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 your host, Katie Cook, Director of Investor Relations. Thank you, Ms. Cook.
You may now begin.
Thank you, and good morning. Before we begin today's call, I would like to mention a few items. First, the slides of the presenters are available on our website at northofsouthern.com in the Investors section. Additionally, transcripts and downloads of today's call will be posted on our website. Please be advised that during this call, we may make certain forward looking statements.
These forward looking statements are subject to a number of risks and uncertainties, and our actual results may differ materially from those projected. Please refer to our annual and quarterly reports filed the SEC for a full discussion of those risks and uncertainties we view as most important. Additionally, keep in mind that all references to reported results excluding certain adjustments, that is non GAAP numbers, have been reconciled on our website in the Investors section. Now, it is my pleasure to introduce Norfolk Southern's Chairman, CEO, Rick Morman.
Thank you, Katie, and good morning, everyone. It's my pleasure to welcome you to our Q1 2015 earnings conference call. With me today are several members of our senior team, including our President, Jim Squires our Chief Operating Officer, Mark Mannion and our Chief Officer, Marta Stewart. As all of you know, earlier this month, we announced 1st quarter earnings of $1 per share, 15% lower than last year. These results reflected lower fuel surcharges on the top line as well as continued weakness in our coal franchise, which restricted growth in revenue and revenue per unit.
Additionally, very severe weather in our service territory slowed our operations, increased our expenses and impacted our volumes. With the exception of the ongoing effect of lower fuel surcharges surcharges and continued pressure in our coal markets, we believe that most of our issues will be largely resolved by the second half of the year. Having said that, we will be up against strong comps, particularly in the second and third quarters as last year's results were record setting quarters for us. Jim will share with you more detail on the revenue trends and the outlook for the remainder of the year. With respect to service, we've already seen steady improvement in our network and we expect to reach our strong twenty 12, 2013 velocity and service levels in the second half of this year.
Mark will provide you with the latest on the relevant service metrics and our operations outlook and Marta will round it all out providing you with details of our full financial results. Before getting down to the details, I'll just reiterate what I told all of you on our earlier call. We have a great team at Norfolk Southern and while there are always uncertainties around our markets, all of us are confident in the long term strength of our franchise and our prospects for future success. On that note, I'll turn the program over to Jim, Mark and Marta, and then I'll return with some closing comments before taking your questions. Jim?
Thank you, Wick, and good morning, everyone. First quarter 2015 operating revenue declined 5% to $2,600,000,000 primarily due to a 100 and $2,000,000 reduction in fuel surcharge revenues as a result of lower fuel prices. Growth in intermodal and merchandise volumes offset coal declines, increasing 1st quarter volume 2 percent to 1,800,000 units. Revenue per unit declined 7 percent, but without the impact of declining fuel surcharges, revenue per unit declined only 2%. Mix shifts between increased volumes of intermodal and decreased volumes of coal offset strong pricing across most of our business segments.
We will discuss the mix impact as we review each commodity group. Overall volume growth of 2% for the quarter was driven by a 5% gain in intermodal and a 3% gain in merchandise markets, partially offset by a 7% decline in coal volumes. After a strong start to the year, volume in the Q1 was again impacted by winter weather conditions and accompanying service disruptions, particularly throughout February. But similar to Q1 2014, we achieved strong volume and improved service levels in March. Breaking out the market segments, starting with cold.
1st quarter volume decreased 7%. Coal burn at Eastern Utilities was down 14 point 5% in the Q1 due to lower national and regional natural gas prices, causing our utility volumes to decline 6%. Volumes to Northern utilities were down nearly 9%, while volumes to Southern utilities were down 2%. Though handling a greater percentage of utility volume to our Southern utilities generally increases our coal revenue per unit, this positive mix impact was more than offset by a 20% decline in export coal volumes in the Q1. Persistent weak conditions in the global marketplace, soft prices and a strong U.
S. Dollar made it very difficult for U. S. Coals to compete in this oversupplied environment. Domestic metallurgical volumes were down 1% with weaker demand for met coals related to softer steel production and sourcing shifts partially offset by market share gains of coke shipments.
This decrease in volume and lower fuel surcharges reduced revenue by $86,000,000 $455,000,000 a 16% decline versus Q1 2014. In addition to the previously discussed mix changes, lower fuel sur surcharges also negatively impacted our to see strong volume growth of 5% to nearly 927,000 units. Intermodal pricing gains outpaced our other business units with continued growth expected the rest of the year. Despite these positive trends, the decrease in fuel surcharge revenues drove the decrease in overall revenue and revenue per unit. The effects of lower fuel surcharge revenues more than offset a 2% increase in average revenue per unit already dampened by negative mix resulting from higher volume increase in international freight.
