Union Pacific - Q2 2014

Transcript

Operator (participant)

Welcome to the Union Pacific second quarter 2014 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. We may now begin.

Jack Koraleski (CEO)

Thanks, Robin. Good morning, everybody, and welcome to Union Pacific's second quarter earnings conference call. With me here today in Omaha are Eric Butler, our Executive Vice President of Marketing and Sales, Lance Fritz, President and Chief Operating Officer, and Rob Knight, our Chief Financial Officer. This morning, we're pleased to report that Union Pacific achieved second quarter earnings of $1.43 per share, an increase of 21% compared to the second quarter of 2013, and another quarterly record. Total volumes were up 8%, and the increases were nearly across the board. We saw growth in 5 of our 6 business groups, with particular strength in agricultural products, intermodal, and industrial product shipments.

We were pleased to see strong volume growth, which, combined with solid core pricing, drove more than 2-point improvement in our operating ratio to a record 63.5% for the quarter. On the operating side, Mother Nature did finally release her winter grip, but we experienced numerous washouts, flooding, and mudslides, which caused disruptions to our network during the quarter. In this environment, increasing velocity and fluidity has been a challenge, but we continue to be focused on safely improving network efficiency and service for our customers. So with that, let's get started. I'll turn it over to Eric.

Thanks, Jack. Good morning. In the second quarter, volume was up 8% compared to 2013, as solid demand across our franchise led to volume gains in 5 of our 6 business groups. We had strong gains in Agricultural Products, Intermodal and Industrial Products, and we also saw strength in Automotive and Coal. In Chemicals, the declines in crude oil volume were mostly offset by gains in other commodities. Core Price improved around 2.5%, which was partially offset by mix to produce a 1.5% improvement in average revenue per car. Our volume growth and improved average revenue per car combined to drive freight revenue up 10%, which set an all-time quarterly record of nearly $5.7 billion. Let's take a closer look at each of the 6 business groups. Ag products led our growth again this quarter.

Volume grew 16%, which, combined with the 2% improvement in average revenue per car, drove revenue growth up 19%. Strong grain demand continued this quarter, with carloads up 43%. Last year, you may remember, we experienced a tight U.S. corn supply and improved world production, which led to lower exports and reductions in domestic demand for livestock feeding. The strengthened U.S. supply and lower commodity prices this quarter drove strong demand for export feed grain. Domestic feed grain demand was also strong across most of our franchise. The one soft spot was in grain, wheat, where the smaller, hard red winter wheat crop led to a slight decline in overall wheat shipments. Grain products volume was up 8%, led by a 15% increase in ethanol shipments.

We had a best-ever quarter for ethanol shipments, driven by favorable producer margins, higher gasoline demand, and low ethanol inventories. DDG shipments grew 33%, driven by strong export shipments to Mexico. Food and refrigerated shipments were up 3% for the quarter. Import beer volume was up over 20%, partially offset by declines in rice exports and lower produce and frozen food shipments. Automotive revenue was up 2% in the second quarter on a 6% increase in volume. Average revenue per car was down 4%, driven primarily by the previously reported change in the way we handle per diem revenue and also by mix. Finished vehicle shipments were up 5% this quarter. North American automotive production continued to be strong, up 4% versus the same quarter in 2013.

Also, the sales rebound that started in March continued to gain strength as the second quarter progressed. On the parts side, volume increased 8%, driven again by strong production demand and over-the-road conversions. Chemicals revenue was up 3% for the quarter, with a 4% average revenue per car improvement, partially offset by a 1% volume decline. Industrial chemicals volume was up 7%, driven by demand in a variety of markets, such as shale-related drilling, inventory replenishment of de-icing materials after a strong winter demand, and increased demand for chemicals used in nylon production. Fertilizer shipments were up 2% for the quarter. Strong export potash demand, coupled with a delayed spring planting season in the U.S., drove the increase. Crude oil volume declined 24% compared to the second quarter of last year, with price spreads again negatively impacting Bakken volume.

Our coal revenue increased 1% on a 1% increase in volume and a 1% improvement in average revenue per car. Southern Powder River Basin tonnage was down 2%, as demand from lower inventories and higher natural gas prices partially offset our previously reported legacy contract loss. Volume was also impacted by network fluidity challenges. Colorado-Utah coal tonnage was up 11%, benefiting from increased demand in the western part of our network, and we continued to see strength from other coal-producing regions, where tonnage was up 12% for the quarter. In our industrial products business, a 12% increase in volume, combined with a 3% improvement in average revenue per car, to produce 16% revenue growth. Non-metallic minerals led to growth in IT again, with volume up 21% for the quarter....

Frac Sand use and shale-related drilling drove the increase, with shipments up more than 25% versus last year. Our lumber shipments were up 17% in the quarter. We were encouraged to see improvement in the housing market driving continued lumber demand. Finally, construction product shipments were up 15% as demand for aggregates and cement continued to be strong, particularly in Texas and California. Turning to Intermodal, revenue was up 16% in the second quarter, driven by a 12% increase in volume and 3% improvement in average revenue per unit. Domestic and Intermodal volume was up 12% in the quarter. New premium services and continued highway conversions contributed to our volume gains. Our international Intermodal volumes were up 13%. Imports to West Coast ports rebounded in the second quarter after declining earlier in the year.

We believe some portion of the strength in the second quarter can be attributed to cargo owners advancing shipments ahead of the July expiration of the ILWU contract. So it is possible that some of our traditional peak international demand has already moved. Let's take a look at how we see our business shaping up for the second half of 2014. In ag products, strength from last year's crop is carrying into the third quarter, and early signs point to another good crop year later this year. If we have another good crop year, we should have a strong second half in grain, but remember that our comp gets much more difficult in the fourth quarter. We also see continued demand for ethanol. The current forecast for ethanol production is 14.1 billion gallons for the year, which would be a record for the U.S.

We expect automotive production and sales to continue to be strong in the second half of 2014, which will drive both finished vehicle and auto parts demand. Most of our chemicals markets should continue to remain solid throughout 2014, though we think crude oil spreads will continue to be a headwind. Low inventory levels and higher natural gas prices will drive demand for coal in the third quarter. As always, weather conditions this summer will also influence demand. We'll be better positioned to meet demand as our operational efficiencies improve. In our industrial products business, frac sand will continue to benefit from shale-related activity. We think the strength in construction products will also continue, particularly in Texas and California, and we are cautiously optimistic that the housing market will strengthen in the second half of the year, driving our lumber shipments.

We think strong demand will continue in domestic intermodal as highway conversions and new product offerings drive growth. International intermodal should benefit from an improving economy, though volumes in the third quarter could moderate because of the advanced shipments we saw in the second quarter. The economy got off to a slow start this year, but it is showing signs of the modest strengthening we expected. Our strong value proposition and diverse franchise will again support business development efforts across a broad portfolio of business. If the economy cooperates, we expect a strong second half of the year. With that, I'll turn it over to Lance.

Lance Fritz (President and COO)

Thanks, Eric, and good morning. Starting with our safety performance, we set first half records in 2 of our 3 major reportable metrics and improved in all 3 year-over-year. Our first half reportable personal injury rate of 1.01 set a first half record and improved 6% versus 2013. The team's commitment to risk reduction, courage to care, and the total safety culture overcame a challenging operating environment. In terms of rail equipment incidents or derailments, our reportable rate improved 4% to 2.95 and also set a first half record. Continued investments in our infrastructure and advanced defect detection technology drove a reduction in track and equipment-induced derailments. We also made progress on human factor incidents through enhanced skills training and root cause resolutions.

