Greetings, and welcome to the Norfolk Southern Second Quarter 2017 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 would now like to turn the conference over to Katie Cook, Director of Investor Relations.
Thank you, Ms. Cook. You may now 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 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 Investors section along with our non GAAP reconciliations. 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 2nd quarter 2017 earnings call. With me today are Alan Shaw, Chief Marketing Officer Mike Wheeler, Chief Operating Officer and Marta Stewart, Chief Financial Officer. Turning now to Slide 4. We are pleased to report another quarter of strong financial results as we have continued to drive both resource utilization and growth. Marking our 6th consecutive quarter of year over year operating ratio improvements and an all time record, we decreased our dollars Income from operations of $888,000,000 was up 15% compared to the prior year period.
Earnings per share increased 26% to $1.71 We continue to successfully execute our multidimensional strategy and achieved another record operating ratio of 68.1 for the first half of the year, a 130 basis point improvement from last year's record. Income from operations was up 11% to $1,700,000,000 and earnings per share increased 20% to $3.18 also a first half record. These results demonstrate that our strategic plan built upon our core pillars of safety, service, stewardship and growth is working as intended, providing a reliable framework that our team has successfully executed upon to propel improved operational efficiencies, which will deliver over $100,000,000 of productivity savings this year. The determination and perseverance of our employees to effect sustainable change has been instrumental in our achievements. Importantly, their work has also established a strong foundation for ongoing growth and success.
As reflected on Slide 5, since the inception of our strategic plan, we have commenced a broad set of initiatives, including reducing G and A and consolidating headquarters, restructuring Triple Crown and Pocahontas Land subsidiaries, rationalizing over 1,000 miles of track, including the shortlining of our West Virginia Secondary and Delmarva South Lines, idling our Ashtabula Docks coal terminal and restructuring yards, including the idling of Knoxville severe yard and Chattanooga and consolidating operating regions and divisions including the recently announced consolidation of our central division. In addition to these initiatives, we have rationalized and revitalized our locomotive fleet, achieving our highest quarterly locomotive productivity and fuel efficiency on record. Productivity initiatives targeting freight car utilization are ongoing as well. Through our dynamic plan, we are continuing to aggressively pursue additional opportunities for improvement. Mike will provide you with an update on our ongoing initiatives and metrics later on the call.
Moving to Slide 6, with respect to our market approach, we remain steadfast in our commitment to deliver quality service that our customers value and growth that complements our network. Alan will provide additional details on some of our ongoing improve our efficiencies and leveraging the strength of our industrial development team to feed our pipeline for future growth. As a result of our initiatives and as you can see on the right of this slide, we've increased volumes by 6% while reducing average headcount versus last year's levels and 10% compared to 2015. Our strategy has supported the return of capital to shareholders through increasing dividend payments and share buybacks. As reflected on Slide 7, cumulative distributions have totaled 17 point $1,000,000,000 since the inception of our share repurchase program in 2,006.
Dividends per share have increased at a 12% compound annual growth rate over that period. In addition, we have repurchased nearly 164,000,000 shares at an average cost of about $65 a share. As we look forward, given the strong financial results we have achieved to date and the confidence we have in our outlook, we are increasing this year's share repurchase guidance by 25% to $1,000,000,000 Turning now to our longer term guidance on Slide 8, we continue to make solid progress toward achieving a sub-sixty 5 operating ratio, which I am confident we will accomplish by 2020 or sooner. I have consistently said that our plan is dynamic and flexible. And as we reach these targets, we are committed to driving performance improvement, whether through improved productivity or growth or both.
I have every confidence in our ability to achieve and surpass our objectives and create sustainable value in both the short and long term. And I'll now turn
the program over to Alan Shaw, Chief Marketing Officer. Alan? Thank you, Jim, and good morning, everyone. Our second quarter was marked by strong year over year volume improvement in intermodal and coal, generating total revenue of $2,600,000,000 up 7% versus 2016. Intermodal reached a record quarterly volume with a year over year increase of 50 7,000 units, benefiting from continued highway conversions and new service offerings.
Utility coal increased 27,000 shipments in the 2nd quarter as a result of a previously reported market share gain and higher year over year natural gas prices. Export coal grew 25,000 units due to improved seaborne pricing, which made U. S. Coals more competitive in the international market. Positive pricing was partially offset by mix, improving our revenue per unit in all 7 groups and 1% in total.
Overall, our merchandise volume was flat in the quarter as gains in frac sand and steel were offset by declines in crude oil. Growth in the metals and construction segment was driven by increases in shipments of frac sand due to increased drilling activity in the Marcellus and Utica Shale regions. Additionally, improvements in steel pricing, change in supply chains and inventory replenishment led to higher volumes in our steel franchise. These gains were partially offset by declines in our crude oil volume, which has been negatively impacted by pipeline activity. Automotive volume declined due to decreases in U.
S. Vehicle production, while paper was impacted by strong truck competition. Merchandise revenue increased 1% versus Q2 2016 to $1,600,000,000 with a corresponding 2% increase in revenue per unit. Positive pricing was impacted by mix shifts as well as excess truck capacity. On Slide 12, intermodal revenue increased 10% to $593,000,000 as volume increased 6 percent to over 1,000,000 units.
Domestic volume grew in the 2nd quarter due to continued highway conversions and collaboration with our channel partners to develop new markets. These gains were partially offset by headwinds due to elevated truck capacity. Our alignment with shipping partners growing at East Coast ports led to 5% growth in our international volume. Revenue per unit was up 4%. Intermodal pricing continues to be impacted by excess truck capacity, a condition we expect to improve as the year progresses.
Tightening capacity is expected to drive stronger pricing growth in 2018. Moving to Slide 13, our coal revenue grew an impressive 32% versus the same period last year to $447,000,000 Volume increased 27% and revenue per unit improved 4% compared to Q2 20 16. Increased utility coal volume resulted from the previously discussed market share gain coupled with favorable natural gas prices compared to prior year levels. Growth in this segment was also driven by increased export volume as tightening international supply improved offset by increased short haul utility north volume and mix shifts within the export market, similar to what we saw in the Q1. Moving to Slide 14, we expect year over year growth in the Q3 led by intermodal and coal with low to mid single digit decline in our merchandise volume.
