Saturday, April 30, 2011

Big spending’s big payoff

Written by  William C. Vantuono, Editor

Prudent and persistent capital investment has positioned Union Pacific for a robust recovery. For a railroad the size of Union Pacific, planning and spending multibillion-dollar capital budgets is an exercise in prudence, precision, and vision.

UP's mastery of this strategy became clear when it emerged from the worst year of the worst recession in eight decades with a set of performance metrics, a level of customer satisfaction, and a balance sheet that can be summed up in one word: strength. Now, with recovery well under way, the immediate need may have let up, but investment in the future hasn't: This year's capital program remains at last year's high level of $2.5 billion.

Speaking with UP chief executive Jim Young, you understand that an unrelenting focus on the future is deeply embedded in this railroad's corporate culture. "We have to take a long-term perspective," says Young. "It would have been very easy to react to the recession and cut the heck out of capacity. The transportation crisis we have in this country in terms of infrastructure is real, and rail has to be part of the long-term solution. We've never stopped putting investment in the ground, and I really do believe that, when the economy fully recovers, our strategy is going to give us a good return."

One area where UP has really sparkled is customer satisfaction. The railroad's customer service index reached an all-time high in 2009, surpassing 2008's record high mark by five points. "If you go back to the past few years, we've focused on understanding our markets and customer needs, and then delivering on that commitment," says Young. "In the recession, the thing we've had to battle is the potential, in cutting costs, of having a negative impact on service. We absolutely did not have that happen. Here's an example: A great productivity enhancement in this industry has been running big trains. If you take that too far, you're holding customers' cars at a yard to build a big train, and you miss your service commitments. Our focus this past year with our operating team has been on productivity, but keeping the service at a high level. The other thing is, great service isn't rocket science. It adds value for the customer, and it allows us to ramp the value up in terms of pricing."

Indeed, new service offerings combined with other service enhancements allowed UP to achieve a 4.5% improvement in core pricing for 2009.

Though he believes the economy has a long way to go to a full recovery, Young has good reason to be optimistic. "Looking at our first-quarter numbers, we were pleasantly surprised that volume came in stronger than expected, but we were pretty conservative going into the year, because it was hard to see any good news," he says. "Agricultural products came in strong, but we may see that fall off a little bit. Automotive is a huge story. Our first-quarter volumes are up 56%, keeping in mind that a year ago, the auto industry was pretty much shut down. We have about 75% of the finished vehicle business west of the Mississippi, so we're feeling pretty good about that sector right now.

"Chemicals were up in the quarter, and that's going to be a function of how the economy is going. Energy (coal) was the only one of our groups that was down. Recall that last year, electricity demand was down in a very weak economy, there were very low natural gas prices, and there was a very mild summer. Those three combined to push coal down, and we went into the winter with very high coal inventories at utilities. The wildcards with coal this year will be what kind of weather there will be this summer, and how strong the economy gets.

"Industrial products are the real test of the strength of our core economy. We saw some growth in that sector that we hadn't seen for over two years. Our intermodal business was up almost 21% in the first quarter, and that's split between international and domestic. International was up about 12%, and it has been a while since we've seen it move up. Domestic intermodal was up 35-40%, and there are several things driving that—consumer demand, some of the legacy contracts—but we've done a good job putting some great new service products into the market, and taking business off the highway. It's really paid off for us. We know that truck capacity has shrunk, and that's got to create good potential for intermodal business."

UP is starting to place stored assets back into service and recall furloughed employees. At the recession's peak, in June 2009, there were 71,000 freight cars and 2,100 locomotives stored, and 5,300 employees furloughed. As of late April there were 38,000 cars and 1,330 locomotives stored, and 2,800 employees furloughed. "We had almost $6 billion in assets not generating a dollar of revenue," Young recalls. "We're not in a real strong hiring mode right now, even though we expect to lose about 3,000 employees through attrition. On top of recalling furloughed employees, we're starting to hire at a few locations, and we're offering transfers to some of our employees. But we have a long way to go."

Continued investment in plant and equipment is key to capturing growth, but an increasingly large chunk of UP's capex budget will be allocated to meeting the industry's 2015 Positive Train Control mandate. UP's projected investment in PTC is staggering—$1.4 billion—"and then there's a pretty substantial ongoing cost to maintain it," says Young. "You can look at it any way you want, but the fact of the matter is, it's going to put pressure on capital. We will make some tradeoffs, in terms of maybe deferring some capital projects down the road. It all adds up and comes out of the same bucket. There's nothing free about PTC. We have a mandate here, and I'm very concerned about the success of the technology. If we're not careful, it's going to cost us capacity. The FRA did two studies. The latest one says for every $20 I invest I save $1. That doesn't even come close to passing any test on cost benefits."

