CSX Corp (CSX) — Q2 2017 Earnings Call Transcript

Thank you, Marcella, and good morning everyone. On behalf of the management team, I would like to welcome you to our quarterly earnings call, and also thank you for your interest in CSX Corporation. Our presentation, our quarterly financial report and our press release which conveyed our results, expanded buyback program and reaffirm 2017 guidance are all available on our website at csx.com in the investor section. In addition, later today, a webcast replay of this presentation as well as our 10-Q will be posted on that same website. This morning, CSX is being represented by its Chief Executive Officer, Hunter Harrison; our Chief Operating Officer, Cindy Sanborn; our Chief Marketing Officer, Fredrik Eliasson; and our Chief Financial Officer, Frank Lonegro. On Slide 2 is our forward-looking statement disclosure. Any statements about the future made during the presentation or during Q&A should be taken in the full context of this disclosure. Turning to Slide 3 is our non-GAAP disclosure and while CSX files all of its financials in accordance with U.S. GAAP, we are providing certain non-GAAP measures to give you a more wholesome understanding of the business. These measures should be taken in the full context of this disclosure and with the understanding that they are not a substitute for GAAP. Finally, we are close to 30 analysts covering CSX. I would encourage everyone to limit their questions to one primary and one secondary.

Thank you, David. Welcome everyone. It's nice to be here with you in beautiful downtown Jacksonville. I’m going to limit my remarks this morning and let Frank and Fredrik take the lead initially, and I'm sure we're going to have a vigorous Q&A session, and I’ll provide most of my remarks or observations during that period. I would say this: I trust you with the press release. I hope you will read it. I thought we had a great quarter, four months have gone by, and a lot has been accomplished. Directionally, I am very pleased with the direction the organization has taken. I understand that in some quarters your expectations were pretty high, which used to be a point of pride, but I’m interested in some of the Q&A. I do believe we’re going to change the format of how we announce earnings in the future to something more conventional, releasing our earnings and the call effectively simultaneously. This change should reduce some awkwardness that we’ve experienced traditionally. So, with that said, let me turn this over to Frank, and let him proceed with the presentation.

Good morning, everyone. Slide 7 reviews our safety service and efficiency performance year-over-year. You can see our train accident performance improved slightly while our personal injury frequency index rose to 1.14, reflecting a slight increase in injuries alongside a significant fleet reduction related to fewer man-hours. The safety of our employees is paramount, and our commitment to them is unwavering.

Let me jump in, Frank. Even though we express injury performance in numerical terms on the slide, safety is always about returning employees home at the end of their shift. Tragically, we had two employees who were killed in an accident that occurred in Washington D.C. this quarter. Our condolences go out to the families of Stephen Deal and Jake LaFave as we mourn the loss of two of our colleagues. It’s a stark reminder that even though railroads are one of the safest industries in North America, they can also be very unforgiving, and our commitment to safety remains.

