Union Pacific - Q1 2013

Transcript

Operator (participant)

Welcome to the Union Pacific first quarter 2013 conference call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded, and the slides for today's presentation are available on Union Pacific's website. It is now my pleasure to introduce your host, Mr. Jack Koraleski, CEO for Union Pacific. Thank you, Mr. Koraleski. You may begin.

Jack Koraleski (CEO)

Good morning, everybody, and welcome to Union Pacific's first quarter earnings conference call. With me today here in Omaha are Rob Knight, our CFO; Eric Butler, Executive Vice President of Marketing and Sales; and Lance Fritz, Executive Vice President of Operations. This morning, we're pleased to announce that Union Pacific achieved record first quarter financial results, leveraging the strengths of our diverse franchise despite significantly weaker coal and grain markets. Earnings of $2.03 per share increased 13% compared to 2012. We efficiently managed our operations in the face of dynamic volume shifts across our network, as evidenced by our record first quarter operating ratio and customer satisfaction results. Putting it all together, it translates into greater financial returns for our shareholders. And with that, I'll turn it over to Eric.

Eric Butler (EVP of Marketing and Sales)

Thanks, Jack, and good morning. Let's start off with a look at customer satisfaction, which came in at 94 for the quarter, tying an all-time quarterly record. That's up 1 point from the first quarter last year, setting a new first-quarter record, and along the way, March tied our best-ever month at 95. We appreciate customer recognition of the strength of our value proposition and continue to work to make it even stronger. As expected, some key markets were a challenge in the first quarter, and as a result, overall volume was down 2%. While chemicals, intermodal, and automotive grew and industrial products was flat, it wasn't enough to offset the challenging market conditions that drove steep declines in coal and ag products. Soft ag and coal demand continues to have the largest impact on overall growth.

Setting the decline in coal loadings aside, the other five groups grew 2.5% despite the drought-related shortfall in ag. Note that the volume comparisons were subject to last year's leap year, which included an extra day of car loadings. Core pricing improved 4%, which, combined with a modest benefit from positive mix and increased fuel surcharge revenue, produced nearly a 6% improvement in average revenue per car. With price-driven average revenue per car gains outpacing the volume decline, freight revenue grew 3% to $5 billion. Let's take a closer look at each of the six groups, starting with the two that saw declines. Coal volumes were down 19%, as high coal stockpiles created by last year's low natural gas prices continued to impact demand.

Core pricing gains and positive mix led to a 16% improvement in average revenue per car, holding the revenue decline to 6%. High stockpiles and inventory reduction initiatives by a specific utility drove the decline in the Southern Powder River Basin shipments, with tonnage down 19%. Although coal stockpiles started to decline from last year's peak, they remain above normal levels. Also contributing to the decline was the previously mentioned loss of a legacy customer contract at the beginning of the year, which more than offset business gains. Colorado, Utah coal shipments also declined. Soft domestic demand, mine production problems, and a weak international market for Western U.S. coal limited shipments with tonnage down 15%. Before we move on to ag, please note that this slide shows the easing comp we had year-over-year in the second quarter.

Ag products revenue declined 9%, with volume down 9% and a 1% improvement in average revenue per car. Last summer's drought continued to impact grain car loadings, with first quarter down 19% from last year. Domestic feed grain shipments declined as tight U.S. corn supply, especially in UP-served territories, led to reductions in livestock feeding and increased reliance on local feed crops. Export feed grain shipments also declined, with improved world production and lower U.S. supply. Grain product shipments were down 4% as reduced demand for gasoline and the increased use of lending credits from previous years to meet the mandate drove a 10% decline in ethanol shipments. A reduced supply and greater emphasis on meeting local demand impacted DDG volumes, which fell 26%.

Food and refrigerated shipments also declined 3%, driven by lower sugar imports from Mexico and new restrictions in Russia and China that limited imports of U.S. meat and poultry. The automotive volume grew 2%, which, combined with an 11% increase in average revenue per car, drove a 13% increase in revenue. The growth rate of the automotive industry continued to outpace that of the overall economy during the first quarter. Drivers that helped the momentum in the automotive market last year continued into the first quarter, largely pent-up demand and an improving overall economy. New fuel-efficient models equipped with more features and technology appear to be compelling consumers to replace vehicles. In addition, a rebound in the housing and construction markets have increased demand for light trucks.

While sales continue to grow, our finished vehicle shipments lag as OEMs had unscheduled downtime to deal with product refreshes and dealers sold off existing inventories to support sales. Parts volume increased 5%, while pricing gains and the previously announced Pacer Network Logistics Management arrangement increased average revenue per car. Chemicals revenue increased 14%, reflecting a 12% increase in volume and a 1% improvement in average revenue per car....Crude oil volume increased 11% from the previous quarter, and more than doubled when compared to the first quarter of 2012. Growth was driven by increased shipments from Bakken, Western Oklahoma, and West Texas shale plays, and UP-served terminals primarily in St. James, Louisiana, and the Texas Gulf Coast. Plastics volume was up 3%, driven by the increased domestic demand and new business.

Growth in the export market was the primary driver of the 4% growth in soda ash. Strong demand from eastern origins, Louisiana, as well as new business to the Gulf Coast, led to growth in LPG, jet, gas, with shipments up 13%. Industrial products revenue increased 6%, even as volume remained flat, driven by 7% improvement in average revenue per car. Non-metallic minerals volume was up 11%, as continued growth in shale-related drilling increased frack sand shipments. Growth in housing starts and residential improvements increased the demand for lumber, with shipments up 18%. Hazardous waste shipments declined 63%, as cuts in government spending resulted in production curtailments during the first two months of the year, impacting uranium tailing shipments.

A slow start for pipeline projects, lower steel production, and softer demand for export scrap was reflected in a 10% decline in steel and scrap. Continued mine production issues continued to hamper export iron ore shipments, leading to a 5% decline in metallic minerals. Intermodal revenue grew 9%, as a 4% improvement in average revenue per car, per unit, combined with a 4% increase in volume. Although the pace of recovery is slow, continued strengthening of the economy drove international intermodal up 8%. While we continue to secure highway conversions with motor carrier and premium LTL customers, overall domestic intermodal shipments were flat, as these gains were offset by declines in select markets. I'll close with a look at the remainder of 2013. Most economic projections continue to forecast slow economic growth.

Although we face continued challenges in some markets, our diverse franchise still provides opportunities to grow in others. Despite softness in coal demand and the previously announced loss of a customer contract at the beginning of the year, we expect coal volumes in the second quarter to see slight gains against an easing comp last year. This assumes a continuation of recent trends in natural gas prices and further coal stockpile reductions. For the full year, we still expect coal volumes to be down slightly. We'll continue to feel the impact of the drought on last year's grain crop through the first half of this year, with second quarter ag products volume expected to be down in the low double digits. Expectations for a more normal crop harvest in 2013 should provide opportunity later in the year.

First quarter auto sales were at a seasonally adjusted annual rate of 15.2 million, the highest quarterly level in 5 years. This steady pace is expected to continue throughout the year, which combined with declining dealer inventories, should be good news for our automotive business. Crude oil should continue to drive chemicals growth, but the pace will ease against the ramp-up of volumes realized throughout 2012. Most other chemical markets are expected to remain solid. Industrial products should also continue to benefit from shale-related growth, with increased drilling activity and a ramp-up in pipeline projects after a slow start to the year. The housing recovery continues to gain momentum, which is expected to drive demand for lumber. Iron ore moves are expected to decline due to softer export demand and mine production issues.

Successful conversion of highway business is expected to drive domestic intermodal growth, while modest economic growth and a strengthening housing market should keep international intermodal ahead of last year. For the full year, our strong value proposition and diverse franchise will again support business development opportunities across our broad portfolio of business. Assuming the economy cooperates and we see a more normal summer weather pattern, we expect a slight volume increase, combined with price gains, to drive profitable revenue growth. With that, I'll turn it over to Lance.

