CSX Corp (CSX) — Q4 2016 Earnings Call Transcript

Thank you, Sherlyn, and good morning, again everyone and welcome to CSX Corporation's fourth 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. 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 over 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 one follow-up question. And with that, let me turn the presentation over to CSX Corporation's Chairman, and Chief Executive Officer, Michael Ward.

Thank you, David, and good morning everyone. Yesterday CSX reported fourth quarter earnings per share of $0.49, up from $0.48 per share in the same period last year. You will note that fourth quarter of 2016 included two offsetting items. In addition, the quarter included an extra accounting week resulting from the company's 52, 53 week fiscal reporting calendar. This benefited EPS by $0.03 in the quarter. On a reported basis, revenue increased 9% in the quarter driven by the benefit of an extra accounting week and strong pricing gains that reflect the value of our service products. Turning to operations, safety performance remained strong, service levels continue to meet or exceed customer expectations, and the company drove nearly $100 million in efficiency gains in the quarter. As a result, CSX produced $1 billion of operating income and a 67% operating ratio. Both of these results reflect the benefit of the extra week and a gain on a recent operating property sale. Now, I'll turn the presentation over to Frank, who will take us through the fourth quarter and full-year 2016 results in more detail as well as providing our initial views on the outlook for 2017.

Thank you, Michael, and good morning everyone. Revenue was up 9% or $256 million versus the prior year driven primarily by higher volumes as a result of the extra week. Total reported volume increased 5% in the quarter, but declined 1% excluding the extra week. We continue to deliver strong core pricing from an improved service product. Same-store sales pricing for the fourth quarter was up 2.8% overall and 3.2% excluding coal. In addition, fuel recoveries declined $10 million in the fourth quarter, but were more than offset by a $13 million increase in other revenue. Expenses increased 2% versus the prior year, driven mainly by the impact of the extra week. Excluding the extra week, expense declined 4%. In the fourth quarter CSX delivered $98 million in efficiency gains and we also recognized a $115 million gain from the sale of an operating property. Further year-over-year expense details can be found in our quarterly financial report. Operating income was just over $1 billion in the fourth quarter. Looking below the line, interest expense was up slightly from last year, reflecting the impact of the extra week. Other income decreased to $72 million driven primarily by an $18 million gain related to a non-operating property sale in the prior year's fourth quarter. In addition, we incurred $115 million of debt repurchase expense in the fourth quarter associated with the call of $1.4 billion of debt that was maturing between 2017 and 2019. Finally, income taxes were $293 million in the fourth quarter with an effective tax rate of about 39%. This included a $10 million unfavorable adjustment related to the apportionment of state income taxes, which impacted EPS by $0.01. Overall net earnings were $458 million, down 2% versus the prior year and EPS was $0.49 per share, up 2% versus the prior year. Now let me provide an adjusted view of our full-year EPS. Beginning with our full-year GAAP EPS of $1.81 we have provided the EPS impact of certain items that all occurred in the fourth quarter. You can see that the $0.08 property gain I mentioned previously was equally offset by the $0.08 impact from the debt repurchase expense in the fourth quarter. In addition, our 2016 EPS benefited $0.03 from the impact of the extra week. Excluding the impact of the extra week and the two offsetting items CSX's 2016 non-GAAP EPS is $1.78, which reflects a more normalized base for year-over-year comparisons. Now let me turn to the market outlook for the first quarter. We expect volume to be flat to slightly up year-over-year in the first quarter, as the industrial economy is stabilizing and energy-related headwinds are moderating slightly. That said, a number of our markets are returning to year-over-year growth in the quarter as we cycle the challenging conditions of early 2016. As you can see on the slide nearly 80% of volume falls in the neutral or favorable category in the first quarter, while a little over 20% of the portfolio is expected to be unfavorable. Agriculture and food is expected to grow as the record grain harvest and new customer facilities are expected to more than offset the strength in the U.S. dollar and a strong South American crop which curtails the U.S. grain export season earlier than normal. Export coal will continue to benefit from China's production cuts driving increased demand for U.S. coal. In particular, the metallurgical benchmark has strengthened year-over-year attracting increased production from U.S. coal producers entering 2017. We expect export tonnage in the quarter to be about 8 million tons. For the full-year 2017, we expect export coal to be in the mid-to-high 20 million ton range. Metals and equipment is favorable as imports moderate compared to last year and domestic steel production increases following successful trade cases. Additional infrastructure projects, increasing rig counts, and wind energy moves, are expected to provide additional volume opportunity. Intermodal is expected to be neutral. On the domestic side, secular growth will continue spurred by new service offerings and our highway to rail program. However, this growth is mostly offset by domestic competitive loss that occurred mid last year. On the international side, volumes are also expected to be roughly flat as we just finished cycling prior year competitive losses earlier this month. Chemicals will be down as the economics of crude-by-rail remain unfavorable. These headwinds are partially offset by higher volume in the fly ash business, which began moving a year ago and ramped up over several quarters to current levels. Domestic coal is also expected to be down, although we are seeing moderating inventory levels and slightly increased coal demand with winter weather, a shortfall competitive loss will result in lower volume for the quarter. As a result, we expect domestic coal tonnage to be around 15 to 16 million tons for the first quarter. Overall the industrial economy is more stable and energy headwinds are moderating. However, we continue to face a strong U.S. dollar and low commodity prices which constrains growth in some markets. As we think about the full-year 2017, we anticipate a healthier volume environment. As a result, we expect the combination of merchandise and intermodal to grow on a comparable 52-week basis in line with the economy. In addition, excluding the short haul competitive loss of about 6 million tons, we expect domestic coal tonnage to be roughly flat to 2016.

