Union Pacific Corporation (UNP) Q2 2008 Earnings Report, Transcript and Summary

Greetings, ladies and gentlemen and welcome to the Union Pacific Second Quarter 2008 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Jim Young, Chairman and CEO for Union Pacific. Thank you Mr. Young, you may begin.

Good morning, everybody. Welcome to Union Pacific's second quarter earnings call. Joining me today are Rob Knight, our CFO; Jack Koraleski, Executive Vice President of Marketing and Sales and Dennis Duffy, Executive Vice President of Operations. I'm pleased to announce today Union Pacific overcame the challenges of widespread flooding in the Midwest, record high diesel fuel prices, and a soft economy to post second quarter earnings of $1.02 per share, a 24% increase over 2007. Quarterly operating income was a record $931 million in the quarter, up 18%. Looking at the drivers of our quarterly performance, discussion has to start with fuel. Fuel became UP's largest expense category in the second quarter as prices increased more than 60% compared to a year ago. Rob will talk to you a more about the flooding impact on our financials, but it did reduce quarterly earnings by about a nickel. Our dedicated employees quickly restored service to customers as they overcame the challenges associated with operating a 32,000-mile factory without a roof. UP's franchise diversity is a great strength and we demonstrated that again in the second quarter. Americans are spending more to fill their gas tanks, leaving fewer dollars available to purchase consumer goods. In fact, the Conference Board's June consumer confidence index reached its slowest level since February 1992. The effect of less confidence in the economy and reduced discretionary income is reflected in our lower quarterly loadings and automotive, industrial products, and intermodal. The offset to consumer weakness is strong demand for our bulk commodities driven by growth in coal, grain, and fertilizer, our agriculture, chemicals, and energy groups each hosted positive volumes in the quarter. And growth in those areas is facing even stronger before flooding impacted our Midwest operations. In fact in April and May, total car-loadings were running about flat through a year ago before finishing the quarter down 3%. So, we clearly lost some of our upside in the month of June. Despite little volume, our second quarter operating revenue was the best ever $4.6 billion. Strong pricing and increased steel cost recoveries both contributed to the gain. Operationally, we had a strong quarter. Dennis will talk to you through our few of the key metrics. So we had best evers in a number of areas despite the flooding challenge. That operational fluidity not only contributed to good cost efficiency in the quarter but also drove record customer satisfaction. Overall, we turned in a solid second quarter performance despite a number of obstacles and we're looking forward to further profitable gains in the quarters ahead. Now, let me turn it over to Jack to discuss our second quarter revenue. Jack?