Comparisons to last year become more difficult as overall volumes began to accelerate sequentially in the Q3 of 2016. Merchandise volume is expected to be negatively impacted by continued diversions of crude oil and natural gas liquids to pipelines. Steel shipments are expected to decline sequentially as customer inventories were replenished in the first half of this year. Moreover, a projected annual 6% decrease in U. S.
Vehicle production will negatively impact automotive volume in the second half, with the largest year over year decrease in the Q3. Partially offsetting these declines, we project continued growth in frac sand due to increased natural gas production, although the year over year growth will be less than what we experienced in the Q2. We are generating opportunities as our customer supply chains adapt to the rapidly evolving e commerce and consumer markets. Our marketing and operations teams are collaborating together with our customers to align their growth with ours through new strategic services that capitalize on these quickly changing market trends. Our intermodal franchise benefited from these new services in the second quarter, which will provide ongoing growth for years to come.
We are also prepared for growth as the truck market continues to tighten, driving highway to rail conversions, strong service products that focus on the needs of our customers as well as efficient operations provide confidence that our growing Intermodal franchise will continue to enhance shareholder value. While we project year over year improvement in the coal market in the second half, the pace of this growth will lessen due to a sequential decline in export coal and higher utility volume in the second half of last year. Export tonnage will likely moderate from first half levels to the 4000000 to 5000000 ton per quarter range with volume contingent on sustained seaborne price levels. In line with our projections last quarter, we anticipate 3rd quarter utility tonnage between 17,000,000 and 19,000,000 tons. With the 4th quarter tonnage contingent on summer burn, stockpile levels and natural gas prices.
Our best in class industrial development team consistently works with potential new customers, strengthening our position in the supply chain. Our list of active projects remains robust and will provide continued growth opportunities that will benefit future year volumes, further underscoring the sustainability of our plan. Our strategic plan maintains a focus on the customer experience. Part of this focus includes working with our customers to align our service metrics with our customers' view of our performance as well as partnering to ensure we provide effective tools to schedule and manage their business with Norfolk Southern. Our aim is to continually evolve the elements of our operations that drive quality growth and efficiency.
This approach increases our value to customers and strengthens our position in the marketplace for the near and long term. As our customers are innovating to serve a dynamic changing world, we are doing the same, working together to design efficient supply chain solutions for their emerging needs. For example, we recently repurposed a Triple Crown yard to provide innovative solutions for the gas market. We further enhanced this service by combining aspects of unit train operations with the demand for single car shipments. Customers value these types of innovative solutions driven by the continuity in our long standing customer relationships, market knowledge and seamless marketing and operating philosophy.
With our strong partnerships throughout the supply chain, we'll continue to enhance our ability to serve our customers while generating strong returns for our shareholders. I will now turn it over to Mike, who will discuss our operational performance.
Thank you, Alan, and good morning. In the Q2, we continued to grow our business and provide a good service product to our customers. We also achieved our strong results while streamlining our operations and idling our largest hump yard to date in Chattanooga. Our all time record operating ratio for a quarter as well as for the first half of the year is a testament to our strategic plan and the hard work of our employees. As shown on Slide 16, there were significant milestones achieved in the quarter as well as the first half of the year that were key drivers of our success.
The efforts towards driving locomotive productivity, fuel efficiency and train length, which we will discuss in more detail later in the presentation, all help to drive our record operating ratio. As noted on Slide 17, we are continuing to take steps to improve service and reduce costs. We idled our largest hump yard yet in Chattanooga in the Q2, and this is the 4th major hump yard item. We have also announced the consolidation of our central division, which will further reduce the number of operating divisions from 10 to 9. This is a continuation of the steps we took in 2016, wherein we consolidated from 11 to 10 and reduced the number of operating regions by a third.
In addition, as we discussed on our last call, we removed another 100 locomotives from service in the 2nd quarter, and we did so while handling more volume. All of these actions drive the pillars of our strategic plan, safety, service, productivity and growth, and puts us on track to exceed $100,000,000 of annual productivity savings this year. Moving to safety on Slide 18, we are pleased to see a 12% improvement in our reportable injury ratio as well as a 23% improvement in our serious injury ratio. These reductions demonstrate our continued dedication to maintaining a safe and productive working environment for our employees throughout operations, which is a cornerstone of our strategy. Working safely and efficiently is a key component of our efforts to drive sustainable value creation.
Our network metric performance shown here on Slide 19 did trend down in the 2nd quarter due to a number of episodic events that were concentrated in the Southeast. More importantly, our metrics have trended higher in the recent weeks. We are confident we will remain at these high levels while handling additional volume and continuing to aggressively pursue productivity initiatives. Our customer facing metrics are allowing us to have specific data driven discussions with our customers, deepening our already strong relationships. Moving to some of our productivity initiatives starting on Slide 20.
You can see we continue to increase employee productivity, which is driven by optimizing our We are on track to set a new record for the full year of 2017. The 2nd quarter was the highest quarterly train length on record and June represented the highest monthly train length at Norfolk Southern. This marks the 7th consecutive quarter of sequential improvement and we are excited to build on our momentum. As shown on Slide 21, train length, along with the continued rationalization of our yard and local fleets, has resulted in significant improvements in our locomotive productivity. We removed 150 locomotives from service in 2016 and another 150 so far this year.
The Q2 was the highest quarter of locomotive productivity in our company history and we are on pace to set a new record for the full year. We will continue to actively manage our locomotives to ensure we are driving the highest value for shareholders while we continue to support the needs of our customers. Not only do these improvements result in lower maintenance costs, they also enhance our fuel efficiency, which I will discuss on Slide 22. Our fuel efficiency improved 7% in the second quarter versus the same period last year and resulted in an all time quarterly record. As you may recall, 2016 was a record year for this measure.
We accomplished this by continuing to improve train 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 long term productivity savings and superior returns for shareholders. We are proud of the accomplishments we have made and continue to identify opportunities to drive additional efficiencies for the benefit of NS shareholders. I will now turn it over to Marta, who will cover our financial achievements.
