CSX Corp (CSX) — Q1 2016 Earnings Call Transcript

Thank you, Nicole, and good morning, everyone. And welcome again to CSX Corporation’s first quarter 2016 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 Investors section. In addition, following the presentation this morning, a webcast 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 the accompanying presentation on slide two. This 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 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 same topic. And with that, let me turn the presentation over to CSX Corporation’s Chairman and Chief Executive Officer, Michael Ward.

Well thank you, David. Good morning everyone. Yesterday CSX reported first quarter earnings per share of $0.37 compared to $0.45 per share in the same period last year. Revenue declined 14% in the quarter; strong pricing across nearly all markets reflecting an improving service product was more than offset by the impact of lower fuel recovery, market conditions that drove a 5% volume decline, including a 31% decline in coal, and a $95 million year-over-year decline in liquidated damages. Turning to operations, CSX remained an industry leader in safety and service measurements continue to advance in the quarter, consistent with our service excellence initiative to meet and exceed customer expectations. Expenses improved 12%, driven by lower fuel prices as well as efficiency gains and lower volume-related costs, reflecting CSX’s ongoing drive to aggressively reduce its cost structure as we continue to reshape the company in the face of this challenging market environment. Including the impact of these cost-saving actions finding liquidated damages, operating income decreased $139 million to $704 million for the quarter. At the same time, the operating ratio increased 90 basis points year-over-year to 73.1. Now I’ll turn the presentation over to Frank, who will take us through the results and second quarter outlook in more detail.