Thanks, Jim and good morning. Our second quarter freight revenue increased 13% to a record $4.3 billion even though continued economic softness and severe flooding held our volume 3% below a year ago. The revenue growth was driven by improved average revenue per car for each of our six commodity groups. Four of the six businesses posted their best ever revenues, intermodal came close, they had a second quarter record and only the automotive business sales has set a new record as our revenues in that business were down 9%. At the same time, customer satisfaction again showed year-over-year improvement. Last month Midwest flooding along with the flooding in the Powder River Basin in late May, clearly affected our second quarter volume with the greatest impact in our coal business. Overall, our volume was tracking flat to last year through April and May, would likely have come a lot closer to finishing there had it not been for the flood. We estimate that the flood caused us around 40,000 loads, but the good news is we think that we can probably recover some of that as we go through the second half of the year. Three groups, our Auto business, Intermodal and Industrial Products saw volumes decline for the quarter. Our automotive volumes fell 20% with the American Axle Strike driving about two-thirds of that decline and the balance resulting from decreased production by the big four auto manufacturers. The economic softness also showed us in our industrial products results where volumes were down 1%. The drop in West Coast port volumes is keeping our Intermodal business kind of sluggish, but most of that volume decline was driven by some competitive losses and the impact of the flood related embargo. The biggest volume offset was an 11% improvement in Ag products helped by continued strong grain market. There’s also a plenty of demand out there for coal where volume was up 2% despite the flood. Our chemical car loadings grew 1%, as the strength in our fertilizer business offset the impact of economic softness in other segment such as liquid and dry, and our domestic plastic business. So this morning what I would like to do is take you just a little more intently on Ag products, energy and our industrial products business, talk a little bit about the highlights we have there in our second quarter. Turning to Ag products, once again Ag products posted the largest revenue gain with an 11% growth in volume combining with a 15% improvement in average revenue per car to drive a 29% increase in revenue. As in the first quarter, worldwide demand for grain and a weak U.S. dollar created a strong export market for feed grains and wheat, both saw volumes grow significantly in all three export markets; the Pacific Northwest, the Gulf, and Mexico. Overall feed grain exports grew 71% in the quarter and wheat exports were up 47%. While narrowed margins and tight credit are stressing the ethanol market, our ethanol markets continue to grow quite well. Our ethanol shipments were up 25% in the second quarter and we saw a 14% increase in DDG. For the second half of the year, the majority of the flood related damage occurred in Eastern Iowa and Southern Illinois, which were not significant UP grain origin. So we're really not expecting to see a big impact on our grain volumes for the rest of the year. And in fact, with worldwide demand for grain, for meat, and poultry and the growth in our produce rail express trains, we expect our Ag business is going to show continued strength throughout the second half of the year. Energy became our first business to top $900 million in revenue for the quarter as our revenue grew 21%, driven by a 19% improvement in average revenue per car and a 2% volume growth. Although both major segments of this market, the Southern Powder River Basin and our Colorado-Utah zones set productivity records for tons per train, weather-related disruptions resulted in the somewhat modest growth against last year's volumes, which incidentally were also impacted by severe weather. Southern Powder River Basin volume grew 4%. May loadings were hindered by mine flooding late in the month and June volumes, of course, were impacted by the Midwest flooding that curtailed shipments to the east, as well as in Iowa and around St. Louis. Chart shows you however that in July, we pretty much put that disruption behind us and we're running a strong. Production issues, utility outages in the St. Louis flood led to a 3% decline in Colorado-Utah tonnage. Looking ahead for the rest of the year, Colorado-Utah looks like it is going to be up about 3% for the year and we're still shooting for 5% growth out of the SPRB. With continued strong demand, the real wildcard for us is going to be the ability of the tight supply chain set, have some opportunity to make up some of the loads that were missed as result of the flooding here in the second quarter. A 10% improvement in average revenue per car enabled industrial products to grow revenue 9% to almost $900 million even as volume declined 1%. With weak demand resulting from the ongoing slump in the housing market leading to mill closures, our lumber shipments declined even further in the second quarter falling 25% below last year. The impact of a weak construction market also showed up in our cement business, combining with the rain in the Midwest to drive volumes down about 11%, but industrial products is our most diverse business group, and there was some good news that helped offset some of the overall volume declines. For instance, our steel shipments increased 20%, as the weak dollar limited steel import, creating a stronger domestic market and inventory replenishment across the United States. The worldwide demand for scrap and finished steel caused scrap prices to double since the end of last year and drove 17% increase in our fair of scrap volumes. Favorable weather in Texas combined with pent-up demand from the first quarter weather issues drove a 6% increase in rock shipments. And as we discussed in Chicago, our wind energy business is expanding by leaps and bounds. We're continuing the conversion to unit trains [ph]. We had two new unit train movement, the wind power component starting up late in the quarter, one moving from Mexico to the Pacific Northwest and another set from California to Texas. Over the second half of 2008, we're looking to win, along with opportunities and other energy-related markets, like resin [ph] and pipe, and continued strong demand in steel to help us offset the soft housing-related markets, which are showing at this point in time virtually no recovery. So as we look to the rest of 2008, we're expecting that our strongest businesses will be those that led the way through the first half, namely Ag products and energy. Chemicals, which is run slightly ahead of last year so far, should stay solid for us. As I highlighted earlier, industrial products is kind of a mixed bag, but we think there's potentially enough upside opportunity to offset the continued weakness in lumber and other markets. Domestic, intermodal, and our automotive parts won't be big growth drivers over the last year, but they should hold their own with volumes pretty much unchanged from 2007. So that leaves us with automotive vehicles and international intermodal. And at this point in time, we really don't see anything that's going to jump-start vehicle volumes. GM's announcement last week was only the most recent reminder of the troubles in the automotive sector as they deal with both the soft economy and changing consumer preferences. In international intermodal, West Coast imports have been down, the soft economy looks like we're going to have a fairly mild peak season. If you put it all together, we expect overall volume in the third quarter's probably going to be down in the 1% to 2% range versus last year. For the full year, it looks like we'll still be down around 1% requesting a relatively soft first half and our expectation that the economic doldrums are probably going to continue through the second half. But as we did in the first half, we will offset the volume softness with price. We'll wrap up the year with a core price improvement in that 5% to 6% range and that should continue to drive top line growth through the end of the year. With that, I'll turn it over to Dennis for the operations update.

