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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the Consolidated Financial Statements and applicable notes to the Financial Statements and Supplementary Data, Item 8, and other information in this report, including Risk Factors set forth in Item 1A and Critical Accounting Policies and Cautionary Information at the end of this Item 7. The following section generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7, of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.
The Railroad, along with its subsidiaries and rail affiliates, is our one reportable business segment. Although revenue is analyzed by commodity, we analyze the net financial results of the Railroad as one segment due to the integrated nature of the rail network.
EXECUTIVE SUMMARY
2020 Results
Coronavirus Pandemic (COVID-19) – 2020 was a year of great uncertainty as COVID-19 spread across the globe. The pandemic caused a dramatic slowdown of the economy as government intervention forced closures and changed individual behaviors, and businesses transformed their operations to protect the health and safety of their employees, customers, and communities. The varying levels of mitigation across different industries had a significant impact on the demand to ship freight in certain market segments. The most notable impact on our revenue was the temporary suspension of automotive production and the corollary effect it had on products used for auto manufacturing. Other reductions in production drove volume declines in a number of other markets as well. The pandemic also disrupted supply chains between Asia and the United States driving declines in intermodal shipments. While second quarter was the hardest hit and volumes have improved sequentially from that quarter, some market segments are still lagging as year-over-year volumes are down.
Safety – The health and wellbeing of our employees was top of mind in 2020 as we navigated the continually changing environment due to COVID-19. We have and are continuing to adapt to protect the safety of our employees, our customers, and the communities we serve. Enhanced safety procedures were implemented across the system, including new procedures and policies based on Centers for Disease Control and Prevention (CDC) guidelines.
We continued our focus on safety to reduce risk and eliminate incidents for our employees, our customers, and the public. While we have implemented new practices, which drove a 17% improvement in our reportable equipment incident rate per million train miles, we have significant opportunity for improvement remaining. Our reportable personal injury incidents per 200,000 employee-hours of 0.90 was flat with last year. We continued to use Total Safety Culture, Courage to Care, and COMMIT (Coaching, Observing, Mentoring and Motivating with Integrity and Trust) throughout our operations. We remained focused on identifying and managing risks and training our employees as their work environment changes.
Network Operations – While the pandemic resulted in significant swings in volume, we were able to adjust our demand-driven resources to reflect these fluctuations with minimal disruptions to our customers. Both our Intermodal and Manifest/Automotive car trip plan compliance improved 6 points in 2020, showing our dedication to providing the customer with a service product that delivers value. Although the environment we operated in changed due to COVID-19, we continued our operational transformation. This was evident as our key performance indicators have improved substantially year-over-year. Transportation plan changes to eliminate switches and improved terminal processes drove an 8% improvement in freight car terminal dwell. Improved dwell coupled with 3% faster average train speed led to a 6% improvement in freight car velocity. We also saw 14% improvement in locomotive productivity and 11% improvement in work force productivity. Additional detail on these metrics are discussed in Other Operating / Performance and Financial Statistics of this Item 7.
Freight Revenues – Our freight revenues decreased 10% year-over-year to $18.3 billion driven by a volume decline of 7%, lower fuel surcharge revenue, and negative mix of traffic (for example, a relative
increase in intermodal shipments, which have a lower average revenue per car (ARC)), partially offset by core pricing gains. Volume declined in almost every market segment due to the deteriorating economic conditions brought on by the COVID-19 pandemic. While some markets rebounded in the last half of the year, particularly grain and intermodal, others still lagged 2019 levels. Shipments of coal, sand, and petroleum products continue to be negatively impacted by the low crude oil and natural gas prices.
Financial Results – In 2020, we generated operating income of $7.8 billion, 8% below 2019, driven by the impacts of COVID-19 and a non-cash impairment charge of $278 million related to our Brazos yard investment. Productivity initiatives, lower volumes, and lower fuel prices drove operating expenses down 11% from 2019. These factors coupled with improved pricing were not enough to offset the impact of the revenue decline. Net income of $5.3 billion translated into earnings of $7.88 per diluted share, down 6% from last year. Despite the adversity from COVID-19, our operational transformation produced an all-time record 59.9% operating ratio, improving 0.7 points from 2019.
Fuel Prices – Our average price of diesel fuel in 2020 was $1.50 per gallon, a decrease of 30% from 2019. The lower price resulted in lower operating expenses of $539 million (excluding any impact from year-over-year volume declines). Gross ton-miles decreased 9% and our fuel consumption rate, computed as gallons of fuel consumed divided by gross ton-miles, improved 2%, both driving lower fuel expense.
Liquidity – We are continually evaluating the impact of COVID-19 on our financial condition and liquidity. On December 31, 2020, we had $1.8 billion of cash and cash equivalents. Despite the pandemic, we generated $8.5 billion of cash from operating activities, yielding free cash flow of $3.2 billion after reductions of $2.7 billion for cash used in investing activities and $2.6 billion in dividends. Even though our share repurchase program was temporarily paused for six months starting in March 2020, we repurchased $3.7 billion of our shares. We have been, and we expect to continue to be, in compliance with our debt covenants. We have $2.0 billion of credit available under our revolving credit facility, up to $800 million undrawn on our Receivables Facility, and three bilateral revolving credit lines, which mature in May 2021, with up to $600 million of available credit. As of December 31, 2020, none of the revolving credit facility, Receivables Facility, or bilateral revolving credit lines was drawn.
Free cash flow is defined as cash provided by operating activities less cash used in investing activities and dividends paid. Free cash flow is not considered a financial measure under GAAP by SEC Regulation G and Item 10 of SEC Regulation S-K and may not be defined and calculated by other companies in the same manner. We believe free cash flow is important to management and investors in evaluating our financial performance and measures our ability to generate cash without additional external financing. Free cash flow should be considered in addition to, rather than as a substitute for, cash provided by operating activities. The following table reconciles cash provided by operating activities (GAAP measure) to free cash flow (non-GAAP measure):
| Millions | 2020 | 2019 | 2018 | ||||
| Cash provided by operating activities | $ | 8,540 | $ | 8,609 | $ | 8,686 | |
| Cash used in investing activities | (2,676) | (3,435) | (3,411) | ||||
| Dividends paid | (2,626) | (2,598) | (2,299) | ||||
| Free cash flow | $ | 3,238 | $ | 2,576 | $ | 2,976 |
2021 Outlook
Safety – Operating a safe railroad benefits all our constituents: our employees, customers, shareholders, and the communities we serve. We will continue using a multi-faceted approach to safety utilizing technology, risk assessments, training, employee engagement, quality control, and targeted capital investments. We will continue using and expanding the deployment of Total Safety Culture, Courage to Care, COMMIT, and Peer to Peer throughout our operations, which allows us to identify and implement best practices for employee and operational safety. We formed an Operating Practices Command Center to identify causes of mainline service interruptions and develop solutions, in addition to, assisting employees with understanding policies, procedures, and best practices for handling trains. We will continue our efforts to utilize data to identify and mitigate risk, detect rail defects, improve or close crossings, and educate the public and law enforcement agencies about crossing safety through
a combination of our own programs (including risk assessment strategies), industry programs, and local community activities across the network.
Network Operations – In 2021, we will continue to transform our railroad to further increase reliability of our service product, reduce variability in network operations, and improve resource utilization. Continued implementation of train length initiatives will allow us to add incremental volume growth to our existing train network. We will continue to make structural changes to improve operational performance and efficiency. A more efficient network requires fewer locomotives, freight cars, and other resources.
Market Conditions – We expect uncertainties with COVID-19 and the economy to continue in 2021. How governments and consumers react to the resurgence, mutation of the virus, and distribution of the vaccine could result in or contribute to customer disruptions, an elongated recovery period, or a downturn from our current business levels. Disruptions in our customers’ supply chains caused by the pandemic or other factors may have an impact on our shipments. In addition, other factors such as natural gas prices, weather conditions, and demand for other energy sources may impact the coal market; crude oil price spreads may drive demand for petroleum products and drilling materials; available truck capacity could impact our intermodal business; and international trade agreements could promote or hinder trade.
Fuel Prices – Projections for crude oil and natural gas continue to fluctuate in the current environment. We again could see volatile fuel prices during the year, as they are sensitive to global and U.S. domestic demand, refining capacity, geopolitical events, weather conditions, and other factors. As prices fluctuate, there will be a timing impact on earnings, as our fuel surcharge programs trail increases or decreases in fuel price by approximately two months.
Significant changes in fuel prices could have an impact on the amount of consumer discretionary spending, impacting demand for various consumer products we transport. Alternatively, those changes could have an inverse impact on commodities such as coal, petroleum products, and domestic drilling-related shipments.