Thank you, Mike, and good morning, everyone. Let's begin with our summarized second quarter results on Slide 24. The continued execution of our strategic plan delivered a 7% increase in revenues, which when coupled with only a 4% percent increase in expenses resulted in more than $100,000,000 of additional operating income and as Jim noted, an all time record low quarterly operating ratio of 66.3. Turning to the component changes in operating expenses on Slide 25. In total, they were higher by $65,000,000 or 4% as our sustained focus on controlling expenses help mitigate costs associated with inflation and with the 6% volume increase.
Slide 26 highlights the drivers of the variance in compensation and benefits, which rose by $36,000,000 or 5% year over year. As I mentioned on last quarter's call, inflationary increases continue at a quarterly run rate of $30,000,000 to $35,000,000 which is higher than historically, primarily due to the large increase in premiums on Union Medical plans. Also previously noted is an increase in incentive compensation associated with the improvement in operating results. Partially offsetting these items were reduced employee levels, which resulted in $16,000,000 of lower expense as headcount was more than 800 employees lower than the Q2 of 2016 and down almost 400 sequentially. With the efficiency improvements Mike mentioned, we now expect that we can hold overall headcount at this lower level for the remainder of the year.
Fuel expense as shown on Slide 27 rose by $16,000,000 entirely attributable to higher prices, which added $18,000,000 Fuel efficiency continues to improve. And as Mike mentioned, we achieved a record on this metric, which resulted in 2% fewer gallons consumed on 6% more volume. Moving on to purchase services and rents on Slide 28. This category was up $8,000,000 or 2 percent year over year, largely due to the increase in intermodal traffic. Slide 29 displays other income, which rose $28,000,000 for the quarter due principally to higher returns on corporate and life insurance and increased income from coal properties.
Turning to income taxes on Slide 30. The effective rate for the quarter was 36.3 percent unchanged from the Q2 of 2016. Summarizing 2nd quarter earnings on Slide 31, net income was $497,000,000 up 23% compared with 2016 and diluted earnings per share were $7 Free cash flow for the 1st 6 months was nearly $700,000,000 up $200,000,000 versus the prior year. And as Jim noted, with the improvement in cash flow and our confidence in future free cash generation, we have increased our full year target for share repurchases from $800,000,000 to $1,000,000,000 Thanks for your attention and I'll now turn the call back to
Jim. As evidenced by our record results just a year and a half into our plan, our team is engaged and energized. Having consistently delivered strong performance, we are confident in our ability to reach a sub-sixty 5 operating ratio by 2020 or sooner. Additionally, as we reach our targets, we'll continue to achieve improvements that drive shareholder value. Before taking your questions, I want to thank Marta for her many contributions and devoted service over the years as she will retire from Norfolk Southern on August 1.
She's been an outstanding leader in our organization, a terrific member of the management team and instrumental to Norfolk Southern's success. On a personal note, she has also been a trusted partner and a great friend. So it is a bittersweet goodbye for me. Our search for MARTA's successor is ongoing. We are working with a nationally recognized executive search firm and are considering both external and internal candidates.
While the search continues, the Board has elected Tom Hurlbut, currently VP and Controller, to the position of Interim CFO effective August 1.
And with that, we'll now open the line for Q and A.
Thank you. We'll now be conducting a question and answer Our first question today is from the line of Allison Landry with Credit Suisse.
Please proceed with your question.
Thanks. Good morning. So I just wanted to ask about the long term target. It seemed like there was sort of a slight shift in the language. Previously, you've talked about a 65% or below by 2020.
And now it's sort of 65% or by 2020 or sooner. Is that should we read anything into that as you're stepping up the operational initiatives as well as various customer projects? Or really, is it just semantics?
Allison, let me start by pointing out again that the Q2 of this year represented our 6th consecutive quarter of year over year OR improvements and all time records in both the quarter and for the first half. So our plan is working as planned, and it's allowing us to deliver a lot of financial improvements through operational gains. So we are very confident that we can reach our goals, and we're pulling all the levers. We've got the pedal to the metal. And as soon as we can get there, we will.
Okay. So is that would you characterize that with good results over the last few quarters as maybe pulling that target forward a little bit?
Yes. Things are going really well. The plan is working as planned, and we're making rapid progress. So yes, we are very confident.
Okay, great. And then if I could just ask about the Q3. Historically, the OR is flat to slightly down on a sequential basis. So as I think about some of the puts and takes on the volume side that you discussed earlier, Is that still the right way to think about it? Or are there any cost items or other items that might drive a deviation from historical patterns?
We do feel confident we'll post a lower operating ratio year over year in the second half of the year. Now the pace of improvements quarter by quarter will depend on various factors. Long term, obviously, the drivers are top line growth and productivity, and that doesn't change. Quarter by quarter, things like real estate gains can make a difference, can tip the balance, and recall that in the Q3 of last year, we did have a significant real estate gain.
Okay, great. Thank you.
Our next question comes from the line of Jason Seidl with Cowen and Company. Please proceed with your questions.
Thank you very much. Could you parse out some of those comments you made about episodic events in the Q2 impacting you a little bit on the negative side? And then maybe talk about how your metrics are trending up and what that can mean on a sequential basis and how we are looking at your numbers from 2Q to 3Q?
Sure. Well, let me set the backdrop and then I will hand it off to Mike to talk about some of the specific things we encountered in the Q2. You did see network velocity slow down a little bit in the Q2 and you saw it well tick up some. We've turned the corner on that. 3rd quarter to date, the metrics are looking good.
We are steadfast in our commitment to deliver quality service and customer value. And network performance, even through the Q2 of this year, remained well above 2015 levels. And as I said, it's been trending higher. So this is the platform for growth, and we are committed to keeping network performance and service performance at a level that allows us to grow and drive productivity as well. So with that, Mike, why don't you comment a little bit on some of the things we experienced in the Q2?
Yes. Okay. Will do. So we had really three things that were going on. They were going on pretty close together, but we had a lot of flooding pretty much between Louisville and Kansas City on that line during the quarter.
