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June 2015
By Jeff Stagl, Managing Editor
A SHORT DETOUR. Perhaps, a very short one. Union Pacific Railroad leaders are hoping a recent off-course swerve has that minimal impact on what had been improving financial performance.
After a string of mostly stellar quarters over the past decade, UP posted mixed financial results in the first quarter. The good: operating income grew 7 percent to $2 billion, net income rose 6 percent to $1.1 billion and the operating ratio (OR) improved 2.3 points to 64.8 compared with first-quarter 2014 results. The bad: operating revenue was flat at $5.6 billion, freight revenue fell 1 percent to $5.3 billion, operating expenses climbed 4 percent to $3.6 billion and volume slipped 2 percent to 2.2 million units.
Plus, diluted earnings that grew 9 percent reached only $1.30 per share, a "sizeable miss" compared with Wall Street analysts’ expectation of $1.37 per share, says Benjamin Hartford, a Robert W. Baird & Co. Inc. analyst. UP last failed to meet a consensus earnings projection in third-quarter 2013 and its last miss exceeding 5 percent occurred in third-quarter 2002.
The main culprits were three struggling traffic segments in 1Q:
• Coal, which posted a 7 percent volume decrease as domestic business was negatively impacted by utilities’ high stockpiles and power plants that switched to lower-priced natural gas as a fuel source, while exports were pinched by slowing demand in China;
• International intermodal, which logged a 12 percent traffic decline primarily because of a longshoremen strike at West Coast ports; and
• Industrial products, which registered a 3 percent volume drop mostly due to a 38 percent plunge in crude-oil shipments and significant decreases in metals/steel and waste product demand.
On top of trying to offset reduced traffic in those sectors, UP spent the first quarter struggling to handle the volume that did come its way. Although the Class I tried to adjust operations to a sharp drop in volume, productivity and efficiency eroded. Why? Resources — namely workers, locomotives and network capacity — weren’t in sync.
"By the end of 2014, we were fully resourced to meet increased demand. [But] over the last few months, volume shifted negative, and as a result, our operation is in catch-up mode," said UP President and Chief Executive Officer Lance Fritz during a 1Q earnings conference on April 24. "Managing a network is a constant balancing act to ensure you have the right resources in the right place at the right time. This act becomes more difficult during significant volume swings."
So now, the railroad’s leaders are trying to find a swing-proof balance and identify more ways to get the Class I back on track. UP’s brain trust acknowledges that the road to superior financial and operational performance is long and winding, and at times fraught with short twists and turns. But it’s a course they believe the railroad must stay to optimally grow and manage the business.
"We’ve been on a good run. When I became CFO 11 years ago, we were in last place in all measures. But we focused on returns and service, and had a decade of good success," says UP Executive Vice President and Chief Financial Officer Robert Knight. "Now, we need to better align resources and continue to be as agile as we can be."
If UP attains the necessary organizational balance and agility, the better chance it’ll reach a full-year OR goal of 60 by 2019. In 2004, the railroad’s OR was 87.5, dead last among Class Is, says Knight. But since that time, UP has shaved 24 points off the ratio with only a 0.2 percent compound annual growth rate in volume, he says. The challenge going forward: taking more points off the OR in a volume-growth environment.
"We felt we were a good railroad [back in 2004], but wanted to be a good railroad and a good investment. We put a lot of energy into service so we can price it well in the market, and we developed a zealot mentality on every dollar spent," says Knight. "We want to keep the OR going."
If UP can continue to trim costs and reduce its OR to the stated goal of 60, the railroad "should be in pretty good shape over the long term," said Investopedia analysts in an April 24 report.
"By the look of things, the company should be able to recover, as some of the things that affected [1Q] results were either one-time events or cyclical downturns in certain segments," they said.
UP’s inability to adjust to slower-paced volume was a hindrance, but the operational struggles were understandable, says Cleo Zagrean, an analyst with Macquarie Securities Group’s Transport & Logistics Equity Research unit.
"It wasn’t like business was up 3 percent for one and down 3 percent for another, it was more like up 15 percent and down 15 percent. It’s difficult to adjust to that level of variability," she says.