Capital Plan – In 2021, we expect our capital plan to be approximately $2.9 billion, essentially flat with 2020. Implementation of our new transportation plan has generated capacity. We will continue to harden our infrastructure, replace older assets, and improve the safety and resilience of the network. In addition, the plan includes investments intended to support growth and improve productivity and operational efficiency. The capital plan may be revised if business conditions warrant or if new laws or regulations affect our ability to generate sufficient returns on these investments. (See further discussion in this Item 7 under Liquidity and Capital Resources – Capital Plan).
Financial Expectations – We expect volume to be up four to as high as six percent in 2021 compared to 2020, provided the second half of the year’s industrial production strengthens as predicted by economists. In the current environment, we expect continued margin improvement driven by pricing opportunities in excess of inflation and ongoing productivity initiatives, resulting in approximately $500 million of productivity savings, while better leveraging our resources and strengthening our franchise. We expect to generate strong cash from operating activities along with maintaining our dividend and share repurchase program. As the continued effect of COVID-19 is still uncertain, it could have a material impact on our 2021 financial and operating results, but our focus will be on what we can manage, such as increasing productivity; seeking new business opportunities; protecting our employees, customers, and communities; and providing excellent service to our customers.
RESULTS OF OPERATIONS
Operating Revenues
| % Change | % Change | |||||||||
| Millions | 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | |||||
| Freight revenues | $ | 18,251 | $ | 20,243 | $ | 21,384 | (10) | % | (5) | % |
| Other subsidiary revenues | 743 | 880 | 881 | (16) | - | |||||
| Accessorial revenues | 473 | 514 | 502 | (8) | 2 | |||||
| Other | 66 | 71 | 65 | (7) | 9 | |||||
| Total | $ | 19,533 | $ | 21,708 | $ | 22,832 | (10) | % | (5) | % |
We generate freight revenues by transporting freight or other materials from our three commodity groups. Prior to 2020, we reported on four commodity groups, thus prior years’ freight revenue, average revenue per car (ARC), and carloadings have been realigned to the new reporting format. Freight revenues vary with volume (carloads) and ARC. Changes in price, traffic mix, and fuel surcharges drive ARC. Customer incentives, which are primarily provided for shipping to/from specific locations or based on cumulative volumes, are recorded as a reduction to operating revenues. Customer incentives that include variable consideration based on cumulative volumes are estimated using the expected value method, which is based on available historical, current, and forecasted volumes, and recognized as the related performance obligation is satisfied. We recognize freight revenues over time as shipments move from origin to destination. The allocation of revenue between reporting periods is based on the relative transit time in each reporting period with expenses recognized as incurred.
Other revenues consist primarily of revenues earned by our other subsidiaries (primarily logistics and commuter rail operations) and accessorial revenues. Other subsidiary revenues are generally recognized over time as shipments move from origin to destination. The allocation of revenue between reporting periods is based on the relative transit time in each reporting period with expenses recognized as incurred. Accessorial revenues are recognized at a point in time as performance obligations are satisfied.
Freight revenues decreased 10% year-over-year to $18.3 billion driven by a 7% volume decline, lower fuel surcharge, and negative mix of traffic, partially offset by core pricing gains. Volume declined in almost every market segment due to the deteriorating economic conditions brought on by the COVID-19 pandemic. While some markets rebounded in the fourth quarter, particularly grain and intermodal, others still lagged 2019 levels. Shipments of coal, sand, and petroleum products continue to be negatively impacted by low crude oil and natural gas prices.
Our fuel surcharge programs generated freight revenues of almost $1.0 billion and $1.6 billion in 2020 and 2019, respectively. Fuel surcharge revenue in 2020 decreased $586 million as a result of a 30% decrease in fuel price and a 7% reduction in carloadings, partially offset by the lag impact on fuel surcharge (it can generally take up to two months for changing fuel prices to affect fuel surcharges recoveries).
In 2020, other subsidiary revenues decreased from 2019 driven by the disruption of the automotive supply chain, which drove lower intermodal shipments and revenue at our subsidiaries that broker intermodal and transload logistics services. Accessorial revenue and other revenue declined driven by lower industrial products traffic.
The following tables summarize the year-over-year changes in freight revenues, revenue carloads, and ARC by commodity type:
| Freight Revenues | % Change | % Change | |||||||||
| Millions | 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | ||||||
| Grain & grain products | $ | 2,829 | $ | 2,776 | $ | 2,756 | 2 | % | 1 | % | |
| Fertilizer | 660 | 653 | 641 | 1 | 2 | ||||||
| Food & refrigerated | 937 | 1,008 | 1,065 | (7) | (5) | ||||||
| Coal & renewables | 1,534 | 2,092 | 2,607 | (27) | (20) | ||||||
| Bulk | 5,960 | 6,529 | 7,069 | (9) | (8) | ||||||
| Industrial chemicals & plastics | 1,845 | 1,885 | 1,828 | (2) | 3 | ||||||
| Metals & minerals | 1,580 | 2,042 | 2,521 | (23) | (19) | ||||||
| Forest products | 1,160 | 1,160 | 1,209 | - | (4) | ||||||
| Energy & specialized markets | 2,037 | 2,385 | 2,131 | (15) | 12 | ||||||
| Industrial | 6,622 | 7,472 | 7,689 | (11) | (3) | ||||||
| Automotive | 1,680 | 2,123 | 2,172 | (21) | (2) | ||||||
| Intermodal | 3,989 | 4,119 | 4,454 | (3) | (8) | ||||||
| Premium | 5,669 | 6,242 | 6,626 | (9) | (6) | ||||||
| Total | $ | 18,251 | $ | 20,243 | $ | 21,384 | (10) | % | (5) | % |
| Revenue Carloads | % Change | % Change | |||||||||
| Thousands | 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | ||||||
| Grain & grain products | 745 | 708 | 723 | 5 | % | (2) | % | ||||
| Fertilizer | 193 | 190 | 194 | 2 | (2) | ||||||
| Food & refrigerated | 185 | 192 | 206 | (4) | (7) | ||||||
| Coal & renewables | 797 | 997 | 1,176 | (20) | (15) | ||||||
| Bulk | 1,920 | 2,087 | 2,299 | (8) | (9) | ||||||
| Industrial chemicals & plastics | 587 | 611 | 599 | (4) | 2 | ||||||
| Metals & minerals | 646 | 744 | 822 | (13) | (9) | ||||||
| Forest products | 220 | 220 | 241 | - | (9) | ||||||
| Energy & specialized markets | 539 | 624 | 565 | (14) | 10 | ||||||
| Industrial | 1,992 | 2,199 | 2,227 | (9) | (1) | ||||||
| Automotive | 692 | 858 | 891 | (19) | (4) | ||||||
| Intermodal [a] | 3,149 | 3,202 | 3,491 | (2) | (8) | ||||||
| Premium | 3,841 | 4,060 | 4,382 | (5) | (7) | ||||||
| Total | 7,753 | 8,346 | 8,908 | (7) | % | (6) | % |
| % Change | % Change | ||||||||||
| Average Revenue per Car | 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | ||||||
| Grain & grain products | $ | 3,797 | $ | 3,919 | $ | 3,811 | (3) | % | 3 | % | |
| Fertilizer | 3,427 | 3,448 | 3,303 | (1) | 4 | ||||||
| Food & refrigerated | 5,047 | 5,241 | 5,171 | (4) | 1 | ||||||
| Coal & renewables | 1,926 | 2,098 | 2,216 | (8) | (5) | ||||||
| Bulk | 3,104 | 3,128 | 3,074 | (1) | 2 | ||||||
| Industrial chemicals & plastics | 3,144 | 3,087 | 3,049 | 2 | 1 | ||||||
| Metals & minerals | 2,445 | 2,745 | 3,067 | (11) | (10) | ||||||
| Forest products | 5,269 | 5,264 | 5,025 | - | 5 | ||||||
| Energy & specialized markets | 3,780 | 3,821 | 3,772 | (1) | 1 | ||||||
| Industrial | 3,324 | 3,398 | 3,452 | (2) | (2) | ||||||
| Automotive | 2,427 | 2,474 | 2,438 | (2) | 1 | ||||||
| Intermodal [a] | 1,267 | 1,286 | 1,276 | (1) | 1 | ||||||
| Premium | 1,476 | 1,538 | 1,512 | (4) | 2 | ||||||
| Average | $ | 2,354 | $ | 2,425 | $ | 2,400 | (3) | % | 1 | % |
*[a]*For intermodal shipments, each container or trailer equals one carload.