As we've discussed before, international intermodal freight has a lower revenue per unit. Merchandise revenue of $1,500,000,000 was $32,000,000 or 2% was down $32,000,000 or 2% for the quarter with a 5% decline in revenue per unit. More than 80% of this RPU decline was due to fuel surcharges. We also experienced negative mix associated with increased volumes in lower rated sand, gravel and aggregates, while higher rated iron and steel volumes declined. Our automotive sector was also impacted by negative mix with decreased auto parts shipments and increased by level of traffic.
Volume for the merchandise book was up 3% overall with the strongest gain in our chemicals due largely to increased shipments of crude oil from the Bakken and Canadian oilfields to East Coast refineries as well as increased with increased vehicle production at several TNS served plants. Our metals and construction markets benefited from increased volumes of aggregates for construction projects in the Southeast as well as increased frac sand volume into the Marcellus Utica region to support natural gas drilling efforts. These increases were partially offset by reduced shipments of steel pipe and steel coil, driven by a softening of the pipe and reduced steel production in the quarter. Agriculture shipments were up 2% with increased volumes of corn moving to Southeast poultry producers as well as increased volumes of feed products and fertilizers. These gains offset reduced volumes of export soybeans resulting from a record South American crop, the strength of the U.
S. Dollar and limited railcar availability. Finally, paper and forest products volumes were flat in the quarter with strength in lumber related to the continuing housing recovery offset by reduced volumes of wood chips and waste materials. Let me close with expected trends in volume and revenue for the balance of the year. First, we expect to drive domestic intermodal growth, while international intermodal shipments will benefit from the recovery following the West Coast port disruptions earlier in the year.
We expect growth in natural gas liquids and despite lower oil prices crude by rail volumes. Double digit growth in housing starts and increases in construction activity should generate more lumber, plastics, soda ash and aggregates traffic. Automotive volumes should grow at a rate better than North American vehicle production driven by output at key NS served plants. Ethanol shipments should increase due to rising gasoline consumption and project related growth, while a stronger crop should push export soybean volumes up later in the year. However, lower oil prices are expected to cause declines in our metals and construction group as drilling activity slows, reducing shipments of pipe, frac sand and other drilling inputs.
Further, production curtailments by major steel producers and high inventories will likely dampen shipments of iron and steel products. Lastly, low natural gas prices, utility stockpiles at or above target levels, a strong U. S. Dollar and global oversupply will make this a challenging year for coal. We continue to obtain price increases at or above the rate of rail inflation in most areas of our business and should see negative price mix effects abate in the second half.
However, high fuel surcharge recoveries in the comparable periods last year are likely to result in lower revenue in the second and third quarters and for the full year. By the final quarter of 2015, however, we expect top line growth to resume. Thank you for your attention. And I will now turn the presentation over to Mark, who will provide an update on our Q1 operations.
Thank you, Jim. Restoring our service levels remains our primary focus. However, safety is at the heart of everything we do. So let's take a look at our safety numbers. Turning to slide 2.
Our reportable injury ratio was 1.08 for the Q1 of 2015 as compared to 1.49 for the Q1 of 2014. The train incidents through March 2015 were 71 versus 61 over the same period last year. Great crossing accidents through March were 76, down from 88 over the same period in are operating at a higher level than we were in the Q4 even with the more challenging operating conditions that existed in the Q1. In addition, as you can see on the right, our service has been trending upward since the end of February. The timeline and trajectory of our service recovery I provided on our last call, which outlined incremental improvement in the second quarter service performance will be near 80% by the end of the second quarter.
And as you see the sizable improvement in train speed and dwell in December was maintained in January. And although February was challenging, recovery has been evident. We expect this trend of increasing train speed and terminal dwell reduction to continue through the rest of the second quarter. We fully anticipate that our end of quarter speed and dwell metrics will be commensurate with the superior service levels we achieved in 20122013. As you have seen, we've made solid improvements and we expect to see even larger gains in our service metrics by the end of the second quarter.
Slide 5 outlines our plan that will lead to these larger gains. We have an increase of 600 conductors and 50 locomotive engineers between March 1 July 1. We expect to take receipt of 40 additional SD-ninety MAX during the same time period and we're already seeing the number of bad order locomotives normalize, which will result in 160 additional locomotives available for service. By the second half of the year, we anticipate we will be storing some of our older higher maintenance locomotives, which will reduce our expenses and strengthen our service reliability. With regard to infrastructure, the connection track in Chicago as well as Goshen Siding East of Elkhart were completed in April.