Lance Fritz (EVP of Operations)

Thank you, Eric, and good morning. Let's start with our safety results. Our first quarter reportable personal injury rate increased from first quarter 2012. The reportable incident rate was abnormally high in February, but moderated substantially in March, and continues to show improvement year-over-year at the start of this quarter. Severe injuries declined sharply in the first quarter, reflecting our work to reduce the risk of critical incidents and the growth and maturation of our total safety culture. Rail equipment incidents or derailments improved to an all-time quarterly record. This improvement is largely the result of a reduction in track-caused derailments, which is a direct reflection of the investments we've made to harden our infrastructure. We also reap the benefits from technological advancements in equipment defect detection.

Moving to public safety, our grade crossing incident rate increased about 14% from the first quarter 2012. Our grade crossing incident exposure is increasing due to growing rail and highway traffic in the South, which has a higher grade crossing density than our overall network. Driver behavior was a meaningful contributor, with an increase in vehicles striking our trains or not properly stopping at crossings. As I said in January, we continue to focus on identifying and improving or closing high-risk crossings and reinforcing public awareness and safe driving practices. Now, let's take a quick look at the traffic pattern shifts we continue to experience on the network. Volumes on the Southern region of our network continue to grow.

In the South, we are near all-time peak carload volume, last seen in 2006, and we are moving it more efficiently with train speed up about 14% compared to 2006. While service was good by historical standards in the South, we experienced some modest operational challenges during the first quarter, which were reflected in our monthly velocity and terminal dwell numbers. We responded aggressively by leveraging our fluid routes and terminals and realigning critical resources. As a result, we completed an aggressive first quarter capital renewal program in the South, and I am pleased to report fluidity has improved substantially over the last few weeks. We're also making continued capacity investments to support volume growth across our diverse portfolio of businesses in the South.

We expect 2013 capacity spending to top 2012, which includes critical double track additions, siding extensions, and terminal capacity. These projects, along with continued process efficiencies, should support further improvement in network fluidity and service performance. The first quarter service results were solid, and our network is well positioned to handle future volume growth. Velocity was basically flat compared to the first quarter of 2012, with the modest slippage I mentioned in the South, offset by strong results in other parts of the network. We continued to provide outstanding local service to our customers with a first quarter best 95% Industry Spot and Pull, which measures the on-time delivery or pulling of a car to or from a customer.

Our Service Delivery Index, a measure of how well we are meeting overall customer commitments, declined modestly compared to the first quarter of 2012. The decline reflects tighter service commitments to our customers, the service challenges discussed earlier, and a mix shift from coal to manifest. Network fundamentals remain solid. We're increasing capacity in the southern region, and we have available capacity in many other parts of the network, as well as roughly 450 employees furloughed and about 800 locomotives in storage. Moving on to network productivity, Slow Order Miles declined 25% to a best ever quarter, first quarter level. Our network is in excellent shape, reflecting the investment in replacement capital that has hardened our infrastructure and reduced service failures. And we continue to leverage existing resources as our intermodal and manifest business volumes grow.

During the first quarter, we turned a 4% growth in intermodal volume into an average train size increase of 2%. Intermodal, manifest, coal, and grain train size lengths all set new first quarter records. Continued deployment of DPU locomotives, our capital investment strategy, and process improvements should continue to drive efficiency gains going forward. Car utilization was 1% unfavorable versus the first quarter of 2012 due to mix. Mix being equal, our car utilization rate would have been unchanged from last year's first quarter. The UP Way is playing a vital role in these results. Employees' engagement is critical to the success of our operating strategy, and as the teams doing the work take ownership of improving their process and outcomes. We remain optimistic on our full-year operating outlook for 2013 and our ability to achieve continued network improvements. There's various room for improvement.

I am encouraged by what I am seeing at the start of the second quarter and for the full year, my expectation is that we will operate at record safety levels while improving service and bringing more productivity to the bottom line. We are committed to operate a safer railroad for the benefit of all of our stakeholders, our employees, customers, the public, and our shareholders. We will remain agile, managing network resources in response to dynamic market shifts while handling growth with efficient and reliable service. Our continuous improvement efforts, particularly the UP Way, will generate further efficiency improvements that add value for our customers. We will continue to make smart capital investments that generate attractive returns by increasing capacity in high volume corridors, while also supporting our safety, service, and productivity initiatives. With that, I'll turn it over to Rob.

Rob Knight (CFO)

Thanks, Lance, and good morning. Before I get started, I'd like to make everyone aware that the 2012 Fact Book will be available tomorrow morning on the Union Pacific website under the Investors tab. So with that, let's start by summarizing our first quarter results. Operating revenue grew 3% to a first quarter record of nearly $5.3 billion, driven mainly by solid core pricing gains. Operating expense totaled $3.7 billion, increasing 2%. Operating income grew 8% to $1.6 billion, also setting a best-ever first quarter mark. Below the line, other income totaled $40 million, up $24 million compared to 2012. A one-time land lease contract settlement added roughly $0.02 in earnings per share compared to last year, which we do not expect to repeat going forward.

For the full year, we're projecting other income to be in the $100 million-$120 million range, barring any other unusual adjustments. Interest expense of $128 million was down $7 million, driven by lower average interest rate of 5.6% compared to 6.1% last year. Income tax expense increased to $588 million, driven by higher pre-tax earnings. Net income grew 11% versus 2012, while the outstanding share balance declined 2% as a result of our share repurchase activity. These results combined to produce a first quarter earnings record of $2.03 per share, up 13% versus 2012. Turning now to our top line. Freight revenue grew 3% to nearly $5 billion.

Volume was down a little over 2 points, partially offset by more than a 0.5 point of positive mix. Fuel surcharge recovery added roughly a 0.5 point in freight revenue compared to 2012.... We also achieved solid core pricing gains of 4%, which was a key contributor to our record first quarter financial performance. Lower coal volumes again hindered further pricing gains. Moving on to the expense side, slide 22 provides a summary of our compensation and benefits expense, which was about flat compared to 2012. Lower volume costs and productivity gains mostly offset inflationary pressures of about 2.5%. And as Lance just discussed, shifts in traffic mix and significant capital replacement work in the South had an impact on operations and associated costs during the quarter.

Workforce levels increased 2% in the quarter, mostly driven by a shift in traffic mix to more manifest business, which required additional resources. Increased capital and Positive Train Control activity also contributed to the growth. Turning to the next slide, fuel expense totaled $900 million, decreasing $26 million versus 2012. A 5% decline in Gross Ton Miles drove the reduction in costs. Although our average fuel price was flat year-over-year, our consumption rate increased 3%, mainly driven by lower coal volumes. Moving on to the other expense categories, purchased services and material expense increased 6% to $557 million due to higher locomotive and freight car contract repair expenses. In addition, under the new Pacer agreement, we're seeing higher costs in the form of logistics management fees and container costs not incurred under the previous agreement structure.

These costs hit both the purchased services and equipment rents expense lines and are recouped in our automotive freight revenue line. Depreciation expense increased 2% to $434 million. Or excuse me, the impact of increased capital spending in recent years was partially offset by a new equipment rate study that we discussed with you earlier this year. Looking at the full year 2013, we expect depreciation expense to be up in the 2%-3% range versus 2012. Slide 25 summarizes the remaining two expense categories. Equipment and other rents expense totaled $313 million, up 6% compared to 2012. Increased container expenses and growth in automotive and intermodal shipments resulted in higher freight car rental expense. Lower freight car and locomotive lease expense partially offset these increases.

Other expenses came in at $237 million, up $21 million versus last year. Higher property tax expense and increased equipment and freight damage costs were the primary drivers. Lower personal injury expense partially offset these increases. For the remainder of 2013, we expect the other expense line to moderate slightly, more in the neighborhood of $225 million a quarter, barring any unusual items. Turning now to our operating ratio performance. For the first time in our history, we achieved a sub-70 first quarter operating ratio of 69.1%, improving 1.4 points compared to last year. Our performance highlights the positive impact of solid core pricing gains and network efficiencies, and is also noteworthy given the fact that we had 2% decline in volume levels this quarter.

