CSX Corp (CSX) — Q1 2018 Earnings Call Transcript

Thank you, Michelle, and good afternoon, everyone. Joining me on today's call is Jim Foote, Chief Executive Officer; and Frank Lonegro, Chief Financial Officer. On Slide 2 is our forward-looking disclosure, followed by non-GAAP disclosure on Slide 3. With that, it is my pleasure to introduce our President and Chief Executive Officer, Jim Foote.

Thank you very much, Kevin. It's great to be here this afternoon with everybody on the call. Before we start with the slides, I would like to make a few comments. CSX had a very good quarter. We are drastically changing the way we operate the railroad by taking millions of unnecessary steps out of the business process that we use to run the railroad. This is producing record operating performance, improved customer service and, when combined, impressive returns to shareholders. The women and men of CSX have accomplished a lot. Clearly, first quarter results are a reflection of all the hard work that has taken place over the past year. We are proud of these results, and I would like to thank all CSX employees for their contributions towards achieving them. With that said, the plan recently laid out at our investor conference is a 3-year plan. We're only 1 quarter in, 1 out of 12, and we still have a lot of work to do to achieve our goals. The good news is that every day I feel a little more confident in our ability to deliver on these targets. And I want to take the time to highlight safety. On my watch, safety will always come first. We have some work to do to improve, and the team is committed to do so. To be the best run railroad, you have to be the safest. Now let's get into the deck, and we'll start with the Slide 5 on our highlights. And this should be a pretty simple quarter to walk through. We only had 1 extra day in last year's first quarter and, other than the restructuring charge last year, just a few relatively minor one-time events that Frank and I will point out. EPS increased 53% to $0.78 versus last year's adjusted EPS of $0.51. The increase was driven by lower costs on flat revenues, which drove a 19% improvement in operating income versus the prior year's adjusted results. The new lower cash rate and share count, down about 4%, also contributed to the significant year-over-year increase. Our operating ratio improved 570 basis points to 63.7% when compared to last year's adjusted OR of 69.4%, a record first quarter. I might be a little biased, but I think it's CSX's best quarter ever. Lower costs in labor and MS&O partially offset by higher fuel costs drove a significant year-over-year improvement. Going to the next slide, Slide 6. Total revenue was flat as price, fuel surcharge and supplemental revenues offset a 4% decline in volume and negative mix. We did see a slight sequential improvement in pricing, excluding coal. Looking at the business segment, each was, to some degree, impacted by either outside influences or a prior period decision. Chemicals were impacted by a few items, including no fly ash movements that occurred last year, lower plastic and pet coke shipments, and virtually no crude-by-rail. Lower North American vehicle production and challenges with rail car availability, which was an industry issue, reduced auto. Ag and food was mainly impacted by lower ethanol business, which we exited because of its low or no margin. And fertilizer revenues, as I mentioned previously, were down due to the Plant City facility closure. Domestic utility coal declines were somewhat offset by a continuing strong export coal market. And intermodal saw strong international volumes. Other revenues increased year-over-year as liquidated damages contributed $19 million, and the remaining increase was driven by higher demurrage and other supplemental revenue. Obviously, we have changed the business practices in this area and are working with our customers to create a more fluid network. On Slide 7, let's take a quick look at our operating performance. We've highlighted some key metrics that you are familiar with. As we outlined at the Investor Day, we continue to make significant progress year-over-year in both train velocity and car dwell. We also saw improvement in train length and GTMs per available horsepower, which represent improved asset utilization and efficiency. It seems like almost every day, we set a new CSX record in one area of our operations or another. We are making progress, but there is clearly more opportunity ahead. Since the beginning of the year, we reduced another 142 locomotives and a total of 816 year-over-year. Service design improvements have seen a reduction in over 40.8 million expected annual car miles and 351 weekly crude starts year-to-date. Brian Barr in our mechanical department has done an exceptional job with line of road failures, improving 35% while doing it with a smaller workforce. Now let me hand it over to Frank, who will take you through the financials and provide more details on the benefits from the operational improvements.

