Greetings, and welcome to the Norfolk Southern Corporation Q4 2019 earnings conference call. At this time, all participants are in listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. At this time, it is my pleasure to introduce Peter Sharbel, Director of Investor Relations. Mr. Sharbel, you may now begin.
Thank you, Rob, and good morning, everyone. 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. Our presentation slides are available at norfolksouthern.com in the Investors section, along with our non-GAAP reconciliation. Additionally, a transcript and downloads will be posted after the call. It is now my pleasure to introduce Norfolk Southern's Chairman, President, and CEO, Jim Squires.
Good morning, everyone, and welcome to Norfolk Southern's Q4 2019 earnings call. Joining me today are Alan Shaw, Chief Marketing Officer, Mike Wheeler, Chief Operating Officer, and Mark George, Chief Financial Officer. 2019 was a remarkable year of transformation at Norfolk Southern. We launched our TOP21 operating plan to transform our railroad while fulfilling our commitment to dramatically improve our service product as we become more efficient. We've made tremendous strides on both of those fronts and delivered progress on our strategic plan. In the face of a challenging volume environment, we're pleased to share results today that demonstrate this organization's strong momentum in streamlining our operations and making substantial progress toward our long-term commitments, thanks to the hard work and significant efforts by our workforce and leaders. Slide four highlights those results. For the quarter, EPS was $2.55, and the operating ratio was 64.2%.
For the full year, income from operations reached record levels at nearly $4 billion, resulting in a record operating ratio of 64.7%, a 70-basis-point improvement over 2018. Earnings per share increased eight percent to $10.25. We've now achieved record operating ratio results for four consecutive years. This year's improvement is particularly impressive against the backdrop of contracting volumes. These records demonstrate our commitment to continuous improvement and underscore our steadfast dedication to creating shareholder value. Despite volumes deteriorating throughout the year, culminating in Q4 and full-year volume declines of nine percent and five percent respectively, we remained focused on running our railroad as efficiently as possible and with a high level of customer service, achieving our locomotive and T&E workforce productivity goals despite having less freight to haul.
These efforts contributed to the record full-year results I mentioned a moment ago, and the core margin improvement accomplished during the Q4 , which Mark will discuss shortly, demonstrates the significant momentum we're carrying into 2020 and beyond. As we enter 2020, we continue to build on the strategic plan initiatives we launched in 2019 while rolling out phase III of our PSR-based operating plan, TOP21, which will drive additional productivity across our resource base, all while maintaining the high-quality service product established in 2019. The team will provide additional details regarding these initiatives as well as further details on our Q4 and full-year results. Alan will cover trends in revenue, Mike will cover operational performance, and Mark will go over the financial results. I'll now turn the call over to Alan.
Thank you, Jim, and good morning, everyone. Macroeconomic headwinds challenged volume in 2019, particularly in the second half of the year. With these tough conditions, we continued our focus on margin improvement, supported by the value that our outstanding service product creates in the market. On slide six, excess truck capacity, trade and economic uncertainty, and manufacturing weakness negatively affected our markets, driving a nine percent decline in volume. We partially mitigated the impact of declining volumes with stronger revenue per unit, excluding fuel, in all three of our business units, including quarterly records in our merchandise and intermodal business groups. Norfolk Southern's revenue per unit has increased year-over-year for the last 12 quarters , despite the market cycles over that period of time. The weak manufacturing environment and low commodity prices drove down merchandise volumes in all groups except chemicals, led by a 17% decline in steel.
Import steel tariffs affected the traffic flows and lower steel prices reflected weak demand. Merchandise volume declines were partially offset by an increase in crude oil, which more than doubled its volume year-over-year. Intermodal revenue declined eight percent due to excess truck capacity in a weak freight environment. International comparisons were difficult as the inventory pull forward drove a spike in Q4 2018 volume. Coal volume and revenue were down 21% year-over-year, with the largest volume decline in utility coal. Our northern utility portfolio was impacted by low gas prices and combined cycle capacity. Export was influenced by falling seaborne met prices and Chinese tariffs, while export thermal prices remained at low levels, making it difficult for U.S. coals to compete globally. Turning to slide seven. In 2019, revenues decreased one percent despite a five percent decline in total volume.
Evident from our margin improvement strategy, revenue declines were partially offset by a three percent increase in revenue per unit. Merchandise revenue reached a record $6.8 billion in 2019, while volume declined three percent. Volume headwinds occurred from weakness in the manufacturing economy, the loose truck market, and declines in steel and natural gas liquids. We were favored by fuel price differentials that boosted crude oil demand to East Coast refineries, and we secured increased aggregate volume. Intermodal revenue decreased two percent on a four percent volume decline, as gains in international were offset by domestic declines.
Lower spot truck prices and excess capacity in the trucking industry reduced domestic intermodal demand in this weak freight environment. Turning to coal, revenue declined eight percent . Utility volume declines were predominantly in the north, where low natural gas prices suppressed coal burn, while southern utilities benefited from inventory build in the first half of the year.
Depressed seaborne coking coal and thermal prices led to lower export volumes and prices that were further impacted by production issues. While uncertain economic conditions negatively impacted revenue and volume in 2019, we maintained our focus on improving our service and creating a product that will enable our customers and Norfolk Southern to grow when the freight environment improves. This approach supports our strategy of margin improvement, which is reflected in our increasing revenue per unit, providing opportunities for operating leverage when demand improves. Moving to our outlook on slide eight. We are closely monitoring developments in the macroeconomy and its impact on the industries and business segments in which we compete, as well as our customers' expectations as we execute our strategy.
GDP growth is expected to be in the two percent range in 2020, with the majority of that growth from personal consumption, creating opportunities in our consumer-driven intermodal and merchandise markets. Continued weakness in manufacturing low commodity prices will impact our coal franchise and other segments of our merchandise markets. Overall, we have not seen an inflection point in volume trends and a high degree of uncertainty exists. We see growth potential as we move into the second half of 2020 due to forecasted improvement in the trucking and industrial sectors and easier comparisons. U.S. light vehicle production is forecast to improve more than five percent in 2020. Improved price differentials are predicted to sustain Q4 2019 crude volume levels through 2020. Overall, we expect total merchandise revenue improvement enabled by our strategy with continued support from our consistent, reliable, and quality service product.