Thank you, Michael, and good morning everyone. When we look at the expectations for expenses in the quarter. As a result of aggressive cost actions taken in 2016, we achieved nearly $430 million of efficiency savings and about $175 million of volume-related cost savings. As we turn to 2017, our intense focus on driving cost reductions across the Company is unchanged and we are targeting full-year efficiency savings of more than $150 million. Looking at the first quarter outlook for labor and fringe, we expect average headcount to be down slightly on a sequential basis. Labor inflation is expected to be around $35 million in the first quarter. In addition, we expect our pension expense to decrease about $15 million versus the prior year in each quarter of 2017. This reduction is driven primarily by adopting the spot rate accounting methodology for applying the discount rate, as well as the benefit associated with a $250 million pension contribution completed in the fourth quarter. The combination of efficiency savings and lower pension costs is expected to more than offset labor inflation. For MS&O expense, we expect efficiency gains in the quarter to help offset inflation. However, we will also be cycling some positive reserve adjustments, for example, improved safety performance in last year's first quarter favorably reduced personal injury reserves. As a result, we expect MS&O in total to be slightly up versus the prior year. We expect fuel expense to increase in the first quarter, driven by the higher cost per gallon year-over-year reflecting the current forward curve. This price increase is partially offset by our continued focus on fuel efficiency. We expect depreciation in the first quarter to increase around $10 million versus the prior year reflecting the ongoing investment in the business. This is partially offset by the favorable impact from an equipment life study. Finally, equipment and other rents in the first quarter are expected to be relatively flat to the prior year with the benefit of improved car cycle times offsetting higher freight car rates and the increase in volume-related costs associated with automotive growth.