Both of these projects will further The full implementation of Bellevue will improve velocity through reduced car handling, improve asset utilization and result in an overall reduction in cost structure. In closing, we're confident our service will continue to trend in the right direction with sequential improvements in the Q2. In the second half of the year, we expect improved metrics consistent with strong service levels as the full effect of our investments is realized. Thank you. And now I'll turn it over to Marta.
Thank you, Mark. Now let's review our financial significantly affected our Q1 results. Jim discussed the 5% decline in revenues and while operating expenses decreased by $61,000,000 or 3%, it was not sufficient to offset the revenue decline resulting in a 9% reduction in income from railway operations and an operating ratio of 76.4%. Slide 3 outlines the major cost categories affected by the weather and service recovery efforts. These are estimated at $42,000,000 the largest portion of which was in compensation and benefits.
Additional service hours were incurred in all areas of operations, including train and engine employees for field service, mechanical employees to higher number of locomotives and maintenance of way employees related to storm cleanup and repair. Similarly, the other listed expenses reflect the increased cost of a slow network and added assets. Purchased services and rents were primarily affected by the decreased velocity, while the last two categories, materials and fuel, affected by the rise in locomotive count. As we previously stated, some of the service recovery costs are expected to continue into the quarter. However, at a lower level currently estimated at $25,000,000 Turning now to Slide 4.
This illustrates the year over year change by expense category. Fuel was the only category that declined versus the Q1 of last year and the decrease was largely attributable to lower prices as shown on the next slide. Breaking down the components of the fuel expense change, dollars 160,000,000 of the reduction was due to price as consumption was flat on the 2% increase percent rise in compensation expenses. We had higher than usual wage rate and payroll tax increases. As discussed during our January call, the union wage increase was effective January 1 versus the July 1 time frame of recent years.
This resulted in a $26,000,000 increase. Payroll tax rates rose on January 1 as well and total payroll taxes were up $14,000,000 In addition, employee activity levels including increased hours, more overtime and more trainees added $14,000,000 and signing bonuses related to our recently ratified agreement with the Brotherhood of Locomotive Engineers added $11,000,000 That labor agreement also calls for a lump sum bonus, which will affect 4th quarter expenses by a similar amount. The final significant item within the compensation area was a reduction in the accruals for such as equipment rents and intermodal operations. As previously mentioned, lower network velocity also caused these costs to rise. Turning to the next slide.
Materials and other expenses rose by 25 11%. About half of the increase was due to higher materials expenses and was associated with both locomotive and maintenance of way usage. Environmental and personal injury expenses also rose in part due to a prior year favorable accrual. And lastly, travel costs increased largely related to our train service employees who had more overnight stays as well as temporary transfers to areas on our systems with crew needs. Depreciation expense displayed on Slide 9 rose by $8,000,000 or 3%, reflecting our larger capital base as we've continued to invest in infrastructure and equipment.
Operating expense headwinds are summarized on the next slide. In addition to the service recovery costs, the wage and payroll tax increases and the lump sum payment, 2015 expenses will include costs associated with the previously announced closing of our Roanoke, Virginia office. Approximately 450 employees will be affected by this move going from Roanoke to either corporate headquarters in Norfolk, operations headquarters in Atlanta or choosing to retire or resign. Moving and relocation costs in 2015 related to this transition are expected to total $35,000,000 and will begin to be incurred in the 2nd quarter, although most of the costs will impact the Q3 when the bulk of the relocations are expected to occur. Efficiencies associated with this consolidation will begin to benefit expenses in the 4th quarter.
Next, income taxes totaled 185 $1,000,000 for an effective tax rate of 37.4 percent compared with 33.6% in 2014. As you may recall, last year contained a $20,000,000 or $0.06 per share tax reduction resulting from a tax law change in Indiana. Net income and EPS comparisons are illustrated on slide 12. The $58,000,000 net income decrease is a 16% decline compared to last year and diluted earnings per share of $1 was 15% lower than last year. As shown on the final slide, cash from operations covered capital expenditures as well as our higher dividend level of $181,000,000 On our Q4 earnings call in January, I mentioned we anticipated returning to a higher level of share repurchases.
During the Q1, we used cash on hand to buy back $415,000,000 of our shares. We now expect full year 2015 repurchases to be between $1,200,000,000 $1,300,000,000 And with that, I thank you for your attention and I'll turn the program
back to Wick. Thanks, Marta. Well, as you've heard, clearly our first quarter results were not as strong as we and you expected that they would be. And in the short term, we faced some continuing headwinds in the tough comps from last year. However, we see continuing strength in the overall economy.