Looking ahead, we remain committed to achieving a full-year sub-65 operating ratio by 2017. Union Pacific's record first quarter earnings drove strong first cash from earning operations of more than $1.5 billion. Free cash flow of $401 million reflects the 12% increase in cash dividend payments versus 2012. Our balance sheet remains strong, supporting our investment-grade credit rating. At quarter end, our adjusted debt-to-cap ratio was 40.2%, which includes our March debt issuance of $650 million. Opportunistic share repurchases continue to play an important role in our balanced approach to cash allocation. In the first quarter, we bought back nearly 2.9 million shares, totaling $394 million.

Since 2007, we've purchased over 94 million shares at an average price of around $80 per share. Looking ahead, we have about 12.2 million shares remaining under our current authorization, which expires March 31st, 2014. So that's a recap of our first quarter results. Looking at the second quarter, although our coal comparison is much easier, we'll see ongoing challenges with weak grain volumes. However, assuming continued growth in the other market sectors, we would expect our second quarter volumes to be flattish year-over-year. Aside from volume levels, we'll continue to target inflation plus pricing gains. We'll also realize the benefits from continued productivity and network efficiencies.

For the full year, assuming the economy continues along its positive trend, with industrial production growth of around 2%, we would expect to see volumes on the positive side of the ledger. We're well positioned to achieve yet another record financial year with best ever marks in earnings and operating ratio, driving even greater shareholder returns this year. So with that, I'll turn it back to Jack.

Jack Koraleski (CEO)

Thanks, Rob. While there's still much uncertainty in the year ahead, our diverse franchise does really support our continued focus on profitable growth opportunities. We continue to pursue evolving business development prospects supported by our value proposition and the efficiencies that rail transportation provides. We're well positioned for upside, but we are just as prepared if our environment should take a turn for the worst. We remain committed to providing safe, efficient, reliable service for our customers to drive greater customer value and increase shareholder returns in the future. With that, let's open it up for your questions.

Operator (participant)

...Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Due to the number of analysts joining us on the call today, we will be limiting everyone to one primary question and one follow-up question to accommodate as many participants as possible. Thank you. Our first question is from the line of Tom Wadewitz of JPMorgan. Please proceed with your question.

Tom Wadewitz (Senior Equity Research Analyst)

Yeah, good morning, and congratulations on the strong results. One, I wanted to ask you about the, you know, one of the popular topics, the crude by rail here. How would you view the potential impact of a decline in oil prices and also changes in the WTI Brent spread? Or if you look at other spreads, that might be helpful for, you know, for inland crude moves. Is that, you know, is that a material source of risk in the near term to volumes? Or are your contracts set up in a way that you have commitments, and so you don't have much sensitivity to the price and the spread moves?

Jack Koraleski (CEO)

You know, Tom, I think certainly it depends on the order of magnitude of the moves that were to take place. We don't see anything in the horizon at this point in time that gives us any concern, but Eric, why don't you expand on that?

Eric Butler (EVP of Marketing and Sales)

Yeah, Tom, there are a couple of factors. We've said previously, you know, crude by rail provides a great value proposition, to the producers in terms of agility, in terms of being able to get to destinations that they previously couldn't get to. So all of that, those value factors remain. Certainly, if the price of oil goes to levels, pick a number, below $70s, mid-$60s, that's gonna impact the amount of production, which, as the total production numbers come down, the total numbers that will go crude by rail will come down. So that clearly, will have an impact if, price of oil goes down. In terms of the spreads, we're probably less concerned, about the spreads narrowing.

You know, again, there's a value proposition we've talked several times in the past publicly, with crude by rail that, again, gets you to destinations, allows the producers flexibility and agility. So we think that even if the spreads get to some narrow, some low single digit numbers, there's still a value proposition for crude by rail. The biggest factor is if crude production goes down, then certainly that impacts us.

Tom Wadewitz (Senior Equity Research Analyst)

Oh, okay. And, what about the, the structure of the contracts that you have in place into the St. James market? Are there some commitments that are multiyear, where you would have some minimum volumes, into those markets, or is it set up in a way that, you know, if things really change, that, that there wouldn't necessarily be volume commitments?

Eric Butler (EVP of Marketing and Sales)

Yeah, as we said, we don't really talk about specific customer agreements. What I would say that you could look at is the fact that the destination providers and the origin producers, they're investing huge dollar amounts of capital to do crude by rail, both in terms of freight cars and facilities. So, that should be a comforting indicator in terms of their long-term commitment to crude by rail.

Tom Wadewitz (Senior Equity Research Analyst)

Okay, great. Thank you for the time.

Operator (participant)

Our next question is from the line of Ken Hoexter of Merrill Lynch. Please proceed with your question.

Ken Hoexter (Managing Director)

Great. Good morning, and again, congrats on some solid performance. Rob, can you just talk about the outlook there that you just ran through? If you look at flat carloads for second quarter, do you still see coal, you know, moderating? Is ag accelerating on the downside? Maybe if you can give a little bit more insight onto some color on what's in that, in your targets there.

Rob Knight (CFO)

Yeah. Ken, just to kind of reiterate what both Eric and I talked about, keep in mind, as I think you know, the coal falloff that we saw year-over-year in the first quarter of being down, you know, 19%. Last year, you recall, we sort of hit the trough on coal, so we do have clearly an easier comp on coal as we head into the second quarter. But as Eric mentioned, we do envision that the ag drought will continue, certainly through the second quarter, and we estimate that's gonna be down in the, call it, you know, low double digits, which is a little bit, you know, worse year-over-year, if you will, compared to what we saw last year.

So when you add it all up, the guidance that we're giving is, you know, assuming all the other markets remain about constant with what we saw in the first quarter, that feels, you know, flattish to us. But full year, again, as if the economy continues to cooperate, which thus far it is, all of those things will sort of neutralize, if you will, when we get to the back half of the year. And we think at the end of the day, at the end of the year, we'll have volumes that overall are on the positive side of the ledger.

Ken Hoexter (Managing Director)

Okay, and then if I can do my follow-up on pricing. You know, was there any on the coal side, were there any contract settlements within that within the yields? And then also within pricing, you mentioned the Pacer Agreement a couple times. Can you kind of talk about or walk through the level of increase? I know you don't like talking about specific contracts, but maybe just magnitude of what we're looking at or continue to go forward on that contract. And then similarly, on pricing on the domestic intermodal side, I think you mentioned it was flat. Can you just kind of run through what you're seeing impact on that as well?

Rob Knight (CFO)

Ken, this is Rob. Let me take the first point, and you asked about the settlements in the coal line. There's a little bit in there. We're not calling out precisely what it is, but it's just a little bit of an impact on the ARC on the coal. And in terms of the other pricing discussions, we don't break out by-

Yeah, we, we don't talk about pricing on particular, arrangements or agreements. So Ken, I'm not, I'm not sure what your question was.

Ken Hoexter (Managing Director)

... I guess you mentioned that auto pricing was up significantly because of the Pacer agreement, so you kind of called it out on there. I mean, can you give us a, I guess, an understanding of what auto would be like without the agreement? I mean, it was a big number in terms of the 10% increase. Is it half of that in terms of magnitude?

Rob Knight (CFO)

Ken, this is Rob again. I mean, the impact on the autos ARC of that new agreement, you know, it's in that number, so it clearly inflated, if you will, the ARC number, the ARC. But that Pacer agreement, as I think everybody's aware, as previously announced, is really just kind of a neutralizing effect. I mean, it's showing up both on the revenue and expense line, but it doesn't change the, you know, the full year economics to us, at the bottom line. But there is a positive impact showing up in that ARC number on the autos line. And you will see that all year.

Ken Hoexter (Managing Director)

Okay. And then lastly, just on the, on the domestic intermodal, I think you had mentioned something on flat there. I just wanna understand that as well.

Jack Koraleski (CEO)

Domestic intermodal?

Rob Knight (CFO)

Yeah, we are continuing to see strength in our domestic intermodal business at the minute. I think I've mentioned our conversion strategy is going well. We're continuing to price to the market, and we're continuing to be pleased with the performance in that business.

Jack Koraleski (CEO)

The volume was flat in the first quarter, Ken. Is that, was that your question?

Ken Hoexter (Managing Director)

Oh, it was volume. Okay, not price. Yeah.

Jack Koraleski (CEO)

Volume, not price.

Eric Butler (EVP of Marketing and Sales)

Yeah, volume was flat.