The truck market remains loose with spot rates leveling off, yet our customers and data providers forecast some tightening later in the year. Based on this information and new business initiatives, our intermodal revenue and volume are expected to grow in 2020. In coal, additional gas and renewable generation capacity continues to erode coal share of electricity generation. Coking and seaborne thermal coal indices are substantially below prior levels, impacting both export volume and pricing. In summary, as headwinds persist in the freight environment, we expect 2020 revenue to be flat with the Q1 similar to the Q4 of last year and conditions improving as the year progresses. We remain focused on a disciplined pursuit of efficiency while recognizing the value our consistent, fast, and reliable service product creates for our customers.
In light of continued economic uncertainty and with our demonstrated willingness and ability to adjust to market conditions, this approach provides the platform from which we will further enhance value for both our customers and shareholders. I will now turn it over to Mike for an update on operations.
Thank you, Alan. Today, I will update you on the state of our operations. In the Q4 , we continued to deliver strong service for our customers and significant cost savings, which drove a record operating ratio for the year. This operational leverage is driven by a relentless execution of the core PSR principles and our TOP21 operating plan. Moving to slide 10. Our network is running fast and on time. Record train performance and record terminal dwell drove near record car level velocity and strong asset utilization for Norfolk Southern and our customers. These achievements support our strategy to meet our customers' expectations while eliminating costs and prudently managing our assets. Our momentum has continued into 2020 and will be a tailwind to our initiatives this year. As seen on slide 11, our operational performance is driving strong service levels as evidenced by our customer-facing metrics.
Intermodal availability, which measures our customer commitment to grounding of the box, shipment consistency, which measures trip plan adherence for merchandise traffic, and local operating plan adherence, which measures execution of the critical first mile and last mile of service. All of these metrics were at or near record levels. We have been sharing our metrics with our customers for well over a decade, and we use them to have data-driven discussions to confirm the value of our service product. We remain committed to providing a high level of service for our customers while achieving our productivity goals. Turning to our service and productivity metrics on slide 12. These metrics align with our strategic plan as they measure key productivity and customer service levels. We have been aggressively reducing our resources to meet our productivity goals, despite the drop in our GTMs.
Starting with the Service Delivery Index, which is the on-time delivery performance of our scheduled shipments indexed to 2018. This is a customer-facing metric that combines shipment consistency and intermodal availability, which were detailed on the previous slide. We exceeded our 2019 goal and actually achieved our 2021 goal two years earlier. We will maintain this high level of service by continuing to execute our TOP21 plan. We exceeded our 2019 T&E productivity goal despite a significant drop in GTMs. We are at our lowest T&E headcount on record while still providing exceptional service. We are realizing the benefit of our TOP21 plan, which has the added benefit of capacity in the train plan to allow for growth on the existing trains.
While we missed our 2019 train weight goal for the full year, we actually met the goal in the second half of the year with the implementation of our TOP21 plan. We have, however, taken another look at our 2021 train weight goal in light of the continued change in the coal market. We believe the new goal of 6,700 tons, which is five percent higher than our baseline, reflects the improved productivity of our TOP21 operating plan while taking into account the projected mix. We also met our goal for locomotive productivity for the year by aggressively rationalizing our locomotive fleet, which is 20% lower than 2018. As mentioned in our previous call, this has allowed us to significantly rationalize the resources associated with the maintenance of these locomotives, including a reduction of 600 positions last year and an additional 135 positions this year.
Regarding fuel, we will benefit from our lower locomotive fleet size, our aggressive implementation of energy management technology, and our DC-to-AC conversions. The cars online continues to be a positive story for Norfolk Southern. As we noted throughout the year, we exceeded our original 2021 goal thanks to our fast and consistent service product. To that end, we have established a new goal of 129,000 cars going forward, which includes cars in storage that can be deployed as market conditions warrant. In summary, we are confident we will meet our productivity goals for this year, as we will now have the momentum of full-year benefits of our previous right-sizing of our workforce and locomotive fleet. This will get us more than halfway to our 2021 productivity goals this year.
As you can see on slide 13, we accelerated our progress in reducing crew starts during the Q4 . We continued to build on the success of TOP21 with phase two of the plan, which included initial consolidation of some bulk movements into the manifest network and dividends from our year-long clean sheeting program. This improved fluidity is allowing for the continued reduction in yard and local assignments. This quarterly year-over-year improvement accelerated in the Q4 , with the majority of these improvements being long-term structural gains. As previously mentioned on the other slide, we have capacity in the new plan to accept additional volumes without a commensurate rise in crew starts.
We anticipate continued strong year-over-year comparisons as we begin to roll out phase III of TOP21, completing delivery of the promised three phases of the program in a year and a half instead of the anticipated three years. Going forward, our network planning and operations groups will be evaluating the plan and the network for further optimizations. In closing, this has been a critical year for Norfolk Southern. We started the year by detailing our implementation of the core PSR principles. We have successfully executed on these principles despite a challenging market. Our service is at record levels. We achieved a record operating ratio, and our serious injury ratio was the lowest in the last five years. We are carrying this momentum into 2020. I will now turn it over to Mark, who will cover the financials.
Thank you, Mike, and good morning, everyone. Before we get into the detailed P&L, I want to point to a chart in the appendix that specifies for you some large and unusual items that impact the results and comparisons versus 2018. I'd like to talk to those impacts up front on slide 15 for the sake of clarity. This chart illustrates the effect of those items on the OR and EPS for the quarter as well as for the year. The reported changes to OR and EPS are reflected on the bottom row, and we distill those drivers in the white rows above. The first item, as you may recall, relates to a property sale in the Atlanta area in the Q4 of 2018.
