UPside potential at Union Pacific Railroad

— by Jeff Stagl, managing editor

In early 2005, more than 320,000 rail cars flooded Union Pacific Railroad's 32,400-mile network. Many cars were stalled in yards or taking extra days to reach their destination. Why? Because North America's largest Class I didn't have enough crews and locomotives to accommodate mushrooming traffic. Also, several severe storms in southern California and the Sierra Nevada region had washed out parts of key mainlines and the railroad had difficulty getting cars moving after weather-related setbacks while handling unprecedented volumes.

As a result, first-quarter 2005 net income fell 22 percent to $128 million, operating expenses rose 10 percent to $2.8 billion and the railroad's operating ratio worsened 1 point to 90.1 compared with first-quarter 2004.

Customers grew frustrated with the Class I's transit times, as well. Seventy-one percent of the respondents to Smith Barney/Citigroup's first-quarter 2005 survey of 1,400 rail shippers said UP's service had deteriorated. In a fourth-quarter 2004 survey, 45 percent of the respondents said service had worsened.

The railroad's network wasn't fluid — a problem that snowballed through 2004 — because UP was taking on traffic that didn't necessarily match what mainlines or yards could handle and operations weren't adjusting quickly enough to seasonal demands, senior execs say.

UP's top brass knew they needed to resist the temptation of a quick fix, such as adding more trains and more cars to an already congested system. Instead, they spent late 2004 and early 2005 making changes to several operational processes. Ones that will take time — perhaps years — to put in place, but pay off by improving service reliability, generating more income and reducing costs for the long haul.

The changes include the Unified Plan, a new operating blueprint UP began to implement in second-quarter 2005 that's designed to reduce intermediate switches, create more direct origin-to-destination trains and quickly restore traffic flows after severe weather strikes; a new car-handling process introduced earlier this year at shippers' facilities to control traffic flows; a car inventory management system that will be rolled out later this year to reduce cars on line; and ongoing "lean" and Six Sigma initiatives to speed up tasks, such as locomotive repairs.

The changes have different purposes but a common motto: never be satisfied with performance and strive to improve every operational aspect. And it will take time for that motto to sink in, execs say.

"If we were in a baseball game, we'd be in the second or third inning, so there's a lot of game left to be played," says UP Executive Vice President of Finance and Chief Financial Officer Robert Knight Jr. "It's a continuous-improvement game and it likely will go into extra innings, or never end."

Game-Changing Events

There are several factors that favor UP's chances in the game. The Unified Plan is taking hold; the railroad is in the midst of hiring 5,000 train and engine-service workers, and acquiring 200 road and 102 low-emission yard locomotives, and 2,700 freight cars; and UP is adding capacity, such as another 50 miles of double track in New Mexico along the core Sunset Route.

Bringing on more crews and power, and changing work processes helped UP get back on the right financial track in the first quarter. The railroad registered best-ever earnings of $1.15 per diluted share — more than double first-quarter 2005's earnings — net income of $311 million nearly tripled, operating revenue of $3.7 billion and commodity revenue of $3.5 billion set quarterly records, and operating income of $605 million increased 93 percent and the operating ratio of 83.7 improved 6.4 points on a year-over-year basis.

Plus, UP's stock price reached $93.35 per share on March 31 compared with $69.70 per share on March 31, 2005.

The operational changes made so far also have helped the network become more fluid than it's been in two years. Average system velocity is up 0.5 mph to 21.5 mph and average terminal dwell time is down about an hour to 29 hours compared with 2005 data.

And UP is meeting car connection commitments 79 percent of the time and industry spot/pulls 87 percent of the time compared with 77 percent each a year ago.

The network is beginning to flow because the railroad is only taking on traffic where UP has the mainlines and facilities to accommodate the freight, says Knight.

"We have caps so we're not flooded with traffic," he says. "We will turn down business that doesn't fit our capacity or bring a sufficient level of return."

The Jury's Still Out

But UP can't afford to turn away a lot of business. To increase revenue and income, execs will need to provide shippers, short-line partners and investors more evidence that the railroad is gaining operating discipline.

"They're getting right-sized with labor and locomotives, and going to a more scheduled operating plan that's starting to take," says UBS Investment Research analyst Rick Paterson. "But it's a slow process to get out of the operational doghouse, and it takes time for simple blocking and tackling to take hold."