Rob Knight (CFO)

Ken, this is Rob. If I could just make one clarifying point on the Pacer question that you asked. I said that the autos ARC reflected this new agreement, but it's not reflected in our 4% core pricing number that we report. That doesn't factor anything related in that number.

Operator (participant)

Thank you. Our next question comes from the line of Scott Group of Wolfe Research. Please proceed with your question.

Scott Group (Managing Director)

Hey, thanks. Morning, guys. Just wanted to follow up on a couple of those things from the last question. With the coal yields being so strong, if it's not legacy repricing, can you give us a sense of maybe what's driving that strength, and if you think it's sustainable? Then, Rob, you mentioned that you're getting good coal yields even without the volume. As the volume starts to come back, can the coal yields, or should they get even better from what we saw in the first quarter?

Jack Koraleski (CEO)

You know, Scott, when you look at the pricing of our coal overall, there was some legacy impact from prior contracts that had been settled, and there was also just the normal escalations that we have in our new contracts going forward. There was some incremental fuel surcharge. There was a little bit of liquidated damages, but not very much. So, that's really it.

Rob Knight (CFO)

Hey, Ken, Scott, if I could just one comment. The ARC number that we reported in the first quarter for, in addition to the comments that Jack just mentioned, there is some mix effect in there. So that, you know, again, if you look at our overall pricing as an enterprise, we reported 4% price, and as I mentioned in my comments, it was hindered somewhat by the lack of volume in coal. But if you're searching in the case, we don't break it out by commodity group, what the pricing actually was. But it is appropriate to take into consideration that the ARC number we reported in coal did have some mix effect in it.

Scott Group (Managing Director)

When you add up all those kind of moving parts of maybe some liquidated damages that don't continue, maybe coal coming back in some parts of on the network, does this kind of double-digit run rate on ARC feel sustainable for the year?

Rob Knight (CFO)

It will depend upon the mix. Again, what we're looking at overall in our pricing is to be inflation plus kind of pricing overall, and that's how we approach the business overall. But when you look at any, any individual commodity group's arc, you can get swings either way, depending on the mix of traffic that that we move that quarter.

Scott Group (Managing Director)

Yeah, that makes sense. And just last thing on the domestic intermodal. I'm a little confused, you're talking about the highway conversions going well, but domestic volumes were flat. What's offsetting that in the quarter? And just any color you can give us there would be great.

Rob Knight (CFO)

Eric?

Eric Butler (EVP of Marketing and Sales)

Yeah, as I mentioned, in a couple of select markets, there were some competitive select markets that had some volume reductions and,

Jack Koraleski (CEO)

Hey, Scott, let me take you back to our past comments, which is: as we take our prices up, there are some businesses going to fall away from the railroad because it doesn't meet our reinvestable standards. So we saw some of that. We were taking some prices up. We've got some new business and highway conversions, and we lost some business that didn't meet our reinvestibility threshold.

Scott Group (Managing Director)

Okay, that makes sense. All right, thanks a lot, guys. Appreciate it.

Operator (participant)

Our next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.

Brandon Oglenski (Senior Equity Analyst)

Yeah, good morning, everyone. I wanted to ask a question on the cost side. You know, when we look at compensation and benefits, it's actually been flat to down for the last four quarters or so. How should we think about headcount and wage inflation and some of the offsetting efficiencies that you're getting in the network, for the rest of the year?

Jack Koraleski (CEO)

Hey, Rob.

Rob Knight (CFO)

Let me start with the headcount question first. Overall headcount for the year, we would expect to float with volume. So again, our projection is that assuming the economy cooperates, that our volume will be on the positive side of the ledger. So the way I would look at it is that we would expect the volume to be up year-over-year, but not necessarily one for one, because there certainly is productivity savings that we will achieve throughout the year. On the cost side, the way I think I would guide you to look at, the way I would expect costs to flow through is we think our labor inflation is going to be around 3%. There were some timing issues-...

That resulted in it being flat, you're right, this quarter and the previous couple of quarters. But probably the right way to look at it is expect that inflation on the wage line is gonna be around 3% going forward.

Jack Koraleski (CEO)

Hey, Rob, one other thing to note is, and we mentioned it in our commentary, headcount will also flux with CapEx and with mix shift to manifest.

Brandon Oglenski (Senior Equity Analyst)

Well, then I take it from that guidance, Rob, then, I mean, should we be looking for more normal comp and then inflation of 3% throughout the year? I mean, depending obviously on the volume outlook then?

Rob Knight (CFO)

I think that's the right way to look at it.

Brandon Oglenski (Senior Equity Analyst)

Okay. And then quickly on purchase services, you mentioned that, the Pacer agreement did escalate costs there. Is that the new run rate that we saw in the quarter for the rest of the year as well?

Rob Knight (CFO)

There could be lots of factors. Obviously, volume overall will play a part in there, but that particular item that we saw in the first quarter will repeat throughout the year.

Brandon Oglenski (Senior Equity Analyst)

Okay, thank you.

Operator (participant)

Our next question comes from the line of Bill Greene of Morgan Stanley. Please receive your question.

Bill Greene (Managing Director)

Yeah. Hi there, good morning. Jack or Rob, can I just ask you to comment a little bit on the return of capital approach? When you think about sort of the circumstances that might cause you to be a little bit more aggressive there, or maybe change the way you think about leverage, 'cause I know you do debt to capital, but I think if you look at it on a debt-to-EBITDA basis or an interest coverage basis, UP is pretty conservatively levered. So maybe you can just comment a little bit on what circumstances you might be willing to be more aggressive in that regard.

Jack Koraleski (CEO)

Sure, Rob?

Rob Knight (CFO)

Yeah, Bill, I mean, as we've said before, we haven't changed our approach. We don't look at just debt to cap. We just sort of use that as a one of the measures that we talk publicly about. We look at all the measures, but where it all starts is we're focused on generating the cash to begin with. We will continue then to deploy the cash by making investments in capital projects where we're confident the return is there. We've set the 30% payout on the dividend, so we would expect that as earnings continue to grow, we expect the dividend to continue to grow along with it. And then we will continue to be opportunistic on the share repurchase activities that, in fact, we've been deploying for the last X number of years.

So in terms of when you add it all up, Bill, as you've heard me say before, we are still comfortable in that, forties, low forties, debt-to-cap ratio. That's not how we drive our business, but that's the kind of a resulting measure that we are still very comfortable with it.

Bill Greene (Managing Director)

Okay. Rob, you also made a comment, in your comments about, core price. And I, I just want to make sure I understood it, and that is that, some of the coal that's repriced didn't move, and I think if we think back to 2012, that kind of caused the reported core price metric to be a little bit lower than might have otherwise been the case. Was that a material impact this quarter? Again, I would have thought we're starting to lap it, but, but maybe you could just give a little clarity there.

Rob Knight (CFO)

Yeah, Bill, compared to sort of normal run rates, which is always the elusive part of that calculation, we'd call it about 0.5 point of price that did not materialize, had the higher levels of coal volume moved under those repriced contracts. So we reported 4% core price. Had it been sort of normal run rates of volumes in the coal world on those repriced contracts, it would have looked more like 4.5.

Bill Greene (Managing Director)

All right. And then, and then one last one just on nat gas. How soon is it at nat gas prices like this, when we see the customers start to react? Is that a lag of, like, six months or, or 12 months? How do we think about that? Thanks for your time.

Jack Koraleski (CEO)

You know, Bill, actually, overall, we've had seen customers start to make the shift back, from natural gas to coal. The bigger problem right at the moment is there's not much demand for electricity or the demand for electricity is softer. So even though we've actually seen some customers start shifting back and taking more coal, we have not seen a substantial increase in coal shipments yet.

Eric Butler (EVP of Marketing and Sales)

You know, this is Eric. If you look back at last year, this time, coal market share of electrical generation was down in the low 30, probably 32, 33, 34%. Today, it's about 40%, so clearly coal has regained market share at 4.42 natural gas. As Jack said, the demand for overall electrical generation is still down, as the economy is still coming back and, we're in shelf months in terms of, weather patterns. So both of those are impacting, the overall electrical demand.

Bill Greene (Managing Director)

Thank you.

