CSX Corp (CSX) — Q3 2018 Earnings Call Transcript

Thank you, Shirley, and good afternoon, everyone. Joining me on today's call is Jim Foote, President and Chief Executive Officer; Frank Lonegro, Chief Financial Officer; and Mark Wallace, Executive Vice President for Sales and Marketing. 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.

Great. Thank you so much, Kevin, and thank you everyone who is on the call. We are very excited about the strong performance of the railroad. Incredible things can be done by incredible people. The CSX workforce is proving every day that they are not going to back down when it comes to running a safe, customer-focused, and efficient railroad. I want to give a special shout out to the operating team that positioned our efforts out of harm’s way in advance of the recent hurricanes. And to Ricky Johnson and all the engineering folks who did an amazing job in getting us back up and running with minimal delay in the aftermath of both storms. Before moving to third quarter results, I’d like to comment on a few initiatives we worked on in the third quarter. First, we made changes to the organizational structure in our operating department, which pushed more real-time decision-making to the field. Our management team has embraced the change, and I am encouraged by the early positive results and momentum it has delivered. Second, we announced new major initiatives at our Northwest Ohio Intermodal terminal. This facility will now function as a traditional Intermodal terminal to drive new revenue opportunities. As part of our plan, we are working with NorthPoint Development to establish a logistics park adjacent to the terminal. This logistics center will require no capital from CSX. We also announced a new haulage agreement with BNSF that enhances western access to the facility. I believe these initiatives will drive long-term growth opportunities for CSX. Now, let’s get to the results. I said it last quarter, and I’ll say it again today: two words sum up everything, great performance. Nothing unusual; these numbers are straightforward. EPS increased 106% to $1.5 versus $0.51 last year. Operating income grew nearly 50%, combined with the lower tax rate and 6% fewer outstanding shares, contributing to the significant year-over-year increase. Our operating ratio improved 970 basis points to 58.7, a substantial improvement and a record third quarter for CSX. The operating results are highlighted by 14% complex growth, including 4% volume growth, combined with lower expenses despite much higher fuel costs. Revenue increased 14% with volume, price, fuel surcharges, and supplemental revenues all contributing to positive growth this quarter. Looking at the business segment, each was impacted by positive pricing and fuel recovery. Merchandise revenues grew 12% this quarter, helped somewhat by lapping some of the service issues last year. Nearly every end market saw a double-digit increase, with the exception of fertilizers, which was impacted by a previously disclosed customer shutdown. I am encouraged by the broad-based growth across this portfolio. Coal revenues increased 14%, with strength in our export business offsetting domestic utility weakness. We also saw good growth in our steel and industrial business. In Intermodal, we saw growth from both price and volume. Finally, in other revenues, similar to previous quarters, we saw an increase in supplemental fees, including demurrage. On the next slide, let's take a look at our safety performance. The safety of our employees is my number one priority. As you can see on these charts, we made some good progress this quarter, and we need to sustain this momentum. The personal injury rate this quarter is encouraging, but we must improve on accident rates. We have an initiative in place to drive further improvement. We have strong turnout by employees in our recent safety survey, which is a good sign of employee involvement. I will continue to prioritize safety above everything else and expect us to make further progress. On the next slide, let's look at efficiency and service. Train velocity and dwell both saw significant improvement over last year, and they are also much better than last quarter. Velocity improved 28%, and dwell improved 26%, both on a year-over-year basis. Cars online continue to trend lower, down almost 14% year-over-year despite a 4% increase in volume. This truly shows the improved asset utilization we are achieving. And you can see our trip plan compliance. This is an essential measure as it reflects not only the railroad's operating performance but, most importantly, how we are performing from a reliability standpoint for our customers. We have seen an improvement of 26% from the first quarter to the third quarter this year. While we have made good progress, there is plenty of room to improve. Now, let me hand it off to Frank who will take you through the financials and operating improvements in greater detail.