We also had some flooding just outside of our Cincinnati terminal, which is a high volume terminal there. Then we also had during the quarter, we had some fires going on down in North Florida that were shutting our line down different times during the quarter. They come near the tracks, we shut the tracks down and open back up. So those three things were going on, dealt with those through the quarter and we feel very comfortable about how we've bounced back. In the last month, our train speed has increased 10% back to prior levels and our dwells back to what it was prior to some of this stuff.
Feel real comfortable about how we've responded and returned service to where we want it to be and it continues to trend higher and we're going to continue to work on that.
So Allison, this is Alan. Jason. Yes, excuse me, Jason. He's the better looking one. We have seen improvement since the beginning of Q3.
We've seen it in our network performance metrics. We've seen it in our customer facing metrics. And more importantly, as Jim and Mike and I get out and talk to our customers, we see it in the feedback from our customers. Improvement in our service product.
Yes. And we're pleased with where it's at and we're going to continue to keep it there and continue to further improve. All
right. I guess my follow-up is going to be more on the top line side. We get our big railroad shipper survey and your Eastern competitor probably got the worst ratings in service and we just held dinner last night with some railroad people and clearly they're having some service challenges over there. Have you seen freight come over from the other Eastern railroads due to poor than expected service, where it can come over? And if it's come over, has it come over at regular pricing?
Or have you been able to actually increase the pricing on that?
Okay. Jason, again, let me just set the stage here, and then I'm going to let Alan comment specifically on what's going on with the top line in that regard. But first off, our focus is very much on enhancing value at NSC and driving our plan to continue to drive productivity and growth. And growth is an important part of that plan. We'll take the market share, whether it's from truck or competitors, as long as it complements our network and obviously falls to the bottom line.
Those are the keys. So Alan, what are you seeing in terms of the landscape?
Jason, we are always talking to our customers. As Jim noted, our primary form of competition is truck. But we're talking to our customers about service products that offer a sustainable view of their markets and allow them to grow. And we have seen some business move over to us. It's a small amount, I'll tell you that, but it's early.
We've got a really good service product. The The customers value the continuity of our market approach, of our operating philosophy and our focus on allowing them to grow with their
Okay. Gentlemen, thank you for the time. And Marta, congratulations on a retirement and best
of luck to you.
Thank you.
Next question is from the line of Tom Wadewitz with UBS. Please proceed with your question.
Yes. Good morning. And also wanted to extend the best wishes to you, Marta, in retirement. Let's see. What I guess the question on rail competition and kind of customer conversations and so forth.
You gave us some perspective on that. I think, Alan, you said it's early. So would you think, I guess, the nature of the customer conversations recently, would you say that this is something that's likely to build in terms of the potential for some business to come over? Or would you say, look, business kind of naturally falls to 1 or the other and you really shouldn't consider too much in terms of share gain as you look the next couple of quarters. How would you frame that?
Yes. Again, let me do the framing and then hand it off to Alan. I want to emphasize that we have been in front of our customers a lot. That is just part of our regular routine. Mike, Alan and I are in front of our customers all the time.
We are going to them. We are in their offices and their conference rooms hearing about their business and how we can gain more of it. So that's a big focus for all three of us. We want the feedback from our customers all the time, and we're getting it. So Alan, talk a little bit more about the market share opportunity.
We're going to capitalize on opportunities that fit our network. And if customers see that we provide a predictable, efficient service product that meets their needs, whether that's in competition with truck or another rail carrier, then we're going to go after that business, Jim, as long as it fits our network and we can drive value to our shareholders.
Okay. But when you said it's early, does that imply that there might be some building in the opportunity? Or am I over reading that comment?
I'll tell you that the average duration of our contract is 3 years. And so there it takes time for some things to play out.
Right. Okay. I guess for the follow-up question, it seems you had weakness in 2015 2016 in coal, some other energy related areas and you've had pretty significant strength year over year in first half. I think we're kind of for the industry transitioning to a slower pace of growth in volume overall. How does that affect how you would view the opportunity for margin improvement year over year?
Or if you wanted to take it and say we're really focused on productivity. Just trying to think about how we think of those 2 things productivity OR improvement as you may have a slower year over year volume growth backdrop looking forward?
Well, let me comment generally. With respect to our coal customers, as with all of our customers, our goal is to serve them. And that means having the resources available to serve them when the demand is there, when they need our service. So we are committed to that. We're committed to serving our coal customers as we all are our other customers as well.
Alan, in terms of resource deployment and market opportunity, what are you seeing?
Well, Tom, within coal, I was with several of our coal customers just last week, and there is optimism, particularly on the export side, for continued strength throughout the year. As you know, the benchmark moved from in the mid-140s to 175 just within a span of a couple of weeks as the Chinese reported record steel production in June. I was also with some intermodal customers, and they're commenting about how they're starting to see tightness in the truck market. That's important for us because as we've noted, truck is our primary form of competition. And so as you see spot rates move up double digit within the last couple of months and maybe start to move above contract rates, that portends well for both volume and pricing opportunities for us into 2018.
Okay, great. Thank you.
Next question is from the line of Amit Malhotra with Deutsche Bank.
First one is on the automotive business. You mentioned the headwind from auto production in the second half. But General Motors production specifically, I think is expected to be down as much as 20% in the 3rd quarter. That's not necessarily organic. I guess it's due to the change over their light truck platform.
I think you guys have some disproportionate exposure there on the Fort Wayne line. If you could just talk about the impact there. I think it will probably be one time given the changeover effect, but any color on maybe what that could have in terms of revenue growth and then also fixed cost absorption in the automotive franchise, that would be helpful. Thank you.
Automotive production in the U. S. Declined 6.5% in the second quarter. It's supposed to be down 9 point 3% in the 3rd quarter. That's the largest year over year decline that is currently being projected.
And so consequently, we see a decline within our automotive volumes, particularly in the Q3.
Yes, I know that. But the question was really on the disproportionate exposure to General Motors and the fact that, that business is going to be down 20%. What type of impact that may have disproportionately to your exposure in the auto business?
We're not going to discuss specific customer relationships. I think I've given you
some
good color as to what we see within our automotive market for the back half of the year.