Thank you, Jim, and good afternoon, everyone. Turning to Slide 9. Let me walk you through the summary income statement. Reported revenue was roughly flat for the first quarter as a 4% decline in volume was offset by the benefits of increased supplemental revenue, higher fuel surcharge recoveries, and solid core pricing gains. Moving to expenses, the P&L reflects our adoption of the new pension accounting standards where only the service cost component of our pension expense is now included in operating expense, while the remaining aspects of pension accounting now fall below the line in other income. Prior year results, including the geography of last year's restructuring charge, have been restated to reflect this new standard. Total operating expenses were 13% lower in the first quarter, 8% lower after normalizing for last year's restructuring charge. Overall, labor and fringe savings of $100 million or 12% year-over-year were driven by an 11% reduction in average headcount. Scheduled railroading enabled train crew savings on multiple fronts. A 22% increase in velocity and a 5% increase in train length enabled an 8% reduction in road crew starts, while the elimination of 8 hump yards last year and a 20% improvement in cars processed per man hour drove savings in yard staffing levels. Improved network fluidity seen through the velocity and dwell metrics, combined with a 20% improvement in GTMs per available horsepower, has helped eliminate rolling stock assets. Our active locomotive fleet was down 23%, and the number of cars on line came down by 11%, the combination of which enabled resource reductions within our mechanical workforce. In addition, the efforts we started in early 2017 with our management restructuring to streamline the management workforce, eliminate bureaucracy and improve the speed of decision-making across the system have resulted in significantly lower labor expense. Fewer management resources also resulted in lower incentive compensation expense versus the prior year quarter. MS&O expense was down 16% against the prior year. The asset efficiency of scheduled railroading, combined with improved year-over-year locomotive availability, resulted in lower fleet counts, yielding lower materials expense, lower maintenance and repair costs and lower levels of consumables. Given the sustainable nature of these asset reductions, we have sold or scrapped hundreds of engines and thousands of freight cars in the past 12 months. The locomotive fleet reductions have also allowed us to rightsize our contracted maintenance services agreement. Fewer crew starts and the more balanced network operating plan also drove reductions in ancillary costs such as hotels, meals, and taxis. Efforts to streamline the workforce and reduce organizational complexity also apply to our contractor and consultant workforce. Working towards our broader total workforce targets for 2018 and beyond, we have made significant progress in reducing our labor footprint with savings from contractor and consultant reductions flowing to the MS&O line. Finally, continued efforts to monetize our surplus real estate portfolio resulted in $32 million of real estate gains in the quarter versus $2 million in the year-ago period. The gains in this year's first quarter are consistent with the guidance we provided at the investor conference, that we would achieve $300 million of cumulative real estate sales through 2020. Looking at the other expense items, depreciation increased slightly due to changes in the asset base driven by capital investments, offset by asset sales. 24% higher fuel prices year-over-year presented a significant headwind, although our continued focus on fuel efficiency through better matching of horsepower to trailing tonnage and increased use of energy management and distributed power technologies drove year-over-year improvement in fuel efficiency despite harsher winter conditions this year. Equipment rents are up slightly due to higher incidental rents, though we continue to drive days per load improvements to reduce our car hire expense. Equity earnings were favorable primarily due to improved performance at our affiliates and tax reform true-ups. Lastly, we are cycling 2017's restructuring charges, part of which are now housed below the line due to the new pension accounting standard. Below the line, interest expense increased, primarily due to the additional debt we issued earlier this year. Tax expense was roughly flat on a 57% increase in pretax earnings, illustrating the favorable impacts of tax reform. Our effective tax rate in the quarter was 23.8%, though we continue to expect around 25% for the full year. All told, these pieces sum to the headline items Jim highlighted in his opening remarks. Importantly, the 63.7% operating ratio we achieved in the first quarter represents a meaningful step toward the 60% operating ratio target we set at last month's investor conference. Turning to the cash side of the equation on Slide 10. Capital investments in the first quarter reflect our recently announced 3-year capital target of $4.8 billion, driven by the reduced capital intensity of the scheduled railroading model. As we've said many times before and reiterate here, our commitment to investing in safety and reliability remains unwavering, and we have undoubtedly become a less capital-intensive company through improved asset utilization that reduces yard infrastructure and rolling stock needs and better processes that serve as an effective alternative to capital investments. Our free cash flow growth of 3% was more muted than our earnings growth would have implied. First and most importantly, estimated federal tax payments for the first quarter are not paid until April. As a result, you see the year-over-year benefits of tax reform in our earnings but not yet in our free cash flow. Second, as with any quarter, there are timing issues that can impact free cash flow on a short-term basis. Here, we made back wage payments in the quarter to employees affiliated with unions that have concluded national bargaining. There were also timing differences in state tax payments and prepaid expenses. Bigger picture, the combination of core earnings growth, lower CapEx, and lower cash taxes will drive significant free cash flow conversion and $8.5 billion of cumulative free cash flow through 2020. Finally, we were pleased to provide significant returns to our shareholders during the first quarter. On February 12, we announced a 10% increase to our quarterly dividend and meaningfully increased our share buyback program to $5 billion, with expected completion in the first quarter of 2019. As you evaluate our buyback cadence in the quarter, remember that our buybacks in the first half of the quarter were premised on a much smaller $1.5 billion program. Since implementing a larger program mid-quarter, we have capitalized on recent mark-to-market fluctuations and repurchased shares at a faster than pro-rata pace. With that, let me turn it back to Jim for his closing remarks.

