Union Pacific Corporation (NYSE:UNP) Bernstein 36th Annual Strategic Decisions Conference May 27, 2020 9:00 AM ET
Lance Fritz – Chairman and Chief Executive Officer
Conference Call Participants
David Vernon – Bernstein Transportation Airline Analyst
Alright. Good morning everyone. My name is David Vernon. I’m Bernstein’s Transportation Airline Analyst. I would like to welcome you to our 36th Annual Strategic Decision Conference live from the shelter and place location of your choice. We are pleased to have Lance Fritz, Chairman, CEO of Union Pacific Corporation. After a 20-year career at the railroad, he is now in the CEO spot. He’s going to start us off with some early comments and then we’re going to go right into Q&A.
Before we begin, I’d like to first of all, thanks Lance and Union Pacific for making this happen. I’d also like to remind investors that they can at any time during the presentation, access the Pigeonhole link on the left of the screen to submit a question that we can try to work in with the conversation. And I would also ask you to take a look at the Procensus survey that’s available on the conference homepage to provide your thoughts on Union Pacific on the way out.
So with that, I will turn the mic over to Lance, who is going to join us from Omaha and will walk us through some prepared remarks and then we’ll get right into Q&A.
Perfect. Thank you very much, David. So let me talk you through just a couple of admonitions first. I’d like to remind everybody that I’ll be making some forward looking statements and those statements are going to be subject to risks and uncertainties. So, I’d ask you to please refer to the UP website and our SEC filings for additional information about our risk factors. While I don’t have a formal presentation go through today, I do want to call your attention to some updated pitch book that we have next to web link for this webcast. So I may refer to some of that material and if I do, I’ll try to bear that in mind that I’m referring back to it.
So before we jumped in, David, there’s just a few things I want to share. One is my sincere appreciation and just all for the work that Union Pacific’s women and men are doing right now to support the U.S. economy. You know, we are an essential industry. All of our shareholders understand that we support all aspects of the U.S. economy. Anything that has to do with global trade, if it has to do with industrial production or if it has to with consumers consuming things that’s all business that we move.
And the men and women of Union Pacific have been doing that service, all through this COVID pandemic. We’re doing great work with Beth Whited in our workforce resources team as well as Jim and Tom in the operations team to keep our employees healthy and safe. And in turn, they’re doing great job in practicing social distancing and great personal hygiene habits, and keeping both themselves and their workers safe at UP, and making sure that their families are safe and helping when they go home.
Just a quick recap of the first quarter, I want to remind everybody what those numbers look like. We had a decline in volume of about 7% of decline in revenue of about 3%, but we grew operating income by about 9% or 10%. We grew cash from operations about the same amount, and that’s on the backs of excellent productivity, reduced our operating expense about 10%.
We recorded earnings per share of $2.15 which was an 11% increase, and we delivered the best in industry quarterly operating ratio of 59.0. We’re very, very proud of those results, but what we’re most proud of is what those results indicate the future holds. Now, that’s a pretty difficult quarter when your volume is down 7%. But in that context, we were coming off of strong productivity in 2019, and we continue to deliver in the first quarter of 2020.
Now, once we started entering April of 2020, last month, volume really dropped off the map. We’re now something like 23% or 25% down in volume. That was hard to keep pace with through the month of April, but it looks like we’ve got our feedback under us again, and we’re doing just great work on the service product and on efficiency. If you looked at the first quarter, every KPI we talked through had improvement.
In the first quarter, we’ve seen that and it’s something to be very proud of in terms of moving both the service product and our efficiencies, at the same time. As we look into the second quarter, we continue to take some pretty significant actions to balance the resources in the business with what’s going on in the top line. I’ve mentioned the 25% down volume, that’s what we had talked about on the first quarter conference call. It’s what we anticipate for the second quarter.
To match that, we continued to make adjustments in our TE&Y in our mechanical and in our engineering workforces. We’ve also asked our managerial staff to take one unpaid week of leave of absence per month for the month of May, June, July and August; and we’ve also had every executive take a 25% salary cut for that same period, and our Board has matched that.