Tough year-over-year comparisons with last year’s 1Q volumes ended up being too high a hurdle for UP to clear, and traffic likely won’t improve until the latter part of this year, when comps get easier, says Zagrean.
Baird’s Hartford agrees. He anticipates a slight volume uptick in 2Q, with higher gains in the second half. Like all railroads, UP is more sensitive to volume swings now, says Hartford.
"In the third and fourth quarters, they could have offsets to soft coal and crude business with industrial products, intermodal and ag. There are weather and seasonality issues for coal, and crude is a variable," he says. "Overall, there is broader industrial activity."
Working in UP’s favor on that front: The railroad has the largest chemicals franchise and footprint on the Gulf Coast, says Hartford.
UP hopes to exploit that advantage to grow volume over the long term, says Knight. Petrochemical shipments will be flowing in the Gulf Coast region over the next two to three years as plastics manufacturing gears up at several huge new plants, he says. Major chemical firms such as Chevron Phillips Chemical Co., Dow Chemical Co. and LyondellBasell are spending about $100 billion to develop large-scale plastics facilities in the region.
"Mostly because of the low price and availability of natural gas feedstocks, it’s cheaper to produce plastics in the U.S. than before," says Knight, adding that gas also can be sourced from nearby shale formations. "A lot will be exported, with some plastics going to West Coast ports to handle because it can’t all go to Gulf Coast ports."
There are several other opportunities for UP to grow volume and revenue in the long term, such as in the automotive, construction, energy and housing sectors. The railroad’s automotive franchise is well situated in the West and "is second to none," with business in Mexico likely to ramp up as new assembly plants open, says Knight. More auto parts are projected to flow into Mexico, with a higher number of finished vehicles to be railed out.
Eventually, there also will be a return to fracking as oil prices rise, giving crude traffic a boost, Knight believes. UP moves much more frac sand and pipe than crude, which surprises some people, he says. In 2014, crude traffic generated 4.5 percent of total volume, and of that, frac sand, oil and pipe accounted for 2.5 percent, 1.5 percent and 0.5 percent, respectively.
In addition, there likely will be a ramp up in construction and housing over time, helping to boost volumes in aggregates, lumber products and other segments, says Knight.
"The underlying economy is cooperating, and we feel good about our long-term prospects," he says.
But before the good times can roll, the railroad needs to amp up its service performance. Service restoration will be critical throughout the remainder of 2015 in order for UP to better manage and take on traffic, says Hartford.
The Class I already has begun to tackle that objective, in part by reducing the 2015 new-hire plan from 2,800 to 2,400 train, engine-service and yard (TE&Y) workers. UP also furloughed 900 TE&Y workers and stored 800 locomotives by May’s end to better align resources with demand.
"It’s been a while since we had furloughs and stored units at those numbers," says Knight.
In addition to right-sizing resources in the near term, the railroad is instituting measures to boost productivity and efficiency for the long term. One of them is a new initiative that positions UP as the first in the North American rail industry to import long rail from Japan to a custom welding facility at a U.S. port.
The Class I plans to soon begin installing quarter-mile-long strings of rail featuring three 480-foot sections instead of 18 standard 80-foot lengths. The advantage: needing only two welds to create a quarter-mile string versus 17 with shorter rail — an 88 percent reduction in welds.
Each weld can weaken rail and cause a weld fracture or other track issues, which in turn can negatively impact service performance while track is repaired.
"It’s all about track reliability. We want to reduce variability," says Lynn Kelley, UP’s vice president of continuous improvement and supply. "This sets a new standard for rail reliability and helps improve customer service."
UP imports the 480-foot-long rail from Japan, where it’s produced by Nippon Steel & Sumitomo Metal Corp. There are no manufacturers of rail that long in the United States; the maximum available length domestically is 320 feet, says Kelley.
In the early 2000s, Nippon produced 480-foot-long rail for UP and then cut it into 80-foot sections to ship it overseas.
"After a while, we thought, why chop it up? But it was cost prohibitive at the time to get the long rail here," says Wendy Whalen, UP’s assistant VP of supply.