First-quarter results didn't show much cost-control discipline. UP's operating expenses rose 9 percent to $3.1 billion primarily because the average quarterly fuel price increased 29 percent compared with the same 2005 period.

"I think the next one or two quarters will show if they're gaining operating discipline and taking costs out," says Paterson.

UBS analysts believe safety metrics are the best indicator of operating discipline. After falling each month between September 2005 and February 2006 from 2.5 to 1.5, UP's reportable injuries per 200,000 manhours increased to 2.1 in March, according to a recent UBS report.

Coinciding with the safety metric's rise, velocity and terminal dwell times were flat in March. The service metrics remained that way through May, the report states

A majority of short lines aren't convinced UP's service performance is improving much, either.

In a recent UBS survey of 31 small roads that interchange with UP, 58 percent of the respondents said they expected the Class I's service to remain the same or worsen. Thirty-nine percent believed service would improve slightly and 3 percent said it would improve a lot.

The 'Show Me' State

Some shippers also haven't seen a noticeable difference at UP. Several shippers — who asked they not be identified — said the railroad's service hasn't gotten any worse, but it hasn't necessarily gotten better, either.

And although the rail industry's largest intermodal shipper wouldn't specifically take UP to task for its performance, United Parcel Service spokesman Norman Black said the company continues to experience service reliability issues in the West.

"We have not seen any level of change this year compared to last year," he says.

However, UP's own customer satisfaction survey of 200 shippers — which the railroad has conducted monthly since 1987 — tells a different story. During the first quarter, the railroad averaged a 70 score compared with the 50s in parts of 2004 and 2005.

Based on a 1 to 5 scale, with 5 being the best, shippers rate UP's performance in 35 categories. If a rating is 3 or lower, a sales or marketing staffer calls the shipper to find out why that rating was given.

"We survey the same shippers each May and the same ones each June, and so on, so we can get a good year-over-year comparison," says EVP of Sales and Marketing Jack Koraleski. "By the end of 2006, we want to get into the upper 70s, and then get into the 80s next year."

UP also conducts a local customer satisfaction survey through which shippers are asked to answer six questions about how well the railroad spotted cars and if cars were picked up on time.

"Customers say that we've improved. Intermodal shippers say our Blue Streak service is as good as it's ever been," says Koraleski. "But we know we're not where customers want us to be."

To get there, UP execs are counting on the Unified Plan. Launched in April 2005, the plan maps out an operating strategy for automotive, manifest and intermodal traffic to reduce terminal handlings and dwell time, and increase velocity. For example, transportation managers changed carload collection points so destination-direct trains operate several times a week instead of daily to free up mainlines.

So far, the plan has helped the railroad reduce intermediate terminal switches by 12 percent and the rate of en route work events by 16 percent.

Currently, UP is implementing the plan in its complex southern region. The railroad plans to improve interchanges with Mexican railroads at six U.S./Mexico border crossings. In March, the Class I and Kansas City Southern de México S.A. de C.V. began capping cars en route to the border at 4,000.

"We're now at about 3,500 cars en route and haven't hit 4,000 since we started," says EVP of Operations Dennis Duffy.

A Plan For All Seasons

UP managers also are working with representatives from MultiModal Applied Systems Inc., which helped develop the Unified Plan's operation planning software, to create software that adjusts operations for seasonal demands.

"We'll be able to determine 'what-if' scenarios," says Duffy.

The Unified Plan's biggest benefit to date: an increase in origin-to-destination trains. The railroad is operating 25 percent more direct trains than it has in previous years, says Duffy.

"It's like a non-stop flight for an airline, and we have an opportunity to create many more of those," he says. "We want to maximize origin-to-destination trains and minimize individual events and handlings."

UP execs also want to implement a new car-handling process at more shipper locations. Launched last year in Phoenix, the Customer Inventory Management System (CIMS) calls for transportation managers to work with shippers to fill manifest traffic spots and limit car inventories to three days to match traffic flows to track capacity, reduce dwell time and improve throughput.

For example, managers convinced a shipper to load and unload cars on Saturdays and Sundays in addition to weekdays so UP could operate seven-day train service.

"It's like the auto industry — they only want to ship cars on weekdays, but they'll do it on Saturdays and Sundays when the market is hot," says Duffy.

