Union Pacific Q3 2009 Earnings Conference Call

Oct.22.09 | About: Union Pacific (UNP)

Union Pacific Corporation. (NYSE:UNP)

Q3 2009 Earnings Call

October 22, 2009 10:00 a.m. ET

Executives

Jim Young - Chairman & CEO

Jack Koraleski - EVP of Marketing & Sales

Dennis Duffy - EVP Operations

Rob Knight - CFO

Analysts

Tom Wadewitz - JPMorgan Chase

Allison Landry - Credit Suisse Walter Spracklin - RBC Capital Markets

Matt Troy - Citigroup

Randy Cousins - BMO Capital Markets

Bill Greene - Morgan Stanley

Ken Hoexter - Bank Of America Merrill Lynch

Gary Chase - Barclays Capital

Justin Yagerman - Deutsche Bank

Operator

Good evening and welcome to the Union Pacific Third Quarter 2009 earnings call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded and the slides for today's presentation are user controlled. It is now my pleasure to introduce your host, Mr. Jim Young Chairman and CEO for Union Pacific. Thank you Mr. Young you may begin.

Jim Young

Good morning everyone. Welcome to Union Pacific's third quarter earnings conference call. With me today in Omaha are Rob Knight our CFO; Jack Koraleski, Executive Vice President of Marketing and Sales and Dennis Duffy Executive Vice President Operations.

Union Pacific's third quarter 2009 earnings totaled $1.2 per share. That compares to earnings of $1.38 per share in 2008, a 26% decrease. These results are clearly driven by the global recession in our related 15% borrowing reduction. Although we'll never be satisfied reporting lower earnings, there are some positives in our results.

The Union pacific team achieved a third quarter best operating ratio by concentrating on our business fundamentals of safety, service, value and productivity. Our safety performance is better in all areas as we continue to gain traction with our safety initiatives.

Our customer service reached all time high. Excellent service reports report Union Pacific's value proposition enabling us to achieve pricing gains that support our capital investments and drive financial returns. We're also generating better margins to improve efficiency. Although the benefits of project operating ratio were evident before the economic downturn, we're taking advantage of the lighter volumes to accelerate productivity efforts.

In addition to running a very solid operation in the third quarter, we're encouraged to see our seven day car loadings increase from second quarter levels. We view this as a sign that the economy has at least stabilized and may be improving slightly. Within this environment however, there is still a great deal of uncertainty. Because of that, we continue to hold a larger than usual cash balance and remain fully committed to maintaining a strong balance sheet.

Now with that, let me turn it over to Jack to talk about our business volumes.

Jack Koraleski

Thanks Jim and good morning. Well the impact of the economic downturn continued to be felt in each of our six businesses during the third quarter leading to that 15% follow-up in volume. Average revenue per car was done 12% as core price gains of 4% were more than offset by a decrease in fuel surcharge revenue and a little negative mix. That being said, we're not shifting our pricing strategy in any way. We're absolutely focused on reinvestibility even though this soft economy is making things a little more challenging for us. So as both volume and average revenue per car down from last year, freight revenue declined 25% to $3.5 billion.

Although volumes were down year-over-year during the quarter, they were improved from the first half of the year with the run rate up about 10% from last quarter. That strengthening was driven by several factors. Seasonality certainly played a role as coal, wheat and intermodal all picked up over the past few months.

We've seen inventory replenishment kind of (inaudible) flow, so it's starting to look like sales rates and inventories are aligning, which is a good sign that we bottomed out. Cash for Clunkers has given a boost to our automotive volumes. Supply chain issues ranging from mine production in Colorado, Utah to bankruptcies in the ethanol market have all improved. Stronger value proposition is attracting new business to the railroad and last but certainly not least, some of the improvement is what our customers are calling stronger demand which offers some hope that will see more signs of recovery next year.

Let me take you through what's happening in each of six businesses. Start with Ag. A 12% decline in Ag products car loadings combined with a 13% decline in average revenue per car to lower revenue 23% for the quarter. Whole grains were down 18% above exports and domestic shipments decline.

Reduced animal inventories and fewer shipments to forward ethanol plants who had a 7% decline in domestic grains and those lower animal counts were also a significant driver over 13% decline in meals and oil shipments. DDG's and ethanol both posted some slight improvement with ethanol getting a boost from the resumed production at the former VeraSun plants. An import beer and volume on our produce rail express service also posted year-over-year gains in the quarter.

Auto revenues decline 30% as a 19% drop in volume combined with the 14% reduction in average revenue per car. Spurred by cash for Clunkers and the resolution of the bankruptcy related plant shutdown, the 19% volume decline represents significant strengthening from earlier this year with volume up over 30% from the second quarter.

Finished vehicles decline 28% year-over-year, but parts were only down 6% as we saw a nearly 50% increase in parts volume, over the prior quarter as manufacturers started to ramp up production in response to the higher sales volumes.

In chemicals, the 16% revenue decline was the result of 7% reduction in average revenue per car and a 10% drop in volume from 2008 levels that were negatively impacted by last year's hurricane. Our plastic shipments grew slightly as export moves offset the 5% decline in domestic market. Continued weakness in the construction autos and industrial sectors of the economy was reflected in the decline in liquid and dry shipments. Caustic soda was the one counter to that trend growing 2% as commodity pricing favored domestic producers versus the imports.

Economic conditions also drove declines in petroleum and soda ash down at 17% and 11% and continued weak domestic demand and a weak export potash market resulted in a 24% drop in our fertilizer shipments. Against last year's best ever quarter, energy volume dropped 14% which combined with an 8% decline in average revenue per car reduced revenue 21%

Coal stockpiles remain high as a result of the recession's impact on industrial production, utility outages, relatively mild summer weather in our serve territory and to a limited degree, lower natural gas prices.