Thank you, Michael and good morning everyone. Let me begin by providing more detail on our first quarter results. As Michael mentioned revenue was down 14% or $409 million versus the prior year. With coal declining 31%, total volume decreased 5% from last year which impacted revenue by about $140 million. In addition, fuel surcharge recoveries declined $139 million. We continue to see strong coal pricing from an improving service product which for the first quarter was up 3.1% overall and 4.0% excluding coal. However, these gains were more than offset by the impact of negative business mix in the quarter. Other revenue decreased $85 million, driven mainly by cycling higher liquidated damages from last year, which totaled $105 million versus $10 million in this year’s first quarter. Expenses decreased 12% versus the prior year, driven mainly by $133 million in efficiency gains, $78 million in lower fuel prices, and $64 million in lower volume-related costs. Operating income was $704 million in the first quarter, down 16% versus the prior year. Looking below the line, interest expense was up slightly from last year with higher debt levels partially offset by lower rates, while other income was relatively flat to the prior year. And finally income taxes were $212 million in the quarter with an effective tax rate of about 37%. Overall, net earnings were $356 million down 19% versus the prior year, and EPS was $0.37 per share down 18% versus last year. Now let me turn to the market outlook for the second quarter. Looking forward we again expect volumes to decline in the second quarter, the challenging freight environment will continue as headwinds in coal, energy and metals volume are expected to more than offset the markets that will show growth. Automotive is expected to grow, as light vehicle production continues to be a bright spot in the economy. Minerals will benefit from the continued ramp-up of the new fly ash remediation project and continued highway construction, driving aggregate movement. Intermodal is expected to be neutral, as we continue to cycle competitive international losses. This will be offset by secular domestic growth, driven by strategic investments and supporting highway to rail conversion. Chemicals volume is expected to decline, as energy markets continue to be marked by low crude oil prices and reduced drilling activity, which will impact our share related products more significantly in the second quarter. At the same time, the core chemical markets remain healthy. Domestic coal will continue to be unfavorably impacted by low natural gas prices currently around $2 and high levels of coal inventory at the utilities. As a result, we expect second quarter tonnage to be around 18 million tons. In addition, we anticipate a similar quarterly run rate for the second half, recognizing domestic coal volume will be largely dependent on weather. Export coal remains pressured by the strong US dollar and global oversupply, as a result we believe second quarter tonnage will be around 4 million to 5 million tons and expect a similar run rate for the remainder of the year. For the full year, we now expect around 18 million tons to 20 million tons of export coal in 2016. Despite a slowly recovering domestic steel production environment, metals is expected to be unfavorable year-over-year as the market works off excess supply from the strong US dollar and imported product. Overall we are still facing significant coal headwinds and a freight environment that continues to experience pronounced challenges associated with historically low crude oil, natural and other commodity prices and a strong US dollar. As a result, we expect second quarter volume to decline in the mid-to-high single digit range year-over-year. Turning to the next slide, let me talk about our expectations for expenses in the second quarter. We expect second quarter expense to benefit from the low fuel price environment and our ongoing focus on driving efficiency gains and right-sizing resources as we continue to reshape the company. Over the course of the last 12 months, we have taken aggressive cost actions with headcount down nearly 4,500 versus the prior year. These actions include our train length initiative, closing facilities in the coal network, consolidating a division headquarters, and streamlining mechanical and operations support functions. These actions along with cycling the impact of winter weather last year through high efficiency gains in excess of $130 million seen here in the first quarter. And for the full year, we now expect to deliver efficiency gains of around $250 million. Looking at labor and fringe, we expect second quarter average headcount to stay relatively flat sequentially. We expect labor inflation to be around $25 million in the second quarter in line with the level seen here in the first quarter. Looking at MS&O expense, we expect inflation and the cycling of an operating property gain from last year to more than offset efficiency gains and volume-related savings. Fuel expense in the second quarter will be driven by lower cost per gallon, reflecting the current price environment; volume-related savings, and continued focus on fuel efficiency. We expect depreciation in the second quarter to increase around $15 million versus the prior year, reflecting the ongoing investment in the business. Finally, equipment and other rents in the second quarter is expected to increase moderately from last year, with higher freight car rates and the increase in volume-related costs associated with automotive growth, more than offsetting improved car cycle times. Now let me wrap up on the next slide. CSX first quarter reflects challenging freight conditions with low commodity prices and a strong US dollar continuing to impact most markets, resulting in a 5% volume decline this quarter. However, as we continue to reshape the company, our focus on pricing for the relative value of rail service, driving efficiency gains and aligning resources to the softer demand environment helps to offset those volume headwinds. Looking ahead, we expect macroeconomic and coal headwinds to continue this year. Low commodity prices and the strength of the US dollar are expected to continue impacting many of CSX’s markets; in particular, we now expect total coal volume to decline around 25% for the full year. Looking at our expectations for the second quarter and full year, the impact of current market conditions on CSX volume, particularly in coal is expected to outweigh the positive momentum we are seeing in service which drives pricing efficiency and right-sizing initiatives. In the second quarter, we expect mid-to-high single digit volume declines with efficiency gain moderating from the level seen here in the first quarter. For the full year, in addition to liquidated damages we cycled during the first quarter, as we previously discussed we will also be cycling a significant property transaction in the fourth quarter. As a result, we continue to expect second quarter and full year 2016 earnings per share to be down from last year. That said, we remain intensely focused on achieving strong pricing that reflects the value of CSX service product, right-sizing resources with lower demand, and pursuing structural cost opportunities across the network. In particular, the aggressive cost actions we have taken over the last 12 months have helped to mitigate the challenging freight environment and weaker volumes. As a result of these initiatives, we now expect to deliver efficiency savings of around $250 million in 2016. With that, let me turn the presentation back to Michael for his closing remarks.

Thank you, Frank. As I think about CSX first quarter performance, it’s clear that the company’s core earning power remained strong, even in an environment in which macroeconomic forces are putting significant pressure on most of our markets. We know 2016 will be a challenging year, and we are focused on delivering the highest level of performance and results possible. In this environment, CSX continues to reshape its business and network for the economy of tomorrow, maximizing growth opportunities in merchandise and intermodal, while also improving the profitability of these markets to help offset the loss of coal. As we look forward, this team is resolute in its commitment to further transform today’s company. The CSX of tomorrow is built on the strength of a premiere network reaching diverse merchandise and intermodal markets. It is focused on delivering service excellence for our customers to support pricing that allows us to continue investing for the next generation and drive ever more efficient operations. And we will leverage technology to further improve safety, service, and efficiency, as we continue to evolve our business for the realities of tomorrow’s economy. As we make decisions today to make that vision of tomorrow a reality, we remain focused on achieving a mid-60s operating ratio longer term and delivering compelling value for you, our shareholders. Now I would be glad to take your questions.