Thank you, Jim, and good afternoon everyone. Before walking through the financials, we've got a number of questions on hurricane impacts. Let me give you a quick summary. The most significant impact from hurricane Florence was the loss of over 5 miles of track due to numerous washouts from flooding. The majority of the financial impact was capital in nature, which I’ll discuss in a few moments. In terms of the P&L, we estimate the EPS impact to be about $0.02 in the quarter, similar to hurricane Irma in last year's third quarter, with most of the impact attributed to lost or hurt revenue. With respect to last week's hurricane Michael, given the location of the landfall and the speed of the storm, we do not expect the impact to be significant in the fourth quarter. Moving to Slide 10, I'll walk you through the summary income statement. Reported revenue was up 14% in the third quarter, driven by 4% lower volume and revenue per unit gains of 9% from higher fuel recoveries, favorable mix and core pricing gains, as well as higher other revenue. The overall pricing environment remained strong in the quarter, with healthy demand levels, tight trucking capacity, higher fuel prices, and support of export coal benchmarks combined with an improved CSX service product. As in the first and second quarters, pricing for merchandise and Intermodal contracts renewed in the third quarter remained particularly strong. Moving to expenses, total operating expenses were 2% lower in the third quarter, reflecting the benefits of scheduled railroading, as expenses were favorable year-over-year, even with higher volumes, higher fuel prices, and the impacts of inflation. Labor and fringe expenses decreased $30 million, or 4% year-over-year, as average headcount was down 8% despite 4% more volume. Significant year-over-year improvements in velocity, on-time originations and arrivals, and trip plan compliance led to significantly fewer active trains and crew stops during a 20% improvement in train crew efficiency. Productive recrews, an indicator of net validity, also improved by 58%. Shifting to mechanical support labor, the active locomotive count was down 12% year-over-year, including an active fleet reduction of over 300 engines since the end of Q2. We have over 800 locomotives in storage in addition to the hundreds of engines we've sold, scrapped, or returned since the beginning of last year. The smaller fleet, along with freight car repair efficiencies, helped drive an 11% year-over-year decrease in our mechanical craft workforce. Our G&A headcount continues to decline as we look for opportunities to absorb attrition. With these operational and G&A labor efficiencies plus the contracted workforce reductions I’ll discuss in a moment, we have nearly achieved our full-year 2000 total resource reduction goal we set on our January call. MS&L expense was lower by 9% versus the prior year. Improved service levels combined with resource and asset efficiencies yielded additional savings. Material savings due to the smaller locomotive fleet are complemented by our decision to store units that are less reliable. The decisions we’ve made around storage, combined with additional fleet-for-liability efforts, drove a 34% year-over-year improvement in our locomotive out-of-service measure and further reduced costs related to materials and contracted maintenance services. Looking at non-labor costs associated with our train crews, the reduction in both road crews and recrews yielded lower hotel and taxi costs. Additionally, MS&L continues to benefit from efforts to streamline contractors and consultants, particularly in our technology department. Similar to recent quarters, results benefited from line sale and real estate gains that were $52 million higher than the prior year. We are continuing to monetize our surplus assets and are making good progress towards our target of $300 million in cumulative real estate sales through 2020, along with potential upside from line sale proceeds. Looking at other expense items, depreciation increased slightly due to the larger net asset base. Fuel expense was up 31%, primarily due to a 27% increase in the per-gallon price and increased volumes that we were pleased to achieve record fuel efficiency in the quarter. We will drive further fuel savings through continued improvement in network efficiency and the increased utilization of fuel optimization processes and technologies. The equipment rents expense declined 18%, driven by significantly improved car cycle times as we continue to see strong year-over-year and sequential service improvements. Equity earnings were favorable, primarily due to the impact of the lower tax rate from our affiliates. We still expect equity earnings from affiliates in Q4 to be between $20 million to $25 million. Looking below the line, interest expense increased primarily due to the additional debt we issued earlier this year, partially offset by a lower weighted-average coupon rate. Tax expense was lower in the quarter, even with significantly better pre-tax earnings, reflecting the continued benefit of tax reform. Our effective tax rate was 22.3% in the quarter, slightly lower than prior guidance, mainly due to settling state tax matters. Absent unique items, we expect our effective rate to be in line with prior guidance of around 24.5% for the fourth quarter. Closing out the P&L: as Jim mentioned in his opening remarks, CSX delivered operating income of nearly $1.3 billion, third quarter record operating ratio of 58.7%, and earnings per share of $1.05. Turning to the cash side of the equation on Slide 11, year-to-date capital investments are down 15%. While we remain on track for the three-year $4.8 billion capital target, we now expect capital investments of about $1.7 billion this year, up from the prior target of $1.6 billion. The incremental capital spending is being used for positive train control, additional investments in positive return projects, and repairs related to hurricane Florence. The reduced capital intensity of the scheduled railroading model, the substantial core earnings progress detailed on the prior slide, and the benefits of tax reform helped drive a 55% increase in year-to-date adjusted free cash flow, resulting in almost 100% free cash-flow conversion of net income. This significant improvement in free cash flow generation helped drive nearly a 50% increase in shareholder returns. We executed $1 billion of share repurchases in the third quarter and have now completed over $3 billion of the current $5 billion buyback authority and remain on pace to complete the program by the end of Q1 2019. As we have stated throughout the year, the CSX board will continue to evaluate cash deployment and shareholder returns on an annual basis.