Soft demand and our contract losses from the first quarter drove a 14% decline in trains out of Powder River Basin and although improved from second quarter, Colorado, Utah shipments continue to be hampered by coal quality problems and production issues resulting in 210 fewer trains than a year ago.

Those economic doldrums are still prevalent in our industrial products business where volumes were down 29%. Add to that a 14% drop in average revenue per car and the result is a 39% reduction in revenue. Softness in housing and construction again drove declines in steel, rock, lumber and cement.

Steel mill capacity utilization strengthened through the year but it's still significantly below last year's level, driving a 50% reduction in steel and scrap shop and shipments for the quarter. Rock inventories remain high with stimulus spending having only a very minor effect so far and the one bright spot has been our new short haul uranium tailings move in Utah that drove over 6,500 unit increase and hazardous waste loadings for the quarter.

Intermodal revenue was down 22% as volume was up 13% and average revenue per unit declined 11%. The weakness of the overall economy continues to be reflected in low west coast import volumes which resulted in the 25% decline in our international intermodal segment.

Our domestic intermodal is again a good news story with volume up 9%, largely driven by the new Hub business. So, it looks like the economy has bottomed out, but unfortunately we're not seeing an upturn yet. We expect volume is going to stay below last year but given the steep fall off in 2008, that shortfall should narrow as we move towards year-end. With winter approaching, really don’t see any pick up in the cards for lumber, stone, cement, asphalt or steel. We have seen some stimulus related projects but they really appear to be replacing other funding sources rather than generating incremental activity at this time. Stock piles are high and demand is soft, so we think Powder River Basin tonnage is going to trail last year's record fourth quarter by about 10%.

While our chemical business should hold its current run rate, wet weather and weak exports could produce another disappointing fall fertilizer market. But against those challenges we do have some bright spots. The fall harvest is looking great and exports are picking up. Ethanol should hold its run rate and with the VeraSun ethanol plants back on line, we should continue to post year-over-year growth in ethanol and DDGs.

With auto inventories having gone from unprecedented heights earlier in the year to relatively low following cash for Clunkers at inventory replenishments should keep volume at least as strong as the third quarter. And with the international peak behind us, such as it was the international intermodal volume would soften through year end. At the same time, domestic should continue to outpace last year with added hub business and the continued strength in our new service offerings.

So we’re staying focused on re-investability, new business development and capitalizing on the opportunities created by a strong value proposition that our service is creating. One of the best proof of that value proposition is what our customers are saying. So I’ll wrap up with a look at customer satisfaction which came in at 88 for the third quarter. That's a five point improvement from last year and our new best ever quarterly mark since we started measuring customer satisfaction back in 1987. During the quarter we also set our best ever monthly record when the satisfaction index closed in August at 90.

So with that, I’ll turn it over to Dennis to talk about our operations.

Dennis Duffy

Thank you Jack and good morning. In the third quarter, the operating team continued to make significant enhancements to both our operating efficiency and service delivery. In fact, the performance of our rail network has never been better. Third quarter velocity increased nearly 16% versus 2008 to a best ever 27.4 miles per hour. Freight car utilization which is cycle time between load and moves set a record at 8.4 days. Lower cycle time means fewer assets are needed, reducing capital and lease expenses.

Terminal dwell time held steady at 24.5 hours. As we discussed in July, we have shut down or significantly curtailed operations at several locations to reduce cost and reflect current demand. We gained these efficiencies while also improving our service performance as shown by our service delivery index in the lower right, and by the record customer satisfaction that Jack told you about. We achieved this performance while also improving our number one priority, safety, making double digit gains year-to-date for all three categories in employee, public and customer.

Our productivity efforts are also paying off in capital activities. Roughly two-thirds of our capital spending this year goes to replacing and improving the infrastructure. A diligent focus on process improvement using lean principles has driven steady productivity gains. This stretches our capital dollars with the pay-off in lower, slower to miles. Fewer speed restrictions means better fluidity and service and reduced operating costs.

On the operating expense side, we set another best ever fuel efficiency rate in the third quarter, 2% better than the same quarter last year, saving about $20 million in fuel costs. We reduced our freight car lease expenses by about $4 million and also reduced overtime and guaranteed costs significantly. All of these productivity gains improve our agility in the uncertain economy. In fact, year-over-year, we were volume variable with our working resources. Gross spent miles were down 17% year-over-year, but we were able to reduce train start and our working recourses even more.

As you heard from Jack, volumes have improved from the April trough. Sequentially gross ton-miles actually increased by about 9% from the second quarter to third quarter. We put a few more resources back in to service, but these were tempered by permanent reductions from attrition, equipment retirements and lease returns.

The work we did over the last couple of years to efficiently handle volume across the network such as the unified plan, various inventory management systems and the operating income statements we installed in our field work units also helped us be more agile in sizing the network in the current environment. The best part of this story however is still in front of us when volumes increased further.

We see strong upside leverage in the operation as a result of long-term structural changes made in our network operations. For example, the Evergreen Process of the Unified Plan, which has created a room to grow in the existing train network without adding additional starts. Changing our locomotive utilization, including expanded use of distributed pair and developing better assigner practices to take greater advantage of technology. These structural changes also create room to grow in the existing train network and improve fuel efficiency.

We maintain search capacity to quickly handle changes in demand, thus creating resiliency and the strategic investments in our infrastructure over the last several years provide us with capacity to grow. The combination of these activities as well as many others, have enabled us to be volume variable and will give us good upside leverage as volumes return. With that, let me turn it over Rob.