Thank you, Jack and good morning. For the operating team the second quarter was a study in contrast. We made significant progress in April and May to improve the efficiency and reliability of the network only to have Mother Nature, set us back track with Midwest flooding in June. Despite these challenges we continue to operate a safer network in the quarter in particular with [inaudible]. Productivity was the real story line for us in the quarter, as we made strong gains in virtually every category. Employee productivity as measured by gross ton-miles per employee improved 3% in the quarter, through [ph] freight train starts were down 4%, and yard local starts declined 5% year-over-year with only a 1% decline in gross ton-miles. And another important driver of our operating performance in the second quarter was our network resiliency. We faced a number of weather-related disruptions on our Northern region beginning in late May. But, unlike the mudslide in Oregon these outages hit us right in the heart of the railroad. The Red Axe [ph], which is the densest part of the network, and in fact at its worst, our simple quarter over coast [inaudible]. Fortunately, we came into this flooding situation with a very fluid network. In the second quarter we experienced a total of 54 network interruption days, nine more than last year. Now some of you might have expected a bigger difference, but you’ll recall that we had flooding last year around the Kansas city area, and in Texas. Our recovery from the flooding was much faster this year than last in part from the continuous improvement principles we acquired and from lessons learned. We set an innovative approach, establishing a co-coordinated redesign of the transportation plan that allowed us to maximize the efficiency of alternate routes. We utilized a permitting process to control the flow of business on to our network. This allowed us to isolate the impact of a flooding to the Northern region. Our engineering team did a great job of pre-positioning resources, so we could get immediately start work to reopen the lines after the water receded. This involved rescheduling some of our work gains, giving us extra resources in the affected areas while reducing the maintenance impact on other parts of our network. In addition, the investments that we made over last couple of years to harden our rail infrastructure and add capacity and surge resources greatly improve the resiliency of our network. The end result of these efforts can be seen in the chart at the bottom left where we improved our quarterly velocity by over one mile per hour versus last year. And if you look at our velocity on a weekly basis, you can see more clearly the improvements we made. We had a nice pickup in velocity through the quarter averaging 23.5 miles per hour in the month of May, our best monthly velocity in five years. Importantly, since we move beyond the major playing issues, velocity has rebounded quickly and we are running at nearly 24 miles per hour today. Our other key operating metrics, inventory and terminal dwell, both improved in a challenging environment. We are translating greater network liquidity into better operating efficiency and service reliability as shown by the charts on the right. Freight car utilization, which measured today between originated car loads was a second quarter best at 9.5 days. As we have improved our system velocity recrew rates, also improved declining more than 2 points year-over-year. To put this in perspective, 1 point of improvements saves us over a 100 train and engine employees. Jack shared with you the high marks that our customers were giving us on their satisfaction survey. Internally we're also setting new record at our service delivery index, which were used to measure customers’ service commitments improved nearly 10% versus last year and set a monthly record in May. So across the board, we are improving operationally. We are consistently executing our transportation plan, which is driving greater overall efficiency and reliability. Looking to the back half of '08, the operating team will continue to execute on the principles that have driven the improvements year-to-date. Safety remains our priority and we will continue with implementing total safety culture across the railroad, summer is the peak maintenance season for our railroad. Our challenge to accomplish these major programs and continue to achieve the necessary throughput to improve service. We expect continued productivity from our structured approach to asset utilization and cost control and customers will see greater service reliability across all of our business segments. So, with that I’ll turn it over to Rob for the numbers.