So, we’re trying to make sure that we’re doing the prudent things to maintain liquidity, but more importantly to match the team size with what’s going out in the marketplace. We’ve done a couple of other things. We temporarily shut down three very large shops, one in North Little Rock called Jenks, that’s mechanical shop, one in DeSoto, Missouri, a mechanical shop, and an engineering shop in Denver, Colorado. And those all will play through this quarter as well.
Our breakdown of our second quarter volumes, bulk down about 19%, that’s mostly driven by coal and reduced demand across frozen refrigerated, a little impact on beer, a little impact on feed and animal proteins, maybe we’ll get into that, some of the impacts that we’re seeing when it comes to beef processing and pork processing. Grain was up about 8%. I think that’s early returns on China, getting back into the market for export grain, which is very welcoming in terms of the Phase 1 China deal.
Hopefully we get into a little bit of that. Industrial production or industrial group was down about 16%. That had a lot to do with low crude oil prices and all the knock-on impacts of that. And intermodal down about 30% and that has to do mostly with both international and domestic and automotive. So, that gives you a little sense for what’s going on in the second quarter.
Our outlook again is for 25% down. We said it’s going to make improving the operating ratio for the quarter difficult. For the year, we said we still anticipate getting priced above inflation dollars. We said we anticipate getting $400 million to $500 million of productivity, that’s after, what was the number $590 million or a high $500 million number in 2019.
We said, we’re going to get solid free cash flow after dividends, after capital, and we’re trimming capital about $150 million to $200 million, that’s from the number that we talked about when we entered the year. And we also suspended our dividend share — or excuse me, our share repurchase program, and we’ve maintained our dividend, and we anticipate giving all the scenarios that we’ve worked through continuing to maintain the dividend.
I want to end these comments with our first priority that’s safety. We’ve made some progress in the first quarter on safety. We’re continuing to see that progress as we move through the second quarter. If we’re going to be the best railroad in North America, we have to be the safest. I’m pleased with the progress we’ve made. I see much more work to be done as we continue to work on safety.
So with that, David, let’s open it back up to you for Q&A.
Q – David Vernon
All right, so, thanks for that introduction. As you think about the steps you’ve been taking to mitigate some of the volume declines and manage through the earnings resiliency. I appreciate the shop closures in the train yard reduction. How should we be thinking about the fixed costs impact, right? The maintenance of the actual network itself, some of the back office and dispatching, operations is running fewer trains. Should we be expecting some amount of deleveraging from that, given the magnitude of bond revise we’re seeing right now?
I’d say, when we look at our overall cost structure, I can say almost with some certainty. The one area the cost structure that’s virtually fixed, at least in any kind of near-term, medium-term is depreciation. After that, we have the ability to move every — most everything else. We’ve got a fixed asset base that generates that depreciation; but when you think about adjusting our cost structure for 25% down in volume, that’s matching our TE&Y to that and then some, which we’ve done.
Our train starts are down somewhere in the mid 30% range. We’re getting locomotive productivity. We’re matching our locomotive headcount to the fewer locomotives that we’ve got running. Our locomotive counts down by something like 40% year-over-year. We’ve got something like one-third fewer cars on the railroad, so the men and women maintaining cars is also down to match that kind of number and also to show a little bit more productivity than that.
It gets harder when you start talking about maintaining the railroad. Our engineering workforce both on the capital and the operating expense side is down. It’s not down in the same order of magnitude as you see in TE&Y and mechanical. And that’s because in order to have a safe, healthy, robust network, you do have to continue to maintain it and maintaining it at a high level.
So for instance, in our overall capital program this year, we’re going to spend somewhere in the neighborhood of I think we said 3.1 and a kicker. At the beginning of the year, we’ve talked about reducing that by $150 million to $200 million. Of that number, there’s something like 1.8, 1.9 that goes into maintaining the railroad. That maintenance number might be tweaked a little bit on the margin, probably doesn’t change that much. So, that kind of gives you a nutshell of the moving parts of our costs.
All right. And as you think about some of the actions you’ve taken to close mechanical shops and obviously the managerial sort of pay reductions, how much of that is temporary and would come back in a volume? Like if you think about the order of magnitude changes you made as cost structure, how much of that is temporary versus sort of something that we should expect to be ongoing? Are those yards closures going to be — or managed yard closures are those going to be extending beyond a volume recovery period? Or will those come back as locomotors come back.