Rob Knight

Thanks, Dennis and good morning. We'll start the review of the financial results so to look at our income statement summary. Third quarter operating revenue totaled $3.7 billion, 24% lower than 2008. The primary drivers were a 15% decrease in car loadings, as well as a $590 million reduction in fuel surcharges. Quarterly operating expenses declined 26% to $2.7 billion a 49% decrease in third quarter diesel fuel prices contributed to the lower expense.

In addition, UP's ongoing efforts to operate with a high degree of volume variability, while increasing organizational efficiency, helped to reduce quarterly cost. Lower third quarter operating revenue and expense combined to produce quarterly operating income of $967 million, a 20% reduction versus 2008. Third quarter freight revenue totaled $3.5 billion down 25% in 2008. Similar to operating revenue, lower volumes and reduced fuel surcharge revenue drove the decline.

In the chart on the left, the blue bars illustrate the year-over-year change in our rate based fuel surcharge program. Of course this program is only one of a number of fuel surcharge programs that the company uses, but it demonstrates the significant decrease in fuel surcharges between 2008 and 2009. The yellow bars illustrate the year-over-year change in average revenue per car. As diesel fuel prices and the related fuel surcharges declined, our customers benefited from lower freight bills. In fact, after seeing a 1% increase in first quarter average revenue per car, third quarter average revenue per car was 12% lower versus 2008.

The mix of our business was negative in the quarter by a couple of points. Over 60% of third quarter car loads were energy and intermodal shipments, groups with the lowest average revenue per car. This more than offset the impact of higher average revenue per car moves such as Ag products and chemicals.

As Jack discussed, third quarter core pricing totaled roughly 4% still strong, but reflective of the very difficult economic environment that we faced today, and given current pricing levels, we now expect full year core price to be closer to the 5% mark. Although clearly pressured by the economy, we remain firmly committed to pricing our business to improve returns which will be evident in our overall profitability.

Turning now to expenses, we'll start with compensation and benefits which totaled nearly $1 billion in the quarter and an 11% decline. During the quarter, Union Pacific continued to take actions to better align workforce levels with demand, through a combination of furloughs, attrition and management actions, third quarter employment levels were 11% lower than in 2008.

In fact, we've seen a sequential decrease in our workforce over the six quarters. In addition to our employment actions, greater overall labor productivity kept average compensation per employee pretty flat in the quarter. This is especially significant when you consider about 85% of our workforce received a 4.5% wage increase on July 1st. For the reminder of 2009, we will continue to manage workforce levels with demand.

Slide 23 shows the year-over-year impact of diesel fuel prices, volumes and fuel surcharges on the quarterly earnings. Third quarter fuel expense declined $669 million in the quarter or 59%. The biggest contributor was a follow-up in quarterly diesel fuel prices which went from $3.70 per gallon last year to a $1.87 per gallon in 2009, saving $442 million.

In addition, third quarter gross ton miles were off 17% year-over-year driving down consumption and saving a $180 million. The red and green bars on the slide demonstrate the quarterly impact from our fuel surcharge lag. As we discussed back in July, earnings in the first half of 2009 benefited roughly $0.40 per share. That earnings tailwind was created as diesel fuel prices declined and the associated fuel surcharge revenue lagged, the lower prices by roughly two months.

In the third quarter however, the relatively stable fuel price environment allowed our fuel surcharge programs to nearly match the price we were paying for fuel. As a result, the combined impact of fuel prices and the related surcharge lag was basically zero in the quarter. At current diesel fuel prices of around $2.05 per gallon, we would expect to lap a very favorable comparison in the fourth quarter. You recall last year's fourth quarter benefited from roughly $0.30 per share earnings tailwind associated with the fuel surcharge lag, and we clearly don’t expect to see a similar benefit this year.

Purchase, services and materials expense declined 16% in the third quarter to $403 million. Lower volumes and increased operating efficiency contributed to lower contract services expenses, reduced crew transportation lodging as well as fewer joint facility cost. We also used less locomotive and freight car materials in the quarter as we performed fewer repairs as a result of lower volumes and having portions of these fleet in storage. In addition, this expense line has a favorable year-over-year variance associated with last year’s hurricanes of about $11 million.

Turning to equipments and other rents. This expense category declined $36 million year-over-year or 11%. Reduced volumes, particularly for shipments of industrial products and intermodal containers reduced short-term car rents by about $14 million in the quarter.

Better asset utilization as well as fewer leased assets also contributed to the quarterly expense decline. In addition, locomotive lease expense declined as a result of restructuring certain locomotive leases from operating, to capital in the second quarter. This transaction reduced equipments and other rents expense by $22 million while increasing depreciation expense $15 million and interest expense $14 million.

Other expense totaled $179 million in the quarter, a decrease of $39 million or 18%. Reduced freight and property damages, employee travel and utilities expense all contributed to this decline. We also recorded less expense for bad debts in the quarter. An improved receivables collections rate and our ongoing efficiency focus helped drive expenses lower. Decreased property taxes offset a portion of this decline.

Turning now to slide 27, we look at our expense variability for the quarter. Union Pacific has taken action throughout 2009 to adjust our cost structure as business volumes have remained low. That work continued in the third quarter in the form of reduced work force levels, stored assets, greater operating productivity and a company wide focus on efficiency. If you normalize for the year-over-year change in diesel fuel prices, we achieved an expense variability rate in the third quarter in excess of 80%.

The organization responded very well to the challenging business environment, which positions us to bring volumes back onto the network in a cost efficient manner. In fact, we expect that we will add volumes to our network at higher margins when the business volumes rebound.

The final proof statement of our quarterly results can be seen in a record third quarter operating ratio of 73.7%. In the face of significant lower volumes, we achieved a 1.2 points of year-over-year improvement. Operating efficiency, focused cost reductions, lower fuel prices and pricing gains all contributed to quarterly progress.

