Greetings, and welcome to the Norfolk Southern Third Quarter 2017 Earnings Conference Call. At this time, all participants are 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.
Thank you, Mr. Moore. You may begin.
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 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 Q3 2017 earnings call. Joining me today are Alan Shaw, Chief Marketing Officer Mike Wheeler, Chief Operating Officer and Cindy Earhart, Chief Financial Officer. It is with great pleasure that I introduce Cindy to our quarterly calls. She brings a strong diverse background to this role. I look forward to her contributions as we continue to execute our strategies centered on safety, service, stewardship and growth.
Highlighting our Q3 results on slide 4, net income was 506000000 and earnings per share increased 13% to $1.75 Our 3rd quarter operating ratio decreased by 160 basis points to an all time quarterly record of 65.9. Our 3rd quarter results are an extension of the performance delivered throughout the year, resulting in a record 67.4 operating ratio and record earnings per share of $4.93 for the 9 month period. These results demonstrate the successful execution of our proactive strategies and initiatives. Our continual focus on delivering results through cost saving efforts, efficiencies and asset utilization have us on track to deliver productivity savings of over 100,000,000 17. The unrelenting focus and resolve of our employees on delivering upon the goals we set out in our strategic plan is evident in our achievements to date.
As shown on slide 5, for 7 consecutive quarters, we have lowered the operating ratio on a year over year basis. We continue to make demonstrable progress toward achieving a sub-sixty 5 operating ratio. Our team remains committed to ongoing productivity initiatives and the pursuit of additional opportunities for improvement. And through these efforts, I am confident that we will reach that goal by 2020 or sooner. We remain focused on both resource utilization and growth as we continue to successfully execute our multidimensional strategy.
Our 3rd quarter volumes increased by 4%, while average headcount was reduced by 4% versus last year's levels. We are resolute in our commitment to deliver a quality service product that our customers value and will provide opportunities for growth. Now, Alan will provide a marketing overview, Mike will detail our operational performance, and Cindy will summarize our financial results. Then we'll take your questions. With that, I'll now turn the program over to Alan.
Thank you, Jim, and good morning, everyone. Our Q3 2017 revenue growth in all three business units reflects the strength and sustainability of our strategic plan. Total revenue for the quarter was up 6% versus 2016, driven by a combination of volume gains in intermodal, coal and steel and increased pricing. Merchandise volume was down slightly in the 3rd quarter as gains in steel, sand and fertilizers were more than offset by lower automotive shipments S. Vehicle production declines and reduced crude oil shipments.
Overall, merchandise revenue was up 3% this quarter as negotiated price increases outpaced volume losses. Intermodal revenue increased $46,000,000 or 8% versus the same period in 2016, resulting from highway conversions, organic growth with our existing customers and new service offerings. Intermodal achieved record volume for the 2nd consecutive quarter as total units once again topped the 1,000,000 unit mark. Our intermodal growth in the 3rd quarter is the result of our market approach, which aligns our service product with the needs of our customers, enhancing their ability to grow while positioning Norfolk Southern as an integral part of their supply chain. Coal posted year over year revenue and volume growth, primarily due to increased export coal volume and pricing.
Coal RPU was up 1% due to the impact of pricing gains that were partially offset by negative mix. Higher growth rates and lower rated export steam negatively impacted RPU despite improved pricing in our export markets. Utility volume decreased as mild weather caused an approximate 15% year over year decline in overall coal burn at Eastern Utilities. Turning to Slide 8, we look ahead to the remainder of the year with confidence based on current economic trends. In merchandise, we expect low single digit growth in the Q4.
Industrial production is likely to drive demand in steel, while growth in construction will positively impact our aggregate volume. Further, we expect increased drilling activity in the Marcellus Utica region will continue to drive growth in frac sand. These increases will be offset by declines in automotive and by lower crude oil, which is adversely impacted by pipeline activity. Intermodal expectations remain strong as tight trucking capacity should be further impacted by the ELD implementation in December. We continue to enhance our service offerings, providing growth opportunities with our customers to further drive revenue, volume and shareholder value.
In coal, we expect 4th quarter utility volume to be in the range of 15,000,000 to 17,000,000 tons impacted by the mild summer weather. Export tonnage should continue to exceed last year's with volume in the range of 5000000 to 6000000 tons. We remain focused on pricing in all of our markets. Current indicators point to higher levels of demand and tighter truck capacity for the remainder of the year, continuing into 2018. Such an environment increases our value in the marketplace and we are confident that improvement will be reflected in our pricing.
Moving to Slide 9, our market approach and current opportunities are consistent with our strategic plan, offering a balance of safety, service, productivity and growth to drive shareholder value. To execute this plan, we deliver customer centric service product that adapts to the needs of our customers, while providing an environment in which it is easy to do business. Our customer centric service product first focuses on tailoring the right service to our customers. We collaborate with our customers to develop the best product that is beneficial to both our shareholders and customers. We pay close attention to customer feedback and continue to make adjustments to meet their needs, viewing our product through the lens of our customers.
Our goal is to enhance the competitiveness of our customers in an evolving marketplace, allowing them to quickly adapt and compete for growth, increasing revenue to Norfolk Southern, while strengthening our role in their supply chain. Lastly, we employ best in class industrial development team to help customers locate or expand on our lines, providing a future pipeline for growth. The continuity of our management team, operating philosophy and long standing customer relationships, combined with improving the customer experience and product is the overarching theme of our growth initiatives. We are confident this approach differentiates our service product, allows us to compete with truck and will continue to provide the revenue and volume growth and shareholder value we delivered this quarter. Thank you.
And now I'll turn it over to Mike for an update on operations.
Thank you, Alan, and good morning. Our service levels are delivering growth consistent with our strategic plan. As shown on Slide 11, there were significant milestones achieved in the quarter as well as the 1st 3 quarters of the year. Our achievements in reducing train accidents combined with our improvements in train length, locomotive productivity and fuel efficiency all help to drive our record operating ratio. Turning to the key drivers of our success on Slide 12.