I anticipate those three shops we talked about earlier, Jenks, DeSoto and the shop in Denver. Those are temporary actions. Now, the judgment call as to when they come back is going to be all about our confidence in our volumes and what the markets are doing. They also might not come back exactly, as they were constituted when we temporarily closed them. That’s going to be very much about volume as well.
So we can flex the workforce in those shops to match the requirements. When it comes to — you’ve mentioned yards, anything we’ve done in terms of designing the network, most of that I would consider permanent like our network yard enclosures, the hump closures, I consider those permanent at least semi-permanent. I consider some of the regional yard work that we’ve done, let’s say in Settegast that we’ve done a little bit in a couple of other places. Those are probably flexible, but for the time being until volume gets really robust, I don’t see a need to bring those back.
And then in terms of what we call RULA, required unpaid leave of absence. That’s the one week a month for four months, and the salary reduction on executives. I consider that temporary as well, but the decision for ending that we’ve announced it for a four month period. That won’t be laid until later call it in July or August, and that’s going to be very much predicated on what volume looks like and what the markets look like. And then what we do after that is predicated on our confidence as we look forward, nothing would please me more than to have those temporary activities and in quickly because we’re seeing going come back.
Okay. And I guess if you think about the productivity and the matching the train starts down with the lower volume levels. It feels like you guys are doing a fantastic job, lengthening train, spreading the volume over a smaller number of train starts. Now when you think about the utilization of that excess capacity on a train start that might have been created, now you’re running at a very high level of utilization. How should we be thinking about the leverage on the upside? Right, if volume does start to come back, will there be that same ability to grow costs at a lower rate? Or will there be potentially some friction as volume doesn’t grow and full train start sort of quantities? How do you think about the incremental leverage on future volume?
We feel very good about the leverage we’re going to experience when volume starts showing back up. You’ve mentioned trade size, so we exited the first quarter. I want to say, our train size average was in the neighborhood of 8,400 feet. That’s continued to grow in April, and we’re going to continue to try to grow it, forward May through the end of the year. When you think about it in that perspective, it’s pretty incredible that we not just maintain, but continue to make progress, even as volumes declined dramatically.
So, what that tells me is, we’re running the network in a way where we can both do an excellent service product, do what we’ve told our customers we would do and do it reliably and consistently. The 90% train plan compliance for the intermodal products and an 80% ballpark for our manifest in automotive and at the same time grow size. And to your point, as volume comes back, because we still see opportunity to grow strength train size, I think we can bring that volume right back into the network. Now, train starts might go up, which I would love to see if it’s required by volume, but I think we can still do that in the context of train size.
And are there any physical limitations within the network on train size? And will that require ongoing expansion of sidings work, things like that? I know you guys have double tracked the sunset quarter. There are certain areas in the network that are in very good shape from a train size perspective, but are there other constraints in the network that you see in the next sort of three to five years that would limit your train size at any level or?
Yes, there are — David, there’s some natural train size limitations, depending on what route you’re talking about. But in all of our most utilized routes, most of them are double track or more; and where we have single track, we have a really targeted effort to increase siding lines and increase the number of siding to be able to continue to enable larger train lengths.
Those areas are mostly between El Paso, Chicago, El Paso, Dallas and Treeport or Memphis and El Paso and Houston and New Orleans. Those three routes we’ve got a game plan this year. We carved it out when we talked about capital early on the year for citing lights and setting extensions and of call it, almost four dozen planned. We’ve got about seven or eight already accomplished. So we’re at a hell of a pace and normally you’re for us might be 10 or a dozen of those a year.
Okay. Maybe talking a little bit about the top line and the commercial opportunities, as you think about the economy slowly moving out of crisis mode and back into what we think might actually be comfortable in recessionary levels of demand relative to where we are today, how are you, where are you most optimistic about the growth outlook in the next 12 to 24 months? Obviously, the economy is going to recover at some point, but if you think about the next step you’re expecting to come into the network, where what we love to like more optimistic for the stock?
Yes, David. So let me go back to the highest level of how you can think about what makes a railroad tick on the top line train, industrial production and consumers buying things. So, let’s start with trade. I think there’s some reason for optimism there. If we allow the China Phase 1 trade deal to mature. China has made all the right comments about wanting to fulfill their obligations.