| Bulk – Bulk includes shipments of grain and grain products, fertilizer, food and refrigerated goods, and coal and renewables. Freight revenue from bulk shipments decreased in 2020 compared to 2019 due to an 8% volume decline and lower fuel surcharge revenue, partially offset by positive business mix and core pricing gains. Continued softness in market conditions due to low natural gas prices and weak export demand drove the 21% decline in coal shipments. The COVID-19 pandemic negatively impacted production of imported beer, food products, and the demand for ethanol and related products contributing to additional declines in volume. Strong demand for export grain, particularly in the fourth quarter, partially offset the losses. | 2020 Bulk Carloads | ||
 | |||
| Industrial – Industrial includes shipments of industrial chemicals and plastics, metals and minerals, forest products, and energy and specialized markets. Freight revenue from industrial shipments decreased in 2020 versus 2019 due a 9% decline in volume, negative mix of traffic, and lower fuel surcharge, partially offset by pricing gains. Although volume from industrial shipments were up in the first quarter, it was not enough to overcome the weak demand throughout the rest of the year as the pandemic impacted a wide range of industries driving year-over-year declines in many of our market segments including industrial chemicals, rock, soda ash, and steel. In addition, low oil prices, resulting in lower drilling, coupled with local sand impacts were the primary drivers behind the 57% decline in sand shipments and 26% decline in petroleum product shipments compared to 2019. Premium – Premium includes shipments of finished automobiles, automotive parts, and merchandise in intermodal containers, both domestic and international. Freight revenue from premium shipments decreased in 2020 compared to 2019 due to a 5% volume decline, lower fuel surcharges, and negative mix of traffic, partially offset by core pricing gains. Volume declines in international intermodal due to trade uncertainty and the COVID-19 impact on supply chains between Asia and the U.S., along with the temporary automotive production halt, drove the decline in premium shipments compared to 2019. These declines were partially offset by contract wins and strength in e-commerce parcel shipments. | 2020 Industrial Carloads  | ||
2020 Premium Carloads  | |||
Mexico Business – Each of our commodity groups includes revenue from shipments to and from Mexico. Revenue from Mexico business was $2.1 billion in 2020, down 10% compared to 2019, driven by a 12% decline in volume and lower fuel surcharge revenue, partially offset by core pricing gains. The volume decline was driven by the COVID-19 pandemic with declines in automotive and intermodal shipments, partially offset by increases in LPG, beer, and grain.
Operating Expenses
| % Change | % Change | |||||||||
| Millions | 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | |||||
| Compensation and benefits | $ | 3,993 | $ | 4,533 | $ | 5,056 | (12) | % | (10) | % |
| Depreciation | 2,210 | 2,216 | 2,191 | - | 1 | |||||
| Purchased services and materials | 1,962 | 2,254 | 2,443 | (13) | (8) | |||||
| Fuel | 1,314 | 2,107 | 2,531 | (38) | (17) | |||||
| Equipment and other rents | 875 | 984 | 1,072 | (11) | (8) | |||||
| Other | 1,345 | 1,060 | 1,022 | 27 | 4 | |||||
| Total | $ | 11,699 | $ | 13,154 | $ | 14,315 | (11) | % | (8) | % |
| Operating expenses decreased $1.5 billion in 2020 compared to 2019 driven by productivity improvements, lower fuel prices, cost savings from lower volume, and lower destroyed equipment and freight costs. Partially offsetting these decreases compared to 2019 are a $278 million impairment charge, inflation, increased bad debt expense, and higher state and local taxes. In addition, expenses were positively impacted by lower year-over-year weather-related costs, partially offset by an employment tax refund recognized in 2019. Full year results for 2020 and 2019 both include a $25 million reduction of expense for 2019 weather-related insurance reimbursements. | 2020 Operating Expenses |
 |
Compensation and Benefits – Compensation and benefits include wages, payroll taxes, health and welfare costs, pension costs, other postretirement benefits, and incentive costs. In 2020, expenses decreased 12% compared to 2019, due to productivity initiatives; declines in carload volumes; lower weather-related costs; management’s actions responding to the sharp decline in volume, including three months of temporary unpaid leave and salary reductions, and almost 6 months of large shop closures (a locomotive shop, a freight car shop, and a maintenance-of-way shop); partially offset by wage inflation, an employment tax refund recognized in 2019, and a one-time bonus payment for agreement employees who worked during the pandemic. Severance costs were relatively flat year-over-year.
Depreciation – The majority of depreciation relates to road property, including rail, ties, ballast, and other track material. Depreciation expense was essentially flat in 2020 compared to 2019.
Purchased Services and Materials – Expense for purchased services and materials includes the costs of services purchased from outside contractors and other service providers (including equipment maintenance and contract expenses incurred by our subsidiaries for external transportation services); materials used to maintain the Railroad’s lines, structures, and equipment; costs of operating facilities jointly used by UPRR and other railroads; transportation and lodging for train crew employees; trucking and contracting costs for intermodal containers; leased automobile maintenance expenses; and tools and supplies. Purchased services and materials decreased 13% in 2020 compared to 2019 driven by reductions in all of the following: locomotive maintenance expenses due to a smaller active fleet, volume-related costs for intermodal and transload services incurred by our subsidiaries, costs for transportation for the train crews, professional services expense, costs associated with derailments, and year-over-year weather-related costs.
Fuel – Fuel includes locomotive fuel and gasoline for highway and non-highway vehicles and heavy equipment. Locomotive diesel fuel prices, which averaged $1.50 per gallon (including taxes and transportation costs) in 2020, compared to $2.13 per gallon in 2019, decreased expenses $539 million (excluding any impact from year-over-year volume declines). Gross ton-miles decreased 9% and our fuel consumption rate, computed as gallons of fuel consumed divided by gross ton-miles, improved 2%, which both drove lower fuel expense.
Equipment and Other Rents – Equipment and other rents expense primarily includes rental expense that the Railroad pays for freight cars owned by other railroads or private companies; freight car, intermodal, and locomotive leases; and office and other rent expenses, offset by equity income from certain equity method investments. Equipment and other rents expense decreased 11% compared to 2019 driven by improved freight car velocity, volume declines, and lease returns, partially offset by lower equity income.
Other – Other expenses include state and local taxes, freight, equipment and property damage, utilities, insurance, personal injury, environmental, employee travel, telephone and cellular, computer software, bad debt, and other general expenses. Other expenses increased 27% in 2020 compared to 2019 as a result of a $278 million non-cash impairment charge related to our Brazos yard investment. Increased bad debt expense, state and local taxes, lower equity income from our investment in Grupo Ferroviaro Mexicano, and write offs of certain in-progress capital projects and lease impairments, were almost completely offset by lower costs associated with freight loss and damage, employee travel, and destroyed equipment.
Non-Operating Items
| % Change | % Change | |||||||||
| Millions | 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | |||||
| Other income | $ | 287 | $ | 243 | $ | 94 | 18 | % | F | % |
| Interest expense | (1,141) | (1,050) | (870) | 9 | 21 | |||||
| Income tax expense | (1,631) | (1,828) | (1,775) | (11) | 3 |
Other Income – Other income increased in 2020 compared to 2019 due to larger gains from real estate sales, including a $69 million gain from a land and permanent easement sale to the Illinois State Toll Highway Authority, partially offset by $31 million in interest income associated with an employment tax refund in 2019 and lower interest income.
Interest Expense – Interest expense increased in 2020 compared to 2019 due to an increased weighted-average debt level of $27.9 billion in 2020 from $24.8 billion in 2019, partially offset by the impact of a lower effective interest rate of 4.1% in 2020 compared to 4.3 % in 2019.
Income Taxes – Income tax expense decreased in 2020 compared to 2019 due to lower pre-tax income. Our effective tax rates for 2020 and 2019 were 23.4% and 23.6%, respectively.
OTHER OPERATING/PERFORMANCE AND FINANCIAL STATISTICS
We report a number of key performance measures weekly to the STB. We provide this data on our website at www.up.com/investor/aar-stb_reports/index.htm.
Operating/Performance Statistics
Management continuously measures these key operating metrics to evaluate our productivity, asset utilization, and network efficiency in striving to provide a consistent, reliable service product to our customers.
Railroad performance measures are included in the table below:
| % Change | % Change | |||||||
| 2020 | 2019 | 2018 | 2020 v 2019 | 2019 v 2018 | ||||
| Gross ton-miles (GTMs) (billions) | 771.8 | 846.6 | 928.6 | (9) | % | (9) | % | |
| Revenue ton-miles (billions) | 385.0 | 423.4 | 474.0 | (9) | (11) | |||
| Freight car velocity (daily miles per car) [a] | 221 | 209 | 198 | 6 | 6 | |||
| Average train speed (miles per hour) [b] | 25.9 | 25.1 | 26.1 | 3 | (4) | |||
| Average terminal dwell time (hours) [b] | 22.7 | 24.8 | 29.8 | (8) | (17) | |||
| Locomotive productivity (GTMs per horsepower day) | 137 | 120 | 106 | 14 | 13 | |||
| Train length (feet) | 8,798 | 7,747 | 7,036 | 14 | 10 | |||
| Intermodal car trip plan compliance (%) | 81 | 75 | 71 | 6 | pts | 4 | pts | |
| Manifest/Automotive car trip plan compliance (%) | 71 | 65 | 57 | 6 | pts | 8 | pts | |
| Workforce productivity (car miles per employee) | 947 | 857 | 839 | 11 | 2 | |||
| Total employees (average) | 30,960 | 37,483 | 41,967 | (17) | (11) | |||
| Operating ratio | 59.9 | 60.6 | 62.7 | (0.7) | pts | (2.1) | pts |
[a] Prior years have been recast to conform to the current year presentation which reflects minor refinements.