Thanks Dennis and good morning. We’ll start off with a quick look at our income statement. Second quarter operating revenue was $4.6 billion, a 13% increase year-over-year. Operating expenses increased 12% in the quarter, driven entirely by higher fuel cost. In fact second quarter operating expenses excluding fuel actually declined 1% or $28 million. Although, we did benefit in the quarter from a $12 million casualty expense reduction that was more than offset by roughly $23 million of higher cost associated with the final cleanup of the Oregon mudslide. The Midwest flooding also added cost to the quarter of a little more than $10 million, but we were able to offset the majority of these through fewer train starts and less fuel compunction. This cost performance highlights our improved operating efficiency and is even more remarkable when you consider the operating challenges that we faced during the quarter. The net result of our operations was 18% growth in operating income to a second quarter best, $931 million. Looking at the drivers of our freight revenue growth, we reported a 13% increase, or $496 million to $4.3 billion. Freight revenue would likely have been about $45 million higher in the quarter, but was impacted by the Midwest flooding, primarily from fewer coal loadings. Increased fuel cost recovery, driven by higher fuel prices, was the largest contributor to our 13% freight revenue increase. Pricing also continued strong for us, as we achieved roughly 6 points of core price improvement in the quarter. Our mix of business was also a positive. In particular, the business group with the highest average revenue per car, agriculture, grew volumes 11% in the second quarter. Turning now to expenses, compensation and benefit expense declined 4% year-over-year to $1.1 billion. We offset general salary and benefit inflation through greater overall work force productivity, as we moved 1% less gross ton-miles, with 4% fewer employees. Training costs were also lower versus last year, as the continuing trend of lower volumes requires us to backfill less attrition. For the remainder of the year, our work force levels will be aligned with anticipated volume and productivity. Cost per employee will likely increase, however, as the nationally negotiated wage increase of 4% went into effect on July 1st. As Jim mentioned, increased fuel expense was a key driver in the quarter, totaling a record $1.2 billion, driven by a 64% increase in average diesel fuel prices for the quarter. This expense category increased more than $400 million versus last year. Although our various fuel cost recovery mechanisms help offset these rising fuel prices, the effect to our profitability cannot be overstated. In fact, in the second quarter alone, we estimate that higher locomotive fuel cost over $0.75 per gallon threshold. Net of our various fuel cost recovery mechanism, reduced operating income by almost $200 million. By consuming 19 million fewer gallons of diesel fuel in the quarter, we somewhat mitigated the impact of higher prices. Consumption was lower as a result of moving 1% fewer gross ton-miles year-over-year, as well as our ongoing efforts to conserve fuel. The operating department’s conservation initiatives, as well as the increased use of newer, more fuel-efficient locomotives have enabled us to consistently improve our quarterly consumption rate. In particular, our June consumption was very favorable year-over-year and better than anticipated. A portion of this variance can be attributed to our business mix, but the Midwest flooding and the associated reduction in train starts was also a factor. Another fuel headwind for us is the increased cost of gasoline and diesel used in our work and fleet equipment. This added $12 million to our second quarter expense. We are committed to improving our fuel cost recovery and reducing the negative impact of fuel on our profitability, but until we reprice all of our legacy contracts, we are exposed to rising fuel prices. Moving to purchase services and materials expense, this expense line increased $16 million, or 3% in the quarter. Cleanup and restoration costs associated with the Oregon mudslide and the June flooding, as well as higher contract costs, were the primary drivers of this increase. True transportation costs were also higher in the quarter as a result of increased fuel costs. On slide 24, we show both depreciation and equipment expenses. Depreciation expense increased 6% in the quarter to $346 million. This increase is driven entirely by higher capital spending. Second quarter equipment and other rents declined 5% to $338 million, a $16 million savings year-over-year. Better asset utilization and fewer shipments of finished vehicles and industrial products both contributed to a reduction in car hire expense. In addition, lower lease expenses for freight cars, containers, and equipments were partially offset by other rental increases. Our last expense group is other, which declined $3 million in the quarter to $199 million. The primary driver of the decrease was a semi-annual actuarial study we completed in the quarter, which reduced casualty expenses by $12 million year-over-year. Our continued safety improvements and lower estimated settlement costs are reflected in the lower expense. Offsetting a portion of this decline were increased utility cost and higher state and local taxes. You'll recall that in 2007, we conducted actuarial studies in the first and third quarters, which in 2008 will be completed in the second and fourth quarters. And in the third quarter of last year, we recorded a $47 million casualty expense reduction. Although, we will see ongoing benefits from our improved safety performance, last year's quarterly reduction will clearly impact the year-over-year comparison. The next slide shows our second quarter operating ratio. We improved our operating ratio by nearly a point in the quarter to 79.6%, our lowest second quarter mark since 2002. Of course back then, we were only paying $0.72 per gallon for diesel versus this year's average price of $3.60 per gallon. You can see the impact of higher fuel prices, adding about 4.6 points to the operating ratio. This further illustrates the substantial headwind we faced from the more than $400 million run-up in quarterly fuel expense. The ongoing strength of our base business, driven by strong pricing gains, improved operating efficiency, and the casualty expense reduction, more than offset those added costs to drive 5.5 points of operating ratio improvement in the quarter. This operating ratio improvement is actually understated a little when you take into consideration the weather events we experienced in the quarter, both this year and last year. You might remember that in 2007, we experienced flooding on our network that reduced our earnings by about $0.05 per share post split. This year we had the impact from both the Oregon mudslide and the Midwest flooding, which all together cost us closer to $0.08 in the quarter. We are pleased by this quarterly performance as we continue to set the bar higher with regard to our profitability. In particular, we know we have a tough comparison going into the third quarter. Turning now to the full income statement, second quarter other income was $17 million less than the quarter at only $19 million, less interest income and a year-over-year decline in gains from real estate sales contributed to this decrease. For the full year, we still expect other income to be in the range of $75 million to $100 million. Interest expense increased 7% in the quarter to $128 million, as a result of higher average debt levels. Income tax expense increased 13% versus last year or $34 million. Higher pre-tax income was the driver of the increase with some offset from a lower tax rate. The effective tax rate in the second quarter of 2008 was 35.4%. This reduction is result of federal tax audits and state law changes, which increased earnings by $18 million after-tax. Through the first half of 2008, our effective tax rate is 35.5%. For the second half of the year, we would expect a more normalized rate of around 38%. Net income was a second quarter best of $531 million, a 19% increase. Earnings per share grew 24% to $1.02 per share. Of course the per share amounts reflect the two-for-one stock split that we completed at the end of May. Similar to the first quarter, our earnings per share growth is outpacing the rate of our net income as a result of our share repurchase program. On a fully diluted basis, our weighted average shares outstanding declined 4% in the quarter. During the second quarter, we repurchased 6.3 million shares of UP common stock at a total cost of a little more than $480 million. Since starting our repurchase program in January of 2007, we have bought back just over 38 million shares, returning more than $2.3 billion to shareholders. Turning now to slide 29 and our balance sheet, our adjusted debt-to-cap ratio is up year-over-year to the mid-40s, with about $12.5 billion of total debt obligations at the end of June. This puts us solidly in the middle of the investment grade credit range, which provides us with good access to the capital markets at a reasonable cost. Let me close today with a look at the third quarter and the second half of 2008. Similar to the drivers of the first half of the year, the key factors in the second half will be volume and fuel. Jack talked to you about our expectations that third quarter volumes could be in the 1% to 2% lower year-over-year range. From a fuel standpoint, our outlook assumes $4 per gallon for diesel fuel in the quarter. That equates to roughly a $135 per barrel for crude oil. At that price, third quarter fuel expense would increase roughly $550 million year-over-year, assuming a flat fuel consumption rate. The good news is that in the face of lower volume and a huge cost hurdle, we still expect solid earnings growth. We would look for third quarter earnings to be in the range between $1.10 and $1.20 per share, or 10% to 20% growth. Put some perspective around this, if third quarter car loads are down 1% and crude is near a $135 per barrel with reasonable refining spreads, our quarterly earnings could be toward the high end of the range. But if car load volume is weaker and we see fuel prices increase, that could bring earnings closer to the lower end of the range. We are also updating our full year outlook. We now expect volume to be down around 1% for the full year. This reflects the tougher than expected start to the year, with volumes already off 1% through the first half. We are also increasing our earnings range from $4 to $4.20 per share for the full year, or growth of 16% to 21%. This is above our previous range and is consistent with our stronger year-to-date earnings, as well as our expectation for continued earnings growth. Our focus on improvement will allow us to drive more of our strong top line growth into greater profitability for our shareholders. With that, I'll turn it back to Jim.