A question on the productivity savings, clearly your first quarter performance was pretty amazing with the $133 million compared to the full year run rate. You did bump up the full year by less than you kind of exceeded your prior guidance for 1Q. Can you just talk about the cadence for the rest of the year and why that appears to step down so much versus the fourth quarter number?

Sure. This is Cindy. I think we’re off to a great start which reflects a lot of hard work by all of our teams to bring in the $130 million of productivity in the first quarter. And as I think about how 2015 progressed, we had a lot of initiatives that we started in the beginning of the second quarter and on into the third quarter around right-sizing our coal facility as well as our train length initiatives. So we’ll be bumping up against those comps going forward, and I also would say there were some benefits to milder weather this year compared to 2015 in the first quarter. That said, we are never done working on our productivity initiatives and the pace of change here has intensified, accelerated and we will continue to bring everything to the bottom line that we can, keeping in mind that we have to balance serving customers and we won’t compromise safety in that effort. And as we go forward and you think about the run rate going forward of $40 million or $50 million in the next three quarters, that is higher than our historical run rate with the exception of 2015 in terms of productivity that we’ll be able to deliver. So if there’s more to get, we will absolutely get it and we’ll be able to update you on that if we see that in future conversations either on the quarterly or on Frank’s roadshows.

If I can just ask one question on coal, what’s your outlook for the rest of the year? Obviously you’ve given us your guidance, but going into 70 and 80, just any new thoughts on the outlook of coal in the medium term?

Sure, this is Fredrik. We guided to about 25% down for the full year. We did about 17 million tons in the first quarter on the domestic side, and our view as we think about the next couple of quarters, we like to think that we’re going to be definitely in the 17-18 million ton range on the domestic side. And then on the export side, we did almost 6 million tons in the first quarter. Traditionally the first quarter is a little bit stronger than the other quarters; at least it’s been like that for the last couple of years. We also enjoyed some spot moves here in the first quarter that we don’t necessarily see in the remaining three quarters, so maybe 4 million to 5 million tons a quarter on the export side. So that gives us a 22 million to 23 million range for coal guidance per quarter as we move through the year versus the 23 million tons we did in the first quarter.

Just wanted to follow-up on the employees. Great job on the larger than expected reduction down 14%, but maybe if you can walk us through why was the average cost per employee up? Last few quarters I guess we’ve seen it down 5% to 9%, this quarter it was up. Maybe you can talk a little bit about what’s in that number in terms of comp or anything else that drives and what should we look forward to that going forward. Thanks.

Ken, it’s Frank. You’re right; headcount was down about 13%-14%, while the labor and fringe line was down about 9% or 10%. So your comp per employee is about 4% or 5% higher. There are a couple of drivers, some of those are industry-related and some of those are CSX specific. Clearly you have general wage inflation of 4% a year or so, and then probably the biggest driver for us is health and welfare inflation. As the industry is reducing resources, you’ve got fewer employees to spread the health and welfare cost over. So both of those are industry in nature. In terms of maybe some CSX specific dynamics, as you furlough employees, generally those are going to be your less tenured employees with lower all-in wages and then maybe as a last point, Ken, when you look at a year-over-year number of employees in training, there were significantly more employees in training in the year ago quarter than there are currently, just given sort of where we are on the resource side and training pays less than marked-up pays. So you got three or four moving parts in there that hopefully answers your question.

So just on the coal market, Michael can you look forward and tell us. I know you’ve talked in the past about natural gas-fired plant closings that were mandated in ’15 and ’16. Is there something that now is done and we should see that pace decelerate as you look forward? I just wanted to say, there was a great answer by Fredrik on what we’re seeing now. But I just want to understand, is this just market dynamics as far as closings or are there more that’s going to structurally change the market and continue at this pace we’ve seen on the decline.

