UNION PACIFIC CORP quarterly report, Q3 FY2009

Union Pacific Corporation — Q3 2009 Form 10-Q

Business context and period. This unaudited filing covers the quarter and nine months ended September 30, 2009, compared with the same 2008 periods. Union Pacific operates one reportable segment: its integrated railroad network.

Financial results and condition

Metric	Q3 2009	Q3 2008	Nine months 2009	Nine months 2008
Operating revenue	$3.671 billion	$4.846 billion	$10.389 billion	$13.684 billion
Operating income	$967 million	$1.215 billion	$2.390 billion	$2.934 billion
Net income	$517 million	$703 million	$1.347 billion	$1.677 billion
Diluted EPS	$1.02	$1.38	$2.67	$3.24
Operating ratio	73.7%	74.9%	77.0%	78.6%

Revenue fell 24% in both comparison periods. Freight revenue declined 25%; Q3 carloads fell 15% and average revenue per car fell 12%. All six commodity groups reported lower freight revenue.
Operating expenses fell 26% in both periods, led by lower fuel prices, lower volumes, workforce reductions and productivity gains. Fuel expense declined 59% in Q3 and 62% year to date; diesel averaged $1.87 per gallon in Q3 versus $3.70 in 2008.
Operating margin, calculated as operating income divided by revenue, was approximately 26.3% in Q3 versus 25.1% a year earlier, and 23.0% year to date versus 21.4%. The reported operating ratio also improved.
Interest expense rose to $156 million in Q3 and $447 million year to date, reflecting higher average debt. Effective interest rates were 6.3% in both 2009 comparison periods.
Nine-month cash from operations was $2.222 billion, down from $3.038 billion. Cash used in investing was $1.741 billion; capital investments were $1.831 billion. Free cash flow, as defined by the company, was $73 million versus $685 million.
Cash and equivalents were $1.435 billion at September 30. Total balance-sheet debt was $9.793 billion, up from $8.927 billion at year-end 2008. Debt to capital was 37.3% versus 36.6%; adjusted debt to capital was 46.9% versus 47.4%.
Current assets were $3.217 billion and current liabilities $2.748 billion. The company had $1.9 billion available under its revolving credit facility, no commercial paper outstanding, and was in compliance with its debt covenant.

Changes, outlook and management commentary

Management attributed weaker results chiefly to recession-driven demand declines and lower fuel surcharge revenue. Year-to-date freight revenue fell most sharply in automotive (47%) and industrial products (36%). Core pricing gains partly offset volume and fuel-recovery declines.
Cost reductions and improved network fluidity partly cushioned the downturn. Average train speed improved 16% in Q3; the workforce was down 11%, and approximately 1,800 road locomotives and 53,500 freight cars were stored at quarter-end.
Management reduced its 2009 capital expenditure projection in April to approximately $2.6 billion from $2.8 billion; spending could be adjusted with business conditions or regulatory developments. Approximately $200 million of planned 2010 capital spending was earmarked for positive train control. The filing provides no specific earnings or revenue guidance.
Other income for the first nine months included a $116 million pretax gain on a Colorado land sale. A 2009 restructuring of leases for 813 locomotives changed them from operating to capital leases, adding about $843 million of lease obligations; a further $100 million locomotive capital lease was entered into after quarter-end.
The receivables-sale facility was renewed in August with capacity reduced from $700 million to $600 million; $400 million was utilized at quarter-end. Investors may discontinue the facility in certain cases if the company’s credit rating falls below investment grade.

Risks, contingencies and unusual items

The company identified 318 sites where it may have environmental remediation liability. It reported a $200 million environmental liability at September 30, while noting that ultimate costs are uncertain.
For the Omaha Lead Site, the EPA has directed the Railroad to perform remediation estimated in an earlier order at $50 million; a 2009 EPA notice also sought work at approximately 9,000 yards as part of a final remedy. The Railroad disputes liability and is seeking a negotiated resolution.
A consent decree resolving government claims concerning restoration work in Nevada requires an $800,000 civil penalty, a $98,000 payment for weed eradication, and monitoring and maintenance of restored areas for five to seven years.
Recorded liabilities included $594 million for personal injury claims and $205 million for asbestos claims. The company also reported $423 million of contingent guarantees, with a $4 million recorded fair-value liability. It stated that known claims and guarantees were not expected to have a material adverse effect, while acknowledging estimation uncertainty.
The IRS has issued notices of deficiency for 1999–2006; the company disputes many proposed adjustments and is at IRS Appeals. The reported liability for unrecognized tax benefits was $50 million.
Management cited economic conditions, customer demand, fuel prices, legal and environmental matters, and other uncertainties as factors that could cause actual results to differ from forward-looking statements. No material changes to previously disclosed risk factors were reported.

Important facts for investors to verify

Whether freight volumes and pricing recover, particularly in automotive, industrial products, international intermodal and energy.
How much operating improvement is sustainable if fuel prices rise or volumes remain weak; monitor operating ratio, service measures and cost reductions.
Capital spending, cash generation and leverage, including the effect of locomotive lease financing and planned positive train control investment.
The outcome and potential cost of the Omaha Lead Site proceedings, other environmental matters, and contested tax assessments.
Availability and terms of receivables financing and credit facilities, including refinancing needs and covenant compliance.