Creating capacity

Growth capital is a priority at UP, and the payoff is impressive.

By William C. Vantuono, Editor

Want to talk about capacity? How about a 100-car unit train rumbling out tyhe Powder River Basin coal fields every 48 minutes? Or 140 trains of all types rolling on a triple-track main line across the Nebraska prairies? Or, taking a broader view, 3,000 trains moving on a 32,000-mile system covering 23 states? This hurculean performance is all in a day's work for the Union Pacific, which is spending $3.1 billion this year in capital improvements, including $841 million to create new network and terminal capacity.

Due mainly to its sheer physical size, but also to a historic commitment to first-class track and rolling stock, no other Class I invests as much in plant and equipment as UP. That commitment remains in place at a time when other industries, in an economy thats now in recession, are retrenching and cutting back. UPs 2008 capital improvement budget is identical to 2007s record high of $3 billion-plus, even though overall traffic has slipped and fuel costs have climbed to stratospheric levels. One difference is that this years budget nearly doubles the amount spent on creating capacity.

We looked at our mix of capital projects and moved some dollars around, says Chairman, President, and Chief Executive Officer Jim Young. But we must continue investing. Otherwise, there wont be enough capacity for future growth. For 2008, in addition to the $841 million for network and terminal capacity, UP budgeted $1 billion for maintenance-of-way and $460 million for locomotives and freight cars. Over the next three to five years, says Young, there should be no significant change in these allocations, unless the economy takes a more serious downturn.

UP still has several major unfilled capital improvement needs. We have at least three years to go on our Sunset Corridor double-tracking program, and we may stretch it out a bit longer, Young says. We may allocate more money to our Central Corridor (which serves Chicago). Were also putting greater priority on capacity improvements that can be achieved through process improvements. However, its hard to predict where we will be five years from now.

UP, like its smaller Class I siblings, is riding the wave of a railroad industry resurgence that so far has defied a recessionary economy that has hurt competing transportation modes. In bearish times, Wall Street has been taking a bullish view of railroads. A share of UP common stock, for example, has increased 20% during the past 12 months, while the Dow Jones Industrial Average has declined 20%. Railroads generally are outperforming the market, as indicated by UPs second-quarter financials, in which it posted record growth in diluted earnings per share, net and operating income, and operating revenue.

In a general sense, the value of rail is starting to show up in the global logistics chain, says Young. Service and productivity have improved. The coal and agricultural business is doing very well. People are looking for a safe harbor for investments and see value in railroads. Tightening of capacity is starting to generate positive, consistent price trends. Indeed, its pricing power thats largely responsible for driving UPs revenues and earnings to record levels.

Though no industry (with the possible exceptions of undertakers and tax preparers) is recession-proof, the railroads have been able to make the most of their inherent flexibility, and their growing importance in global logistics. Look at our swings in traffic, says Young. Agriculture and coal are up. Housing and motor vehicles are down. Our export business, with the worlds demand for coal and the value of the U.S. dollar, is growing. Im not sure if this is a trend, but our business has really been impacted by the world economy. In terms of the U.S. economy, which is cycle-driven, were much less dependent on it, and less impacted by swings, than we used to be.

One sector important to UPs prosperity (and railroad prosperity in general) is the surge in biofuels production, ethanol in particular, which appears to be here for the long term. For UP, ethanol is a $300 million a year business, including DDGs (distillers dried grains), Young notes. The ag sector is pretty hot worldwide, and we expect it to be strong for a long time to come.

Analysts agree. Elliott Gue, an energy sector expert, recently remarked that railroads are a play on three big secular themes: the drive for increased energy efficiency, growth in coal, and the agriculture boom. They are no longer totally dependent on the U.S. economy for growth. Its no longer appropriate to look at [them] as viciously economy-sensitive. The traditional relationship between the broader market and the rails has been breaking down for several years, but this trend appears to be accelerating.

Union Pacific offers a convenient example of the bullish forces at work, particularly in the coal and agriculture industries. UPs energy segment is its largest by revenue; it accounts for just shy of 20% of the companys business. Strong demand for coal has made this segment a real bright spot for the railroad in recent years. Better still, UP still transports coal under contracts signed years ago at lower freight rates. As these contracts expire, it should see strong pricing gains as it signs new deals. Agriculture is its most profitable business in terms of average revenue per car.

The chemicals segment is a solid, growing business. Demand for fertilizers is booming because of rising prices for agricultural commodities. And shipments of petroleum-related chemicals have also remained firm.

The railroads are taking steps to cut their costs and improve the traffic flow across their lines. UP has implemented a scheduled railway, adopted a sophisticated computer system and locomotives designed to reduce fuel consumption, and added capacity on parts of its network where there are visible bottlenecks. The result: Its costs have been falling, and network reliability has been improving.

UP has implemented a scheduled railway, adopted a sophisticated computer system and locomotives designed to reduce fuel consumption, and added capacity on parts of its network where there are visible bottlenecks. The result: Its costs have been falling, and network reliability has been improving. These steps have added to profitability.