Sure, Ken, this is Fredrik. Frankly, based on the very low demand levels we’re seeing as we go through plant by plant and look at their closures that we expect in ’16, ’17 and ’18 which really covers all the announced closures that we have on our network. Based on the outlook that we have for the rest of the year now, which is consistent with the guidance, there’s only less than 1 million tons that we have in for those plants that have announced to close, which means that the closure side of things is really behind us to a very large degree as we move forward because of the fact that the demand levels are so low.

Can you guys help us on the top line? I know you’re talking about mid-to-high volume declines for 2Q, but how do we think about the contribution from price within the headwinds from mix? Does that get easier or more challenging as we progress through the year?

This is Fredrik again. Yes, the second quarter and probably even the third quarter are going to be challenging quarters from the volume perspective. It’s not really until we get to the fourth quarter we will have a little bit easier comparisons year-over-year, both on the coal side and on the general merchandise side as well. We’re going to have a negative mix with us as long as our coal business is declining as fast as it is and our intermodal business is growing as fast as it is. Clearly, we are very transparent about what we’re doing from a pricing perspective, and that’s going to continue to be helpful as we move through the year.

I guess what I was getting to is more from the top line perspective, should we be thinking a similar outcome then what makes us - I think you’ve referred to this in our prepared remarks that mix might offset the favorable impact on pricing looking forward. So top line could be down a little bit more than volume.

Well I think as you try to model out what we’re doing, we’re kind of giving you the individual components. And the one piece we haven’t talked about is of course fuel as well. So you got to put those pieces together yourself. We’re very explicit in terms of what we’re seeing in each individual market; we certainly expect continued strong pricing as we move forward and then of course we have the variance of fuel or whatever that is going to do.

A quick question on the impact of the dollar. The trade weighted index was about 5% off from the peak. Are you still calling out some pretty negative headwinds when the dollar turns on commodity prices both on the exports and on disruptive imports. Do you think if it stays at this level Fredrik that we’ll start to see some relief towards the end of the year or do you think you need another 5% down move to really get some relief from some of these commodity markets?

Well, the dollar’s still well above its 10-year average and so forth, but it is clear that it’s been helpful in certain areas the fact that it has taken a step back over the last two months or so. One area where we had seen that is in the export coal side on the metallurgical side with a benchmark actually stepping up a little bit from, I think the low price in Queensland index trading forward and I think the benchmark for some of the spot moves are actually even higher than that at this point. And we’re also seeing, while it’s not directly dollar related, some of the potential tariff and countervailing duties that we’re seeing in the metals business, we’re starting to see drive down some of the imports into the country which is starting slowly but surely to I think to help our metals business as well. But it is fair to say that even with that sort of a relief over the last two months on the dollar; you’re looking towards the fourth quarter I think until you’re going to start seeing meaningful improvements in the volume performance.

And then on the productivity side, you mentioned that the train length initiative is basically approaching a one-year anniversary, so comps are going to get a little bit tougher, but maybe if you can just recap the last year, some of the accomplishments and what you think is reasonable for in that context for some of the goals looking out through the rest of this year and into 2017.

Sure, Brian. Over the year of 2015, we saw 16% gains in our train length and we’re up to about 6,400 feet in total. We saw probably the smallest incremental change in the fourth quarter as we had really largely put in place all that we felt comfortably we could in maintaining service to our customers, and we are bumping up against challenges in the single track territory where our siding length is a bit limited for us. Going forward and in this year we are planning to increase siding length in our core door from Nashville to Cincinnati. That is presently limited to 6,500 feet, so we’re making some structural adjustments to help us continue it, and we should see those investments being in place and available to us in the back half of this year. So I would also say that one of the benefits of the initiative that we’ve seen is the ability to flex as seasonality impacts volumes. So in summer months we feel that with a little bit less volume that’s typically out there that we’ll be able to continue to utilize train length and in terms of reducing our cost gives us the ability to adjust where we haven’t before and certainly if anything changes either up or down we’ll be able to adjust accordingly to maintain train length. So we feel really good about the initiative and our team in the field has done a fantastic job putting it in place.

