Union Pacific Corp (UNP) — Q3 2022 Earnings Call Transcript

Thank you, Rob, and good morning, and welcome to Union Pacific's third quarter earnings conference call. With me today in Omaha are Kenny Rocker, Executive Vice President of Marketing and Sales; Eric Gehringer, Executive Vice President of Operations; and Jennifer Hamann, our Chief Financial Officer. Before discussing results for the quarter, I want to thank our employees for their tireless efforts over the past several months to improve service levels. I'd also note the dedicated service of our craft professionals throughout the recent very lengthy labor negotiation. The new agreements based on the Presidential Emergency Board recommendations reward our employees for their hard work. And with roughly half of our unions ratifying agreements, we are looking forward to completing this process and moving forward. Now turning to our third quarter results. This morning, Union Pacific is reporting 2022 third quarter net income of $1.9 billion or $3.05 per share. These results include the impact of a $114 million charge for prior period estimates related to the new labor agreements. Excluding that charge, adjusted net income is $2 billion or $3.19 per share. This compares to third quarter 2021 results of $1.7 billion or $2.57 per share. Our adjusted third quarter operating ratio of 58.2% is 190 basis points higher than 2021. Costs related to higher inflation and ongoing network inefficiencies were offset by fuel surcharge revenue, volume growth, and strong core pricing gains to produce adjusted operating income growth of 13%. We made real progress during the quarter to increase network fluidity and better meet customer demand. And as you'll hear from the team, we're continuing to take steps in the fourth quarter to better meet that demand and drive costs from the network. While the year hasn't played out as originally planned, our volumes have outpaced our peers, demonstrating the growth mindset that we're instilling within our organization. So with that, let me turn it over to Kenny for an update on the business environment.

Thank you, Lance, and good morning. Third quarter volume was up 3% compared to a year ago as carloads increased across all three of our business segments. Although overall volume was up, we undoubtedly had left demand on the table as we continue to improve service across the network. Freight revenue was up 18% driven by higher fuel surcharges and strong pricing gains. Let's take a closer look at each of these business groups. Starting with Bulk, revenue for the quarter was up 16% compared to last year driven by a 14% increase in average revenue per car, reflecting higher fuel surcharges and solid core pricing gains. Volume was up 2% year-over-year. Coal and renewable carloads grew 5% year-over-year driven by continued favorable natural gas prices and two contract wins that started on January 1. Grain and grain products volume was up 3% with strong domestic feed grain and increased biofuel shipments for renewable diesel. Fertilizer carloads were down 7% year-over-year due to reduced shipments of export and domestically consumed potash. And lastly, food and refrigerated volume remained flat in the quarter. Moving on to Industrial, Industrial revenue was up 15% for the quarter driven by a 4% increase in volume and an 11% improvement in average revenue per car due to higher fuel surcharges and core pricing gains. Energy and specialized shipments were down 3% compared to 2021 driven by pure petroleum shipments primarily due to regulatory changes in the Mexico market. Volumes for forest products were down 2% year-over-year primarily driven by lower demand for corrugated boxes. This was partially offset by positive year-over-year lumber shipments. Industrial chemicals and plastic shipments were up 8% compared to 2021 due to new business wins, customer expansion, and market demand. Metals and minerals volumes continued to deliver robust year-over-year growth. Volume was up 7% compared to last year primarily driven by an increase in frac sand shipments, growth in construction materials, and metals business development. Turning to premium, revenue for the quarter was up 25% on a 3% increase in volume. Average revenue per car increased 21% due primarily to higher fuel surcharge revenue and core pricing gains. Automotive volume was up 19% driven by strengthening production and inventory replenishment. Finished vehicles increased by 33%, and auto parts increased by 11% against a softer comparison from last year. Intermodal volume was flat. Domestic intermodal was down 3% due to softening demand driven by a 16% decline in parcel shipments. However, international volume strengthened by 4% from ocean carriers shifting more freight to inland terminals. Now moving to our outlook for the rest of 2022. At a macro level, we will be closely watching our markets to see how inflation and interest rates will impact our overall volume. But here is where we sit today with our markets. Let's start out with our bulk commodities. We expect biofuel shipments for renewable diesel to continue to grow due to solid market demand and business development wins. For coal, we anticipate continued favorable natural gas prices to generate demand for both domestic and export shipments. However, the opportunity to capture demand is dependent on the available resources. And our outlook for grain is also dependent on our service recovery. But as we've mentioned before, we have a tough comparison in the fourth quarter as exports were strong last year. Moving on to Industrial. The forecast for industrial production is decelerating, and demand is softening in forest products. However, we expect construction to be a positive due to strong project demand in the south. And lastly, for premium, we are closely monitoring domestic intermodal demand as spot truck rates fall and inventories climb. We expect parcel and truckload demand to remain soft as consumer preferences have shifted more to experiences versus goods. We're also watching the international markets closely, but we expect to be positive in the fourth quarter due to easier comparisons. And we expect growth in Automotive to be driven by improving supply for parts and inventory replenishment. Overall, we still foresee a favorable demand environment for the fourth quarter. Crew availability continues to improve, which will help us capture more growth and support our business development wins as we head into 2023. With that, I'll turn it over to Eric to review our operational performance.