The safety of our employees and the communities we serve continues to be our top priority. Our reportable and serious injury ratios are stable and we are on pace to achieve our lowest train accident frequency on record. For service, we achieved sequential improvement in our network performance metrics. Specifically, our service composite metric is back near 80%, which points to resiliency in our operation. This is particularly notable given volume was up sequentially while we also successfully controlled costs.
Our current service levels are allowing us to not only take on short term opportunities, but also positions us to have more impactful discussions with our customers concerning long term opportunities. Moving to some of our key productivity initiatives on Slide 13, we are driving improvement in all areas. Our continued rationalization of our yard and local fleets has resulted in significant improvements in our locomotive productivity. The 3rd quarter was the highest quarter of locomotive productivity in our company's and we are on pace to beat last year's record performance. Not only do these improvements result in lower maintenance costs, they also enhance our fuel efficiency, which improved 4% in the quarter and was an all time quarterly record.
As you may recall, 2016 was a record year for this measure and we are on track to set a new record this year. These measures have been driven by optimizing our train plan and our improvements in train links, which is something we must balance with service. As you may recall, 2016 was a record year for this measure and we are on track to set a new record for the full year. In closing, we are confident we will continue to provide a level of service to our customers that will grow our business while at the same time driving sustainable productivity savings and superior returns for shareholders. We are proud of our accomplishments and continue to identify opportunities to drive additional efficiencies for the benefit of NS shareholders.
I will now turn it over to Cindy, who will cover our financial achievements.
Thank you, Mike. Good morning, everyone. As Mike and Alan have discussed, we continue to execute on our long term strategy and the operating results for the 3rd quarter show we are 1, reducing costs 2, driving productivity and 3, growing the company. On Slide 15, you'll see we delivered a record quarterly operating ratio of 65.9, a 160 basis point improvement over Q3 2016. We accomplished this by growing revenues 6%, as Alan described, while holding expenses to a 3% increase resulting in an 11% rise in income from railway operations.
Now turning to the component changes and operating expenses on Slide 16. In total, operating expenses were higher by $55,000,000 or 3%, notwithstanding the 4% increase in volume. Improved productivity helped to offset higher inflation. The area of largest variance in the quarter, compensation and benefits rose by $64,000,000 or 9% year over year. There are 2 primary reasons for the increase.
1st, improved operating results led to an increase in incentive compensation of $47,000,000 over the Q3 2016. And second, inflationary increases continue at a quarterly run rate of about $30,000,000 which is higher than historical inflation. As discussed in previous quarters, the increase is primarily due to the large increase in premiums on union medical plans. Partially offsetting these items were reduced employee levels, which saved $26,000,000 Headcount was about 1100 employees lower than the Q3 of 2016 and down over 300 sequentially. Year over year, we are handling more shipments with fewer people.
We expect to enter 2018 with some employment levels flat to slightly higher than where we are now as we hire and train T and D employees ahead of the 2018 peak demand months in summer and fall. Fuel expense rose $17,000,000 entirely attributable to higher prices, which added $20,000,000 The average price per gallon for locomotive fuel was $1.70 this year versus $1.51 in the Q3 of 2016. Sustained improvements in fuel efficiency resulted in 2% fewer gallons consumed on 4% more volume. As Mike mentioned, we posted record fuel efficiency metrics and we expect our ongoing initiatives to further increase train links and reduce fuel consumption to support continued improvement. Purchased services and rents decreased $9,000,000 or 2% year over year.
Equipment rents decreased by $6,000,000 due to lower automotive traffic and improved equipment utilization. The materials and other category decreased 24,000,000 or 13% year over year. Lower equipment and roadway material usage drove over half of the decrease. As we've reduced the locomotive fleet in service, locomotive repair costs have decreased. 3rd quarter 2017 also included $9,000,000 more from gains in the sale of operating properties.
Moving to Slide 17, which shows the full income statement. You can see the strong operating results fell to the bottom line producing net income of $506,000,000 up 10% compared with 2016. And diluted earnings per share were $1.75 a 13% improvement. Wrapping up our financial overview on Slide 18. We continue to return value to our shareholders through dividends and share repurchases.
Free cash flow was $1,200,000,000 for the 1st 9 months and over $1,200,000,000 has been returned to shareholders. As we announced last month, the Board increased our share repurchase authority by 50,000,000 shares and extended the program through 2022. Our financial results for the quarter demonstrate our continued focus on cost reduction, productivity and growth. Thanks for your attention, and I'll turn the call back to Jim for closing remarks.
Thank you, Cindy. As we head toward the end of 2017, we remain as committed and energized as we were at the onset of our plan to deliver sustainable changes that will improve bottom line results for shareholders. Our plan is dynamic and flexible and provides an adaptive platform that will be the foundation of success for our employees, customers and shareholders. We have consistently delivered strong performance and we are confident in our ability to achieve further improvements and reach our objectives that will drive shareholder value. With that, we'll now open the line for Q and A.
Operator?
Thank you. We'll now be conducting a question and answer Our first question will be coming from the line of Allison Landry with Credit Suisse. Please proceed with your question.
Thanks. Good morning. I was wondering if you could speak to your view on the tightness in the truck market and how you think that could help results in 2018 from both a volume perspective and a price perspective? And then sort of along the same lines, in terms of potential share gains from CSX. Could you elaborate or provide some color on what you think you received from them and how much you would expect to keep or give back?
Thanks.
Well, let's take the truck capacity question first. It certainly is an encouraging environment. We are seeing truck capacity tight and getting tighter. Alan, why don't you provide some specifics?
Yes. Allison, as you know, we've clearly stated that our primary form of competition is truck. And within the East, we have a unique opportunity to divert shipments away from the highway to rail, obviously, within intermodal container, but also within a boxcar, a GON and within a multi level. And as truck capacity tightens and that's the narrative that we hear from our customers on a daily basis, that has volume up implications for us and importantly it has pricing implications. I think certainly I think we're seeing some of that volume matriculate to us now and the pricing will continue into 2018 as our customers and we go through bid season.
With respect to share gains, once again, our primary form of competition is truck. We are going to put out a very dependable service product and a very consistent approach. We feel like our customers value that approach. And so that has been reflected in our volumes and in our revenue.