In public safety, our grade crossing incident rate improved slightly versus 2013. To make continued progress, we are focused on improving or closing high-risk crossings, as well as reinforcing public awareness through our use of targeted safety campaigns. In summary, the team has made terrific progress towards getting every one of our 47,000 plus employees home safely at the end of each day, despite adverse weather conditions and the risk that comes with a stressed network. Moving on to network performance. In April, we discussed the impact the polar vortex had on first quarter operations. Starting the second quarter, we generated sequential performance improvement while growing volumes. By late May, we felt we were well positioned to continue to make incremental advancement. Unfortunately, flooding severed a number of key corridors in June, including our East-West mainline, impacting our ability to generate the improvement we anticipated.

The episodic weather events were compounded by an increase in track maintenance work and interchange fluidity issues. As Jack noted earlier, while we were pleased to see increased demand, the network was challenged to absorb the stronger volumes while performing at suboptimal levels. Fortunately, we were able to use our unique franchise to mitigate some of the impact. We adjusted transportation plans to use alternate switching yards and gateways and moved resources to where they were most needed. Using surge resources, we've increased our active locomotive fleet by more than 800 units and our total TE&Y workforce by around 800 since last fall. We have more resources on the way. We've roughly doubled our TE&Y hiring plan from our original expectations and now plan to hire 3,200 TE&Y employees for the full year to cover both attrition and growth.

In addition, we've added $150 million to this year's capital plan, which now includes a total of 229 new locomotives... Our service performance fell short during the second quarter, which is reflected in the metrics we report each week to the AAR. Second quarter velocity was down 7% and freight car dwell up 12% when compared to 2013. The interruptions and subsequent limits on network capacity also drove a decline in our service delivery index, a measure which gauges how well we are meeting overall customer commitments. On a more positive note, we were able to maintain local service within a reasonable range, registering a 93.9% industry spot and pull.

This metric, which reflects the tighter service commitments we introduced this year, measures whether a car is delivered to or pulled from a customer's facility on time. In addition to surge resources, infrastructure investments have also improved our resiliency. The team is working very hard to handle our customers' growing volumes while restoring the service they expect from us, and I am confident we are well positioned to do so. Speaking of demand, as Eric noted, the volume trends we saw earlier in the year were largely sustained in the second quarter, with volume growth in each region of our network. We realized productivity with the volume growth despite the headwinds we faced during the quarter. So while we incurred some incremental costs associated with a congested network, we handled 8% volume growth with a 5% increase in regional TE&Y workforce.

Productivity improved from an increase in average train lengths in all major categories and from T plan adjustments that reduced online work events. Our dedicated craft professionals and managers generated these results using the five key drivers to make a difference in safety and productivity and in serving our customers. One of those five key drivers is Capital Effectiveness. We increased our targeted 2014 capital spend back in May to around $4.1 billion. Roughly $2.4 billion of that is replacement capital, with most of that to renew our track infrastructure. We are on target for the year, as roughly half of that program work is now complete. Spending for service growth and productivity will total around $1.2 billion. Capacity, commercial facilities and equipment are the primary drivers.

This year's forecasted new capacity includes 56 miles of double track on the Sunset Route and another $300 million or so on the southern region. The investments in the south add critical capacity and fluidity to a historically constrained part of our network. We are also accelerating investments to support growing volumes in our north-south corridors. We're purchasing 229 locomotives, more than 400 freight cars, as well as 5,000 domestic containers. Spending on positive train control will total about $450 million for the year. All of these projects positively impact safety, whether they support replacement, service or growth, and the growth capital projects must meet aggressive return thresholds in order to be funded. To wrap up, our first order of business is to safely improve network performance while serving customer demand.

We are working hard to provide customers with a value proposition that supports growth with high levels of service. As I mentioned in April, our recovery is partly dependent on interchange fluidity, so we continue to work with our connecting railroads to improve performance at key gateways. We expect to generate record safety results on our way towards an incident-free environment. Our investments in surge resources and network capacity have proved invaluable as we handle network challenges, service interruptions, and increased demand. Our focus on reducing variability in the network has never been more important to generating sequential improvement. Ultimately, safety and service will drive our ability to leverage unit growth to generate solid productivity, all of which creates value for our customers and increased returns for our shareholders. With that, I'll turn it over to Rob.

Robert Knight (CFO)

Thanks, Lance, and good morning. Let's start with a recap of our second quarter results. Operating revenue grew 10% to an all-time record of more than $6 billion, driven by strong volume growth and solid core pricing. Operating expenses totaled just over $3.8 billion, increasing 6% over last year. Although operating challenges and our recovery efforts did increase costs during the quarter, our operating income still grew 17% to a record $2.2 billion. Below the line, other income totaled $22 million, down 4% from 2013. Interest expense of $138 million was up 4% compared to the previous year, primarily driven by increased debt issuance during the first half of 2014. Income tax expense increased to $789 million, driven primarily by higher pretax earnings.

Net income grew 17% versus 2013, while the outstanding share balance declined 3% as a result of our continued share repurchase activity. These results combined to produce best-ever quarterly earnings of $1.43 per share, up 21% versus last year. Turning now to our top line, freight revenue grew 10% to a quarterly record of just under $5.7 billion. This was driven primarily by volume growth of 8% and core pricing gains of just under 2.5%. Business mix was about 0.5% unfavorable, as the positive mix impact in grain and frac sand volume was more than offset by the increase in intermodal and shorter-haul aggregate and cement shipments during the quarter. Other revenue increased 12% in the quarter.

Primary drivers included subsidiary-related volume growth, as well as the change in the way we handle per diem revenue on auto parts containers, which Eric just mentioned. Slide 22 provides more detail on our core pricing trends in 2014. As we pointed out on our first quarter call, 2014 is a legacy light year, so we are not seeing the 1.5 of legacy benefit which we achieved in 2013. Even without this legacy tailwind, our core pricing gain for the quarter was just under 2.5%. This was up slightly from the first quarter and also continued to exceed ex-inflation, which remains low, as we expected. We remain committed to a strategy of pricing to market at reinvestable levels that are above inflation.

This enables us to earn the returns necessary for continued investment in our franchise. Moving on to the expense side, slide 23 provides a summary of our compensation and benefits expense, which increased 5% versus 2013. Higher volumes and inflation were the primary drivers of the increase, along with some increased costs associated with running a less than optimal network. Looking at our total workforce levels, our employee count was up 1% when compared to 2013. However, the reduction in the number of employees associated with capital projects helped to offset some of the increase in non-capital related workforce levels. If you exclude capital-related employees, our workforce was actually up approximately 2.5%, with just over half of this increase coming in the TE&Y.

For the full year in total, we plan to hire about 5,000 people to cover growth and expected attrition of just under 4,000. This total includes the TE&Y hiring, which Lance mentioned earlier. Over the long run, as we hire and train new employees for growth and attrition, we expect to see our workforce levels increase with volume, but not at the same rate. Lastly, we still expect labor inflation to come in under 2% for the full year. Turning to the next slide, fuel expense totaled $923 million, up 7% when compared to 2013, driven primarily by higher gross ton miles associated with increased volumes. Compared to the second quarter of last year, our fuel consumption rate improved 1%, while our average fuel price was flat at $3.10 per gallon.