Thanks, Kenny, and good morning. Turning to Slide 9. Our year-to-date safety results are demonstrating meaningful and sustained improvement compared to 2021. Safety impacts every facet of our business: our employees, our customers, and our shareholders. While our safety management system is promoting the right culture, our #1 priority remains returning every employee home safely at the end of the day. Taking a look at our current network performance on Slide 10. Our operating metrics steadily improved through the third quarter, aided by improving crew availability from hiring initiatives, lower recrew rates, and improved crew utilization. Our hiring and training pipeline is strong. To date, we have graduated 890 employees and have an additional 518 currently in training, all expected to graduate by January of 2023. We have now hired 1,408 new transportation employees, exceeding our goal for the year. Freight car velocity is approaching 200 miles per day, up from its low in April. Even more encouraging, the improvement came while moving 10,000 more weekly carloads. By utilizing approximately 250 borrowed-out employees and adding new graduates to some of our challenged crew locations, we have been able to add more coal and grain sets back into the network. We also reduced our recrew rates from a peak of 11% in April to now around 7%. Exiting the third quarter, the network is in a more solid and fluid state than earlier in the year. Going forward, we are building upon these improved results to drive excess cost from the network. Now let's review our key performance metrics for the quarter, starting on Slide 11, which remained challenged when compared to 2021 even considering the relatively easy comparison from last year's wildfire and weather events. However, both freight car velocity and manifest and auto trip plan compliance strengthened sequentially from last quarter's results. Intermodal trip plan compliance was flat sequentially and remains impacted by persistent supply chain challenges, resulting in elevated chassis street times and container ramp to well. We continue to make progress at the West Coast ports as the number of stacked containers decline. Turning to Slide 12 to review our network efficiency metrics. During the third quarter, as performance improved, we were able to remove and stage locomotives across the network to improve overall fleet utilization. As a result, locomotive productivity did improve sequentially although remains below last year's metric. Entering the fourth quarter, as we continue to improve train speed and other measures, locomotive productivity will continue to strengthen as well. Third quarter workforce productivity was flat as both the labor force and car miles increased. Train length improved 1% compared to the third quarter 2021 as the team utilized longer trains to handle increasing volumes. We now anticipate completing an additional four sidings in 2022 on top of the 20 sidings in our original plan. This will bring the total sidings completed since 2019 to 80. These sidings are a key enabler of our ability to effectively use our resources and drive productivity. Wrapping up on Slide 13. I'm encouraged by the progress we've made, but our work is not yet done. Using our PSR principles, we will further improve our service product and build a more resilient network. Our trajectory to this point reflects the great team we have at Union Pacific, and my thanks goes out to everyone for their efforts and dedication. To finish 2022, we remain focused on further reducing excess inventory, safely improving operational efficiency, and using our crews and locomotives even more effectively. Ultimately, as is always the goal, we need to run the network and manage our assets in a more than volume-variable manner. To that point, we are storing excess international intermodal well cars as the expected levels of volume did not materialize while at the same time, to capture demand in other areas, we are bringing cars out of storage. Additionally, to support bulk demand, we will continue hiring programs and send additional borrowed-out employees to crew-challenged locations in our northern region. As we wrap up the year and I look forward, I am confident that the foundation we are building will provide a better service product for our customers. With that, I will turn it over to Jennifer to review our financial performance.

