front in the industry. Have you guys learned anything through this process? Has your views changed on the future of potential larger M&A? Or has it only gotten harder based on what we've seen?

It sure looks like it's getting harder for Class 1s to emerge after CP-KCS. Based on the language and the posture coming out of the STB, they don't look like they are interested in further consolidation.

Okay. But could you see value longer term with potentially an East-West tie-up hypothetically?

Yes, hypothetically, Brandon. If the STB took a posture that said, "We'd love to get to a place where there's 2 very large railroads serving North America" and their regulatory burden on incremental mergers reflected that, absolutely. But right now, that doesn't appear to be the case.

Okay. On the commercial side, you guys just onboarded the Knight-Swift business, if I'm not mistaken. Can you give us an update on how that's been and potentially how much that could impact your business?

Yes. It's been seamless. And I'm very, very proud of the team for that. I just spent a little bit of time a few weeks ago with Dave Jackson, their CEO, and he was very complimentary of the process. So we spent a lot of time with many different elements of our team and their team to make sure that the driver experience was going to be rock-solid, that drivers had all that they needed to be fluid in and off our ramps in the change, that we had the capacity to handle their business and that we had the reservations necessary for them in our intermodal train reservation system. All that went flawless.

Yes. As well as all the back office. I mean there's a lot of behind-the-scenes work that goes on to make sure that we're communicating well with each other. And again, planning was very important, getting the teams together early. And it's gone very well. And that's given us the road map for when we look to Schneider and how we're going to onboard that business.

Amen.

Yes. And Schneider was announced just recently. Is that correct?

Yes. I think in January, middle or late January.

And any way to quantify potential impacts from these 2 new wins?

Yes. So there's a nice little bump up in domestic intermodal volume to begin with. Knight-Swift is smaller than Schneider. But what's really important is they're both growth engines in their own right. Knight-Swift is absolutely dedicated to growing their intermodal business. And for those of you that know them, that is a really strong operating team so we love having them as a new customer and partner. And Schneider, the same way. They're absolutely dedicated to their intermodal business. They want to see it grow, and they've been growing it. And so that will be another nice growth engine to have. Now that's on top of Hub who's a phenomenal growth partner and larger than the 2 of them. And also, we've got existing customers like XPO and other IMCs that are quite good at meeting their customers' needs as well.

And I guess more broadly, including international intermodal, I think a big question at this conference is will there be an inventory restock this year? Do you see your end customers saying, "We're still short on inventory?" Or is that a little bit overstated?

No, that's not overstated. As we talked earlier in the conversation, supply chains are so screwed up to the extent that retailers do not have what they want when they want it and neither do manufacturers. And so I think you could see restocking occurring as the supply chain heals through the year and potentially into next year.

Yes. Finished vehicles, the same way. I mean you still -- car lots are quite bare right now. Used car prices are very high. So you know that there's a restocking that needs to happen just in that one segment of the business.

Yes. And Lance, I think in your prepared remarks, you talked about opportunities in plastics, steel markets as well as autos. What's the most exciting amongst these?

What's most exciting to me is the fact that we're getting broad business development and the momentum. And the other thing that's very exciting is we're landing large-scale long-term industrial facilities on the railroad. It's been a long time since we've seen the kind of scale of economic development landing on the railroad in the form of a steel plant or plastics expansions. I mean that's -- it's really encouraging. It's encouraging for the U.S. industrial economy.

Yes. Well, in Prime Pointe, the industrial development that we have close to our Dallas intermodal terminal, while we've had that in existence and have been working on that for several years, I would say the intention and intensity of customers looking to sign businesses there is up 4, 5x what it was just a year or so ago.

It's hard to say, Brandon -- when I hear us talk like that, you could think, "Is that a marker of onshoring?" And I don't know. I think it's early to say that. It's a marker of economic activity for sure.

Okay. And longer term, do you think your business could sustain volume growth in excess of industrial production?

That's still what we're planning on.

Yes.