Maybe a question for Cindy just following up on the productivity. When you think about the increase from the $200 million to the $250 million, if you could maybe breakdown sort of those specific components a little bit to sort of looking at the puts and takes on some of the expenses. I’m just kind of curious kind of where that comes from, maybe how much weather and maybe how much is headcount, wanted to get a sense there.

As far as going forward, let me try and understand your question.

The incremental between $200 million and $250 million for the target for the full year.

Well I think a lot of it is the initiative that we already have in place. I think the benefit that potentially you’ll have is to be able to continue to right-size and streamline which is also been a big part of our initiative. So we’ve got technology and Michael mentioned in his prepared remarks utilizing that in automation. So it will be some additional benefits to headcount I believe.

And then Fredrik maybe a question for you on the market outlook. I guess, putting coal aside for a moment it seems like we’re still sort of maybe a bit weaker than seasonally expected at least as far as the outlook for the second quarter. Just want to get a sense the last couple of weeks we’ve seen some challenges intermodal or sort of slip back again. I just want to get a sense of kind of how you feel about where we stand with volumes, the economy just generally outside of some of the specific pressure points like coal. Sure. If taken to the highest level from what we see the economy, I think we still see the overall economy progressing in that 2%-2.5% range, kind of uninspiring growth. Clearly we’re still dealing with the aftermath that we saw last year both on the energy side and also the strength of the dollar and the low commodity prices. And as I said earlier that’s going to be with us for at least another two quarters and it is also why we guided to volumes to be down a little bit more year-over-year sequentially in the second quarter. Specifically, the last couple of weeks to your question, we look at our four key markets: merchandise, intermodal, coal, and auto. Our merchandise business has stayed probably some of the two strongest weeks in fact in the last two weeks, but then we have seen some weakness in our coal markets which is consistent with our guidance. We also had some operational issues with some of the terminals we serve in the export side that impacted our volumes. Our auto business was very strong early on in March. We probably had 65% of our cars under load and that’s kind of cycling through that right now. But we continue to see good strength there for the rest of the year, and yes we have seen a little bit of weakness in the intermodal space over the last few weeks, but I don’t think anything that has structurally changed there. So it’s going to be a tough second quarter, but I don’t think it’s a reflection of where the economy is heading or anything like that.

Wanted to ask either Michael or Fredrik on pricing. You continue to get very good pricing in merchandise and intermodal, and then the totals a bit less. How do you think that changes? Is that something that you kind of sustain through the full year, and is there a point where if you say rail traffic does - I mean you’re saying it’s going to be weak for a couple of quarters, does the same store price are getting decelerate through the year and it’s somewhat of a timing impact or would you say, hey look we can just keep doing this and we are kind of immune to softness in track, we’re immune to excess rail capacity. So just wondered if you could kind of talk about that, because the numbers are pretty good, they are very good in intermodal and merchandise, but it just seems like there’s a lot of excess capacity out there.

We’re certainly not immune to what’s going on in the marketplace and I think you’ve seen a reflection of that here in the quarter versus the fourth quarter as you’ve seen a sequential downtick in our pricing. There are obviously specific drivers of that, we work with our customers on a deal-by-deal basis to understand their needs and what opportunity to drive price is. A critical component of supporting our pricing right now is of course the fact that our service product has improved significantly. And I think our customers value a long-term access to our network and the markets that we provide. Clearly the market is softer now than it was a year ago, but yet our pricing is frankly up year-over-year as well. So we’re going to work with our customers, our prices are going to reflect what the market allows us to do. At the same time, it’s critical for us to be able to price so we can reinvest in our business. And there’s been a strategic imperative of ours for a long time, but underlying all that pricing is a service excellence for our customers.

So that having been said, do you think it’s more likely that you see stability through the year in your same store price or do you think there’s some risk that you see deceleration in that as we look forward?