Thank you, Cindy. Service and efficiency measures are trending well year-over-year due to train length reflecting two initiatives that offset one another in the quarter, both integral to Precision Scheduled Railroading. The first is balance—we have expanded the days of service on most trains to seven days per week, which is instrumental to improving cycle time and asset utilization, but negatively impacts train length. The second is unit train conversions into the scheduled merchandized network, which reduces both asset and resource intensity and increases train length. Moving forward, you should see train length increase sequentially. Dwell and velocity have both improved, reflecting the early successes of Precision Scheduled Railroading. These improvements are noteworthy given the rapid pace of change we’re driving. Balancing the train plan, merging unit trains into the scheduled network, and converting for flat switching has reduced handling times, improved transit times and velocity, and allowed us to idle 26,000 freight cars and 900 engines. Fuel efficiency has also improved year-over-year with 900 fewer engines in service and a more fuel-efficient active fleet. Turning to Slide 8, we’re encouraged by the financial results driven by the early implementation of Precision Scheduled Railroading. Revenue was up 8% driven primarily by core pricing gains of 3.7% all in and 2.2% excluding coal, volume growth of 2%, and higher fuel recoveries. We also had liquidated damages of $58 million in the quarter, which reflects the resolution of a longstanding dispute, and it is recorded in the other revenue line. GAAP expenses were up 6% and down slightly when excluding the restructuring charge. Efficiency savings of $90 million more than offset the impact of inflation in the quarter. Labor and fringe expenses showed favorable results, reflecting 2,200 fewer resources. Additionally, we also concluded a decade-long condemnation proceeding, resulting in $55 million in favorability. Fuel expense was higher, reflecting a 15% price increase. Strong revenue gains combined with cost control drove very strong incremental margins. Reported EPS was $0.55 with a 67.4 operating ratio. Adjusting for the restructuring charge, EPS was $0.64 with a 63.2% operating ratio. The reconciliation of GAAP to non-GAAP is in the appendix of these materials. Slide 9 illustrates that our free cash flow generation continues to improve, given largely by three factors: strong top line gains, cost control, and reduced capital intensity. Our success in generating free cash flow has enabled us to increase our shareholder distributions year-over-year, with over $750 million of share buybacks year-to-date, including nearly $500 million in the second quarter. You can also see the impact of our recent $0.02 dividend increase. The company's improved financial performance is reflected in our trailing 12-month ROIC of 10%, nearly four points better than last year. Finally, our adjusted EBITDA ratio remains stable as higher earnings offset the impact of additional debt. Turning to Slide 10, the third quarter volume outlook shows nearly three-quarters of our business is expected to be favorable or neutral. Export coal demand remains strong, and we now expect to ship around 30 million tons for the year. The revenue per unit will moderate sequentially as global benchmarks come down. Consumer sentiment remains positive, driving intermodal growth in the third quarter. As a reminder, in August, we will cycle the shortfall domestic interchange loss we've mentioned previously. We expect continued economic growth along with a tightening truck market, which should support growth in several of our merchandise markets. However, a few of our markets will experience year-over-year volume declines in the third quarter due to market-specific headwinds you’re familiar with. Auto shipments will be impacted by softening production as reflected in the forward views of North American light vehicle production. Crude oil trends have essentially remained unchanged, essentially offsetting the growth we expect in the core chemicals markets. And domestic coal remains challenged largely due to the impact of the shortfall competitive loss since January 1st. Before I wrap up on Slide 11, two housekeeping items: One, our fiscal year will now tie to the calendar; as a result, the third quarter of 2017 will have one more day than the third quarter of 2016. In the fourth quarter of 2017, we will also have one more day than the comparable 13-week fourth quarter of 2016. Additionally, as a result of a recent state tax law change, our effective tax rate for the third quarter will be between 39% and 40%, as we revalue the deferred tax liability for that particular state. Now to Slide 11, we're off to a good start in 2017. Our first half performance provides this team with continued confidence in our full-year expectations, and we are reaffirming that guidance today. Excluding restructuring and assuming no weak genomic or coal-related disruptions, we are on track to deliver a mid-60s operating ratio, record efficiency gains, EPS growth of around 25%, and free cash flow of around $1.5 billion. With that backdrop, the CSX Board of Directors has authorized a $500 million increase to the share repurchase program, bringing the total authorized program to $1.5 billion. We are continuing to evaluate the optimal capital structure and cash performance strategy for the Company and are committed to maintaining an investment-grade profile. We are excited to host our 2017 Investor Conference on October 29th and 30th at Palm Beach and look forward to sharing with you our multi-year strategy and associated financial targets. With that, we would be delighted to take your questions.

You mentioned in the press release that there are some impairments on PTC of about $10 million or so. I wanted to get if there is any opportunity to talk more about that system. How do you stand right now? Are you seeing any implementation effects and why did you take the impairment? And overall, what sort of OpEx are you running through the P&L this year? And how do you expect that to progress over the next couple of years?

Hi Brian, it’s Frank. Thanks for the question. In terms of impairments, about half of the $10 million impairments were in positive train control. The others were in a smattering of technology projects that are not necessarily consistent with Precision Scheduled Railroading, so we stopped those. Back to the PTC, half of the equation was really divided into two parts. As we’ve reduced the locomotive fleet, we don’t have plans to return them, so some of the labor costs associated with those engines for PTC won’t be necessary. Therefore, we need to pull it out of the capital plan and roll it through the P&L. The other part was some signal design work we did based on anticipated traffic flows. We won’t necessarily be upgrading those to PTC, so we had to roll those through as well. We’ll continue to assess things obviously; impairments are somewhat unusual. In terms of your OpEx question, I know there has been a lot of commentary on that based on other statements recently made by CN and UP this year. Let me tell you where we are on the OpEx perspective. Our OpEx on PTC has been ramping up for several years; our full-year 2017 will be about $150 million. That encompasses a ramp-up since about 2009. And the cash piece is about one-third, while the depreciation piece makes up nearly two-thirds. When you look at the cash piece, it’s really as our corporate phone bill goes up because it’s a very communication-intensive system that raises our expenses. We’ve got some of that in hardware, software, and maintenance support too. We likely will have a terminal run rate in 2020 of around $200 million to $250 million, and again, I think that’s split between depreciation and cash expenses, roughly the same. Cindy can talk more about that on the project.