Operator (participant)

Our next question is from the line of Justin Yagerman of Deutsche Bank. Please receive your question.

Speaker 23

Hey, good morning, guys. It's Rob on for Justin. Eric, could you talk a little bit more with regard to your coal outlook? This morning, Peabody raised their expectation in terms of the coal burn by about 20 million on both the high and low end for the US. What sort of growth are you guys expecting in terms of consumption across your utilities? And would that imply upside to what's baked into your guidance currently?

Eric Butler (EVP of Marketing and Sales)

I think in Rob's comments, we kind of indicated, we said slightly increased from a second quarter with easier comps. But the fundamental issue really is gonna come down to the overall demand and then how competitive coal will be against natural gas. So you need the economy to come back strong, you need the large steel mills to start using electrical generation, you need normal weather patterns in the summer. And as all of those things happen, you'll see the demand for electricity go up. And again, as I said, current coal market share has grown back to 40. It'll never get back to the 50s. That historically was, but it's better than the low 30s. So...

I haven't seen that Peabody outlook, but my guess is that they're expecting normal weather patterns and continued economic growth in the economy to drive electrical demand.

Speaker 23

No, that's fair. Coal is always a tough one to model. Looking forward, I guess, Rob, circling back on Bill Greene's prior question, when you're saying with coal getting back to kind of normal normal type burn levels, would flat year-over-year in Q2 imply normal normal coal levels, and we should be thinking about kind of a 4.5% core improvement looking forward?

Rob Knight (CFO)

You know, it's always difficult to predict what normal is, but we are assuming, as Eric said, you know, the positive news of coal being a greater market share. We do have the easier comp. And if volumes materialize, we, you know, we would hope to see that in our, in our margins on that business that we've repriced. So I guess I would say that we are looking at things to be more normal as we look out for the balance of the year.

Speaker 23

That's helpful, and I guess before I turn it over, Lance, if you could talk to the intermodal train length extension. You saw over 2% year-over-year improvement on intermodal boxes. Could you talk how that played out on both the domestic and the international train starts across your intermodal franchise? And thanks for the time.

Lance Fritz (EVP of Operations)

Sure. Off the top of my head, I do not have the detail on how that splits out more on the domestic side, but we've got plenty of train size opportunity both sides.

Operator (participant)

Our next question is from the line of Chris Wetherbee of Citigroup. Please proceed with your question.

Chris Wetherbee (Senior Research Analyst)

Thanks. Good morning. Maybe just a question on the coal inventories. Eric, I know you mentioned that they were still elevated. Can you just give us a rough sense of kind of where they stand relative to historical norms? I mean, are we still, you know, pretty far away from getting back to normalized levels?

Eric Butler (EVP of Marketing and Sales)

Yeah. So, the numbers haven't come out for the latest month, but as of the numbers that came out in March, they still showed overall for the whole country, 11 days above normal. There's probably some pretty wide swings in that number between eastern utilities and western utilities. I would expect a large number of the utilities in our serving area are getting pretty close to normal. There are probably some that are below normal because they've taken some aggressive inventory actions. So, I would expect that when you see next month's number come out, you'll see some pretty normal and may even perhaps below normal inventory numbers.

Chris Wetherbee (Senior Research Analyst)

Okay. And is there any reason to think that the level of what should be normal changes at all going forward, just with the relationship between natural gas and kind of where we are currently with the shale activity, or kind of old normal's the right way to think about it?

Eric Butler (EVP of Marketing and Sales)

Yeah, I don't really see a huge change for the coal-centric utilities. They're still... It's in their best interest to burn coal, and they're, in essence, competing against the natural gas-centric utilities. So, they're gonna get their burn patterns up, and they need a certain run rate to protect their burn patterns, to protect against outages. So, I don't see a significant shift in what has been historical normal inventory patterns for coal-centric utilities.

Chris Wetherbee (Senior Research Analyst)

Okay, that's helpful. And I just wanna come back to, and I apologize, on just the mix aspect within coal yield and trying to get kind of a handle on how to think about that. Can you give us a little bit of color on what kind of drives the big mix changes? Is it just seeing more volume that had been repriced, legacy volume that had been repriced, moving relative to other business within the commodity group? Or I guess we're just trying to think about how to, you know, project this out in the next couple of quarters. So just any little bit of color around the positive mix dynamic in the first quarter would be helpful.

Eric Butler (EVP of Marketing and Sales)

Yeah, so when we talk about mix, we're talking about the mix of Southern Powder River Basin coal, Colorado, Utah coal, export coal, et cetera. And so, if you look at some of the places where there are volume reductions, we've had positive mix in other areas because of some of the new Southern Powder River Basin coal opportunities that we have.

Chris Wetherbee (Senior Research Analyst)

Thank you.

Operator (participant)

Our next question is coming from the line of Chris Ceraso of Credit Suisse. Please proceed with your question.

Chris Ceraso (Managing Director)

Hey, thanks. Good morning. So not to beat a dead horse, but I do have a couple of follow-ups on coal. First of all, can you just give us a ballpark out of the, let's say, 19 percentage point decline that you had in coal in Q1? How much of that was associated with the lost business? Was it 5 points out of the 19 or something in that neighborhood?

Rob Knight (CFO)

Rob?

Yeah, Chris. The contract that we've spoken about previously was about five percentage points on the volume.

Chris Ceraso (Managing Director)

Okay. And then if I kind of put together all the things that you've talked about so far, that coal is back up to 40% of the burn, that inventories at the utilities in the West are back to normal or maybe below normal, your comps are getting easier. If we start to see increased volumes of coal, should we expect that the pricing gets better 'cause you'll start to move some of the stuff that you didn't move last year, where you had recontracted at higher rates?

Lance Fritz (EVP of Operations)

You know, it's really largely dependent on which customers grow, in what areas, and how those kind of play themselves out.

Eric Butler (EVP of Marketing and Sales)

And again, as we talked in the past about our pricing calculations, certain things may not-

... come up in our pricing calculations, but they will show an improved margin as reprice business that those volumes come back. You'll, you'll see that in our margins, even if you don't see it in our pricing calculation.

Lance Fritz (EVP of Operations)

Okay. Then just one follow-up, the depreciation, bonus depreciation, Rob, how much of a drag on cash flow do you think that might be for UP in 2013 versus 2012?

Rob Knight (CFO)

Of course, as you know, we're getting still the benefit in 2013 of 50% Bonus Depreciation. So, it, which was what it was last year. So that, that is not a huge driver in 2013, but starting in 2014, we'll start to feel the impact of, assuming there's no Bonus Depreciation beyond 2013, we'll start to feel more of an impact. There's a slight benefit this year when you add it all up that.

Operator (participant)

Thank you. Our next question comes from the line of Walter Spracklin, RBC Capital Markets. Please proceed with your question.

Walter Spracklin (Managing Director and Equity Research Analyst)

Thanks very much. Good morning, everyone. Just wanted to follow up again on the intermodal side. I think when we look at the highway conversion opportunity, I think largely the assumption has been that given your length of haul, you have somewhat less of an opportunity than perhaps some of your Eastern peers. Have you looked at the market for hauls of above, you know, say, 500, 600 miles, to address what that upside opportunity is? And can you share that with us if you've had a look at that?

Jack Koraleski (CEO)

Yeah, we have. Eric?

Eric Butler (EVP of Marketing and Sales)

Yeah, Walter, I guess I'm not necessarily sure I'm tracking why a longer length of haul should result in fewer opportunities. We actually think the opposite, that longer lengths of haul should result in more opportunities. Our current total size of our intermodal book of business is about 3 million units a year, closely equally divided between domestic and international. We size the domestic attainable market opportunity, and we talked about this in Dallas, I think last fall. We size that as somewhere around 10 million units. Now, not all of that will be easy to convert. If you look at customers, there's a stratification of large, mid-size, and smaller customers. The large customers, the Walmarts, the Targets of the world, they're very intermodal-centric already because they see the benefits of intermodal.

They can tune their supply chains to intermodal. You go to the mid-size and smaller customers, we certainly, that's the target-rich environment, and we're working aggressively to sell the value of intermodal to them, and some of that requires them to tune their supply chains a little differently. But that's the market opportunity, the business development opportunity, and frankly, why we're so excited about the future potential.