Thanks, Rob. As we look ahead to the second half of the year, we'll continue to face challenges from higher fuel prices and a softer economy. We remain committed, however, to driving productivity improvements throughout the organization, while providing a safe, reliable service product to our customers. The end result of these efforts will be a record financial performance for Union Pacific and greater financial returns for our shareholders. So with that, we've got time to take a few of your questions. Question and Answer

Thank you. Ladies and gentlemen, we will be no conducting a question-and-answer session. [Operator Instructions]. Our first question this morning will be coming from the line of John Larkin with Stifel Nicolaus. Please go ahead with your question, sir. John Larkin - Stifel Nicolaus & Company, Inc.: Good morning, everybody.

Good morning, John. John Larkin - Stifel Nicolaus & Company, Inc.: I had a question regarding the tremendous unit revenue performance in both the Ag and the energy as these segments both up in the high teens and I was wondering if you could comment a little bit on how much of that was price, how much was still surcharge, how much might have been the use of larger hours on average and how much might have been a change in the length of coal?

Jack, you want to try a short at that one.

In the energy business, John, we did have some repricing of a couple of our legacy deals and so the price component of that number was stronger than what we saw overall from the average for the quarter. And in the Ag business quite honestly it is just the strength of the market that’s allowed us to go in and whereas typically we might take one or two price increases over the course of the year. We have been able to do three or four. So our core pricing in both of those segments have been at the higher end of our business groups.

John, the other thing I would remind you is that you have a real [inaudible] on the Ag and energy, energy obviously we have got a big book of our legacy contract. So while we had a nice increase on the average revenue per unit, it really doesn't reflect what the market is right now, it is much higher than what we had in the second quarter. John Larkin - Stifel Nicolaus & Company, Inc.: Okay. I also had a question regarding the clean-up expenses with national disasters, such as the Oregon mudslide, and the flooding in the Midwest, you can recall that a couple of your other U.S. railroads in the phase of other disasters have had insurance recoveries on clean-up and rebuilding expenses. Is that something that applies in these cases?

Well, the Iowa floods we don't see that being something that we recover in insurance. The Oregon mudslide is one that we do have some coverage on. At the end of the day though, you still you may recover insurance but you pay it back over the long term. John Larkin - Stifel Nicolaus & Company, Inc.: Got it. That's all I had. Thanks very much.

Thanks, John.

Thank you. Our next question is coming from the line of Thomas Wadewitz with J.P. Morgan. Please proceed with your questions, sir.

Let's see, I think, the only thing that really stands out the most in the quarter to me seems to be the cost improvement, the operating performance despite the headwinds in June. Where... how much of the benefit is that improvement really came in on the cost side? I guess if you look at headcount reduction in rent or was a lot of that held back by the flood impact and I guess if we look forward, do we say, okay, you are going to continue to improve and may be the cost improvement [inaudible] similar phase or is there some further acceleration. Clearly, you have a lot of momentum in the operating side. I just want to get thoughts on that.

Well, Tom I think the best slide, debt [ph] issues in there, was the velocity for foreign assets. If you look at, we had a dramatic fall off, we were running strong right before the flood. That's out here and then we have recovered and that's not by accident, that's by plan in terms how we’re running our network today. We still have I think substantial opportunity for productivity improvement going forward here. So the rate that you have seen, while it was dampened somewhat by the floods and weather, we are going to continue. We said long-term, our productivity opportunities and said at a minimum we want to offset inflation. And Dennis, you want to add to that.

The one thing I'd add to it Tom, is that we tried to show you at our previous analyst sessions that we have a very structured approach to cost reduction asset utilization and I think you are starting to see some significant payoffs from our efforts on the unified plans and performing our network and running in much disappoint operation and we expect that to continue.