Since 2006, the work of project operating ratio has helped us to take nearly 7.5 points off of our operating ratio despite seeing car loading declines of almost 19%. Taking a look at the full income statement, other income totaled $14 million in the third quarter, down $9 million versus 2008. Less rental and interest income as well as lower gains from real estate sales contributed to this decline.

Third quarter interest expense increased $26 million to $156 million. Higher year-over-year debt levels and a slightly higher effective interest rate drove the increased expense. Income tax expense was 24% lower in the quarter to $308 million. Lower pre-tax income was the primary driver of the decline offset somewhat by a lower effective tax rate last year. Our third quarter 2009 effective tax rate was 37.3%, 0.7 points above the 2008 rate. On a full year basis, we expect the effective tax rate to be close to 37%.

Third quarter net income totaled $517 million, a 26% decline or earnings of $1.02 per share. Slide 30 shows our quarter end cash position and all in debt level. We continue to maintain above average cash balances as warranted by the economic environment. Adjusted debt levels increased to $14.5 billion reflecting new debt issuance over the past year.

For the fourth quarter, our expectations continue to be driven by the economy. As Jack mentioned, the volume comparisons become increasingly favorable as we move towards the end of the year. In particular, we experienced a 10% decline in seven day car loadings between November and December last year. Although we don’t expect to see declines of that magnitude in 2009, weekly volumes will likely slow between Thanksgiving and New Year's.

We also face a good head wind from fuel in the fourth quarter. As I discussed earlier, the fuel surcharge lag contributed roughly $0.30 per share to quarterly earnings in 2008 adding significant pressure to year-over-year comparisons this year.

Regardless, we will stay focused on controlling the parts of the business within our control which will position us for strong upside and increasing returns when the economy dose improve.

With that, let me turn it back to Jim.

Jim Young

Thanks, Rob. As we close out to final months of 2009, we'd like to share our early thinking in what's ahead in 2010. We don’t expect a quick rebound in our position ourselves for slow recovery. Net environment remain dedicated to running our railroad efficiently as possible while providing customers with the strong service product. Excellent service creates market opportunities, attracts new customers and supports future pricing gains.

We're still developing our capital plan for 2010, but our spending level will be balanced between current low demand levels and our commitments to long-term strategic growth. Although we won't be taking any new locomotives next year, we will have the additional burden of implementing positive train control. The safety bill requires complete installation by year end 2015. So, we'll aggressively pursue meeting this deadline.

Looking beyond today's economic challenges, we believe UPs accelerated productivity efforts will drive significant upside leverage when volume start to improve enabling UP to deliver increasing financial returns and growing cash flow.

With that, let's open it up to your questions.

Question-and-Answer Session

Operator

Thank you. We'll now be conducting a question-and-answer session. (Operator Instructions). Our first question is coming from the line of Tom Wadewitz with JPMorgan Chase. Please proceed with your question sir.

Tom Wadewitz - JPMorgan Chase

Let's see, I wanted to get a sense of your operating leverage which you might see through expanded train size, assume you see some pickup in industrial volumes looking out in over a couple of quarters. So, I guess to get at that, can you give a sense of what your average train length is at the present time, setting aside, maybe coal and AG, but if you look in the schedule network, average train length and perhaps what you could get to giving sidings or other constraints if you see improvement in volumes?

Jim Young

Tom, that’s difficult question because the ability to absorb volume in the near term, it comes back to a function by corridor, by yard, by type of business. We are managing our train length pretty efficiently. We're running pretty decent sized trains right now. When you look at it, because again, if you look at the drop off in volume in the reduction in train start, you'll see we've done a pretty good job of matching that.

The real upside in my mind comes into the context of think about, we've got 1700 locomotives that are stored and we’re depreciating. So, if you see some of that increase volume, we won't see an incremental cost in terms of locomotive ownership. There is room in certain quarters in terms of absorption of train size, we do have our train crews that we're running, what we call a low mile strategy, which says that they've have got some opportunity to move up. But to put a specific number on it is pretty tough right now. I would tell you this. There is significant leverage as the volume comes back in terms of our ability to convert that into bottom-line income. Dennis if you want to add anything in that?

Dennis Duffy

No, to come across the board, whatever the train type is, we have room to go. And I will also just tell you this, our train length's on the intermodal side, the auto side and the manifest, other than the auto side and the manifest side are the largest they've been, but as Jim said, since we've added DPU to as you saw that two-thirds of our gross ton-miles, we have significant growth opportunities, never one of the train class categories.

Tom Wadewitz - JPMorgan Chase

Okay guys. That’s helpful. What my other question would be on with respect to coal and I apologize as I missed this in your prepared remarks, but can you give us a sense of the magnitude of stockpiles in your specific region and does that imply that kind of the negative case would be a step-down in volumes next year in coal or is it more realistic to say, hey you're running at a low rate and maybe the negative case for coal volumes next year is something that’s kind of flat with this year.

Jim Young

Jack?

Jack Koraleski

Tommy, you think about what could drive coal next year? There are so many variables including, is there going to be a cold winter or a hot, warm winter, hot summer. What's going to happen with the export markets, all of those things? I can tell you that our stockpile situation is relatively high, probably higher. There was a report out just recently that said on average somewhere in the neighborhood of 20% higher than a year ago. So, there is a significant coal stockpile out there, but there is a lot of conditions that would determine whether or not we are going to see down, flat or even potentially some up volumes next year.

Operator

Thank you. And our next question is from the line of Chris Ceraso with Credit Suisse Group. Please proceed with your question.