All right, thanks, Frank. Turning to Slide 13 and wrapping it up on a forward-looking basis, on last quarter's call, I said we were expecting revenue growth for this year to be in the mid-single-digit range. We are now looking for full-year growth to be 6% to 8%. Clearly, we are doing better than we expected coming into the year. A lot of this is due to the continued strength of export coal, but all of our business groups are doing well. On the Intermodal side, we have made significant strides in reengineering our franchise to drive sustainable profitable growth. Our goal of making CSX the best-run railroad in North America is clearly obtainable, and I am proud of what has been accomplished and very encouraged about all the opportunities in front of us. I want to thank everyone for their hard work and commitment.

In the interest of trying to get to everyone, I will ask that panelists limit themselves to one question and one follow-up as needed. Shirley, we'll now take questions. Thank you.

I wanted to ask about the revenue per RTM trends this quarter. It looks like it was up a little more than 3% for the first time you've seen since 2Q of 2017. So just wanted to understand what's driving that, if it's mix, price, a combination thereof, and if there's an impact that we should be thinking about or if this helps us to understand the success of precision railroading so far?

I’ll just comment on the last part. The RTM growth that we saw in Q3 is a combination of everything: strong pricing environment, mix, and volume.

I was asking about if this tells us something about where you are with the success or progress of precision railroading so far?

I would say, yes. Clearly, we are doing very well. And service is excellent. The pricing environment is very, very good. Customers are moving more freight back to the railroad. And that is a trend that will continue.

Okay. Thank you for your time.

Allison, it's Jim. Clearly, part of our strategy is to price appropriately for the service we are providing, and to the extent that CSX provides a better product to sell, we will recognize higher prices moving forward.

I wanted to talk a little about OR expectations as we move forward. Obviously, the operating ratio has performed extremely well over the last couple of quarters. I guess Jim, can you put that into context with your 60 OR target? Can you talk about the timing of getting towards that and maybe the sustainability of these great margins that we're seeing?

Well, as I said eight months ago, we set a target to achieve a 60 operating ratio in three years. Everybody thought we were crazy when we put that out. Now we've come in with two consecutive quarters of industry-leading results. I have more confidence that we can hit a 60 operating ratio in three years since we are already there today. But that does not mean we've run out of opportunities. I'm comfortable with the reengineering steps that we've taken so far on our Intermodal business, but we are holding back until after peak season.

And then just a quick follow-up on the pricing side. I know you don’t give a core pricing metric anymore, but, Jim, you've been helpful in terms of characterizing the price environment over the last couple of quarters. Just wanted to get your thoughts on 3Q, relative to the last couple of quarters.

In our prepared remarks, we mentioned that renewals continued to be strong compared to a same-store sales type of measure, which continued to be elevated. We did have one restructuring that was a little less than we would like, but excluding that, you would have seen a continued sequential increase in same-store sales. The environment remains very strong, and the service product is excellent.

Jim, can you provide some context about the challenges and opportunities of adjustments you're making on the Intermodal side, especially given CSX's standalone position compared to when you were at CN?

I'll take the second part of your question first. I believe we can take the Intermodal business from the slowest dog to the middle of the pack. If you believe in your franchise and the quality of your product, you can sell it as a value-add service to customers. We're in the process of disassembling the old independent structure of the company because it's not an independent company. It's part of CSX, and those trains run on the railroad, not on an independent Intermodal railroad. This will lead to a more efficient and effective product for our customers and improve profitability.

Frank, can you update us on export coal for Q4? It seems like it's running at the rate you mentioned last time, so any characteristics would be helpful.

Export coal heading into Q4 is expected to remain strong. Demand is still robust and benchmarks are strong, so we anticipate continued strength in our export coal business.

Congrats on the very strong results. Export coal has been highly favorable, which has helped this year's performance. As we think about the operating ratio from 2018 to 2019, how much of the improvement will depend on export coal volumes?

It's more about what would happen if coal prices were to decline and the potential impact on our performance. We will maintain a healthy coal business going forward because it has a meaningful impact on our performance.

If I could just ask one quick follow-up. Employee headcount was down another 8% this quarter. As your revenue guidance goes up, should we expect a flatter employee headcount next year?

We will continue to become more efficient. We will have a target for employee reductions based on attrition and managing expectations. While headcount may be reduced, we will ensure we have sufficient workforce to handle volume.