Yes, we’re about 40% of our PTC miles in service at this point. We feel very comfortable that we’ll have the majority of our commitment by 2018, with hardware completion continuing to be implemented across our subdivisions as we progress through this year and next year into 2020.

Thanks, Frank. I know you’ve spent a lot of time on PTC in the prior role, so just to confirm: is the $200 million to $250 million kind of annual rate split between OpEx and D&A? So it’s kind of an all-in expense cost given the network?

Yes, Brian, just to clarify, that's a terminal run rate, and we're looking at that for 2020 or 2021.

Right, right. Okay, great. And then just a quick follow-up on the high-level market view. We’ve seen the U.S. dollar on a trade-weighted basis basically decline since the beginning of the year. I think it’s down almost 7% to 8% year-to-date right now. So, Fredrik, what are you seeing in terms of various puts and takes, especially in exports? When does that decline start to become more beneficial and start showing up in grabs for more exports, along with fewer disruptive imports?

Yes, I think we've been encouraged to see some signs of strength in the domestic production side, especially as the dollar has weakened, which is helpful to U.S. exporters. Specifically for export coal, a weaker dollar is beneficial. As we look at some other markets, we do expect to see some benefits, although we haven't observed a lot of that yet. But any time we see a weaker dollar, it generally helps.

Hi, great. Thanks. Good morning. Hunter, I want to touch a little bit on sort of expectations and maybe the cadence of improvement. Your points earlier were well received in terms of expectations, but maybe you could help us understand how some of the changes you’ve been implementing early on in this process play out in the physical world, like closing hump yards, working with the employee group, and generating productivity. Just wanted to get a sense of how we should start thinking about that as we move into the second half of the year?

I appreciate your question, Chris. It's an important one. You need to consider the sensitivity in your plans. When we make operational decisions, such as cutting expenses or adjusting operations in early April, the full impact on our profit and loss statement may not be visible until August or September, influenced by agreements and tax considerations. While we can predict when some benefits will start to materialize, it's inherently complex and varies by situation. The situation we discussed remains unchanged. We're currently operating with about 900 locomotives and could see that number rise to around 1,000. It's hard to determine where it will stabilize. Regarding inventory, whether we count stored items or not, we've reduced approximately 60,000 freight cars, going from 200,000 earlier in the year down to 135,000 or 140,000. We expect a significant decrease in the hump numbers in the coming year. This process has emphasized teamwork. Initially, we had around 12 humps, but we anticipate reducing that to about three, potentially two or four, which is a notable decrease. Reducing the number of humps doesn’t necessarily mean we will sell all the land linked to them, which offers some hope. Our capital expenditures are expected to decline considerably in the next few years unless new opportunities present themselves. We are looking at a reduction of around $500 million for this year, and on a year-over-year basis, that’s about $100 million. Looking ahead, if we can align various components, the overall health could be quite strong. We feel the company is in a solid position, but our main focus remains on instilling a cultural change, which is a significant challenge for any organization. This issue exists at all levels, and we noticed it frequently before I joined. I want to highlight how our peers adapt to market dynamics. In a recent employee meeting, I was surprised to see that a considerable number of management-level individuals needed assistance with cultural transitions. Change can be tough, but I believe we can manage it effectively. The team is coming together, and you're raising a crucial question: what’s more difficult than hitting our financial targets? The true challenge will be the cultural shift, which poses a considerable hurdle as we move forward.

Sure enough, that's a very comprehensive and helpful answer; I appreciate that. The follow-up would just be in terms of initial customer reactions and how you think about the business from a volume standpoint as you progress through your cost and operational efficiency efforts going through the rest of the year. Have you been surprised? Has the customer reaction been more negative or has it been what you expected in terms of the reaction from customers? Are you seeing any negative volume impacts?

I wanted to comment, and then I’ll let Fredrik jump in. This is not a lot different from what I expected. Customers, like many people, often dislike change. I've spent some time talking with them on the phone and face-to-face explaining where we’re going, why we want to get there, and the reasons for the changes we’re implementing. This may involve a bit of pain. I don't know frankly how to accomplish that without a little discomfort. Most have been empathetic. They remember the changes and hopeful that improvements can follow, but some, of course, have raised eyebrows or concerns. That said, I don’t believe we’ll lose business due to these changes. If we provide comprehensive service as we’ve discussed, the market will reward us—but if not, we won’t succeed. We’re aware that if we fail to earn that business, it will reflect on our organization and our service metrics. I’ll stop here and let Fredrik comment.