That particular gain was $112 million and creates an OR headwind of 380 basis points in the Q4 of 2019 and 100 basis points for the full year, with a headwind to EPS of about $0.30. Next was the $32 million receivable write-off arising from a legal dispute that we called out in the Q3 . This reduced the 2019 OR by 30 basis points and EPS by $0.09. The final headwind involves the non-operating impairment that we booked in the Q2 related to the natural resource assets we have been actively marketing. In the Q3 , we took an additional $21 million impairment related to those same assets, and that had a $0.06 impact to EPS in the quarter. When added to the Q2 impairment loss, the EPS impact for the full year was $0.14.
You'll note we had a low effective tax rate in the quarter. This was driven by certain income tax credits authorized by Congress in December of 2019, which were retroactive to 2018. The impact to the Q4 EPS was $0.07, and for the full year, it was $0.04. Beyond these unusual items, the core improvement in the OR was 240 basis points for the quarter and 200 basis points for the full year, while core improvement to EPS was $0.28 for the quarter and $1.23 for the year. Now moving to the Q4 slide 16, revenue was down seven percent in the quarter, driven by a nine percent volume contraction, partially offset by RPU improvement. Operating expenses, as reported, were five percent lower, including five points of headwind from the absence of the prior year land sale. Drilling into the expense categories on slide 17.
As Mike illustrated earlier, our TOP21 PSR-based operating plan has reduced the amount of resources we need to run the network, resulting in fewer trains and lower crew starts, manifesting in substantial cost savings across multiple expense categories. Starting with compensation and benefits, we drove a $127 million reduction in expenses in the Q4 . That's a decline of 17% on a 16% reduction in employees. Our employment levels declined throughout the quarter, this, along with lower overtime, health and welfare benefits, as well as less recrews, saved us $86 million. This favorability was partially offset by $17 million of additional expense due to inflation in pay rates. In the quarter, incentive compensation expense was lower by $57 million, due largely to last year's higher payout that disproportionately impacted the Q4 of 2018.
We drove average headcount down by approximately 1,500 employees from last quarter and have reduced by 4,200 compared to last year. Run rate benefits from this will continue into 2020 on top of additional efficiency actions. Moving to fuel. Reduced consumption and lower prices drove a $52 million decline in fuel expense. We improved on our fuel efficiency as fuel consumption declined by 11% on the nine percent decrease in volumes, despite adverse mix from weaker coal, where our fuel efficiency is strongest. Here in 2020, fuel efficiency is getting intense attention through various initiatives, including continued locomotive upgrades and deeper energy management penetration, as Mike mentioned. Moving over to purchased services, rents, and materials. Our initiatives to improve asset utilization are also driving a reduction in expenses.
The increased network velocity, improved fluidity, and fewer locomotives and freight cars on the network drove $15 million in savings associated with equipment rents and $12 million in savings of material cost. These savings were partially offset by increased detouring costs due to a bridge washout and derailment expenses that amounted to $13 million collectively. The fast response and strong execution by our operations team limited the financial impact of the derailment to only half of the $25 million we signaled at the last earnings call. When looking at the big picture, the underlying change to our cost structure accelerated in the Q4 as we continued to drive resource reductions through the end of the year. The full-year effect of those savings will be realized in 2020. Moving to slide 18, let's take a look at our summarized Q4 financial results.
Other income included $31 million of favorability from investment returns on our corporate-owned life insurance, where we had positive returns in Q4 2019 versus losses in Q4 of 2018. We also had $50 million of higher gains on the sale of non-operating properties than prior year. These amounts were partially offset by the additional $21 million asset impairment loss that I mentioned earlier. The lower effective tax rate of 19.6% was driven by both the retroactive tax credits as well as higher non-taxable returns on the corporate-owned life insurance. Income taxes will represent some headwind in 2020 as we expect the tax rate to be between 23% and 24%. Shifting to the full year on slide 19, we delivered impressive results for the year in the face of accelerating declines in revenue and the net headwind items we discussed on slide 15. We reduced railway operating expenses by $192 million.
We set company records for operating income and operating ratio. Our railway operating ratio improved 70 basis points over 2018. Net income improved by two percent, diluted earnings per share grew eight percent to $10.25 for the full year, aided by a five percent reduction in our average share count. Achieving the cost reductions while pushing delivery performance for our customers to record levels demonstrates our commitment to long-term value creation. Recapping on slide 20, our full-year cash flows from operating activities was $3.9 billion, and free cash flow for the year was a record at nearly $1.9 billion. Dividends and share repurchases for the year totaled over $3 billion. To close, we clearly have created momentum on the cost side, despite the volume challenges and obstacles that were unforeseen at the beginning of the year.
It's that momentum, plus new initiatives, which provides us with strong leverage going into 2020 to continue to drive profit growth and margin expansion. Thank you. I'll turn the call back over to Jim.
Thank you, Mark. As you've heard on the call today, the Norfolk Southern team made tremendous strides in executing the strategic plan we laid out a year ago. Amid a rapidly changing macroeconomic landscape, we pivoted our productivity initiatives and achieved a locomotive fleet reduction of 20% and a workforce reduction of eight percent for the full-year average, with those figures accelerating to 22% and 16%, respectively, in the Q4 . These resource adjustments significantly outpaced the volume declines, demonstrating strong cost momentum while maintaining exceptionally strong customer service levels. Turning to slide 22, I'll wrap up with our 2020 expectations. First and foremost, we will continue to execute our strategic plan with the top priority of running the most efficient railroad possible while being a best-in-class supply chain partner for our customers.
As you heard, we are modeling net overall revenue to be flat for the year, with persistent headwinds in coal to be offset by improving comparisons in merchandise and intermodal as the year progresses. Within that environment, we have confidence that our productivity and efficiency formula will result in significant operating ratio improvement this year that will get us more than halfway to our committed 60% OR in 2021. Lastly, as we continue to execute our highly effective locomotive fleet modernization program, we're targeting a capital expenditures program between 16% and 18% of revenues. We remain committed to returning capital to shareholders through a one-third dividend payout ratio, with remaining cash and borrowing capacity used for share repurchases. This disciplined capital allocation strategy represents our commitment to enhanced shareholder value through returning capital and ensuring Norfolk Southern is positioned for continued success.