You should expect that as we see growth in merchandise and Intermodal, we will have the capacity to add resources with high incremental margins. Efficiency will continue to be a focus.

Can we touch on the efficiency gains? Is there more room on equipment reductions or is that the end of equipment efficiency gains?

Never. We will continue to improve our metrics. As we improve velocity and efficiency, we can further reduce the number of locomotives and cars. Each improvement creates additional capacity.

I just wanted to clarify about a contract you mentioned. Excluding that, rates would have been up sequentially on contracts, correct?

That's correct. That one restructuring deal from last year skewed the data; otherwise, we would have seen continuing sequential increases.

We're talking about merchandise and Intermodal contracts here.

Wanted to ask about the Intermodal changes made and the framework of those changes. Can you give an update on what you've done and what might happen in Q1 next year?

The announcements made in late-August and early-October combined will have about a 7% volume impact, similar to changes seen last year.

Can you offer insights into engaging the sales force and how they are selling the service with customers?

I've been focused on organizing a team that can provide exceptional service. We completed a sales meeting to clarify our goals: to sell service, not just price. Our sales team is incentivized to do their job and earn their keep.

The haulage agreement with BNSF is set to begin at the end of the month. We're excited about this forward-looking agreement and anticipate growth in Intermodal business in Q4.

Can you reconcile the increase in demurrage fees considering your service levels have improved significantly? What should we expect in terms of customer compliance?

The year-over-year change in transit times shows improvement, but we were a bit surprised that customer behavior hasn’t changed as much as expected. It may come down as trucking capacity loosens.

What impact will the recent fee changes have on the equipment and other rentals?

The rent reduction is primarily due to significant improvements across our lines, reducing the need for car hires. We won’t provide run rates for specific expense line items, but improvements in velocity will lead to efficiencies.

Mark, can you share your perspective on how customers are engaging with CSX now compared to last summer? What's the competitive outlook for multi-year contracts into 2019?

I've been spending time re-establishing relationships with customers. They appreciate the improvements we've made, and many are moving more freight back to us rather than truck. For example, we see double-digit growth in our forest products and metals businesses.

Can you remind us of the long-term revenue outlook provided in February? Could it be conservative given the circumstances?

We did not give volume guidance; we provided revenue guidance. We will discuss plans for 2019 in January.

Can you provide guidance on real estate gains and headcount for Q4? Is the goal for a 6,000 headcount reduction still valid?

We are at or near our target for 2,000 total workforce reductions this year. We aim to maintain labor efficiencies even with expected volume increases. Real estate sales this quarter generated $43 million from line sales and $10 million from real estate. Gains will depend on if we see closures.

Jim, could you provide some updates on the new coal team? What structural changes are you assessing for the coal franchise?

We're always looking at our structure to maximize value but have no immediate changes planned. We recently hired Shawn Yates as Vice President for Coal. He brings expertise and innovative ideas to enhance our coal business.

On CapEx, you mentioned pulling forward spending on PTC. What drove that decision and what is the expectation for total CapEx for PTC moving forward?

No change in overall guidance for the full PTC project. We've been stating $2.4 billion for completion. We plan to submit our request for extension in the next couple of months. Our three-year $4.8 billion CapEx target remains intact.

About the CapEx increase this year related to hurricane relief, should we assume that is a small portion of the overall budget of $4.8 billion?

Yes, the impact of Hurricane Florence is expected to be around the $20 million range, and PTC funding has had some advancement as well. We have other high-return projects that we're implementing. The major increases to revenue are tied to improvements, but we won't provide guidance on customer behavior.

I'm wondering if the revenue guidance increase stems from export coal visibility or the broader non-coal business ramping up?

All our business units are growing; the economy is strong, and our customers are optimistic. This gives us more confidence in our 6% to 8% revenue growth outlook.

While export coal is a big contributor, I'm pleased with the strength of our service product. We're gaining market share on the merchandise side, and we've seen solid growth in Intermodal.

Your service levels have improved significantly since this time last year. Can you remind us what level of SCB supervision still exists?

We are no longer under the same level of supervision; we’ve improved significantly, and there’s no reason for any added oversight.

Can you provide color on the lawsuit against your regional peer regarding access to the Port of Virginia?

It’s a corporate governance issue regarding access to the terminals in Virginia. We believe we’re not being provided the appropriate access.

Can you update us on the process for naming a permanent COO? What does the board want to see before making that decision?

We have an excellent team and do not plan to hire someone externally in the near term. We believe in the strong talent we have and will ensure we have a succession plan developed. Thank you for your interest as always, we will provide more updates at the end of the year. Thank you so much.

Thanks, everyone.