And as Jim described, we have a lot of opportunities in many of the markets we serve and a great franchise with which to capitalize on these opportunities. In addition, we're well on the way to restoring our network velocity efficiency, which will drive further costs out of our operation. And as all of you know, that will also enable us to secure more business at rates that drive positive returns for our shareholders. As we do that, we also remain committed to returning cash to our shareholders as demonstrated through our strong dividend history as well as through our share repurchase whereas Marta just mentioned, we're now targeting between $1,200,000,000 $1,300,000,000 in share repurchases this year. In sum, we have a proven strategy for success and the right people and resources to successfully execute it.
Thanks, and I'll turn it back to the operator for your questions.
Thank you. At this time, we'll be conducting a question and answer Thank you. And our first question is coming from the line of Bill Green with Morgan Stanley. Please proceed with your question.
Hi, good morning. Jim, you obviously identified in your slides the challenges ahead from the fuel surcharge mechanism. We asked this last time as well, but since we've gone another quarter and now with the preannouncement, is there any reason to think that you might sort of address that again and come back and say maybe we need to adjust that and change that going forward? A number of the freight transports have rebased fuel surcharges given the volatility there. So what are your thoughts on fuel surcharges?
We are working towards shifting more of our revenue to an OHD based fuel surcharge mechanism over time. And so that's going to take a while. It's contract by contract. Customers have their own preferences. Our overall goal will be to increase rate and grow the revenue.
And but we recognize that our reliance on WTI and our fuel surcharge program creates volatility in our earnings and that's undesirable. So we will be working over time to shift to a more OHT bench
program.
Okay. And then Jim or even WIC, how do you get confident in volume growth being actually a good thing? Obviously, last year, we had service challenges and we had unexpected growth. And now we're having sort of a change in the macro outlook that's created some excess resources and yet the service levels aren't back. So can you sort of walk us through your thoughts on does it make sense instead to sort of let's focus on getting the right kind of business on the network to result in a better margin, a better outcome and not worry so much about the volume growth instead.
Do you know what I'm getting at right? So it seems like there needs to be more of a focus almost on shrinking the business that will improve the service which is even better for price.
Well, Bill, I understand your question and I think it's a very reasonable and interesting one. One of the things that I will say about our volume growth is we don't go out and try to grow volume at rates and margins that don't make sense from the standpoint of shareholder value. So we're not we're certainly not in the mode of let's just grow volume for volume sake. And in fact, if you look at a lot of our volume growth this quarter, it's been in intermodal where we've made a lot of investments and where we're now seeing as Jim mentioned very positive pricing trends. So we don't see that as a problem.
In fact, we see volume growth at good rates as a strength for us. We also don't see that volume growth as severely impacting in any meaningful way our service recovery. Our service recovery is based upon getting the right resources in there. We think we've largely done that and we're on the right path back. Last year, as you mentioned, we had some volume growth we clearly did not foresee in the second and third quarter and got caught short primarily on the crew side.
So the volume growth we're having right now, we see as desirable. We see it as continuing to be a good thing for us. As Jim mentioned, in this quarter in particular, and although we may see it for a little while longer, we saw some mix effects even within our merchandise business that didn't overall didn't help our overall RPU. But even within that, the somewhat lower rated traffic that was growing was still good margin business and business that we want to continue to handle. Thank you.
Thanks, Bill.
Our next question comes from the line of Allison Landry with Credit Suisse. Please proceed with your
question. Hi, yes. This is Ken on for Allison. How are you guys doing today?
Good. Thank you, Ken.
So just a quick question on the buyback. So I mean, as you mentioned, the buyback was pretty big in Q1 and you highlighted a target of $1,200,000,000 to $1,300,000,000 for the full year. Just curious on how that could possibly trend through the next few quarters and whether there's any limit on how big of a buyback you can in any one quarter? Thanks.
Well, the estimate of $1,200,000,000 to $1,300,000,000 is just a little bit higher what we were what we projected on the January call. And so we're very comfortable with that level. We did not issue debt last year. We have plenty of debt capacity this year and we're comfortable with our projections that that's going to be an amount of cash we're going to be able to return to the shareholders.
Got it. Thank you. And just as my follow-up. So you mentioned that utility coal stockpiles were currently above target. Just curious how far above target you're seeing the stockpiles currently trying to your utilities?
And how long you would expect it to take to get back to that target level if we assume a normal weather environment?
