Union Pacific Corporation (UNP) Earnings Call Transcript & Summary

Good morning, everybody here in person and on the webcast. Really happy to kick off Deutsche Bank's 2022 Transportation Conference with Union Pacific. I can't think of a better company to start the conference with, the largest public railroad in the country, $150 billion of market capitalization. We're very honored to have Jennifer Hamann, Executive Vice President and CFO here; Eric Gehringer, Executive Vice President of Operations; of course, Brad Stock, Investor Relations. Union Pacific is obviously a great company and a very high-quality company. It's going through some interesting times on the back of PSR, positioning itself for growth. So Jennifer and Eric, I think you're going to spend maybe 5 or 10 minutes, or not even that, with some prepared remarks, and then we'll jump right to the Q&A. Thanks for being here.

Thank you, Amit, for inviting us. Pleased to be here, and good morning to everybody here in the room and on the webcast. The slides that are going to accompany our prepared remarks, which -- we're not [ Lanstar ] so hopefully it's different than what I'm seeing in front of me here, can be found on our investor website next to the webcast for this event. Before we start, though, I do want to remind everyone that we will be making some forward-looking statements, and those statements are subject to risks and uncertainties. So please refer to the UP website and SEC filings for additional information about our risk factors. If you look on Slide 3, we show a quick recap of our second quarter results. And as we had expected, the second quarter was a challenging quarter for us as we took decisive actions to improve network fluidity. The actions had an impact both on our cost structure and on our volume performance. Outside of our control, rising fuel prices during the quarter presented a significant headwind as well. Together, these factors led to an elevated operating ratio for the quarter. And while our performance both operationally and financially did not reflect our best, we still achieved quarterly financial records. And this really demonstrates the great work that we've done through our PSR adoption to make Union Pacific a more resilient, efficient and profitable company. If you turn now to look at the third quarter, Slide 4 shows you the current volume picture. And the volumes across all 3 of our business teams do continue to be impacted by our network performance and recovery efforts. However, that impact lessens each day. As Eric will discuss in a moment, we're encouraged by the improvement seen in fluidity and crew availability and have begun to place some stored cars back into service. And as we unwind some of the actions that we took in the second quarter to restrict volumes, we are now seeing an improving trend in our carloadings. Overall, third quarter volume to date is up 2% versus last year. If you look at each business team in a little bit more depth, you see bulk is flat versus last year as coal is down 1%. Fertilizer had a tough start to the quarter, down 9%. However, green and grain products is up 5% to offset some of those initially challenged areas. And we are seeing sequential gains in both coal and grain, and that's a clear manifestation of both better car cycle times that are now turning into increased loadings. Industrial was up 3% versus last year, driven by continued broad-based industrial market growth. Metals and minerals is leading the way, up 6%, and we continue to see strength in our industrial chemicals and plastics, which are up 4%. Our business development efforts really are continuing to drive our success here in the industrial space. And finally, premium is up 2%, and that's driven by automotive volumes, which are up 16% as we see continued recovery of those markets against an easy comparison versus 2021. Intermodal is down 1% as parcel is starting a little slow compared to last year, and domestic and international are flat as the supply chain challenges persist in this space. And now let me turn it over to Eric to provide an update to you on our service.

Thanks, Jennifer, and good morning. So starting on Slide 5, we continue to see gains in our operating performance metrics even as carloadings improved sequentially. Our current freight car velocity is around 190 miles per day as we remain committed through our network operations and improving our service product. Crew availability continues to improve with the charge training pipeline as we work towards our stated hiring goals. We have already graduated 597 employees in 2022 and have an additional 525 currently in training. Those efforts have been buoyed by the strength of our employee referral program which has added over 675 new railroaders to Union Pacific. In addition, we've seen a significant reduction in our recrew rate of around 7%. As a more fluid operation improves crew availability and efficiency, these improvements provide confidence that the network can handle more volume. As Jennifer mentioned, we have begun to reduce the number of system cars stored, while also placing more bulk sets into service in order to better meet the demand that exists in the marketplace. Now turning to Slide 6 and a look at how we remain focused on productivity. While building a more consistent and reliable service product is at the forefront, we have not lost our focus on efficiency. In particular, we view technology as a key enabler for us going forward to unlock network capacity, drive better service and enhance safety. We're advancing technology-driven productivity initiatives across the entire network. DigiCrew allows conductors and engineers to complete multiple tasks, such as pulling train list or train summaries and verifying power and reporting potential safety issues from a single mobile interface. And recently, we piloted a new control yard system for switching cars, Mobile NX and Mobile Terminal. This control system allows a single operator to align switches through a simple tap of a clicker on their work desk. On the capital side, we are making investments to automate both the unloading of ties and tie plates, helping to offset the rising cost of materials for track renewal. In addition, we are increasing the use of autonomous inspection techniques. While not only improving the safety of these tasks, autonomous inspection is also more precise in identifying potential issues and plays an important role in preventing derailments. And we're making investments to modernize our locomotive fleet. These investments improve the reliability of the fleet, fuel efficiency and reduce our carbon footprint as we strive towards our greenhouse gas emission reduction targets. To that end, turning to Slide 7, where we just, a few weeks ago, announced a historic locomotive modernization deal and an agreement of more than $1 billion, Wabtec will modernize 600 locomotives over the next 3 years, starting in 2023. The total order will enable Union Pacific to realize approximately 210,000 tons in annual emission reductions. Upon completion, each modernized locomotive will be more than 80% more reliable, will be more fuel efficient by up to 18%, will have a lower emission profile and have a greater eligibility. The increased fuel efficiency gains are driven by new technology and support our long-term goal to improve fuel consumption rates on an annual basis by at least 1%. This is another major step towards moving freight more efficiently and sustainably across our network. Turning it back to Jennifer.