Okay, great. And just a follow-up, as you think about just sort of the whole pricing umbrella, are you seeing an underlying acceleration in your core pricing growth, whether I guess compared to the Q2?
As we're renegotiating contracts in the Q3, we've seen more strength, particularly on the truck competitive business, as you would expect.
Okay. Excellent. Thank you.
Our next question comes from the line of Chris Wetherbee with Citigroup. Please proceed with your question.
Hey, thanks. Good morning, guys. I wanted to talk a little bit about sort of operating leverage as we think forward and sort of along the lines of the last question, you see it seems like there's an opportunity for both price as well as volume as you move into next year as the truck market is beginning to tighten up. You put together good incremental margins in the Q3. Just want to get a rough sense of maybe how you think about sort of that cadence as we go forward with the productivity initiatives you have and sort of
the pricing, if you put it all together into Mosaic, how you think
about that over the next several quarters? If you put it all together into Mosaic, how you think about that over the next several quarters?
Good morning, Chris. Yes, we have seen a nice trend in operating leverage and incremental margin thus far this year. Looking out, the cadence will depend to some extent on the mix of volume growth we experienced. Cindy, maybe you could address that a little bit further.
Yes, sure. Hi, Chris. As Jim said, we've seen good incremental margins and I think we expect to see those going forward. Just to remind you, I think we've talked about this before is that we see sort of a hierarchy in terms of incremental margins in our business. The highest, of course, is merchandise, followed by coal and then intermodal.
So it really will be dependent upon where we see the incremental growth going forward.
Okay. But the setup that we have in terms of what's sort of working in sort of a tighter truck market, doesn't lead you one way or another when you think about that?
Well, as Alan said, we do see the opportunity from a tightening truck market, not only in our intermodal franchise, but in general merchandise as well. And there we do have significant incremental margin opportunity. In addition to the extent we are able to price into a tightening truck market, that too should support incremental margin going forward.
Okay. That's helpful. And just a quick follow-up on headcount. I just wanted to make sure I was clear on sort of how you think about the progress in both Q4 and then maybe going forward. It sounds like there's some incremental heads maybe coming to get advance of some peak business in 2018, but I just want to make sure I understood the cadence of that.
Thank you.
Cindy, why don't you take that one?
Yes. So Chris, we certainly we've seen good headcount reductions. Our year over year headcount is down about 1100. I did mention in my prepared remarks that we expect headcount in the Q4 to be flat or slightly up and that's really all dependent on our T and E hiring. We are hiring kind of ahead of our peak demand months in the summer and fall going in 'eighteen.
So that's where you're seeing the increases.
Perfect. Thank you very much.
Our next question is from the line of Tom Wadewitz with UBS. Please proceed with your question.
Yes. Morning and congratulations on the strong results. Let's see, I wanted to ask you about pipeline on productivity and just how we might think of drivers of margin expansion if you look out into 2018. So I think you've had a number of structural cost reductions that you put in place over the last few years and you're putting up nice incremental margins and further productivity gains. How do you think, Jim or Mike, about about what's in the pipeline going into next year in terms of structural cost takeout or just what would support operating leverage and margin expansion next year?
Good morning, Tom. Productivity certainly has been a key driver of financial improvements this year and last and we expect that to to continue. We've made a lot of progress in a couple of key areas already. We kicked off some of the records that we achieved in the Q3 as part of Mike's presentation. And yes, there are many additional productivity opportunities in the pipeline.
Mike, why don't you comment on that?
Yes. Okay. So I would just note that there are some things that are going to run through 2018 that we initiated this year, the reduction or the idling of 1 of our terminals earlier this year. The 100 and 50 locomotives we've taken out of service, that was a first half thing that we'll run through all of next year. And then the division consolidation we told you about before actually goes into effect next week.
So a lot of those things will run through full year next year. But we continue to take a look at optimizing the train plan and as you saw that we had 4% more volume out there, but we reduced crew starts by 2%. So we handled 4% more volume with 2% less crews. So that's optimizing our train plan and train length. So we continue to take a look at how we can take costs out of the railroad.
It may not necessarily be a big terminal or anything like that, but it's taking costs across the railroad or anything like that, but it's taking costs across the railroad out of the network, but still making sure that we're able to provide the service that our customers are looking for. So we've got a lot of initiatives going on, more to come and we balance that with service, but we're not letting up.
Okay, that's helpful. Maybe just a follow-up on that. So if you look at 2018, what do you think will be the bigger driver of margin expansion? Would it be volume growth, the net supporting operating leverage, longer trains and so forth? Or do you think a bigger opportunity is for more of the kind of pure cost or productivity, whether that's facility rationalization, changing the train plan, however you would frame it?
Tom, ours is a balanced plan. It's balanced, it's dynamic and it's flexible as well. And that's why we've been able to consistently deliver strong performance. So our expectation looking into 2018 and beyond is that we will continue to deliver bottom line improvements through a combination of growth and productivity.
Okay, great. Thank you for the time.
Thank you. Our next question is from the line of Ravi Shanker with Morgan Stanley. Please proceed with your question.
Thanks. Good morning, everyone. Jim, we saw headlines a couple of weeks ago about the various labor unions coming together to come up with an agreement with the Class 1 rails, which is pending ratification from the rank and file. I was wondering if you had any initial thoughts on how that
representing about 60% of our employees. It is out for ratification and we'll await the results of ratification before commenting further on the agreement.
Okay. And just as a follow-up, I'm sorry if I missed it, but did you quantify any impact from the hurricane in the Q3? And also given that you mentioned that your primary competition is truck, How much customer overlap do you really have with your Eastern partner in that if you have customers who are unhappy with their service, they could look to you as a long term alternative? Thanks.
We did not quantify any additional expenses as a result of the hurricanes in the Q3. Alan, why don't you comment on the landscape, the competitive landscape?
Yes. Our primary form of competition is truck, Ravi. We do share some customers with CSX. And as I suggested, we're offering a differentiated service product and a long term approach of a balance between cost effectiveness and supporting our customers' growth. And so to the extent the customers are looking for a dependable service provider, we're there.