We really don’t forecast price. You’ll have an opportunity to see price as we disclose our earnings each and every quarter. But strong pricing is important to what we’re trying to do strategically, and we’re going to work with our customers to make sure that they get service that they need to be successful in their market place and at the same time we need to be able to continue to invest in our business.

Just real quick, you at least objectively appear to become more and more aggressive in share repurchase in the recent quarters. Refresh on how you think about that? Is it a fixed dollar mark you’re putting towards your purchase and so as stock price falls are you going to buy more or is it some of the metrics returning the level through which you’re being aggressive to share repurchasing?

No, we’re being very rational about it as a matter of fact. I mean we have guided previously that it would be about $250 million to $260 million a quarter, so I think all you are seeing is us being the beneficiary of deploying that in a lower stock price environment and so that rational approach will value more shares obviously in a lower price environment and fewer shares in a higher price environment. So we’re not trying to pick the stock, we are trying to run a good railroad, and so as the price goes down we’ll buy more as the price goes up we’ll buy fewer.

Going back on Donald’s question, from a share repurchase perspective, and if we look at maybe CapEx that 1Q is a little bit lower. You talked about some of the rationalization of infrastructure and that kind of thing, could you talk about maybe the CapEx outlook not just for this year, but going forward should we see it continue to turn lower as whatever the metric is, I guess percentage of revenue is probably not the right measure anymore. But should we expect it to trend lower and if so how do you reallocate maybe that free cash flow?

Sure. As you know we entered this year and put a plan together on the capital investment side that took out over $100 million on a year-over-year basis, and that was just reflective of the environment that we’re in. As you look forward I think we have some significant things that will be rolling off; positive trend control would clearly be one of those. And as we look at the asset intensity of our business, there may be some opportunities on the infrastructure and on the equipment side. At the same time, as you’ve heard Cindy mention making sure that we can keep pace with the train length opportunities that we have, and investing in sidings going forward is going to be important for us; technology investments will also be important for us and making sure we have a good safe and reliable railroad is going to be important for us. So I do think you’ll see some moderation over time as we continue to target 16% to 17% of revenue as our long-term goal, and I think we have line of sight to that over the next few years. So, I do think you will continue to see us deploy capital in a balanced view with capital investment being the first priority, second priority being dividends, and then the third priority being buyback. So I think you will continue to see us take that balanced approach.

And then Fredrik on the coal outlook, and longer term you got a huge shift in the portfolio makeup of eastern utilities. I guess the Southern company just announced another plant site for a nuclear reactor in South Georgia to go along with the two to build a plant. I mean you’ve got this incredible amount of electricity production coming online from nuclear. I know you’ve talked a little bit about the plants that are targeted to shut down from ’16 to ’18, but is there any concern that as you go out further on that curve that you start to see additional coal facility shut down as a result of maybe some of this nuclear beginning to come online. I think we have seen a lot of change over the last couple of years. Who would have thought that in four years we would lose $1.4 billion of coal revenue and we’re pretty much on target here in 2016 to lose at least $500 million of coal revenue. And so clearly based on what natural gas prices are right now, there’s an economic interest in diverting a lot of the utility plants away from coal towards natural gas and in some instances like you pointed out to also to nuclear. We do think though that where we are at these very depressed levels both because of natural gas prices being so low and most likely an unsustainable low place, and the fact that stockpiles are also very, very high that there are opportunities to see some pickup at some point. But there’s no doubt that the trend on the utility side is downward going forward. But I don’t think it’s anywhere close to the pace that we’ve seen here over the last four to five years. So we’re monitoring that very closely; we’re of course also looking at the direct impact of the regulation that is going to kick in potentially, as we get into 2020 and beyond. But I think as we look at the next couple of years, we have seen a significant portion of the pain behind us and right now it’s about seeing where natural gas prices will stabilize and when do we get through this overhang in the stockpiles to get back to more normalized levels. When that happens, we’ll see where it is. But the general term is obviously, it’s a downward path.

Bye everyone. Thank you for joining us and we will see you again next quarter.