Norfolk Southern Corp (NSC) — Q2 2017 Earnings Call Transcript

Thank you, Rob, and good morning. Before we begin, please note that during today's call, we may make certain forward-looking statements, which are subject to risks and uncertainties and may differ materially from actual results. Please refer to our annual and quarterly reports filed with the SEC for a full discussion of those risks and uncertainties we view as most important. The slides of the presenters are available on our website at norfolksouthern.com in the Investors' section, along with our non-GAAP reconciliation. Additionally, a transcript and downloads will be posted after the call. Now, it is my pleasure to introduce Norfolk Southern's Chairman, President, and CEO, Jim Squires.

Good morning, everyone, and welcome to Norfolk Southern's second quarter 2017 earnings call. With me today are Alan Shaw, Chief Marketing Officer; Mike Wheeler, Chief Operating Officer; and Marta Stewart, Chief Financial Officer. Turning now to slide 4, we're pleased to report another quarter of strong financial results, as we've continued to drive both resource utilization and growth. Marking our sixth consecutive quarter of year-over-year operating ratio improvements and an all-time record, we decreased our second quarter operating ratio by 230 basis points to 66.3%. Income from operations of $888 million was up 15% compared to the prior-year period. Earnings per share increased 26% to $1.71. We continue to successfully execute our multidimensional strategy and achieved another record operating ratio of $68.1 million for the first half of the year, a 130 basis point improvement from last year's record. Income from operations was up 11% to $1.7 billion. And earnings per share increased 20% to $3.18, also a first half record. These results demonstrate that our strategic plan built upon our core pillars of safety, service, stewardship, and growth is working as intended, providing a reliable framework that our team has successfully executed upon to propel improved operational efficiencies, which will deliver over $100 million productivity savings this year. The determination and perseverance of our employees to effect sustainable change has been instrumental in our achievements. Importantly, their work has also established a strong foundation for ongoing growth and success...

Thank you, Jim, and good morning, everyone. Our second quarter was marked by strong year-over-year volume improvement in intermodal and coal, generating total revenue of $2.6 billion, up 7% versus 2016. Intermodal reached a record quarterly volume with a year-over-year increase of 57,000 units, benefiting from continued highway conversions and new service offerings. Utility coal increased 27,000 shipments in the second quarter as a result of a previously reported market share gain and higher year-over-year natural gas prices. Export coal grew 25,000 units due to improved seaborne pricing, which made U.S. coals more competitive in the international market. Positive pricing was partially offset by mix, improving our revenue per unit in all seven groups, and 1% in total. Overall, our merchandise volume was flat in the second quarter as gains in frac sand and steel were offset by declines in crude oil. Growth in the metals and construction segment was driven by increases in shipments of frac sand due to increased drilling activity in the Marcellus and Utica Shale regions. Additionally, improvements in steel pricing, change in supply chains, and inventory replenishment led to higher volumes in our steel franchise. These gains were partially offset by the decline in our crude oil volume, which has been negatively impacted by pipeline activity. Automotive volume declined due to decreases in U.S. vehicle production. While paper was impacted by strong truck competition. Merchandised revenue increased 1% versus the second quarter 2016 to $1.6 billion, with a corresponding 2% increase in revenue per unit...

Thank you, Alan, and good morning. In the second quarter, we continued to grow our business and provide a good service product to our customers. We also achieved our strong results while streamlining our operations and idling our largest hump yard to date in Chattanooga. Our all-time record operating ratio for a quarter as well as for the first half of the year is a testament to our strategic plan and the hard work of our employees. As shown on slide 16, there were significant milestones achieved in the quarter as well as the first half of the year that were key drivers of our success. The efforts towards driving locomotive productivity, fuel efficiency, and train length, which we will discuss in more detail later in the presentation, all helped to drive our record operating ratio. As noted on slide 17, we are continuing to take steps to improve service and reduce cost. We idled our largest hump yard yet in Chattanooga in the second quarter, and this is the fourth major hump yard idled. We have also announced the consolidation of our Central Division, which will further reduce the number of operating divisions from 10 to 9. This is a continuation of the steps we took in 2016, wherein we consolidated from 11 to 10 divisions and reduced the number of operating regions by a third. In addition, as we discussed on our last call, we removed another 100 locomotives from service in the second quarter, and we did so while handling more volume. All of these actions drive the pillars of our strategic plan: safety; service; productivity; and growth; and puts us on track to exceed $100 million of annual productivity savings this year...