Now let me talk about our capital investment plan for 2017. For this year, CSX's total capital investment would decrease to $2.2 billion, which includes about $270 million for Positive Train Control. As you will recall, our 2016 capital investment totaled $2.7 billion which included $307 million of payments in 2016 for locomotives purchased under seller financing and delivered in 2015. As a result, we expect our 2017 capital investment to decline nearly $500 million from the 2016 level and begin returning to our long-term core capital investment guidance of around 16% to 17% of revenue. Looking at our capital allocation for 2017, you can see that over half of the investment will still be used to maintain infrastructure to help ensure a safe and reliable network. In addition, our 2017 equipment investment is down significantly from the prior year due to the completion of our locomotive purchase commitment. A major shift in our 2017 capital plan from last year is the significant increase in strategic investments which support improved service, long-term growth and efficiency initiatives under the CSX of Tomorrow strategy. Finally, looking at our investment in Positive Train Control, we have invested $1.8 billion through the end of 2016 and we plan to invest about $270 million in 2017. CSX is on track to meet the legislative timeline for PTC. As we look at the path to achieving this goal, we now believe the total cost of PTC implementation will be about $2.4 billion before any third-party recoveries.

Well, thank you, Frank. In a year where the industry faced sustained low commodity prices and a strong U.S. dollar that had broad-based market impacts, CSX lost another $470 million in coal revenue and experienced declines in nearly every other market. Faced with these challenging business conditions, the company generated strong financial results driven by decisive actions to produce an all-time record of nearly $430 million of efficiency gains. Our performance underscores this team's ability to rapidly adapt to changing economic conditions and the restructuring of the energy markets. Looking forward, the CSX of Tomorrow strategy drives growth in the more service-sensitive merchandise and intermodal businesses. We will achieve this by emphasizing reliable and cost-effective service, realigning our far-reaching network, and deploying additional technology solutions to further improve safety, efficiency, and service. In addition, the more favorable economic conditions overall, and the prospects for more balanced regulation, coupled with the quality of our network, our team, and our strategy, lead us to expect full-year earnings per share growth in 2017 despite the overhang of the strong dollar and low global commodity prices. Longer-term as we continue the company's transformation we remain committed to achieving a mid-60s operating ratio. And with that, we'll be pleased to take your questions.

Hey, thanks. Good morning, guys. Wanted to see if you could talk a little bit more about the 2017 volume outlook. Frank, I know you mentioned I think merchandise and intermodal growth in line with the broader economy and you've talked a lot about coal, so that's helpful. But could you give us some sense about how you're looking at the broader economy and maybe what are some of the puts and takes as you think about that merchandise and intermodal business for the full year of 2017?

Sure, this is Fredrik. I would say that if we look at our merchandise business, we feel positive across the board about our ability to generate growth in essentially all of those markets, in line with the overall economy. The economy has certainly faced challenges on the industrial side in 2016. However, as we enter 2017, we sense some momentum. We are optimistic about what we observe in the merchandise sector. On the national intermodal side, we have cycled through some of the losses that affected us in 2016, which will be beneficial. Additionally, on the domestic front, we continue to experience the vibrancy we have enjoyed over the past decade, enabling us to grow that market well above the overall economic growth. Taking all these factors into account, I believe that on the merchandise intermodal side, we will be able to grow in line with the economy, and hopefully we will receive some of the momentum we are currently experiencing to continue improving, perhaps even slightly above expectations. We will keep you informed throughout the year about our progress.

Hi Christian, it's Frank. We should be able to make good progress there. The challenge that we're going to have obviously is when you look at the numbers that we have on a reported basis there are things in there obviously that need to be pulled out in order for us to really look on a comparable basis. So you saw a two-year run sub-70% but each of those years had something in there that helped on the operating ratio side. So we're doing everything we can on the operating ratio certainly on the cost side, you're going to hear from Cindy that she'll do everything she can to pull productivity, Fredrik is going to continue to rely on that improved service product to drive pricing from the top-line side, you see an improving volume environment. And so with less coal declines that certainly sets us up for a positive 2017.

Good morning. I apologize for any background noise as I'm currently traveling. I would like to know more about the factors behind the increase in labor cost savings, which rose from $53 million in the third quarter to $76 million in the fourth. It seems your total productivity savings for 2017 is significantly lower than the impressive figure from 2016, yet labor savings are increasing sequentially. Can this trend in labor savings continue, and how do you view this in relation to the addition of sightings and longer trains? Thank you.

