Greetings, and welcome to the Norfolk Southern Third Quarter 2018 Earnings Call. At this time, all participants will be in a listen only mode. A brief question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. I'd now like to turn the conference over to Clay Moore, Director of Investor Relations.
Please go ahead, Clay.
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 3rd quarter 2018 earnings call. Joining me today are Alan Shaw, Chief Marketing Officer Mike Wheeler, Chief Operating Officer and Cindy Earhart, Chief Financial Officer. Starting with our financial highlights on Slide 4. We delivered another quarter of record financial results. Income from operations was over $1,000,000,000 an increase of 14%.
Net income was $702,000,000 up 39% over the prior year, and earnings per share was $2.52, a 44% increase. The operating ratio of 65.4 percent is a 3rd quarter record for our company and marks the 11th consecutive quarter of year over year operating ratio improvement. As 2018 draws to a close, we are poised to achieve another year of solid OR improvement and strong bottom line results. Given the progress we've made in the last 3 years and the likelihood we will meet our current financial goals well ahead of schedule, we are moving forward on the next round of initiatives to drive shareholder value. We look forward to briefing you on these new initiatives and the associated financial targets at our upcoming Investor Day on February 11 in Atlanta, Georgia.
Please save the date. Now to provide further insight into our Q3 results, Alan will cover trends in revenue, Mike will give you additional color on the state of operations, and Cindy will detail our financial results. I'll now turn the call over to Alan.
Thank you, Jim, and good morning, everyone. Starting on Slide 6, the success of our market approach is clearly demonstrated by sustained growth in revenue, revenue per unit and volume. This quarter marks the 7th consecutive quarter of year over year revenue gains with 7 quarters of strengthening RPU and 8 quarters of volume improvement. For 5 consecutive quarters, we achieved steady year over year increases in RPU less fuel, which is hugely important to operating income. We have succeeded despite the negative mix impact of continued strong volume growth in intermodal, with balanced and consistent RPU increases in all three of our business units.
The increasing intermodal RPU, coupled with productivity improvements, consistently enhances intermodal profitability, augering well for the future, given that intermodal remains one of the fast growing segments of the freight market. The strength of our multifaceted plan generated revenue, RPU and volume growth across most markets in our intermodal and merchandise business units. Our balanced focus on margin, price and volume continues to produce revenue growth, benefiting our tarp line as well as operating income. Slide 7 highlights the results of our plan that generated 10% revenue growth in the 3rd quarter. This gain was a product of sustained volume improvements, higher pricing and increased fuel surcharge revenue.
In merchandise, we achieved record revenue, RPU and RPU excluding fuel in the 3rd quarter. Volume growth was led by gains in ethanol and crude oil. RPU grew year over year for the 10th consecutive quarter, highlighting our emphasis on pricing. For the 4th consecutive quarter, Intermodal achieved record revenue with 2 consecutive quarters of 20% year over year growth. This increase was generated by records in volume and RPU less fuel.
The strong economic environment, coupled with a tight truck market continues to drive demand for Norfolk Southern's Intermodal franchise, resulting in significant growth. Pricing gains led to substantial improvement in RPU less fuel and RPU during the quarter. Coal revenue was up 3% in the 3rd quarter with positive pricing and export volume growth that was partially offset by declines in our utility market. Our strategy delivered strong results in the Q3 with revenue and RPU increases in every business group, underscoring our commitment to competitive pricing as well as our ability to capitalize on market conditions. The continued strength and improvement in our top line metrics illustrates the confidence customers have in our approach.
Moving to slide 8, our outlook for the Q4 remains positive. We expect revenue and volume to improve with continued strength in consumer demand and the industrial economy, leading to growth in intermodal and manufacturing markets, including automotive and plastics. The favorable differential in oil prices is expected to increase volume in our crude franchise. Coal volumes are projected to be up year over year in the Q4, driven by growth in both the utility and export markets. Similar to the Q3, we anticipate 4th quarter utility volumes to be in the 15,000,000 to 17,000,000 ton range.
Export volumes are expected to remain in the 6000000 to 8000000 ton range. Pricing to the value of our product remains a key element of our strategy, and we expect that strategy to deliver year over year improvement in RPU in the Q4. Our balanced strategy and franchise have positioned us for growth, allowing us to expand with both our existing customers and new customers, maintain a sharp focus on productivity and capacity and deliver results for our customers and shareholders. We are integrated in our customer supply chains and consistently work to understand their markets, partnering for their success and enabling long term value for NS shareholders. This sustained and balanced approach to both revenue and income growth is delivering results and we look forward to a strong finish in 2018.
With that, I'll turn it over to Mike for an update on our operations.
Thank you, Alan. We are pleased the velocity of our railroad continues to improve while handling record volume for a 3rd quarter, as well as achieving a record 3rd quarter operating ratio for the company. Moving to Slide 10, our reportable injury ratio for the quarter improved year over year and sequentially. The safety of our employees and the communities we serve continues to be our top priority and where we focus a lot of attention. Our service levels are improving as evidenced by our service composite, speed and dwell all improving sequentially.