Our primary focus is on securing business from the highway, and we see that spot rates are up 15% in trucking and drive in over the last couple of months and are up about 25% year over year. That's also buttressed by an improving economy in which consumer confidence and the PMI for new manufacturing are at effectively 13 year highs. So that's our focus is on competing with truck. That's been our thesis. That's the opportunity provided to us by operating in the East and that's where we're going to see a lot of
growth. Great. Thank you.
Our next question is from the line of Jason Plaidall with Cowen. Please proceed with your question.
Thank you, operator. Hey, guys. I want to just focus on freight that you might have won from your Easter competitor due to their service issues in the quarter. It seems like whatever you did take on didn't negatively disrupt your network and you kept your service levels high. Could you talk a little bit about the thought process of taking on that freight and how likely it is that you're going to retain it?
Sure. I would emphasize that our goal is to grow while pushing hard on productivity as well. So, we believe we have an excellent service product in the marketplace that allows us to compete with truck and rail. Alan, talk a little bit about the specifics on in terms of market share, rail market share in the quarter.
Yes, Art. Jason, as we've talked before, there's a lot of collaboration within Norfolk Southern about volume opportunities. And our primary focus was on making sure that any volume we brought on was accretive to the bottom line and to our shareholders and did not disrupt the responsibility that we have to our existing customer base to provide a consistent and predictable service product. And so that's how we went into this. We could be judicious with the unit trains that we added and we look for opportunities to add trains into our scheduled merchandise network and within intermodal.
We also made sure that anything we brought on in the short term did not necessarily reduce our ability to handle additional business at higher returns in the long term.
Okay. That's some good color. And I guess my next question is going to be on the incentive comp. Obviously, it was a little bit higher than I expected. It was actually higher than you saw an increase last year in Q3.
What should we look for incentive comp in 4Q?
Hi, Jason. This is Cindy.
Hey, Cindy.
Yes, you did notice we talked about in the prepared remarks that incentive comp was up $47,000,000 year over year. And maybe just a little bit of context. If you think back to 2015, we had a 0 bonus. Then going into 2016, we had a we did have a bonus, but it was a lower level of bonus. And then this year, really based on improving business results, you've seen the incentives comp go up.
So when we think about 4th quarter, the expectation was you would see a similar year over year increase in incentive comp in the 4th quarter.
Our next question is from the line of Amit Mehrotra with Deutsche Bank. Please proceed
with your question. Thanks. Congrats on the good results. I wanted to ask if you could just offer some thoughts on growth. I guess relative to the underlying market, there's obviously some idiosyncratic things happening, whether it's market share opportunities, truckload capacity tightening, pricing.
So against that backdrop, just wanted to try to get a sense of your thinking about volume growth, revenue growth actually potential relative to the actual underlying markets that you're serving? Thanks so much.
Balance is really the key. We are aiming to grow, but while achieving ever improving productivity as well. So Alan, why don't you talk a little bit about the major verticals and our growth expectations there as outlined in our current long range plan?
Sure. Amit, we're pretty excited about the environment in which we're operating right now. We see truck capacity tightening significantly, buttressed by an improving economy, which should certainly assist our intermodal markets. It will also assist many of our merchandise markets as we implement and continue to implement our plan of a strong service foundation, schedules that meet our customers' needs, an equipment strategy that supports growth, technology improvements that optimize the distribution of the equipment and make it easier to do business with us. All of that is part of our strategic plan.
It's all designed to compete with truck. And so those are positives for us. As I look into the Q4, I'll draw your attention to export. We're still projecting 5,000,000 to 6,000,000 tons of export coal. Recognize last year, the 4th quarter was our highest export coal quarter.
I think through 3 quarters, we did about last year, we did about 10,000,000 tons of coal export and in the Q4, we did 4,600,000. So the comps get a little bit more difficult. We also had a much milder summer in the East and the start to the fall has been mild. And so I think we're going to be somewhat limited in our utility volume in the Q4.
Okay. That's helpful. And just one follow-up for me if I could. And it's really a question about CapEx and cash deployment. The CapEx requirements of the business and really the industry, I guess, are kind of staying where they are today or if not going maybe a bit lower over the foreseeable future.
Some companies, some of your peers in the U. S. At least have committed to maybe more ambitious share repurchase activity. I wonder if you could talk about that. You've chosen to pay down some debt.
I just wanted to see if maybe we should expect a little bit more of a pivot on the cash deployment side towards more of what some of your peers are doing. Thanks.
In terms of capital allocation, generally, our approach is very disciplined. We are putting the money back into the business that we need to, to reinvest in the business to keep our service strong. In terms of shareholder distributions, we're targeting a 1 third payout ratio with incremental free cash flow going toward share buybacks. Cindy, talk about the change that we made in the buyback program recently and our expectations for shareholder distributions for the whole
year. So we did announce the Board approved $50,000,000 more in share repurchases through 20 22. In terms of the share repurchases, we also increased that this year. We started out guiding at about $800,000,000 repurchases and we're at $1,000,000,000 And so going forward, as Jim said, we have a very disciplined approach to cash deployment. We'll invest back in the business.
Our plans are to distribute back to shareholders via dividends and over the long term get to about a 33% dividend payout ratio and then use remaining cash to have share repurchases. So that's our strategy going forward and I think that's been our approach all along.
Okay. All right. That's very clear, guys. Thanks so much for taking the questions. Appreciate it.
Our next question comes from the line of Matt Troy with Wells Fargo. Please proceed with your question.
Yes, good morning. Just wanted to get a split. You talked about 4% volume growth in intermodal. I was wondering if you could provide some detail as to what the growth rates were in domestic versus international? Yes, Matt,
ports that we served were impacted by the hurricanes. And so that was somewhat of a drag. And then domestic was up about 7%, 7.5%.
Okay. And is it fair to think, given all the talk and anticipation about capacity issues in trucking, in a better pricing environment potentially emerging next year. Is the biggest bite of the apple when we should think about the cadence of pricing improvement in intermodal? Is it still should we still be kind of bogan the 2nd quarters where you really get that biggest bite or is it more spread out now?
Well, that's that is certainly when bid season typically occurs for our customers. We've already negotiated 85% of the revenue for this year. We've already negotiated about 54% of the revenue for next year. So it does, Matt, as you noted, it is tied to the bid season for our customers and it's also tied to the contract renewals that we have.
