CSX Corp (CSX) — Q3 2015 Earnings Call Transcript

Thank you, Shirley, and good morning, everyone, and again welcome to CSX Corporation's third quarter 2015 earnings presentation. The presentation material that we'll be reviewing this morning, along with our expanded quarterly financial report and our safety and service measurements, are available on our website at CSX.com under the investor section. In addition, following the presentation, a webcast and podcast replay will be available on that same website. This morning our presentation will be led by Michael Ward, the company's Chairman and Chief Executive Officer, and Frank Lonegro, our Chief Financial Officer. In addition, Cindy Sanborn, our Chief Operating Officer, and Fredrik Eliasson, our Chief Sales and Marketing Officer, along with Clarence Gooden, our President, will be available during the question-and-answer session. Now, before I turn the presentation over to Michael, let me remind everyone that the presentation and other statements made by the company contain forward-looking statements. You are encouraged to review the company's disclosure and accompanying presentation on slide 2. The disclosure identifies forward-looking statements, as well as the uncertainties and risks that could cause actual performance to differ materially from the results anticipated by these statements. In addition, at the end of the presentation, we will conduct a question-and-answer session with the research analysts. With nearly 30 analysts covering CSX today, and out of respect for everyone's time, including our investors, I would ask as a courtesy for you to please limit your inquiries to one question and, if necessary, a clarifying question on that topic. And with that, let me turn the presentation over to CSX Corporation's Chairman and Chief Executive Officer, Michael Ward.

Thank you, David, good morning, everyone. Yesterday, CSX announced third quarter financial results that demonstrate our ability to effectively manage in a dynamic marketplace. Our results included net earnings of $507 million, which translates to earnings per share of $0.52, a third quarter record. Looking at the top line, revenue in the quarter declined 9% as pricing gains were more than offset by lower fuel recovery, the continued transition in CSX's business mix, and a 3% volume decline as we cycled 2014's high demand environment. At the same time, we continue to be an industry leader in safety, and we are leveraging our improving network performance to deliver strong service and efficiency savings to help reduce operating expenses. As a result, CSX delivered operating income of $933 million and a third quarter record operating ratio of 68.3%. As we look across our business, low natural gas prices are clearly challenging domestic coal volume. More broadly, low commodity prices and the strength of the US dollar continue to challenge many of our other markets. In this environment, our goal remains providing safe, reliable service that consistently meets our customer's expectations. That service is the foundation of our ability to create long-term value for customers and shareholders, as it supports pricing for the value of our service and produces increasingly efficient operations. Now, I will turn the presentation over to Frank, who will take us through the financials and the outlook in more detail.

Thank you, Michael, and good morning, everyone. Let me begin by providing some more detail on our third quarter results. As Michael mentioned, revenue was down 9% versus the prior year. This was driven mainly by a $175 million decline in fuel surcharge recoveries and a $75 million impact from lower volume. At the same time, core pricing gains were essentially offset by negative business mix. Volume decreased 3% from last year with low natural gas prices impacting domestic coal volume and low commodity prices coupled with the strong US dollar challenging export coal and some of our merchandise markets, particularly metals. Core pricing continues to improve sequentially and for the quarter was up 4.6% overall and 4.4% excluding coal. Other revenue decreased $32 million versus the prior year, driven primarily by lower liquidated damages and an adjustment to reserves related to volume-based customer refunds. Expenses decreased 11% versus the prior year, driven mainly by a $145 million favorable impact from lower fuel prices. Our ongoing focus on efficiency drove $42 million in productivity gains in the quarter, while lower volume resulted in over $70 million of cost reduction versus last year. As a result, operating income was $933 million, down 4% versus the prior year. Looking below the line, interest expense was similar to last year. Other income was favorable as we cycled environmental charges from non-operating activities, as well as costs associated with the early retirement of debt from the prior year period. And finally, income taxes were $292 million in the quarter with an effective tax rate of about 37%. Overall, net earnings were $507 million, essentially flat to last year, and EPS was $0.52 per share, up 2% versus the prior year. Now, let me turn to the market outlook for the fourth quarter. Looking forward, we expect volumes to decline in the fourth quarter. Although we are projecting stable to favorable conditions for several key markets, this will be more than offset by unfavorable conditions for the remainder of the portfolio. Intermodal continues to be a strong growth engine as our strategic network investments support highway to rail conversions and growth with existing customers, and automotive is expected to grow along with light vehicle production trends. Agriculture is neutral as strength during the fall harvest season and our improved efficiency will be offset by weakness in export grain and the continued risk of ethanol imports, driven by a strong US dollar in a challenging global market. Chemicals are expected to be down materially as energy markets reset to an environment marked by low crude oil prices and reduced drilling activity. We expect that crude oil volumes may be down at least 25% in the fourth quarter on a sequential basis. Metals is unfavorable as the strong US dollar and high levels of imports continue to negatively impact domestic steel production levels. As such, we expect the year-over-year rate of decline to be similar to what we experienced in the third quarter. Domestic coal will continue to be unfavorably impacted by sustained low natural gas prices, and we now expect domestic coal volume to decline around 20% in the fourth quarter. As we look ahead to next year, significant coal headwinds are expected to continue in 2016. Sequentially, our quarterly run rate for domestic coal volume in 2016 should hold relatively flat to the level we expect to see in the fourth quarter.