Okay. That's fair. And then one follow-up with me. Just piggybacking on the last question with respect to OR expansion in the back half. I mean, the contribution margins, the incremental margins in the first half has just been unbelievably strong.
That those productivity initiatives have definitely dropped to the bottom line and then the business obviously really capital intensive. But just a question on your ability to maintain the incremental margins that you did in the first half and the second half. Obviously, mixes and volumes are not going to be as strong as you as they were in the first half, but then the productivity and the headcount will stay flat sequentially. So just the puts and takes there in terms of your ability to maintain incremental margins maybe in the neighborhood of where they were in the first half? That would be helpful.
The key is the plan's dynamism and flexibility, and that's what we have done for the last year and a half. We have responded to changing business conditions as necessary to continue driving results. And so when necessary, we'll lean into productivity. And for the long term, it's all about a multidimensional approach, a combination of growth and productivity at any given time. Maybe it's a little bit more growth, maybe it's a little bit more productivity.
So we'll be flexible.
Okay. All right, guys.
Thanks for taking my questions. Appreciate it.
Our next question comes from the line of Ravi Shanker with Morgan Stanley.
Please proceed with your questions.
Thanks. Good morning, everyone. Can you just comment on pricing in the second quarter and kind of the gap to inflation, kind of how you see that evolving to the year because it does look like inflation was higher in the second quarter and is probably going to accelerate into the second half of the year?
Yes. Our rate of year over year pricing growth in the second quarter was consistent with what we saw in the first quarter, and the rate of year over year pricing growth was consistent with what we saw in 2016. So we're committed to focusing on price and recognizing the value of the service product that we provide, and we're committed to pricing long term above inflation.
But can you do you feel like you're going to get there in the second half of this year as well? Yes. Got it. And as a follow-up, in the intermodal market, are you confident that the rising tide of pricing in all of trucking will help intermodal pricing over time? I'm just wondering if there's enough overlap between the kind of mom and pop truckers who are most impacted by ELDs and the intermodal market as it stands right now?
Yes. We are very confident that it's going to provide pricing opportunity for us, and it's going to provide volume opportunities
for us. We've got great channel
partners out there who are working to grow their business, and we've got a service product and schedules that support their growth. Now most of that growth from ELDs will come in 2018.
Thank you. Our next question comes from the line of Ken Hoexter with Bank of America.
Please proceed with your question.
Great. Good morning. And also congrats to Marta on her retirement. Great working with you over the years. Michael or Jim, can you talk about the experience on the hump yard in Chattanooga?
You shut it down. Did you convert that to a flat yard? Did you shift the business elsewhere? Just want to understand, is that replicable as you think about your network? Or was this just from maybe shrinking business in that region and you didn't need it and you moved it elsewhere?
Can you maybe walk through a little bit about that?
Sure, Will. So we idled the hump, but we are using that yard and it's in a great location for us because it has a lot of feeder lines from our network going into it to do block swapping. So while we idled the hump, we now do a lot more block swapping. We do more blocking further into the network. So it has given us good productivity because the cars are getting through there faster and providing even better service because less time on the network getting to the customer.
So that's the piece to it where it's a big yard in a great location to be able to do a large amount of block swapping.
And again, Michael, maybe your thoughts on is that something that's replicable to other yards? I mean, you talked about the number of hump yards in the past. Is that something you plan on continuing the conversions to other yards?
We continue to look at it. It has to make sense. It has to end up getting traffic through the network faster and taking costs out or a balance between the 2. So we're only going to do it if it hits those criteria.
So is there when you look at this example, is it something that's accelerating and you look at it and say we're going to do more? Or is this just a one off? I just want to understand if this is something you can replicate to your other yards.
Yes. And we can replicate it to other yards that may be in yards that aren't necessarily hump yards and do more of the block swapping in locations where it makes sense, something we've been doing over the last couple of years. But we've done it more aggressively lately, and this is one piece of it, and we're doing it more aggressively at other locations.
All right, great. Marta, if I can have a follow-up with you on your employee levels, you talked about being flat going forward. Maybe talk about the cost per employee impacts there. You talked about a couple of things that drove costs up in the quarter. Can you talk about up 8% year over year on a cost per employee base?
Is that something you look to continue in the back half of the year? Or is there something that can maybe slow down on the increased costs?
Well, Ken, the cost per employee was up in the 2nd quarter as you noticed. It was up for two reasons. One of them is the one we've been talking about all year and that's the 5% inflation, which is higher than normal inflation. And the other factor why in the second quarter the cost per employee was up was due to the incentive comp and you should expect to see the increase in incentive comp continue in the 3rd 4th quarters.
All right. Thank you.
You're welcome.
Our next question is from the line of Chris Wetherbee with Citigroup. Please proceed with your question.
Hey, thanks. Good morning. I wanted to talk a little bit about productivity and sort of the progress to the $100,000,000 target that you talked about. Can you give us a sense of sort of how far along in that you are so far through the year and maybe some of the potential variability, the drivers in the second half of the year, particularly in a slightly lower or potentially meaningfully lower volume growth environment?
We're making excellent progress in productivity. You saw Mike's data points there, record locomotive productivity, record fuel productivity and across the board, significant cost savings as a result. So we're going to continue to push. We're not done. We will continue to strive for ever better productivity performance in all of the areas where it matters most, employees and locomotives and fuel efficiency and facilities and so on.
Okay. That's helpful. I guess, trying to get a sense, do you think there's sort of upside potential for that $100,000,000 I don't know sort of how you think about sort of the ability to I know you've talked about it being continually sort of adjustable, but just kind of curious about that.
Yes. No, we think we'll be able
to do better than the 100,000,000
dollars Okay. That's helpful. I appreciate it. And then a quick follow-up on coal and specifically thinking about sort of the export market, Alan, you mentioned sort of an increase in the seaborne prices. When you think about sort of the second half or maybe more specifically about the Q3, Should we see yields in coal collectively kind of mirror what we saw in the Q2?
Just kind of get some sense around that because there's been some volatility with the mix of your business and sort of exports when they're moving and when they're not.