Okay. And my one quick follow-up would be, I know you don't guide to core pricing, but it sounds like it's going to be a better year next year. Can you just give us your expectations for rail inflation in 20 18? Thank
you. Right now, all inclusive less fuel is at 1.9% for next year.
Great. Thank you.
Our next question comes from the line of Brandon Oglenski with Barclays. Please proceed with your question.
Hey, good morning, everyone, and thanks for taking my question. And congrats to Jim and team. It's not awesome that your OR is beating the competition here. But Jim, I want to ask along those lines. I mean, we've seen a lot of volatility in your company's earnings in the past, especially with swings in export coal.
Obviously, that market can shut off and turn on very quickly. But it sounds like you're planning for a higher labor cost outlook, higher headcount next year, if I'm not mistaken by the comments you've made. So how could you mitigate the risk that maybe that market turns off quickly? What can be done on the cost structure that would keep the OR trajectory heading lower?
The plan is dynamic and flexible and that's really been the hallmark of our execution over the last couple of years. As you've seen business ebb and flow, we have been able to make adjustments and to react to changes in the marketplace. And that's what we'll continue to do. We will continue to drive hard on productivity and growth wherever growth is available. If market conditions change, we will again adapt and be flexible.
Okay. And I hate to nitpick on the call, but Cindy, it looks like your other cost line came in at about $40,000,000 And if I go back the last few quarters, you've been running, let's call it, somewhere between $75,000,000 $80,000,000 I know that you called out $9,000,000 in land sale gains, but was there something else that favorably impacted the quarter? Or is that the new run rate that we should be looking at going forward?
Yes. Brandon, as you said, I did call out $9,000,000 increase year over year in the on sale of operating properties. And obviously, those things change from quarter to quarter. It's hard to predict when you're going to have gains. In terms of the large number of gains from year over year in Q3, I think we talked about Q3 of 2016, I think we talked about around $28,000,000 worth of large gains.
In this quarter, in 2017, we had about $38,000,000 worth of large gains. So that has some impact. That's probably the biggest thing. And again, it's hard to predict from quarter to quarter.
Okay. That's actually very helpful. Thank you.
Our next question is from the line of Ken Hoexter with Merrill Lynch. Please proceed with your question.
Great. Good morning. Jim, I guess, 3rd quarter is typically your best operating ratio. And looking at the cost strides you've made, do you need to overhaul ops like Hunter suggests to get down to the 60% range? Or can you keep doing the blocking and tackling as you've been doing to get to this point to get that progress?
And maybe talk about the is that a realistic progress for your network to get to over a longer term? I know 65% is your near term one. And then just your thoughts on the $100,000,000 productivity. You mentioned you beat the target. I guess maybe thoughts on the potential of scale as you move forward this year?
Sure. Good morning, Ken. So let me begin by emphasizing that we've been making significant progress on our long term objectives and achieving and exceeding our goals. So you saw in the Q3, the 7th consecutive quarter of year over year operating ratio improvement. And that gives us confidence that we're going to be we'll continue to drive the operating ratio and the bottom line.
And that we'll get to that sub-sixty 5 OR by 2020 or sooner. In terms of productivity, we've said that we expect at least $100,000,000 this year. Right now, we think that will probably be closer to $150,000,000 for the full year.
Great. And is there have you set a scale for next year yet or is that still just part of the $650,000,000 total?
Well, I can tell you this. We have the pedal to the metal. We are pushing as hard as we possibly can on all aspects of our strategic plan and we certainly expect to achieve significant additional productivity savings next year and beyond.
And then just a quick one, I guess Cindy, long term debt went up, rates are climbing, but interest expense went down sequentially. Was there anything in that number that altered that interest expense
savings? Ken, I would say that there was not really anything that would impact that. We did do a payoff of higher rated debt in the quarter. So that did impact it.
But yet your long term debt went up sequentially. I guess I could talk to you offline. It just seemed like your long term debt went up sequentially.
Well, you're seeing older debt at a higher rate roll off and be replaced by new debt at a lower coupon.
Yes. As part of the exchange, Ken, we exchanged about $550,000,000 $750,000,000 worth of debt.
Okay. Thanks for clarifying. Appreciate it. Thanks for the time. Thanks for the insight.
Thank you. Our next question is from the line of Scott Group with Wolfe Research. Please proceed with your questions.
Hey, thanks. Good morning, everyone. So, wanted to just kind of revisit the headcount and just more broadly the productivity discussion. So obviously nice spread between volume growth and headcount this quarter, but we are seeing service issues when we just look at train speeds lower year over year. Do you think are we kind of at the point where we can't cut headcount and can't cut locomotives anymore and it's more just about leverage from volume or is that not the message?
And then if we are sort of at that point where we're seeing some service issues, do you focus more on price than volume next year? I know you're going to say you're going to focus on both, but if you had to kind of prioritize price versus volume next year, how would you answer that?
Okay. Let's talk about service before and I'll comment generally and then Cindy can go back over our expectations for headcount this year. And then Mike, maybe you can weigh in on kind of the resource balance. With respect to service, we are steadfast in our commitment to deliver quality service that our customers value. That's key to the value proposition.
For the Q3 as a whole, we saw network performance rebound back to 1st quarter levels and roughly target composite service metric levels. And in that context, we were able to grow volume and the top line and while providing a high level service product to our customers. So that's the paradigm. That's what we will be looking to do going forward. Now Mike, why don't you start and talk a little bit about the resource balance and then Cindy will come back in and talk about where we expect headcount to go.
Yes. So it's not like we don't have opportunities out there as we continue to look at the network and see what business grows on the network where we can optimize the costs. We still have resources available to us locomotives. We have about almost 400 units stored and available to help us handle growth. But it doesn't mean we're not looking at finding ways to reduce the cost structure of the railroad long term.