Walter Spracklin (Managing Director and Equity Research Analyst)

Okay.

Jack Koraleski (CEO)

Walter, when Eric talks about the 10 million opportunity, that does not include another 2.5 million-3 million trucks that moves back and forth between Mexico and the United States. As you know, we're building a new intermodal facility down in Santa Teresa to really target that northern Mexico, the maquiladoras, and those kinds of things, which will hopefully make a dent in that 2.5 million-3 million unit opportunity as well.

Walter Spracklin (Managing Director and Equity Research Analyst)

That's great color. Can you give us a sense of the available capacity on average of your intermodal trains? Roughly, how much incremental volume could we see go onto your intermodal network without at fairly high incremental margin?

Jack Koraleski (CEO)

Sure. How about Lance?

Lance Fritz (EVP of Operations)

Sure. So again, that depends very much on the lanes that the, that the opportunities show up in. But just giving you an aggregate sense, I think we've averaged, what? 170 units a train in the first quarter, and most of our lanes could probably handle 250± units.

Walter Spracklin (Managing Director and Equity Research Analyst)

Wow.

Lance Fritz (EVP of Operations)

Again, very dependent on where it shows up, very lane-specific.

Walter Spracklin (Managing Director and Equity Research Analyst)

You're fully double stack capable, roughly your network?

Lance Fritz (EVP of Operations)

Virtually everywhere.

Walter Spracklin (Managing Director and Equity Research Analyst)

Yeah. Okay, thanks very much. That's all my questions.

Operator (participant)

Our next question comes from the line of Cherilyn Radbourne of TD Securities. Please proceed with your question.

Cherilyn Radbourne (Managing Director)

Thanks very much. Good morning. I just had a question about your ag business. Obviously, the USDA is forecasting some pretty large crops this year. I just wonder, as you look out over your draw territory, what's your read on soil moisture conditions, and I guess, the risk of continued dryness in some areas and floods in others?

Jack Koraleski (CEO)

Well, I tell you what, right here in Nebraska, after the past month or so, we're about ready to stick a fork in this drought. We've had some nice, heavy rains and heavy snows and things like that. And hopefully, that is doing its job in terms of replenishing the moisture content in ground. Eric, you want to put some technical around that?

Eric Butler (EVP of Marketing and Sales)

Yeah. You know, if you look at last year, Cherilyn, the USDA said last year was gonna be one of the five best years in all of history, and then we know what happened. So I take forecasts with a grain of salt at this time of the year, simply because so much of it is weather dependent. As Jack said, it appears to be a great start in our growing season, nice moisture in our key breadbasket, so we're all excited about that. We're not out of the woods yet, and we do need it to continue. And you not only need it certainly for the spring planting season, but you also need moisture in the critical part of the heat of the summer.

There's a long, long tail left before we can feel comfortable about the predictions of-

... what will happen in the harvests of at the late, latter part of the year.

Cherilyn Radbourne (Managing Director)

Okay. And, switching gears, just in terms of the public crossing accidents that you're experiencing in the south, which is really a function of your growth there and the whole region's growth, how disruptive, for you from an operational standpoint are those? And how quickly do you think you can bring that back down?

Jack Koraleski (CEO)

Okay, Lance?

Lance Fritz (EVP of Operations)

Yeah, sure. Excellent question, and just to preface this, this is an extremely frustrating statistic for us. We've been working very hard on impacting the trend for the past several years, particularly down in Texas. The short answer on how disruptive it varies, but generally speaking, it's a couple hours of downtime as the accident gets investigated and cleaned up. So they are. They have an impact. It's variability. It's not same order of magnitude, typically, as a derailment. And in terms of when can we start moving the needle on the number, I'm telling you, we're doing everything in our power right now to try to impact that number. As we look at it, in large aggregate, we're about on top of last year's statistics. They're pretty volatile, so the...

What you saw in the first quarter is a little degradation, but in general absolute number, we're a bit worse, but trying to navigate on top of last year's number. It involves a lot of things like an audit and blitz of our railroad to find where the risk is. The risk moves and grows rapidly with development of industry around us, and then engaging the local authorities to care as deeply about the issue as we do to impact driver behavior. So there's a lot of activity going on there.

Jack Koraleski (CEO)

That's a very difficult issue, and sometimes you're just, I was surprised, actually, that... We don't have the power to even put a stop sign up without getting the approval of the local authorities, and sometimes they just say, "No." So, driver behavior and getting everybody on the same page we are as to how important this is.

Cherilyn Radbourne (Managing Director)

Thank you.

Operator (participant)

Our next question is from the line of Thomas Kim of Goldman Sachs. Please proceed with your question.

Thomas Kim (Senior Equity Research Analyst)

Thanks very much. I'd like to follow up on the comment about cross-border. Can you just remind us how much Mexico contributes to the bottom line presently? And given the tremendous growth prospects, you know, what do you think it might look like over the next few years?

Jack Koraleski (CEO)

Rob?

Rob Knight (CFO)

Yeah, Tom, we don't give the bottom line, but I'll give you the top line. It represents about 10% of our business levels currently, and it's been growing nicely the last several years. Across the board, a mix of the commodities has been growing at a pace greater than our overall volumes have been growing.

Thomas Kim (Senior Equity Research Analyst)

Okay. And then just a more housekeeping-related question. With regard to the $40 million in other income, we estimate that, I think you mentioned land sales contributed about $0.02 a share. What's the remainder of the $40 million?

Rob Knight (CFO)

You know, it's miscellaneous transactions. I wouldn't call anything out in particular that is driving that. That's a relatively normal; the balance would represent a relatively normal run rate for us.

Thomas Kim (Senior Equity Research Analyst)

Okay. All right, well, thank you very much.

Operator (participant)

Our next question is from the line of Jason Seidl of Cowen. Please proceed with your question.

Jason Seidl (Managing Director)

Yeah, good morning, guys. I guess my question is more longer term here. You know, I look at your 65. It seems fairly attainable. I mean, you just reported a first quarter that had fewer working days in it. You know, you had a record OR. You know, coal's under pressure, ag's under pressure. Talk to me about that goal that you have out there and what some of your underlying assumptions are for, in terms of some of the commodity groups and also your core pricing, which also seems fairly strong, ex coal at 4.5%.

Jack Koraleski (CEO)

Sure, we think it's attainable, too. Rob, do you want to?

Rob Knight (CFO)

Yeah, Jason, I mean, you've heard me say this over the years. I mean, it's not a, it's not an end game. It's the next target that we've put out there, not unlike when we set the original 75 target. We got there as efficiently as we could and got there a little early. Then we set the low 70s, got there as efficiently as we could, and got there a little early. We hope to get to this, the previous, you know, sub-67 earlier, as we mentioned last fall, and I'd say the same, make the same comment about the sub-65.

So we're gonna get there the same way we're gonna get from where we are today to the sub-65 is the same way we got from the, you know, the high 80s down to where we are today, and that is efficient, safe operations, leveraging productivity, providing great service to our customers allows us to price it fairly. Fuel can obviously be a whipsaw on us, depending on what fuel does, in terms of the calculation on the operating ratio. But I would just take comfort that we're going to, that our assumption is a normal economy, that the economy cooperates and fuel prices, you know, are normal, if you will, and we're gonna go after it as efficiently and as quickly as we can.

Thomas Kim (Senior Equity Research Analyst)

And in terms of the assumptions for coal and its market share versus nat gas in that 65 OR?

Rob Knight (CFO)

I mean, we don't get into that level of detail, other than I would say it's sort of a normal. I mean, we certainly think that Powder River Basin coal is here to stay, perhaps at lower levels than what we historically experienced, but our assumption is that it's sort of normal from here on out, if you will.

Thomas Kim (Senior Equity Research Analyst)

Okay. And my follow-up question: You know, on your southern region, it seems like you had a little bit of challenges operationally, and, you know, is it starting to feel better already in Q2, and how should we look at that throughout the year?

Jack Koraleski (CEO)

Sure, Lance?