Additionally, our network velocity as measured at the car level is currently near our highest levels for this year. All four measures are currently pacing at or ahead of our 3rd quarter performance. Turning to Slide 11. In addition to improving service for our customers, we are also driving improvement in our efficiency. A record 3rd quarter train length helped drive an all time record crew productivity for Norfolk Southern.
Specifically, we handled 5% more volume with just a 2% increase in crew starts. We also achieved an all time quarterly record for fuel efficiency. All of these factors combined to help us achieve a record 3rd quarter operating ratio as well as an all time record OR for the 1st 9 months of the year. Turning to Slide 12. To drive further improvements in the velocity of our operation, we are undertaking the development of a new operating plan.
The first step is to streamline the railroad, which will allow us to move assets faster and create capacity for our customers to grow. This process, something we refer to as clean sheeting, starts in the terminals and local serving yards where cars tend to accumulate as they navigate the first or last mile of their trip. The goal is to increase fluidity by reducing car inventories, accomplished in part by increasing service frequency for customers. We also work cooperatively with the customers to create efficiencies in service. We are encouraged by the results we have seen so far as Clean Sheeting underpins our new operating plan going forward.
As seen on Slide 13, our new operating plan will be built on key principles. As mentioned, it starts with clean sheeting, which will drive car level velocity higher and lower cars online. This will allow us to build more blocks of traffic in the local serving yards that can be picked up by a through train, bypassing the major classification yards. We will also work with our customers and short line partners on additional blocking opportunities. The blocks will be integrated into the system using different train types and drive further velocity improvements and efficiency.
Lastly, we are continuing to evaluate our accessorial program to ensure high asset utilization and capacity for growth. We will provide more details on these operating plans at our upcoming Investor Day in February, including our expectations as to the value we are creating through the new operating plan. I will now turn it over to Cindy, who will cover the financials.
Thank you, Mike, and good morning. As Jim said earlier, we've delivered another quarter of record financial results. Let's take a look at the details starting on Slide 15. As Alan discussed, we had strong revenue growth of 10%, which when combined with the smaller increase in expenses resulted in the 2nd consecutive quarter of income from railway operations of over $1,000,000,000 14% higher than last year. We also achieved a record 3rd quarter operating ratio of 65.4, improving on last year's results by 110 basis points.
Just as a reminder, 2017 results have been recast to reflect the required reporting reclassification of certain pension and post retirement costs. Slide 16 illustrates the component changes to operating expenses. In total, operating expenses increased by $152,000,000 or 9%, primarily driven by higher fuel prices and volume related costs. Fuel rose by $76,000,000 primarily due to higher prices, which added $65,000,000 Consumption was up 4% over the prior year relative to the 5% increase in shipments. Purchased services and rents increased $73,000,000 or 19%.
About half of the increase was attributable to higher expenses for purchased services, including volume related increases, additional transportation and engineering activities, as well as higher technology costs. Higher equipment rents expense reflected slower network velocity, the cost of additional short term locomotive resources as well as the growth in traffic volume. We expect about half of these additional equipment rent costs to come out in the 4th quarter. The materials and other category increased $38,000,000 or 23%. Last year's gains on the sale of property were approximately $36,000,000 more than the current year.
We have also incurred increases in derailment related expenses and additional costs associated with the ongoing relocation of our dispatchers to Atlanta. This year also includes higher locomotive material usage costs due to more locomotives in service. These amounts were partially offset by $20,000,000 of rental income associated with operating property, which you will recall was now included in this expense category. Finally, compensation and benefits decreased by $46,000,000 or 6%. Incentive compensation was $45,000,000 lower than in the Q3 of 2017 based on the timing of accruals, which were a headwind in the Q3 last year.
Reduced headcount levels saved $10,000,000 over the same quarter last year. Headcount was approximately 320 positions fewer than in the Q3 of 2017 and down about 100 sequentially. Consistent with the 1st two quarters, lower health and welfare rates also resulted in savings of approximately $8,000,000 versus last year. Over time and re crews added $15,000,000 of costs. Now moving to Slide 17, you can see a summarized look at our record 3rd quarter results.
Income before income taxes increased 14% and we achieved record 3rd quarter net income of $702,000,000 up 39% from last year. Diluted earnings per share was also a 3rd quarter record of $2.52 a 44% improvement year over year. Wrapping up our financial overview on Slide 18. Free cash flow for the 1st 9 months was a record $1,600,000,000 and over $2,900,000,000 has been returned to shareholders via a 19% increase in dividends as well as share repurchases through both the previously announced accelerated share repurchase program and our ongoing open market purchase program. Our share repurchase programs underscore our confidence in the business as we continue to drive growth and create shareholder value.