Of course, it’s a difficult environment to do that in, but they are back in the market for American soybeans, wheat. And so those are good signs. So I think in the trade side, that’s going to have a ton of pressure against it as global economies are in recession, and it will be very dependent on how quickly they can come out of recession after having burdened themselves with quite a bit of debt.
But having said that, there’s a lot of cash sloshing around and so, we’ll have to see what trade does. In terms of industrial production, uh, in the United States, the United States and more broadly in North America is extremely well positioned to take advantage of whatever demand exists around the globe.
We need to see our own economy from up above. We also need to see economies around the globe for a month. I would say, there’s reason for some optimism domestically, and there’s also a potential tailwind. I know several of our customers have been thinking about. What are they going to do with their supply chains, and maybe not in total, but in part as a reaction to what they’ve experienced through COVID?
And you hear a lot about on-shoring and near-scoring, and I think there’s an opportunity for some of that to occur. Then when you think about the consumer, that’s the part that has me most puzzled, it will drive the other two, by the way. But consumers, they’re in a spectrum right now from can’t wait to get out of the house and do things, get back to normal, spend my money to — I’m really, really afraid for my personal health and I’m not going to get back out and active until I become confident that I’m safe and my family’s safe.
And I think consumers are all over in between those two goalposts. I think it’s very important what our communities do to help consumers feel safe and healthy and cared for. I think it’s very important what we as businesses do to help our employees and customers feel the same way, so that we can get back to consuming at a normal pace.
What will help us is automobile plants are starting to open up, that’s a point of optimism, that’s happening as we speak. There’s sign here and there that the housing market hasn’t completely cratered, and it’s always had room to run because of a weak recovery from the great recession. So, I think it’s a pretty balanced mix, David that I see in terms of headwinds and tailwinds.
Okay. And then one market you didn’t mention is coal. Obviously, structural declines and we don’t need to get into the drivers there. But I did want to check in with you real quickly, there is some perspective out there in the market that forward curve on natural gas is starting to pop-up a little bit with the decline associated to gas. Is there any — have you guys been able to identify like what percentages of decline in coal are as a result we just lower economic activity versus source competition? And is there a potential for that to maybe bounce back a little bit in ’21, ’22, as we kind of get back to a more normal level of economic activity?
That’s a great question, David, and we do not have a precise breakdown. We know for sure there’s been impact on both sides. Back in the day when I ran the coal business, now this is going back always. We always talked about the three-legged stool in energy consumption market, which is consumers, industrial and commercial things retail, restaurants, et cetera. And now used to break out about a third, a third and a third, maybe which with the weakest third, being the commercial piece.
Well, we all know commercials, really dried up here recently. So, I got to believe you can take about 20% plus of overall electricity demand and say, it’s exceptionally weak or gone for this short period of time. From a secular perspective, there’s nothing that I see that says coal is going to somehow stop and reverse those secular trends. From a competitive fuel perspective, unlike you, I see reason to believe as rig count gets put under pressure and some of them domestic shale plays, the corollary gas production is also going to start to come under a little pressure.
I don’t think it gets $3 million or $4 million of BTU, but if it can just get back to $2 and $2.50 cents, it takes some of the heat off some of our energy producers.
So, then one last question on this whole issue of top-line, right, we have heard about — ancillary regionalization of supply chains and frankly the maturation for freight as big picture items out there and it’s very tantalizing to think of this idea that, oh, regionalize all these manufacturing operations, that we really get a kind of volume. How from your perspective, does the interplay between the loss of the trade component with the increase in the regional production activity components? Is that a net positive for the railroad industry in revenue firms, I’m mix terms and I imagine you’re swapping intermodal traffic, like how do you think about that? If this does actually play out in the next sort of 5 to 10 years, what’s the net benefit?
So, when I think about near-shoring and on-shoring, for me, it starts with, that creates an opportunity for our commercial team to get facilities landed on Union Pacific franchise, right? So job one is, if we can have a rail serve location where UP serves it, that’s a fantastic situation because now we can compete for inbound and outbound. If it lands in the United States, that can be pretty good. We depending on where it is, we can compete for inbound and outbound.