Great. Thanks a lot, Frank. As I said at the very beginning, it's a very simple and clean quarter for everyone to understand. And so in conclusion on the last slide here, a little bit about the financial outlook. As I've said before, I expect revenue to be up slightly for the year, and I have increased confidence in this outlook given the start of the year. Also, as many of you are aware, I am happy to say that we are no longer under the requirement to have weekly calls with the STB. We have improved our service, and I expect that to continue. As we demonstrated in the first quarter, we expect a solid step-down each year in the operating ratio. There remains significant work ahead to deliver on our 2020 target of a 60% OR. However, our goal of making CSX the best run railroad is in sight, and we are working hard to achieve that. So I would like to turn it back to Kevin now. We can start, and Frank and I will be glad to answer any of your questions.

Okay, Michelle, I think we're ready to take questions.

I guess, maybe I want to start on the revenue side. So, Jim, you kind of outlined the outlook for some modest revenue growth over the course of the year. I guess, when you think about sort of volume and price, could give us a little bit of sort of help there? When you looked at yields in 1Q, they certainly were good. Can you give us a sense of maybe where core pricing is and maybe what that assumption is of mix of volume and price as the year progresses?

Yes, I mentioned that prices have improved slightly in sequence. Excluding coal, we can clearly expect to see a small increase in our supplemental revenues throughout the year due to the implementation of more specific demurrage policies, for instance. Additionally, fuel surcharge will fluctuate as the year progresses. Overall, I believe there is a fairly solid environment for pricing.

Okay. So cadence could get a bit better as the year progresses. That's helpful. And then just maybe a follow-up on...

But a much shorter way of saying it, yes.

Yes. I appreciate it. Now your color was greatly appreciated. And then, I guess, just trying to get a sense of what maybe normal seasonality from an operating ratio perspective might look like. So you guys are doing some dramatic things on the cost side, so it's a little hard to kind of see through that and relate it back to your historical patterns from 1Q and then how the rest of the year typically plays out. Is there anything you can help us with and maybe, Frank, sort of headcount expectations? We saw where you ended the quarter. But anything you do on sort of the cost or cadence of the OR improvement in 2018 would be helpful.

Clearly, the first quarter, so I think in everybody's opinion here, is the toughest operating environment for CSX. And I'll let Frank jump in if he has anything additional to that.