So if I look at, I think, equipment rents here improved about 130 basis points year-over-year if you look at as a percent of revenue and then headcount was down 4%. Is that type of case probably can continue for few more quarters and might even accelerated much if you don't have more weather events, is that a fair way to look at it?

Well, I'd be careful about just extending it out. [inaudible] a great one in there is we are reducing our lease locomotives, short-term lease locomotives, which is directly related to the velocity improvement, or end the year with fewer locomotives when you look at it and as we’ve said you before, part of the additions, and all that's looking backwards were the part of challenges we had with velocity, but we’ve got opportunities going forward. Rob, you want to add?

One comment. Just to remember last year's third quarter was a very good performance period. So while we continue to make the improvements, you got headwind of a difficult component third quarter. The other point I would make to your earlier comment is on the fuel consumption. As we pointed out the fuel consumption in June as a result of some mix issues and the weather was extraordinarily good and I wouldn’t anticipate that that run rate would continue, we'll continue to make improvements but that particular run rate could help us on the fuel consumption side in the second quarter.

Okay. And what... it seems like improvement in velocity is a good indicator at the present time, some improvement in your cost side performance. Where do you think velocity may ultimately go to, is it realistic to look back to '02 and say you get to those levels or you think there is a sense maybe going into next year, you could even exceed those type of levels?

We're going to continue to improve our velocity, part of this will... part of this in my mind is, is the market willing to pay for the service fees, there are two equations of velocities, which are reducing assets, improving the returns. The other fees, in fact my head of marketing actually missed the slide, so I have to bail him out here, on the customer satisfaction side. If you look at, we had a customer satisfaction for the quarter of 83, the best since merger and there is a great value there from the customer base as we turn their assets and provide great service. I don't have a number... I mean we don't have a number [inaudible] what's the ultimate velocity what we're focused on is every year improving our asset utilization earnestly [ph].

Okay. And then I guess last one, I'll pass along to someone else. On legacy contracts, I think you commented that coal got a bit of boost from some legacy pricing in second quarter. Is there more, I guess your contract is kind of second half loaded, so can we see a little further acceleration even in effective pricing on some of the lines in second half as more of those legacy yields are repriced here?

You will see the carryover effect of things we've done so far Tom and really from this point forward, the bulk of them are going to be year end expirations. We don't really have many coming up here in the third and fourth quarter.

Okay great, well, congratulations on the strong results.

The other thing regarding the energy business was also in some of our export co-opportunities. We have a new move of export coal that's driven down to Mexico. We've also stated moving some coal off the West Coast to Asia and both of those helped us as well from a pricing perspective this quarter.

Okay. Great. Thank you.

Thank you. Our next question is coming from the line of William Greene with Morgan Stanley. Please go ahead with your question sir.

Hey Jim, maybe I can just follow-up with one comment you just made here at the end. The service improvement, should we think about that as being able to extend the period where you can kind of the same as modest 6% core pricing or could it actually mean that contracts you’ve already priced even more upside, so we can think of maybe even growing that core price.

So, I think they’re... both exposed there really as were you, and we said it consistently, there is a market price for obviously the service we're providing today, but we clearly are seeing some very good opportunities where we're clearly entering new markets providing service products. So I think the value of railroads really are... really showing through right now with our customer base, so I see that upside on both sides.

Okay. And then you mentioned that you think coal to be strong. Do you have a sense for where your stockpiles are? I mean is this something where you just going to makeup the flooding or we actually have even more pent-up demand there?

Stockpiles at the moment are declining and but that's really not unusual for this time of the year. I mean this is the heavy season burn. So you would expect that, I don't know that they would say they are declining at an alarming rate, they are kind of seasonally acting the way we think. So we think we will have stockpile replenishment as well as some upside opportunities collectively for some export business and then we got some other recoveries stuff that’s out there. So, I think there is three things that again contribute to our strong second half for coal.

Okay. And then just last question, at the analyst day you mentioned that you had seen lumber shipment sort of, seen no longer to deteriorates sequentially. Are you seeing any signs that things are getting better now in that world or was that just sort of a fluke?

I'll answer that one. I don't think we’re now what 25% in quarter, that’s on top of, we are down almost 50% I think from where we were in the peak. I don't see anything out there on the housing side that there is a recovery in the near-term, where our planning cycle next year say, certainly peaks up. Now we are fortune to have good mix of business. If you look, fuel was up what 15% or so, 17% stone, some of that is related to highway constructions. But I don't see anything in the near term that is going to drive our private lumber business backup.

Okay. Thanks for your help

Thank you. Our next question is coming from the line of Ken Hoexter with Merrill Lynch. Please go ahead with your question, sir.