If it lands in Mexico or Canada, it gets a little more tenuous but you can still kind of compete depending on how the overall book of business looks. It’s hard to say whether that’s winning or losing versus having it land at a port. You know, the West Coast ports handle a fair amount of volume, maybe 60% plus 63% of overall U.S. imports, but that doesn’t mean necessarily that Union Pacific automatically gets a share of that business.
We have to compete with transloading to truck. We have to compete with alternative rail carriers. We have to compete with alternative ports. Our favorites are the Port of Long Beach LA go up to Seattle, Tacoma, maybe Benicia, maybe Hueneme, but there’s many more all along the Eastern seaboard. We like it when it hits the Gulf Coast.
We like it more when it hits the West Coast. We don’t like it when it hits the Canadian West Coast. So it’s very dependent on the specific circumstance. What I like, is when a customer starts talking about near-shoring off-shoring, we have an opportunity to be in the mix, and where that facility is going to go make it competitive, and try to secure inbound and outbound.
And that net revenue opportunity for the rail industry is a little higher for localized manufacturer than just import?
For the entire industry, it probably is.
Okay. Now, I wanted to talk a little bit about the issue of service levels and the growth dividend that might come from the implementation of PSR. This is something that’s talked about with investors quite a bit. How do we think about that latent share potential that’s out there for Union Pacific? As a result of the fact that maybe you are running a more fluid network with a little bit more consistent levels of service. I forget about the grades of service, but as we think about consistency and on time. How do we think about that latent share potential? Have you guys tried to kind of dimension what that would look like for you in the next three or five years?
Yes, we do look at that and we look at it in two context. One is highway conversion of truck to railroad in the intermodal product — domestic intermodal, and boxcar and carload. I wouldn’t forget that there’s a fair amount of our carload business that’s truck competitive. And with unreliable or inconsistent carload service product in history, some amount of that truck competitive market went away from us.
So we see opportunity there, and it shows up in things like specialty grain, it shows up in food. It shows up in some manufactured product, it shows up along the Maquiladoras in the Northern tier of Mexico. And we are seeing wins there. I mean, right now we’re just being overwhelmed by the lockdown of the U.S. economy and global economies. But even in that context our commercial teams doing awesome work, securing singles and doubles in the carload world.
In the domestic intermodal world, it’s all about having that 90%-ish plus minus trip planning compliance consistency on all the number of lanes that we serve, which is the most competitive profile in the industry. And then finding the sweet spot with customers that value that and we’ve been having some success there as well. Right now, most of that success is in parcel. If you think about e-commerce and what’s going on is, as consumers are locked down.
Ecommerce is very, very strong and that tends to drive parcel and we’re seeing pretty good strength in the parcel world. At the same time, we’re seeing opportunity to put domestic intermodal ramps in locations around the network where they didn’t use the fit, if we were trying to fill a complete train of boxes.
In today’s world, we’ll take a ride from Southern California to Council Bluffs on a intermodal train, there’s plenty of traffic to hitch a ride there, and then take those wells put them in a manifest service product to get them to Butler, Iowa for Northeast Iowa intermodal ramp that we’ve done in partnership with Valor Victoria in a short line and that’s looking to be a really strong product and we’re going to try to find other places to do that in the network as well.
So, as you think about that, that intermodal business in particular, right the last couple years, there’s been a bit of a rollercoaster ride 2018, 2019 as the volume was through the roof. The last two years, you have been seeing some share loss despite the higher and working — the higher service level, the better consistency, all that kind of stuff. How do we think about the drivers of that share loss? And what can you do to turn the tide on that and maybe reclaim some of that share of the intermodal competitive business?
It’s a great question. When I think about any market that we serve, there’s always a couple of dynamics in play. One is to your point, which is the market is going to present to you as the book of opportunity. Right now the book of opportunity in trucking has been retarded a bit for railroads in intermodal because trucks are losing capacity. They’re aggressive on pricing, their prime — one of their primary costs and fuel is down pretty dramatically. So, there is a pretty tough environment to compete in the truck conversion world.
And having said that, that market is so huge that there’s always opportunity there, then the second way I look at that is exactly from that perspective, given what the market presents to you, how effective are you at competing for it. The thing that PSR has done for us as, one has fundamentally shifted our cost structure, so that things that didn’t look attractive to us in 2018 or 2017, can look attractive to us now and generate a nice margin.