Before we turn it over to questions, I want to thank each and every NS employee for their hard work and commitment to the strategic transformation of our railroad. Thank you for your attention. We'll now open the line for Q&A. Operator?
Thank you. We'll now be conducting a question-and-answer session. If you'd like to ask a question, please press *one on your telephone keypad, and a confirmation tone will indicate your line is in the question queue. You may press *two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Due to the number of analysts joining us on the call today, we ask everyone to please ask one primary question and one follow-up question to accommodate as many participants as possible. Thank you. Our first question comes from the line of Bascome Majors with Susquehanna.
Yes. Thanks for taking my question here.
Mark, you've been in the CFO seat for about three months now and have had some time to get the lay of the land. Can you just take a step back and give us, versus your expectations coming in, what's as expected, maybe what has surprised you? Are there any changes that we should expect to see as investors with you leading the finance organization versus how NS has handled things historically? Thanks.
Thanks for the question. Yeah. Coming in from the outside, a different industry, a culture that clearly is different than the one I've come from, I would say that I'm surprised that we see a great blend here of long-tenured industry experts who are very passionate about not just the business, but the industry itself, and the infusion of new talent that come from different walks of life and different industry experiences, and that they're actually being welcomed with their new ideas, including my own, frankly, coming from the outside. That's been kind of a pleasant surprise, I would say. I was not expecting such a welcoming with regard to the new ideas and new concepts being brought in. I'm also kind of impressed by the speed and agility of an old company, so to speak, to react to a very rapidly changing economic environment.
You see the charts that Mike showed on how quickly we've taken resources out to respond to volume declines. That nimbleness, I would say, has surprised me. Coming in, another big observation is just how capital intensive this business is compared to where I've come from. We obviously spend a couple billion dollars a year in CapEx. We've got over $30 billion of fixed assets. It's certainly an area that I need to drill into a little bit more on understanding why we spend so much. Certainly, half of that is related to maintaining this big infrastructure to serve your customers and to do it safely. I do want to understand the rationale for the spends that we have, the justification financially for them, and the prioritization process. It's something that I expect to dig into a little bit.
Maybe you've seen a little bit on this call, too. We just want to be transparent with the investment community about the path that we're on, which is to get to a 60% OR by 2021.
Thank you so much for the answer.
Thank you.
Our next question is from the line of Scott Group with Wolfe Research. Please proceed with your question.
Hey, thanks. Morning, guys. Mark, I'm hoping you can help us with a little bit more clarity on some of the numbers here. Can you give us what the real estate gains above the line were in the Q4 and any expectations for this year in terms of what's assumed in the guidance? Similarly, with incentive comp, I know it was down in 2019 versus 2018. Any way to think about, is 2020 a year of a headwind, tailwind, or normal? Any help there?
Sorry, the second question, Scott?
Was just on incentive comp. Should we think about that as a headwind in 2020, or is it 2020 versus 2019 sort of just a normal year on incentive comp?
No, we would hope that incentive comp is a headwind because we're hoping to have a better year in 2020 than we did obviously this year, where we fell a little bit short. Clearly, that'll be a little bit of headwind for us. With regard to the real estate, excluding the big one that we carved out for you, gains in the year were a little bit higher than they were last year, less than $20 million. In the Q4 , roughly half of that benefit we saw in the Q4 of this year. We had about $10 million of additional gains in 2019 versus the Q4 of 2018, excluding the big one that we carved out. The guidance, Scott, on real estate, in any given year, we're expecting $40 million-$60 million of gains. It's going to be lumpy, be back-loaded.
It could happen middle of the year. You know with real estate, you never are quite sure when you can get things to close and get over the finish line. We ended last year excluding the big gain in that range. The same thing this year, we ended within that range.
Okay, that's helpful. On the revenue guidance of flat, maybe if you have a thought on, are volumes down and yields up, and then it does feel like you guys are losing some share on the volume side, but clearly doing well on the yield side. Are you okay with that yield-up strategy and the trade-off of better yields but weaker volumes than maybe your peer, or do you feel like you've pushed it too far? Just some thoughts, how you're approaching the market.
Scott, it's Jim. Let me take the second part of that, the market share question, and then I'll turn it over to Alan to give you some more color on the components of our revenue guidance for this year. We are targeting the truck market. That's the market share opportunity. That's the big opportunity for us, and that is the linchpin of our growth strategy, is getting trucks off the road onto the railroad. There are opportunities there when it comes to our growth engine, intermodal, and there are also opportunities in the merchandise realm. We are also certainly committed to achieving value for the services we provide, which value is quite strong these days. We've got a great service product out in the marketplace and we're very proud of that and think that we can create value for our customers through that service.
Alan, a little bit more color on the 2020 revenue outlook.
Yeah, Scott, coal's going to be a drag throughout the year, and it's going to be a drag both in volume and in price. We've got a great service product out there. We're taking a long-term view of our markets. We take a long-term view of our approach with our customers as well. We're very disciplined in securing the value and understanding the value that our service product creates for our customers. As Jim noted, our eyes are on that $800 billion truck market. That's where the growth opportunities are, and that's where we're going to see improvement as the year progresses. It requires fierce competition and putting new products out there, new logistics services that our customers value.
We're doing it from a platform in which I'll remind you, we went out in front of our customers, and we told them what we were going to do with our operating changes with PSR. We did it. We've created a lot of credibility with our customers for our no surprises approach to our operating plan changes. We implemented it flawlessly. What's unique about Norfolk Southern is that as we implemented PSR, our service got better. We're in a great position to grow as we move forward. If you think about truck and the opportunities there, it aligns perfectly with the unique strengths of our franchise. We have a powerful intermodal franchise, and we have a very broad and diverse merchandise franchise as well. We're focused on opportunities to take business from truck and merchandise as well.
Okay. Thank you for the time, guys.