Based on our estimates, utility stockpiles in the South at the end of March were at around 71.5 days in the North 65.3 days. Rough target for Southern stockpiles of 70 and for the Northern utilities about 50 days. So as between the 2, the Northern utilities are a bit more overstocked. The stockpile trends will depend heavily on the weather pattern in the summer. And all of our assumptions around utility coal, in fact, do assume a normal weather pattern in the summer, which would drive our volume assumptions going forward.
Perfect. Thanks a lot guys.
Thank you.
Our next question is from the line of Tom Kim with Goldman Sachs. Please proceed with your question.
Thank you. Marta, I wanted to ask about your Roanoke relocation. You talked about the incremental costs you're going to incur this year, but I was wondering what are the savings we should anticipate next year? And then I guess more importantly, are there further opportunities to rationalize or consolidate your operations? And is there a pipeline that you might be able to sort of allude to?
Thank you.
Well, the Roanoke relocation has, Tom, 2 components to it. I mean the primary reason why we decided to do that was because we think it will be more effective for our people to be in fewer locations. So we think that will help the operations of all the departments that are involved. So that was number 1. But as a result of doing that, it was sort of a catalyst to accelerate some G and A reductions that we had been planning for the next 3 or 4 years.
And so that allows us to because some people are choosing not to move that allows us kind of accelerate those as I said. And so we think we'll have about 150 G and A positions between now and the end of the between the Q3 and the end of Q1 of next year that will come out as a result of that.
Great. That's helpful. And I had a question with regard to the coal and in particular I guess the coal exports. What are the levers you can adjust to a potentially longer and deeper down cycle for export coals? I mean to what extent would it make sense to maybe even rationalize terminal interest?
And then maybe even with rolling stock, is there something you could do there? Like are you satisfied with utilization levels? Or could you do anything with regard to even that side of the business? Thanks.
For starters, we can be very nimble with our equipment asset serving our coal business, our export coal business. We can obviously redeploy the locomotives. We can downsize or curtail whole car replacements. So we have complete flexibility with regard to the equipment. The infrastructure adjustments would involve adjustments to maintenance levels, particularly in the coalfield and in some cases, perhaps, a longer term mothballing of the asset.
But most likely, the infrastructure side would involve service reductions until the volumes return.
Okay. Thanks a lot.
Our next question comes Our next question comes from the line of Ram Selman with Deutsche Bank. Please proceed with your question.
Hey, good morning guys.
Good morning.
With regard to the kind of merchandise outlook, With regard to the kind of merchandise outlook, obviously there are a couple of puts and takes with regard to your growth expectations
with weakness
on the softening steel production side as well as growth in several other end markets. When I'm thinking about the crude by rail outlook, it sounds like you're expecting continued growth. I would imagine we should be seeing that volume growth decelerate and potentially decline in the back half of the year, but was hoping for a little bit more color in terms of your expectations regarding that end commodity.
Sure. So we handled around 29,000 crude by rail shipments in the Q1 of 2015. That compares to 22,000 crude by rail shipments in the comparable quarter last year. That's an increase of 34%. Now since the Q1 of last year, we have had a handful of new customers come online.
With softening oil prices, we do expect the growth rate for crude by rail to decelerate. But we think we should be able to maintain a ratable 29,000 or 30,000 car loadings per quarter this year. That would imply growth year over year in the Q2 and for the full year, but we would be modestly negative relative to the crude by rail volumes in the 3rd Q4.
Okay. That's really helpful. And then with regard to the train length opportunity on the merchandise network, do you feel like as the service improves that there should be the opportunity to extend out those train lengths in the back half of the year? Or given some of the softening of kind of the growth in crude by rail as well as likely declines in the steel production, Will that be an offset in terms of your ability to gain some operating leverage in the merchandise network?
Yes. We're always looking for ways to increase our average train length. And in fact, we are seeing an increase in our merchandise train length even now. I think we're in the neighborhood of 5,900 feet currently and keeping in mind that around our system, our siding capacity at a minimum is in the 8,000 foot range. So a lot of room to grow there and that's something we continue to work on and that has mostly to do with continuing to adjust our train plan, our operating network plan to be the most efficient.
Thank you.
Our next question comes from the line of Scott Group with Wolfe Research. Please proceed with your question.
Hey, thanks. Good morning, guys.
Good morning, Scott. Good morning, Scott.
