CSX Corp (CSX) — Q2 2016 Earnings Call Transcript

Thank you, everyone, and again welcome to CSX Corporation’s second 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 Investor section. In addition, following the presentation, the 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 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. 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 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 the same topic. And with that, let me turn the presentation over to CSX Corporation’s Chairman, Chief Executive Officer, Michael Ward.

Well, thank you, David. Good morning everyone. Yesterday, CSX reported second-quarter earnings per share of $0.47, compared to $0.56 per share in the same period last year. Revenue declined 12% in the quarter; a strong pricing across nearly all markets was more than offset by the impact of a 9% volume decline, which included a 34% decline in coal, as well as negative mix and lower fuel recovery. Regarding operating performance, CSX continued to deliver strong safety performance and service continued to meet and exceed customer expectations and drive further efficiency. In the quarter, CSX continued to aggressively and successfully reduce its cost structure throughout the network, recognizing that this company's long-term future is built on a fluid and efficient network, serving primarily intermodal and merchandized markets. Despite these cost-saving actions, operating income declined by $177 million to $840 million. At the same time, the operating ratio increased 210 basis points year-over-year to 68.9%. Now I’ll turn the presentation over to Frank, who will take us through the second-quarter results and third-quarter outlook in more detail.

Thank you, Michael and good morning everyone. Let me begin by providing more detail on our second-quarter results. As Michael mentioned, revenue was down 12%, or $360 million versus the prior year, driven primarily by lower volumes. Total volume decreased by 9%, which impacted revenue by about $260 million. In addition, fuel recoveries declined by $98 million. We continue to see strong coal pricing from an improving service product, which for the second quarter was up 2.9% overall and 4.0% excluding coal. However, this was partially offset by negative business mix in the quarter. Other revenue decreased by $29 million, driven mainly by lower incidental charges and coal-related revenue from affiliate railroads. Expenses decreased 9% versus the prior year, driven mainly by $96 million in efficiency gains, $86 million in lower volume-related costs, and $56 million in lower fuel prices. Operating income was $840 million in the second quarter, down 17% 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 $262 million in the quarter with an effective tax rate of about 37%. Overall, net earnings were $445 million, down 20% versus the prior year, and EPS was $0.47 per share down 16% versus last year. Now let me turn to the market outlook for the third quarter. Looking forward, we expect year-over-year volumes to decline in the third quarter, in the mid to high single digit range. Despite some markets growing, the majority of our markets will be down with the most significant declines continuing to be concentrated in coal and crude oil. Automotive is again expected to grow, as light vehicle production remains higher on a year-over-year basis. Minerals volume will be higher with a continued ramp-up of the new fly ash remediation business and ongoing strength in construction, which drives demand for aggregates. Agricultural products are expected to decline as the strong dollar and low commodity prices continue to pressure, both domestic and export shipments. Chemicals will be down due to the continued declines in share-related products resulting from low crude oil and natural gas prices. We expect crude oil volume to be moderately lower on a sequential basis. Domestic coal will continue to be unfavorably impacted by an excess supply of natural gas at a price point that favors gas burn over coal in the East. In addition, coal inventories remain high, and year-over-year volume declines will continue to be significant although less severe than the second quarter due to softer comps in the back half of 2015. Export coal should be moderately lower in the second half of the year from the first half tonnage run rate, consistent with the seasonality we have seen in recent years. Despite modest improvements in the met and thermal benchmarks, the export market will remain pressured by the strong U.S. dollar and global oversupply. That said, we saw more spot moves than anticipated in the second quarter. As such, we now expect full-year export coal tonnage of around 20 million tons. For the total coal market, we continue to expect full-year tonnage declines of around 25% with third-quarter coal tonnage roughly stable sequentially to what we've seen in the first half of this year or approximately 22 million to 23 million tons in the quarter. Intermodal is expected to be down, as we continue to cycle prior competitive losses in international through the remainder of 2016. Domestic intermodal is anticipated to be roughly flat in light of difficult comps that reflected new business shifting to CSX in the third quarter of last year. Overall our business continues to reflect a market environment driven by low crude oil, natural gas and broader commodity prices, as well as continued strength in the U.S. dollar.

Good morning. In terms of productivity, we have seen improvements in our network performance, as indicated by our service measurements. We focus on structural changes and streamlining processes within our incentives. These are the key areas we examine. Looking at our progress, we are building on some significant initiatives from late 2015 and earlier this year, but we have a substantial base of ongoing initiatives. Some of these were expedited, and as we look to the future, I believe we will continue to achieve results in the latter half of the year as discussed by Frank. Although quarterly numbers may be slightly lower, they will exceed our traditional quarterly performance. Looking ahead to 2017, I am confident we can manage inflation effectively. Our CSX of Tomorrow initiatives, especially around network improvements, automation, and technology, will support our ongoing productivity. Additionally, I want to emphasize that our actions are proactive and are guiding our decisions concerning our smaller coal portfolio and the need to provide safe and reliable service in our merchandise and intermodal operations. This is integral to our CSX of Tomorrow strategy, and we are committed to executing it, which will enhance both our service quality and efficiency.