And two is with our service product the way it is, we can take on test loads intermodal and prove out the product and gain confidence of the shippers and beneficial cargo owners. We’re doing all of the above and again, it’s largely being crowded out by the impact of COVID. But when the impact of COVID tones down and starts abating and going away. I have lots of confidence in our ability to get a growth dividend from what we’ve done with the network.
So, you feel like the share you should have for the quality of service is going to be greater than it would have been sort of pre crisis at a given level across all people?
I think that’s fair.
All right. So, thinking a little bit about, sort of your priorities as a management team and as a Board of Directors. As you think about the world post on pandemics. How do your priorities shift a little bit as you think about cutting costs levels of investment? We talked a little bit before we started around, sort of work from home types of things, how are the priorities for us to the shifting in the post pandemic world as you as you start thinking about the world after this crisis?
So, there’s one set of priorities that don’t shift at all and that is, if you think about our overarching strategy. It can be boiled down to as simply as this, operational excellence which is execute the business product that you’ve got right now well. Grow, which is use that excellent service product, that new cost structure to be able to find business that fits the network well, generates attractive margins and bring it onto the network.
And then there’s a final piece which is looking into the future and that’s transform what service products we’re providing as a supply chain participant. When I think across that spectrum, those first two buckets, that’s like motherhood and Apple pie to us, that’s waking up every morning, breathing oxygen and getting after it as union Pacific being the best freight railroad in North America.
That last piece is about the future and promise and we’re seeing, COVID is probably impacted some of our serve markets, some supply chains in ways that might be permanent. We talked a little bit about near shoring on shoring. Clearly as people are working from home more, we’re seeing more pressure in e-commerce and that’s probably going to accelerate a few of those trends.
And we’re seeing because of disruption in supply chain, really strong demand for a supply chain tools that provide clarity from source to use, and make it simple, easy, real time. We look at that and call that customer experience. The customer thinks, well, that’s my supply chain and I just want it to be one stop shop. I want it to be simple, easy, and I want it to be repeatable. So all of that probably will impact what we’re doing as we look forward.
Okay. And I want to talk a little bit about Unified Plan 2020, right. You were the CEO of the railroad in the pre-PSR world, CLO anyway and involved with a railroad sort of before PSR and after PSR. Can you talk a little bit about for a generalist portfolio manager? It doesn’t understand the business, but how do you think about what this whole PSR Unified Plan thing is as — in relation to what is the way you used to operate? And maybe also comment a little bit on, why it took so long to want to adopt this operating model, which has all these tremendous efforts?
It’s a great question, David, and I’ll own it. I owned, let’s see the Northern region and the Southern region in the late 2000s, and then I owned the railroad, as EVPO for about four or five years in the early 2010 before becoming CEO. And in that timeframe, we were definitely running the railroad in a fundamentally different way. We really cared about train velocity. We used all of the assets at our disposal.
We had 14 network yards. We used use them all. We were not afraid to stop a train, break down a train. We thought it was a benefit to us to have lots of different services, lots of different unique commodity trains running in the name of customer service. And I’ll drag everybody backwards. I’ll remind you, when we were in the first part of the 2010, we were right up there with any rabbit in the industry in terms of improving operating ratio or being an excellent margin generator.
Fast forward that to about ’16, ’17 and the early part of ’18, and in my new role as CEO, I was growing frustrated with our performance. We had plateaued at about a 63 operating ratio, something like that. We hung in there for about three years and what I was seeing in the field was, regardless of the best team on the field, working their asses off, giving everything they got, our results were fragile.
Some days they were excellent, some days they were mediocre. And I came to the conclusion that it was a planning problem, and here’s the fundamental difference between plans. It’s very simple. We went from focus very much on the train and shifted that focus to the car. So, we shifted focus to moving cars all the time, not letting them dwell, don’t switch a car if you didn’t have to, break down all of those unique commodity trains and try to run as many mixed manifest trains as we could, that gave cars rides earlier and deeper into the network, so they wouldn’t dwell.
And so, the outcome of that is our car dwell in yards is down dramatically, and that’s because of T-plan and philosophy. Our freight car velocity is up dramatically, that’s because we focused on it. Our locomotive utilization is up dramatically, that’s because we’re not running as many boutique trains, which inherently across the board retarded our train size. Train sizes up dramatically, which is pure productivity, and that’s because we’ve mixed the manifest traffic and are tacking on all kinds of different cars onto an intermodal train or intermodal wells onto a grain train or the automotive network has been really absorbed into a mixed network.