[b] As reported to the STB.
Gross and Revenue Ton-Miles – Gross ton-miles are calculated by multiplying the weight of loaded and empty freight cars by the number of miles hauled. Revenue ton-miles are calculated by multiplying the weight of freight by the number of tariff miles. Gross ton-miles and revenue ton-miles both decreased 9% in 2020 compared to 2019, driven by a 7% decline in carloadings. Changes in commodity mix drove the variance in year-over-year decreases between gross ton-miles, revenue ton-miles, and carloads.
Freight Car Velocity – Freight car velocity measures the average daily miles per car on our network. The two key drivers of this metric are the speed of the train between terminals (average train speed) and the time a rail car spends at the terminals (average terminal dwell time). Continued implementation of our new operating plan was the primary driver of the improvement from 2019 as both average terminal dwell and average train speed improved compared to 2020. Average terminal dwell time decreased compared to 2019 largely due to improved terminal processes, transportation plan changes to eliminate switches, and reduced carload volumes due to COVID-19. Average train speed in 2020 improved as weather-related challenges slowed trains in the first half of 2019. Train speed remained relatively flat year-over-year in the second half of the year.
Locomotive Productivity – Locomotive productivity is gross ton-miles per average daily locomotive horsepower. Locomotive productivity increased 14% in 2020 compared to 2019 driven by a 24% reduction in our average active fleet size due to transportation plan changes and lower locomotive dwell times.
Train Length – Train length is the average maximum train length on a route measured in feet. Our train length increased 14% compared to 2019 as a result of blending service products, transportation plan changes, and completing 36 siding extension projects.
Car Trip Plan Compliance – Car trip plan compliance is the percentage of cars delivered on time in accordance with our original trip plan. Our network trip plan compliance is broken into the intermodal and manifest products. Intermodal trip plan compliance improved versus 2019, due to improved train speed and reduced dwell at our origin and destination ramps. Manifest car trip plan compliance improved compared to 2019 due to improved car dwell in our yards, increased train velocity across the network, and more
reliable first and last mile service. Both metrics were aided by reduced carload volumes due to COVID-19 and milder weather.
Workforce Productivity – Workforce productivity is average daily car miles per employee. Workforce productivity improved 11%, reaching an all-time record as average daily car miles decreased 9% while employees decreased 17% compared to 2019. Lower volumes drove the decline in average daily car miles. The 17% decline in employee levels was driven by productivity initiatives, a 7% decline in carload volumes, and a smaller capital workforce. At the end of the year, approximately 4,100 employees across all crafts were furloughed.
Operating Ratio – Operating ratio is our operating expenses reflected as a percentage of operating revenue. Our operating ratio of 59.9% was an all-time record and improved 0.7 points compared to 2019 mainly driven by productivity initiatives, lower fuel prices, and core pricing gains; which were partially offset by a negative mix of traffic, a one-time impairment charge, inflation, and other cost increases.
Return on Average Common Shareholders’ Equity
| Millions, Except Percentages | 2020 | 2019 | 2018 | |||
| Net income | $ | 5,349 | $ | 5,919 | $ | 5,966 |
| Average equity | $ | 17,543 | $ | 19,276 | $ | 22,640 |
| Return on average common shareholders' equity | 30.5% | 30.7% | 26.4% |
Return on Invested Capital as Adjusted (ROIC)
| Millions, Except Percentages | 2020 | 2019 | 2018 | |||
| Net income | $ | 5,349 | $ | 5,919 | $ | 5,966 |
| Interest expense | 1,141 | 1,050 | 870 | |||
| Interest on average operating lease liabilities | 64 | 76 | 82 | |||
| Taxes on interest | (282) | (266) | (218) | |||
| Net operating profit after taxes as adjusted | $ | 6,272 | $ | 6,779 | $ | 6,700 |
| Average equity | $ | 17,543 | $ | 19,276 | $ | 22,640 |
| Average debt | 25,965 | 23,796 | 19,668 | |||
| Average operating lease liabilities | 1,719 | 2,052 | 2,206 | |||
| Average invested capital as adjusted | $ | 45,227 | $ | 45,124 | $ | 44,514 |
| Return on Invested Capital as Adjusted | 13.9% | 15.0% | 15.1% |
ROIC is considered a non-GAAP financial measure by SEC Regulation G and Item 10 of SEC Regulation S-K and may not be defined and calculated by other companies in the same manner. We believe this measure is important to management and investors in evaluating the efficiency and effectiveness of our long-term capital investments. In addition, we currently use ROIC as a performance criteria in determining certain elements of equity compensation for our executives. ROIC should be considered in addition to, rather than as a substitute for, other information provided in accordance with GAAP. The most comparable GAAP measure is Return on Average Common Shareholders’ Equity. The tables above provide reconciliations from return on average common shareholders’ equity to ROIC. At December 31, 2020, 2019, and 2018, the incremental borrowing rate on operating leases was 3.7%.
Adjusted Debt / Adjusted EBITDA
| Millions, Except Ratios | Dec. 31, | Dec. 31, | Dec. 31, | |||
| for the Twelve Months Ended | 2020 | 2019 | 2018 | |||
| Net income | $ | 5,349 | $ | 5,919 | $ | 5,966 |
| Add: | ||||||
| Income tax expense | 1,631 | 1,828 | 1,775 | |||
| Depreciation | 2,210 | 2,216 | 2,191 | |||
| Interest expense | 1,141 | 1,050 | 870 | |||
| EBITDA | $ | 10,331 | $ | 11,013 | $ | 10,802 |
| Adjustments: | ||||||
| Other income | (287) | (243) | (94) | |||
| Interest on operating lease liabilities | 59 | 68 | 84 | |||
| Adjusted EBITDA | $ | 10,103 | $ | 10,838 | $ | 10,792 |
| Debt | $ | 26,729 | $ | 25,200 | $ | 22,391 |
| Operating lease liabilities | 1,604 | 1,833 | 2,271 | |||
| Unfunded pension and OPEB, | ||||||
| net of taxes of $195, $124 and $135 | 637 | 400 | 456 | |||
| Adjusted debt | $ | 28,970 | $ | 27,433 | $ | 25,118 |
| Adjusted debt / Adjusted EBITDA | 2.9 | 2.5 | 2.3 |
Adjusted debt to adjusted EBITDA (earnings before interest, taxes, depreciation, amortization, and adjustments for other income and interest on present value of operating leases) is considered a non-GAAP financial measure by SEC Regulation G and Item 10 of SEC Regulation S-K and may not be defined and calculated by other companies in the same manner. We believe this measure is important to management and investors in evaluating the Company’s ability to sustain given debt levels (including leases) with the cash generated from operations. In addition, a comparable measure is used by rating agencies when reviewing the Company’s credit rating. Adjusted debt to adjusted EBITDA should be considered in addition to, rather than as a substitute for, net income. The table above provides reconciliations from net income to adjusted debt to adjusted EBITDA. At December 31, 2020, 2019, and 2018, the incremental borrowing rate on operating leases was 3.7%.
LIQUIDITY AND CAPITAL RESOURCES
We are continually evaluating the impact of COVID-19 on our financial condition and liquidity. Although the situation is fluid and highly uncertain, we continue to analyze a wide range of economic scenarios and the impact on our ability to generate cash. These analyses inform our liquidity plans and activity outlined below and indicate we have sufficient capacity to sustain an extended period of lower volumes.
At December 31, 2020, we had a working capital surplus due to an increased cash balance held due to the uncertainty related to COVID-19 compared to December 31, 2019, where we had a working capital deficit due to upcoming debt maturities. As past years indicate, it is not unusual for us to have a working capital deficit; however, we believe it is not an indication of a lack of liquidity. We also maintain adequate resources, including our credit facility and, when necessary, access the capital markets to meet any foreseeable cash requirements.
We generated $8.5 billion of cash from operating activities in 2020. Based on the strength of our cash position, we completed a $1.0 billion debt exchange; redeemed the $500 million principal outstanding of 4.0% notes due February 1, 2021, on November 1, 2020; repaid the $300 million outstanding bilateral revolving credit lines that we assumed earlier in the year; repaid the $400 million outstanding on the Receivables Facility; and reduced our commercial paper outstanding from $200 million to $75 million. We have been, and we expect to continue to be, in compliance with our debt covenants. Our bad debt provision was adjusted to reflect deteriorations of customers’ creditworthiness. We maintained the dividend during 2020 paying out $2.6 billion and repurchased shares totaling $3.7 billion. In the third quarter, we completed our $2 billion accelerated share repurchase program entered into on February 18, 2020, and resumed share repurchases in the fourth quarter after suspending share repurchases in March 2020.