Great, good morning. Just on the oil side, now that we have seen a bit of a pull back you were talking about [inaudible] and the impact to earnings but since we seen a $20 pullback, I'm just wondering do you see any of that domestic intermodal that Jack, you were talking on might be good in the second-half. Do you see any of that may be potentially going back to the truck or do you think you keep winning even at these high lumpy [ph] levels

Ken, I really think that the domestic intermodal will stay fairly strong for us over the… even at the pullback 20 bucks. I think we're going to see a sustained demand or some good initiatives that we have in the marketplace. We’ve got some great service product and our service is getting better and better all the time. So one of the cool things we’re seeing happen right now is that the service gap between truck and rail as our service improves and this highway congestion gets worse we’re closing that gap and so we've got a lot of very strong products particularly on the Southeast and the Sunset route [ph], or places like that. I think we will continue to make inroads even as fuel prices bring that down. Well, part of the domestic, two things. One obviously, the economy. But there is a second one here is what is happening with excess freight capacity today. And we know it's been shrinking in terms of if you look at equipment being sold overseas, we've actually have seen some areas that have we saw some shortages in terms of equipment. So I think there are obviously fuels of energy cost are big feel to the truckers, but there are other factors that have played out here.

Okay. Just a two quick technical questions if I can. In the annual targets, are you using the $1.02 or you excluding the tax gain in that full-year target?

We are using the $1.02.

Okay. And then the same for was it last quarter you also had the tax gain?

Yes. We are including that.

Okay. Thanks. And then on the fuel Rob, do you use WTI or diesel in your surcharge rate?

We’ve had several different surcharge, but very little of it is WTI. DOE is the persona driver.

Okay. And then I think you rather, it was mentioned earlier but intermodal was driven by competitive losses, I think maybe Jack mentioned that. Can you talk about the scale of what on the international side is being losses, you're going outward or East or is it being lost to other carriers out West?

Ken, we lost some business to rail in terms of the contract. So, it wasn't really shifting to these.

Okay. And then the pricing mix in that high teens performance this quarter great 16% yield. I think can you simplify that what percent was share price?

Fuel price is up about 6%.

So [inaudible] 5% range:

Right.

Okay. And the last question I have is, just as you look on the 4% increase in cost, the employee decrease [ph] and the new contract that Rob talked about... just wondering what... are there anything specific that you need to do in order to offset this, immediate increase in this quarter or is that going to be something you just trying to keep the ongoing productivity that gradually offset that, so could we see… is that why you are being cautious on the third quarter because of the scale of that employee cost decrease [ph]?

You're going to have the pressure as Rob mentioned but would need to continue to focus on our productivity, we are now reducing recrews, we talked about that before. We... our recrew rates while we had a good improvement year-over-year we're still running about 8% or 8.5%... 8% or 9%, so we got to keep focused on the productivity piece.

Right. Thanks so much for the time. Great job.

Okay Ken.

Thank you. Our next question is coming from the line of David Feinberg with Goldman Sachs. Please go ahead with your question, sir.

Good morning, gentlemen.

Hi David.

One question, because weather has been such a hot topic, I figure, I might as well ask it, I guess [inaudible] is that having any impact on you, close to Texas?

No major impact.

Say that again.

Not a major impact at all.

You made some comments about your international Intermodal business in the second half of the year, talking about a mild peak season. I was wondering if you provide some more color, were you speaking specific to UNP or those comments based on your outlook for the U.S. economy, does it have to relate to the fact that you lost this contract? I'm Just trying to understand what led you to think that the peak season will be mild, is this overall or were customer-specific?

Well, we are speaking to UNP but it really starts at where do you think consumer spending is going to go. I mean of course, part of peak is getting ready for Christmas. Our auto producers, which also are part of peak as they are producing new models, we don't expect that to be strong this year. So, it is unique to UP but it also reflects the reflex what's happening in the overall economy. We will have a peak, it just simply... it may be only a hill instead of a mountain.

Fair enough. And then last question, you talked a little bit about truck-to-rail conversion, can you talk about length of haul, I understand you have some new service offerings that are helping you win but are those offset... what's the length... what's the typical length of haul, shorter in duration or they longer, is there any difference [inaudible]?

Typically long haul business, it's West Coast to the Southeast, Northern California business heading to the east.

Are you seeing anything on north, south moves in the Midwest shorter distances or not yet?

Not particularly strong.

Thanks very much.

Okay David.

Thank you. Our next question is coming from the line of Ed Wolfe with Wolfe Research. Go ahead with your question, sir.

Hi thanks. Good morning guys.

Good morning Ed.

What happened in the last two and a half weeks that allows you to print such a strong number at the end of the quarter, I mean you still talked about Nickel of impact from the West Coast, so, what really happened at the end of the quarter that was so positive and can you talk about that relative to how July begins?

Well, Ed, we ended up with just a much stronger finish to the quarter. It was when we gave our guidance, the fuel impact or the weather impact came in pretty close to what we thought, but we saw a pretty strong bump quarter in the quarter... at the end of the quarter. And right now, it’s… if you take auto side of the equation, we are….Dennis, we had shown you what was happening with coal running over 37 trains a day out of PRB and coal. So it's seeing a little bit stronger. But it just… it doesn't take much when you look at… our productivity came in a little bit better, and then fuel, fuel consumption came in better.

Right. Jack talked before about Oregon through PRB and Gulf. Can you us a sense for on the export grain side for the mix of volume or revenue in terms of how that puts up?