A lot of initiatives going on. Already talked about the ones we've done this year that are roll through. We're not giving up on any of that, but I'll say that we also make sure that we've got to have a good service product. And Jim noted, it did improve sequentially over the quarter and you noted some increases in fuel and train speed. I would just point out that we the end of the Q3 is we had several hurricanes that hit our partners on the west and as well as 2 of them that impacted us and we held some traffic in our terminals for that till our customers got back up to speed or our partners got back up to speed.
But really no damage to our railroad and we rebounded quickly. So that's kind of what you're seeing. So we feel comfortable about where we're going on further cost reductions, but still making sure that we are taking care of the service.
Now with regard to headcount specifically, Cindy did state that we expect headcount to be flat to up slightly at the end of this year versus today. But there's a specific reason for that. So Cindy, go over the training cycle and the onboarding process.
Sure. As I said, the flat to slightly up was really completely dependent upon hiring ahead of what we see peak demand season for crews in the summer and the fall of 2018. As you know, the cycle to hire and train and have those folks available takes several months to get that done. So that's really what's driving the headcount. As I said before, 1100 folks down quarter over quarter.
That's really across the company in all areas. And productivity is extremely important to us and we're going to be pushing on that again in all areas. And we look very closely at T and E And you'll note that I think our volumes are up year to date about 5% and we've really held the T and E headcount pretty flat throughout the year. So it's something that we look very, very closely at.
Yes. And that bump up is in the neighborhood of maybe 200 more employees for the next quarter or so until we get them ready to go out here. So it's slightly up and it's by design.
So that's helpful. I don't know, Alan, if you addressed kind of that price versus volume prioritization point. And then just to clarify on the headcount. I think earlier in the year, you said, hey, we may need to add some T and E, but there's still non T and E that we can reduce. Are we running out of that non T and E to reduce?
Well, I'll take that one. Look, the focus is on all areas of headcount as Cindy said. We are looking at all aspects of employment and staffing and looking for reductions and have achieved reductions across the board. Now with regard to your price versus volume question, it really isn't a question of price versus volume. It is both and we are looking to achieve both volume growth and price increases commensurate with the service product we have out in the marketplace.
Okay. And then if I can just ask one more. Alan, so you talked about some of the weather issues in coal. Any way to give a preliminary view on export and then domestic coal for next year? Meaning, do you think the run rates that you talked about for Q4 are sustainable into 2018 or do we need to reset those lower for 2018?
For export coal, what we're hearing, Scott, is that, that market has legs through potentially through the first half of next year. A lot of the run up in price has been event driven, which isn't necessarily good, but I think it also supports the theory that the market out there for export coal is fairly tight. Although I can paint the other picture, as you're aware API2 is backwardated right now. So that suggests it's going down. The best I can do, Scott, is kind of tell you what we're hearing, which I just did, and then point you towards the economic metrics that we're looking at or indicators that we're looking at.
With respect to utility coal, that's going to be highly dependent upon the weather. Natural gas prices are pretty similar to where they were at this time. Last year stockpiles are down slightly versus last year. I think they were down about well, they're at like 79 days. They're off about 22 days from the high, which was May of 2016.
And really what happens in the Q1 and Q2 next year is going to be dependent upon weather patterns in the East in the winter. Does that make sense?
Yes, no, it does. Thank you, guys.
Our next question is from the line of Justin Long with Stephens. Please proceed with your question.
Thanks and good morning. Alan, I think you mentioned a little over half of your revenue for 2018 is negotiated at this point. Given that visibility, could you just talk high level about how the price increases for that business compared to the last pricing upcycle that we saw. I'm just curious if you could provide some perspective on how the pricing environment next year could compare to the acceleration we saw in 2014 2015?
Sure. So Justin, the as I think I noted the contracts that we renegotiated in the Q3 generally had a higher level of increase than what we were able to secure in the second quarter. So that's a positive for us. I'll note that one of the things that really supported year over year rate increases this year within coal was the export market, and we certainly don't expect that level of run up next year. As trucking firms, we've got a lot of business that's transactional and that is going to offer support for pricing.
Okay. But if you look at those non coal businesses and where pricing is coming for next year, I mean is that roughly in line with what you saw when things picked up in 2014 2015?
There was a lag there too, because the uptick was relatively sharp, certainly a lot sharper than folks had anticipated, generally in March of 2014. We might be a little bit ahead of it this year in terms of the outlook because the commentary about the tightening truck market has been out there for a bit, particularly associated around ELD. So we're certainly factoring that into our conversations with our customers and our bid approach. And frankly, on the last call, you
talked about roughly on the last call, you talked about roughly 50% to 60% of your revenue that's typically renegotiated each year. When you look at what's left or I guess that other call it 50% or so or a little under 50% for next year. Is there any color you can provide on the commodity breakdown of this revenue that's still left for renewal? I'm just curious if it's more weighted towards a specific business or commodity group?
Well, we've moved more towards shorter term pricing than export. So that has to be renegotiated. But once again, that's less than 3% of our overall volume. With intermodal, there are defined escalators, but there's also transactional business and that has offered support for us. I know that even this quarter, we had RPU growth in all 7 of our major groups, same thing we had in the 2nd quarter.
2nd quarter, I would say truck capacity was loose. 3rd quarter truck capacity tightened and we were able to continue that March.
Our next question is from the line of Brian Ossenbeck with JPMorgan. Please proceed with your questions.
Hi, good morning. So Alan, just wanted to see if you had thought through some of the contingencies that might need to be put in place if there was trade disruption with Mexico, given all the rhetoric and headlines of NAFTA? So can you give us a sense of how much volume in revenues for Norfolk are really tied to cross border trade?
Good morning, Brian. Let me say that we are certainly pro trade as a company and in an industry and in favor of trade regimes that promote cross border flows. Alan, comment specifically on scenarios for us.
Yes, Brian, it is a it's a very small component of our revenue. We have every intention of growing that and we're working on opportunities to put together products that would improve that. But it's something that we're monitoring very closely. There have been 4 negotiations so far and there are 3 more that are scheduled.
Right. And to clarify, small meaning less than 5%. Is there a threshold you would consider putting that below?
Yes.
Okay. And then one for Mike. You talked a lot about train lengths increasing them. You have obviously had a great run with that at this point. Are there you talk about balancing it with service.