Allison Landry - Credit Suisse

This is Allison Landry in for Chris. I was wondering if you guys could give some color on what percentage of your contracts have been locked in for 2010.

Jim Young

Jack?

Jack Koraleski

Allison if you look right now, it's pretty difficult to say. We are in the process of renegotiating right now and looking at those contracts and it's just really too early to say what percent has been done or what happened. There is still a lot of things that are going to have to be decided here before we get to year end.

Allison Landry - Credit Suisse

Okay and then some of the other railroads have talking about maintaining our expectations of above rail inflation. Would you say that that’s true for you guys as well?

Jack Koraleski

Allison, I'm not going to give any specific guidance here other than I'll tell you, if you think about Union Pacific, we have the biggest book of legacy deals still in front of us and I do see positive upside in pricing.

Allison Landry - Credit Suisse

And then maybe just turning to fuel, seems like the gallons consumed are trending better or lower than the volume declines. Can you talk about maybe some fuel efficiency measures that you guys are gaining on?

Jack Koraleski

Duff?

Dennis Duffy

You bet Allison. We have a comprehensive fuel conservation program. Obviously our DPU program, where we're using the distributor power. We think that generates about 4% to 6% fuel savings versus conventional power configurations. We put in a fuel conservation speed where we use a maximum speed of 50 at the most efficient, fuel, frontal positions. Our powered axle, the way we distribute power we've been able to take advantage of our AC technology that’s lowered the number of units required by over a 100 and its generated some fuel conservation savings for us and then the last thing I'd mention is our fuel masters program which is our engineers,our operating cap engineers, practicing good operating practices and teaching others and there is a reward recognition program in there that’s been a significant contributor to our field conservation efforts.

So it’s a multi-facet approach.

Operator

The next question is coming from the line of Walter Spracklin of RBC Capital Markets. Please proceed with your questions.

Walter Spracklin - RBC Capital Markets

Just on the back on pricing, I noticed, you are indicating that quarter was 4% I know that’s down from where you would been up until recently and now you're guiding more towards the 5%. Just wanted to get a better sense. You mentioned that there is a mix effect in there and there is also the sort of general economic pressure. Is there anyway you can break out what's pushing that down. Is it the pressure you're getting from customers given the economic environment or was it more of the mix effect during that quarter?

Jim Young

Jack, can you take that?

Jack Koraleski

Although there is a number of things that impact the pricing in this quarter, we've said in the past that our legacy deals are not evenly distributed throughout the year nor are they even distributed evenly year-to-year. So we had a situation in the second half of '09 here where we have lapped some legacy renegotiations from last year. So, last year we had a very nice price increase as we stepped those rates up to market this year. Now from the rest of the year on it's been replaced by more normal escalations, that’s one factor.

Second factor for us is, I had a 4.5% increase in price in my international intermodal business that was completely offset by contract provisions in my legacy intermodal business that required price decreases. So, that was a fairly large head force.

And then the third factor I would say is the escalation contracts in the escalation vehicles themselves for instance. (Inaudible) was only up 2.5% in the quarter last year was up close to 5%. So, those are kind of the three swing factors that were out there.

Walter Spracklin - RBC Capital Markets

Second question is for Jim. Washington, still no word from them. Can you give us an update on, we had been hearing rumblings that a bill has surfaced that’s guys have had a look at, you might be alright with. Is there anything you can provide us understanding there is some confidentiality there, but any update you can provide us on what’s coming in Washington?

Jim Young

Well Walter, we're still waiting to see an actual bill or language. It’s about every other week. I would say this though. We've been in discussion with Chairman Rockefeller and Chairman (inaudible) for years in terms of our concerns, what's required in terms of ensuring that this industry can still afford to invest discussions and replacement cost. So, I am confident that they're listening because both members who have an influence want to see more business moving on railroads. So, we'll see what comes out. We'll get a chance to look at it and take it from there.

Walter Spracklin - RBC Capital Markets

Nothing on timing though?

Jim Young

There is a lot of issues going on in Washington today that I am not certain about new regulations on the rail road industry are a priority. Although, I am concerned and I have said this to members that uncertainty is a problem in our industry and we've got to have some certainty when we start thinking about long-term investment decisions. They realize that. So, but we've got a great story to tell as you know. We've made a lot of investment. You've got to be careful about using this any new regulations too far because investment will dry up and that's been our message to the members.

Operator

Our next question is coming from the line of Matt Troy of Citigroup. Please proceed with your question, sir.

Matt Troy - Citigroup

I was wondering if you could talk about Jack what you are hearing from customers. If I look at the fourth quarter, we really only have six weeks left. So you get the drop off in the Thanksgiving week, get the drop off in the last two weeks of December. First quarter is kind of starting to shape up to be a black hole. I am just wondering if you could talk about what you're hearing from customers in terms of their shipping intentions and capacity requirements beyond what is the end of this peak season which really didn’t materialize.

Jim Young

Jim, Matt, that’s kind of a mixed bag. So, I just kind of think for instance, I think coal is going to just going to stay where it is as I said in my remarks, its going to be down 10% from a year ago and we're going to get down to the contract minimums and things both with ourselves and also with the utilities. So, that's not going to go up.

The Ag world is going to be strong for us I think and the export market has taken out both soybeans and then once the corn harvest is completed, I think we'll see strength and that should take us into the first quarter easily and we should be pretty decent there.

Chemical run rate is about where it's going to be. Plastic is faring a little bit better because of exports. I think the fertilizer is going to be disappointing. I think that's going to be kind of seasonally appropriate from the levels that it is. We’ll see a downturn through the holidays, but then it will kind of show some uptick in the first quarter.