Thank you. As Frank discussed, it's clear this continues to be a challenging freight environment with plenty of macroeconomic headwinds. Thanks to the extraordinary work of our employees, CSX is delivering record levels of efficiency and rightsizing resources to the business demand of today. Looking longer term, the company has a bright future as the men and women of CSX are simultaneously positioning the company for growth, where we have the resource flexibility to serve future demand. This will position CSX to maximize long-term opportunities in both our merchandize and intermodal markets. As a result, we continue to be enthusiastic about the core earning power of the company as the market headwinds subside. As we work to transform this company into the CSX of tomorrow, we must grow and make more profitable the merchandize and intermodal markets, which represent our future. At the same time we will continue to preserve the business value of coal, recognizing that it will become a smaller but still important part of our company. Our future evolves leveraging a premier highly efficient network that reaches diverse merchandize and intermodal markets and nearly two-thirds of the American consumers. It requires consistent excellent service for customers, which in turn supports efficiency, profitable growth, and pricing that allows us to continue investing for the future and includes technology solutions to drive an ever more safe, reliable and efficient railroad. As we manage today's business environment to deliver on the future potential, we continue to focus on achieving a mid-60s operating ratio longer term to deliver compelling value for you, our shareholders.

Hey, good morning and thanks for taking the question. Frank, I think on the last call you had indicated that with regard to the earnings cadence, you thought the decline in Q2 would be the largest for the year. As I think out to the back half of the year, with the puts and takes of holding a little bit stronger than what you had anticipated in Q2 cost actions being a little bit more, how should I think about that earnings cadence as I look out?

Yes, I think as we look at Q3 earnings on a year-over-year basis, we had mentioned that they will be down. We haven’t sized that as you know. We've got a challenging market environment that I know Fredrik will get into later in the call impacting the top line. There are comps that begin to ease as we get into the back half of the year. Although as we mentioned, volumes in the third quarter will be down mid-to-high single digits, with crude down international intermodal losses in the coal as we mentioned on a year-over-year basis down as well. So we got some negative mix and as moderating productivity as we get throughout the year, obviously we've delivered about $230 million in productivity in the first half and that implies a certainly moderating productivity level as you get into the Q3 and Q4 and then we try to give you some clarity in the third quarter remarks about where incentive comp might be and certainly with fuel prices where they're going and cycling some of the fuel positives that we had in the third quarter of last year; we're going to have a net fuel headwind as well. So we've got some challenges looking ahead of us in the third quarter, but as I’m sure Cindy will mention later in the call, everything is on the table on the productivity side and pricing continues to be favorable given the environment.

Thanks. Good morning everyone. So I will hit on the efficiency, so obviously a pretty impressive phase so far this year. I am not surprised that you raised that target of $350 million. This then raised the natural correction as to what innings we're in with the productivity gains here. So just how deep is that well that you can grow from?

Hey, Ravi it’s Frank. I think what the numbers would imply in the second half would be about $60 million a quarter. It never works out perfectly as you know, but that’s a general run rate in the second half of the year. As we get closer to the end of the year, we'll be able to give you a little bit more guidance on 2017, but like Cindy mentioned and I'll reiterate, our goal is always to offset inflation with productivity and depending on how those numbers play out as you get into forecasting next year’s inflation numbers, you should see us have confidence in our ability to continue to do that in 2017.

Hey, good morning. Just wanted to follow up on Frank’s comment on the increasing CapEx and accelerating locomotives purchasing, just wondering why you're accelerating the CapEx? Did you get better pricing on equipment, and does that change your thoughts on cash flow buybacks and use of capital as we move forward?

Hey Ken, honestly, it was the avoidance of seller financing charges that we would have incurred if we had stuck with the original deal to pay off the engines next year. So, it’s just a timing over a couple of months. No impact on cash flow. It’s kind of a one-time thing switch between 2017 and 2016.

Good morning, everyone. So I want to follow-up on Ken’s question on CapEx. So you talked about the ability in 2017 to get back towards a core investment around 16% to 17% of revenue, but I’m assuming that excludes spending on things like PTCs. So, you might not be willing to tell us right now what you think the non-core items might be in '17, but may be if you could give us some context on what non-core investment has been for the past couple of years?

Sure. So the only thing that we exclude from core investment is positive train control. If you look at what we're doing this year, our all-in number of $2.7 has the $300 million increase for the engines that I just mentioned. It has $300 million for positive train control, which gets you down to the $2.1 billion of core capital that we had started the year talking about and as you might remember, that was a decline of over $100 million in core capital from 2015. You will continue to see us focus hard on core capital and making sure that we’re making the right decisions in terms of infrastructure, equipment and return-seeking investments.