Is there any point in the East specifically where you have to worry about longer trains potentially blocking some grade crossings or interfering with some commuter traffic or other traffic patterns you might cause some congestion in local communities because we are starting to hear a little bit of concern from the regulators just in the East region in general on that aspect in particular?
Yes. So on the train length, we go to great effort to make sure the train lengths don't impact grade crossing. We try to keep our grade crossings clear and make a big effort at that. So train link isn't really that much of an issue for us that it can be making sure that certain single track territories have enough capacity, but so far into the Q4, it continues to look good. So, you know, so far into the Q4, it continues to look good.
So we're very selective about what we do. We've got a lot of planning that goes into it. So to make sure that we don't break the problems that you're talking about because we're very mindful of those.
Okay. Well, thanks for the details. Appreciate it.
Our next question is from the line of Bascome Majors with Susquehanna. Please proceed with your question.
Thanks for taking my questions here. So I wanted to follow-up on a couple of earlier questions on what the tightening trucking market really means for Norfolk next year. And specifically, do your contractual obligations to your key domestic intermodal partners in the intermodal business there in the defined escalators that you mentioned in response to Justin's question give you the flexibility to push harder on intermodal pricing next year?
Bascome, I think the key is the opportunity for both us and our channel partners in a tightening truck environment. We have strong relationships with channel partners throughout the intermodal business and we expect to grow along with them. So we see it as a win win for Anas and its channel partners.
I mean, are you suggesting that it's really more about for you volume than pricing next year, just given some of the constraints in your contracts or is it an opportunity to dip more aggressively in both?
We see it as an opportunity to grow both volume and rate next year.
Thank you. And I just want to clarify one other comment that you made. You're talking about adding employees to get ahead of kind of the peak T and E training period in the spring summer. Are there any furloughed employees that could potentially be bought back at a lower cost and lead time compared to kind of the 6 to 9 month training of brand new employees that you've talked about in the past when headcount is getting a little tighter?
No, we've pretty much got all the furloughs back just maybe a handful less double digit, low double digits at best. So no, we don't have that out there. But we stay in close coordination with marketing as to what they see. And you talked about the 6 to 9 months, we spent a lot of time reducing that timeframe down also. So we do 2 things.
1, we feel like we can bring them back and get them or bring them on board and get them qualified quicker and we're pretty surgical about when we hire them so that they're available when we need them. So those are the two things that make us feel good about having the right T and E crew base ahead of when we need them.
Thank you for your time.
Our next question is from the line of Walter Spracklin with RBC Capital Markets. Please proceed with your question.
Hi. Good morning. This is Sunil Manas on for Walter Spracklin. Just wanted to circle back real quickly to CapEx. How should we be thinking of your CapEx here given the volume growth?
Specifically, like at what point could there be requirement for incremental CapEx to support the growth?
Well, we're
working on our capital plan for 2018 even as we speak. I will have more to say about that early next year. But I will say this, ours is a very disciplined approach to capital spending. We're looking to maximize returns on capital from our capital spending plan going forward. And that will include the usual categories of capital spending, both maintenance spending and growth spending.
And just a quick follow-up on the savings and the expectations initiatives you noted, are there certain regions of your network or lanes where you see the most opportunity?
I'm sorry, I didn't understand the first part of the question. Could you repeat that?
Yes, sorry. So on the productivity savings you're expecting for Q4 and you mentioned expectations for further savings into 2018, are there certain regions of your network or lanes where you see the most opportunity?
Productivity really is a network wide opportunity. So we see opportunities to drive productivity throughout our network.
Okay, got it. Thanks so much.
Our next question is from the line of Cherilyn Radbourne with TD Securities. Please proceed with your question.
Thanks very much and good morning. I also wanted to dig in on the record train lengths a little bit. Can you talk about where you're making those gains? And what I'm driving at there is, I assume that your coal network is close to optimal. So I'm curious if you're seeing improvement in merchandise or intermodal or both?
Yes, the answer is both. Intermodal has been the biggest driver, but merchandise has well and you're right, the coal unit trains have been optimized for a while. I will tell you on some of the other unit trains, stone and agriculture, we have increased those in coordination with our customers. So intermodal is the big driver, but merchandise is also growing as well.
And just by way of a quick follow-up, you've been seeing some puts and takes in terms of the merchandise volumes. Is that creating any challenges in terms of making improvements in the merchandise network?
Well, Alan, why don't you go back over the merchandise growth trend in the quarter and let's use that as the foundation for addressing her question about train sizes and operations in the merchandise network generally.
Yes, Cherilyn, we started to see some fairly robust growth sequentially as we move through the Q3 effectively up until the hurricane started to impact our customer base. And so it took a pause in September, has started to rebound in the Q4. We're seeing strength in steel. We're seeing strength in frac sand, seeing a little bit of crude oil, although that will be a year over year decline, but it's picking up sequentially. Automotive will post better comps in the 4th quarter year over year than it did in the Q3 as U.
S. Vehicle production declines are year over year less. And ag has kind of got off to a slow start in the quarter due to a delayed harvest, although within the last 7 days, we've started to see that volume pick up as well.
So much of the growth that Alan just went through in the merchandise arena has occurred within our scheduled train network. And that's one reason why you're seeing the incrementals you're seeing. We're also seeing some growth in unit trains as well.
Our
Our next question is from the line of Ben Hartford with Robert W. Baird. Please proceed with your question.
Hey, Mike, quick question for you on the topics of dwell and train velocity addressed earlier. Is it fair to assume that you're expecting improvements in both of those measures in 2018? Obviously, the hurricane disruptions aside, just as volume growth decelerates from peak 2Q levels 1? And then 2, if so, what is your what is kind of a longer term target for both of those metrics? Can we view the 2012, 2013 levels as high water marks?
And do you have visibility to returning to or perhaps exceeding those in both dwell and velocity?
Yes, I think those are both numbers that we feel very comfortable about gave us a really good service product that allowed our customers to grow on our railroad. So yes, we do expect those to improve into 2018, absolutely.
Okay. Thank you.
The next question is from the line of David Vernon with Bernstein. Please proceed with your question.