Our next question comes from the line of Allison Poliniak with Wells Fargo Securities. Please proceed with your questions.
Hi, it's Allison. Just a question. I want to circle back to the cars online commentary. If I heard you correctly, I think you said that that number included a level of storage so that there is some flex, once volume are expected to improve. Can you just go through that again? Sorry.
Yes, that's right, Allison. That's how we calculate that number. We do it that way because we want to focus on the velocity of our entire car fleet, including those that are in storage. That's an asset that remains on the books, and we want to make sure that it too is being taken into account as we think about utilization of the freight car asset.
Yeah, this is Mike. Of that 129,000, we have 17,000 cars in storage that is available to us to flex up when the business arrives, and we're pretty excited about that.
Great. Just obviously, you're well into your strategic plan. Looking back over that in the past few months, what's been your greatest surprise in terms of your ability to perform in this environment?
I think Mark did a good job describing the progress that we have made, the core operating and core earnings improvement that we made in the Q4 . The momentum stands out for all of us, I think, and that's not a surprise in that we've been driving it. We've been focused on accelerating the improvements as we've moved throughout the year. We did it in Q4 , and that will carry over into 2020 and beyond.
Great. Thank you.
Our next question comes from the line of Ken Hoexter with Merrill Lynch. Please proceed with your question.
Hey, great. Good morning. Jim, maybe just expanding on that target of the 235 basis points year-over-year or maybe for Mark. Does that include the headwind of the incentive comp returning the $40 million-$60 million real estate gains? Maybe just your thoughts on what's going to happen with the employee base moving forward. Is this kind of the run rate level? Do you still see more productivity on the employee side? Thanks.
Mark?
Yeah, Ken. Look, I think in terms of headcount, we've taken a lot out this year. There's actually more to come. Not only will we enjoy the benefit of the full year effect of those employees that came out in the back half of this year, but there are more to come in the beginning part of this year. Frankly, we just have to see how volume shakes out and determine how much further we can go and absorb the volume that we're assuming to get returned in the back half of the year. Sorry, the first half of your question, Ken?
Was just to ensure that the 235 basis points improvement, which is great, but does it include the headwind of incentive comp?
It does.
The real estate gains that you mentioned, it's all baked in, right?
It's all baked in, Ken.
Okay.
The incentive comp returning to normal and the real estate gains being in that $40-$60 range, it's all part of the calculus.
It's a big number. Thank you. I guess my follow-up for Mike. It looked like you had no targeted improvement in the Service Delivery Index. Are you changing it to tighten your range, or why would there not be, given all the moves you're making in it, I guess a target for improvement there?
Overall, we're pretty happy with our customer service levels, and our customers are as well. I will say we are targeting tightening some of our windows for delivery to customer and be better on the consistency part. That's a part of it, but it doesn't roll up necessarily into changes at the macro level. Yeah, we're pleased with our service, but we're going to continue to dial it in.
Get better and better and compete with trucks.
Hey, Ken, if I could add something. We collaborate with our customers on our service targets. Mike noted that for years, we've been putting service targets out there for our customers and sharing with them our performance. In 2019, we upped the ante. We went out in front of our customers and said, "Here's what's going to change with PSR implementation, and here's how your service is going to improve." We delivered it. As you're going to see, our PSR implementation continues to evolve. We continue to make improvements, and we're putting a product out there that helps us compete with truck. As the truck market tightens, as we move throughout the year, it's going to be a growth driver for us. We're very confident in the quality of the product that we're delivering, and we're pricing to that effect.
Great. Thanks, Alan, Jim, Mike and Mark. Appreciate it.
Thank you.
Our next question is from the line of Tom Wadewitz with UBS. Please proceed with your questions.
Yeah, good morning. Thank you for the detail on the 2020 outlook. It's very helpful in terms of just how to think about things and also the framework on OR progression is very helpful. Thank you for that. Wanted to see if you could offer some thoughts on two of the segments where you have not seen improvement yet. I'm thinking of purchase services expense. Would you expect that line to improve in 2020 or 2021 as a result of phase III in TOP21 or the terminal improvement program? How do we think about that line? Also maybe a little more on fuel efficiency.
Mark?
Yeah, I'll take that, Tom. Look, purchase services, clearly, there is intermodal terminal operating costs that are in there. I wouldn't call them strictly volume variable. There's an element of fixed cost in there as well, or committed costs in there. Bear in mind that in our purchase services category, we've also got other things that are not volume variable. For example, a lot of the maintenance costs for the network that you don't capitalize flow through this line. When you have repairs to rails and you have to maintain the trees and ensure that the lines are clear, a lot of the costs for maintenance of the infrastructure cannot be capitalized. It goes into this category. Building leases and rental costs are in there.
The other piece that you have to bear in mind, Tom, is there's a fair amount of technology cost that flows through there, similar to what I described with maintenance. There is a lot of the IT spend that can't be capitalized, runs through this line category, and frankly, it's a growing category. The good news, however, is a lot of those investments we're making in technology are delivering returns in other lines in the P&L, as you saw through the call today. We're investing in things like automation. It allows us to leave ourselves of some headcount related to more transactional tasks. We expect to continue to invest in this technology element as well. That's in large part why purchase services is not moving as quick as we like.
All of that said, I've got to dig in there a little bit. We've talked about it quite a bit. We've got to look at this bucket for opportunities in 2020. It is an area where I think it's right for us to dig into a little bit more. Your second question on fuel. We made progress in Q4 with some levels of efficiency. We're really relying on a step change improvement going into 2020 in fuel. The team is organized well. We continue the upgrades from DC-to-AC. That provides a lot of benefits to us in many ways, including fuel. On top of that, we're having deeper energy management penetration. It's clearly an area in 2020 that we hope to see significant progress on.
Just if I can get a brief follow-up. Jim, I think there was maybe a little increase in discussion in December on volume sensitivity of the 60 OR target for 2021. Your guidance for 2020 seems to indicate there's not a lot of concern about volume, but how should we broadly think about volume sensitivity of getting to 60? Do you need to improve volume growth in 2021, or how do we broadly think about that? Thank you.