Thank you, Mike, and good morning, everyone. Let's begin with our summarized second quarter results on slide 24. The continued execution of our strategic plan delivered a 7% increase in revenues, which, when coupled with only a 4% increase in expenses, resulted in more than $100 million of additional operating income, and as Jim noted, an all-time record-low quarterly operating ratio of 66.3%. Turning to the component changes in operating expenses on slide 25. In total, they were higher by $65 million or 4%, as our sustained focus on controlling expenses helped mitigate costs associated with inflation and the 6% volume increase. Slide 26 highlights the drivers of the variance in Compensation and Benefits, which rose by $36 million or 5% year-over-year. As I mentioned on last quarter's call, inflationary increases continue at a quarterly run rate of $30 million to $35 million, which is higher than historically, primarily due to the large increase in premiums on union medical plans. Also previously noted is an increase in incentive compensation associated with the improvement in operating results. Partially offsetting these items were reduced employee levels, which resulted in $16 million of lower expense, as headcount was more than 800 employees lower than the second quarter of 2016 and down almost 400 sequentially. With the efficiency improvements Mike mentioned, we now expect that we can hold overall headcount at this lower level for the remainder of the year...

Thanks. Good morning. So, I just wanted to ask about the long-term target. It seemed like there was sort of a slight shift in the language. Previously, you've talked about a 65% or below by 2020, and now it's sort of 65% by 2020 or sooner. Should we read anything into that as you're stepping up the operational initiatives as well as various customer projects, or, really, is it just semantics?

Good morning, Allison. Let me start by pointing out again that the second quarter of this year represented our sixth consecutive quarter of year-over-year OR improvements and all-time records in both the quarter and for the first half. So, our plan is working as planned, and it's allowing us to deliver a lot of financial improvements through operational gains. So, we are very confident that we can reach our goals. And we're pulling all the levers. We've got the pedal to the metal. And as soon as we can get there, we will.

Wow. Thank you very much. Could you parse out some of those comments you made about episodic events in the second quarter impacting you a little bit on the negative side? And then maybe talk about how your metrics are trending up and what that can mean on a sequential basis, and how we're looking at your numbers from 2Q to 3Q?

Sure. Well, let me set the backdrop, and then I'll hand it off to Mike to talk about some of the specific things we encountered in the second quarter. You did see network velocity slow down a little bit in the second quarter, and you saw dwell tick up some. We've turned a corner on that. Third quarter, to date, the metrics are looking good. We are steadfast in our commitment to deliver quality service and customer value. And network performance, even through the second quarter of this year, remained well above 2015 levels. And as I said, it's been trending higher. So, this is the platform for growth. And we are committed to keeping network performance and service performance at a level that allows us to grow and drives productivity as well. So, with that, Mike, why don't you comment a little bit on some of the things we experienced in the second quarter.

Yeah. Okay, will do. So, we had really three things that were going on. They were going on pretty close together, but we had a lot of flooding pretty much between Louisville and Kansas City, on that line. During the quarter, we also had some flooding just outside of our Cincinnati terminal, which is a high-volume terminal there. During the quarter, we had some fires going on down in North Florida that were shutting our line down at different times during the third quarter. They'd come near the tracks, so we shut the tracks down and opened it back up. So, those three things were going on, dealt with those through the quarter. And we feel very comfortable about how we bounced back. In the last month, our train speed has increased 10% back to prior levels and our dwell's back to what it was prior to some of these issues. So, feel real comfortable about how we've responded and returned service to where we want it to be. It continues to trend higher, and we're going to continue to work on that.

So, Allison, this is Alan – or Jason, excuse me. We have seen improvement since the beginning of the third quarter. We've seen it in our network performance metrics. We've seen it in our customer-facing metrics. And more importantly, as Jim, and Mike, and I get out and talk to our customers, we see it in the feedback from our customers. They sense the improvement. They're seeing the improvement in our service product.

All right. I guess, my follow-up is going to be more on the top line side. We did, as you know, our big Railroad Shipper survey. And your eastern competitor probably got the worst ratings and service. And we just held dinner last night with some railroad people, and clearly, they're having some service challenges over there. Have you seen freight come over from the other eastern railroads due to poorer-than-expected service, where it can come over? And if it's come over, has it come over at regular pricing, or have you been able to actually increase the pricing on that?