Our principal sources of liquidity include cash, cash equivalents, our receivables securitization facility, our revolving credit facility, as well as the availability of commercial paper and other sources of financing
through the capital markets. On December 31, 2020, we had $1.8 billion of cash and cash equivalents, $2.0 billion of committed credit available under our credit facility, up to $800 million undrawn on the Receivables Facility, and three bilateral revolving credit lines, which mature in May 2021, with up to $600 million of available credit. As of December 31, 2020, none of the revolving credit facility, Receivables Facility, or bilateral revolving credit lines was drawn. We did not draw on our revolving credit facility at any time during 2020. Our access to the receivables securitization facility may be reduced or restricted if our bond ratings fall to certain levels below investment grade. If our bond rating were to deteriorate, it could have an adverse impact on our liquidity. Access to commercial paper as well as other capital market financing is dependent on market conditions. Deterioration of our operating results or financial condition due to internal or external factors could negatively impact our ability to access capital markets as a source of liquidity. Access to liquidity through the capital markets is also dependent on our financial stability. We expect that we will continue to have access to liquidity through any or all of the following sources or activities: (i) increasing the utilization of our receivables securitization, (ii) issuing commercial paper, (iii) entering into bank loans, outside of our revolving credit facility, or (iv) issuing bonds or other debt securities to public or private investors based on our assessment of the current condition of the credit markets. The Company’s $2.0 billion revolving credit facility is intended to support the issuance of commercial paper by UPC and also serves as an additional source of liquidity to fund short term needs. The Company currently does not intend to make any borrowings under this facility.
LIBOR Transition – Each of our $2.0 billion revolving credit facility, three bilateral revolving credit lines, two term loans, and Receivables Securitization Facility currently use LIBOR as the benchmark for its floating interest rates. Authorities that regulate LIBOR have announced plans to phase out LIBOR so that it will, at some point, cease to exist as a benchmark for floating interest rates. To address the phase out of LIBOR, the agreements for substantially all of these facilities include a mechanism to replace LIBOR with an alternative rate or benchmark under specified circumstances through an amendment to the agreements. As part of this process, we will need to renegotiate our agreements to reference that alternative rate or benchmark, and may need to modify our existing benchmark replacement language, or obtain replacement facilities, and the use of an alternative rate or benchmark may negatively impact the terms of our facilities, including in the form of an adverse effect on interest rates and higher borrowing costs and interest expense.
| Cash Flows | ||||||
| Millions | 2020 | 2019 | 2018 | |||
| Cash provided by operating activities | $ | 8,540 | $ | 8,609 | $ | 8,686 |
| Cash used in investing activities | (2,676) | (3,435) | (3,411) | |||
| Cash used in financing activities | (4,902) | (5,646) | (5,222) | |||
| Net change in cash, cash equivalents, and restricted cash | $ | 962 | $ | (472) | $ | 53 |
Operating Activities
Cash provided by operating activities decreased in 2020 compared to 2019 due primarily to lower net income, partially offset by a deferral of employment tax payments allowed by a provision in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
Cash Flow Conversion – Cash flow conversion is defined as cash provided by operating activities less cash used in capital investments as a ratio of net income.
Cash flow conversion rate is not considered a financial measure under GAAP by SEC Regulation G and Item 10 of SEC Regulation S-K and may not be defined and calculated by other companies in the same manner. We believe cash flow conversion rate is important to management and investors in evaluating our financial performance and measures our ability to generate cash without additional external financing. Cash flow conversion rate should be considered in addition to, rather than as a substitute for, cash provided by operating activities.
The following table reconciles cash provided by operating activities (GAAP measure) to cash flow conversion rate (non-GAAP measure):
| Millions, | |||||||
| For the Year Ended December 31, 2020 | 2020 | 2019 | 2018 | ||||
| Cash provided by operating activities | $ | 8,540 | $ | 8,609 | $ | 8,686 | |
| Cash used in capital investments | (2,927) | (3,453) | (3,437) | ||||
| Total (a) | 5,613 | 5,156 | 5,249 | ||||
| Net income (b) | 5,349 | 5,919 | 5,966 | ||||
| Cash flow conversion rate (a/b) | 105 | % | 87 | % | 88 | % |
Investing Activities
Cash used in investing activities in 2020 decreased compared to 2019 primarily driven by reduced capital investment in locomotives and freight cars and increased real estate sales.
The following tables detail cash capital investments and track statistics for the years ended December 31, 2020, 2019, and 2018:
| Millions | 2020 | 2019 | 2018 | |||
| Ties | $ | 507 | $ | 427 | $ | 444 |
| Rail and other track material | 471 | 561 | 608 | |||
| Ballast | 225 | 271 | 216 | |||
| Other [a] | 584 | 694 | 576 | |||
| Total road infrastructure replacements | 1,787 | 1,953 | 1,844 | |||
| Line expansion and other capacity projects | 332 | 357 | 286 | |||
| Commercial facilities | 171 | 183 | 234 | |||
| Total capacity and commercial facilities | 503 | 540 | 520 | |||
| Locomotives and freight cars [b] | 269 | 610 | 716 | |||
| Positive train control | 79 | 95 | 158 | |||
| Technology and other | 289 | 255 | 199 | |||
| Total cash capital investments | $ | 2,927 | $ | 3,453 | $ | 3,437 |
*[a]*Other includes bridges and tunnels, signals, other road assets, and road work equipment.
*[b]*Locomotives and freight cars include early lease buyouts of $38 million in 2020, $290 million in 2019, and $290 million in 2018.
| 2020 | 2019 | 2018 | ||||
| Track miles of rail replaced | 468 | 534 | 700 | |||
| Track miles of rail capacity expansion | 83 | 55 | 39 | |||
| New ties installed (thousands) | 4,671 | 3,475 | 4,285 | |||
| Miles of track surfaced | 10,414 | 7,741 | 9,466 |
Capital Plan – In 2021, we expect our capital plan to be approximately $2.9 billion, essentially flat with 2020. While implementation of our new transportation plan has generated capacity, we will continue to harden our infrastructure, replace older assets, and improve the safety and resiliency of the network. In addition, the plan includes investments intended to support growth and improve productivity and operational efficiency. The capital plan may be revised if business conditions warrant or if new laws or regulations affect our ability to generate sufficient returns on these investments.
Financing Activities
Cash used in financing activities decreased in 2020 compared to 2019 driven by lower share repurchases, which were paused in March of 2020 due to the uncertainty of COVID-19 and resumed in the fourth quarter of 2020, with the exception of the final settlement in July 2020 of our $2 billion accelerated share repurchase program entered into on February 18, 2020. This decrease was partially offset by an increase in debt repaid.
See Note 14 of the Consolidated Financial Statements for a description of all our outstanding financing arrangements and significant new borrowings.
Share Repurchase Programs
Effective April 1, 2019, our Board of Directors authorized the repurchase of up to 150 million shares of our common stock by March 31, 2022, replacing our previous repurchase program. These repurchases may be made on the open market or through other transactions. Our management has sole discretion with respect to determining the timing and amount of these transactions. As of December 31, 2020, we repurchased a total of $40.9 billion of our common stock since commencement of our repurchase programs in 2007. The table below represents shares repurchased under repurchase programs during 2020 and 2019:
| Number of Shares Purchased | Average Price Paid [a] | ||||||
| 2020 | 2019 | 2020 | 2019 | ||||
| First quarter [b] | 14,305,793 | 18,149,450 | $ | 178.66 | $ | 165.79 | |
| Second quarter | - | 3,732,974 | - | 171.24 | |||
| Third quarter [c] | 4,045,575 | 9,529,733 | 98.87 | 163.30 | |||
| Fourth quarter | 3,780,743 | 3,582,212 | 198.07 | 167.32 | |||
| Total | 22,132,111 | 34,994,369 | $ | 167.39 | $ | 165.85 | |
| Remaining number of shares that may be repurchased under current authority | 111,022,970 |
*[a]*In the period of the final settlement, the average price paid under the accelerated share repurchase programs is calculated based on the total program value less the value assigned to the initial delivery of shares. The average price of the completed 2020 and 2019 accelerated share repurchase programs was $155.86 and $167.01, respectively.
*[b]*Includes 8,786,380 and 11,795,930 shares repurchased in February 2020 and 2019, respectively, under accelerated share repurchase programs.
*[c]*Includes an incremental 4,045,575 and 3,172,900 shares received upon final settlement in July 2020 and August 2019, respectively, under accelerated share repurchase programs.
Management's assessments of market conditions and other pertinent factors guide the timing and volume of all repurchases. We expect to fund any share repurchases under this program through cash generated from operations, the sale or lease of various operating and non-operating properties, debt issuances, and cash on hand. Open market repurchases are recorded in treasury stock at cost, which includes any applicable commissions and fees.