Well, thank you, Frank. As you heard today, CSX is taking action to manage the challenges of this dynamic marketplace. With currency and commodity prices continuing to impact coal and several other merchandise markets in 2016, we will continue to match resources to the business environment. At the same time, we remain committed to delivering strong service that supports operating efficiency and creates customer value necessary to support strong pricing, which enhances our ability to invest for the future. Through these strategic investments and productivity initiatives, we are positioning the CSX network to leverage longer-term opportunities for profitable growth in our merchandise and intermodal markets. As such, this management team absolutely believes that CSX can and will achieve a mid-60s operating ratio longer term. We will now be glad to take your questions.

This is Eric Morgan with Brandon's team. Thanks for taking my question. I want to focus on intermodal, obviously, a really strong growth domestically, and called out some share shift on the international side. Can you talk about just the outlook for each of those segments and if that sort of the growth domestically is really sustainable throughout next year?

Well, thank you, Eric, this is Fredrik. On the domestic side, we are seeing the benefit of the investment and improving service product that we are seeing. We have been able to grow that business somewhere between 5% and 10% over the last several years. We are seeing a little bit of an enhanced growth here this quarter, as we know one of our customers who has the contractual ability to further diversify the portfolio is doing just that here in the quarter. So we are seeing a little bit of an uptick in the growth with that customer right now beyond what we would normally see, but we feel good about that business and feel good about the ability to continue to grow that at a multiple of economic output for a period of time here going forward. On the international side, we are experiencing growth with several of our existing customers. We have lost several contracts over the last 12 to 18 months, but overall we feel very good about our network reach and the service that we are providing, and so we feel good about that business going forward and we want to make sure that we continue to reinvest in that business, a critical goal of ours as we move forward.

Hey, good morning. Thanks for taking my call. So I just wanted to ask a little bit more about the coal outlook. Maybe you can just run through some of the assumptions you are embedding in the domestic coal kind of holding where it is right now and maybe retirements, natural gas, and any coal to gas switching, and then if you can touch briefly on export coal, a lot of the thermal pricing we're seeing now suggests that there's not a whole lot that's going to be economic going into Europe at least, especially when you adjust for FX. So I'd like to hear a little bit more behind your assumptions there. Thank you.

Sure, it's Fredrik again. Regarding domestic coal, Frank provided an overview. We expect a 20% year-over-year decline in the fourth quarter and a run rate of approximately 21 million tons for domestic coal next year. There are two main factors affecting this: first, we are currently being dispatched last due to natural gas prices, which won't change unless those prices rise. Secondly, we have about 3 million tons this year that we won't see next year because of planned closures. Additionally, utility inventory levels remain high, leading to challenges next year. Of the 21 million tons I mentioned, around 15 million tons will be from utilities, and about 6 million tons will come from net coke and iron ore. On the export side, we achieved about 18 million tons in the first half and are targeting an implied guidance of 30 million tons, with 12 million tons in the second half. I believe a run rate of 24 million tons for next year is reasonable, but we'll have a clearer picture by the fourth quarter as we navigate a tougher market compared to six months ago. We'll have a better understanding of the export market as we approach the fourth quarter earnings release.

Okay, Brian, this is Cindy. Frank mentioned that we are analyzing and looking at what we need to harvest from our existing coal network, where we have seen the most significant declines in Appalachia. We haven't announced anything yet, but we have plans to do so and stay tuned on that one.

Hey, good morning, guys. Thanks for taking the question. Cindy, if you could just bear with me, I wouldn't mind just following up a little bit on that. If there is any way you can give us a sense of what might be on the table, if it's sort of shuttering lines completely or at least sort of dialing the volume dynamic down quite a bit. I mean, is everything on the table? I'm just kind of curious if there is any incremental detail you can add to that. Thank you.

Chris, I think everything is on the table. And as far as whether it would be facilities or lines, I think you will understand and appreciate that we want to be able to talk about those things internally before we do externally, but there's really not anything that's not on the table.

