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Rating Action:

MOODY'S UPGRADES UNION PACIFIC CORPORATION'S SR. UNSECURED RATING TO Baa2 AND COMMERCIAL PAPER TO PRIME-2; OUTLOOK STABLE

20 Oct 2003
MOODY'S UPGRADES UNION PACIFIC CORPORATION'S SR. UNSECURED RATING TO Baa2 AND COMMERCIAL PAPER TO PRIME-2; OUTLOOK STABLE

Approximately $9.9 billion of debt affected

New York, October 20, 2003 -- Moody's Investors Service upgraded Union Pacific Corporation's (UP) senior unsecured debt to Baa2 from Baa3, and its commercial paper to Prime-2 from Prime-3.

The upgrade reflects: the successful reduction of adjusted debt of approximately $1.6 billion from the high point following the Southern Pacific acquisition; UPs improved financial performance, with a record of strong free cash flow while maintaining sufficient capital investment; solid and sustainable railroad operations; and, strong liquidity with a manageable debt maturity profile.

The stable outlook reflects Moody's expectations of: free cash flow generation that will remain solidly positive after adequate investment in the railroad infrastructure; conservative financial policies with a very substantial portion of free cash flow directed towards further debt reduction; intense emphasis on continuous productivity gains and cost conscious operations; and, the prospects for cash proceeds from the potential near-term IPO of Overnite Trucking (senior unsecured at Ba1, stable).

The outlook or ratings could be favorably adjusted with: further meaningful effort by UP to reduce financial leverage and improve its balance sheet; increased free cash flow through market penetration, with stronger freight pricing; evidence of producing a sustainable return to at least cover UP's cost of capital; and,the prospect of any material merger remaining low.

The debt reduction achieved over the last several years is about equal to Moody's estimate of the cash cost of integrating the former Southern Pacific and Chicago and North Western railroads (which were acquired in 1996 and 1995, respectively). Debt was repaid through cash from operations as well as proceeds from asset sales. UP's indebtedness is now about equal to Moody's expectation at this point following the acquisitions. Importantly, Moody's notes that UP continued its high level of capital investment throughout the merger integration process, and despite the industrial slow down. Moody's views this consistent investment positively, suggesting the railroad is well positioned to participate at the moment any industrial recovery is realized, as well as provide the consistently higher service levels necessary to penetrate the long-haul transportation markets. Moody's believes that UP has yet to achieve all of the revenue synergies expected from the mergers, and is not likely to recognize these gains until the industrial economy recovers solidly. Greater free cash flow, and the potential for accelerated debt repayment from that cash flow, is possible.

UP's balanced revenue base also supports the rating, as the less sensitive hauls (such as coal) often offset the more cyclical sectors of chemicals and automotive (which are currently down). A meaningful portion of UP's revenues (chemical, automotive, intermodal and some of the industrial hauls) are somewhat cyclical, and the overall long-term volume growth is likely to be modest and remain linked to industrial production. Coal is UP's largest segment (at 23% of rail revenue). While UP has a strong and very profitable position servicing the attractive western coal deposits, it is likely to be competitively challenged over the near term with flat pricing and volume at best. Chemicals is also likely to be under pressure with high feedstock prices at the chemical plants UP services, and auto shipments (UP is the largest western hauler) could also be weaker without continued auto OEM incentives. Nonetheless, UP is focused on leveraging its extensive rail infrastructure with a number of customer specific programs to increase profits with premium service offerings -- which are branded in some cases, such as 'Blue Streak' service for UPS or the 'Express Lane' trans-continental shipments of fresh fruit and vegetables. Industrial products and intermodal are expected to post moderate revenue gains, also.

UP also has a strong record of operating cost management. Each business unit is expected to post productivity gains to at least offset inflationary pressures --- increasingly a challenge, but achievable, in Moody's view. Continued outsourcing of locomotive maintenance, full implementation of remote control devices in yard and switching operations, automated crew calling, and the lower railroad retirement tax are all expected to benefit costs going forward. UP has good labor relations with manageable contracts in place for substantially all of the crafts. UP's unfunded pension obligation is comparatively modest, considering the size of the company and the number of retirees. Most of UPs retirees are covered by the Railroad Retirement Act, which UP has been funding currently. UP also has a strong record of corporate governance; the Board is independent and the directors have broad and balanced experience and are active in the oversight of UP's business.

Moody's notes that the ratio of UP's adjusted debt (including its considerable lease obligations and A/R securitization) to free cash flow is still somewhat high for its rating level. At FY 2002, free cash flow was approximately 6% of debt, and Adjusted Debt to EBITDAR was 3.1x. Moody's expects the company to remain relatively leveraged for some time given the considerable, but necessary, capital expenditures. CAPEX are likely to average $2.0-2.1 billion over the cycle, well in excess of depreciation.

UP schedules its rail operations somewhat less than other railroads -- partly a consequence of UP's much more extensive and longer rail network with more complex switching requirements. However, the company is addressing that issue by introducing customer specific products and by emphasizing service and coverage through its extensive network. Longer term, UP could have a labor issue in both replacing the skilled workers as they approach retirement, and appropriately sizing the labor force as customer service requirements increase. About 20% of the company's rail workers will be eligible for retirement over the next five years. UP's asbestos exposure appears manageable, and relatively modest in comparison to the railroad's ongoing personal injury and occupational illness payments.

Liquidity remains strong and is supported by the solid free cash flow, increased cash balances, and strong revolving credit arrangements from a syndicate of relationship banks. We expect minimal use of the confidence sensitive markets (no commercial paper issued at present), and UP's scheduled debt maturities over the next several years are generally lower than the expected free cash flow. As well, UP has consistently enjoyed good access to the capital markets. UP has no material rating triggers other than a pricing grid in its revolver and a trigger in its securization program which could limit or eliminate receivables sold if the ratings drop below investment grade.

The ratings reflect UP's current legal structure. Debt obligors are Union Pacific Corporation (the holding company) and the Union Pacific Railroad Company (UPRR, the operating railroad). All predecessor railroads have been legally merged with and into, and the debt assumed by, UPRR. Ratings on the holding company debt reflect the structural subordination to the secured debt and the railroad equipment trust certificates (ETC) issued by the railroad operating company. The railroad ETCs take into account the special protection afforded investors of rail equipment debt under U.S. bankruptcy law, as well as quality of the equipment financed and the leverage of each transaction. The Missouri Pacific 1st Mortgage bonds take into account that the bonds are secured by the assets of the former Missouri Pacific Railroad, which have a book value exceeding the face value of the bonds. The Missouri Pacific general income bonds are notched down because the bonds include a feature whereby interest is payable only if a certain amount of operating income is recorded. Other ratings are adjusted to reflect the legal obligor.

Union Pacific Corporation senior unsecured, issuer rating and guaranteed IRBs to Baa2 from Baa3; commercial paper to Prime-2 from Prime-3; subordinated shelf to (P)Baa3, preferred shelf to (P)Ba1

Union Pacific Capital Trust Trust preferred to Baa3 from Ba1

Union Pacific Railroad Company ETCs to Aa3 from A1; guaranteed IRBs to Baa1 from Baa2

Missouri Pacific 1st Mortgage bonds to A3 from Baa1; Income bonds to Baa2 from Baa3

Chicago and North Western ETCs to Aa3 from A2

Southern Pacific Transportation ETCs and Pass Through Certificates to Aa3

Union Pacific Corporation, based in Omaha Nebraska, owns and operates the Union Pacific Railroad Company, a Class I railroad.

New York
Michael J. Mulvaney
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Robert Jankowitz
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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