Lance Fritz (EVP of Operations)

Yeah, it is starting to look better. The actions that I mentioned in my comments regarding utilizing fluid routes, terminals, making sure we adjusted our resources rapidly, that made a difference in the tail end of March, and we're looking much more favorable in the South right now in the first few weeks of this quarter.

Jack Koraleski (CEO)

Plus, we had our maintenance programs were very heavy in the first quarter. That was planned. Those are now starting to, to be completed, and some additional capacity projects coming on as we go through the year with capital, and each one of those adds a margin of fluidity and, and, improvement in our variability.

Thomas Kim (Senior Equity Research Analyst)

Okay. So all things being equal, we should start seeing that come out in your weekly performance numbers?

Jack Koraleski (CEO)

Yep, I expect so.

Thomas Kim (Senior Equity Research Analyst)

Fantastic. Gentlemen, thank you for the time, as always.

Lance Fritz (EVP of Operations)

You bet, you.

Operator (participant)

Our next question is from the line of Keith Schoonmaker of Morningstar. Please proceed with your question.

Keith Schoonmaker (Director of Industrial Equity Research)

Yeah, thanks. This is probably related to Jason's question there, I guess, on how the improvements were accomplished in Southern region fluidity. But related, of the year's $1 billion or so growth in productivity CapEx, at this point, can you cite a couple of projects that are perhaps the most material likely to impact income or ROIC over the rest of the year and next?

Jack Koraleski (CEO)

Uh, Lance?

Lance Fritz (EVP of Operations)

Sure. So we've got some new capacity in commercial facility spending that'll have some impact. We've got a very large facility in Santa Teresa. It includes an intermodal ramp that we think is gonna really aid what Jack talked about in terms of cross-border truck traffic and conversion to intermodal.

Jack Koraleski (CEO)

Plus, fueling.

Lance Fritz (EVP of Operations)

Plus, a fueling facility.

Jack Koraleski (CEO)

Efficiency.

Lance Fritz (EVP of Operations)

We've got some excellent work going on in terms of more fluid operations to our crude oil destinations. We should see benefit to that over the years. We've got capacity that's being spent up in the northern tier of our network, as well as in Texas, to enable incremental, more fluid frack sand movement. We've really got it spread all over the railroad, largely concentrated in Texas and Louisiana, but there are key projects all over the railroad that are unlocking critical pieces of capacity for us.

Jack Koraleski (CEO)

There are some things, Keith, that we have kind of scaled back, given the volumes that we're seeing and the way the economy is running, like, for instance, the double tracking of the Sunset Corridor. We're 70% done with that, and but we're pacing it a little differently to watch in terms of the volume, but long-term potential is the ability to take that from 55 trains a day to 90, which would be a huge step forward for us. We have the Mississippi River Bridge that we're continuing to work on. That is a key bottleneck that would be eliminated as we go through that project.

And the Blair, we have a Blair Cutoff that is not order of magnitude that big, but anything that would save 3 hours-4 hours of transit time on the trains that go through our central corridor to Chicago, eventually helps the bottom line enormously.

Keith Schoonmaker (Director of Industrial Equity Research)

Great. Thank you. And maybe a quick shorter term question, perhaps for Eric. We're seeing stronger growth in housing at last. Lumber improved 18%, probably as a result of that. Could you comment on where and how material housing improvements are showing up elsewhere, be it light trucks, some intermodal, et cetera?

Eric Butler (EVP of Marketing and Sales)

Yeah, great question. We're excited about the housing improvement, finally. Housing is actually running ahead of the original Global Insight estimates, and I think the housing, or the lumber producers are pretty positive about the trends that they're seeing and, the housing start numbers that they're seeing. Housing, in addition to impacting lumber, it's also gonna impact our intermodal business. As you know, once homes are built, you have to furnish them. And so both on the international intermodal business and the domestic intermodal business, we think that housing will have an impact on that. We think housing will also have an impact on ancillary business, like our steel wheel, rebar business, which goes into construction, our cement business. Our cement business, we think that that will strengthen as housing strengthens. So, all of those are things that will go as housing goes.

Keith Schoonmaker (Director of Industrial Equity Research)

Eric, it sounds like you're using future tense, though, that those are still sort of pending improvements. Am I reading that correctly?

Eric Butler (EVP of Marketing and Sales)

No, you know, I've been around here long enough where I remember when housing was regularly 1.7 million-1.8 million starts a year. So even though we're back up to around 970 off a low of below 600, 970 still feels low to me, so I feel like it's back regular normal when it gets above 1.3, 1.4, 1.5.

Jack Koraleski (CEO)

But if you look, Keith, like at our cement business, I think it was up about 6% in the first quarter. Our plastics business, which would include things like PVC pipe and those kinds of things that are using in housing construction, were also up in the first quarter. So we are seeing the residual impact that goes along with the incremental lumber.

Keith Schoonmaker (Director of Industrial Equity Research)

Thank you.

Operator (participant)

Our next question comes from the line of John Mims of FBR Capital Markets. Please proceed with your question.

John Mims (Senior Equity Analyst)

Yeah, thanks. Good morning, guys. Thanks for taking my call. Just one quick one for me this late in the call. Eric, I stepped away for a minute. Could you repeat what you were saying about international intermodal and maybe add to, you know, any comments related to outlook for any sort of a peak season in 2013 or 2018?

Eric Butler (EVP of Marketing and Sales)

What I was talking about international intermodal is that as housing starts to increase, you, you need to furnish the homes, and so we do see a trend between international intermodal upswing as housing start improves. That was the connection that I was making. You know, last year, what we said was that it was a muted peak season. I think we used those words last year. It's early in the year, and it's, at this point in the year, what happens in peak will determine on the economic conditions, consumer confidence, retail sales, all of those things will determine kind of what happens in peak volumes.

John Mims (Senior Equity Analyst)

Mm-hmm.

Eric Butler (EVP of Marketing and Sales)

But right now, we are expecting the intermodal peak to be stronger than last year. Okay. The order of magnitude is, we're not sure of yet. It really depends a lot. Bidding season is just coming in right now for a lot of those international contracts between the retailers and the ocean carriers and things like that. So there's still a lot to be determined in terms of how that'll play out for summer.

John Mims (Senior Equity Analyst)

Right. Okay, so as of right now, though, it's still just more of a read on the macro versus you having real conversations as far as stage engine capacity with the liners or with, major shippers?

Eric Butler (EVP of Marketing and Sales)

Right. That's right.

John Mims (Senior Equity Analyst)

Cool. All right. Thank you so much.

Operator (participant)

Our next question comes from the line of Ben Hartford of Robert W. Baird. Please receive your question.

Ben Hartford (Senior Equity Research Analyst)

Hey, good morning. Just to expound on that, I guess this 8% growth in the first quarter, I'm assuming that's not a run rate for the balance of the year, and that the first quarter, you did benefit to some degree from certain shippers shifting away from the East Coast to the West Coast, ahead of any sort of East Coast ILA strike during the first quarter. Is that right? Is that the right way to think about the volume growth in the first quarter?

Eric Butler (EVP of Marketing and Sales)

Yeah, we do not expect to see that kind of run rate for the year. There was some nominal impact of shifts from the East Coast, but very small. The bigger factor, frankly, was the timing of the Chinese Lunar New Year this year versus last year, and there was actually some advanced shipping because of that. That was probably the larger impact. Plus, we did see an impact, inventories were pretty thin after the holiday season last year, and we did see an impact of inventory catch up in January.

Ben Hartford (Senior Equity Research Analyst)

Okay, good. And then on the coal side, I know you kind of earmarked a number of different various items that drove RPU above expectations to this $2,300 level. Is this a good level to be thinking about then? I mean, you kind of hit on mix, legacy, fuel surcharge and some liquidated damages as well, driving that number. But is this $2,300 level a good level to think about for coal as it relates to RPU for the balance of the year?

Jack Koraleski (CEO)

Rob?

Rob Knight (CFO)

You know, as we indicated in some previous discussions, I'd be careful using a run rate of ARC, because mix can have such an impact on that, up or down. So again, we're gonna aggressively go after providing the good service and price repricing where we can, but the ARC number can move on you.

Ben Hartford (Senior Equity Research Analyst)

Okay, good. Thanks.