There also was no ship capable of carrying rail that long, adds Kelley.
In late 2010, UP managers began to hold discussions with Nippon officials about shipping the high-strength, head-hardened and continuous-cast rail to the United States in 480-foot lengths. Nippon agreed to design and build the "Pacific Spike," the world’s first long-rail ship. It took 18 months to build the ship, which was completed in August 2014.
The 623-foot, 23,000-ton Pacific Spike features three cranes designed to simultaneously unload five rails weighing 10 tons. The rail is shipped to the Port of Stockton, Calif., where UP built an $18 million facility to weld the long rail. The welding facility is equipped with an overhead crane designed to lift the heavy rail.
The long rail is unloaded from the Pacific Spike, stacked three bundles high onto specially designed rail cars and moved from the dock to custom storage and welding areas. Standard weld techniques are used to create the 1,440-foot strings because "it’s the same type of premium rail, just with fewer welds," says Kelley.
The long rail also can be installed the same way as quarter-mile-long sections of continuous-welded rail.
So far, three ships have delivered the long rail to the port and welding operations continue. Installations will begin over the next few months, says Kelley. Since it’s premium rail, the long rail will be installed where it best makes sense, such as on a high gross-ton line or a geographically challenging route, she says.
Performing trackwork in an optimal area to reduce variability and improve customer service also was the goal of a maintenance "blitz" or "swarm" UP conducted in March. For the first time in about 20 years, the railroad shut down an entire subdivision to conduct months’ worth of track maintenance work in eight days.
From March 1-8, 400 workers descended on the Giddings Subdivision to perform a multitude of work on a line running from Hearne to West Point, Texas. The crews replaced 34,000 ties, undercut 17 miles of ballast, replaced six bridges and repaired two others, and completed 1,650 feet of work at grade crossings.
The line was chosen as the swarm’s site because there were many good rerouting options for trains, says Ken Sito, a senior assistant VP in UP’s Engineering Department. UP is building a large classification yard in Robertson County, Texas, between Mumford and Hearne. Seven UP lines converge in southern Robertson County, connecting markets in Dallas/Fort Worth, Houston, Austin and San Antonio, as well as the remainder of east Texas and the Gulf Coast.
About 25 trains needed to be rerouted each day during the swarm, and traffic on the Texas line impacts traffic on other lines in the state and throughout the network, says Sito.
"We wanted to make sure the reroutes were executed and train commitments were met," he says. "Once you’re into the swarm, there’s no turning around. The track is out of service."
The Class I conducted the swarm to reduce the amount of track curfews needed to complete more than six months’ worth of work in 2015.
"It eliminated a lot of train delays for work that would have been done in future work windows if they were spread out this year," says Sito. "We need to improve customer service and operations, and eliminate delays caused by engineering work."
Because of the swarm, the Giddings Subdivision line also will need fewer track repairs, helping to boost train velocity and safety.
In December 2014, engineering department managers decided to completely shut down the line to expedite work via a swarm. UP hadn’t conducted a blitz since the mid-1990s, and even then, the chosen coal line wasn’t completely shut down, says Sito. The line remained open to trains for six hours each night.
Now, department officials are deciding whether UP should conduct more swarms. Several teams are analyzing the Giddings Subdivision blitz — which was completed without any injuries — to determine improvements that could be made and identify additional locations, says Sito.
"There are other areas in Texas with reroute capabilities, so I think we could do more in Texas," he says.
"Doing more" is the mantra being recited railroad-wide as the Class I tries to take the appropriate measures to boost operational and financial performance. To that end, UP will remain focused on service and cost efficiency, said CEO Fritz during the April 24 earnings conference.
"Our goal is to provide our customers with excellent service wherever the need arises," he said. "We expect to see solid improvement in network performance over the coming months."
There are a number of factors working in UP’s favor, which likely will pay off a bit further along the financial growth course, CFO Knight believes.
"The diversity of our business mix and the strength of our franchise long term still provides us stronger optimism," he says. "That’s why we think, longer term, the expectation still is that volume will be on the positive side of the ledger."
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