So, all those things over the course of, call it, two years, we’re approaching two years in August, 2020, have just fundamentally changed how the railroad operates and it’s the next step in making a safer, more reliable, more efficient and relevant.
And as you think about the experience with Unified Plan and making the shift away from that custom bespoke sort of set of train services towards a more productive set of services, how is that affecting your thinking about longer-term margin targets? Are you still sort of thinking 55 is the limit? Or is that even better than that based on this new operating model?
Yes, I wouldn’t talk to 55 is the limit, for us it’s a target. Based on our performance in the first quarter of this year at 59, and what typically is one of the hardest quarters to generate margin. We feel confident that’s still an appropriate target. Clearly, COVID has thrown us off our game, right. I mean, we’re doing yeoman’s work, Jim and Tom, Eric Gehringer and the team are doing great work at matching our activity against volume and win some and continuing to generate productivity. It just gets really hard when you start saying 23% and 25% declines in volume.
Good news is that’s not going to last forever, and when that volume comes back, I think that first quarter shows us what the promise could be as we look out. Now you’ve got to be really crystal clear as well, 55 as a target. We haven’t put a date on it. We also know the end game winning long-term value creation is about increasing cash flow generation, which comes from increasing operating income. So, that’s where our crystal clear focus is and we think we need to get that both with top-line with productivity, and with price.
And I guess as you think about that, that margin level versus growth, right? I mean, I’d imagine that there are parts of the railroad that are running it at 50 today. If you wanted to hide off some of the less contributory that in particular you could probably strangle in or that’s better than you are today at a smaller base. As you and the team are thinking about that, that rate of revenue growth versus the rate of margin. How do you balance the tension between those two because obviously, you could be a bigger railroad and a 62 than you would be a 58? And how do you think about — how do you think about that balance? And is there any sort of margin point where you start to say, you know what, it’d be better to have a little bit of growth here versus just pushing on the margin?
David, there might be that point at some point in the future. We don’t see it right now, for yet. And I would tell you, if we thought that — to your point, if we thought we could generate long-term, better cash, better operating income, and hence a greater value, enterprise value at a 62 operating ratio. We stopped talking about 55. We start talking about 62.
What we think we can do is we think there’s still room to continue to improve margin based on what we’ve seen and how we’re running the network right now. And at the same time, use that new cost basis and efficiency. And let’s not forget, first and foremost the service product, the reliability to grow the top-line. So in a short in a nutshell, we think we can get both right now.
Okay? Now as we think about the other ways to affects costs other than the operating plan? We were together never once together one of your prior Investor Days and we’re talking about you were excited about rolling out of tablets into the field operations. And I think it was like 2015 or 2016 at the time, which didn’t sound particularly revolutionary. We’ll go through it a little bit. But as you think about the runway for technology to actually further improve the efficiency and drive further margin gain, where you see in terms of investing in these tools and technologies, whether it’s automated inspection tunnels or tracking section cars, or drones for tracking section and that kind of stuff? Could you give us a sense for kind of what you’re thinking about in terms of the next three to five years and putting capital to work beyond just changing the operating plan or at work or where you’re doing the work, but like — actually technology components of it?
Yes, David. Let me tell just a really brief story. I remember that conversation. And the nature of technology on a railroad when we’re huge deployed outdoor factory like us, that experimentation with tablets five years ago today is every single crew on the Union Pacific has essentially a handheld device that looks a lot like my Apple iPhone. It’s not an Apple product. And they record their work on that device.
They can in the time of COVID to keep social distancing. They can actually close up their shift on that and report to and from work. And it keeps our inventory more accurate for customers and records work more accurately. So it takes rework out of the office environment. That’s 100% implemented across the network. Not sure if we’re the only freight railroad that’s done that, but I know we’re in the lead there.
So, let me come back to overall technology and say, I’ll answer that question in the context of, there’s technology that we’ve got deployed from a platform perspective, technology in the field, and then technology and decision making. So let’s talk platform.