Chris, the only thing I'd add, as you implied seasonality for the rest of the year, remember that we had a couple of fairly significant one-time items in the second quarter, so you probably need to adjust a little bit for that one. On the headcount side, I mean, you see the 3,000 year-over-year in the first quarter, and it really doesn't matter whether you look at average headcount or ending headcount, we're down about 3,000 employees year-over-year. When you add in contractors, it's a little bit more than that on a year-to-date basis, about 1,100 down year-to-date, and that's against the goal that Jim set on the fourth quarter call of around 2,000. So we feel like we're in pretty good shape on that one.

Jim, how do the service failures of some of your peer railroads affect your ability to maintain this level of improvement, considering the volume of traffic that is exchanged with other railroads, whether they are your eastern peers or those to the west or north? Could you discuss the constraints you perceive as a result?

Well, Ken, it's clear that we're part of a network, and we are affected to some extent by our interchange partners, whether they are in Chicago, Memphis, or even Canada, wherever we interchange traffic. Naturally, we would prefer a more fluid network as it would benefit us. However, if we look at our operating performance in the first quarter and how we managed our network during that time, it's evident that the scheduled railroad model is effective. We passed the stress test. Hunter didn’t create a unique environment for this railroad; we are operating under the same winter conditions and circumstances as everyone else, yet we improved significantly. This illustrates the resilience and strength of our organization to perform even better in the future, based on our historical operating performance metrics.

Yes. Truly a great job. Just didn't know if there was a limitation based on what you saw, but great job. The follow-up would just be on the sustainability of your other revenue surcharges. Does business adapt now that they see that you're increasing your rates on demurrage and other items? Or does that come back down as your customers adapt? Or do you expect that to continue to grow as you've changed the business based on what you've seen in the past?

Ken, it's Frank. We highlighted the liquidated damages component in the prepared remarks, which you can examine as a one-time item for the quarter. Our aim is not to generate significant profits from supplemental revenue; rather, we want to influence customer behavior to establish a 7-day-a-week service, achieve balance, and implement the principles of scheduled railroading. We also require assistance from customers to expedite car turnover. This initiative is primarily about changing behavior, and I wouldn't suggest that the run rate observed in the first quarter will be indicative for the rest of the year.

Congratulations on the great results, really strong OR and cost side performance. Wanted to get your thoughts, kind of a granular one and then maybe a broader question. The comp and benefits per worker we were thinking maybe be up year-over-year was down, and, I guess, incentive comp was down. Can you help us think about, is that against the backdrop where performance is good? Is incentive comp going to be down in coming quarters? Or was that kind of a one-off? And how do we think about comp per worker as we look at second quarter, third quarter? Does that continue to be down? Or how would we think about that relative to first quarter?

Got you. Tom, Frank. You're right, on a comp per person basis in the quarter, we were better by about 1%. And you're right, the driver is largely the year-over-year favorability on incentive comp, probably a tad of employee mix in there as well. As you think about modeling in the future, if you assume static employee mix, you're really just talking about inflation and then you're spreading your fixed costs. I think what you're going to see on the incident comp piece depends on how we do against our plan as the year goes on. We did have a fairly significant headcount reduction year-over-year that drove it lower in the first quarter. And then as you think about the fourth quarter, remember, we had a fairly significant reversal of incentive comp in the fourth quarter of last year that we'll cycle. That was the reversal of Hunter's options, about a $30 million number, so just as you think through how to model that, those are probably the big moving parts.

I just want to go back to the volume questions. So you've kind of outlined at the Investor Day to us that, ultimately, the improved cost, improved service, your ability to grow the business faster is more of a 2019, 2020 story. But I'm wondering, given some of the service issues we're seeing elsewhere and the trucking capacity problem, is there kind of an opportunity here to see an acceleration? How's the conversation with customers going? How do you feel about your ability to begin to leverage this service and cost story a little bit earlier?

About six weeks ago, we presented our plan in New York. At that time, the weather conditions across North America were tough, and the railroads were facing significant issues. The industry was aware of the ELDs and other challenges present. Currently, there haven't been any major external factors prompting us to reconsider our outlook for the rest of the year. Despite the tough conditions, our railroad was operating effectively six weeks ago. Internally and externally, we haven't seen much change. Our service remains exceptional, and our approach to leverage this service while ensuring we are fairly compensated is unchanged. We do not intend to alter that strategy just to increase volume on the railroad.