Moving on to our other expense categories, purchase services and materials expense increased 9% to $636 million due to volume-related subsidiary contract expenses, higher locomotive and freight car material costs, and crew transportation and lodging expenses. Depreciation expense was $470 million, up 7% compared to 2013, consistent with our 7%-8% full year guidance. Slide 26 summarizes the remaining two expense categories. Equipment and other rents expense totaled $316 million, which was up 5% when compared to 2013. Higher freight car rental expense was partially offset by lower freight car and container lease costs, resulting from the exercise of purchase options on some of our leased equipment. Other expenses came in at $228 million, up $9 million versus last year.

Year-over-year improvement in our freight damage costs and environmental expense was more than offset by increases in our property tax expense. For 2014, we still expect the other expense line to increase between 5% and 10% for the full year, excluding any unusual items. Turning to our operating ratio performance, pricing the business at reinvestable levels and strong demand continues to drive our results. We achieved a quarterly record operating ratio of 63.5%, improving more than two points when compared to 2013. Through the first half of the year, we've achieved a 65.2% operating ratio, an improvement of 2.2 points over last year. We also remain committed to achieving strong cash generation and improving overall financial returns.

Turning now to our cash flow, record first half earnings resulted in cash from operations of over $3.2 billion. This is roughly flat with 2013, reflecting primarily the headwind this year in bonus depreciation and the timing of cash tax payments. Capital invested totaled $2.2 billion year-to-date. This includes about $260 million for the buyout of the finance lease on our headquarters building, which was put in place back in 2004 and is in addition to this year's $4.1 billion capital plan. In addition, we returned $776 million in dividend payments to our shareholders.

Taking a look at the balance sheet, we increased our adjusted debt by approximately $1.1 billion since the first of the year, bringing our adjusted debt balance to $13.9 billion at quarter end. This takes our adjusted debt-to-cap ratio to 39.4%, up from 37.6% at year-end 2013. We continue to work towards our targets of an adjusted debt-to-cap ratio of approximately 40% and adjusted debt-to-EBITDA ratio of about 1.5. Opportunistic share repurchases continue to play an important role in our balanced approach to cash allocation. As you may recall, our new repurchase authorization of up to 120 million shares post-split over a four-year time period went into effect January first of this year.

Since the first of the year, we've bought back 16 million shares, totaling about $1.5 billion. This brings our cumulative share repurchases since 2007 to 228 million shares.

... When you combine dividend payments with our share repurchases, we returned over $2.2 billion to our shareholders in the first half of this year alone. These combined payments represented a 51% increase over 2013, again, demonstrating our continued commitment to increasing shareholder value. So that's a recap of the second quarter results. As we look to the remainder of the year, continued strength in the economy, solid core pricing at reinvestable levels above inflation, and improvement in network performance will help us achieve margin improvement, record financial results, and strong returns for our shareholders. With that, I'll turn it back over to Jack.

Jack Koraleski (CEO)

Okay, thanks, Rob. As we move into the second half of the year, our network velocity and fluidity are improving, which will better position us to serve the strong demand we're currently seeing in the marketplace. With our increased capital budget of $4.1 billion, we are committed to invest in the resources necessary to run a safe, efficient, reliable railroad, which supports our value proposition for our customers, and we're optimistic about the second half of the year. As always, we are closely monitoring the economic landscape, along with the major drivers across all of our business segments, including the potential impact that weather could have on grain and coal. As the economy gradually continues to improve, the power of our diverse franchise is providing business growth opportunities in all of our commodity groups.

The men and women of Union Pacific are committed to safely improving our network performance, allowing us to provide customers with the excellent service they deserve, while rewarding our shareholders with increasing returns. So with that, we're gonna open up the line for your questions.

Operator (participant)

Thank you. We'll now be conducting a question-and-answer session. If you'd 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'll be limiting everyone to one primary question and one follow-up question to accommodate as many participants as possible. Our first question comes from the line of Bill Greene with Morgan Stanley. Please proceed with your question.

Bill Greene (Global Director of Research)

Yeah. Hi, good morning. Thanks for taking the question.

Jack Koraleski (CEO)

Morning, Bill.

Bill Greene (Global Director of Research)

I wanted to chat a little bit more on pricing. We saw, as you show, Rob, in your slides, the Core Price metrics started to tick up again. Assuming that inflation doesn't fall further from here and capacity is getting broadly pretty tight in the marketplace, do you feel like we've seen the trough in the Core Price metrics?

Jack Koraleski (CEO)

Eric?

Eric Butler (EVP)

As we've said in the past, Bill, we expect strong pricing opportunities as we see continued strength in demand. We price for reinvestibility, and we price to the marketplace. We have mentioned in the past that we do have part of our escalators that are based on A-LIF, which is still modest, but we continue to see pricing opportunities as the demand strength continues.

Bill Greene (Global Director of Research)

Okay. And then, Jack, I'm curious about your views on OR. You didn't mention it, but obviously, we know you've said this in the past, that the guidance that you've given in the past, that you're already kind of there. And if we look at third quarter, that's typically a better seasonal quarter for you than second. Of course, you won't have any weather effects. So it would seem that third quarter should see a nice improvement on OR. But where do you think the wall is, if you will? Is there a limit? Is there a number you worry about, or you think that's about as good as we can do, or is that just really a theoretical and we're not even close?

Jack Koraleski (CEO)

You know what? We're not seeing a wall at this point in time. Rob has said many times, Bill, that when we reach our guidance of sub-65, we're gonna move on from there and continue. Every time we look at productivity, core pricing, the opportunities to grow our business, the reinvestment that we're making in our infrastructure to support that growth at profitable levels, we are enthusiastic about our ability to do better on Operating Ratio.

Bill Greene (Global Director of Research)

That's great. All right, thank you for the time.

Operator (participant)

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

Scott Group (Managing Director and Senior Analyst)

Hey, thanks. Morning, guys. So wanted to get your take on some of the implications of the BN service issues, just because they're continuing, I think, longer than maybe some had expected at the beginning of the year. And do you think this is creating more longer-term or maybe permanent market share gains? And do you think there's an opportunity for kind of incremental share gains next year? And then just wondering if you're seeing any competitive response from them on the pricing side that could limit some of the pricing opportunities.

Eric Butler (EVP)

Eric? So I've said, BN is a strong competitor. They're a capable competitor. They have said they will get their network back, and we are taking them at their word. We're in a competitive marketplace, and we continue to see them being an effective competitor in the future. We as always, we look for we focus on business development, and we look for opportunities that we could price effectively, it works well with our network, and we're focused on that, and we're focused on that for the long term.

Scott Group (Managing Director and Senior Analyst)

Yeah, I mean, that's all fair. I mean, clearly when we look at the volume between you and BN, clearly there's been some share shift. Maybe I'm not asking for specific conversations, but what are you hearing from customers? Do you, do you think that that's gonna stick with you? And do you think that could there be opportunities for more of it?