I'll conclude my remarks by saying the 3rd quarter financial results demonstrate our continued commitment to deliver on our strategic plan objectives and to drive ongoing improvements. Thank you for your attention, and I'll turn the call back to Jim.
Thank you, Cindy. Guided by the strategic plan we announced in late 2015, thanks to the hard work of our management team and employees, we have consistently achieved the results we promised shareholders. This year, we are on track for another year of OR improvement and strong bottom line growth, and we are confident we will make further progress next year and beyond. In the last few months, we have begun overhauling our railroad from top to bottom, leaving no stone unturned in the quest for efficiency, growth and shareholder value. As we revamp how we operate, we will listen to our customers and find new ways of meeting their needs.
We will use our knowledge of our company to innovate from within. We will bring in outsiders where they have experience or skills we lack. We will collaborate with our supply chain partners and others to learn their best practices. And yes, as you just heard from Mike, we will implement PSR principles where they lead to a better result for customers and shareholders. All of the above.
We are open to all good ideas that will advance customer service and shareholder value regardless of the source. In summary, we are excited about the momentum we have today and intend to deliver on our promises in the future as we have in the past. We look forward to announcing new financial targets at our Investor Day in February and to showing you the path we will take to get there. Thank you for your attention. We'll now open the line for Q and A.
Operator?
Thank you. Due to the number of analysts joining us on the call today, Our first question is coming from Allison Landry with Credit Suisse.
Certainly, great to hear about implementing precision railroading. Jim, just on one of your last comments, you mentioned that you guys are going to try to implement it as long as it improves customer service and enhances shareholder value. So is there anything that maybe you see in PSR that may not fulfill those two initiatives?
Well, Allison, as I said, ours will be an all of the above approach to improving customer service and productivity. We will implement PSR principles where they can allow us to better serve our customers and shareholders along with ideas we get from our customers, our supply chain partners, from those both inside and outside the company today. We will endeavor to implement a new operating plan while minimizing service disruption. And we're not going to sit out growth while we do so. This remains an environment very conducive to growth and we are determined to capitalize on it.
Okay. So just I guess, thinking about that, does that tell us that maybe you're not fully embracing it like we've seen at CSX and perhaps maybe you're taking a similar approach as Union Pacific? Is that a fair way to think about it?
We're looking at everything out there, including elements of PSR that are complementary to our strategy. So it's too soon to go into the specifics of our new plan. We will give you those specifics in February along with the new financial goals. But suffice it to say, our goal is to produce a railroad that provides a more consistent service product at a lower cost.
Okay, great. And then if I could just get in my follow-up question, could you help us to frame or quantify how much the network inefficiencies cost you in the quarter? I know that there was some elevated equipment costs and some derailment costs and of course the network velocity and whatnot. Maybe if you could help us to understand what the impact of that was in the quarter? Thank you.
Sure. Well, we did have some lingering service related busts as we indicated we would last quarter. Cindy can give you some more specifics on the individual line items. But despite the additional expenses, we were able to produce another quarter of year over year operating ratio improvement and significant incremental margin from the growth. Cindy?
Sure. Allison, you're right. We did continue to have some network velocity costs. We have not quantified those really since the Q1. We do continue to see them come down somewhat.
You did see some elevated equipment at rents. As I pointed out, in my comments, we expect about half of the increase of what you saw on equipment rents to come out in the Q4. And we expect velocity cost to continue to come down as the service improves.
Great. Thank you so much for the time.
Next question comes from Jason Seidl with Cowen and Company.
Thank you, operator. Good morning, everyone. I want to switch it up and talk a little bit about intermodal here for a minute. Obviously, you've been growing in that area and that's part of your growth plan going forward. We're still in a fairly tight truck market right now, but as you guys know that changes over time.
Can you talk about the plan and how much it's predicated on trucking capacity being tight out East and what Norfolk can do to grow that even in, let's say, a flat truck market as opposed
to a tight truck market?
Alan, I'll let you take that one. Let me say though that Intermodal has been a consistent grower for us through tight and less tight truck markets. Alan?
Jason, we've grown our revenue in intermodal year over year for 8 consecutive quarters. As Jim knows, that includes a very loose truck market at the end of 2016 early 2017 and then what we're experiencing right now. We're very encouraged by what we're hearing from our channel partners with respect to the outlook for next year. We still expect truck rates to go up. We still expect intermodal loadings to go up next year.
And there's a gap there between intermodal pricing and truck market pricing that we're going to lean into and be able to price into.
And I'll link this to your new operating plan, and I understand the details will be given at the Investor Day. But how crucial is the new operating plan to continuing to grow intermodal and even more importantly, continuing to realize the price for your services?
Alan? Jason, we've got we have a great intermodal franchise and we run a lot of point to point trains in that franchise. And we're working very closely with our customers and within the operations division on improving the productivity. And you're seeing that reflected in bottom line results. And we're going to continue to focus on price.