Well, let me say first, this is a cost structure, cost reduction-based plan, particularly in 2020, where we forecast flat revenue. It's all about achieving the efficiencies that we've tried to lay out for you, that we have achieved already in 2019, and then rolling into this year and next. As far as 2021 is concerned, maybe get a little bit of a tailwind from some growth at that point. We're not factoring in a lot. It remains fundamentally an efficiency-oriented financial plan, even as we move into 2021.
Great. Thank you for the time.
Thank you. Our next question is from the line of Christian Wetherbee with Citi. Please proceed with your questions.
Hey, thanks. Good morning. Wanted to dig in a little bit on the coal outlook, if we could, specifically maybe exports. Alan, can you help us understand a little bit better how we should be thinking about, I think there's two impacts here, probably one on the volume side and then on the yield side. Maybe sequentially on the yield, should we expect a step down in 1Q as some of these contracts get reset based on commodity prices? How should we think about the volume? Just trying to put some numbers around the coal headwinds we're looking at in 2020.
All right, Chris, let's refresh where we were as we move through 2019. In Q1 and Q2 2019, met coal prices were above $205 a metric ton. They started cascading down. They were around $160 in the Q3 and closer to $140, $145 in the fourth. As we've talked about frequently, we saw sequential declines in both volume and in price in our met coal franchise, which is export franchise, which is about two-thirds of our export coal, which makes up about 25% of our overall coal volume. Right now, where coal prices are now, it's in the low $150s. You're going to see a lot of pressure on price. Just recall, Chris, that our RPU in export coal met was at its highest point in the Q1 of last year, as prices were at the highest point.
Comps are most difficult in the beginning of the year. There's not a lot of demand in Europe, and as a result, you're seeing coals sourced from other locations globally are being put out onto the water, and so there's increased competition for us there. Of course, you know what's going on with thermal. That is going to have a market impact on export thermal volumes. You're going to see volume pressure in both met and thermal exports, and you're going to see particular price pressure on met exports.
Okay. The yield pressure's toughest in the first part of the year 2020?
Relative to last year, yes.
Got it. Okay. All right. No, that's helpful. Jim, maybe a bigger picture question coming back to the last one about OR in 2021 and some of your thoughts there. Some significant improvement this year and expectations for 2020. When we think about maybe some of those tailwinds that you could get from revenue growth potentially returning in 2021, and given the progress you've made so far, how do you think about sort of the potential of the business? I think a lot of us spend time focusing on year performance relative to peers. Is that the right way we should be thinking about it? Some of the numbers that we're seeing from some of the other rails out there, are those the types of potential ORs we can expect from Norfolk over time?
Just want to get a sense of how you're feeling about it kind of partway through this PSR initiative?
Should we see upside in the top line, we would expect much of it to flow through operating income and to the bottom line because there will be significant operating leverage in that growth. That's not our base case, as we've been through, but the growth will return and resume at some point. We think we get a lot of operating leverage because we have restructured our costs and believe that we can handle volume growth with the resources on hand. There will be areas where we have to increase spending to handle the volume growth, depending on how much it is. By and large, we believe we can handle the volume when it returns with our existing resources.
Okay. That's helpful. Thanks very much for the time. I appreciate it.
Our next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.
Hey, good morning, everyone, and thanks for taking my question. I guess, Jim, maybe following off that line of questions, as we look at phase III of the TOP21 plan, is that going to drive pretty significant operational changes here, and that's why you guys have the confidence on the cost outlook and the OR improvement in 2020?
That will contribute to it, for all the reasons that the last major iteration of TOP21 drove efficiencies. Yes, that's a piece of this. In the next iteration of TOP21, we will continue to focus on train consolidations, on decreasing circuity, on running longer, heavier trains to meet the goals that we put out there for those things. It's further to the types of goals that we were pursuing in the previous versions of the plan. I think at some point going forward, this becomes continuous improvement. Really, in a way, we're already there. We are looking every day, every week at shorter trains and working on a plan in consultation with our customers in the field to fold those trains into the network and achieve those efficiencies on an ongoing continual basis.
Okay. Appreciate that response. Not to get too specific on this call, but Mark, can you talk to the other expense line item? I think, if we look at it the last few quarters, it was running around a $60 million run rate. Is that the right level to think in 2020?
Other expense?
Yes.
Yeah, that's about the right level to be thinking about it, Brandon.
Okay. Thank you.
The next question is coming from the line of Justin Long with Stephens. Please proceed with your question.
Thanks and good morning. Maybe to start with the quarter, there were some one-time items that you called out in the prepared remarks. I was wondering if you could just help us understand if all of these items were baked into the guidance that you gave for 2019. I just wanted to get a better understanding of how things performed operationally in the Q4 versus what you expected.
Refer to Mark's opening slide for the components of the OR change and the EPS change, some of which were non-recurring, others of which represent core earnings production during the quarter. Mark?
Yeah. When you go back to the appendix chart, basically the property sale in 2018, we knew when we were building the 2019 plan that we wouldn't be having a similar sale of that size. The receivable write-off and the two asset impairments that we incurred in Q2 and Q4 were unforeseen. Those impacts are clearly not contemplated when the 2019 guidance was given.
There were some other things, the taxes were lower.
Yes
tax rate was lower in the Q4 . That was not something that we projected when we gave the guidance on the quarter.
Basically, think about it as those three rows, the receivable write-off asset impairment and the retroactive income tax credit, were the surprises to us at the time of guidance a year ago.
Okay, great. That's really helpful. Secondly, I wanted to ask about intermodal. Would love to get your thoughts on domestic intermodal growth this year and what you're expecting. Just from a margin perspective in intermodal, as PSR gets fully implemented in that network, how do you expect the incremental margins within intermodal to stack up relative to the rest of the business? I know historically you've talked about intermodal incrementals being lower than general merchandise and coal. I'm just wondering if that rank order could change post PSR.
Alan?