Net control is our rewrite of our overall enterprise system. It’s virtually done. We’re right now this year in testing phase. And will be in full implementation at the end of the year, going into next year. That’s designed on micro services architecture. It sounds like interesting words. It’s the same architecture that Facebook uses, that Netflix uses, and it’s very sophisticated.
The coolest thing about it is it enabled API’s, which are all the rage right now. And an API is ability for a customer to tap right into our network, our system, extract the data they need, manipulate it in the way they need it and put it to use. And we’ve set up I want to say we’re in the neighborhood of 15 API’s right now going to probably double that number this year. So, that’s a cool platform to start with. Its industry leading, nobody matches it in the rail industry and its industry leading in a lot of industries.
If you look at our CADx system, so that’s our new computer aided dispatch that is going to enable us to go have more effective needs passes on the railroad. That’s right in the process of implementation. So, those are platforms there’s many more. If you think about asset utilization and safety on the railroad, that’s things like you brought up drones, wayside detection and we use all those technologies deployed right now.
Then you go back over to decision making tools and that’s things like Tableau, Pros, Salesforce, things that help our team integrate with customers more readily, more easily make better decisions on price and bring that to both the bottom line and the top line. And we’ve done activity against every single one of those areas and it’s working across the board.
And then, one last question on sort of the capital envelope. Obviously, the CapEx numbers have been kind of working down a little bit, as you’re running more efficiently through locomotives, things like that. If we think about, what’s the right way to think about the level of capital spend you will need and whether or not we should be expecting you to have to kind of spend more to generate growth, right? Is there some algorithm there where if you were to expand the networking vehicle to drive additional growth or should we be thinking about it more as you’re going to respond to the capital plan based on what opportunities that are actually present?
David, in terms of the core railroad, I really don’t see a need for a lot different capital profile than what we’ve got right now. We’ve been guiding for some time to a 15% or less CapEx to revenue that we don’t plan capital from the top down. But every time we model out scenarios, it looks like that’s still an appropriate number. That doesn’t mean we don’t put growth capital into the railroad.
I just mentioned earlier in our conversation, you know, the neighborhood of four dozen siding or siding extensions, that are helping us get productivity and reinforced the excellent service product. There could be capital that we deploy in ways outside the railroad, as we’re thinking about supply chains and being more involved in supply chains in different ways, but it’s premature to talk about that right now.
Okay, we’re coming up to the end of our 15 minutes here. I did want to give a chance just to find out, first of all to say, thank you for joining us. It’s great to have you back at our conference and it’s always a pleasure to get a chance to talk to you a little bit. But I also want to just give you a few minutes to close us out and what kind of message you want to give to investors about. Why UNP is the right place to put their capital to work? What you can offer investors as a differentiated value proposition, anything you’d like to kind of close this out?
Absolutely, David, and thank you. First, I’ll start with a reflection of the value of us as an investment, is that we’re the most valuable transportation company in the world, publicly traded. The reasons for that are, we’ve got a franchise that’s second to none in a wonderful market to be competing in. We serve the Western two-thirds of the United States. They have wonderful growth opportunities in terms of population centers. It’s where a lot of activities happening.
We’ve got all the best border point, access to and from Mexico about 70% of Mexican rail business we enjoy and we compete aggressively to maintain that and grow it. We’ve got a wonderful network transportation model right now, that’s generating world-class industry class operating ratio, operating margins, and it’s got a lot of promise to do more so in the future. As COVID recovery occurs, we’re well positioned to take advantage of increased global trade, increased U.S. industrial productions, Mexican industrial production, and an increase in U.S. consumption of goods like housing, cars, whatever.
We’re also really well positioned to take advantage of U.S. MCA, which is just going into force on July 1st of this year. And we’re in a great position to benefit from the relationship that’s strained right now, but over a long period of time will always be critically important between the United States and China, and the United States and other critical trading partners. So, we’re a great investment. We’ve got tons of upside, and I would encourage you all to take a serious with us.
All right. Well, thank you very much, Lance, for joining us, and thank you to the Union Pacific team for helping us to pull this distributed conference off. We’re going to wrap it up. I would ask participants to please remember to take a look at that Procensus poll. That’ll give you some real time insight into how other investors are also thinking about the opportunity.
And with that, we will wrap it up and look forward to talking to you next time.
Thank you, David. We’ll see you.