Thanks, Eric. So to wrap up on Slide 8, we have a quick recap of the updated guidance that we provided at our second quarter earnings release back in July. But first, building off of what Eric just mentioned in terms of our locomotive modernization agreement, it's important to note that our long-term guidance for capital spending of less than 15% of revenue remains unchanged. We expect the locomotive investment to be ratable over the 3-year contract period. As to 2022, our volume and operating margin guidance that we updated in July is unchanged, and it really does reflect the impact though of our first half results. For the second half, though, we believe there's a great opportunity for us to demonstrate our ability to successfully grow volumes while improving and sustaining service levels. While not the year we envisioned back in January, we still have the opportunity to finish the year strong and enter 2023 in a great position to onboard Schneider and deliver a quality service product to all of our customers. Turning to Slide 9, I want to take just a minute to step back and look at the longer-term Union Pacific story. Through our PSR implementation that began in late 2018, we have driven significant value to our shareholders. From 2018 to 2021, we improved our operating margin by 450 basis points while generating significant cash from operations. And over that period and through the pandemic, we maintained a strong balance sheet as reflected by the recent upgrade we received from Moody's to A3. This performance enables us to provide our owners with an industry-leading dividend payout and return cash through share repurchases. Looking ahead, the fundamentals we outlined in last year's analyst meeting for long-term success remain unchanged. Our team is energized around our strategic plan to serve, grow, win together. And that plan has started to demonstrate success in the business that we've won over these past few years, and will be further evident as we execute and deliver on the great potential of the UP franchise. With that, Amit...

Great, that was perfect. Thank you so much, Jennifer and Eric. So we're going to get into all the fun questions about yield and revenue and volume and all that stuff that I know you love, Jennifer. But before just to start, I want to start a little bit big picture because the biggest problem in the industry right now is service and the promise of Precision Scheduled Railroading, the promise of PSR. I wanted to ask that question both from a cost structure perspective and then also from just on the ground, what's happening, Eric. So I guess, first and foremost, the whole industry has gotten really lean from an OR -- and you saw that OR chart, it's pretty remarkable. A lot of that disproportionately has come from headcount reductions as you've jettisoned the network and made the network a little bit more simple and straightforward. The question is that when you run so lean, your ability to kind of bounce back from challenges is limited. And so how do you think about the cost structure evolving to maybe dealing with the known, unknowns that come out over the next couple of years? And then, Eric, the service issues during the pandemic was really labor-oriented, kind of upstream labor at the ports, downstream at the drayage side and then also the distribution labor. Where are the bottlenecks now in service? I mean if you -- there are a lot of people on this webcast, in this room that maybe are not as in the weeds on what's happening with service and supply chain. So maybe you can just be a little bit more granular and talk to us about what's happening in the network right now and where you're seeing the most pinch points.