We've talked earlier about the cadence of pricing opportunities within intermodal would last well into 2019. We still expect that to occur and we're going to continue to focus on productivity.
Appreciate the time as always.
The next question is from the line of Justin Long with Stephens. Please
So I was wondering if you could talk about the timing and scale of implementing this new operating plan. Just wanted to get a better understanding of how we should think about the rollout. And as you go through process, would you be open to the idea of bringing someone in with PSR experience in some of these operating principles? Or do you feel confident with the team you currently have in place?
Justin, let me take the second part of that question and then I'll let Mike talk about the sequence of events. Obviously, we're going to give you more detail on the new operating plan in February. We have brought in those with PSR experience, and we will continue to do so, recognizing that we don't have a monopoly on good ideas and that we can benefit from the perspective of those outside the company who have implemented PSR principles and other best practices. Mike?
Yes. So talking about our plan, we are currently doing the clean sheeting now. We are currently out across the railroad looking at our local yards and terminals and working with customers and how we get that done. And we will be doing that for several months now. And at February at the Investor Day, then we'll start telling you about what we're going to do with the operating plan that's been developed from the clean sheeting that we've done across the railroad.
But there'll be different cadences to this. We're going to do certain changes to the operating plan, get that in place, get the benefits of that across the supply chain and then we'll take another step forward, harvest some more benefits. So it's going to be it's going to have cadence to where we do some, do some more and continue to get the benefits.
Okay. And secondly, it seems like one of the areas of focus in the new strategic plan will be reducing equipment on the network. You mentioned cars online. Do you have any initial thoughts on how your locomotive and railcar needs could change over the next couple of years? Just curious what you see as the targeted size of your equipment fleet relative to where it is today?
We'll give you more information on those kinds of targets in February. Obviously, better locomotive and freight car productivity will be key elements of the plan. As Mike went through, one of the big goals is to drive down cars online and increase overall network velocity. That implies significant productivity in both locomotive and freight car categories.
Okay. I'll leave it at that. Thanks for the time.
The next question is coming from the line of Amit Mehrotra with Deutsche Bank.
So I fully appreciate, I guess, the time it takes to form and communicate a new operating plan. So we can certainly wait until February for that and I look forward to that. But a plan, I think, is probably devised with some specific targets in mind or some philosophical view about what the returns in the business should be either on an absolute basis, but probably more appropriately relative to what the benchmarks are achieving in the space. So I know I asked this exact same question last quarter, so forgive me. But Jim, as you think about what the company is managing to now actively, are there any structural reasons for the profitability of Norfolk Southern to be any different than CSX and kind of over a mid to long term timeframe?
Our financial objectives in the next long range plan will be the same sorts of objectives that we have driven toward in the current long range plan, I. E, both top line growth and, of course, earnings growth through a combination of revenue and margin improvement, The latter being critical to financial success in our industry, we certainly recognize that and we'll be pushing hard for significantly lower operating The railroads being a capital intensive business, we focus heavily on return on capital. So you will see objectives in each of those categories in February. And I can assure you they will be aggressive goals. We're working hard on them and putting in place the specific initiatives that will allow us to drive shareholder value.
Okay. Thank you for that. And then just one follow-up for me. Last quarter, you and Cindy talked about the balance sheet being evaluated to have an optimal capital structure. I fully understand the operating plan takes maybe a long time to formulate, but the balance sheet actions should be, I think, relatively straightforward given your communications with the credit rating agencies.
You did raise some debt. You did an accelerated share repurchase relatively recently. Is that all we should expect on that front? Or should we expect some communication? Or can you update us now on where you think the optimal leverage for the company is?
I'll turn it over to Cindy for her thoughts on financial strategy, but let me say again what we have achieved thus far. In 2018 alone, for the year to date, dollars 2,900,000,000 in capital return to shareholders via a 19% increase in dividends and the ASR and normal course share buybacks. Cindy?
We will continue to evaluate the balance sheet, but I will say that as we said in the last quarter that we feel pretty comfortable with the continue to talk about that and we will update you again in February. But for now, I think we're comfortable in that range.
Got it. Okay, guys. Thanks so much. Good luck with everything. Appreciate it.
The next question is from the line of Chris Wetherbee with Citigroup. Please proceed with your question.
Yes. Hey, thanks. Good morning, guys. First, I want to start on the pricing side. Alan, you kind of mentioned a little bit of what was going on in the intermodal side.
I think you also mentioned some improvements on the coal side too. But as you start to think about 2019, presumably there's sort of a bigger percentage of your contracts that may come up in the earlier part of 2019. Just want to get a sense of maybe how we should be thinking about the momentum. Is there an opportunity to get better price in 2019? Are some of the factors that you're kind of seeing now potentially with volume decelerating, at least growth decelerating a bit?
Will that have an impact? Just want to get a sense of maybe how you're thinking about the setup in the context of the sort of new operating plan you're doing? Will pricing be a tailwind, a greater tailwind in 2019?