So maybe to address service first and take a bigger-picture approach. Clearly, you've shown improvement, but some of the other rails are struggling. Jim and Ed, you've seen a lot of service disruptions in the industry in the past. You know what it takes to fix some of these issues. With that in mind, when you look at the North American rail network as a whole today, do you have any thoughts around the timing of when we can return to an environment of normal fluidity?

No. I can comment on how CSX is running. I can't comment on when other railroads are going to do that. It'd just be inappropriate for me to comment.

Okay. Fair enough. And maybe to go back to pricing for my second question. Seems like things are moving higher, coal being the exception. Could you talk about your view on coal pricing going forward? I'm just curious if you expect this downward pressure to continue and if you're pursuing any changes as it relates to the percentage of your contracts that have a fixed component.

Well, two pieces of businesses here, the export business, both of the thermal and met, pricing is kind of driven by other indices that we really don't have a lot of control over, and so that piece of business kind of goes up and down with those indexes. On the utility side of the business, clearly, the coal-fired utilities, in competing with other utilities, generating facilities that are using natural gas to run their turbines, the coal guys have a disadvantage just on a cost per million BTU basis. So to the extent that we can work with those customers, those coal-fired utilities, to give them a more lower-cost basis on a delivered per million BTU basis, we will try to do that and see what happens.

Jim, any perspective on international intermodal, in particular, your service being a standout relative to the other rails. But any other concerns for the steamship lines with regard to network fluidity broadly in diverting some of the flows away from the East and the Gulf Coast over to the West to improve transit times? Have you seen any or have you heard any talk about that as we enter the spring peak?

I'm putting up a big for sale sign in Jacksonville, Savannah, Virginia, Baltimore, New York, and New Jersey. We're open for business and ready to take on freight. I'm confident that we can handle it all without any issues.

Okay. And then more broadly on protectionism. Several weeks now into a lot of the rhetoric around tariffs, obviously, on the steel and aluminum side and, on the grain side, down more recently. Any thoughts that you have as it relates to consequences near-term that may have arisen given the rhetoric that we've now been absorbing over the past couple of months?

No, I keep receiving inquiries about becoming an expert on tariffs, which I am not. Right now, opinions vary daily on whether this situation is favorable or unfavorable. Anecdotally, we are considering moving more petcoke and exploring opportunities with steel mills on a rail we are opening. That's just anecdotal information. As the situation develops, I expect there will be both negative and positive aspects, but it's too early to predict what those will be.

I wanted to touch back on price a little bit, excluding the coal franchise. Jim, I think you mentioned there was some sequential improvement there. Can you give us a sense of how much of your book of business for 2018 has already been repriced?

In what segment of the company?

Ex-coal.

It's fair to say that about one-third of the business transitions each year, which is a useful metric. However, I can't provide any more specific guidance than that.

I want to clarify your strategy on intermodal in light of the current truck market. Are you prioritizing obtaining pricing from existing customers rather than focusing on converting truck shipments to rail? Or are you also pursuing volume opportunities?

Well, clearly, we're focused on two things, one, growing the business; two, profitably. So volume with price equals top-line growth. And whether that's an existing customer giving more volume or whether it's a new customer that could give me volume I don't have today, that is always the equation. I do not have a scorecard in my office that says R to R, or whatever you call it, road to rail and how many did I get today. That's not a game that's going to make me any money. Just taking a truck off the highway and putting it on the railroad, if it's not priced right and it's not moving in the right and specific corridor, it adds no value to me. And at the end of the day, it adds no value to the customer because we probably don't do a very good job for him. So whether it's an intermodal customer or whether it's a merchandise customer, the whole objective here is to go to the customer and say, 'I can provide you with value,' whether it's the merchandise customer that we talked about before or whether it's the intermodal customer who wants to take advantage of the railroad in connection with their over-the-road trucking operation.

And so I think we're done with all the questions, so we'll wrap it up here.