Thanks, Eric, and good morning. I'm going to start on Slide 15 with a walk down of our third quarter operating ratio and earnings per share. Our reported operating ratio of 59.9% and earnings per share of $3.05 includes a $114 million change in estimate related to the Presidential Emergency Board recommendation and subsequent ratified and tentative labor agreements. At a high level, the $114 million charge negatively impacted third quarter operating ratio by 170 basis points and reduced EPS by $0.14. For more granular information on the charge, please refer to the appendix slide at the back of the presentation deck. It's important to note, however, that while our general wage accruals weren't far off the PEB recommendation, we did not accrue for the $1,000 annual bonus payments. Core results in the quarter continue to reflect inflation and network inefficiencies as our operating ratio was unfavorably impacted 310 basis points but contributed $0.20 to EPS. Importantly, we did make sequential core improvement in our operating ratio of 40 basis points versus the second quarter. Decreasing fuel prices in the quarter and the roughly two-month lag in our fuel surcharge program favorably impacted our quarterly operating ratio by 70 basis points and added $0.37 to EPS. Finally, third quarter results also include the favorable comparison to last year's weather and wildfire events, which adds 50 basis points to OR and $0.05 to EPS. Looking now at our third quarter income statement on Slide 16, where we provide both reported and adjusted numbers that exclude the impact of the labor charge. Throughout my remarks, I will speak to the adjusted results. Operating revenue totaled $6.6 billion, up 18% versus 2021 on 3% year-over-year volume growth. As we have seen throughout the year, higher fuel prices are the primary contributor to higher operating expenses, which increased 22% to $3.8 billion. Excluding the impact of higher fuel prices, our expenses were up 10% in the quarter. Third quarter adjusted operating income totaled $2.7 billion, a 13% increase versus 2021. Other income increased $86 million driven by higher real estate income, including a $35 million gain on sale and pension benefit. Income tax expense increased 13% as a result of higher pretax income, partially offset by corporate income tax rate reductions in three of our operating states. As a result of those changes, we now expect our full year tax rate to be around 23%. Adjusted net income of $2 billion increased 18% versus 2021, and adjusted earnings per share was up 24% to $3.19. Operating revenue, operating income, net income, and earnings per share were all quarterly records. Looking more closely at third quarter freight revenue, Slide 17 provides a breakdown, which totaled $6.1 billion, up 18% versus 2021. Year-over-year volume gains, supported by our business development efforts and sequentially improving operational fluidity, increased freight revenue 325 basis points. Fuel surcharge revenue impacted revenue by 13 points, reflecting the impact of higher year-over-year diesel prices and the two-month lag in our recovery program. Total fuel surcharge revenue was $1.2 billion in the quarter. Strong pricing gains when combined with a slightly negative business mix drove 200 basis points of freight revenue growth. Lower petroleum shipments, combined with higher rock and auto part shipments, contributed to the negative mix. From a price standpoint, we have now lapped the positive benefit from coal contracts indexed to natural gas prices, so the year-over-year benefit is minimal. And as we experienced in the second quarter, network fluidity limited the upside for both price and mix. Setting these headwinds aside, we are confident that we will yield price dollars that exceed inflation dollars even with a higher inflationary hurdle than expected at the start of the year. Moving on to Slide 18, which provides a summary of our third quarter adjusted operating expenses where the primary driver again this quarter was fuel, up 71% on a 67% increase in fuel prices. While we saw fuel prices come down some in the quarter, our average quarterly fuel price was $3.96 per gallon, only $0.07 lower than the second quarter's average price. Our fuel consumption rate achieved an all-time quarterly record in the quarter, improving 1% versus 2021 as a result of productivity gains and a more fuel-efficient business mix. Looking closer at the other expense lines, adjusted compensation and benefits expense was up 12% versus 2021. This includes an additional $19 million related to this quarter's accrual for wage increases and annual bonus. Total third quarter workforce levels increased 3%. Management, engineering, and mechanical workforces grew 3%, while train and engine crews were up 5% primarily reflecting year-over-year increases in our training pipeline. As you heard from Eric, we have now exceeded our 2022 hiring goals. Cost per employee came in higher than anticipated, up 8% primarily driven by wage inflation. We also experienced continued cost pressures related to network inefficiencies with higher overtime and borrow-out costs. For the fourth quarter, we expect the year-over-year increase to be around 7%, in line with tentative and ratified wage increases. Purchased services and materials expense remained elevated, up 23% driven by higher cost to maintain a larger active locomotive fleet, volume-related purchase transportation expense associated with our Loup subsidiary and inflation. Equipment and other rents decreased 1% driven by higher equity income that more than offset increased car hire expenses. Other expense grew 18% in the quarter, a bit higher than we anticipated as a result of increased casualty expenses associated with freight loss and damage and personal injury. For the fourth quarter, we expect other expense to be flat versus 2021 as we are anticipating the receipt of an insurance settlement for last year's bridge fire. Overall, inflation and cost inefficiencies offset the benefits of volume leverage and resulted in fuel-adjusted incremental margins of just 2%. Although not the results we know we can achieve, it still reflects positive progress from the second quarter and provides us with momentum as we wrap up 2022. Turning to Slide 19 and our cash flows. Cash from operations through the third quarter increased 9% to $7.1 billion. Our comparable cash flow conversion rate was 80%, and free cash flow totaled $2.1 billion. Although this is a decrease of $517 million versus 2021, it includes $745 million of increased cash capital spending and $317 million in higher dividends. With the increased capital spending to date, we now expect full year 2022 capital to be around $3.4 billion, up slightly from our prior guidance, but well within our overall guidance of less than 15% of revenue. Year-to-date, shareholders have received $7.9 billion through dividends and share repurchases. This level of cash returns demonstrates our firm commitment to rewarding shareholders with strong returns. Related to share repurchases, we now expect to buy back roughly $6.5 billion in 2022. Although we repurchased shares at a strong pace in the third quarter and expect that to continue for the remainder of the year, we have been impacted by higher-than-anticipated inflationary pressures and service costs. Lastly, we finished the third quarter with a comparable adjusted debt-to-EBITDA ratio of 2.8x as we continue to maintain a strong investment-grade credit rating. In fact, during the quarter, we received an upgrade from Moody's to A3, and we are now A-rated across all three credit agencies. Also during the quarter, we issued $1.9 billion in debt, which included $600 million of green bonds, our first such issuance. Wrapping up on Slide 20. With a little over two months left in the year, we are focused on building upon the positive momentum of the third quarter. The operating team is executing on its plan to improve operating performance and capture additional unmet customer demand. As you heard from Kenny, however, markets are softening a bit, and that is resulting in a slight reduction in our overall volume expectations, now more in the range of 3% growth for full year 2022. With more clarity on the impact from the new labor agreements, our operating ratio outlook also has changed. We now expect our reported full year operating ratio to be around 60%. As we close out 2022, attention is quickly turning to 2023. While we are not yet ready to share our outlook, it is important to reiterate our long-term view. Our focus on generating strong cash returns and improving ROIC remains unchanged, and we are firmly committed to achieving the goals established at our May 2021 Investor Day of a 55% operating ratio and incremental margins in the mid- to upper 60s. Since establishing those targets and even achieving them in a few quarters, the environment has changed with higher inflation and a weaker economic outlook. The road to achieving those milestones now is a bit longer, but our road map to success is still the same, supported by our great employees and the foundation of UP's strong and diverse franchise, we will leverage volume, pricing, and productivity to achieve those goals. With that, I'll turn it back to Lance.