Just to address that, I’d say we’re keenly focused on product development. If we take the scheduled merchandize network and look at transit time, we’ve improved across the board compared to last quarter. Now, I understand there will be transitional issues, but Cindy and my team are working closely with customers to fine-tune the operating model. Ultimately, we expect to improve our service product significantly, benefiting both customers and CSX.

Yes, great. Good morning. So, Hunter, I just wanted to clarify that all metrics are moving in the right direction except one. The dwell time is concerning as I see it ranging 40 to 50 hours, which seems unusual when I would typically expect 20 to 30 hours. I know you made significant changes transitioning from hump yards to flat switching. So can you provide your thoughts on this increase and how you view the impact on the third quarter? Do you expect dwell times to come down?

Sure, Tom, I think a lot of people don’t understand the nuances of dwell time perfectly representing our model. It’s not advantageous to have dwell time minimized; rather, we need to establish planned dwell time effectively—we don’t want to hurry and wait unnecessarily, which spends money without value. If we were to designate an optimal dwell time, it could be 20, or perhaps more. If we run multiple terminals effectively but also face sluggish periods like holidays when business might fail, the dwell time can see fluctuations. But if we ensure that we’re hitting our tenure schedule effectively, the dwell time should stabilize around our defined standards. So if we notice a dwell time of 40 to 50 hours, it's a concern worthy of attention to determine if it’s due to service failures or operational issues. In summary, while we don’t want excessive dwell, the fluctuation is to ensure the demand is stable. We’ve seen significant improvements and I expect our metrics to remain positive.

Okay, thank you. My second question would be on full-year guidance. When considering the upside in the second quarter, it appears your full-year expectation incorporates maybe some conservative sentiments. Assuming $0.64 for second quarter, it seems it implies limited sequential improvement for the second half. Is it appropriate, in your opinion, to view your guidance as conservative, or should we anticipate that sequential growth in the second half may be limited?

I think you need to remain sensitive to timing. We discussed the operating decisions we made and how it may take some time to reflect in the P&L. I believe the operating targets we’re addressing remain unchanged. Although, the challenges we see require a leap of faith on behalf of the management team. It’s an operating change, and while short selling appears to be settling in, we may adjust our short-term expectations as we solidify our long-term outlook. Ultimately, I’m confident we’ll be able to achieve our target for mid-60s by the end of the year.

I wanted to follow up on the headcount. Hunter, you mentioned earlier that you are taking reductions and today you stand at a reduction of about 2,300 employees. Does that include the 1,000 management positions that were cut?

Yes.

And then, Frank, on the contractors, can you provide how many you currently have employed?

We haven’t published that number yet, but let me give you a sense of what we are going to do. As Hunter previously discussed, we are looking to insource resources economically and absorb them over the existing employee population. This will result in a conversion rate of two to three contractors removed for every employee added. Clearly, we expect this to have a positive impact seen on the MS&O line and potentially we’ll see reductions in both contractor and consultant expenses. On the analytics we discussed previously, we would expect an incremental 1,000 reductions, not just in management, but also in union and contractor areas. We’ve made great progress on that, and there could be 3,000 by the end of the year. We’ll manage these three elements closely as we identify the resources in the field required to operate and also tight management of attrition.

Let me note a comment regarding the context. It’s crucial that we allow employees to create value. One of our proudest moments was at Illinois Central, where we had a significant reduction in operating ratio. Yet we maintained a steady employee count, allowing those team members to add value in their positions. This is about resource management, not simply stripping heads out. If employees cannot work productively, we need to make necessary adjustments. However, we’ve seen promising behavioral shifts, and it's clear that our new team will contribute positively to the organization and the longer-term strategy.

Thank you for that context, Hunter. You also made some comments earlier on long-term share gains in merchandise. Should we be viewing that as a similar path to where CP is today? In other words, does CSX shift from a cost improvement strategy to a top-line growth journey? Do you expect to take share in merchandise primarily from trucks, or do you see room for CSX to gain share from competitors as well?

That’s an excellent question. Yes, we aim to advance CSX over time. A key lever for us will be maintaining low costs and efficiency. Cost efficiency will directly correlate with customer growth opportunities. We’ve observed that our greatest avenues for growth do not lie strictly with railroads but within the highway sector. Our efforts will be aimed more at positioning ourselves to enhance service delivery and differentiate our product offering. Improvements in service reliability and efficiency should aid in recapturing market share. This requires a commitment to develop the tools and strategies necessary to compete effectively in the market without strictly evaluating historical performance. We appreciate the caution; we’ll build a plan that creates opportunities for growth by enhancing value through service improvements.