Jack?

Right now, the markets are favoring some of the Pacific Northwest shipments, and so we are seeing product move from the Midwest, up to the PNW. But we are seeing uniform strength whether it is moving in Gulf, PNW or Mexico right at the moment. It's typically for us the PNW would be one of the, one of the weaker market, but it's pretty strong right now. So all three outlets for our international grain feeds are doing quite well.

But in terms of the size of each one, where are they right now?

I don't have the specifics on that, Ed.

Relative to each other…

Pardon me.

Relative, are they fairly even at this point… not just specific, but just relative to where more volumes were?

You can have more volume would be flowing Gulf of Mexico then you were to the PNW. That would be the smallest of the three for us.

And the Gulf and Mexico, where is that mostly moving to?

Part of it… in terms of the final destination?

Yes

Asian markets.

You have concerns at all at the end of the year based on what we’re hearing from Australia in terms of after two years of drought, it feels like they are going to have some very strong planting?

I think where that' going to impact us is going to be in the weak markets. If you look at last year's weak crop around the world, the U.S. had the bumper crop. Everything else was relatively soft. So the Australian wheat crop and others are going to bounce back. That said, we are going to basically, probably diminish some of the strength in wheat sometime around the fourth quarter but I think we'll still have plenty of market demand for our products and that shouldn't be an issue. Another place where we've seen some pretty strong exports is also to Europe or in Italy in particular through our wheat products. And so we think some of that's going to roll back a little bit here in the fourth quarter. But it is not going to be draconian by stretch of imagination. We will still have solid market demand for our grain products.

Revenue forecast, you have a little bit last weak but made up in other areas basically [ph]?

Yes, corn is going to be okay despite the kind of the concerns right now. In our served territory, our corn crop should be good. I mean, you know always have that normal crop risk that you have to worry about early frost and those kinds of things. And some of the loss acreage got transplanted into soybeans and again, you know the soybean market should be strong, the acreage is looking good. The corn profit itself the quality of the crop, we were concerned that the quality of the crop was going to be weak but it's actually the latest projections of back up to 150 bushels in acres. So, it should be good.

Okay, and just shifting here Jack, to coal and export coal you talked about Mexico and West Coast. Can you talk a little bit about what the size of that export coal product is currently in and what the capacity is to stand that over the next couple of years?

Yes. Well, this year in total, Ed we will probably do about 4 million tones of export and probably 1 million to 1.250 million of that is going to be throughout the West Coast going to steel producers in the Asian Rim countries. Probably a half of million tones down to Mexico and then the balance is going to move through the river and head off to Europe, Spain and other places. That's kind of the run that there is right now. There is actually more capacity out there, I think from the port perspective and the rail perspective than there is right now at least on the mine side of things. So, yes, in fact we could get greater production out of Colorado- Utah. I think we would have some greater upside potential right and I think in the first quarter I mentioned that our export potential were somewhere in the neighborhood of 8 million tones alone just off the West Coast. I think my team now would say new interests, new contracts would say that export market is probably somewhere in the 15 million tone range, in terms of what the potentials. We don't know how many of those will come to fruition, but we are feeling actually pretty good. We spend a lot of time working with ports. We think there is port potential capacity out there that's been used that we have the opportunity and I think our biggest concern right now, our biggest opportunity is that we can get more production out of the mine.

What's your best guess in the mine can get you more production?

They are working hard at it, it is pretty hard to determine...

The quarters are years away.

I would say is, the quarters, I would say next year I think over the time period, I think you’re 12 to 18 months away. Ed, I think question though was long term, when does Australia come back into market I think again they are talking about a couple of years. RPB could be of interest as moving export. So, I think again we export coal in cycles and this is one of the positive ones here. I think if it's sustainable, you will see the supply chain respond. The other thing we're seeing on is just a pullback phenomena of the Eastern Appalachian coal going international. Because we have got a lot more interest now from Eastern utilities running to bring in PRB coal. Typically what they are trying to do is blend it. So they don't have to make major modifications to the boilers. But there is far more interest in trying to make those movements happen now as well.

And is that magnifying itself or manifesting itself in terms of test run or request for a test, where are you in that process.

Yes, it’s a combination of test run, but it's not only any, I mean any rail road that has a test run, whether it is us, or whether it is our competition the contracts when they come up for opportunistic bidding will be a free flow for all of us.

Okay. When is [inaudible] of that and then I just had one quick one [inaudible].

We could actually see some of the come to fruition in 2009

Okay, just the last one. You talked about the split between 6% pricing, what the other 9% or so, how do that split between fuel and mix. Give or take?

Two points may be mix, Ed.

Thanks for the time. That's helpful.

Thank you, ladies and gentlemen we’ve reached the end of our allotted time for questions. I would like to turn the floor back over to Mr. Jim Young for closing comments.

I want to thank everybody for being on the call this morning. I hope to see we've got some great upside going forward here and look forward to talking to you again here in our third quarter call. Thank you.

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.