Jack Koraleski (CEO)

You know, Scott, I think you're seeing some of both. I think there are some places where we've been able to pick up some share. And of course, the opportunity for us is to demonstrate to customers the power of our franchise, the ability to provide safe, reliable, consistent service, day in and day out. And we're hopeful that that has some stickiness to it and that that business will hang with us even as the BNSF recovers. There is some other business, you know, where, you know, basically, our franchise isn't quite as strong as theirs to the end market location. And in all likelihood, as the BNSF service returns and they're able to take the business back, it's gonna shift back to them. So I think you see some of both.

Scott Group (Managing Director and Senior Analyst)

Okay, that makes sense. And then just last thing on coal. Volumes have been struggling recently, and I'm guessing that's more of a rail service issue than a demand issue. Any way of putting some numbers around, you know, how much coal you think you're missing out on because of some of the network issues, and how much pent-up demand there could be once the network's back up and running?

Jack Koraleski (CEO)

Eric?

Eric Butler (EVP)

As you said, we are seeing strong coal demand, and I think as Lance and Rob both said in their prepared remarks, we did have network fluidity challenges. Weather and natural gas pricing will determine the demand in the future, but at this point, we see pretty good upside demand from our current run rate of coal volumes.

Robert Knight (CFO)

Scott, if I can just jump in, this is Rob. What I would look to is the inventory levels are still below where the utilities would like them to be. I mean, if you look at it on a five-year average. So as we are in the throes of the winter, or excuse me, the summer air conditioning burn season with low inventories, we think that gives us increasing opportunities.

Jack Koraleski (CEO)

Yeah. In fact, Scott, if you looked at those numbers, in May, it was like 19 days below, and in June, it's dropped to 16. So there has been some improvement in the inventory levels, but there's still lots of opportunity for us as we see the second half of the year.

Scott Group (Managing Director and Senior Analyst)

Okay. That's, that's good. All right, thanks, guys.

Operator (participant)

Our next question is from the line of Rob Salmon of Deutsche Bank. Please proceed with your question.

Rob Salmon (VP)

Hey, good morning, guys. As a follow-up to the kind of core pricing discussion earlier, could you elaborate in terms of where you're seeing that acceleration come? Has this been driven by the market share gains that you've had? Any sort of incremental color you could provide would be helpful.

Eric Butler (EVP)

I think we've said in the past that, a portion of our business, about 30% of our business is really repriceable at any one point in time. And I think pretty much across the board, with strong demand, we're seeing, the opportunities, for price improvement.

Rob Salmon (VP)

That's helpful. And then a clarification with regard to the, the hiring that you guys had discussed. It sounded like that's a net incremental 1,000 employees, with 5,000 being hired for growth, but then you got 4,000 in attrition. Am I thinking about that right?

Robert Knight (CFO)

Rob? Yeah, that's exactly right. And, you know, it's not an exact number, but what we're basically saying is fairly high hiring numbers, fairly high attrition rate, and the net number will ultimately be driven by what the volume ends up being because we still squeeze out and expect to squeeze out productivity, but it's a high-class problem for us as volume grows, for us to continue to increase our hiring levels.

Rob Salmon (VP)

Rob, as a clarification, what volume are you guys expecting in the back half with that 1,000 additional headcount?

Robert Knight (CFO)

Yeah, great question. I mean, we're obviously not going to give you that guidance other than we, you know, do see, as Eric walked through, a lot of optimistic opportunities for us. So, without giving a specific number, we hope the economy continues to cooperate, not only for the balance of this year, but as we head into 2015.

Rob Salmon (VP)

Fair enough. Appreciate the time.

Operator (participant)

Our next question is from Ken Hoexter with Bank of America. Please receive your question.

Ken Hoexter (Managing Director)

Great. Wonderful. Good morning. Eric, can you just dig in a little bit on the, on the comments on the pre-shipping and, and your thoughts there on intermodal as we head in not only the next couple of months, but maybe even into the back half of the year, just given what level you thought was pre-shipped and, and what do you think the outcome of that is over the next couple of months?

Eric Butler (EVP)

Hey, Ken, as we said, our international intermodal was up about 12% in the second quarter. I would say going into this year, we probably would have expected a 3%-5% improvement in second quarter. And we clearly were above that, and so we think that most of the increase beyond that was not necessarily organically marked or business driven, but related to the pre-shipping. And so we think that that will not probably impact the volumes in the third quarter.

Ken Hoexter (Managing Director)

Great. And then your thoughts on CapEx. I know, Lance, you delved into a lot of the detail of different projects, but when you think about this level of volumes and the speed, and obviously CapEx takes time to roll in, is there concern in the near term about ability to handle, you know, whether it's pinch points or ability to keep pace with the volume growth that you're seeing right now, given that you're kind of almost at your targets for your weekly carload growth?

Eric Butler (EVP)

Yeah. So can we feel confident that our network can handle the kind of volumes that look like they're coming our way as we proceed through the second half? You know, our capital plan is targeted at specific bottlenecks and constraints. It's coming to fruition as we would like it to. And so going forward, we feel pretty good about being able to handle the volumes that that we're seeing.

Jack Koraleski (CEO)

Yeah, Ken, this is Jack. In fact, you know, right now we're moving some of the strongest volume we've seen all year, and yet our operating statistics and performance is improving, so we feel really good about that.

Ken Hoexter (Managing Director)

All right, great. Thank you very much for the time.

Operator (participant)

Our next question comes from the line of Allison Landry of Credit Suisse. Please proceed with your question.

Allison Landry (Senior Transportation Research Analyst)

Good morning. Thanks for taking my question. Just as a, a follow-up to the last question discussion, is it fair... You know, I, I know that you guys are bringing on some additional headcount and locomotives, but you're also expecting network velocity to improve and, you know, benefit from some productivity gains. So if I think about incremental margins in the third quarter and the fourth quarter, is it possible or, or fair to say that we could see an acceleration from the 58% that you posted in 2Q? Not that that wasn't a good number, of course.

Robert Knight (CFO)

Rob? Well, Allison, as you know, we don't give guidance on that, but we're the entire team is focused on, in fact, making improvements everywhere we can. I mean, if the economy cooperates, you know, that's a great opportunity for us to move bills, very strong volumes, gives Eric a chance to price it right. Lance has talked about the improvements that we're progressing and, in fact, seeing in our operating efficiency, which should help us on the cost side. So we're focused on doing that. I'm not going to give guidance on that number, but we're focused on improving our margins.

Allison Landry (Senior Transportation Research Analyst)

Okay. With respect to the sequential improvement in pricing and the 30% of your book that's sort of tariff-based, what could we see in the back half of the year? You know, is there the potential to see another 50 basis points or something like that, you know, potentially by the end of the year as a result of, you know, more upward adjustments on spot business?

Robert Knight (CFO)

You know, Allison, that's way too specific. We're not gonna go down that line. We are gonna continue, as we said, to price to the market and to have reinvestability as our threshold, and we've got it headed in the right direction.

Allison Landry (Senior Transportation Research Analyst)

Okay. Thank you for the time.

Operator (participant)

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

Chris Wetherbee (Senior Transportation Research Analyst)

Thanks. Good morning. Rob, if I could ask about the repurchase activity in the quarter, certainly seemed to step up quite nicely. And you think out over the course of the next several quarters and maybe into the next year or so, as you're approaching some of your leverage targets, you're getting closer to that, can we see a sustained level, kind of in line with what we saw in the second quarter? Was that a bit of a catch up or a true up? I just wanna get a rough sense of maybe how you think about the pace of that repurchase activity going forward.