From January 1, 2021, through February 4, 2021, we repurchased 2.1 million shares at an aggregate cost of approximately $442 million.
Accelerated Share Repurchase Programs – The Company has established accelerated share repurchase programs (ASRs) with financial institutions to repurchase shares of our common stock. These ASRs have been structured so that at the time of commencement, we pay a specified amount to the financial institutions and receive an initial delivery of shares. Additional shares may be received at the time of settlement. The final number of shares to be received is based on the volume weighted average price of the Company’s common stock during the ASR term, less a discount and subject to potential adjustments pursuant to the terms of such ASR.
On February 19, 2020, the Company received 8,786,380 shares of its common stock repurchased under ASRs for an aggregate of $2.0 billion. Upon settlement of these ASRs in the third quarter of 2020, we received 4,045,575 additional shares.
On February 26, 2019, the Company received 11,795,930 shares of its common stock repurchased under ASRs for an aggregate of $2.5 billion. Upon settlement of these ASRs in the third quarter of 2019, we received 3,172,900 additional shares.
ASRs are accounted for as equity transactions, and at the time of receipt, shares are included in treasury stock at fair market value as of the corresponding initiation or settlement date. The Company reflects shares received as a repurchase of common stock in the weighted average common shares outstanding calculation for basic and diluted earnings per share.
Contractual Obligations and Commercial Commitments
As described in the notes to the Consolidated Financial Statements and as referenced in the tables below, we have contractual obligations and commercial commitments that may affect our financial condition. Based on our assessment of the underlying provisions and circumstances of our contractual obligations and commercial commitments, including material sources of off-balance sheet and structured finance arrangements, other than the risks that we and other similarly situated companies face with respect to the condition of the capital markets (as described in Item 1A of Part II of this report), there is no known trend, demand, commitment, event, or uncertainty that is reasonably likely to occur that would have a material adverse effect on our consolidated results of operations, financial condition, or liquidity. In addition, our commercial obligations, financings, and commitments are customary transactions that are similar to those of other comparable corporations, particularly within the transportation industry.
The following tables identify material obligations and commitments as of December 31, 2020:
| Payments Due by December 31, | |||||||||||||||||
| Contractual Obligations | After | ||||||||||||||||
| Millions | Total | 2021 | 2022 | 2023 | 2024 | 2025 | 2025 | Other | |||||||||
| Debt [a] | $ | 48,525 | $ | 1,975 | $ | 2,280 | $ | 2,246 | $ | 2,265 | $ | 2,245 | $ | 37,514 | $ | - | |
| Purchase obligations [b] | 2,790 | 1,174 | 547 | 246 | 204 | 162 | 457 | - | |||||||||
| Operating leases [c] | 1,830 | 325 | 273 | 229 | 220 | 216 | 567 | - | |||||||||
| Finance lease obligations [d] | 517 | 135 | 111 | 81 | 68 | 45 | 77 | - | |||||||||
| Other post retirement benefits [e] | 410 | 49 | 45 | 44 | 39 | 39 | 194 | - | |||||||||
| Income tax contingencies [f] | 74 | 1 | - | - | - | - | - | 73 | |||||||||
| Total contractual obligations | $ | 54,146 | $ | 3,659 | $ | 3,256 | $ | 2,846 | $ | 2,796 | $ | 2,707 | $ | 38,809 | $ | 73 |
*[a]*Excludes finance lease obligations of $449 million as well as unamortized discount and deferred issuance costs of ($1,538) million. Includes an interest component of $20,707 million.
*[b]*Purchase obligations include locomotive maintenance contracts; purchase commitments for fuel purchases, ties, ballast, and rail; and agreements to purchase other goods and services.
*[c]*Includes leases for locomotives, freight cars, other equipment, and real estate.
*[d]*Represents total obligations, including interest component of $68 million.
*[e]*Includes estimated other post retirement, medical, and life insurance payments, and payments made under the unfunded pension plan for the next ten years.
*[f]*Future cash flows for income tax contingencies reflect the recorded liabilities and assets for unrecognized tax benefits, including interest and penalties, as of December 31, 2020. For amounts where the year of settlement is uncertain, they are reflected in the Other column.
| Amount of Commitment Expiration per Period | |||||||||||||||
| Other Commercial Commitments | After | ||||||||||||||
| Millions | Total | 2021 | 2022 | 2023 | 2024 | 2025 | 2025 | ||||||||
| Credit facilities [a] | $ | 2,000 | $ | - | $ | - | $ | 2,000 | $ | $ | - | $ | - | ||
| Receivables securitization facility [b] | 800 | - | 800 | - | - | - | - | ||||||||
| Bilateral revolving credit lines [c] | 600 | 600 | - | - | - | - | - | ||||||||
| Standby letters of credit [d] | 19 | 16 | 3 | - | - | - | - | ||||||||
| Guarantees [e] | 10 | 5 | 5 | - | - | - | - | ||||||||
| Total commercial commitments | $ | 3,429 | $ | 621 | $ | 808 | $ | 2,000 | $ | - | $ | - | $ | - |
*[a]*None of the credit facility was used as of December 31, 2020.
*[b]*None of the receivables securitization facility was utilized as of December 31, 2020. The full program matures in July 2022.
*[c]*None of the bilateral revolving credit lines were utilized as of December 31, 2020. The programs mature in May 2021.
*[d]*None of the letters of credit were drawn upon as of December 31, 2020.
*[e]*Includes guaranteed obligations related to our affiliated operations.
Off-Balance Sheet Arrangements
Guarantees – At December 31, 2020 and 2019, we were contingently liable for $10 million and $15 million, respectively, in guarantees. The fair value of these obligations as of both December 31, 2020 and 2019, was $0. We entered into these contingent guarantees in the normal course of business, and they include guaranteed obligations related to our affiliated operations. The final guarantee expires in 2022. We are not aware of any existing event of default that would require us to satisfy these guarantees. We do not expect
that these guarantees will have a material adverse effect on our consolidated financial condition, results of operations, or liquidity.
OTHER MATTERS
Labor Agreements – Approximately 83% of our full-time employees are represented by 13 major rail unions. Pursuant to the Railway Labor Act (RLA), our collective bargaining agreements are subject to modification every five years. Existing agreements remain in effect until new agreements are ratified or until the RLA procedures are exhausted. The RLA procedures include mediation, potential arbitration, cooling-off periods, and the possibility of Presidential Emergency Boards and Congressional intervention. The current round of negotiations began on January 1, 2020, related to years 2020-2024. Contract negotiations historically continue for an extended period of time, and work stoppages during negotiations are rare (see “Strikes or Work Stoppages Could Adversely Affect Our Operations” in the Risk Factors in Item 1A of this report).
Inflation – Long periods of inflation significantly increase asset replacement costs for capital-intensive companies. As a result, assuming that we replace all operating assets at current price levels, depreciation charges (on an inflation-adjusted basis) would be substantially greater than historically reported amounts.
Sensitivity Analyses – The sensitivity analyses that follow illustrate the economic effect that hypothetical changes in interest rates could have on our results of operations and financial condition. These hypothetical changes do not consider other factors that could impact actual results.
At December 31, 2020, we had variable-rate debt representing approximately 1.2% of our total debt. If variable interest rates average one percentage point higher in 2021 than our December 31, 2020, variable rate, which was approximately 1.3%, our interest expense would increase by approximately $3.3 million. This amount was determined by considering the impact of the hypothetical interest rate on the balances of our variable-rate debt at December 31, 2020.
Market risk for fixed-rate debt is estimated as the potential increase in fair value resulting from a hypothetical one percentage point decrease in interest rates as of December 31, 2020, and amounts to an increase of approximately $4.7 billion to the fair value of our debt at December 31, 2020. We estimated the fair values of our fixed-rate debt by considering the impact of the hypothetical interest rates on quoted market prices and current borrowing rates.
Accounting Pronouncements – See Note 3 to the Consolidated Financial Statements.
Asserted and Unasserted Claims – Various claims and lawsuits are pending against us and certain of our subsidiaries. We cannot fully determine the effect of all asserted and unasserted claims on our consolidated results of operations, financial condition, or liquidity. To the extent possible, we have recorded a liability where asserted and unasserted claims are considered probable and where such claims can be reasonably estimated. We do not expect that any known lawsuits, claims, environmental costs, commitments, contingent liabilities, or guarantees will have a material adverse effect on our consolidated results of operations, financial condition, or liquidity after taking into account liabilities and insurance recoveries previously recorded for these matters.
Indemnities – Our maximum potential exposure under indemnification arrangements, including certain tax indemnifications, can range from a specified dollar amount to an unlimited amount, depending on the nature of the transactions and the agreements. Due to uncertainty as to whether claims will be made or how they will be resolved, we cannot reasonably determine the probability of an adverse claim or reasonably estimate any adverse liability or the total maximum exposure under these indemnification arrangements. We do not have any reason to believe that we will be required to make any material payments under these indemnity provisions.