Thank you, Jennifer. As you heard from Eric, our year-to-date safety metrics have shown good sustainable improvement, which is very encouraging. However, the most important metric is for all of our employees to go home safely every day. We remain relentless in pursuit of that ultimate and most important goal. On the sustainability front, during the quarter, we announced a $1 billion agreement with Wabtec to modernize 600 locomotives over the next three years. This is a key investment as we work to reduce our carbon footprint and meet our 2030 SBTI targets. This investment also supports what our customers need as each modernized locomotive is significantly more reliable. This is true game-changing for Union Pacific. As we close out 2022, we look to capitalize on the demand available to us as we sequentially improve operational efficiency. And although we're still putting together our 2023 plan, we like our positioning relative to the industry, considering our great customer wins like Schneider, expected strong coal demand, and a positive impact on our construction business associated with the infrastructure bill. I also want to reiterate Jennifer's point about our long-term view. We are committed to achieving a 55% operating ratio and mid- to high 60s incremental margins. These goals are achievable. And as we safely and efficiently improve operations, our customers, our employees, our communities, and our shareholders will all win together. With that, let's open up the line for your questions.

So I know you said it's still too early to talk more about 2023, but just given the importance of volume growth and visibility to that, Kenny, maybe I just wanted you to go through some of the areas you have a little bit more confidence and visibility at this point. And also, can you touch on the impact of the stronger dollar as it relates to the various end markets because it has been disruptive in the past for you? And then, Lance, any update on the negotiation process considering one of the unions rejected the contract, and I believe the National Rail Conference also rejected their counteroffer last night. An update on thoughts ahead and timing would be appreciated there.

Thanks, Brian. I'll start with a look at the labor negotiation, and then we'll turn it over to Kenny for talking about 2023 growth potential. So when we look at the overall negotiation, we've got on UP property five unions; on the industry, six unions that have ratified. That's about half the unions. We've got four that are out for ratification votes still, and then we've got the BMWED that's rejected their ratification early and are back into negotiation. A couple of things to note. We've got an agreed-upon status quo or maintained status quo with BMWE while we're negotiating out what they take back to their membership. And one of the reasons, maybe we think the predominant reason for that original vote not to be ratified is that the PEB recommended both wages and they also, for the BMWE, recommended a change in their compensation for travel to the work site because about 40%, sometimes more, of that work team goes to away-from-home work sites, works for seven days, and then comes back. So a change in that travel allowance and a change in the per diem while they're away from home. That negotiation on UP property just finished up last week. And so as the members were ratifying the vote, there was a section of it that they really didn't have clarity on. We think that clarity makes that vote more straightforward. And so that's part of the negotiation that's happening is exactly what's going to be embedded in the agreement when it goes back out for ratification. Ultimately, I remain confident that we're going to get our temporary agreements ratified and be able to avoid a strike. That's still a possibility, but I don't think it's a probability.

I’ll start by addressing the currency question first. Recently, Lance and I returned from Asia, and we observed what you're referring to. We're closely monitoring consumer spending patterns and have noticed an increase in spending on services compared to goods. This trend is reflected in parcel shipments, and we'll continue to track it on a weekly basis. I also mentioned some markets where we have a positive outlook, particularly coal. Eric and his team, along with our commercial leaders, have done well in responding swiftly and allocating additional resources to seize this opportunity. Regarding the biofuel market, we’re optimistic about the growing order book, and we plan to launch two new plants in the next three to six months, which is encouraging. The grain market will present challenges, but we will see how it develops. In the Industrial sector, the housing market is causing a slight decline in our lumber shipments. However, in construction products, our rock shipments remain strong, which is a positive sign. Our metals business is performing well, particularly with rebar used in highway and road construction, which is encouraging. Additionally, sheet and coil products are benefiting the automotive sector, which is also showing improvement. Currently, dealer inventories at their facilities are low, around 30, and some OEMs report dealer inventory levels in the single digits or teens, which bodes well for us. In the international intermodal segment, we anticipate a favorable outcome for the rest of the quarter with an easier comparison. We'll continue to keep a close watch on domestic performance as we progress.