Robert Knight (CFO)

Yeah. And as you know, we don't give guidance as to what we're actually going to buy, but I would say there was nothing unusual in the second quarter other than we continued. It starts with generating strong cash on the front end, which is our entire team's focus. That gives us then the opportunity to reward shareholders, and we will continue to be opportunistic with our share repurchase program as we were in the second quarter. So I can't give you a precise number, but we felt pretty good about what we were able to do in the second quarter under that philosophy, while at the same time reinvesting in the business with a strong capital program and with an increased dividend payment that you saw year-over-year.

Chris Wetherbee (Senior Transportation Research Analyst)

Sure. Okay. That's helpful. I appreciate it. And then if I could just get you guys. Just curious to get your take on the crude by rail rules or the proposal that came out yesterday. Just get a rough sense of maybe how you think about that 2-year timeframe and maybe some of the other puts and takes that are in there. Seemed relatively okay. The timeline seemed a bit tight relative to our expectations, but just curious your take on that.

Jack Koraleski (CEO)

You know, Chris, I'm kind of there with you. There was really not anything in there that was totally a surprise to us. We have been actively involved with the Department of Transportation, the AAR, and others, in helping to do everything we can to make what is already a safe product safer. And so some of the ideas that are in that NPRM have already been implemented, and some that are still there that we still need to work with, and so we want to be a voice at the table. The two-year timeframe, you know, the timeframe really just evolves around what is the capacity in the industry to rebuild and to build new tank cars, and two years does feel a little tight.

And if we go too far down that path, then that says some product isn't gonna be able to move, which is not the right solution. But so far, I have to say that I think we've got a good track record of having thoughtful approaches to this, and we're looking forward to sitting down again and filing our comments, sitting down with Secretary Foxx and others to work through what is the right solution here.

Chris Wetherbee (Senior Transportation Research Analyst)

Okay. That's helpful. Thanks very much for the time. I appreciate it.

Operator (participant)

Our next question comes from the line of Walter Spracklin with RBC. Please proceed with your question.

Walter Spracklin (Managing Director)

Thanks very much. Good morning, everyone.

Robert Knight (CFO)

Good morning, Walter.

Walter Spracklin (Managing Director)

I guess coming back on the pricing question, just talking a little bit more broadly, I heard, I think it was Jack, it might have been Eric saying, you know, sticking to your approach of pricing in line with inflation. A number of your competitors have taken it a little bit, a step further now and looking a little bit more at yield management and focusing on customers that perhaps are not pulling their entire weight, and looking a little bit more on return on invested capital as the metric by customer, as opposed to pure pricing. Eric, have you looked at doing that? And I guess I'm asking the question in the context of intermodal, specifically with the tightening truck market.

Could there be opportunities that just, you know, a blanket price in line with inflation is not the right approach, but rather looking at it from a more opportunistic perspective, given some of the tighter capacity constraints that are going on, particularly in trucking, but across your entire book of business?

Eric Butler (EVP)

Walter, I'm not, I'm not sure. Hopefully, we have not given a, an indication that our pricing strategy is to price in line with inflation. Our pricing strategy is-

... price to the market at reinvestable levels, which basically means to make sure all of our business is generating an effective return on investment. So, that's the strategy that we've had for a number of years. We think it's the right strategy. We think it's helping to drive the financial results we're producing, and we're committed to that strategy.

Walter Spracklin (Managing Director)

Then specifically on particular markets, notably trucking, where perhaps the pricing might have not been where you wanted it to be, can we potentially see an uptick in pricing in those areas driven by the tighter trucking market, I guess, is where I'm going?

Eric Butler (EVP)

Yeah, we do see the trucking market tightening, we see drivers tightening. The trucking market is an effective competitor for a wide swath of our business, not just Intermodal business. And, certainly, as their costs go up, that gives us opportunity to seize more demand for our network, and we're seeing that, and we have been seeing that, and we're going to continue to price to the market based on that.

Walter Spracklin (Managing Director)

Okay. My second question here is just more of a broader question, and certainly for you, Jack. There've been talk a little bit, and I heard you reference the dependence on your partner on the other side for turning assets, or your interchange partner. There's been talk about potentially, you know, down the road, improving service broadly for the railroad industry through a cross-the-Mississippi type of merger. Is that something that you just think is not on the table from a regulatory approval standpoint, or is that something we as investors should think about? It might, you know, obviously not in the near term, but perhaps a little further down the road as a viable opportunity.

Eric Butler (EVP)

I think that's pretty much off the table.

Walter Spracklin (Managing Director)

Okay, great. That's all my questions. Thanks very much.

Operator (participant)

The next question is from the line of Jeff Kauffman with Buckingham Research. Please proceed with your question.

Jeff Kauffman (Equipment Equity Research)

Thank you very much, and congratulations on a strong quarter.

Eric Butler (EVP)

Thanks, Jeff.

Jeff Kauffman (Equipment Equity Research)

A question of a different kind. I wanna focus a little bit on cash. Going back historically, you generally don't have less than $1 billion of cash on the books, and I'm just looking, you're down about $700 million from where you were cash-wise a year ago, and I know a lot of that's gone to CapEx, share repurchase, and dividends. If you're gonna stay within the boundaries of the growth targets you're at, is there a cash level you wanna stay at? And we would assume that if the share repurchase were to continue at this level, it would have to result in more debt.

Eric Butler (EVP)

Rob?

Robert Knight (CFO)

Yeah, Jeff, I mean, as you know, we and most companies in corporate America are holding more cash today than maybe historical numbers would have suggested. But I wouldn't get too hung up on quarter-end cash balances from one quarter to the next because there's all kinds of timing issues, which really was the big explainer of some of the changes that we saw in our second quarter, whether it's tax payments, timing of tax payments year-over-year, that's all factored, debt, timing that we choose to do.

So again, our focus, the way I would answer that, is our focus, as I said earlier, the entire team is focused on generating quality cash from operations so that we continue to have the opportunity to reinvest in the business, continue to move our dividend up, and continue to be opportunistic with share buybacks, which I think we, in fact, have walked our talk in terms of what we've done over the last several years.

Jeff Kauffman (Equipment Equity Research)

Okay, so your point is that this is more of a working capital anomaly in 2Q. But I, I guess my question is, is there a certain level of cash you wanna keep on the books? Should I think of this as kind of a, a bottom in terms of where you want cash to be?

Robert Knight (CFO)

No, I wouldn't look at that. I mean, it's not a hard number on the cash. Again, as you know, we're focused on improving, which we did in the second quarter, our debt to cap ratio. We've said we wanna get to that low forties number, and we've got a little bit room or opportunity to continue to progress in that direction. I would look more at that number.

Jeff Kauffman (Equipment Equity Research)

Okay, guys, thanks.

Operator (participant)

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

Brandon Oglenski (Senior Equity Analyst)

Hey, good morning, everyone.

Eric Butler (EVP)

Morning.

Brandon Oglenski (Senior Equity Analyst)

Eric, I wanted to ask you about your Mexico franchise and the opportunity that you're seeing, you know, both in the auto sector and with your new intermodal facility that you have in New Mexico. Is that driving a lot of incremental growth, in the system?