Climate Change – Although climate change could have an adverse impact on our operations and financial performance in the future (see Risk Factors under Item 1A of this report), we are currently unable to predict the manner or severity of such impact. However, we continue to take steps and explore opportunities to reduce the impact of our operations on the environment, including investments in new technologies, using training programs and technology to reduce fuel consumption, and changing our operations to increase fuel efficiency.
CR****ITICAL ACCOUNTING POLICIES
Our Consolidated Financial Statements have been prepared in accordance with GAAP. The preparation of these financial statements requires estimation and judgment that affect the reported amounts of revenues, expenses, assets, and liabilities. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The following critical accounting policies are a subset of our significant accounting policies described in Note 2 to the Financial Statements and Supplementary Data, Item 8. These critical accounting policies affect significant areas of our financial statements and involve judgment and estimates. If these estimates differ significantly from actual results, the impact on our Consolidated Financial Statements may be material.
Personal Injury – The cost of personal injuries to employees and others related to our activities is charged to expense based on estimates of the ultimate cost and number of incidents each year. We use an actuarial analysis to measure the expense and liability, including unasserted claims. The Federal Employers’ Liability Act (FELA) governs compensation for work-related accidents. Under FELA, damages are assessed based on a finding of fault through litigation or out-of-court settlements. We offer a comprehensive variety of services and rehabilitation programs for employees who are injured at work.
Our personal injury liability is not discounted to present value due to the uncertainty surrounding the timing of future payments. Approximately 94% of the recorded liability is related to asserted claims and approximately 6% is related to unasserted claims at December 31, 2020. Because of the uncertainty surrounding the ultimate outcome of personal injury claims, it is reasonably possible that future costs to settle these claims may range from approximately $270 million to $295 million. We record an accrual at the low end of the range as no amount of loss within the range is more probable than any other. Estimates can vary over time due to evolving trends in litigation.
Our personal injury liability activity was as follows:
| Millions | 2020 | 2019 | 2018 | |||
| Beginning balance | $ | 265 | $ | 271 | $ | 285 |
| Current year accruals | 72 | 78 | 74 | |||
| Changes in estimates for prior years | (3) | (11) | (16) | |||
| Payments | (64) | (73) | (72) | |||
| Ending balance at December 31 | $ | 270 | $ | 265 | $ | 271 |
| Current portion, ending balance at December 31 | $ | 60 | $ | 63 | $ | 72 |
Our personal injury claims activity was as follows:
| 2020 | 2019 | 2018 | |
| Open claims, beginning balance | 1,985 | 2,025 | 2,090 |
| New claims | 2,577 | 3,025 | 3,188 |
| Settled or dismissed claims | (2,665) | (3,065) | (3,253) |
| Open claims, ending balance at December 31 | 1,897 | 1,985 | 2,025 |
We reassess our estimated insurance recoveries annually and have recognized an asset for estimated insurance recoveries at December 31, 2020 and 2019. Any changes to recorded insurance recoveries are included in the above table in the Changes in estimates for prior years category.
Environmental Costs – We are subject to federal, state, and local environmental laws and regulations. We have identified 373 sites where we are or may be liable for remediation costs associated with alleged contamination or for violations of environmental requirements. This includes 29 sites that are the subject of actions taken by the U.S. government, 18 of which are currently on the Superfund National Priorities List. Certain federal legislation imposes joint and several liability for the remediation of identified sites; consequently, our ultimate environmental liability may include costs relating to activities of other parties, in addition to costs relating to our own activities at each site.
When we identify an environmental issue with respect to property owned, leased, or otherwise used in our business, we perform, with assistance of our consultants, environmental assessments on the property. We expense the cost of the assessments as incurred. We accrue the cost of remediation where our obligation is probable and such costs can be reasonably estimated. Our environmental liability is not discounted to present value due to the uncertainty surrounding the timing of future payments.
Our environmental liability activity was as follows:
| Millions | 2020 | 2019 | 2018 | |||
| Beginning balance | $ | 227 | $ | 223 | $ | 196 |
| Accruals | 76 | 67 | 84 | |||
| Payments | (70) | (63) | (57) | |||
| Ending balance at December 31 | $ | 233 | $ | 227 | $ | 223 |
| Current portion, ending balance at December 31 | $ | 65 | $ | 62 | $ | 59 |
Our environmental site activity was as follows:
| 2020 | 2019 | 2018 | |
| Open sites, beginning balance | 360 | 334 | 315 |
| New sites | 96 | 114 | 91 |
| Closed sites | (83) | (88) | (72) |
| Open sites, ending balance at December 31 | 373 | 360 | 334 |
The environmental liability includes future costs for remediation and restoration of sites as well as ongoing monitoring costs, but excludes any anticipated recoveries from third parties. Cost estimates are based on information available for each site, financial viability of other potentially responsible parties, and existing technology, laws, and regulations. The ultimate liability for remediation is difficult to determine because of the number of potentially responsible parties, site-specific cost sharing arrangements with other potentially responsible parties, the degree of contamination by various wastes, the scarcity and quality of volumetric data related to many of the sites, and the speculative nature of remediation costs. Estimates of liability may vary over time due to changes in federal, state, and local laws governing environmental remediation. Current obligations are not expected to have a material adverse effect on our consolidated results of operations, financial condition, or liquidity.
Property and Depreciation – Our railroad operations are highly capital intensive, and our large base of homogeneous, network-type assets turns over on a continuous basis. Each year we develop a capital program for the replacement of assets and for the acquisition or construction of assets that enables us to enhance our operations or provide new service offerings to customers. Assets purchased or constructed throughout the year are capitalized if they meet applicable minimum units of property criteria. Properties and equipment are carried at cost and are depreciated on a straight-line basis over their estimated service lives, which are measured in years, except for rail in high-density traffic corridors (i.e., all rail lines except for those subject to abandonment, and yard and switching tracks) for which lives are measured in millions of gross tons per mile of track. We use the group method of depreciation in which all items with similar characteristics, use, and expected lives are grouped together in asset classes and are depreciated using composite depreciation rates. The group method of depreciation treats each asset class as a pool of resources, not as singular items. We currently have more than 60 depreciable asset classes, and we may increase or decrease the number of asset classes due to changes in technology, asset strategies, or other factors.
We determine the estimated service lives of depreciable railroad property by means of depreciation studies. We perform depreciation studies at least every three years for equipment and every six years for track assets (i.e., rail and other track material, ties, and ballast) and other road property. Our depreciation studies take into account the following factors:
Statistical analysis of historical patterns of use and retirements of each of our asset classes;
Evaluation of any expected changes in current operations and the outlook for continued use of the assets;
Evaluation of technological advances and changes to maintenance practices; and
Expected salvage to be received upon retirement.
For rail in high-density traffic corridors, we measure estimated service lives in millions of gross tons per mile of track. It has been our experience that the lives of rail in high-density traffic corridors are closely correlated to usage (i.e., the amount of weight carried over the rail). The service lives also vary based on rail weight, rail condition (e.g., new or secondhand), and rail type (e.g., straight or curve). Our depreciation studies for rail in high-density traffic corridors consider each of these factors in determining the estimated service lives. For rail in high-density traffic corridors, we calculate depreciation rates annually by dividing the number of gross ton-miles carried over the rail (i.e., the weight of loaded and empty freight cars, locomotives, and maintenance of way equipment transported over the rail) by the estimated service lives of the rail measured in millions of gross tons per mile. Rail in high-density traffic corridors accounts for approximately 70 percent of the historical cost of rail and other track material. Based on the number of gross ton-miles carried over our rail in high density traffic corridors during 2020, the estimated service lives of the majority of this rail ranged from approximately 24 years to approximately 48 years. For all other depreciable assets, we compute depreciation based on the estimated service lives of our assets as determined from the analysis of our depreciation studies. Changes in the estimated service lives of our assets and their related depreciation rates are implemented prospectively.
Estimated service lives of depreciable railroad property may vary over time due to changes in physical use, technology, asset strategies, and other factors that will have an impact on the retirement profiles of our assets. We are not aware of any specific factors that are reasonably likely to significantly change the estimated service lives of our assets. Actual use and retirement of our assets may vary from our current estimates, which would impact the amount of depreciation expense recognized in future periods.
Changes in estimated useful lives of our assets due to the results of our depreciation studies could significantly impact future periods’ depreciation expense and have a material impact on our Consolidated Financial Statements. If the estimated useful lives of all depreciable assets were increased by one year, annual depreciation expense would decrease by approximately $68 million. If the estimated useful lives of all depreciable assets were decreased by one year, annual depreciation expense would increase by approximately $72 million. Our 2020 depreciation studies have resulted in lower depreciation rates for some asset classes. These lower rates offset the impact of a projected higher depreciable asset base, resulting in a flat year-over-year total depreciation expense in 2021 versus 2020.
