UNP

Union Pacific Corporation 2006 Annual Report Summary

Business Context and Reporting Period

This Form 10-K covers the fiscal year ended December 31, 2006. Union Pacific Corporation (UPC) owns Union Pacific Railroad Company (UPRR), a Class I railroad operating 32,339 route miles across 23 states in the western two-thirds of the United States. The company serves as a critical link between Pacific and Gulf Coast ports and eastern gateways, with significant traffic to Mexico and Canada. UPRR operates as a single reportable segment, transporting commodities including agricultural products, automotive, chemicals, energy (primarily coal), industrial products, and intermodal freight.

Key Financial Metrics

Note: Free Cash Flow is defined by management as cash provided by operating activities less cash used in investing activities and dividends paid.

Material Changes vs. Prior Period

• Revenue Growth: Operating revenue increased 15% to a record $15.6 billion, driven by a 15% increase in commodity revenue. This was fueled by yield increases, fuel surcharges, and a 3% volume increase to record levels.
• Profitability: Operating income surged 61% to $2.9 billion, and the operating ratio improved by 5.3 percentage points to 81.5%.
• Fuel Costs: Average system fuel prices rose 16%, adding $393 million to operating expenses. However, fuel surcharge programs recovered approximately 90% of the additional expense above the base price.
• Capital Spending: Cash capital investments totaled $2.2 billion in 2006, up from $2.2 billion in 2005, focused on track maintenance, capacity expansion, and equipment upgrades.
• Debt Reduction: Total debt decreased by $636 million year-over-year, improving the debt-to-capital ratio.

Guidance, Outlook, and Risks

2007 Outlook: Management anticipates revenue growth and financial results exceeding 2006 levels. Specific targets include:

• Commodity Revenue Growth: 6% to 7% year-over-year.
• Earnings Growth: 10% to 15%.
• Operating Ratio: Below 80%.
• Capital Plan: Approximately $3.2 billion in investments for 2007.

Risks and Contingencies:

• Regulatory: The Surface Transportation Board (STB) issued a decision limiting how railroads calculate fuel surcharges on regulated traffic, though management does not currently expect this to materially impact their ability to recover costs.
• Environmental & Legal: Significant pending litigation includes the Omaha Lead Site (EPA order for $50 million interim remedy), various diesel spill claims in California and Illinois, and asbestos-related claims (liability recorded at $302 million).
• Operational: Risks include network congestion, severe weather disruptions, labor negotiations (87% of workforce is unionized), and dependence on two key locomotive suppliers.
• Accounting Changes: The company adopted FAS 158 in 2006, requiring the recognition of the funded status of pension and postretirement plans on the balance sheet, resulting in a $79 million reduction in shareholders' equity.

Investor Verification Checklist

• Fuel Surcharge Effectiveness: Verify the ability to pass through rising fuel costs given the new STB decision on surcharge calculations.
• Environmental Liabilities: Monitor the status of the Omaha Lead Site negotiations and the potential for increased remediation costs at the 367 identified environmental sites.
• Asbestos Exposure: Review the assumptions regarding future asbestos claim frequency and settlement values, as 84% of the recorded liability relates to unasserted claims.
• Capital Allocation: Assess the return on the projected $3.2 billion capital investment plan for 2007, particularly regarding capacity expansion in constrained corridors.
• Labor Relations: Track the progress of collective bargaining agreements with 14 major rail unions, as contract renewals could significantly impact wage and benefit costs.