Eric Butler (EVP)

We're excited, Brandon, about our new intermodal products and services, and Santa Teresa has facilitated us being able to put some new products and services in the marketplace, and we're gonna look to grow that even more in the future. So, we view that as upside and excitement for us. Our Mexico franchise, as we've said in the past, we have the premier Mexico franchise with six border crossings, and we're continuing to focus and invest in strengthening our Mexico franchise with all of our Mexican rail partners. So that's gonna be an area of focus for us in the future. As you suggest, auto manufacturing in Mexico is growing. Historically, they've been call it 1.5-2.5 million vehicles a year.

They're projecting over the next 3, 4, 5 years to grow to 4 million cars a year production in Mexico with all of the new plants. As anything, really what's gonna drive the level of our auto business in the future is sales, because wherever the car is produced, hopefully we'll have a chance to move it, given the strength of our franchise. So growing the absolute number will really still depend on what's happening with automotive sales.

Brandon Oglenski (Senior Equity Analyst)

Well, appreciate that, Eric. And Lance, I wanted to ask about, you know, network velocity and obviously, the favorable leverage you've been getting on your TE&Y headcount. Is that gonna continue, or do you need to ramp that a little bit faster to get the network to where you want to see it? And does that necessarily mean that you can't still get leverage if velocity is improving?

Lance Fritz (President and COO)

Yeah. So, Brandon, we love to get the leverage through service improvements. Service improvements are our favored way of kind of leveraging growth. If you look back at the second quarter, we leveraged the growth, but we were behind the eight ball when it came to our service product. As we look forward, the addition of resources like labor are gonna help us improve our service product, and we still expect to get leverage productivity off the volume as we add that labor.

Brandon Oglenski (Senior Equity Analyst)

Thank you.

Operator (participant)

The next question is from the line of Jason Seidel of Cowen and Company. Please proceed with your question.

Jason Seidl (Managing Director)

Thank you. Good morning, guys. When we look out to the third quarter, I was just curious, when you look at your base plan for, you know, putting more locomotives into play, calling more people back to work, you know, what's your base plan for the ag crop? Because it seems to me that, you know, if the ag crop is good again, you could have increased demands on both you and your Western partner, and we all know that the BN hasn't had a good time of it this year. So I'm just curious what sort of the base outlook you have for the crop is.

Lance Fritz (President and COO)

Eric?

Eric Butler (EVP)

So Jason, the latest reports from the Department of Ag says that the corn crop is as good as it's been in the last 20 years. There's still weakness in the wheat crop, but if you're talking about the corn crop, we're expecting, and I think the Ag Department of Agriculture estimates suggest that we're looking at perhaps another record corn crop year, which again will say that the transportation network will see strong demand for moving that. We feel pretty good about where we are with that. We have ramped up to handle the incremental demand from last year's record corn crop, and we are in a position to maintain that level if the crop comes in that strong. So we feel pretty good about how we're positioned to handle that potential demand.

Jason Seidl (Managing Director)

Okay. Very good. And if I can go back to pricing, you know, given how tight the truckload market's been and that we've seen the carriers now take rates up every chance that they can sort of get their hands on, should we look at sort of your core pricing here in 2Q as maybe the bottom for the year as you get a chance to reprice some of this intermodal business going forward?

Eric Butler (EVP)

Jason, so, again, I hate to sound like a broken record, but we're continuing to look at a pricing environment that we think is strong, and we're gonna price to the market, ensuring that business is reinvestable, and that's our focus. That will continue to be our focus.

Jason Seidl (Managing Director)

Well, let me ask it a different way then. You said that about 30% of your business at any given time may be up for pricing. Out of that 30%, how much is intermodal?

Eric Butler (EVP)

We don't, we don't go into that level of specificity typically.

Lance Fritz (President and COO)

Jason, this is Rob.

Operator (participant)

Thank you. The next question is from the line of John Larkin with Stifel. Please receive your question.

John Larkin (Managing Director)

Good morning, gentlemen.

Lance Fritz (President and COO)

Morning, John.

John Larkin (Managing Director)

Thanks for taking the question. Had a question about all of the operating challenges you faced in the second quarter, which sounded fairly substantial, yet the operating ratio was absolutely spectacular. Do you want to share with us perhaps the cost of all of that flooding and all of the congestion that remains from the winter, et cetera, and perhaps what the quarter would have looked like had you not had those operating challenges?

Lance Fritz (President and COO)

Rob?

Robert Knight (CFO)

Yeah, John, I mean, I'm not given the specific number, and it's hard to exactly split the hairs between was it weather? Was it, you know, was it added cost as a result of some of the challenges that Lance talked about? It was kind of all of the above, and they were, without giving a precise number, they were, you know, somewhat meaningful, if you will. If you look at our labor line, you look at some of the purchase services, you look at some of the other cost items, they were in there. So your point is well taken, that, you know, had we not incurred those costs, things could have been slightly better.

I think you're focused on the right thing, that we did a good job of improving our margins in spite of some of those challenges. And some of those challenges clearly were brought on by a very strong ramp-up in volume, so that helped, of course, contribute towards the positive volume and margin improvement. So again, without breaking out the numbers, we think that does give us an opportunity at if the economy stays strong and demand stays as strong as it is, for us to make the improvements that Lance talked about, for us to continue to improve our our returns and our margins.

John Larkin (Managing Director)

Got it. Thanks for the answer. Second question, related to some of the capital investment that you're making on the southern part of the network, where you've had some capacity challenges over the last couple of years. That area appears to be right on top of the area that will be ultimately supporting a lot of new investment in chemical, petrochemical plants, refineries, things of that nature. Where do we stand in the build-out of all that chemical industry infrastructure, and when do you expect to start to benefit from traffic emanating out of those new facilities or the expanded facilities?

Lance Fritz (President and COO)

You know, John, I think, overall, we're really expecting that the investment in the chemical industry really starts to hit our network sometime in 2016.

kind of, 2016, 2017 kind of zone. That's when we see the bulk of it, and certainly, the investments we're making today are anticipating some of that, as we see, not only because of the, oil business and things like that, but also everything else that's happening in our southern region. Lance, do you want to-

Jack Koraleski (CEO)

Yeah, I would remind you that the beauty of the investments that we're putting down in the southern region is that they can be broadly utilized for different commodity groups. You point out one, the chemicals franchise. We're using them right now for our strong grain shipments down to the Gulf, and we can use them for many, many frac sand. It's beautiful to leverage that capital that way.

Yeah, we have a very important project going on right now. It's one of the biggest congestion points on our railroad called Tower 55. We're about halfway through that project. We'll have it done by probably the first of September or around that point. But getting that bottleneck out of our network before this business starts to come on stream is an important step forward to us as we look ahead.

John Larkin (Managing Director)

Thank you for the caller.

Operator (participant)

The next question is from the line of David Vernon of Bernstein Research. Please go ahead with your question.

David Vernon (Senior Analyst)

Hi, thanks for taking the question. Eric, as you think about the RPU development in intermodal, could you talk a little bit about how mix played in there? You had good growth in international and domestic. Would you say mix was kind of a headwind to the RPU development or neutral, or maybe a little bit of a tailwind?

Eric Butler (EVP)

Mix was a little bit of a headwind in the second quarter, really for some of the new products and services that we put in place, were shorter haul than some of our traditional long-haul, international intermodal business and domestic intermodal business. But, it was just nominal in the second quarter.