Under group depreciation, the historical cost (net of salvage) of depreciable property that is retired or replaced in the ordinary course of business is charged to accumulated depreciation and no gain or loss is recognized. The historical cost of certain track assets is estimated by multiplying the current replacement cost of track assets by a historical index factor derived from (i) inflation indices published by the Bureau of Labor Statistics and (ii) the estimated useful lives of the assets as determined by our depreciation studies. The indices were selected because they closely correlate with the major costs of the properties comprising the applicable track asset classes. Because of the number of estimates inherent in the depreciation and retirement processes and because it is impossible to precisely estimate each of these variables until a group of property is completely retired, we continually monitor the estimated service lives of our assets and the accumulated depreciation associated with each asset class to ensure our depreciation rates are appropriate. In addition, we determine if the recorded amount of accumulated depreciation is deficient (or in excess) of the amount indicated by our depreciation studies. Any deficiency (or excess) is amortized as a component of depreciation expense over the remaining service lives of the applicable classes of assets.
For retirements of depreciable railroad properties that do not occur in the normal course of business, a gain or loss may be recognized if the retirement meets each of the following three conditions: (i) it is unusual, (ii) it is material in amount, and (iii) it varies significantly from the retirement profile identified through our depreciation studies. During the last three fiscal years, no gains or losses were recognized due to the retirement of depreciable railroad properties. A gain or loss is recognized in other income when we sell land or dispose of assets that are not part of our railroad operations.
We review construction in progress assets that have not yet been placed into service, for impairment when events or changes in circumstances indicate that the carrying amount of a long-lived asset or assets may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash flows are less than the carrying value of construction in progress assets when grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent, the carrying value is reduced to the estimated fair value.
Income Taxes – We account for income taxes by recording taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of events that have
been recognized in our financial statements or tax returns. These expected future tax consequences are measured based on current tax law; the effects of future tax legislation are not anticipated. Future tax legislation, such as a change in the corporate tax rate, could have a material impact on our financial condition, results of operations, or liquidity. For example, a permanent 1% increase in future income tax rates would increase our deferred tax liability by approximately $521 million. Similarly, a permanent 1% decrease in future income tax rates would decrease our deferred tax liability by approximately $521 million.
When appropriate, we record a valuation allowance against deferred tax assets to reflect that these tax assets may not be realized. In determining whether a valuation allowance is appropriate, we consider whether it is more likely than not that all or some portion of our deferred tax assets will not be realized, based on management’s judgments using available evidence for purposes of estimating whether future taxable income will be sufficient to realize a deferred tax asset. In 2020 and 2019, there were no valuation allowances.
We recognize tax benefits that are more likely than not to be sustained upon examination by tax authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely to be realized upon settlement. A liability for “unrecognized tax benefits” is recorded for any tax benefits claimed in our tax returns that do not meet these recognition and measurement standards.
Pension and Other Postretirement Benefits – We use an actuarial analysis to measure the liabilities and expenses associated with providing pension and medical and life insurance benefits (OPEB) to eligible employees. In order to use actuarial methods to value the liabilities and expenses, we must make several assumptions. The critical assumptions used to measure pension obligations and expenses are the discount rates and expected rate of return on pension assets. For OPEB, the critical assumptions are the discount rates and health care cost trend rate.
We evaluate our critical assumptions at least annually, and selected assumptions are based on the following factors:
We measure the service cost and interest cost components of our net periodic benefit cost by using individual spot rates matched with separate cash flows for each future year. Discount rates are based on a Mercer yield curve of high quality corporate bonds (rated AA by a recognized rating agency).
Expected return on plan assets is based on our asset allocation mix and our historical return, taking into consideration current and expected market conditions.
Health care cost trend rate is based on our historical rates of inflation and expected market conditions.
The following tables present the key assumptions used to measure net periodic pension and OPEB cost/(benefit) for 2021 and the estimated impact on 2021 net periodic pension and OPEB cost/(benefit) relative to a change in those assumptions:
| Assumptions | Pension | OPEB |
| Discount rate for benefit obligations | 2.42% | 2.22% |
| Discount rate for interest on benefit obligations | 1.91% | 1.57% |
| Discount rate for service cost | 2.62% | 2.36% |
| Discount rate for interest on service cost | 2.54% | 2.23% |
| Expected return on plan assets | 6.25% | N/A |
| Compensation increase | 4.40% | N/A |
| Health care cost trend rate: | ||
| Pre-65 current | N/A | 5.42% |
| Pre-65 level in 2038 | N/A | 4.50% |
| Sensitivities | Increase in Expense | |||
| Millions | Pension | OPEB | ||
| 0.25% decrease in discount rates | $ | 13 | $ | (5) |
| 0.25% increase in compensation scale | $ | 9 | N/A | |
| 0.25% decrease in expected return on plan assets | $ | 10 | N/A |
The following table presents the net periodic pension and OPEB cost for the years ended December 31:
| Est. | ||||||||
| Millions | 2021 | 2020 | 2019 | 2018 | ||||
| Net periodic pension cost | $ | 98 | $ | 50 | $ | 34 | $ | 71 |
| Net periodic OPEB cost | (3) | (1) | 10 | 23 |
CA****UTIONARY INFORMATION
Certain statements in this report, and statements in other reports or information filed or to be filed with the SEC (as well as information included in oral statements or other written statements made or to be made by us), are, or will be, forward-looking statements as defined by the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking statements and information include, without limitation, statements in the Chairman’s letter preceding Part I; statements regarding planned capital expenditures under the caption “2021 Capital Plan” in Item 2 of Part I; and statements and information set forth under the captions “2021 Outlook”; “Liquidity and Capital Resources” in Item 7 of Part II regarding our capital plan, “Share Repurchase Programs”, “Off-Balance Sheet Arrangements, Contractual Obligations, and Commercial Commitments”, “Pension and Other Postretirement Benefits”, and “Other Matters” in this Item 7 of Part II. Forward-looking statements and information also include any other statements or information in this report (including information incorporated herein by reference) regarding: potential impacts of the COVID-19 pandemic on our business operations, financial results, liquidity, and financial position, and on the world economy (including our customers and supply chains), including as a result of decreased volume and carloadings; closing of customer manufacturing, distribution, or production facilities; expectations as to operational or service improvements; expectations regarding the effectiveness of steps taken or to be taken to improve operations, service, infrastructure improvements, and transportation plan modifications; expectations as to cost savings, revenue growth, and earnings; the time by which goals, targets, or objectives will be achieved; projections, predictions, expectations, estimates, or forecasts as to our business, financial, and operational results, future economic performance, and general economic conditions; expectations as to operational or service performance or improvements; expectations as to the effectiveness of steps taken or to be taken to improve operations and/or service, including capital expenditures for infrastructure improvements and equipment acquisitions, any strategic business acquisitions, and modifications to our transportation plans, including leveraging PTC; expectations as to existing or proposed new products and services; expectations as to the impact of any new regulatory activities or legislation on our operations or financial results; estimates of costs relating to environmental remediation and restoration; estimates and expectations regarding tax matters; expectations that claims, litigation, environmental costs, commitments, contingent liabilities, labor negotiations or agreements, or other matters will not have a material adverse effect on our consolidated results of operations, financial condition, or liquidity and any other similar expressions concerning matters that are not historical facts. Forward-looking statements may be identified by their use of forward-looking terminology, such as “believes,” “expects,” “may,” “should,” “would,” “will,” “intends,” “plans,” “estimates,” “anticipates,” “projects” and similar words, phrases, or expressions.
Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times that, or by which, such performance or results will be achieved. Forward-looking statements and information are subject to risks and uncertainties, including the impact of the COVID-19 pandemic and responses by governments, businesses, and individuals, that could cause actual performance or results to differ materially from those expressed in the statements and information. Forward-looking statements and information reflect the good faith consideration by management of currently available information, and may be based on underlying assumptions believed to be reasonable under the circumstances. However, such information and assumptions (and, therefore, such forward-looking statements and information) are or may be subject to variables or unknown or unforeseeable events or circumstances over which management has little or no influence or control, and many of these risks and uncertainties are currently amplified by and may continue to be amplified by, or in the future may be amplified by, the COVID-19 pandemic. The Risk Factors in Item 1A of this report could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in any forward-looking statements or information. To the extent circumstances require or we deem it otherwise necessary, we will update or amend these risk factors in a Form 10-Q, Form 8-K, or subsequent Form 10-K. All forward-looking statements are qualified by, and should be read in conjunction with, these Risk Factors.
Forward-looking statements speak only as of the date the statement was made. We assume no obligation to update forward-looking information to reflect actual results, changes in assumptions, or changes in other factors affecting forward-looking information. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect thereto or with respect to other forward-looking statements.
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