So Jim, I know you talked about expectations for revenue to remain down the next couple of quarters. I'm wondering if you can share with us a view if you think that the revenue declines moderate in the second and third quarter? Or do they stay here or maybe even get worse? And if you think based on that, is it should we continue to expect kind of these double digit type earnings declines? And I know you don't typically give that level of color, but obviously a lot of us had struggled modeling the numbers in the Q1.
So it might be helpful just to get your perspective on near term earnings and revenue.
Sure. Well, let me start by reminding you of the fuel surcharge comparisons in the second and third quarter. So in the Q1 of this year, we booked $163,000,000 in fuel surcharge revenue. That was $132,000,000 decline year over year. Last year in Q2, we booked $358,000,000 in fuel surcharge revenue, dollars 3 $69,000,000 in the Q3 of last year.
So assuming stable oil prices for the next couple of quarters, that would imply roughly $200,000,000 less fuel surcharge revenue per quarter for the 2nd Q3. Then in the Q4, the comparison gets a little bit easier. Last year, we took in $308,000,000 in fuel surcharge revenue in the 4th quarter. So that right there is a pretty significant revenue headwind for the next couple of quarters. On the other hand, as I said, we expect some of the negative mix effects we saw in the Q1 to begin to abate.
And so by the Q3, we based on our current forecast, we'd be looking for revenue per shipment excluding FSCs to turn favorable. And similarly, revenue ex fuel surcharges in the Q3 would turn favorable. And then by the Q4, we start to see overall growth in the top line. Now that obviously has a volume component as well. And there, we're feeling pretty bullish.
Obviously, the declines in gold volume are not helping. But we are feeling as if on the utility side, natural gas substitution has run its course and we should be able to see a fairly stable utility coal volume run rate for the balance of the year, albeit with the tough comparisons to last year. So that's our overall outlook on the revenue. And so we have a lot of opportunities to grow revenue. And as I said, the negative mix effect should begin rolling off in the second half.
Okay. That's helpful. Thank you. And then just other question as we think bigger picture. A lot of the rails have operating ratio targets in that 60% low 60% range.
And I'm wondering as you think about the business Jim, are there do you think that there's structural differences for you or Eastern Rail in general? Or is that eventually a place where you think you can get to with the right mix of revenue and cost?
Last year at this time, we were on the verge of producing some of the best quarters that we have produced this company's history and the lowest operating ranges as well. And that was possible because we were seeing significant growth, volume growth in our merchandise and intermodal businesses in particular and that was sufficient to more than offset declines in our coal business. And that's the formula for us going forward. We will begin to see our coal volumes stabilize at some point. And we will, we believe, grow our merchandise volumes, our highest incremental margin volumes and our intermodal volumes with substantial price increases to boot.
That is a formula for continued improvement in our financial performance and for materially lower operating ratios in the future.
Yes. Let me add to that. I think that sure, inherently if you railroads are franchise businesses, the West looks different than the East, which looks different in Canada. But we as Jim mentioned, we came off we come off a year where we took our operating ratio for the year below 70 for the first time. We expect to continue to drive operating ratio improvement.
And we have a very, very strong franchise particularly in terms of intermodal and merchandise. So I think that the pace of when you get there is obviously always something that the economy will largely determine as well as our own efforts. But we have internal goals for driving operating ratio down. We can and we believe that we'll continue to do that.
Thank you. Our next question comes from the line of Tom Wadewitz with UBS. Please proceed with your
question. Yes. Good morning. I wanted to ask you a little bit about pricing. You've got a lot of moving parts in the revenue side and you've highlighted the mix headwinds, but is there any way to kind of disentangle that and talk about core price?
Give us a sense of where you're at in Q1 or if you don't want to do that, if you just talk about progression, should we expect ex mix to see acceleration in year over year price? Or did you kind of already get the step up tighter rail capacity in Q1 and it's just negative mix rolling off? Or how do we think about the how much core price you're getting and whether that accelerates if you look into 2nd quarter to 3rd quarter?
We were successful in meeting our goal of increasing pricing core pricing at a rate atorbetterthanrailcostinflation measured based on all inclusive less fuel in the Q1. In most of our businesses, Generally speaking outside coal, we were able to drive pricing higher. And I think most encouragingly, we saw the largest core price increase across our book of business in our intermodal line.
Just to refresh, so what
Expect in the future as well Tom.
What did you see you referred to ALIF. Where did you see ALIF in the Q1?
So reported ALIF in the Q1 was 2 0.8%.
Okay. And so it's not there's not really caveats that you're saying across the book you would have done better than that 2 point percent if we looked at a core price kind of taking out mix. Is that fair or?