David Vernon (Senior Analyst)

And within that domestic intermodal business, you know, we hear a lot about, you know, chassis problems, you know, particularly around some of the international moves and the potential for driver shortages to maybe make it more difficult to get some of the retail products into market. Are you seeing some of those pressures as well, or are you guys been able to kind of manage through that, those sort of first mile, last mile challenges without a lot of problems?

Eric Butler (EVP)

I think we are seeing some of those pressures, nothing that's beyond our ability to manage through on a tactical basis. We do have some major initiatives underway to really address making our first mile, last mile process a lot more effective. And one of the good things about the challenges that you see kind of in the dray network with the driver shortage is that it really emphasizes to go rail as long as you can and as far as you can on the rail network. So we do think we're gonna see some upside from that.

David Vernon (Senior Analyst)

All right. Well, outstanding pricing on the intermodal side. Appreciate the time, guys. Thanks.

Operator (participant)

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

Justin Long (Managing Director of Equity Research)

Thanks, and good morning.

Eric Butler (EVP)

Morning.

Justin Long (Managing Director of Equity Research)

You talked about the 229 locomotives that are coming on in 2014. I was wondering if you could talk about the timing of these deliveries over the course of the year. And also, as you look into 2015, do you have a rough idea right now of how many locomotives you'll need relative to this year in terms of new orders?

Eric Butler (EVP)

Lance?

Lance Fritz (President and COO)

Sure. So, we are receiving locomotives in the second half of the year. It's a good portion of that 229. And if you look out into 2015, we have not solidified our plans yet, but we could very well be in the market in 2015.

Justin Long (Managing Director of Equity Research)

Okay, great. And secondly, in June, you announced a ramp of your premium intermodal service from Chicago to the West Coast. I was wondering if you could talk about the mix of your intermodal business. Do you expect to bring more of your intermodal volumes in-house over time, or do you think that mix between what you handle internally versus working with the IMCs will stay about the same?

Eric Butler (EVP)

Eric? Yeah. So, we have hardly none of our intermodal business today that we do outside of IMCs. IMCs are our strategy, our market channel strategy to go to market. We do have an internal IMC that is focused on the auto parts business, subsidiary, UPDS. But other than that, we, our market channel strategy today is to work with IMCs.

Justin Long (Managing Director of Equity Research)

Okay, and there's no plans to change that going forward?

Eric Butler (EVP)

Not at this time.

Justin Long (Managing Director of Equity Research)

Okay, great. I appreciate the time.

Operator (participant)

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

Tom Kim (Tech executive)

Morning. Thank you. I have a couple of questions around locomotive productivity and fuel burn. We did see a modest improvement in the second quarter, and I'm wondering, with the additional locomotives being added in the second half, should we anticipate the consumption rate to pick up near term, or and then possibly trend down again longer term?

Lance Fritz (President and COO)

Lance? Yeah, sure. So new locomotives are actually a benefit to OR, but there's just, I don't think there's going to be enough new locomotives coming online in the second half to measurably show up in OR. I will tell you that I'm pretty proud that we got some OR reduction, which is improvement in the first half, given the fact that our network was a bit sluggish and we pulled out a fair number of stored locomotives that are not our most fuel-efficient locomotives. So that, that just demonstrates that our, that our activity on OR is getting traction, and I, I expect that to continue.

Tom Kim (Tech executive)

Great. And then, do you have, like, a longer-term target where you think your fuel consumption rate would be, you know, given the newer locomotives that your guys are going to be adding over time?

Lance Fritz (President and COO)

Sure. Better.

Tom Kim (Tech executive)

Okay. All right, if I could just add, I had a question on your comment earlier on labor attrition. Is there any particular reason behind it? Is it just simply retirements?

Eric Butler (EVP)

It's primarily retirements.

Tom Kim (Tech executive)

Okay. And then, with retirements, could we assume that, with your new hires, that there should be an incremental, unit labor cost to sort of benefit?

Eric Butler (EVP)

Not really. Rob, you want to comment on that?

Robert Knight (CFO)

Yeah, John, I mean, given the, the labor agreements, no, there really isn't a meaningful—we, we incur, when we hire somebody, some training and hiring costs, but in terms of the ongoing wage, there's no real difference.

Tom Kim (Tech executive)

Okay. Thanks very much.

Operator (participant)

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

Keith Schoonmaker (Director of Industrials Equity Research)

Thanks. I have a couple quick questions on longer-term capital deployment. Rob, I believe you mentioned purchasing some leased equipment. Could you expand on this strategy? Well, what portion of equipment is currently leased, and was this just optimistic or a shift in ownership strategy?

Robert Knight (CFO)

Yeah. Yeah, it's not. It's an ongoing. I mean, where it makes economic sense for us to take advantage of some of the markets and, you know, long-term deals. So I wouldn't read anything into that. There's no shift in strategy. It's just where it's sort of opportunistic. We're able to take advantage of that in the second quarter.

Keith Schoonmaker (Director of Industrials Equity Research)

Okay, thank you. And, CapEx longer term, CapEx to fulfill PTC mandate is still quite high this year, rounding to $500 million, I think. Given the reality of the implementation schedule, how do you now see the PTC spend fading over the next several years? And, and when PTC slips to maintenance, rather than build out, do you expect to step down in total CapEx?

Robert Knight (CFO)

Rob? Yeah. I mean, just to remind you, what we've said in terms of our total capital spend for Positive Train Control is going to be in the neighborhood of $2 billion-ish, total. We're spending, to your point, our plan is to spend about $450 million this year, which is, the high water mark thus far on our spend. You know, the deadline, we'll see where, what the date actually ends up, being. But if it's, if the deadline, gets moved back, our expectation is the spend on the capital side will still be in that $2 billion neighborhood. We don't want it to shift the deadline and result in higher spending, so we're very focused on that.

To your point, in terms of what might shift, we've said before, you perhaps had heard me say before, that there will be an ongoing expense in our OE, and that shows up most notably in depreciation, which, in fact, we're starting to see that in our numbers this year. So as we start to depreciate those new PTC assets, you will see an increase in our depreciation expense related to that. And again, we are seeing some of that this year.

Keith Schoonmaker (Director of Industrials Equity Research)

This is kind of a devilish question, but if you hadn't had to make the PTC spend, what, what do you think you would have bought with that money, or would have CapEx just been lower?

Robert Knight (CFO)

Well, I would just say it's all return based. I mean, I wouldn't... I don't have a clean answer to that other than, we didn't back off on spending other, worthwhile projects on our network where the returns were there, and we were confident. So it's not as if it was a, you know, a simple trade-off there. We'll always look at, as we look at capital spending, we'll always look at our business case and the expected returns that we will, expect to generate out of those, capital investments, and that's all included in the guidance that we've given of 16%-17% of revenue as we look forward. That's not how we build our capital budget, but that's kind of a guiding light of how we expect to, size up our capital spending as we look forward.

Keith Schoonmaker (Director of Industrials Equity Research)

Thank you.

Operator (participant)

Our next question comes from the line of Cleo Zagrean with Macquarie. Please proceed with your question.

Cleo Zagrean (Transportation Analyst)

Good morning, and thank you. Also a question on intermodal. Could you share with us your insight into the main pockets of growth opportunity, maybe across service offerings or types of customers, especially with West generally seen as a more mature market than the East, and your numbers obviously proving that wrong this quarter?