I guess maybe I wanted to clarify a point on the full year operating ratio. So I just wanted to make sure, I think you said reported 60 for the full year. So does that include the $114 million that's sort of excluded from the adjusted third quarter? I guess that's my first question. Just sort of piggybacking on that, as you think about the sequential progression, it sounds like yields probably decelerate just given what's going on with fuel. But can you talk a little bit about sort of the cost dynamic? Maybe moving forward, it seems like maybe a bit bigger than normal seasonal step-up in the operating ratio in the fourth quarter versus the third quarter. Can you just sort of elaborate a little bit on that? That would be helpful.

Sure, Chris, and thanks for that question. You did hear right. So the 60% is the reported operating ratio, so that does include the impact of the PEB, the $114 million that we took the charge for relative to the change in estimates as well as the ongoing impact, which, as I mentioned in my remarks, was $19 million in the third quarter and will be likely a similar amount in the fourth quarter. So we absolutely do have that cost inflation. You also, I think, referenced fuel. That is going to flip on us, we believe, from third quarter to fourth quarter where it was a tailwind for us in the third quarter. That flips back to a headwind of a decent amount, we think, now in the fourth quarter. So that's going to be an impact. And of course, mix was a little bit negative for us here in the third quarter. That's probably going to look a little bit worse as we move into the fourth quarter. So kind of putting all those things together cumulatively on a sequential basis, we are expecting the operating ratio to deteriorate some even as we're bringing more volume on and still working to take costs out of the network. But we have those headwinds. And as you know, with those inflationary things, in particular, while we're very confident we're going to offset that with price, there is some timing there.

Wanted to focus a little bit on the intermodal side and break up between both domestic and international. On the domestic side, you obviously called out sort of a weakening truck market going to be a little bit of a challenge. How should we think about that going forward in terms of the yields? And on the international side, how should we think about what we've seen as a big shift from the West Coast to the East Coast? How much of that traffic shift do you think will be permanent in the long term?

Kenny?

I'll begin with the international intermodal segment. One encouraging aspect is the increasing percentage of traffic moving to our inland facilities from the West Coast. This indicates that less product is being transloaded on the West Coast, which is positive for us. We're actively promoting our products and solutions to customers in this context. For instance, our Katoen Dallas to Dock facility experienced its highest volume of West-bound traffic last quarter. Additionally, we launched our Global 4 ag relo facility in August, which contributes to enhancing our offerings. It's important to keep these developments in mind when considering the dynamics between the West Coast and East Coast. On the domestic front, we're closely monitoring our parcel business as we approach the end of the year. We've noticed a slight rise in inventory, which is reflected in some of our inland terminals, albeit minimally. While spot rates have decreased, this trend hasn't affected contract rates yet. We'll have more clarity as we enter the bid season on December 4.

Yes. And Jason, I'd just add one thing, and that is we're encouraged by the movement of the international boxes between ports and inland, right? That's fluid, looks pretty good. We've taken some of the box count down off of the ports. That's approaching back to normal. We still have an issue with trying to get boxes off the inland ramps and process through warehouses. There's a lot of inventory sitting in warehouses right now. And the U.S. consumer is going to have to chew through that for us to be able to get street times and boxed well on the destination side back to normal.

Okay. Regarding the comments I made about yields, if we see a decrease in the contract rates on the truckload side, Kenny, how should we consider the impact on intermodal yields as we look to 2023?

So first of all, I think, again, it's just a little too soon to tell. Hey, I'm not ready to concede all the tightness that Lance just talked about, might not show up in firming prices on the contract side. So it's just a little too soon to call that out.

Doubtless, there's a headwind there through the bid season, and we'll have to just see how it plays out.

Eric, you spent most of this year, probably even much of last year trying to bring on resources, mostly labor, but all these resources that you needed for fluidity and productivity, et cetera. And now you feel like you're getting close, if not there, into a slowing demand backdrop. So as you look about going forward, do you have the flexibility and the nimbleness that you've had in prior cycles to maybe manage some of those resources down if demand is weaker than you expect? Or do you need to keep the network a bit more over-resourced in the short term, given these challenges that you've had and maybe even more intense scrutiny from the regulator?

Yes. I appreciate that question, Jon. Without a doubt, as we've demonstrated in multiple times, unfortunately, we have the ability to bring down our resources in line with volume. In my prepared comments, I made a point to point out that we want to be more than volume-variable. So that playbook is known, and we've demonstrated an efficiency in being able to do that. Now as we think about that and we think about the last 1.5 years to your point, there are three things that we continue to be focused on. Our ability to hire no matter what the market is remains critical. As part of that, we continue to work on how we think about making our jobs even more attractive to the population. So no matter what the market is, we can attract the talent that we need. At the same time, as we look at resources and continue to be able to balance them, to your point, you will see us, as we've had in the past, reestablish AWTS, which is a way for us to have a little bit of a buffer. It's not thousands of people. It's a couple of hundred people to be able to react both on the upside and the downside. So we have that playbook. We clearly have demonstrated our ability to execute it, yet we continue to take lessons we're learning to make that playbook even stronger.