Right, right. So with the exception of coal as I mentioned virtually across the book, now there were pockets where it was stronger. But on average, we were able to meet the goal of increasing core prices at that rate.
Okay. And what about the aspect of accelerating? I mean, it seems like you're pretty optimistic about improving the network performance. So you would think that customer service would improve as you look into through second quarter into second half. I guess the truck market seems like it's loosened a bit, maybe freight overall isn't as strong, but do you think there's more momentum in pricing that that would accelerate?
Or have you kind of achieved the run rate in Q1 and you stay stable next couple of quarters?
We will stay focused on raising prices at a rate better than at or better than real inflation. That's our long term goal. The contracts vary quarter by quarter. The pricing opportunity varies quarter by quarter. But overall, we're going to stay very, very focused on that goal and are confident we can achieve it.
Right. Okay. Great. Thank you for the time.
Our next question is from the line of Matt Troy with Nomura Securities. Please proceed with your question.
Thank you. I just had a question maybe a big picture overview of the network. You guys have done a good job of explaining your target of returning the service metrics be it speed or dwell or your composite service indices back to kind of the peak 2012, 2013 levels by 2Q. And you've also kind of outlined very nicely what you intend to do to get there. I just wanted to take a step back and maybe understand from an operational perspective, if we were to look at a network map, kind of a heat map, if you will, what are the key areas that you need to address the pinch points, if you will?
As you've given us the pieces to get us there, the targets that you'd like to reach, I just would like a better understanding because we're only 6 to 8 weeks out from kind of middle of the second quarter or the start of the Q3, when you can hit these goals, what are the focal points that will help you get to these targets? Thanks.
Well, our most challenging part of the system last year and into the Q1 was our Chicago line and really principally between Chicago and the Cleveland area. And a lot has gone on in order to increase our velocity. And I'll say that that area is running really well now. There's just been a lot of focus on it. So in order to do that, there was we really pinpointed the manpower increases, which has come along very nicely.
And I'll just say that we're in pretty darn good shape up in that area from a manpower standpoint now. Another thing that has been going on for a longer period of time is infrastructure improvement up there. And I did mention the fact that we've got a couple of significant infrastructure projects that are now complete, that just give us it just gives a bigger pipe to run that traffic through there. So keeping in mind that parts of that area up there will run 100 or more trains a day. So infrastructure improvement, nice increases.
The Bellevue project, like I said, is more to come, which will be very helpful as well as we go through the summer. So that's the
area we put a lot of concentration into
and it's paid off very nicely.
And of other things going around other parts of the system and other very important parts of the system. But that was a big focus and it had a it's really had a nice ending.
Okay. Thank you. And my follow-up would be on the intermodal piece. The international volume growth of 8% makes sense given the potential for some diversions residually from the West Coast port strike or work stoppage. But the domestic piece, the volumes up only 3% was a little bit lighter than I think we've become accustomed to seeing through given your good traction and progress in highway conversions.
Wondering if you could just update us on kind of the CordAir Gateway strategy and was that 3% representative kind of more of a GDP level growth what you'd expect this year or were there mix factors or contractual factors that said we saw a little bit of a dip in the growth in domestic intermodal for you folks should kind of resume at a multiple of GDP as it has been in the past?
Thanks. Sure, Matt. Let me take a stab at that. So within the domestic intermodal book, we obviously have several channels. The intermodal company IMC channel, principally hub and hunt, grew at 6%.
So that's a little closer to expect to see would expect to see or better out of that channel going forward. Our premium and Triple Crown books declined somewhat and that's what to the overall 3% increase in volume in the total domestic book. Going forward, we do think that we can continue to drive the entire domestic intermodal franchise at growth rates more like mid high single digits.
Great. Thanks, Jim.
Our next question is from the line of Chris Wetherbee with Citigroup. Please proceed with your question. Mr. Weatherby, your line is open for questions. Our next question is coming from the line of John Barnes with RBC.
Please proceed with your question.
Hey, thanks for taking my questions. First, on the operating ratio improvement, so not asking for a specific target, but whatever we model for OR improvement, you've kind of given you've got the service related costs, you've got the savings from Roanoke, you've got some things like that. Can you just talk about the magnitude of each of those and kind of from most important to least important, what's going to drive the improvement going
forward? Well, the main thing that will drive improvement will be getting the network back to the velocity that Mark mentioned. So the train speed, the terminal dwell improvements that he mentioned he thinks we'll have in the second half of the year that is the main thing that will help us with expenses. I would like to point out if you're looking at the OR that going forward as Jim mentioned, the fuel surcharge component of it is going to be quite a drag on our operating margins the rest of the year.