Eric Butler (EVP)

Yeah, Cleo, we, we're seeing pretty good growth across the breadth of the intermodal market, whether you're, talking about motor carriers or brokers. I, I think the western part of the U.S., if you want to consider it west of the Mississippi, probably has as much or more opportunity as the eastern part because we have longer hauls, which should make it easier for, to make the conversion from truck to rail. So I think we're seeing strength pretty much across the breadth of our, intermodal, customers.

Robert Knight (CFO)

We're also hopeful, Cleo, that our investment in the Santa Teresa facility will draw truck traffic that's moving today from Mexico into the US to our intermodal facility in Santa Teresa, and then we can move it east or west from that point. We're pretty excited about that market opportunity as well.

Cleo Zagrean (Transportation Analyst)

Thank you. And the second question has to do with resource management, your view on management of resources to manage variability, spikes in demand, like we've experienced so far this year. Has this experience of the winter and the sharp volume led you to consider strategic changes in how you look at asset ownership, or are you managing through it as a tactical way to within the same strategic framework that you are happy with?

Robert Knight (CFO)

I think, I think our performance through the first half of the year has been quite good, given what we had to face in terms of the weather conditions and the congestion it caused nationwide on the rail industry. I think one of the things that you've seen, and I think one of the earlier questions about, how did we get to the 63 operating ratio here in the second quarter, is because over the years, we have really shifted our approach. We have, we have become much less reactionary and much more,

Aticipatory. And so as we see things starting to develop on the horizon, we immediately start a planning phase that says, we're gonna mobilize materials, we're gonna mobilize people where they need to be. We're going to be doing some alternative scenario planning as the way to minimize disruption to our network and to our customer service levels. And I think that shift to anticipating is really what's been kind of the key behind some of our performance, certainly in the first half of the year. And so we learn something from every event. We learn something from every thing that happens on our railroad, and our goal is to take that and work it into our planning structure so we become even more effective and better going forward.

Cleo Zagrean (Transportation Analyst)

Any particular pockets of tightness across your segments that you would like to comment on for the next year?

Jack Koraleski (CEO)

Eric, what do you think?

Eric Butler (EVP)

We, Cleo, we're seeing pretty good demand, and our first look at the 2015 forecast is pretty good demand across our book of business. And so I don't think there's any one place that would stick out beyond any other places.

Jack Koraleski (CEO)

You know, Eric, if you, if you look at it from a network perspective, Cleo, we are investing in the areas where we anticipate we are going to be tight, and we've talked openly about investing in the southern region and also in the north-south corridors.

Cleo Zagrean (Transportation Analyst)

Very much.

Operator (participant)

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

Cherilyn Radbourne (Managing Director)

Thanks very much, and good morning. I'm just gonna ask one because it's getting late here. But I wanted to ask a question on interline connectivity, which was an issue in the quarter, and I think the first half of this year has exposed the fragility of Chicago. So I just wondered if you could give some color on how much of your traffic touches Chicago and, you know, the extent of opportunities you think are out there to reasonably divert that to other interchanges over time.

Jack Koraleski (CEO)

Yeah, I would. So I'm gonna start, Cherilyn, and just say, you know, I think if you look at Chicago, I don't know that I would necessarily describe it as fragility. I think Chicago got hammered with a snowstorm about every two weeks, and frigid cold temperatures, so it never melted. It just kept building up and building up. I think that was a key problem there. We have worked with all of our interline partners in terms of, not only their fluidity but also our fluidity. We're all in this together, and so we have done a lot of redirecting out of Chicago into the St. Louis area or down to Memphis in working with our interchange partners, for the mutual benefit of both of our railroads as we work through those issues. Lance, why don't you? Sure.

So you had asked how much of our business? It's a fair portion. Call it a quarter of our business ultimately moves through, into, out of Chicago. And when you think about our activity in Chicago, CREATE has really done a very good job of improving the Chicago gateway with interline partners. The gateway, since the start of CREATE, has improved by about a third in terms of the amount of time it takes a car to traverse. And Jack mentioned it as well. We've got ongoing investments in Chicago, one of which is going to be in connection with Metra, where we add a third main line to our critical east-west route in and out of Chicago.

I'm very optimistic both in the level of activity and engagement we have with our interline partners and in the progress that we've seen. This winter was exceptional. It was an exceptional winter, and it had exceptional impacts on the railroad. Even so, volume still continued to move through the gateway.

Cherilyn Radbourne (Managing Director)

Okay, thanks for the detail. That's all for me.

Operator (participant)

Our next question is from the line of Tyler Brown of Raymond James. Please proceed with your question.

Tyler Brown (Associate VP)

Hey, good morning.

Jack Koraleski (CEO)

Morning.

Tyler Brown (Associate VP)

Hey, Eric, I just wanted to double-check, but did I hear that you guys are planning to add 5,000 EMP and UMAX containers this year? I'm just curious. Seems like a pretty big add, or was that somewhat replacement?

Eric Butler (EVP)

Yeah, so part of it is replacement. As we discussed, our business is growing. And actually, as we look into the future, and we don't talk about this in specificity, but there's a bunch of containers that are aging out, and so, you know, we're trying to do some level set planning and management strategically. But you could think of it as part replacement, part growth, part future level set planning.

Tyler Brown (Associate VP)

Okay, that's perfect. And then just kind of following up on that, but on the rail-controlled side, have you guys implemented any kind of, call it, general rate increases or maybe tariff increases on that rail-owned pool of containers?

Eric Butler (EVP)

So, the pricing that we're putting in our Intermodal business, we are increasing our prices in our Intermodal business on whether they're rail-owned containers or private-owned containers. The pricing, because the demand is going up, pricing is going up.

Tyler Brown (Associate VP)

All right, perfect. Thank you.

Operator (participant)

Our next question comes from the line of Benjamin Hartford with Robert W. Baird. Please proceed with your question.

Benjamin Hartford (Senior Analyst)

Hey, good morning. Thanks, guys. I'll be quick. It's been long. Did you mention earlier when you expect the, the network to be, quote, unquote, "normal" in the back half of the year? Did you provide a timeframe?

Jack Koraleski (CEO)

No. Lance, you want to comment? Yeah, we did not provide a timeframe, but what we did say is we're positioned to improve, and we expect to improve.

Eric Butler (EVP)

We're seeing improvement right now.

Jack Koraleski (CEO)

We are seeing improvement as we speak.

Benjamin Hartford (Senior Analyst)

Okay, and assuming that we do, you know, normalize before the upcoming winter, how should we think about network utilization, given the volume level that we have seen, given some of the locomotive investments and the container investments and other car type investments that you have made? Is there a... Can you provide some sort of figure as to what effective network utilization will be in kind of a steady state or normal network fluidity environment?

Jack Koraleski (CEO)

It's pretty difficult to do that, Benjamin, if you think about it, because it depends on where the business comes, what kind of business it is, and all that. What we can tell you is, at this point in time, as we look ahead, even at the volume levels we have, we're still open for business, we still have capacity, and we're looking forward to additional growth.

Benjamin Hartford (Senior Analyst)

That's helpful. Thank you.

Operator (participant)

Thank you. There are no further questions at this time. I would like to turn the floor back over to Mr. Jack Koraleski for closing comments.

Jack Koraleski (CEO)

Well, great. Thanks, everybody, for joining us on the call today, and we look forward to speaking with you again in October. Take care.

Operator (participant)

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