UP has implemented CIMS for 60 percent of its industrial customers and expects to reach 70 percent — including those in Houston and Fort Worth, Texas — by year's end. Since rolling out the system in Phoenix, Las Vegas and East Los Angeles, dwell time and switches have been reduced between 20 percent and 50 percent, says Duffy.

Scientific Slant

The Class I also is registering benefits from various lean and Six Sigma initiatives, which rely on science-based analyses to improve work processes. For example, the railroad is operating the equivalent of 50 additional locomotives on its network because diesel shops have sped up locomotive repairs, says Duffy.

"We mapped out every step needed to service a locomotive, determined which steps were value-added and took out the non-value-added ones," he says.

A 25-person staff is dedicated to developing and implementing lean and Six Sigma initiatives, which this year will focus on intermodal ramps and run-through tracks.

UP also expects to derive operational benefits from a car inventory management system that will be rolled out at the railroad's Omaha, Neb., Harriman Dispatch Center this year. Comprising a network management system and software, the system is designed to determine optimal train flows to reduce cars on line.

"We'll standardize response mechanisms to recover quickly from events, like storms," says Duffy.

By 2009, the railroad also plans to have the third generation of its Computer-Aided Dispatch or CAD System up and running to better integrate road dispatching and yard operations.

"We'll get 25 percent more capacity by integrating those," says Duffy.

Tracking Growth

UP plans to spend $485 million this year to ensure its network and facilities have additional capacity, too. The budget is part of the railroad's $1.5 billion track improvement program and overall $2.75 billion capital spending plan.

By year's end, UP will have double-tracked half of the 760-mile Los Angeles-to-El Paso, Texas, Sunset Route, as well as built a second mainline between two San Antonio, Texas, yards, a third mainline at its North Platte, Neb., yard, and new intermodal and auto ramps in Salt Lake City.

Next year, the Class I plans to complete a signaling project on its Omaha-to-Chicago double mainline that calls for installing Centralized Traffic Control and universal crossovers, placed every 15 to 20 miles. The project will improve throughput by enabling faster trains, such as intermodal, to pass slower coal trains.

And UP expects to operate many coal trains, especially out of the Powder River Basin (PRB). To accommodate the traffic, UP and BNSF Railway Co. plan to spend $100 million during the next two years to build more than 40 miles of third and fourth mainlines along their joint PRB line.

Coal and intermodal loads are driving UP's traffic surge of late. Through June's first 10 days, the railroad's second-quarter traffic volume was up 5 percent compared with the same 2005 period. Energy volume was up 8 percent; intermodal, 7 percent; automotive, 5 percent; and agricultural products, 3 percent.

Burgeoning low-sulfur coal demand, eastern U.S. mine issues and "carryover business" from last year, when severe weather damaged the joint line, are driving coal traffic, while increasing Asian imports to West Coast ports continue to propel intermodal moves, says Koraleski.

UP also is registering growth in industrial products traffic and ethanol carloads are up 50 percent.

"We're moving ethanol east for the first time and in unit trains for the first time," says Koraleski.

By year's end, UP's traffic should be up 3-plus percent compared with 2005, says CFO Knight.

"We keep hearing that there's a softening in the economy, but we're not seeing it," he says. "Lumber traffic is a little soft, but that's about it."

The projected traffic growth should boost full-year commodity revenue by 12 percent or more compared with 2005, Knight says. He also anticipates full-year earnings per share to fall between $5 and $5.20 (compared with $3.85 in 2005) and the annual operating ratio to improve by 4-plus points (from 86.8).

"Our overall goal is to get the operating ratio into the mid-70s," says Knight.

Rates Up, Expenses Down

To do so, UP will need to reduce operating costs, especially fuel expenses. The railroad, which is recovering 90 percent of diesel costs through fuel surcharges, needs to get to 100 percent, says Knight.

UP also will have to continue raising rates. In the first quarter, the railroad obtained a core increase of 6 percent — the highest core hike in the Class I's history, Knight says.

"But it all ties back to our service offering," he says. "We need to make it clear to shippers that our service is a value proposition."

Unfortunately, that proposition isn't entirely clear as yet to shippers. UP execs know customers' patience is wearing thin. But execs believe they're on the right path.

"We're going to continue bringing on the right volumes to improve returns and providing the service to attract volumes — it's all inter-related," says Knight. "I'm confident we're moving in the right direction."