Look, Jason, again, let me just set the stage here, and I'm going to let Alan comment specifically on what's going on with the top line in that regard. But first off, our focus is very much on enhancing value at NSC and driving our plan to continue to drive productivity and growth. And growth is an important part of that plan. We'll take the market share, whether it's from truck or competitors, as long as it complements our network and obviously falls to the bottom line. Those are the keys. So, Alan, what are you seeing in terms of the landscape?

Jason, we are always talking to our customers. As Jim noted, our primary form of competition is truck. But we're talking to our customers about service products that offer a sustainable view of their markets and allow them to grow. And we have seen some business move over to us. It's a small amount, I'll tell you that, but it's early. We've got a really good service product. The customers value the continuity of our market approach, of our operating philosophy, and our focus on allowing them to grow with their customers.

Yeah. Good morning, and also wanted to extend the best wishes to you Marta in retirement. Let's see. I guess, the question on rail competition and kind of customer conversations and so forth, you gave us some perspective on that. I think, Alan, you said, it's early. I guess, with the nature of the customer conversations recently, would you say that this is something that's likely to build in terms of the potential for us and business to come over, or would you say, look, business kind of naturally falls to one or the other, and you really shouldn't consider too much in terms of share gain as you look the next couple of quarters? How would you frame that?

Yeah. Again, let me do the framing, and then hand it off to Alan. I want to emphasize that we have been in front of our customers a lot. That is just a part of our regular routine. Mike, Alan, and I are in front of our customers all the time. We are going to them. We are in their offices and their conference rooms, hearing about their business and how we can gain more of it. So, that's a big focus for all three of us. We want the feedback from our customers all the time, and we're getting it. So, Alan, talk a little bit more about the market share opportunity.

So, we're going to capitalize on opportunities that fit our network. And if customers see that we provide a predictable, efficient service product that meets their needs, whether that's in competition with truck or another rail carrier, then we're going to go after that business, Jim, as long as it fits our network and we can drive value to our shareholders.

Yeah. Thanks so much for taking my questions. First one is on the automotive business. You mentioned the headwind from auto production in the second half, but General Motors production, specifically, I think is expected to be down as much as 20% in the third quarter. That's not necessarily organic. I guess, it's due to the change over their light truck platform. I think you guys have some disproportionate exposure there on the Fort Wayne line, if you could just talk about the impact there. I think it'll probably be one-time given the changeover effect, but any color on maybe what that could have in terms of revenue growth, and then also fixed cost absorption in the automotive franchise. That would be helpful. Thank you.

Automotive production in the U.S. declined 6.5% in the second quarter. It's supposed to be down 9.3% in the third quarter. That's the largest year-over-year decline that is currently being projected. And so, consequently, we see a decline within our automotive volumes, particularly in the third quarter. We're not going to discuss specific customer relationships. I think I've given you some good color as to what we see within our automotive market for the back half of the year.

Okay. That's fair. And then one follow-up with me, just piggybacking on the last question with respect to OR expansion in the back half. I mean, the contribution margins – the incremental margins in the first half have just been unbelievably strong. Those productivity initiatives have definitely dropped to the bottom line, and then the business obviously, really capital-intensive. But just a question on your ability to maintain the incremental margins that you did in the first half in the second half. Obviously, mixes, volumes are not going to be as strong as they were in the first half. But then the productivity and the headcount will stay flat sequentially. So, just the puts and takes there in terms of your ability to maintain incremental margins maybe in the neighborhood of where they were in the first half, that'd be helpful. Thank you.

The key is the plan's dynamism and flexibility. And that's what we have done for the last year and a half. We have responded to changing business conditions as necessary to continue driving results. And so, when necessary, we'll lean into productivity. For the long term, it's all about a multidimensional approach, a combination of growth and productivity at any given time. Maybe it's a little bit more growth; maybe it's a little bit more productivity. So, we'll be flexible.

Thanks. Good morning, everyone. Can you just comment on pricing in the second quarter and kind of the gap to inflation, kind of how you see that evolving through the year, because it does look like inflation was higher in the second quarter and is probably going to accelerate into the second half of the year?

Yeah. Our rate of year-over-year pricing growth in the second quarter was consistent with what we saw in the first quarter. And the rate of year-over-year pricing growth was consistent with what we saw in 2016. So, we're committed to focusing on price and recognizing the value of the service product that we provide, and we're committed to pricing long-term above inflation.