Hey, good morning guys and thanks for taking the question. Alan, I wanted to ask you a little bit about the pricing opportunity in intermodal. If you go back the last 10, 15 years, the intermodal RPU for Norfolk hasn't really budged that much despite 3% inflation in highway cost and a higher oil price and all that. Is there something about the market dynamic or the density you have your network that's giving you a little bit better leverage to pricing in intermodal over the next 5 to 10 years? I'm just wondering how those negotiations are going with shippers and what's giving you a chance to maybe take a little bit more price up relative to truck than you have in the past?
Well, David, what's occurred is that we're starting to see a much tighter truck environment. And we've got some market approach that our customers value. We've got a service product with schedules that meet their needs. And so our conversation with them is, how do we grow together? And we firmly believe that negotiated rate increases reflect the value of your service product.
And we're leaning into price. We're not putting new dots on the map. We've got our capacity. We will continue to invest in the big areas like Chicago and Atlanta. But our focus is on utilizing the existing capacity that we have to and leaning into price to drive shareholder return.
Are you passing up on a little bit more of the business that might be out there right now relative to maybe you were 5, 10 years
ago? 5, 10 years ago, we implemented some corridor strategies, which have been very beneficial to us. For instance, the Heartland corridor we put in to handle business between the Ohio Valley and Chicago and Norfolk. And as volume moves to the East Coast ports, that's something that's going to support our growth and we've got the capacity in place. Now it's our opportunity to leverage it.
David, one thing to bear
in mind as you look at the trend in our intermodal RPU over say the last 5 years is the effect of the Triple Crown downsizing. Our Triple Crown business had a significantly higher RPU than the average intermodal RPU. And when we, all intents and purposes, shut down that business, it did have a dampening effect on reported RPU, albeit it was the best thing for the bottom line.
All right. I appreciate that color. And then maybe Cindy, just as a quick follow-up, is there can you give us a range for what we should be expecting on property sales on a kind of annual rolling basis here and comment whether or how the property sales impact management incentives on EBIT and OR?
David, it's really hard to tell you how property sales are going to come in from quarter to quarter as I said before. I mean, they're obviously going to and operating sales will have an impact on our OR, which does impact our incentive plan. I will tell you though that when you look at our operating property sales in the 3rd quarter, they were our improvement in OR year over year was not dependent upon those property sales. And we expect 4th quarter that we'll also have year over year operating ratio improvements and they will not be dependent upon those sales.
But is Norfolk maybe using property sales as a little bit more of a lever here for OR just given that the incentives in place and should we be expecting more relative to trend or is this just going to come up how it comes up?
Yes. I mean, I think that obviously we will always look at property that we have that's no longer, is used in the business and we will try to get rid of it. And as I said, it's very difficult to predict. Getting rid of that property is part of our strategy, but at the end of the day, it's really not going to be a big driver of our OR. The things that we talk about service, productivity and growth are going to be the things that drive our OR.
All right. Thanks a lot for the time guys.
Our next question is from the line of Tyler Brown with Raymond James. Please proceed with your question.
Hey, good morning. Hey, Alan, it seems like the prospects for domestic intermodal look really strong. I think volumes are at record levels. But I was wondering if could talk about IMC box availability? And second, do you and your pool partners have any plans to add to the E and P fleet to maybe support growth?
Or do you feel like there's enough capacity there?
Tyler, capacity is tight with boxes, which is good for pricing opportunities, particularly on the transactional level. As Jim noted, we're currently in the process of developing our capital plan for 2018.
Okay. That's helpful. And then Jim, this is more of a strategic question and I can't remember where I saw you speak. I think it was one of the rail shipper conferences. But I recall your presentation was really revolving around NS's strategy about revamping how you face the customer.
So I was just curious if you or Alan could just talk about where you are in that program, maybe what kind of initiatives, maybe technologies that we and customers would expect? And then what do you hopefully hope to yield from these investments?
Well, I'll quickly turn it over to Cindy to go through some of the specific technology investments that we are making. But first, I do want to reiterate the importance to our strategy of customer engagement and customer interface. We are working hard to get closer and stay closer to our customers. And one of the main ways we're doing that is through investments we're making in technology. I
would characterize it maybe in 3 different areas. And I would characterize it maybe in 3 different areas. The first is, our how we face the customer. We have a big project to upgrade our portal and basically change not just the look and feel of it, but really everything behind it, the data, the data accuracy, the timeliness, we want to make it very easy for customers to be able to get the information that they need when they need it. We are secondly working on what we call customer relationship management, which is really technology within this company so that no matter where you are in the company, marketing, accounting, transportation, customer service, we all have one view of the customer, we all have the most relevant data and we can interact with the customer having that type of information and managing issues.
And then I think the 3rd part is we are looking very closely at the technology that we have implemented within our customer service center and looking to upgrade that so we can better serve our customers. So a lot of effort around that multi year project, but we think will be very beneficial for both us and our customers.
And Tyler, it's an ongoing process, as Cindy said. We're implementing some things now. Something we're investing ahead of the curve in some areas and some things we'll be rolling out next year. The foundation of it is a predictable service product. What differentiates us is our equipment strategy for growth, homogenizing the fleet that offers for better asset turns, that offers better equipment reliability, the ability to provide equipment in safe working order to our customers on time, better transparency for our customers.
It's a customer engagement focused on proactive notification and a seamless interface with the customer. It's collaboration with our short line partners and economic development partners to extend our network reach. It's innovative service products that utilize and generate a return on our existing assets. All those things are part of our strategy to differentiate ourselves and help us compete with truck.
And let me just close the subject by pointing out that all of these different initiatives we've described are coming to fruition now and will continue to do so in the future. This has been a major emphasis and focus of our team since I became CEO. And Alan, Mike, Cindy and I have all spent a lot of time with our customers gathering their input, their ideas for improvement and how we can refine and improve our service product. And that's where those ideas came from and that's why we are driving so hard to implement them. Thank you.
Thank you all for your questions. I'd also like to take this opportunity to thank all of our employees for their contributions to a record breaking quarter. Our balanced and successful approach focused on increasing efficiency and delivering a strong customer service product gives us confidence in our ability to achieve our goals and deliver sustainable value. Thank you.
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.