Intermodal, its going to follow a seasonal pattern although our domestic I think is going to outperform a year ago levels and both because of Hub but also because of (inaudible) new international alliance with Norfolk Southern and the (inaudible) service that we started up this year all of those things.

Automotive guys tell me they are expecting it to kind of stay strong here for a while. The inventory replenishment cycle, they are not going gangbusters in terms of overtime and everything else to fill the inventory levels back up. So, we talked to several of them recently and it sounds like through the first quarter we should be okay.

And that would leave the IP guys and I think construction season has for all intents and purposes shut down and I think the IP world is going to stay where it is. I think it's going to be a tough first quarter and the hope appears to be second quarter of 2010. They are hoping to see at least some minor rebound in the construction industry. The one exception might be steel, the steel capacity utilization now has crossed I think 62% with the most recent number I saw and if that were to continue, we could see a little bit of an uptick in our steel car loading and may be buck the more seasonal trend there.

Matt Troy - Citigroup

Thanks for that comprehensive answer. I would take those comments and then just ask Dennis, in terms of operations if we do see that seasonal sequential decline from mid December into January. Is it reasonable to assume you'll be taking actions either on the headcount front or from just the network productivity perspective to be able to scale back for a reduced traffic levels with that normal seasonality. What are the one or two levers you can pull in the near-term for 1Q?

Dennis Duffy

Yeah, absolutely Matt we would do that and we have been doing that. I think you saw that demonstrated here in our numbers this quarter. While the first things we do is obviously going and adjust our unified plan and we've been doing that on a daily, weekly, monthly basis, commensurate with the demand, that will adjust our train starts and the other one that you heard was the initial question series about train size. We've been consistently taking up train size and then we'd adjust obviously our yard operations which we have been driving more towards our more efficient yards, downsizing and or shutting down our smaller yards. So those are just three classic things that we'd start with immediately and those are on an ongoing process for us.

Operator

Our next question is from the line of Randy Cousins with BMO Capital Markets. Please proceed with your question sir.

Randy Cousins - BMO Capital Markets

Jim you talked about accelerating productivity efforts and your ability to accelerate productivity efforts. If we have a sort of half speed or say, volume recovery that's on the weaker side of the equation, how much of an opportunity is there to take additional costs out of the system or have we taken the cost structure down to as good as we're going to get. Is there another point of OR that can come out just by running the rail road better?

Jim Young

Well I will give you the number in terms of the OR, you know the biggest challenge we have right now, we're all struggling with right now is when you pick that point of the uptick and our assumption here the next year or so is we're not going to see anything significant. Many of the issues Rob mentioned our project OR initiative we've had underway for really a couple of years right now. There are short-term, there are kind of mid-term and long-term types of opportunities that have come out of that. So, we're going to continue to be aggressive on our efficiency in this environment and on the other hand we have to be prepared for when this thing picks up. So, I expect us to continue to show good cost performance.

Randy Cousins - BMO Capital Markets

So is that a case of sort of offsetting inflation or is the situation where you can actually do better than just in system inflation?

Jim Young

If you work for me, your minimum target is offsetting inflation. Now I think there are cases we've done better when we look at it. You have to be smart about. Listen, the other caveat here we have to be careful on is, we're not going to jeopardize service, it is so important for us right now with our service metrics. We have customers that have not considered rail before that are starting to look at rail. Customers are seeing that value proposition that helps in the pricing initiatives that we take a look at. So, there's a whole spectrum of things we look at and consider but again, it doesn’t end in one year, and it's going to be a tough year next year in volume and we're going to respond with our efficiency.

Randy Cousins - BMO Capital Markets

Jack, I wonder if you could comment on the growth in the domestic business, ex-Hub. So, we know you got the Hub business, but are you getting growth quarter-to-quarter in your domestic business or from Q2 to Q3 taking out the Hub factor in terms of the numbers?

Jack Koraleski

Randy I would say in a down economy our domestic business without Hub would be flat to may be slightly up with a variety of things happening within that mix and Hub pushes us over the top in terms of growth.

Randy Cousins - BMO Capital Markets

And then just to sneak in, could you comment on the pricing in your intermodal business? Are you still seeing pressure on the price front, from the trucking competition, particularly in the domestic front?

Jack Koraleski

On the domestic front, my bigger issue is my legacy contract.

Operator

The next question is from the line of Bill Greene with Morgan Stanley. Please proceed with your question.

Bill Greene - Morgan Stanley

I just wanted to follow-up on a couple of the comments. Jack you mentioned that it was too soon to talk about what's reprised for 2010. I think last year this time you'd mentioned that at the start of the year for 2009, you expected roughly 70% of the business kind of locked in on price. Will there be any reason it'd be different this year, when we look at 2010?

Jack Koraleski

Yeah, this is a much different economic scenario than where we were last year. Even at this last year, we still hadn't really realized the full extent of just how bad things were going to get. So, I think there is a lot more moving pieces. It’s a lot more difficult economic scenario and it could turn out to be the same, I'm just not prepared to say that yet.

Bill Greene - Morgan Stanley

And then Jim as you think about managing the volume rebound overtime and UP has done a phenomenal job talking out costs to the downside, so you have not shown very much negative operating leverage. There's some skepticism that you can show positive operating leverage when volumes come back. Are you willing to sort of meter this in through price or something? Could we expect maybe lower than expected volume recovery, because you're only going to take volumes back at an incrementally higher margin or how do you think about that? Because I've got to believe that some of these costs are going to come back.

Jim Young

Well you clearly will have some comeback and the obvious one, feels about a 100% variable with volume when you look at it. Our first criteria when you look at it is, where does it fit on the reinvestability strength. That's your first test in terms of taking any business back and the second one; every group in this company has taken cost up.