Justin, we are expecting some growth in our intermodal franchise as the year progresses. As I noted, we're collaborating with our customers to look for logistics solutions that fit their needs. We're really fortunate because we're aligned with the best channel partners in the business, and they're focused on growth. They understand our network, and so we're collaborating to see where we can compete with truck. We're encouraged to see an inflection in spot rates in truck. We haven't seen a big uptick in it, so the first order or first derivative isn't all that great, but the second derivative is, and it's certainly stabilized and is improving. That's going to provide some headroom for incremental volumes for intermodal as the year progresses, in addition to the new service products that we're launching.
As we go through TOP21 V3, we're going to look at consolidating some business. We're also going to look at reopening some lines and introducing new businesses for us.
Justin, in terms of the incrementals within the intermodal sector, I would say this. For the last couple of years, the incrementals have actually been excellent during periods in which we were growing volume. Looking back historically, one of the things that did hold intermodal incrementals back a little bit was fixed costs associated with the intermodal volume growth, i.e., terminals and equipment costs. As Mark went through, we're very focused on asset cost in this plan, and in the case of intermodal, making maximum use of the assets that we have, the terminals, the equipment that we have today, and keeping to a minimum the growth CapEx that we're putting into that business. Lots of initiatives around terminal improvement processes, and particularly in the environment we're in, keeping a lid on equipment costs.
Okay, great. I appreciate the time.
Our next question is from the line of Walter Spracklin with RBC Capital Markets. Please proceed with your questions.
Yeah, thanks very much. Going back to the materials and other line item, I just want to be clear, forgetting for now the fourth quarter 2018 impact and just looking at your quarterly run rate through 2019, you were averaging anywhere from 190 - 196, and you stepped down to 130 in the fourth quarter. Is that all due to the gain that you had in the Q4 , and can you tell us exactly what the gain was, the amount of the gains in the Q4 ?
That was the property gain.
Right.
The absence of the property gain from last year, which was $112 million.
Yeah, no, forget last year. I'm just talking the cadence of the materials and other line expense through 2019 was $190 million, and it stepped down $60 million in the Q4 . I'm just trying to understand what caused the quarter sequential step down from what was $190 per quarter through 2019 to drop to $130.
Some of that was the efficiencies that we achieved in material spending in the Q4 , as Mark went through. This is one efficiency pickup by virtue of having a smaller locomotive fleet and a car fleet out there where we incur lower equipment maintenance expense.
What was the gains in the quarter, I guess, is the question I'm asking?
Mark?
It was around $40 million, $45 million.
You were guiding at the beginning of the year for 30-40 for the full year, and you did 45 in the Q4 . Am I getting that right?
40-60.
Well, we're guiding now 40-60. I don't know what was said at the beginning of the year.
We've always said that this is going to be lumpy and unpredictable. Now you do tend to get more real estate closings at the end of the year. I think that probably is a pattern that you see a little bit better gain in the Q4 . You know, it.
It is. We've produced about $40 million-$60 million, excluding one-off gains like we had in the Q4 of 2018. That's about what we expect to do going forward. It will vary by quarter from time to time.
Okay, you were at 30 - 40 embedded in your guidance for 2019 at the beginning of the year, now it came in, as I understand it, 40 - 60, of which 45 was included in the Q4 .
Right.
Correct.
Okay. Got it. Okay.
We ended the year closer to 60.
60, okay. Of which 45 was all in the fourth quarter.
That's correct.
Got it. Okay. Thank you for clarifying. On the tax item or the tax, 19 of retroactive tax adjustment, which would get your effective tax rate back up to around 22%, still trending fairly quite a bit below where. Was there anything else in the quarter versus the guidance that you were giving before of 23%-24%? Or is that just a lower tax rate? Yep.
Yeah, we had more benefits than we assumed from the COLI gains, which are tax exempt. In addition, we had the 45G tax credits that we just talked about and disclosed, but there was also higher deductions from stock-based compensation. Everything kind of just went in the right direction for us this year, so that's why the ETR effect ended a little bit lower than what we would typically guide.
Is there something there you would call out as just kind of an exceptional number, because I don't mind lower taxes on lower expenses, but that retroactive tax adjustment, is there anything else that was retroactive or was one time in the quarter?
There was nothing out of period in the quarter, no.
Okay. Last question here is on the revenue. You have revenue flat for next year. The guidance that you'd given through the year last year was a little bit more on the optimistic side. Obviously, a lot of things happened unexpectedly. What confidence do you have that while you're giving flat guidance, it is above your peer? Are you being a little bit more optimistic? Is it just the coal markets that you serve are just a little bit more advantageous? Can you give us a sense of what comfort you have that flat and rebounding off, I think you said Q1 will be the same as Q4, which is coming off a minus seven percent base. That suggests it's going to be a pretty heady growth rate offset in the back half of the year.
Alan?
Yeah. Walter, our growth is targeted towards the back half of the year, and it's reflecting the strength of our intermodal franchise and some revenue growth within merchandise. It's about launching new products that generate revenue growth with our customers. We're confident that we're going to be able to execute it.
Thank you. Our next question is from the line of Brian Ossenbeck with J.P. Morgan, please proceed with your questions.
Thanks. Good morning. Question for Mike on train weights. Can you just clarify if you said that the second half met the target when you put in the new operating plan, was that the new or the old target that you were tracking against? If you can just comment on the level of confidence you have in meeting the new target, especially if coal declines more than expected, maybe if some mix shift that goes towards the lighter intermodal, or even if volumes come in lower than you would think at this point.
Yeah. That was against our 2019 goal. For the full year, we met that goal for the back half. Like we said we would on the calls because TOP21 rolled in and drove train weight increases, particularly in the merchandise market. Our merchandise trains continue to be strong and growing in train length. Intermodal is not, and that's an area we have to continue to focus on, and phase III of the TOP21 plan does that.
Okay, despite the lower mix of coal, the key is really phase III in terms of building bigger and longer trains, even if volumes are flat or possibly down?