I wanted to get a sense of earnings performance in the quarter relative to your own expectations. You kept full-year guidance unchanged, but there’s about $100 million of benefit in the quarter that might be considered extraordinary. If you could discuss how your near-term assumptions have changed, if at all, and what kind of incremental profit improvement you expect for the second half even as revenue looks to be flat or down, thanks.

A lot of questions last night implicitly asked: 'Did we know about these factors?' Areas like the 10-year-plus condemnation litigation coming to a conclusion, or with liquidated damages disputes resolving—those were known in terms of timing, but clearly when it would hit an exact quarter and we couldn’t be 100% sure. We did anticipate a bit more inflation this year than originally expected and tax rates likely will be higher than initially planned. We’re experiencing fuel price fluctuations more significant than even we had early anticipated. And similar to previous quarters, there are always numerous moving parts. In terms of the second half, you should observe area productivity improvements and expectations at a target we previously set for the total. We expect that as we can see improvements from our teams running more effectively week-over-week. Additionally, Fredrik and his team are strategically navigating pricing policies to align with market opportunities.

Thanks for that, Frank. Just to clarify—so you believe productivity inherently tends to show on the bottom line when volumes and revenues work together. Given that you expect a slight moderation on volume for the second half will the productivity drive results to follow through in a way that aids your earnings, effectively maintaining profitability even in the absence of growth?

Yes, absolutely. In essence, we do believe that productivity gains can buoy our overall earnings even when the revenue doesn’t climb at similar paces. We’re projecting strong productivity improvements that should yield positive momentum for the back half of the year. In terms of our capital structure, we’ve taken a fresh look at the balance sheet and leverage ratios, factoring in free cash flow. With a new CEO and board, we've decided its prudent to thoroughly analyze capital structure discussions. We’re not committing to a dictated strategy but are finding a roadmap forward to maximize flexibility for the management team and board to weigh these financial decisions.

I’d like to follow up on the previous comment you made. Hunter, can you help frame some of the topics that you expect to cover at the upcoming investor day? What do you expect to learn or communicate in those dialogues?

What do you want to hear? I mean we’ll delve deeper—this shall not be a restatement of numbers heard today. We’ll peel back the layers and detail why our humping model might not be in line with where we ultimately want it to be. We want to showcase improvement opportunities from utilizing our locomotives more effectively, how our operations can evolve, what successes we've had in increasing productivity, and perhaps there's an opportunity for fun along the way. Our intent is to ensure shareholders gain insight into our restructuring efforts, helping them understand why we are adjusting in line with our strategy that will drive long-term profitability. If you have any specific inquiries or requests for topics of discussion, we’d love to know.

Are you confident you'll have made enough progress by that event to provide long-term operating ratio targets and balance sheet objectives?

Absolutely. The trends will be visible—a lot of our discussion will showcase where we stand on our metrics. We will demonstrate our vision moving toward low 60s consistently while the Board and management will validate their long-term targets.

Could you help us break down overall performance in the quarter versus your expectations? Did any extraordinary adjustments prompt reconsideration of guidance, especially as we navigate the second half?

We anticipated potential implications with large settlements and any similar situations. We placed our forecasting within a range for potential revenue changes. We recognize the complications that come along with unexpected changes, but observe a pattern of year-over-year improvements in overall performance, and trust that will be reflected.

Hunter, to clarify, there will be no revisions to guidance and expectations remain intact?

That is correct.

Could you comment on the progress in closing hump yards? The metric mentioned before on dwell time remained somewhat elevated.

When considering operational improvements amidst transitions, customers don't perceive consistent service as typically leading to pricing sensitivity. As significant changes occur, expect to navigate challenges with the key objective to ultimately elevate the track record overall. Understanding up-to-date means of service reliability takes precedence.

I wanted to assess the trajectory of freight demand moving forward as it relates to consumer sentiment. Can you share recent trends in productivity and performance, particularly as we head into the next quarter?

Overall, we have witnessed positive product trends in multiple areas and find ourselves optimistic as we anticipate demand increases, although we must remain vigilant of market fluctuations influencing that growth.

To clarify on pricing—has the competitive environment impacted your decisions in terms of pricing strategy, considering the increasing demands or market conditions?

We aim to maintain consistency in our value proposition while remaining sensitive to market factors. These insights drive operational efficiency while remaining observant of opportunities in our competitive landscape.

I appreciate every participant's time and attention today. We are committed to the roadmap ahead and anticipate positive results as we integrate our new strategies. Look forward to continuing our dialogue and to seeing you at our Investor Conference in October.