Sometimes there is, you look at things when you have the kind of challenges we have, I've seen our team really put on the table some things in terms of accelerating cost reductions that you ask the question, is it absolutely mission critical and in the environment we’re in, its not, and we're going to be very, very cautious about adding cost in and as we move forward.

Obviously you're going to have some cost increase there, that’s clear, but we do have good leverage and many of the costs that have come out of here, at least as I see in the next two, three years are not coming back.

Bill Greene - Morgan Stanley

You mentioned the locomotives, not being able to leverage that. Does this mean we wouldn’t have to take any locomotives going forward, so we can actually see a reduction in gross CapEx too?

Jim Young

Well, I said in my comments that we will not take any new deliveries next year. We're sitting on I think around 1700 right now. So, we've got quite a bit of room in terms of taking volume before we're back in locomotive market.

Operator

Our next question is from the line of John (inaudible) with Robert W. Baird. Please proceed with your question sir.

Unidentified Analyst

On the coal side, is there any evidence that as you bump up into some of these minimum contract agreements with the lines and the utilities, any evidence that that’s taking away in any meaningful way from the first half, 2010 demand?

Jack Koraleski

I don’t see that John. This is Jack. I just don’t see that at the moment.

Unidentified Analyst

So, it's not a wide spread hitting up against the minimums?

Jack Koraleski

No. Well, although at the end of the day here with higher inventories clearly coal volumes in first half. I want to make sure I understand the question. You're going to have some pressure in the first half in coal simply because your inventories are high.

Unidentified Analyst

No. I understand that. I guess I'm just wondering are you bumping into your minimums widespread, which to me it would indicate that there is some additional weakness even above and beyond just the inventories stockpiles that may occur in the first half at 2010.

Jack Koraleski

No. I think we don’t see anything there. Nothing significant.

Unidentified Analyst

And then on the domestic intermodal side, you got to imagine that’s [inaudible] one of the more price aggressive of places just given what's happening on trucking world, but can you talk a little bit about when truck pricing turns, how you are positioned to benefit from that? And how quickly you can see the benefit from that?

Jack Koraleski

Yeah, there is a couple of perspectives there. You've got to show the service product first and you can have because, jumping back and forth between truck and intermodal. Customers don’t just do that routinely, we got a great service products in place, new offerings that we're putting in place. You have to ask the question on the impact of both demand and fuel. You've got fuel now, with over $80 a barrel that will start to come through the market. Obviously that should help us in the rail side because we are more fuel efficient.

I don’t know if you can say there is a magical point here. If anything, we probably have seen, if there is any ship going on, its just been the last, right now with what we're calling it a peak. There's been some pick up demand there, but I don’t think there is any magic number that tells you automatically start to see a swing.

Operator

The next question is from the line of Edward Wolfe of Wolfe Research. Please proceed with your question sir.

Unidentified Analyst

This is Scott (inaudible) for Ed. Quick one on pricing, can you just give a little color on the 4% pricing for the quarter. Can you give a sense on where you've started the quarter and where you finish if there was any difference in 4% throughout?

Dennis Duffy

Scott I hadn’t thought about it that way, but no. I don’t really see much difference between the beginning and the end of the quarter other than just the way the escalation played out in terms of formulas, but no real substantive change in activity, thought or strategy.

Unidentified Analyst

And as you look at 2010, for the legacy contracts that come up are they more front end or back end loaded for next year? And then just can you talk as you've got any big international intermodal contracts coming up next year?

Dennis Duffy

I have some in front and I have some mid-years and I don’t have any major international intermodals.

Unidentified Analyst

Just a little housekeeping now. For headcount, can you just give us some color on where you finished the quarter and then where we should see headcount going from here? I know it's down from second quarter to third quarter. Are you planning on keeping it flat into fourth or should it be up or down from here?

Jack Koraleski

Well a total number is down what 11% I believe till a year ago. We're taking a hard look. Keep in mind we're still experiencing attrition. Well the rate of attrition has slowed down a little bit. We'll still probably in total loose about 3000 or so, 2500 employees this year that leaves. So we're managing that. We have a pretty much a hiring freeze, other than a few pockets in the company. So, we're going to continue to manage it in terms of lining up as much as we can with volumes.

Unidentified Analyst

So fair to think headcounts not up from where we saw it in third quarter?

Jack Koraleski

That’s right.

Unidentified Analyst

And then just lastly, on the coal side, can you give an update on Colorado, Utah and when you're expecting those mines to come back and then just refresh us on when the contract losses in for PRB coal lapse?

Jack Koraleski

The contract lapses, this is Jack, Scott. Contract lapses will lapse January 1st and Colorado and Utah, I'd love to tell you, but I really don’t know. They are dealing with geology issues; they're dealing with coal quality issues. I have no way of knowing how that's going to fare next year. We've seen this happen before and then all of a sudden they hit a solid beam of coal productions very well and then they get back into problems. So, it's pretty hard for us to determine that.

Operator

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

Ken Hoexter - Bank Of America Merrill Lynch

Just a quick question on the intermodal legacy contract that you mentioned that was bringing down rates. Can you delve into that a little bit, I'm unfamiliar with why you have built in price reductions into the contract?

Jack Koraleski

They are legacy deals Ken.

Ken Hoexter - Bank Of America Merrill Lynch

How long is that contract? Okay forget it. Sorry about that, I get it now. And then excuse me on this contract, but still confused by the comment on why you can't talk about the percentage that's locked in for a year ahead. Wouldn’t the contracts be locked in today or next year already, a certain percentage of them or I just don’t understand how much could be in flux at this point?