So I'll start and then go to you, Eric. So in terms of the cost profile, you know we have the long-term goal of the 55% operating ratio, and we still very much believe that, that is within our sight. And there's a variety of ways to achieve that. There's through greater operating leverage, and that's the piece that certainly you saw us start to do at the end of last year, beginning of this year first quarter, 4% volume growth. We didn't have that in the second quarter, but we had to take on some more resources. But with even that same level of resources, if we can generate greater operating leverage, that's going to have a tremendous impact. We also know that the resources that we have in our network today, we're not using this -- so that's another opportunity in terms of being able to do -- reduce our recrew rates, reduce -- held away from terminals some of the arbitraries, limos, lodging, all of those things, but kind of escalate as you're not running as efficiently. You see that in our purchase services line as well with some of the increased costs when you're putting locomotives back into service and you're expediting materials to do that. So you're taking actions, prioritize the service over some of the costs. And we were very upfront about that. We knew that, that's what we needed to do in the second quarter. So productivity, operating leverage. And then the other piece is what Eric touched on, is all of the opportunities that are out there ahead of us when you think about technology. I just see technology playing a huge role for us going forward that is going to enable us to continue to be very productive, continue to be cost efficient, help us be safer and provide a better service point.

When we look at the second quarter and the sort of, I can call them chaos costs, the costs that you had to throw at the service deterioration to fix that, is there a way to kind of order of magnitude size that up? I mean if you look at nonfuel revenue growth and nonfuel OpEx growth, it looks like maybe it was like $200 million, $300 million of inefficiencies in the quarter. I don't know if you've talked about that or you've attempted to estimate kind of what that...

No, we've not sized that precisely. But certainly, when you think about the cost lines, I mean, you're hitting it. It's the comp and benefits line, certainly has impacted purchase services fuel as we're not running as efficiently. Granted, we did a pretty good job from a [indiscernible] but we know it could have been better had we been running more productively. Certainly, a little bit in the other cost line, but most of it, I would say, is comp and benefits, purchased services, and then equipment rents, too. When you just think about car hire, the car velocity is down when we're not spinning the assets as quickly as we see escalations there.

And then, Eric, you guys have -- I mean it's been a pretty remarkable bounce off the bottom, going from 177 car miles per day, they're like over 190 now. I feel like you guys have been the most proactive in addressing this as quickly as possible and see successes, but we're still about 10% below maybe where we need to be. But just talk to us about what you changed to get those early wins and where are the main issues that are popping up now that are limiting your ability to get to that 200 maybe as quickly as possible, or what do you think we can get there?

Sure. We came out, to your point, we bottomed out around 74. Our biggest push at that point was to be able to get rid of excess inventory, right? Now not all inventory is bad, this is specifically excess inventory. And it's that excess inventory that creates kind of that bad cholesterol, bad congestion. So our push in conjunction with our customers was to see that situation for what it was. Our recovery was a function of how quickly could we get rid of that excess inventory. To your point, all the way through May, June and up to about 4th of July, we did it exceptionally well. And we got into 4th of July and we got into Father's Day, and for the Union Pacific at least, that's our third and fourth most impactful holidays from a crew availability perspective. And you're also in the middle of summer vacations. Now that we've gone through both of those, and we have that at our back pushing us, crew availability is starting to improve more than just a little bit. And with that comes a fluidity that drives that velocity. So right now, the challenge remains the same. To your point, there's a gap of about 10 miles per day. To get above 200, that's not a stopping point. That's where we have our eyes on right now to see how fast can we get there, to push to get there as fast as we can.

But operating inventory is still quite high, over 190,000. We've still been able to kind of improve the velocity on a car mile basis. So there's something else that's helping, right? So if you could talk about do you expect the operating inventory to continue to come down? And then the other question too is that the customers were putting their cars on your lines because maybe the cars weren't cycling fast enough. And so the trip plan wasn't really being followed as well. And I'd like to dig into that a little bit because part of Precision Scheduled Railroading is not just fixing the network, but it's that daily, on that morning call kind of that making sure that everybody is doing what they're supposed to be doing and -- it's almost like a little bit of an accountability for everybody in stepping up and doing what they're supposed to do. Can you just talk about like that process of PSR kind of post fixing the network or changing the network, making sure that everybody is being held accountable for what they need to do to make sure the trains run on time?

Yes. I mean there's extreme accountability around that. To your point, PSR is all about the fundamentals and executing them day in and day out. So as we look especially certainly in the last 4 months as we've been coming out of April, the push that we've done to get our first OS, which is a measure of on-time performance, we're back to historical highs on that. Our push on over-the-road performance, we continue to improve on that every single month. Our push on car dwell, which is really one of the kind of foundational PSR fundamentals, right? You didn't see our car dwell go up to 28, 29, 30 hours across the system. In fact, for the last 6 months, we've been able to hold it in that 23.5 to 25. That's the biggest indication that PSR is still how we run the railroad. And that accountability drives that particular metric.

So in your crystal ball right now when you look at service metrics, I mean, with Father's Day and July 4 kind of in that rearview mirror, are we now kind of in this point where we can see a steady slope up in service metrics would you put it out every Wednesday? Or are we still in the process of maybe 2 steps forward 1 step back, 2 steps forward?