Eric, you mentioned in the slides that you're exceeding your hiring goals for T&E this year. Can you help us understand how much more hiring might be necessary to maintain the required service levels? What are your thoughts on headcount for next year? While I realize you don't have specific volume plans yet, are we still in the process of catching up from a headcount standpoint to properly resource the network? If we reach 1,400, will that be sufficient?

Yes, David, great question. So to reiterate, we set out the year to start hiring 1,400 people. You heard in my prepared comments that we've done that. Now admittedly, one-third of that 1,400 have been hired, and they're in the training pipeline. So we won't see the benefit of having them until the end of the year, between now and the end of the year, really. As we think about looking out at our hiring demands, as you pointed out and as Kenny highlighted, there are obviously questions about the markets. We'll stay close to those. We'll use the same process that we've employed in the past to ensure that we don't fall short of hiring. And at the same time, as we look, we're really focused on attrition. You have a couple of questions that are outstanding with regards to the implications of the ratification with some population of our employees, and we're going to react to that accordingly. So it's really about the markets, what do we need to be staffed for that and contending with attrition.

Is it correct to consider that a buffer is necessary for some agreements related to additional pay and paid time off, as well as for having more staff? Is this aspect taken into account in your hiring plans, and how should we view it in terms of productivity?

It has always been considered. Certainly, within the agreements pending ratification, there are discussions about additional time off, and we will make adjustments as necessary. The key aspect to focus on is how we approach the AWTS program to ensure its effectiveness, which involves a few hundred people. It is feasible, and it’s something we can depend on.

But David, it's important to remember what Eric mentioned. We still expect to be volume-variable even with those agreements. So, we will see volumes exceed whatever happens in the economy, but headcount won't grow to the same extent.

100%. One last thing to note, David. We got to step a little carefully here. We've committed and we've started and been in negotiation with some of our crafts, the unscheduled jobs specifically to try to find ways to get scheduled time off. Part of the PEB and this negotiation address that, but it's a far bigger issue that needs to be addressed on property in job design. That's underway. We think there's a path to do that without a substantial or kind of meaningful impact on overall headcount requirement because what we're trying to do is we're trying to make availability of employees flat across the week, right? So you don't get spikes in crew availability and layoffs. And the way you do that is you make time off predictable, and we think that trade-off is feasible. We think it's absolutely going to be happening. We don't think there's a large impact on employment through that.

And it could actually give us better crew availability.

I understand that it’s too early to provide guidance for 2023, and you reaffirmed your commitment to the long-term targets. However, Lance, I would like to know if you are confident that you can achieve pricing that exceeds inflation next year, considering the higher inflation pressures and the challenges affecting the top line from current macroeconomic conditions.

Yes, Ravi. Short answer, yes. Longer answer, there are a lot of moving parts. There are going to be some headwinds into next year. Inflation is quite real. But as we look at rolling up a budget and starting or really at the tail end of putting our plan together for sure, we are confident we can get pricing above inflation.

Kenny, I want to go back to your comment that you put out there about leaving demand on the table. Can you maybe help us understand or quantify what you think that headwind was? And then as you're talking to potential new customers, has the service challenges that you guys faced this year impacted some of that conversion to new accounts? Just any thoughts there?

Yes, a couple of things. One is, I'll tell you, Allison, that's hard to quantify. Clearly, we saw second week of September, mid-September, and it probably lasted for a couple of weeks a dip in our carloads, probably more noticeable in our premium network than it was in our carload network. So Allison, I can't give you a number.

Yes, we can tell her where it's at, right? Most likely, we left stuff on the table in coal, probably some left on the table in grain. I think that's where Allison is looking for.

Yes. I would say this mainly pertains to our bulk market, particularly in our coal business, with some activity in our grain and fertilizer sectors. Additionally, we observed increased demand in our rock network, primarily related to our unit train business, which requires a significant amount of crews and resources.

And Allison, it’s clear that the third quarter saw less activity than the second quarter. As we move into the fourth quarter, the situation is similar. The goal isn’t to eliminate all unmet demand; in fact, it’s beneficial to have more demand than resources at times. However, we need to ensure that this situation isn’t due to performance shortcomings, meaning we should not be missing out on demand because of our performance issues.

So the thing I'm encouraged by, and Eric talked about this is that we did have more resources, and we have added more sets in. We are putting more resources up against it. We do have more crews coming on. So I'm more encouraged now we're in a better place. Lance, you talked about it, second to third, but we're in a better place today. And we're working closely together. That's on the unit train network. What you don't see is that our commercial team is working closely with operating on the carload side. So if we are seeing a little bit of softening on the lumber side, we're supplementing a little bit of boxcar and covered hoppers to capture areas where we do see the demand. The other part of that, I think you talked about just overall new customers coming into the network. Our customers face some of the same challenges that we did in terms of hiring and getting some of the resources. So they understand that. They realize that, that was a, I'll call it a short-term challenge for us. We're bringing on more resources to give them confidence. We're putting more capital for the growth. And so that gives us a lot of good things to articulate to our customers as we're talking about our preparedness in the future.

