“We Are the Green Solution”

What's a few billion dollars spent on infrastructure when your vehicles get more than 700 mpg? An interview with Robert M. Knight Jr., EVP and CFO, Union Pacific Corp.

Rob Knight is one CFO who is still bullish on his business. And why not? His company — Omaha-based Union Pacific Corp., the country’s largest railroad — has managed to deliver earnings and dividend growth even in the teeth of recession. The railroad’s strong revenues from shipments of coal and agricultural products have offset falling demand for automotive and housing-related freight, while highway congestion and environmental concerns increasingly make rail transport seem like an efficient green alternative. That’s not to say Union Pacific, which operates 33,000 route miles of track in 23 Western and Central states, is immune to the downturn. Its overall freight volumes shrank in 2008, and it expects flat or falling volumes in 2009. But as the 51-year-old Knight explains, a diverse customer base and a dedication to efficiency have kept Union Pacific’s financial performance on track. The railroad’s Q3 2008 earnings per share ($1.38) and operating income ($1.2 billion) were up 38 percent and 21 percent, respectively, and at press time Knight was optimistic that the fourth quarter would produce comparably sunny results.

How much has the recession hurt Union Pacific?

Our volumes in the third quarter were down 5 percent, which is a pretty big swing in our business. But a point or so of that was related to the hurricanes [Gustav and Ike]. We estimate volumes will be down more than 5 percent in the fourth quarter. Having said that, business continues to be fairly good in the rail industry. We’re getting all-time levels of positive feedback on our service products, and productivity continues to improve. We’ve been able to move the pricing of our product up to market-level rates. We estimated for the entire year of 2008 we will get in the range of 5 to 6 percent core pricing [gains].

Does that same yin-and-yang effect pertain to fuel prices?

The increase in fuel prices last year did force us to incur a huge cost. We have fuel-surcharge mechanisms, but they don’t recover 100 percent of those costs. [On the other hand,] rail is the most efficient mode of transportation. We can move one ton 790 miles on one gallon of diesel fuel. We are three to four times more fuel-efficient than a truck. We also have two-thirds less of a carbon footprint than other modes of transportation, including trucks. So we are kind of the green solution, which favors us moving forward.

What do you forecast for 2009?

In our third-quarter earnings release we said we see volumes for 2009 being flat to negative 2 percent. That was an early look, however; we have not finalized our 2009 plan.

Did you take business from trucks when fuel prices were sky-high?

On the margin you might have seen a little shift. A lot of the product that moves by truck needs to get there now. Rail hasn’t been that kind of a service; it’s more of a 24-hour-window kind of commitment. But as the consistency and reliability of our service improve, we’ve been able to narrow that gap. We’re able to make commitments in a 4-to-8-hour time frame, and that opens more doors for us. We’ll never be in the market for just-in-time, but we are well positioned to continue to grow our market share in intermodal. We do offer a lot of advantages over trucks. Take Los Angeles: there’s only so much more room to put more trucks on highways there. So as its economy expands, railroads — and in particular Union Pacific, because Los Angeles is a major market for us — are well positioned to take advantage of that growth.

We’ve written extensively about the drop in capital spending, but Union Pacific budgeted about $3.1 billion last year for capital improvements. What did you spend it on?

Every year we need to spend more than $2 billion on what we call replacement costs — replacing existing track, ties, and ballast as they wear out. That leaves about $1 billion in 2008 going toward capacity-expansion initiatives, like the Sunset Corridor, a route between Los Angeles and El Paso that is the single largest rail-expansion project in the country right now. It is completely single-tracked; about half is double-tracked, with another 350 miles left to build.

How much does it cost to lay new track?

About $2 million a mile.

How has the credit crunch affected your ability to borrow?

We are in the commercial-paper market, although our costs are a little higher. We recently did a $750 million debt deal; the coupon was about 7.8 percent. We were pleased to get it done. This, along with our strong cash from operations, enables us to continue toward our goal of making capital investments.

Yet you have to be very careful about those investments.

What makes the rails unique is we pay our own way. When we put $3.1 billion into our structure, we have to earn a return on that. Thus the need to get pricing up so we can get adequate returns.

Do you expect further improvements to pricing?

Roughly 20 percent of our total book of revenue comes from what we call legacy contracts. Those are long-term contracts that were negotiated during times when the market was much lower and our service wasn’t as good as it is now. As those contracts term out over the next several years, we’ll be able to [price] them up to market rates.

This past September, a commuter train and a Union Pacific train collided near Los Angeles, with many fatalities. What is the industry now doing to make sharing rails safer?

There’s a technology called positive train control that [the industry is] testing and aggressively working on. It’s a predictive collision-avoidance technology. When you get into areas like Los Angeles, Chicago, and the Northeast, there are multiple conflict points between freight and commuter operations. The technology that is being tested would, simply put, enable one train to know what the other is doing.

What metrics matter most to you?

One gauge of progress that we pay particular attention to is productivity as measured by operating ratio. In the rail industry, operating ratio is the inverse of operating margin. Each point of operating-ratio improvement is equivalent to about $150 million of operating income, and since 2005 we have taken more than 11 points off our operating ratio, so it’s a big improvement. We started at about an 85 percent operating ratio, and in the third quarter we reported a 74.9 percent ratio. By 2012, we expect it to be in the low 70s. By comparison, an outstanding, lights-out ratio would be below 70. We did this by launching an effort that involved every one of our almost 50,000 employees. I’ve had more than 2,000 suggestions for improvements come from our employees around the country.

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