Chris, very good question. So the seaborne $75 And so within export, there will be pressure on pricing, although we still expect and are confident that it's going to be up year over year. The rest of the impact on RPU is going to just be highly dependent upon the mix within our utility franchise and whether we handle more U South or more U North. Last year, we were handling about 55% of our utility coal was U South, which tends to be longer haul and higher rated. This quarter, it was about fifty-fifty.
So that puts pressure on RPU also.
And fifty-fifty is probably a good number to use going forward for this year?
It's going to be dependent upon the weather, Chris. Okay.
Thanks for the time. I appreciate it.
Our next question is from the line of Justin Long with Stephens. Please proceed with your questions.
Thanks and good morning. Maybe to follow-up first on that last question. I wanted to ask about your expectation for consolidated RPU going forward. I know there are a lot of moving pieces, but when you think about export coal likely to moderate sequentially, intermodal looking like it will be the leader in terms of near term volume growth. Just from a directional standpoint, do you think that RPU ex fuel can still be up year over year in the second half?
Yes. I think we've given
you a lot of inputs on it, Justin. If you look at our RPU for our 7 major commodity groups in the second quarter, it was up between 2% 5%, and our total RPU was up 1%. So it's heavily influenced by mix. I've given you some guidance on our utility coal volumes, our export coal volumes, what we're seeing in intermodal and what we're seeing in merchandise. So we're very confident in our approach to pricing and the level of year over year price increases we get.
The overall RPU for the corporation that falls out is going to be heavily dependent upon those mix factors.
Okay. And maybe to follow-up on some of the market share questions earlier. I was curious if there were any major contract wins or losses during the quarter that we should keep in mind for the back half of this year in twenty 18? And then as a follow-up to that, looking out over the next 12 months, how much of your total book of business do you expect to reprice?
Justin, as I talked about, any market share shift that we've seen so far in the early stages is pretty minimal. It's there, but it's minimal. So far for this year, we've got about 80 percent of our revenue is committed. Most of what is uncommitted so far for the remainder of this year is in export. And in any given year, we're going to renegotiate about 50% to 60% of our revenues.
Great. That's really helpful. Appreciate the time today.
Our next question comes from the
line of Walter Spracklin with RBC.
Just wanted to go back to coal for a moment. I know it's difficult to forecast out, but you've given us good color into the back half of the year. As you're situating and talking to your customers about 2018 and kind of assuming any no change in weather, no significant changes in weather patterns. How are stockpile levels that among your customers that would give you indication as to just directionally on both export and utility, domestic utility, do you expect it to be higher, lower or about the same compared to the 2017 levels?
Walter, good question. So right now, the stockpile levels at utilities that we serve, and this is a publicly available number, are about 15 days below where they were last year. However, recognize they're still 22 days above target. So we've made a lot of improvement over the last 12 months in the stockpile levels. June was very mild and that significantly impacted coal burn to the negative.
Last year in June, stockpiles dropped by about 6 days. This year, they only dropped by about one day. So as I think about the outlook going forward, July has been hot. Natural gas prices, while down versus June, are still up above where they were this time last year. And so it's going to be heavily dependent upon how the rest of the summer weighs out in terms of load demand and natural gas prices.
And that's just a function of the fact of coal being a load follower.
Right. So too early to tell even directionally which way you see coal going in 2018?
It's going to be heavily dependent upon how the summer plays out. We had a very, very hot summer last year, and that really benefited our volumes in our utility coal franchise through the second half of last year and through the Q1 of this year.
Okay. Fair enough. Just housekeeping now for Murda. Other income run rate, I know it moves around a lot. Is there even an annual number?
I know you kind of dipped down last year from 100 down to 70 and now maybe turning back up at around over 100. Is there a kind of a run rate even on an annual level we can plug into there? And also tax rate going into 2018, are you seeing any major changes in the guidance you've given for this year going into 2018?
Well, Walter, you have it about right and looking at the longer at the mid last few years estimate of about $100,000,000 So that's probably as you know there's a lot of different pieces in there. So estimating that for the annual is probably the best thing you could do looking at the recent year's average.
And
then what was your second question?
And this tax rate, you've been guiding us at kind of around 36%. But longer term, you talked a bit about 37%. So we're using 36% for the back half of the year and 37 percent 2018 and beyond. Is there any reason why we should change that?
I'm glad you asked that question too because you should be using a 37% for the full year and one of it has been lower in the first half for the reasons we discussed in the Q1. In the Q3, we expect an increase above 37% because there's a state tax law change, which is increasing their income tax rate. And therefore, we expect to have about $13,000,000 of additional because we have to adjust our deferred taxes. So when you work that into the mix for the full year, we expect the rate to be about 37%.
Okay. And 37% into 2018 as well?
Yes, sir.
Okay.
Thank you very much.
Our next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.
Good morning, everyone, and thanks for taking my question, and congrats, Marta. It would be nice. So I want to come back to the first question on this call, Jim or maybe even Marta, on the sequential outcome in OR. If I look back maybe the
last 5 or 6 years,
I think you guys are averaging a back half OR that's down maybe 100 to 200 basis points sequentially. But you guys did talk about sequential declines in metals. We've talked about the coal situation with exports most likely coming down and headcount being flat from here. I mean, should we think that that normal relationship holds this year or do those items potentially mean it's less or more?
As I said, we do expect a lower second half operating ratio versus 2016. Now quarter by quarter, things like estate gains, the timing of real estate gains, which are difficult to predict, can tip the balance versus the prior year. And also bear in mind that in the Q3 of last year, we did have a significant real estate gain. Now long term, it's all about growth and productivity. Those will be the drivers of improved operating ratio and earnings.
Okay, Jim. And I guess following up from that, how important is volume growth in 2018 to maintaining the trajectory on OR improvement? Let's just say that we have another dull year and can't get a lot of growth in the network. Is that going to push plans back a bit? Or what you've talked a lot about the dynamic plans.
What could be dynamic about it next year if we don't see growth for the industry?
Sure. Volume growth is certainly one piece of the puzzle. Pricing is another in the top line. And then it's all about expense control and driving productivity. We demonstrated the ability to drive productivity to the benefit of a lower operating ratio and earnings growth in 2016 when we didn't see much volume growth.