Jack Koraleski

When you stop and you look at the contracts, there are some that are in place, there are some that have contract provisions that are still variable as to where the price is going to play itself out. Even in some of the contracts as we negotiate the escalation in terms will vary with respect to our cap for pay list and those kinds of things and they are all variable and so, its pretty difficult in this environment to give you any assurance that I have locked in 65% of my price in the market place because there are too many variables to let me tell you that and have you count on it.

Channel though, we got to be careful a little bit. The fact is though, pretty major book of our business is locked in, the contract base when you look at it. Tell me what’s the percent of our total book that’s contract?

Unidentified Company Representative

44% long term and about 30% one year deal.

Jack Koraleski

So again I would be careful coming away from here that there is a major shift in terms of the percent of our book that’s contract or not. We're still in some negotiations. We're not going to getting into details here. But there isn’t a major trend change from what we’ve seen in the past.

Ken Hoexter - Bank Of America Merrill Lynch

And Jim just to wrap up, you talked a bit about the regulatory picture earlier to one of the questions. I just want to understand, are you seeing any activity pick up right now, as health care seems to slow down? We just hear so many different things about the relative seeing something or something is coming, it's imminent. I just wanted to understand what your perspective is if you're hearing kind of chatter picking up at all or is it just slow and consistent?

Jim Young

I think its been consistent in terms of where we’re at. I don’t see healthcare as diminishing in terms of the focus in DC today. We're waiting to get a kind of first look here and everybody will see that. I would just be cautious about overreacting to anything that comes out.

Operator

The next question is from the line of Gary Chase with Barclays Capital. Please proceed with your question, sir.

Gary Chase - Barclays Capital

Jack, can I just ask you to clarify, I apologize, just on the legacy domestic business that’s our cap right? I mean that’s going to presumably change looking forward that’s just the temporary issue. Or is that a longer-term price reduction?

Jack Koraleski

Gary, there are other cap issues and there are other contract provisions that I am really not at liberty to talk about.

Gary Chase - Barclays Capital

When you think about the intermodal business, you look at what’s going on it. Is there a transloading phenomenon that’s affecting the domestic versus international mix just when you look at how the volumes are playing out versus what we’re seeing elsewhere?

Jack Koraleski

In the past it’s always been, here we kind of cycle back and forth here. You have a lot of international business that ocean carriers would like to transload into domestic boxes where movement into the U.S. so they can get their boxes back to the Far East. Then that kind of went away and now it's kind of cycling back again where we are doing some transloading on the west coast in to domestic boxes and just returning the empty international ones.

Gary Chase - Barclays Capital

Is there any way to get a read on how much impact that’s having or it's too hard to tell?

Jack Koraleski

That’s pretty tough to tell.

Gary Chase - Barclays Capital

Okay. And then I don’t know I guess for everybody, when you think about where that leverage point is, where the volume will really matter and have the biggest incremental impact. Is there a way to think about generically where that is? Which commodity grouping I would think intermodal? Is that a fair assessment?

Jack Koraleski

Gary I think it falls in the [future]. I am not sure if I understand your question but…

Gary Chase - Barclays Capital

If you think about the opportunity to add one incremental car to a train as opposed to…

Jack Koraleski

Well it's going to be your manifest network, it will be your intermodal network, auto is one, but you think about coal, you don’t add coal in car loads. You add coal in train starts. But even in areas or grain shovel, even in those areas, you still will have leverage. Again, my example is locomotives. We're depreciating the cost locomotives in the books not earned in a dollar revenue. So, it varies by group but each one clearly will show I think good leverage.

We need to get another question. You want to go in the back of the line or how you deal with it Gary?

Gary Chase - Barclays Capital

I'll let it go.

Operator

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

Justin Yagerman - Deutsche Bank

Wanted to get a sense, you talked a bit about fuel on the performance has been good, but as you bring back potentially locomotives hopefully as the economy improves, what's the MPG kind of impact to that and how much of an offset can you guys create with things like improving distributed power across your network and that kind of thing.

Dennis Duffy

Well Justin, we don’t expect to see a significant increase here. First of, we still have some of our more fuel efficient locomotive stored. So, in terms of if we have to bring locomotives back, they are not going to be at a degraded consumption rate at this point and we still think we've got room to grow on. I showed you that about two thirds of our gross ton-miles are in (NYSEARCA:DPU). We can still have incremental growth there. And we've got room to grow on our TPA, that's our new tons to power to actual that we’re allocating power with, and our fuel conservation speed and our fuel master. So, we expect the continuous improvement yet even if gross ton-miles do go up which as you saw here in the third quarter went up 9% 3Q versus 2Q and we still took a fuel utilization down 2%. So, we expect more of the same.

Justin Yagerman - Deutsche Bank

That's great to hear. And I know that you guys have mentioned, there were a couple of questions on what's going on in the domestic intermodal side and you do have a legacy contract there that at least one that is weighing on profitability in that piece. There has been a lot of talk in the market place about there being conversations around that contract. Can you at least give us some color as to whether or not you are in those conversations and if so, do you think that any kind of resolution if there is one brings things back towards more of a market rate on that piece of business?

Dennis Duffy

Justin, I'm not going to get into the details other than to tell you we are always in discussion with our good customers. So, more to come in that.

Justin Yagerman - Deutsche Bank

And then, any more color than what you guys already saying on PTC and the cost potentially, on the timing for any roll out there?

Dennis Duffy

No.

Justin Yagerman - Deutsche Bank

Okay. All right. Well, I appreciate the time gentlemen.

Operator

Ladies and gentlemen there are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Jim Young

Well, thanks everyone for joining us in the call. I hope you heard from our team here, we see nice opportunity next year and let's hope the economy starts to turn. We'll see you in about three months. Thank you.

Operator

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

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