It looks like we're opening up a little rough morning here. But thinking about your volume outlook with falling demand but improving fluidity, how do you win share in that environment, particularly given the rapidly loosening trucking environment? I guess I'm more speaking on intermodal, Kenny. It looks like your volume target for the fourth quarter is down to maybe 7%, given that full year 3% target. And then how do you win share if your trip plan compliance is still 58% to 62%? I mean, it just seems like after PSR, we should have been able to bounce back. I get the employees are still coming on, but just given that differential. And then, Jen, can you just clarify some comments you made on the real estate gain and pension? Just to clarify what was maybe one-time versus ongoing?

We mentioned that we had a real estate sale that affected other income, contributing $35 million in real estate income. The pension benefit increased by approximately $14 million to $15 million year-over-year. This trend has been observed throughout most of the year, and while it may not continue at that level, we expect it to persist in a lesser capacity into the fourth quarter. However, I would classify the real estate component as more of a one-time event.

Yes. I mentioned earlier about our premium side, which is quite mixed. We anticipate our international intermodal business will grow in the fourth quarter. We will be monitoring domestic intermodal closely. I spoke about the changes in preferences and now want to discuss the fourth quarter and 2023. Looking ahead to 2023, we have already pointed out the addition of another large private asset customer, which is a positive development for us. Our strategy to thrive in this market relies on the investments we're making. We are optimistic about the increased ramp capacity we are implementing. We are excited about the technology enhancements we are introducing to the intermodal network, specifically the precision gate technology, which will improve the experience for drivers. There is significant investment going into the intermodal network, including extending sidings and infrastructure, as we prepare to compete effectively and grow in the future.

And part of, Ken, your question is predicated, I expect you to snap back quicker given PSR, why isn't your trip plan compliance better on premium and on your manifest side. And the short answer is they continue to improve. As we see car velocity, which is now approaching the 200 number the last couple of days, that continues to improve. And what you saw posted for second Q and 3Q is much better now in print as we're entering 4Q.

But is that what gets you to the 80s from the 50s, 60s? Is it the employees? Is it the speed? What gets you back to where you were running?

Yes. So the biggest opportunity we have is really the congestion that we saw have been working through. And Lance pointed out earlier in the conversation regarding the west ports and the fluidity there. That translates. If you look into our velocity gains throughout this quarter, a big portion of that has been on the intermodal side. When I look on a daily basis at our arrival performance at terminals as well as our departure, those are both improving. Those are contributors to increased TPC. Yes, additional people are helping in certain particular markets, but it really is about the fundamentals, and I see them improving week over week.

Jennifer, the 3Q to 4Q OR deterioration, is that relative to the reported or the adjusted? And then just bigger picture, you reiterated this year pricing in excess of inflation. But with that positive price and positive volume, margins are going to be down about 300 basis points this year. So maybe just sort of help connect those two comments. And then maybe more importantly, just what's your confidence of improving the OR next year relative to this 60 OR we're seeing in 2022?

Yes, Scott. The remarks about the fourth quarter refer specifically to the adjusted figures, which stand at 58.2. We are observing some sequential decline in that adjusted metric, although not in the reported figures. That's an important distinction. Regarding 2023, we are still finalizing our plans, and there are many variables at play. The main concern is how the economy will perform. However, we recognize that we have growth opportunities, as mentioned by Kenny and Lance. Additionally, we are confident in our ability to maintain pricing that exceeds inflation, and we believe our growth trajectory will remain positive as we move into 2023.

And maybe just to ask it differently, like if we got positive price and positive volume, and we're giving up 3 points of margin, what were the causes of that 3 points that maybe could go away next year or maybe not, I don't know?

In this quarter, we experienced a margin decline of 310 basis points due to service inefficiencies and inflation. That accounts for the 300 points. We are working on better offsetting this, although we don't have an inflation estimate for next year yet. It will certainly be affected by the rising wages. At the start of this year, we anticipated inflation to be around 3%, which would have been higher than historical figures, but it now appears to be closer to 5%. Inflation has accelerated in the latter half of the year, especially with recent wage settlements. Adjusting our pricing to reflect this will take some time, but we remain confident in our ability to manage it.

In terms of the intermodal business, I was hoping you could give us some perspective on how the onboarding of Knight-Swift has progressed year-to-date, the extent to which both partners may have left opportunities on the table in the first year based on supply chain congestion and whether you think that represents a tailwind as you look ahead to 2023.

We have been very encouraged. I think Knight-Swift would also agree the onboarding has gone very well. Both companies have stayed very close to each other. Sure, there have been some supply chain challenges, but chassis dwell is not where it should be. It actually stayed pretty elevated for some time now. So there could be some volume tailwind as that kind of loosens up as we move into the future. But I can tell you that onboarding them has gone very well, and I'd use the word seamless.

Great. So Lance, you talked about the path to getting to a 55 OR. I was hoping you could just elaborate on that a little bit. And do you think that's primarily driven by price? Or are there further efficiency gains that you guys think you can realize to get there? And then on the pricing point, obviously, the labor negotiations have been very public. I wanted to know to what extent that's kind of influenced discussions with customers on how much yield you might be able to get as you think about 2023?