And that's what we'll do again if that's the way 2018 plays out.
Okay. Thank you.
Our next question is from the line of Bascome Majors with Susquehanna. Please proceed with your question.
Yes. Thank you. Wanted to drill down a little bit more on the merchandise portfolio. I think it's pretty well understood the challenges you're seeing in auto, some of the challenges that you're seeing in other parts of that portfolio, but also some of the growth you're seeing in the frac sand business. But if we could take a step back and maybe think about the industrial merchandise, the non crude chemicals, the paper and forest products, that kind of core industrial business, what's the outlook for these non sort of specific issues you're focusing?
Do you think we'll see growth in those parts of the portfolio in the second half of the year? And what are you hearing from customers?
Avaskum, what we're hearing from customers is optimism. Certainly, the plastics franchise will continue to be strong for us as polyethylene plants come online. Lumber is has been impacted by tariffs and kind of an inventory overhang. We think that will unwind itself in the 3rd quarter, but that will put pressure be dependent upon crops. We participated in soybean exports last year.
Now while that's less than 0.3 percent of our overall revenue, we're probably not going to have as much of a soybean export program this year because South American production has been so strong. Generally, though, if you look at things, industrial production has improved each of the last 5 months, and manufacturing seems to have firmed. So longer term, we're focused on growing this part of our franchise. That's why our industrial development department is so critical to what we do. And you heard Jim talk about it.
Our pipeline very robust for new projects, probably more robust than it's been since the Great Recession. Now that won't necessarily drive volumes this year, but that's longer term growth opportunities. To us, that indicates confidence on the part of our customers in the economy and confidence on the part of our customers in doing business with Norfolk Southern over the long term.
I appreciate that comprehensive answer there. Just wanted to clarify. I think you said you expected merchandise volumes to be down low to mid single digits year over year in the Q3. Can you just confirm that?
And go ahead. You asked them, that's what I said.
Yes. And if I look sequentially, that implies a little weaker quarter over quarter trend than you typically see in the book as a whole. Is that just a function of some of the auto pressure? Is there something else going on there or maybe even sequinservatism?
Yes, Baskin, that is a function of the auto pressure. It's also, as I noted, 2nd quarter steel volumes were benefited from a slight inventory rebuilding. And you've seen steel prices and capacity factors pull back in May June. Now they've improved a little bit in July, so we'll see how that plays out. But it also reflects a little bit of pressure on steel in the Q3.
Our next question is from the line of Scott Group with Wolfe Research. Please proceed with your question.
Hey, thanks. Good morning, guys. So just wanted to follow-up there just on this kind of auto steel discussion. Obviously, we can see that auto is 9% of your total revenue this quarter. But when you think about the derivatives that go into the auto sector, what percentage of your total business do you think is tied to autos?
And as we think about autos and steel and maybe some of the other derivatives slowing in the back half, should we think about those as having higher or lower than normal incremental margins?
Scott, there are some inputs into it. Certainly, carbon black or plastics or steel are the primary ones. Auto doesn't make up a material portion of our volumes in those groups. But the if there is a pullback in auto, that will have a little bit of pressure in those markets.
But is there any way to say like so, yes, autos are 9% direct autos are 9% of the business, but if we add up all the derivatives, it's total exposure to autos is 15% or 20%. I don't know. Is there any way I can just try and help put that in perspective?
It's not a material number.
You're saying not materially above the 9% that we can see that's directly auto?
Right. It does have an impact, but it's you've noted a 9% to 15% or 20%. It's not in that range.
Okay, okay, good. And then just on the utility coal side, utility coal volumes were up 23% in the second quarter. It looks like the guidance for the 3rd quarter is that utility coal is going to be down year over year. I'm surprised down just given the you still have the contract win from CSX. So did we hear that right?
And given that dynamic and then what you talked about on the export side, do you think RPU in coal is positive or negative in aggregate in the Q3?
Scott, you did hear that right. That's exactly how I guided. If you recall, Q3 of last year, we saw a significant jump in our coal volumes sequentially from about 15,000,000 tons in Q2 of last year to over 18,000,000 tons in the Q3 of this year. That benefited from a very hot start to the summer, including June. We haven't seen that this year.
And so that puts pressure on our utility coal volumes in the quarter.
And then just so given that dynamic of utility coal down, export up, but export rates falling a little bit, in aggregate, do you think coal RPU is positive or negative year over year in 3rd? I know you said export is positive. I'm just trying to think in aggregate for coal.
Yes. We won't guide the specific RPUs in specific markets on a quarterly basis, but you've got all the right thoughts there in terms of the move in parts.
Okay. All right.
Thank you, guys. Appreciate it and best of luck to you, Marta.
Thank you.
The next question is from the line of Cherilyn Radbourne with TD Securities. Please proceed with your question.
Thanks very much and good morning.
Good morning.
I wanted to ask a question about your strategy of integrating more closely with customers across the supply chain. Can you talk about how broadly you're approaching that? In other words, have you started with a few key customers or a few key business lines? Or is it more general than that? Well, we
customers across various parts of our business. And then we have taken that feedback along with feedback we have received from a bigger group of customers. And some of that feedback has been informal as we've been out there meeting and talking with our customers. Some of it has been more formalized. We
took all
of that. We have been working on redesigning our customer interfaces, our equipment strategies, sitting down with the customers about service parameters, what do you consider to be service excellence? Well, that's what we are going to try to deliver. And so it's been a very broad based and comprehensive effort to take in our customers' feedback, to understand their service needs and to redesign our network around what they want.
And just by way of a quick follow-up, as we go forward, how do you plan to internally measure success? Is it economy plus growth or some other metric?
Well, a couple of dimensions there. Certainly, one measure of success would be how we are doing from a service standpoint relative to the shared KPIs we have developed with our customers. And then we will recognize success in both top line growth and margin expansion, margin expansion and bottom line growth. I mean, that's the key, obviously, is to garner revenue growth that translates to better margins and a better bottom line.
Best wishes to Marta as
well. Thank you.
Our next question comes from the line of Brian Ossenbeck with JPMorgan. Please proceed with your question.
Hey, good morning. Thanks for taking my question.