Well, you know as well as I do, it's still a 32,000 mile outdoor factory, right? And we're still in the midst of weather events, at least peak weather events. We've been very fortunate this year and we've weathered them very well. Our goal right now is just sequential improvement and getting above 200 as quickly as we possibly can. There's nobody in Union Pacific more than me that wants to see that trajectory just be exactly what you said week after week. Okay, maybe it's the competition.

We both would.

Yes. That's right.

But the metric that -- people say, well, what should we watch, what should we watch? It really is car velocity and car loadings. Because we very much know the demand is there. We want to continue to spool up the railroad. And with that comes greater carloadings. The fact that we've got our folks coming out here in the month of August, and that training pipeline is well charged now. That really puts us in a good position to be able to.

Yes, it's really nice to see this positive relationship between service and volume because there could be a situation where volume is deteriorating, and through that, you get less congestion and better service. So that's really a nice positive relationship. So can we talk about volume and mix in the quarter? So Jennifer, you said volumes are up 2%. I think they're actually up 3% now with last week's data.

The difference in calendar quarters.

Right, right. And RTMs are also moving in the right direction. I think our RTM is up a couple of percent. So can we talk about mix? Because obviously, mix is such an important driver of productivity and revenue intensity for the network. Do you feel good about mix? Can you just talk about mix on either sequential or year-on-year basis, however you want to look at it?

Yes. So when we came into the year, we were expecting mix to be kind of a first half, second half story, where the first half was going to be pretty positive mix since we saw growth in bulk and industrial. And then the second half, we expect it to be more intermodal-centric from a growth standpoint and that we would move to more of a probably a negative mix in the second half. What you're seeing right now is intermodal volumes are still down. And so versus what we had expected coming into the year, I think mix is probably a little bit more positive here in the second half. We'll see how the quarter plays out. There's still basically half of the quarter left. But coal has been, call it, the upside surprise relative to what we saw at the beginning of the year as natural gas prices have stayed high. The mix of coal is not maybe quite as favorable when you think about it from an average revenue per car standpoint versus industrial. Industrial is your highest average revenue per car business. And so you have to think about it in that context. But relative to what we would have thought back in January, we're probably seeing a little bit more favorable mix, although I'd love to see that into [indiscernible] because that would mean a lot of good things in terms of the overall supply chain.

Yes. Do you see decent acceleration, at least in like grain RTMs and fertilizer RTMs? I know that small auto RTMs are moving up in the right direction. I mean these are all obviously decently high, very high revenue per carload business.

If you're looking just at that premium sector, when you see that automotive growth versus intermodal, that's obviously a positive.

So can we talk about how this feeds into yield for -- in the near term at least? So you've got a little bit of headwind on fuel, at least when you look at fuel prices, they're coming down. They held in there in July, they're starting to come down a little bit. Maybe fuel's a little bit more of a headwind on yield in the third quarter versus the second quarter. You got maybe better mix. Talk about -- do you think we've seen peak yield for UNP and then it comes down in the back half? Or are we in a position where there's still a little bit more pricing and mix that can keep yields where they are?

Well, let's talk the difference between fuel and then pricing. So from the fuel standpoint, when you think about it, remember, we've got a 2-month lag on our fuel surcharge program, on most of them. Intermodal is a little bit more timely, but the bulk of our fuel surcharge programs have a 2-month lag. So what you're seeing in the second quarter -- excuse me, in the third quarter, July was based on June, August is -- excuse me, July was based on May, August is based on June. So you're seeing some of those high prices from a fuel surcharge standpoint still roll through. And July was still relatively high priced. I think second quarter, in general, we paid a little over $4 a gallon. We paid over $4 a gallon in the month of July. So there's been some variability there, but I don't see fuel surcharge as something that's going to have less of an impact relative to our yields relative to our revenue in the third quarter versus the second quarter.

Okay. So you've got a little bit higher volume sequentially. You've got flat to up yield sequentially. The revenue is better sequentially. When I look at the operating ratio guidance for the full year, embedded in that is this pretty significant unwind of the inefficiencies that you guys had in the second quarter. I mean it's a big number because you're not actually -- if you look at the implied change in profits to two stage versus first stage relative to the change in revenue, it's a huge, huge incremental margin assumption. And so I wonder if you can comment on that in terms of how you feel about that 58 OR today, given that we're now almost in September and where service is today.