Yes. Okay, Ari. So the path to 55 is really pretty plain. It hasn't changed. This year, we ran into a rough patch. We ran the network type. We got into trouble on our crew availability, and we're digging out of that. We've made progress in the third quarter, and we'll make another strong step to normal in the fourth quarter. I anticipate we enter into the back half of 2022 in the 200-plus car velocity. We're essentially there at this point and need to grow from there and then be normal going into 2023, which I anticipate is going to be the case. As we do that, there is, for sure, an opportunity to take excess cost out of the network. Now having said that, we're fighting against pretty significant inflation. You see it in the PEB, but it's across the board on our services and our inputs. We're going to have to overcome that with price, and we anticipate we will. We're confident we will, but that's not helpful on the OR side, right? So you got to create margin somewhere. For us, that's got to be incremental volume. At this point, incremental volume is going to be a more important part of the three-legged stool into the future years. We're set up well to exceed what the industry is going to do. We're doing that this year. I think we're going to do that again next year, and we're going to have to make hay with it. And that's what gives us confidence that we're going to be able to improve margins going into next year. That's the clear path to a 55 operating ratio. And again, I don't think we said it yet today, but reiterating leading the industry in terms of our margins. So Kenny?

Yes. I mean, we've said it as a management team, we're going to cover inflation with price. But just to get a little granular here, our commercial leaders have done a really good job sitting now with customers, making adjustments to the rate real time, again, real-time discussions to reflect the inflationary environment that we're seeing to date. And so we're articulating the why behind the need for those adjustments with rates, especially in light of the capital that we're expending and then also the fact that sequentially our service is improving.

Jennifer, I wanted to clarify the transition from 2022 to 2023. I know there's a lot of macro uncertainty, but with the tentative agreement in place, can you provide some insight into the additional headwind this may create in 2023? The slide you shared suggested it might be around $44 million annually. Is that an accurate way to estimate the incremental headwind from day one in 2023? Additionally, Kenny, Lance mentioned aiming for 200 car miles per day, but there's still a significant gap given the current fuel costs and the economics of rail transportation. Considering the near-term weekly volumes seem to be fluctuating between 160,000 to mid-160,000, if you manage to improve cycle times to reach or exceed 200 car miles per day, will that enable you to increase the volume you can move in the near term? Can we expect an immediate increase if you achieve those 200-plus car miles per day, considering the current economic conditions?

Okay, Amit. Thanks for that. Let me start, and then we'll turn it over. So the 22 you referenced is for the first quarter and second quarter. That was before the wage increase that became effective July 1. And so the thing you have to remember is the way that the wage accruals or the wages work is it's a July 1 increase. So effective July 1, we went from, I think it was 3.5% to a 7% increase. And so when I referenced in my comments, $19 million was the wage impact inflation, that's the third quarter impact, similar amount in the fourth quarter. Those two impacts will carry into first and second quarter of next year. And then July of 2023, it goes to a 4% increase. So that's how you need to think about that. So 7% increase first half, 4% increase in the second half in terms of just the wage inflation piece relative to that. Does that make sense?

Yes, it makes sense, but I'm just trying to see if you can give us a number. It seems like if it's $20 million for the third quarter and fourth quarter, plus another incremental amount, it appears to be around $50 million to $60 million in net incremental next year compared to 2022.

Yes, in the first half, we're looking at around $36 million to $38 million, and then something slightly less in the second half, which is going to be around 4%. You're approaching this correctly. However, this reflects wage inflation. We recognize that there are ongoing inflationary pressures, especially in our contracted labor services. While I do not have the complete annual inflation figure ready to disclose, we are certainly seeing wage inflation, along with PEB inflation. Additionally, we anticipate inflation to exceed 5% this year. I’m not sure we will reach that level next year, but it will be considerably higher than our prior expectations of around 2.25% from our May Analyst Day. We are significantly past that point now.

Yes, oh, yes. Kenny, there was a question in there about...

Yes, Amit, we are monitoring the economy and tracking our carloads on a daily, weekly, and monthly basis. As the velocity improves, we observe demand in several areas, such as coal, rock, auto, finished vehicles, and auto parts. Therefore, I believe there is still an opportunity for us to capture more volume in the near term.

Sorry, I had some technical issues before. But just a quick question on the auto sector. Is that something that could deviate from the economy, just given dealer inventories at the lot as we think through to next year? I mean, will there need to be fill regardless to what happens to the consumer outlook?

Yes, we certainly believe so. There are just a number of markers that point to it. I talked about the supply of the dealership is very low, much lower than the OEMs wanted to be. Average age of a car out there now is 13 years old. There's just a lot of pent-up demand in terms of shippable, non-shippable, meaning the OEMs have actually produced the cars, and they haven't moved via rail yet. And then just the fact that, again, the part supply, the semiconductor chip, I think that's going to improve here. And so based on those things, we feel very bullish on that auto part in the finished vehicle side.

Thank you, Rob, and thank you all for joining us this morning and for your questions. We look forward to talking with you again in January to discuss our fourth quarter and full year results. Until then, please take care.