Chris, great question. Pricing is going to be a key component of our plan moving forward as it is now. The price that we secured in the Q3 was the highest level that it's been in 6 years, and we set a quarterly record for price within our intermodal franchise. As I've noted, we see a lot of strength and support for pricing moving well into 2019, particularly in truck competitive markets. Coal pricing is going to be dictated by seaborne coking coal prices, which right now remain elevated, and natural gas prices, which right now are fairly strong, there's a lot of strength in our truck competitive markets.
And so we continue to see opportunity and momentum within pricing for intermodal and our merchandise franchise.
Okay. Okay, that's helpful. And then just maybe a detailed question here. When you're thinking about headcount, I guess, maybe putting the new operating plan aside for the time being, as you're thinking about the next quarter or 2, maybe this question for Cindy, how should we be thinking about sort of the cadence of headcount growth or contraction? You've had a nice deceleration here.
Volume growth continues to be pretty decent. Just want to get a sense of where you're getting to the point where you feel you might have to start adding resources either sequentially or year over year?
Cindy? Sure, Chris. So if you looked at headcount, we said we were down about 300 year over year and down about 100 sequentially. We were hiring T and E in the Q3, and we actually increases in our T and E headcount, but we were able to reduce other the areas other than T and E to kind of keep that number down or relatively flat. Going into the Q4, we expect to continue to be hiring some T and E, particularly in our main corridors.
But we will also continue to try to manage the non T and E headcount. So you can expect to see it flat, maybe up slightly into the Q4. And then into 2019, we'll talk a little bit more about that as our plans come together.
Flat to up sequentially in 4Q? Just want to make sure I'm sure on that clear then. Okay, great. Thanks for the time. I appreciate it.
Our next question is from Walter Spracklin with RBC Capital Markets. Please proceed with your question.
Yes. Thanks very much. Good morning, everyone. So with regards to the new plan, have you started it now? Or is it something that you formulated and you plan on implementing and telling us about on February?
Just trying to understand whether the results are something we can see on a continuous basis Or is it something that kind of starts at a certain period in the future, certain time in the future?
We have begun implementing the clean sheeting part of the new operating plan. So yes, that has been underway for some time now. We've been going across the railroad from location to location, clean sheeting as Mike has described. And we'll continue to push hard on that until we have laid the foundation through the clean sheeting process for a new operating plan for the network.
And part of prior plans at other railroads entailed a fairly significant headcount reduction and quite a change in the infrastructure within each of the organizations. And we've heard you would have seen very significant reductions in number of hump yards and so on. Your approach in the past has been a little bit more balanced, I think you've termed it, Jim. Will this plan be more aggressive on headcount reduction and infrastructure changes or continue to be more on the balance side?
Labor productivity being a key component of overall productivity and necessary a necessary component of further progress on the operating ratio, we will be focusing on that element of the plan certainly. As we roll out the new operating plan, we would expect to achieve greater labor productivity as well as asset productivity 30% reductions in
labor force. We've seen 30% reductions in labor force, we've seen 75% reductions in number of hump yards. Improvement could be a little bit or a lot. I'm trying to get a sense of are we incremental improvement or is it along the lines of these other very significant changes in infrastructure and labor force?
We'll give you more details in February. But as I have said, we do expect to put some aggressive ambitious goals out there for the operating ratio and for further overall financial improvement. Labor productivity and asset productivity, network productivity will be absolutely part of that and will be necessary to achieve those goals.
Okay. Thank you very much.
Next question is from the line of Scott Group with Wolfe Research. Please proceed with your questions.
Hey, thanks. Good morning, guys. Can you give us any sort of hurricane impact in the quarter and any sort of guidance on incentive comp year over year for the Q4?
Hey, Mike, why don't you take the hurricane question and then Cindy talk a little bit more about incentive compensation?
Yes. We weathered the hurricanes really well. Hurricane Florence came on land and we were able to restore our main lines pretty quickly within 24 hours. We did have some water impact around Newbern that we had some of our bridges underwater, but we were able to use short lines to reroute that traffic to some of our major customers. So Hurricane Florence was really a short term impact to us.
We got the railroad up very quickly. And same thing with Hurricane Michael. It moved across our network pretty quick. We were responding right behind it as it came in, pretty much removing trees and putting generators out at signals and grade crossings and again got the railroad up very quickly. So both storms that move right through our network, we were able to recover quickly.
And really that's a testament to our engineering folks who staged a lot of equipment, assets, generators out in the right location so that we could recover quickly, and we did. So we had very minimal impact, and we're able to get the railroad up very quickly. Cindy?
Yes. In terms of the cost of the hurricane, I mean, I think all of our preparation work really paid off and the costs were really not significant at all in terms of the hurricane. Okay. And the costs were really not significant at all in terms of the hurricane. On your second question around incentive comp, you'll recall and I said in my comments that Q3 of 2017, we had a large incentive comp adjustment.