I think there's plenty of opportunity to do that. Now it's up to us to execute.

Okay. And coming back to the capital side and maybe ESG. I think you said you're selling this now to customers. Are customers coming to you saying, "We need to get carbon out of our supply chain and rail intermodal is a piece of that?"

To a degree. I would say the conversations are going in that direction rapidly. More commonly, it's part of the conversation. It's not necessarily the starting point. There's a few circumstances where it is a starting point and that's critical. But I would say that the continuum that we're operating in right now is anywhere from it's table stakes to even be in the conversation with that customer that you have a good greenhouse gas, climate action plan that you've made commitments and that you can help them. So I'd say that's some of the most advanced conversations we're having, all the way back towards it might be part of the RFP but I'm not sure how important it is to them in their decision-making.

Yes. And I would just add 2 things to that. So it's not just intermodal. We can convert customers that are moving by truck into boxcar, into gondolas depending on -- intermodal is the one that's most top of mind, but we have opportunities to make truck conversions across our network really. And then really, Scope 3 is where we fall in for our customers. And the emphasis, as you know, has really been on Scope 1 and 2 to start. But as Scope 3 becomes a bigger emphasis, that's where we have the opportunity to play a much bigger role.

Yes. So to your point, Brandon, it's coming. We can see it coming. The kind of feedback and questions and pressure we get from you as investors, all of our customers are experiencing the same thing.

Okay. And along those lines, we've got a question talking about the capital side. Will there be a big capital cycle to replace diesel electric locomotives with green power?

There could be, yes. I mean, I think the question there is what's the technology going to be. We're obviously investing in our fleet today to make it more fuel efficient. When we do the locomotive modernizations you've heard us talk about, it becomes 5% more fuel efficient with 53% reduction in emissions. So that's a huge step forward but it is still a diesel locomotive. So we're looking at alternate propulsion. You saw, what, maybe 2, 3 weeks ago, we announced that we were going to buy 20 battery electric locomotives. Those are for switch operations. We're going to test it in a couple of different climates, but that really is a test of the technology as well.

Absolutely.

We think we want to start in the yards because it's shorter haul, it's not as heavy traffic. Can the batteries sustain and perform in that environment? If so, then can we work on the next level, which would be road? Or do we need to look for other technologies like hydrogen?

100%.

And I guess maybe a broader question. What technologies are you guys developing right now or buying that could change the way operations are today?

So there's a complete spectrum of what we're working on. It's as fundamental as the blocking and tackling on the customer experience. Our new CIO, Rahul Jalali, he's partnered up with Eric and Kenny. And they have taken a very deep dive on every aspect of the customer's interaction with us to understand where are those pain points, where do we screw up, where do you have to click through 8 times instead of one time. And all of those are being addressed in priority order. So that's going to fundamentally change the experience of the customer so that converting to rail becomes less of a scary process. It's -- the pathway is more open. All the way through enabling mobile devices for our employees to do all kinds of things. We've got 12,000 Zebra devices now. All TE&Y use them. It's essentially a -- it's a Samsung cellphone that is disabled as a cellphone and enabled as a work device. And those work devices, we now have an application where if you're in a terminal, you're in the yard and you're switching and the switches are powered up, you can line your routes from your phone -- from your work device. You don't have to walk anywhere. You don't have to call somebody and have them do it. You can line it up yourself. And it's mistake-proof. It will tell you if you line up a route that you shouldn't do because it's either lined against you in certain ways or it's going to take you into a place that you're not intending. So there's things like that. There's decision-making tools that we're using, whether it's intermodal vision or UP vision or shipment vision for the customer base, yes. So I mean across the spectrum.

Well, great presentation, guys. It sounds like a lot going on in a favorable way at Union Pacific. Unfortunately, I think we're out of time. Thank you for coming down and being at the conference.

Yes. Thank you, Brandon. It's a pleasure.

Thanks, Brandon. Yes, thanks.

Thank you, Lance.

All right, buddy.