Hey good morning, thanks for taking my question. So if you can just give us an update on the CCX projects. Can you talk about CapEx, what type of CapEx you’re expecting there? Is that something we can do in a public-private partnership and how close are you to stripping out and finding a site for that investment?

Yes, this is Michael, we're really excited about the CCX opportunity. We're finding that we’re getting great cooperation from the state and local officials. We're very encouraged that we will be able to work cooperatively with them. As you mentioned, it's a public-private partnership with the State providing back half of the funds and us providing the other half of the funds. We think it's going to be a tremendous economic development opportunity for the State of North Carolina and we're very excited about the progress we're making on it. The exact location hasn’t been finally determined at this point, but we're continuing to make good progress.

Good morning, thanks. I was wondering if you could talk a little bit about the mix during the quarter, in particular it looks like maybe there was some positive mix within the coal segment. So just wanted to see if you could help us understand if that was on the domestic side or export, what drove that and is that something we should expect to persist in the third quarter?

Yes, so Allison on the coal RPU specifically, we did have some positive mix. Obviously we also had the help of fixed variable contracts and continued pricing on the domestic side. Offsetting that is of course fuel surcharge revenue coming down and then the actions that we've taken on the export coal market. I do think that it changes quarter-by-quarter, but it is a sustainable level and there will be quarters when it will be up and there will be quarters when it will down. The focus on our part is to make sure that we continue to do core pricing appropriately and then let fuel and mix fall where it was going to fall.

Good morning, guys. Wanted to follow-up on the CapEx side and just kind of talk a little bit about locomotive spend. So you pulled some forward into 2016, how should we think about the change in locomotive spend as we go into 2017 and 2018?

Sure. So if you take just a year or two view of that and you look at where we are from a locomotive storage perspective, we got about 350 engines in storage and then as you look towards the back half of the year as Cindy gets the deliveries of about 60, 65 of the remaining engines from the purchase commitment that we had started in 2014, I think you should expect in the volume environment that will continue to store engines through that period. As you look forward in the '17 and '18 assuming volumes stay essentially where they are, I doubt you would see us in the market for new locomotives.

No, I would say, as we look ahead in the engines that we have stored, the 350 that Frank mentioned are readily able to be brought back to service if we need them. In addition to that, we have as we take locomotives out this year, some have gone into recommended retire status, which would not be in our store count.

Good morning. Thank you for taking this call or the questions gentlemen. Help me think about this strategically or help me understand how you think. I understand how the strength of the U.S. dollar is affecting, negatively affecting ag exports and exports of other commodities. I understand why crude being under 70 is affecting negatively chemical volume and everything related to fracking and nat gas obviously under 4 is going to continue to be a headwind for coal. So what's your crystal ball? Not that your crystal ball is any better than anyone else's but you have to have a plan, what do you plan? Do you expect the dollar to stay strong, crude to stay above under 70 and nat gas to stay under 4 for the foreseeable future? Is that your expectation or are you planning for the dollar to get weaker, for crude to go back up and nat gas to go back up?

That's where the flexibility I think in our resource planning is critical because, to your point earlier, there is a lot of crystal balls out there but I’m not sure which crystal ball is better than the other. As I said earlier, we do go out to our customers in the fall to try to get a sense of what they're seeing in the different markets that we serve and then from there, we take their best input and triangulate with other things to put together our perspective on 2017. And it is a very volatile marketplace right now where it's very hard to predict. We have laid out that overall from a coal perspective, we do think that there is a secular decline that we're heading towards and certainly we’ve seen the vast majority of that already.

Hey good morning Mike. Congratulations.

Thank you.

Hi, good morning and thanks for taking the question. Just wanted to see how much granularity on the accelerated productivity targets you are willing to share with us. There are a lot of initiatives obviously underway, coal network rationalization, longer trains, closing down some excess facilities, eliminating duplicate overhead, all of those are very admirable initiatives. Are there any two or three of those that have really been the primary reason why you've almost achieved your entire former productivity target in the first six months that had originally been established for the entire year?

John, I think some of what we've been able to do is put a series of initiatives together, mostly structural with the closure of facilities like late last year in the coal network and moving forward into this year where we also closed Russell Yard. But it's not just in the coal space. We’ve also announced publicly where we’ve consolidated facilities and set in Central Florida with Winston Yard in Tampa, a consolidation actually in Tampa and also streamlining on mechanical facilities and shops that are aligned more with our outer triangle in the core network that we have. Our job is to really become less resource-intensive so between train length and the density of the train, as well as the density of the route that we route the train has also allowed us significant savings across the board. So I think there is really no one thing; I think that we’ve accelerated that, we’ve really answered your question. We are able to put initiatives in places, we are doing so and continuously looking for more.

Thank you, Scott.