Nevertheless, UP is committed to PTC. "We're going to spend $200 million this year, and that will go up substantially next year," says Young. "But I'm very concerned that we're going down a road that will cost this industry billions and that has very few benefits. In reality, PTC will raise the cost of doing business with the railroad, and our customers are going to bear the cost of this investment. That might mean we're going to end up with more product moving on the highways. We all know that the safest way to move product is on the railroads. Every member of Congress I've talked to wants more business shifted off the highways onto the railroads, but quite honestly, it's tough to look at some of the policy questions coming out of Washington that support that view."

What capital projects may have to be cut back? "It all comes out of the same bucket, so every potential capital dollar is on the table," says Young. "We have several bottlenecks we're working on. The top-priority projects will continue, but when we get down into the lower tier where there's a much longer-term view, we may end up pushing projects off a year or two, and try to catch up later on. It really boils down to the math in this business, when you think about free cash flow and financial return. There's not a lot of room."

(For additional perspective on PTC, specifically, that of Assistant Vice President Transportation Systems Jeff Young, see p. 29.)

For return on invested capital, Union Pacific's typical hurdle is 20%. "However," says Young, "not all of this is math. At the end of the day, we're still making a bet on what we think volume growth will be five or 10 years out. For example, we're building a new intermodal facility in Joliet, Ill., that's going to be open this summer. It's a $400 million investment. We're making a long-term bet that the intermodal business is going to continue to grow. So we start with a 20% hurdle, but again, it's all a collection of assumptions for the future."

For programmed maintenance, this year will be a typically busy time for UP's track forces. Scheduled in the railroad's $1.6 billion budget (this is on top of engineering capex) is installation of 4.2 million ties, 800 miles of rail replacement, and 200 miles of ballast undercutting, most of that to mitigate coal dust fouling on the Powder River Basin routes. One benefit that came out of the recession is what UP calls "capital effectiveness," more work done with the same capital dollars through enhanced productivity. "We call this TCO—Total Cost of Ownership," says Vice President Engineering Dave Connell. "It focuses on identifying the theoretical capacity of a process, instead of our historical output. Our field and staff management work toward removing the controllable barriers to move closer to the theoretical output. This resulted in us being able to add more than 400,000 ties to last year's program. TCO is being implemented across all our capital maintenance processes. This may not sound as exciting as building things, but it allows us to leverage our capital dollars to build more or spend less, whichever is appropriate for a given project."

Another area where UP has extracted efficiency is Distributed Power. There are currently 2,755 road locomotives (33% of the fleet) equipped with GE Locotrol technology. "In 2009, approximately 65% of our train starts used DP," says General Manager Operating Practices Larry Breeden. "Our goal for 2010 is to use DP on approximately 70% of train starts."

Use of DP, says Breeden, has eliminated helper locomotives, and the extra infrastructure and time required to operate them, included cutting them in and out of a consist. DP has resulted in reduced in-train forces and less stress on track, improved acceleration and fuel efficiency, and reduced braking distances. "Over the past few years, we've seen a 45% drop in train separations resulting from drawbar failures," he says. "Improvements in brake application and release have brought braking distances to within 30% of that of an equivalent train equipped with electro-pneumatic brakes. We can now operate unit coal trains of up to 136 cars, with head-end and rear-end power."

Other efficiency-improving locomotive technologies currently under evaluation are New York Air Brake's LEADER, GE's Trip Optimizer, and Invensys's Fuel Optimizer.

UP has the largest fleet of new-technology switcher locomotives—gensets and battery hybrids—165 total. General Director Car and Locomotive Engineering Michael Iden, whom Breeden calls "the father of the genset," developed that technology with National Railway Equipment Co. 10 years ago.

The next technological challenge is meeting U.S. Environmental Protection Agency Tier III (2012) and Tier IV (2015) locomotive emissions standards. "Both standards will require some sort of exhaust gas after-treatment," says Iden. "This, plus onboard PTC equipment, introduces a whole new level of complexity that will further complicate locomotive maintenance and that could also reduce fuel efficiency. We're not sure at this point what effect after-treatment and PTC will have on locomotive reliability and utilization."

Undoubtedly, there is more passenger rail in Union Pacific's future. "We may at times be viewed as passenger-unfriendly, but often that's a misperception," says Young. "We of course have to protect freight, but we're very active on passenger rail projects. We've told the cities or agencies that want to add commuter or high speed rail that we want to work with them. We've developed models that help simulate how you mix freight and passenger. That really came out of the Chicago to St. Louis project, which was one of the high speed projects that got some really good funding from Washington. It will be built on UP right-of-way, and will be 110 mph (FRA Class 6). It's going to require a substantial investment to make it work, and that could be a model for how you approach these types of projects.

"The key is that we have to protect freight capacity. The freight system in this country is unique in the world. Sell off our freight capacity, and you wind up putting economic growth on the highway."