We did an adjustment in 2018 in the Q2. Going into the Q4, it will really depend on the company performance as to whether there's any sort of adjustment to incentive comps. So we'll just have to wait and see how we do as the Q4 continues.
But nothing obvious on the year over year comp, good or bad for 4Q, Cindy?
No. Nothing.
Okay. And then Jim, you mentioned that you brought in some precision railroading people. Can you maybe add a little bit more color there? Is it senior people? Is it people in the yards?
Just how many people? Just maybe a little bit more there
would be helpful.
Well, we have people on the ground with PSR experience assisting us as we move through clean sheeting. We also have people who are advising us on the new plan as we put it together, the new operating plan, the new strategic plan, with that kind of a background. So we feel we've covered the bases. And as I said before, we know we don't have a monopoly on good ideas. We are open to all best practices, including but not limited to PSR.
And but are you sort of open to adding to the C suite or executive sort of levels if appropriate?
I have total confidence in my team. And I believe that we have what we need in that team to deliver the results that we will lay out for you in February, just as we have delivered the results for you up to this point for the last 3 years.
Okay. Thank you, guys. Appreciate the time.
The next question comes from the line of Brandon Oglenski with Barclays. Please proceed with your question.
Hey, good morning, everyone. Alan, I wanted to come to your revenue outlook because it looks like you have pretty bullish comments across your 3 segments here, merchandise, intermodal and coal.
I was wondering if
you could balance that in the context of the looming tariffs on a lot of Chinese goods that could be implemented in January. Have you heard any concerns from your customer base around what's upcoming in 2019? Brandon, However,
you take a look at the macro data, the inventory sales ratio However, you take a look at the macro data, the inventory sales ratio remains flat and at a pretty low level, which indicates the demand for product is pretty strong. You take a look at manufacturing in September, it was up 5.1% year over year, the strongest gain in almost 8 years. Retail sales in the Q3 were up 5.9%. So the economy remains very strong. The tariffs add some uncertainty to what our customers are thinking.
However, the underlying economy is, as represented in the macro numbers is very strong, which gives us a lot of confidence in our volumes and our revenue in the Q4 and well into 2019.
Okay. I appreciate that, Alan. And then, Jim, maybe a little bit more strategic one and I don't want to focus necessarily on your competitor, but if CSX were to run at a significantly lower operating ratio and we've seen them improve system velocity, and I know it's not defined the same anymore. But is that a concern for you if you can't get your cost base down equal to your competitor? Is there a lot of traffic that potentially could be at risk as you look out over the next couple of years?
Well, let me state what I think is the obvious. We are focused on enhancing value at Norfolk Southern, leveraging our franchise. And we have, for the last 3 years, fulfilled our commitments to shareholders. Think about it. Think back.
Over 500 basis points improvement in the operating ratio in 3 years, double digit EPS growth, Ahead of schedule on both of those metrics, which we laid out 3 years ago, substantial shareholder value delivered. So we will continue to push for the best possible result at Norfolk Southern. We are very confident in our prospects and we'll give you the details on the new plan in February.
Okay, Jim. Thank you. The next question is from the line of Taran Kratiwala with Scotiabank. Please proceed with your questions.
Yes, good morning. Thank you for taking my question. I guess just talking a little bit about BSR here. One of the other things that does happen is quite a bit of an improvement in CapEx and you have talked about obviously reducing cars online and so on and so forth. Should we assume just sort of directionally that CapEx should be going down here going forward?
Or do you think it sort of stays aligned a little bit?
We believe that 16% to 18% of revenue is an appropriate range for capital spending. We believe that's necessary in order to sustain our franchise and to invest for growth. In addition, we have significant expenditures now and on the horizon for locomotives. We're in the middle of a substantial locomotive conversion program and we intend to continue layering in new locomotive acquisitions as well.
Okay. Thank you. And I guess just one more. I don't know if it's possible to give some early indications on coal here for next year just on the export side. Obviously, this has been pretty strong on export coal.
Just wondering, do you think that there's potential for growth, further growth in the coal franchise on the export side next year?
Certainly, the seaborne prices have increased as the year has progressed. And if that holds into next year and coal production comes online, then yes, we could see growth in our export coal franchise next year.
Thank you very much.
The next question is from the line of Bascome Majors with Susquehanna. Please proceed with your question.
Yes, good morning. We've seen some pretty credible press reports about you relocating your headquarters from Norfolk to Atlanta. And this morning, you just announced the February Investor Day to be held in Atlanta. I know this isn't a done deal, but can you talk high level? Is this a synergy play just to get management closer to the operating team, a local talent pool play or really just more about cost reduction?
And maybe just a little bit about the real estate situation that's creating this opportunity and whether or not you'd expect that to be net cash positive to your investors?
