UNP

Union Pacific Corp. 10-Q Summary: Period Ended September 30, 2006

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2006, and the nine-month period ended on the same date. Union Pacific Corporation (UPC) operates as a single reportable segment through its subsidiary, Union Pacific Railroad Company (UPRR). The company reported record commodity volumes and improved operating metrics, driven by robust demand, yield increases, and network management initiatives.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Operating revenue increased 15% in Q3 and 17% year-to-date (YTD). Growth was driven by a 3% increase in volume, improved yields, and fuel surcharges which generated an additional $222 million in Q3 commodity revenue.
• Profitability: Operating income surged 56% in Q3 and 64% YTD. The operating ratio improved by 5.0 percentage points in Q3 and 5.3 points YTD compared to 2005.
• Expense Drivers: Operating expenses rose 8% in Q3 and 10% YTD. Fuel costs increased significantly (diesel prices up 20% in Q3), accounting for $130 million of the Q3 expense increase. However, fuel surcharges recovered approximately 89% of the additional fuel expense in Q3.
• Comparability Factors: 2005 results were negatively impacted by weather and operational disruptions (West Coast storm, SPRB Joint Line disruption, Hurricanes Katrina and Rita), which reduced 2005 net income by approximately $77 million. Conversely, 2006 benefited from the settlement of insurance claims related to the 2005 storm.
• Tax Impact: 2005 included a one-time $118 million reduction in income tax expense due to IRS settlements. 2006 effective tax rates were normalized at 35.9% (Q3) and 36.9% (YTD).

Guidance, Outlook, and Risks

• Capital Expenditures: Management expects 2006 capital expenditures to be approximately $2.8 billion. Plans are being evaluated to increase 2007 capital expenditures by about 15% to approximately $3.2 billion to support capacity expansion for intermodal, coal, and agricultural products.
• Operational Outlook: The company continues to focus on increasing velocity and asset utilization. Record volumes were handled in Q3 2006, exceeding 2005 records by 3%, while average terminal dwell time improved by 7%.
• Risks and Contingencies:
  • Legal Proceedings: A shareholder derivative lawsuit regarding safety reporting was settled in August 2006 with no admission of liability; the company will pay $1.125 million in plaintiff attorney fees. The U.S. government filed a claim for over $246 million regarding a 2000 fire; the company disputes the amount and believes it has adequate insurance.
  • Environmental: The company faces criminal misdemeanor charges for alleged Clean Water Act violations at Taylor Yard. It also has identified 376 sites for potential remediation, with a recorded liability of $211 million.
  • Asbestos: A liability of $304 million is recorded for asserted and unasserted asbestos claims, expected to be paid through 2034.
  • Market Risks: Exposure to fuel price volatility and interest rate fluctuations, though managed through surcharges and hedging instruments.

Investor Verification Checklist

• Fuel Surcharge Recovery: Verify the sustainability of the 89% fuel cost recovery rate in Q3 2006 as diesel prices fluctuate.
• 2005 Comparability: Confirm that the significant year-over-year growth is not solely due to the one-time operational disruptions and tax benefits in 2005.
• Capital Spending: Monitor the execution of the planned 15% increase in 2007 capital expenditures and its impact on free cash flow.
• Legal Exposure: Track the resolution of the $246 million U.S. government fire claim and the criminal environmental charges at Taylor Yard.
• Debt Covenants: Review compliance with debt covenants, specifically the debt-to-net-worth ratio, given the company's leverage levels.