In the third quarter, we have shown the importance of running a tight, efficient, and reliable network. We are operating in a very dynamic environment. Currently, we have 1,200 T&E employees on furlough and have significantly reduced our training efforts. We will continue to adjust our operations to align with demand. We have the option to bring back furloughed employees if necessary, though there are some locations with very few furloughed employees where we may need to hire. We will provide opportunities for existing employees in deep furlough to return to those locations. Overall, we are managing both hiring and the available furloughs effectively.

Hi. Yeah, good morning, Michael. Good morning, everyone. So, I wanted to ask you a question to start with on the pricing side. You guys have done a great job at ramping up the pricing and really capturing the opportunity with the further ramp up in same store price. I think when we saw the tightness in 2014, we thought, 'Well, maybe there's at least two years of good price.' But, obviously, 2015 volumes have been pretty tough. How do you think that translates into pricing in 2016? Would you say, 'Well, given the weakness in volumes, we are likely to see a deceleration versus the same store price?' Is that realistic or do you think there's some way that you can just really leverage your position in the market and sustain what's been very good pricing this year?

Well, I think the key thing is continued service excellence for value proposition with our customers. And that's what Cindy's team is doing a great job here as the resources have arrived to really provide the in-service excellence for our customers. So, we are pleased with the results here in the third quarter in terms of the same store sales. And, as you well know, you will be able to see that each and every quarter, as we move forward, in terms of what we are able to accomplish. But, strong pricing is a critical component of what we're trying to do from an overall value equation. It's one of the key levers we are pulling. And, as we tip to improve our service product, we feel good about what we are going to do going forward as well.

Well, I do think and just going back to your first point, you know, we do look at pricing as being critical in terms of what we are doing, and we said this for a long time, strong pricing is paramount to our long-term success financially. That's a key driver for us going forward as well.

Good morning. Thank you for taking my question. Regarding your comments on coal for 2016, particularly on the domestic side, could you provide some insights on coal yields considering the variable coal price structure? We noticed some impact this quarter, but any information regarding 2016 would be appreciated. Thank you.

Yeah, so in terms of the coal yields overall, not just on domestic, but on the export, if you look at the book of business as a whole, there are three, really, drivers there. One hand we are clearly getting core pricing in that business and we expect to continue. Clearly, the export side is very difficult right now, but on the domestic side, we are getting some good core pricing. On the fixed variable, was clearly also a big driver here in the third quarter, as the volume came down significantly, about 20% of the utility contracts have that sort of structure, in terms of their contractual nature. And then also lapping, fully lapping the significant pricing declines that we took in our export market in the second half of last year, having fully lapped that was also very helpful as well. So we have three drivers. As we move forward, I think you are going to continue to see the export market being very challenged. And there's little opportunity, if any, to really improve pricing there. But, on the rest of the market, we are going to continue to see what the value proposition is. And we are going to look, plant by plant, to see what we can do.

Hey, good morning. And thanks for taking my question. As a quick follow-up to Alison's question with regard to the fixed variable component. With the domestic coal expected to be down even more strongly next quarter, should we expect coal yields to improve sequentially, even with the lower fuel price? Or is kind of Q3 a pretty good run rate for us?

I think, to Tom's dismay, a few questions earlier; we tried to stay away from specifically forecasting our pricing. Mix will always play an impact in it. But, ultimately, the same store sales, I think, is the best way to look at our pricing. So, we are going to continue to do what we can to capture the value that we provide in the marketplace and then let the chips fall where they may in terms of what the ultimate number will be.

Sure. I just wanted to ask a little bit more about the coal outlook. Maybe you can just run through some of the assumptions you are embedding in the domestic coal kind of holding where it is right now and may be retirements, natural gas, and any coal to gas switching, and then if you can touch briefly on export coal, a lot of the thermal pricing we're seeing now suggests that there's not a whole lot that's going to be economic going into Europe at least, especially when you adjust for FX. So I'd like to hear a little bit more behind your assumptions there. Thank you.

First, I want to reinforce that you speak to coal, and I'd like to finish it all out in the first quarter. We will obviously update you then so you get the full picture. Currently, we're investing in coal this year, on the CFD side; we have also made continued investments in our coal structures and be a long-term partner in maintaining some sort of capability there, which is the goal of ours.

This is Ryan. I have a question regarding the coal outlook for next year. Maybe you can walk us through your expectations there. Are you expecting a better recovery period or a similar trend, or is there a lot of uncertainty on the horizon?

So, I think here in terms of what we are seeing, the black pessimism about the outlook will remain for next year. It's going to be a reality that with lower prices, that's just going to have an impact. At the same time, we are focused on real-time improvements to ensure we're working together with our employees and teams to do what we can in the overall productivity and meet our customer needs.

At the same time, coal still represents a meaningful part of our overall business strategy, and even if projections suggest continued challenges, we trust we will continue to be a key player in ensuring it remains an operational community.