We are considering headquarters relocation to Atlanta as has been reported in the press. It is not a done deal. A number of aspects of the relocation still have to come together for it to become a reality for us. The impetus for headquarters relocation is alignment and teamwork. It's our belief that we will function more effectively as a team.
We will be more aligned if we are in one place. We do own property in Atlanta, which we have been seeking to sell for some time now. And that would be one aspect of headquarters relocation that would need to be resolved before we do it. And we will certainly report to you as we report our results any real estate gains that might accompany that transaction.
Thank you. The next question is from the line of Tom Wadewitz with UBS. Please proceed with your questions.
Yes, good morning. So I wanted to ask you about the kind of, I guess, the broader review on the approach on PSR and so forth and the financial targets. As you in February, if you think about that backdrop, how much does a review of profitability of the segment play in? I think a component we've tended to see with PSR and other railroads as you look through the book and say, okay, maybe this is a piece of business we're not making a lot of money on, we can see some of it go away, or we pretty significantly changed the service that we offer. So I'm just wondering is that part of what you're doing here in PSR or the other strategic?
Or do you think the volume you have is good volume and you don't need to see some of it move away?
What you have described, Tom, certainly is a part of the strategic review that we have underway. Now that's something that we do all the time. We are always looking at our book of business and seeking to optimize its profitability by one means or another. So that's ongoing. That's not necessarily new, but yes, at a high level, we are doing that as part of the new long range plan.
Alan?
Tom, you see us continue to take a look at our intermodal franchise. And we've announced some lane closures over the last year, 1.5 years and yet still have shown 8 straight quarters of volume improvement. Those actions and the productivity improvements that they generate as well as opportunity has really helped us improve the profitability of our intermodal franchise and allowed us to reinvest in it. As Jim noted, this is it's an ongoing effort across all of our business units. So it's nothing new.
It's part of good housekeeping that we do every day.
Okay. Good. That's helpful. And then maybe just one on the current dynamic in the truck market, how that affects you. I think it's hard to tell.
It seems like broader freight backdrop is pretty strong. That said, you see evidence of softening in the truckload spot market, maybe not so much on the contract side. Have you seen some kind of wrinkles of weakness coming in? And how do you think about the kind of how tight things are and the kind of outlook for pricing going forward?
Tom, our channel partners have indicated to us that they're expecting a very strong 4th quarter. And with consumer confidence being at an 18 year high, we expect that to continue well into 2019. Our contract structure will allow us to continue the momentum with pricing. So we're very confident about volume opportunities and pricing opportunities in the truck competitive environment for the remainder of this year and next year.
Right. Okay. So you really haven't seen signs of weakness?
No.
Okay, great. Thank you for the time.
The next question is coming from the line of Ken Hoexter with Merrill Lynch. Please proceed with your questions. Great.
Good morning. Jim or Mike, I guess, I just want to understand what changed through your process and maybe mindset here as you kind of step over to this Clean Sheeting PSR process. You've always talked about this is the right plan for you in terms of focusing on top line growth. And I guess maybe just to understand, is this kind of an evolution of that same plan or a complete overhaul and looking at your peers saying we need to kind of shake that up. And I guess within that, Mike, I don't know if you want to maybe walk through the process of clean sheeting in terms of what you've been doing so far?
Well, Ken, let me respond first and then I'll turn it over to Mike. Certainly, we are looking to change the way we operate. That's necessary. The network has evolved over the years. It's time for a major network overhaul, an operating plan overhaul anyway.
So that's something that we are focused on as a natural development in the life of the network, if you will. It's time for that kind of a bottom up review of how we operate. So certainly the underpinnings of it are organic in that sense, driven by our customer base, our mode of operation up to this point and the need to continue to push productivity and efficiency while preserving the capacity for growth. Mike, a little bit more about Clean Sheet?
Yes. This is evolutionary. And as Jim noted, we've optimized our networks in the past, and now we're going to take the next step and kind of optimize them together. But clean sheeting is really a deep dive at our local serving yards and kind of the nodes to that area. And we bring our service design folks in, we bring our customer service folks in, we bring marketing folks in, we look at all the local service schedules and we make sure they're synced up as good as they can with the main train network.
We talk to customers about how we get traffic in and out of their facilities quicker, get them through our yards quicker. So it's a deep dive at all of these nodes across our network, which are the local serving yards. And it's a pretty intense work that we do. We do it over several weeks and then we come out of there with a better, more efficient operating plan and you saw some of the results we showed you.
So does it go so far as to just looking at improving the performance at those yards or does it step back in terms of the clean sheeting, in terms of your network structure, right? So when you look at a pier now that's, I guess, ripping up the entire hub and spoke concept of intermodal, I know, Alan you mentioned closing some lanes, but does it kind of structurally change how you think about even the yards themselves?
So what happens is after the clean sheeting is done, then you're able to put the train plan network in a more optimal fashion where you get the benefits of what you've done with Clean Sheeting. Does that answer your question?