It's August 16. So I'll argue that we're almost in September, because every week counts here, Amit, in terms of how we're able to improve the service product and how we're able to bring the volumes on. I just reiterated the OR guide of the 58, so we still feel comfortable with that. As I think about it, it really is about 2 things, both of which Eric and team are executing on is moving more volumes, so getting that operating leverage and then working to take costs out where we have some inefficiencies. And so those are the keys as well as continuing to get good price on the business that we're moving. So that's how we looked at it. That's how we're continuing to look at it, and that's what we're seeing here so far through the third quarter.

And then, Eric, the network maybe is divided into different districts. And I think you guys have seeing more pressure in certain parts of the network than others. You're throwing a lot of resources at it, and I think it's more surgical in terms of where you're applying those resources. If you could talk about where are the main issues today and the network that you're seeing whether it's regionally or what parts of the network and how you're adding resources to address that maybe more surgically.

Yes. And there's really only 2 groups of resources you'd be talking about. So at the beginning of the year, we identified another 100 locomotives or just A100 locomotive set to put into the Southeast. And I can actually tell you, starting 3 weeks ago, we actually started to point some of those locomotives out as the network has continued to heal itself. And that will be our continued challenge as we work through the third quarter and into the fourth. Now when we pull those out, we put those at the ready. So they don't always necessarily go into long-term stores, they're available for us, most importantly. But as we see upside potential for growth, we have the resources available. The other area that you would look at from a resource perspective is borrow outs. You know -- like I mean, we're talking about 9,000 transportation employees. And so when you're talking a couple of hundred borrow outs across the system, that's a key initiative for us right now as we continue to hire to make sure that we can meet that upside demand. If you look at the network and where are they at because that's an indication of where I feel that we had to put additional people to be able to meet that demand, they're largely across the northern region of our system. So think Nebraska up to, say, Washington and Oregon. Now those are some of our most challenged areas to hire. But in the last 2 months, I've actually seen us making even more progress in those areas to be able to successfully hire. We also came out 3 weeks ago with a new program where if you hire into an area, say, Houston, for example, and we're having say, success in Houston with the hiring, but we need you to move to Nebraska or Washington, we'll actually offer a financial incentive for you to move up there based on a certain commitment you have to make. And that's starting to pay dividends as well. So I look forward to taking out the locomotives and moving them over to the growth. I look forward to the continued hiring, which will allow us to draw down the borrow outs. And as far as the system is concerned, and what part am I watching, I'm always going to watch the Southeast portion the most. That's where we drive the vast majority of our volume, that's also where we drive the vast majority of inventory. As the Southeast goes, largely goes the system from a manifest perspective. And being 70% of our car velocity, manifest is always my #1 focus.

And just building off of that. So with those borrow outs going into, call it, the mid-section of network, that ties into Eric's comments about bringing more of the coal sets back into play so we can move more of that coal demand. And that's how we're looking to generate more of those car loadings and capture that demand.

And you're getting ready to move a lot more volume on the intermodal side over the next 12 to 18 months. I mean you started with Knight-Swift, I guess maybe started a little bit slower, I don't know if you would agree with that or not, at least when looking at Knight's volumes, intermodal volumes. But just talk about what the network needs to do to kind of get ready for that. I know you're moving around some routes a little bit. If you could just talk about what you're doing to get ready for that big one Schneider is starting January next year.

Yes, there's a ton of activity around that. And we always start by reminding everybody that the activity I'm about the list. It's not just for Schneider, it's for our entire intermodal portfolio of customers. So let's just start, and this is in no particular order. First thing you're seeing us do is the capital investments that we've made historically, but we're also making additional capital investments this year. So the one that you're referencing is our work in Lathrop, which is in Northern California to be able to do an expansion project to support Schneider, the growth of Schneider and the growth of the remaining customers. I've got asked questions in the past about, well, you turned on the hump in Davidson. Just to be really clear, the only reason the hump in Davidson is open is because we need to facilitate additional capital expansion at the Inland Empire. The hump in Davidson will not forever remain open unless it really truly comes from growth. At the Inland Empire, we're making additional investments to build out another 75,000 lifts per year. You also see us making the investment in Twin Cities Intermodal Terminal for 100,000 lifts. We've now finished 18 sidings year-to-date out of the 22 that we're targeting. Now when you asked about handle in Schneider, remember that as we think about the railroad, the first thing we're focused on is taking any latent capacity we have on our existing transportation plan, filling that with Schneider and other business wins. Then we'll get into, do we have to add additional train payers, i.e., L.A. to Chicago. So that work is going on right now too, is revising the transportation plan and then aligning resources accordingly. But the best thing we can do is make sure we're using our existing latent capacity, both on the actual trains and the track to be able to bring on Schneider's...