Sure. This is Cindy. In terms of labor savings in the fourth quarter, we experienced some benefits in volume that allowed us to avoid adding headcount at a one-to-one ratio. We anticipate that this effect will continue in an environment where volume is increasing. Over the past six quarters, we've seen a decline in volume and have adjusted several expenses, particularly headcount, to reduce costs. Additionally, we've made structural changes that have also contributed to lowering expenses and headcount. Looking ahead at structural changes, you mentioned sighting capacity, and as we have discussed in the past, we need to invest to enhance train length. We plan to invest in 2017 and 2018 to support this initiative, and we expect to see some benefits in 2018 that will be reflected in headcount due to these structural changes. That said, we are constantly seeking ways to improve our expense control, including areas like headcount and fuel, while ensuring that we maintain service quality for our customers.

Yes. Sure Tom. First of all, we really don't forecast price. Now I think you know that since 2012 when we saw the peak of the market has been coming down, we've been pretty public about the fact that we've both obviously want to continue to optimize the bottom-line for us, but also strategically do what we can in partnership with the producers to stay keeping investors in a very difficult time, which we're obviously going through. Now clearly the market has come back here a lot faster than a lot of people had thought and certainly we expect the same sort of partnership on the way up as we saw on the way down, there are other factors that come into play than just index themselves. There is a spread between different types of quality of coal. There is also the fact that there is, well the benchmark has going up significantly in first quarter. The spot market is a very different place. So there's a variety of things that come into play but overall that partnership that I think we've established over the last few years, we certainly expect it to go both ways.

Good morning, everyone. I want to approach the CapEx question from a different angle. Can you help me understand your strategic thinking regarding the fluctuations in CapEx? In my view, isn't it generally more cost-effective in the long run to invest more in CapEx during periods of lower traffic? Doesn't having a well-invested and well-maintained infrastructure make it easier to achieve a lower operating ratio consistently? If that's the case, why aren't you using the current decrease in demand as a chance to ramp up CapEx instead of slowing it down?

Well let me try to tackle the question in a couple of different ways. In terms of the CapEx that's deployed in any given year, the amount of work associated with that CapEx can change depending on how much volume is on the railroad. When you look at 2015 and 2016, we got a lot of work done for the money that we had especially on the infrastructure side. In addition to the volume levels, all the work that we did on train length and reducing the number of active trains that we had out there gives our engineering forces the ability to get more work done. We saw some good work by our procurement department really looking at how they can leverage lower cost environment that drives CapEx savings on the materials which again allows us to get more work done. So beneath the coverage there, there actually is a recipe that is really aligned with what you're talking about. On the equipment side of the house, it really is going to depend on what types of traffic we have, what are our storage levels on equipment and both on the locomotive side and the freight car side. But what you're seeing us do is really strategically invest to transform the company and the network and the service products much more aligned with the revenue portfolio that we expect in the future, which is very different than the revenue portfolio we've had for the last 10 years.

In the tax proposals, obviously there are going to be moving parts in terms of what is the ultimate rate that applies to corporations as well as how bonus depreciation is going to be handled as well as the expensing of interest. So if you just go all of that through the model and think through what is that imply from a cash flow perspective, it's certainly positive from a free cash flow perspective, we would have to revalue the deferred tax liabilities. But that would be sort of more of a one-time hit as we reset the EPS number based on that that revaluation. In terms of use of cash obviously, we would continue to apply a balanced approach to capital deployment. We would look hard at capital investments that might be able to; to be pulled forward and certainly we would look at the shareholder return aspects of dividends and buybacks as well.

Well David, thank you very much for your inline question, and I think we appreciate your view and we absolutely agree that we have a responsibility to maintain our capital investment whether times are good or bad. And during the hard times, we're seeing that we can take market share and grow our revenues while also ensuring safety and reliability and service. We've appropriated a sizable portion of capital toward strategic investments in CSX of Tomorrow, which we believe will drive the next chapter of growth for CSX.