Yes. No, I appreciate the time. Thanks guys.
Our next question is from the line of David Vernon with Bernstein. Please proceed with your question.
Hey, good morning guys. It would be great to get a sense for one of
the tenants your plan here is that you're going to be integrating some of
the other segments into the merchandise network. I'm assuming you're talking about intermodal and merchandise. Exactly how separate have those networks been running to date? And when do you and can you give us some sense of how much of the networks are actually going to be integrated?
Yes. So our multi level and intermodal networks have pretty much been integrated for several years. And Alan noted the productivity we've got out of those. So those have kind of been integrated. Merchandise has been optimized and developed on its own.
And then the bulk networks kind of been its mainly its own separate network. So those are the 3 separate networks. We have done some integrating different parts of that, but not at the level that we're looking at for the next operating plan.
And I guess as you start to kind
of think about putting that premium traffic in with some of the carload traffic, is that going to have an impact, do you think, on the services that you're actually able to offer to the marketplace as opposed to having 1, 2, 3 day a week service? Are you going to be able to offer a broader set of service as well kind of going down as we move through the next couple of years?
Yes, absolutely. I mean, this is intended to make sure we actually provide more service to the customer. So yes, that's what we expect.
The frequency of service certainly can increase under this new operating plan, we believe. Our goal, as I said earlier, is to achieve this with a minimum of network disruption. That doesn't mean service won't change to some customers, however. It will, it will. There will be different service parameters in some cases.
Our goal is to provide a more consistent lower cost service product.
I guess just within your markets, Jim, right, obviously in the eastern part of the United States, I would imagine that getting to a more frequent more frequencies on a day a week basis would give you a significant advantage relative to truck. Is that right? Or am I thinking about that wrong?
Yes, that is true. And that also can result in cost reduction because of the increased velocity of the network.
Excellent. Thank you.
Next question is from the line of Brian Ossenbeck with JPMorgan. Please proceed with your questions.
Hey, good morning. Thanks for taking the question. Maybe just go to Alan on domestic coal. You mentioned in his slides in the prepared remarks there's some increasing demand utility coal. Can you give us a sense of where the stockpiles are?
What the winter setup looks like from a network and equipment perspective? And then just any sort of outlook with natural gas here cracking above $3 for the first time in a long time?
Hey, good morning, Brian. Stockpiles have largely declined over the last year. In the North, they're at about 50 days. They declined about 30 days in the last 12 months. And in the South, they're about 65, 66 days.
We estimate they've declined about 22 days within the last year. And so you see that setup for increase in demand for our services in the Q4 and in the Q1 of next year. Obviously, with natural gas prices closer to $3.25 or $3.20 that helps too, because as you noted, that's up about $0.22 per million BTU is where it was this time last year.
Okay, got it. And then on the export side, I know you gave some color on that already, but was there any impact from the hurricanes as they came through the network? I know you don't really have any storage capacity at Lambert's Point, but is there any sort of catch up that you would expect to hit the Q4?
We had a force majeure within our coalfields for about 3 days earlier this month as a result of the hurricanes. And so you'll see a little bit of catch up associated with that. We also did some maintenance at our Lambert's Point facility as well. So we fully expect that assuming good production that export volumes will ramp up sequentially week over week as the quarter progresses.
Okay. Thanks, I appreciate it.
Our final question is from the line of Matt Russell with Goldman Sachs. Please proceed with your questions.
Yes, thanks for taking my questions here. Just first on the PSR initiatives, can you differentiate how much of this is an opportunity for you to just improve your own results, how well you run your business versus how much of this is something that you need to do to bring down the cost structure to fend off competition as the trucking market eventually does recover and as your peer in the East has brought down its own cost structure?
We believe that by implementing best practices developed from within, developed with our customers in a consultative process, developed with our supply chain partners and including PSR practices can lead to both a better and more consistent service product and a lower cost structure.
Got it. Okay. And then just quickly on crude, seeing a nice pickup there. Are most of those barrels coming in from Canada? Or are you seeing any split between the Canadian mix versus the Bakken mix?
And if you have contracts or you're part of the contracts tied to those barrels?
Yes, Matt. Most of our increase in crude oil volume is the Western Canadian Select, which is I'm sure you're aware is very much in the money. There's a great arbitrage opportunity on the East Coast for that. So that's where we're seeing the volume growth. We expect it to continue in the Q4 and continue well into 2019.
So we're optimistic about our volume outlook for the remainder of this year, whether it's in coal or intermodal or merchandise, and we expect that to continue in 2019, both for demand for our product and our ability to price.
Great. Thanks very much.
Thank you. At this time, I will turn the floor back to Jim Squires for his closing remarks.
Thank you, everyone, for your questions today. We are excited about the momentum we have. We intend to deliver on our promises in the future as we have in the past. We look forward to announcing new financial targets at our Investor Day in February and showing you the path we will take to get there. Thank you very much.
This will conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.