Operator (participant)

Our next question is from the line of John Larkin with Stifel. Please proceed with your question.

John Larkin (Managing Director)

Yeah, thank you for taking the question this morning. Maybe more of a conceptual question on the intermodal side. The UP's service levels have improved dramatically over the last 10 years or so, and have generally caught up to the other big western railroad. And I guess the question is, as you see the service levels right now, where do you think you have a competitive advantage versus the competitor? Where do you think the competitor has an advantage? Is that how you think of marketing the service, in particular, market power lanes, where you might have better on-time performance or better velocity? And based on some of the investments that you're putting into the ground now, will you see that competitive positioning change at all here over the next couple of years?

Jack Koraleski (CEO)

Yeah. Eric?

Eric Butler (EVP of Marketing and Sales)

Yeah, so good, good question. To start with, we, as we look at our intermodal network, we are actually proud of the fact, we go to many more places than our competitor in the West in terms of our franchise, in terms of origin, destination, points where we have service to. And that's really the power of the diversity of our franchise. We just get to and from many more places than the customer base. A large portion of the customer base does see value in that. Having said that, for the places where we do compete head-to-head, we kind of assess where we are very regularly.

We are pleased that in most of the places where we compete head-to-head, we think our service is as good or materially better in the majority of the places where we compete head-to-head. There are a couple of places where our competitor has a slight advantage, and we're continuing to put initiatives and strategies in place to ensure that we have the best service in the industry.

John Larkin (Managing Director)

Thank you, Eric. Then, maybe one question that you don't need to answer if you don't want to, but I'll ask it anyway. With respect to operating ratio as the key metric to focus on for the future, you've said, again, here today, that you believe you'll get to a 65 or lower for the full year 2017. That seems like a very achievable target, as one of the other analysts mentioned. But what happens if in 2016, Eric, comes to Jack with a $400 million project that has a 68 operating ratio on it? Does that put you in any position of-

... saying, no to that project? Or, do you feel as though you can still accommodate that and, you know, access that incremental traffic, would return on invested capital be a better measure or some other measure that takes into account, the generation of free cash flow? Just conceptual thought in terms of whether operating ratio is the correct metric.

Jack Koraleski (CEO)

You know, John, when we look at business opportunities at a high level and at a specific level, we're really focused on the reinvestibility of the business, our ability to provide good, efficient, safe, and consistent service for that customer. And then we deal with it on that basis in terms of the acquisition or whether we take on the business or not. We don't really think about it in terms of the operating ratio, but I will turn that over to Rob in terms of a broader discussion of-

Rob Knight (CFO)

Yeah.

Jack Koraleski (CEO)

The key measure.

Rob Knight (CFO)

Yeah, John, I mean, I get your point, and I would say that we set operating ratio target out there just as a way of kind of speaking in our organization as setting our mind towards making financial improvement. At the end of the day, it's focused on returns. So, we know we've still got room to go in improving our operating ratio, which will improve our earnings, which improves our cash, which, if we do all the investments correctly, improves our returns. So they all kind of go together, but at the end of the day, it's the improving our returns.

Jack Koraleski (CEO)

It's really a portfolio of measures.

Rob Knight (CFO)

Yeah.

Operator (participant)

Thank you. Our next question comes from the line of Jeff Kauffman of Sterne Agee. Please receive your question.

Jeff Kauffman (Managing Director)

Thanks for taking my question, guys. It's been a long call, and most of mine have been answered, so let me just throw a quick one out there. I see the car loads for the crude business. If I thought about that in terms of trains per day, and how to allocate those car loads, roughly how many trains a day are you doing in the crude business relative to how many trains a day for the system total? And is it fair to assume, this would be the follow-up, that it's longer haul business and therefore a higher RPU than your average, chemical, RPU?

Jack Koraleski (CEO)

Lance?

Lance Fritz (EVP of Operations)

Sure. Trains per day, we're in the 5± ballpark. Length of haul,

Jack Koraleski (CEO)

750 miles.

Lance Fritz (EVP of Operations)

Yeah.

Jeff Kauffman (Managing Director)

All right. And how many trains per day for the total network? Total.

Lance Fritz (EVP of Operations)

Oh, in the total network, moment in time, but for instance, right now, we probably have 820 trains on our network.

Jeff Kauffman (Managing Director)

Per day?

Lance Fritz (EVP of Operations)

Excuse me. You're asking a question that I don't think I can answer because the question I just gave you was terminating or originating trains per day on crude, and the trains per day in the network, I look at as inventory. So I really can't answer your question the way you've asked it.

Jeff Kauffman (Managing Director)

Okay, fair enough. Thank you.

Operator (participant)

Our next question comes from the line of David Vernon of Bernstein. Please receive your question.

David Vernon (Managing Director and Senior Analyst)

So Rob, there's a note in here talking about a new equipment rate study on the depreciation line. Did that lower the rate that you guys are depreciating the equipment at on a go-forward basis, or could you add some color to that?

Rob Knight (CFO)

Yes. I mean, the result of the study was it elongated, if you will, the depreciation on those assets. Combine that with the fact that we're running fewer gross ton miles, resulted in a lower depreciation rate than, than what we've previously experienced.

David Vernon (Managing Director and Senior Analyst)

So I think the depreciation rate was 5.6% in the last Q. Do you know the number off the top of your head, or should we just wait for the Q?

Rob Knight (CFO)

In the first quarter, depreciation rate was 3%.

David Vernon (Managing Director and Senior Analyst)

3%, okay. And, the fuel surcharge revenue in the quarter?

Rob Knight (CFO)

I'm sorry?

Jeff Kauffman (Managing Director)

Fuel surcharge revenue in the quarter.

Rob Knight (CFO)

About half a point on the revenue line.

Jeff Kauffman (Managing Director)

0.5 point on the revenue line.

Rob Knight (CFO)

Yeah.

Jeff Kauffman (Managing Director)

Okay. Thanks. That's it for me.

Operator (participant)

Our next question is from the line of Justin Long of Stephens. Please proceed with your question.

Justin Long (Managing Director)

Thanks, and good morning. In the quarter, your volumes were down a little over 3% sequentially, but operating expenses were up nearly 4% if you look on a sequential basis. Just on a high level, can you talk about some of the puts and takes that drove that discrepancy? And would you say that's not a trend you would expect going forward?

Rob Knight (CFO)

You know, mix is always a factor in that particular calculation when you look at car loading sequentially and expense going forward. So I guess I would say that take the guidance that we've given you in terms of the components as best you can, as the best way of looking at it, rather than trying to calculate that particular sequential relationship.

Justin Long (Managing Director)

Okay, fair enough. And then, as a follow-up, could you, could you comment briefly on CapEx and remind me where you stand from a rail car equipment perspective and any investments you might need to make there, given your volume outlook for the remainder of the year?

Jack Koraleski (CEO)

Sure. Our current CapEx is targeted at about $3.6 billion for the year, which is down just a bit from last year. It does include some equipment acquisitions that are needed for business growth and replacement of retiring assets. If you had some specific question beyond that?

Justin Long (Managing Director)

Maybe specifically on the car types that you're looking to purchase this year.

Jack Koraleski (CEO)

Lance?

Lance Fritz (EVP of Operations)

Sure. We're picking up some auto racks. We're picking up some food-grade covered hoppers. We're picking up you know, a handful of other types.

Jack Koraleski (CEO)

Reefers.

Lance Fritz (EVP of Operations)

Yeah, reefers.

Jack Koraleski (CEO)

Refrigerated box cars-

Lance Fritz (EVP of Operations)

Mm-hmm.

Jack Koraleski (CEO)

and some containers.

Rob Knight (CFO)

John, it's less than $200 million of the $3.6 billion, just to kind of size it for you.

Justin Long (Managing Director)

Okay, great. That's, that's helpful. I appreciate the time today.

Operator (participant)

Thank you. We've come to the end of our time for questions and answers today. I will now turn the floor back over to Mr. Jack Koraleski for closing comments.

Jack Koraleski (CEO)

Well, great. Thanks so much for joining us on the call today. We look forward to speaking with you again in July.

Operator (participant)

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.