Good morning.
I just had a quick one on PTC positive train control. If you just give us a sense of where you are this year in terms of OpEx and D and A, what's in the 2017 numbers? And when you look forward to 2020, obviously, there's still a lot of moving parts, the systems being developed and tested. But I imagine you have some idea of what's baked into your 2020 guidance. So if you can just kind of give us a starting point where you're at now and where you expect that to settle in 2020 when the system comes online?
Well, let me comment
on the state of implementation, and then I'll turn it over to Marta to address the expense components. So we're making excellent progress on PTC. We do expect to meet the deadlines and have the system fully installed next year. And then we will begin then to turn it on across the board. So everything is going very well in terms of the implementation.
Longer term, we're seeing an opportunity to utilize PTC in various ways. So that's all a good thing. Now Marta, why don't you talk about the expense components of PTC going forward?
Certainly. Well, the first thing to note is that the PTC related costs are included in our long range guidance. And so the bikes folks have estimated what they think the costs will be associated with that and is included in all of our plans. So now with regard particularly to this year, we expect that we'll have we have included in depreciation probably about $60,000,000 Going forward, upon total completion, it will probably be about $100,000,000 but again, it's in our expectations. With regard to the maintenance costs, the way his team is approaching that is to include the PTC maintenance for the years going forward as part of our overall maintenance budget.
So we don't have a specific number for that because they are integrating the work in with their other work. Mike, do you have anything to add to that?
No. But there this from a dollar standpoint, it's not a material increase in those costs. But again Because
you're incorporating it into.
Yes, incorporated into and it's already in our 2020 plan.
Okay. So it sounds like the biggest increase is going to come from just depreciating the assets that you're putting into place and you feel like part of the maintenance you can kind of leverage with what you're already doing on the network? Yes.
I mean it certainly has additional extra work with it, but they're going to incorporate it with it. And going forward, of course, for reporting purposes in the R1 and so forth, we will break out the portion that's PTC. But again, the important point that Mike and I are both making is that it is integrated with our plan.
Okay. And then just quick follow-up for Alan. If you can just you talked about the trucking market getting tighter in 2018, and you posted record intermodal volumes this quarter. So maybe you can just talk a little bit more about the international side, some of the poor activity picking up on the East Coast investments being made or just being raised, that sort of thing, how those partnerships are progressing and when you might expect to see some of that activity?
Brian, good question. We've got some great relationships with our steamship lines and our port partners. And we benefited from the shift of volume from the West Coast to East Coast. Our exports through the excuse me, imports through the East Coast are up 13% in the quarter. And so we have seen already the benefit of that growth in volume and expect to continue to do so.
Okay. Thanks for your time this morning.
Our next question is from the line of John Larkin with Stifel. Please proceed with your question.
Thanks for taking my question. Good morning, everybody, and best wishes to you, Marta. Just wanted to ask a bit of a brain teaser on the RPU math. I think Alan, you'd mentioned that of the top 7 commodity groups, the RPU there has risen year over year, somewhere between 2% 4% depending upon the commodity group, yet the overall RPU growth is up 1%. Could you explain what I'm missing there in terms of that translation from a bunch of groups growing 2% to 4%, yet the overall is growing at only 1%.
Yes. John, it's a mix impact. So it's RPU is up between 2% 5% for each of our 7 commodity groups year over year in Q2. However, if most of your volume or a large percentage of your volume growth is at lower rated intermodal, while intermodal RPU can be up 4%, it will have a drag on the overall RPU for the company. So that's an important fact to remember as we look at RPU.
It isn't always reflective of price or of value to the corporation.
Okay. That is very helpful. And then just maybe a follow on regarding the PTC line of questioning a couple of questioners ago. As you look out, it's pretty clear that you've planned out through 2020 and maybe beyond. As that PTC CapEx begins to fall off and you have gotten the network into great shape and made a lot of the operational changes that you're going through now.
Where do you see the sort of long run CapEx settling out as a percentage of revenue? There is 1 railroad you're aware of, I'm sure that has targeted sort of a 15% number. Is that a sustainable number and reasonable to apply to Norfolk Southern? Or do you have a different dynamic at work?
Well, John, post PTC, we do see CapEx coming down somewhat as a share of revenue, for example. Exactly where that lands, I think we'll have to see. It's really there's no fixed ideology there. Our goal is to invest as much as we possibly can and generate shareholder value and appropriate return on capital. So that's the goal, but as much but not more than we can while generating excellent returns.
So I think we'll see. It's likely to come down post BTC. But again, it's really all about paying close attention to the return on capital, make sure we're generating an appropriate return and investing just enough to do that.
Our final question comes from the line of David Vernon with Bernstein Research. Please proceed with your question.
Alan, maybe when you talk about the tightening of the truck market, as you think about how that's going to impact core price and maybe even volume a little bit, when should we start to expect that to come in if we see this sort of sustained tightening of the truck market that some of the truckers are talking about right now? When should it show up in the Norfolk P and L or core pricing metrics?
David, I believe that will start to show up in 2018. It will have to be reflected through trucking bid season later in the year. And then so we'll start to see it in our contract negotiations later in the year and into next year. Potentially, it could we could start to see it in volume later in the year, but you'll see it in pricing in 2018.
Okay. And then maybe just a quick follow-up. I think in talking to some guys around the coal fields, there is a little bit of speculation that the recent uptick in the met coal settlement is a result of U. S. Miners maybe not having the capacity to spool up more production for met.
Are you hearing anything about the supply constraints kind of restricting availability of U. S. Met coal exports? Or is that something that you feel your customers are going to be able to respond to if demand stays strong?
I think a lot of what we've heard is that it's a result of is the increase in Chinese steel production, and the Australians have taken some production offline. They've guided to that. We're going to continue to watch production. And David, to your point, production is going to limit probably our export volume in the second half of the year.
And that so but that should still give you an ability to kind of benefit from the price without the volume though, right?
Yes. Yes, it will.
All right, thanks.
Thank you. At this time, I will turn the floor back to Jim Squires for closing comments.
Well, thank you, everyone, for your questions today. We look forward to speaking with you again in October.
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. We thank you for your participation.