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
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
Union Pacific Corporation, based in Omaha Nebraska, owns and
operates the Union Pacific Railroad Company, a Class I railroad.
Michael J. Mulvaney
Corporate Finance Group
Moody's Investors Service
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service