It's phase III and it's what Jim talked about, this continued optimization of the network. We continually look at trains that aren't running at sizes we want them to and find ways to make them bigger and without affecting service, and we're doing that as we speak.
Okay, thanks. Quick follow-up from Mark, if I could, just on the CapEx. You mentioned you're taking a look at some of the line items, trying to figure out the spending level. Obviously, it's a short time in the seat for now, but just want to make sure I wasn't reading too much into that because clearly Norfolk Southern has a heavy locomotive rebuild program, but clearly your peers are spending, in some cases, quite a bit less from a CapEx intensity. Maybe you can just expand on that a little bit. Thank you.
Look, right now the way we spend our CapEx budget, as Jim said, it's between 16% and 18% of revenue. Roughly 60% of that is supporting the core network. It's the maintenance of way, and it's the rail replacement, ties, and ballast. We put roughly 20% for the locomotive upgrades, and that's again the DC-to-AC conversions. As I've learned, this replacement approach is actually generating very reliable product that's performing very well in the field, and it's actually much cheaper than buying newer locomotives. That's logical.
Then the other 20% bucket is comprised of a lot of other things, but primarily IT spend and digital technology spend. That's how we break down our CapEx. I'm getting in, and I'm just trying to understand it because obviously it's a big use of funds for us, and I want to understand the disciplines around it and just pressure test a lot of the assumptions that have been in there on the adequacy and how much we need to spend. That's not to say that we're going to change the guidance anytime soon. I'm just letting you know that coming in fresh, because it was in response to that question, what are the things that surprised me?
It was looking at this level of spend, and as I learn the industry, I'm understanding it better, but it doesn't mean I'm not going to bring a different lens to it and push a little.
Thank you. Our next question is from the line of Jason Seidl with Cowen Company. Please proceed with your question.
Thank you, operator. Morning, gentlemen. Want to go back to international intermodal. Clearly, there was some headwind pull forward in the 4Q, but if I recall, that actually pushed into 1Q a little bit. When should we see the inflection point of those volumes turning up? Does the uncertainty of the coronavirus actually impact you guys at all, or is that too early to tell yet?
Alan?
Hey, Jason, you're absolutely correct. We did see elevated international intermodal volumes in the first couple of months of 2019. As the year progresses, comps will get a little bit easier for us, and then that's when we're expecting to start seeing growth. With respect to the coronavirus, it doesn't help. There's no doubt about that. We've talked to our customers about that, and the level of impact that they're anticipating is unknown at this point. It's all speculation. We're paying close attention to it, as are the steamship lines that we serve.
Okay. My follow-up's going to be on the domestic side of things. A couple of railroads, let's call it the last year and a half, pulled back a little bit on some of the lanes that they serve with PSR. Do you think that there is a need for more lanes going forward once the market does tighten up in the U.S. truckload, or do you think the lanes that the industry currently has are good enough to service and get that freight back from the highways onto the railroads?
Jason, I think there's both. I think as the truck market tightens, we're going to see the benefits of our powerful intermodal franchise in organic growth in the lanes that we serve. As I noted, we're working feverishly with our interline partners and with our customers to look at new lanes that offer value to our customers and offer value to our shareholders. This is not static. It's a dynamic review of our overall franchise, finding areas where we can provide value, and we can support our channel partners' growth. As I noted, we're aligned with the best channel partners in the industry, I'm pretty confident that collaborating together, we're going to find avenues for growth.
Thank you. Our next question is from the line of David Vernon with Bernstein. Please proceed with your question.
Hey, guys. Thanks for taking the question. I wanted to ask a little bit about where we should be expecting headcount to come in in 2020. You ended the year down pretty considerably. Should we be expecting that kind of run rate level, or should we be expecting further reductions from where we ended the year on headcount?
Mark?
We're not going to provide a specific headcount number. We are coming down again from where we're going to end 2019, for sure. As I mentioned, we're going to keep pushing it, and then we're going to see where volume goes. We talked about, we're expecting volume to start turning a little bit for us a little bit in the back half, and if it's not there, we're going to continue to push on employment levels. We don't have a specific number to share with you.
Nothing that's in the budget that you could give us a sense for how much additional headcount reduction there should be in the year?
No. We clearly have a budget, but it is not going to be something that we talk about because we will flex, just like this year. Depending on where volume is, we may go heavier.
Okay.
You certainly saw, David, in the Q4 , when we had to flex, we did. We picked up the pace throughout the second half, particularly in the Q4 . We will do what's necessary.
Okay. Then I guess maybe just sequentially, Mark, the other expense line came in at $11 for the Q4 from $95 in Q3, $60s in Q1 and Q2. Is there anything that explains that sort of sequential step down in the other expense line for our Q4?
I think, yeah, it's a little bit of the land sales. It's the gains that we had that were back-end loaded from the property sales that we talked about. We had more of the land sales that came through in the fourth quarter compared to the prior three.
Thank you. We've reached the end of our question and answer session. We have time for one final question coming from the line of Jordan Alliger with Goldman Sachs. Please go ahead with your questions.
Yeah. Hi, thanks. Just a quick question. A lot of talk on the domestic intermodal front, but I'm just curious, can you talk about international? What proportion of your intermodal franchise is international, whether it be volume or revenue? How do you think about that as we approach 2020, given still the noise around tariffs? I'm just sort of curious also how the international franchise actually performed in 2019, just as a relative sense for looking forward.
Jordan, our international intermodal franchise is about 35% of our overall intermodal franchise as measured by volume. As I noted earlier, we're running up against some pretty tough comps to start the year with the pull forward of activity in the Q4 of 2018 that bled over into the Q1 of 2019. We're expecting that the comps will improve as the year progresses. As with all of our markets, we're generally not expecting growth until the second half of the year.
Thank you.
Thank you. This concludes our question and answer session. I will now turn the call back over to Mr. Squires for closing comments.
Thank you, everyone. We appreciate your questions this morning and look forward to talking with you again when we announce our first quarter 2020 earnings.
Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may disconnect your lines at this time, and have a wonderful day.