Great. Good morning. And, also, congrats to Marta on her retirement. Great working with you over the years. Michael or Jim, can you talk about the experience on the hump yard in Chattanooga? You shut it down. Did you convert that to a flat yard? Did you shift the business elsewhere? Just want to understand, is that replicable as you think about your network, or was this just from maybe shrinking business in that region, and you didn't need it, and you moved it elsewhere? Can you maybe walk through a little bit about that?

Sure will. So, we idled the hump, but we are using that yard, and it's in a great location for us, because it has a lot of feeder lines from our network going into it to do block swapping. So, while we idled the hump, we now do a lot more block swapping, we do more blocking further into the network. So, it is giving us good productivity, because the cars are getting through there faster and providing even better service, because of less time on the network getting to the customers. So, that's the piece to it, where it's a big yard in a great location to be able to do a large amount of block swapping.

And, again, Michael, maybe your thoughts on, is that something that's replicable to other yards? I mean, you talked about the number of hump yards in the past. Is that something you plan on continuing the conversions to other yards?

We continue to look at it. It has to make sense. It has to end up getting traffic through the network faster and taking cost out, or a balance between the two. And we're only going to do it if it hits those criteria.

Well, Ken, the cost per employee was up in the second quarter as you noticed, and it was up for two reasons. One of them is the one we've been talking about all year, and that's the 5% inflation, which is higher than normal inflation. And the other factor why in the second quarter the cost per employee was up was due to the incentive comp. And you should expect to see the increase in incentive comp continue in the third and fourth quarters.

Hey, thanks. Good morning, guys. So, just wanted to follow up there just on this kind of auto, steel discussion. Obviously, we can see that auto is 9% of your total revenue this quarter. But when you think about the derivatives that go into the auto sector, what percentage of your total business do you think is tied to autos? And as we think about autos and steel, and maybe some of the other derivatives falling in the back half, should we think about those as having higher or lower than normal incremental margins?

Scott, there are some inputs into it. Certainly, carbon black or plastics or steel are the primary ones. Auto doesn't make up a material portion of our volumes in those groups, but if there's a pull-back in auto, that'll have a little bit of pressure in those markets.

Thanks very much. Good morning, everyone. Just wanted to go back to coal for a moment. And I know it's difficult to forecast out, but you've given us good color into the back half of the year. As you're situating and talking to your customers about 2018 and kind of assuming no significant changes in weather patterns, how are stockpile levels among your customers that would give you indication as to just directionally on both export and domestic utility? Do you expect it'd be higher, lower, or about the same compared to the 2017 levels?

Walter, good question. So, right now, stockpile levels at utilities that we serve, and this is a publicly available number, are about 15 days below where they were last year. However, we recognize they're still 21 days above target. So, we've made a lot of improvement over the last 12 months in the stockpile levels. June was very mild, and that significantly impacted coal burn to the negative. Last year, in June, stockpiles dropped by about six days. This year, they only dropped by about one day. So, as I think about the outlook going forward, July has been hot. Natural gas prices, while down versus June, are still up above where they were this time last year. And so, it's going to be heavily dependent upon how the rest of the summer weighs out in terms of load demand and natural gas prices.

Hey, good morning. Alan, maybe, when you talk about the tightening of the truck market, as you think about how that's going to impact core price, and maybe even volume a little bit, when should we start to expect that to come in if we see this sort of sustained tightening of the truck market that some of the truckers are talking about right now? When should it show up in the Norfolk P&L or core pricing metrics?

David, I believe that'll start to show up in 2018. It'll have to be reflected through trucking bid season later in the year, and then so we'll start to see it in our contract negotiations later in the year and into next year. Potentially, we could start to see it in volume later in the year, but you'll see it in pricing in 2018.

I want to thank Marta for her many contributions and devoted service over the years, as she will retire from Norfolk Southern on August 1. She's been an outstanding leader in our organization, a terrific member of the management team and instrumental to Norfolk Southern's success. On a personal note, she's also been a trusted partner and a great friend, so it is a bittersweet goodbye for me. Our search for Marta's successor is ongoing. We are working with a nationally recognized executive search firm and are considering both external and internal candidates. While the search continues, the board has elected Tom Hurlbut, currently VP and Controller, to the position of Interim CFO, effective August 1. And with that, we'll now open the line for Q&A.