And then from network velocity, kind of what's the next couple of catalysts there?
After network velocity?
Yes.
So it's just the general productivity. And again that network velocity we think will begin to will happen towards the end of the second quarter. So we expect that improvement to happen in the second half of the year.
If you look at our track record for the 2012, 2013 period and we discuss this a lot. When you ramp the network up, you start to take not only do you take the costs out that Marta has been discussing, but it then sets the stage for even further projects to continue to drive costs down, particularly as volume grows. And it's that combination of an ever higher network velocity. Mark mentioned Bellevue and we talked to you about the savings that are coming online as we turn Bellevue on. But it's a combination of having a stable high velocity volume growth that really drive the economics of Norfolk Southern and for that matter any railroad.
Okay. All right. Thank you
for that color. And then my follow-up is, Jim, you talked about stability on the coal franchise. Can you talk about how you weigh getting to maybe a more stable, but lower level of coal, both on the domestic and the export side? And when you start to make maybe some of those service begin to downsize or rationalize the size of your coal support network. I mean, when do you begin to do that?
What do you have to see from a stability standpoint to really start to hammer the cost on the coal side if stable is going to be what we get going forward?
Let me start with the utility side of the franchise and give you some of our assumptions for the balance of the year. And I'll be referring to utility tonnage here. We did 20,100,000 tons of utility coal in the Q1. And our current forecast has that level of utility volume holding basically steady for the remainder of the year. As I mentioned, we do believe that gas substitution with nat gas in the current price range has run its course.
There's very little tonnage left to come out due to mats. And of course, the implications of carbon regulation down the road are somewhat unknown at this point. But in terms of mats, we'll maybe see 500,000 fewer tons this year. And so at that level of volume, that's albeit significantly depressed from last year and even more so from years past, we probably do not have an opportunity and would not want to take out significant infrastructure. On the other hand, we can and already have downsized our equipment investments in our coal business.
At this level of volume, we can make do with our current coal car fleet for some time. They have been relieved of a significant capital investment in coal cars. That pertains really more to the export side of the business. So let me touch on that as well. We handled 5,300,000 tons of export coal in the Q1.
That's down significantly from last year Q1, which was our peak quarter for export coal. For the remainder of the year, we are calling for 4,500,000 to 5,000,000 tons of export. Feel pretty confident on the thermal side of that. If there's a downside, potentially it would be more on the met side. Our central lab producers are very challenged right now.
But again, at kind of a $20,000,000 annual run rate 20,000,000 ton annual run rate for export coal, we probably would not want to significantly downsize our infrastructure. Although, we do have the opportunity to reduce spending on equipment and the people side of it is something we can modulate as well.
All right. Thank you so much for your time.
Thanks.
Our next question is coming from the line of Chris Wetherbee with Citigroup. Please proceed with your question.
Good morning, guys. This is Prashanth in for Chris. I apologize earlier. We're having a little headset issue here. I realize we're running late a little bit late in the call, so I'll keep it brief.
We're curious to know about the growth potential for the core business taking apart leaving aside fuel, surcharge and coal. If you get a coal normalization, do you think we could see the core grow in double digits? And in 2015, are really coal and service, is that the biggest factors preventing that? Is there any way to isolate either? Is that the right way to sort of think about that?
Thanks.
Well, if by core business, you mean our merchandise business, our industrial product businesses, yes, we do see growth potential there in 2015 and beyond, definitely. Now there are always puts and takes. We have some challenges in our Metals and Construction franchise right now due to very low steel prices and Wall Street Journal quoted $4.44 per ton as the going price for hot rolled coil this morning. That's down from $4.74 at the end of the March. So steel prices are very depressed and the capacity utilization is tracking below 70%.
So we have some challenges on that side of our Met Con franchise. On the other hand, still within Met Con, aggregates were up significantly, construction car loadings were up, cement traffic was up, all driven by housing and road construction. So there are definite bright spots. On the energy side of the core franchise as well, we see continued opportunity. Over in Chemicals, we were able to grow NGLs, crude by rail, we've already discussed.
Our plastics businesses were up. Those are all indications of a pretty healthy industrial economy and should be the drivers of significant growth in our in our Industrial Products franchise going forward. Our ag volumes were up in the Q1 as well and we see continued promise there for the balance of the year as well. So overall, we feel real good about our industrial products franchise, albeit there are always a few soft spots. And intermodal continues to grow.
And on top of the volume growth this year, we expect to see significant price increases. I mentioned that our core prices were up in our intermodal business more than in any other business segment in the Q1 and that's very, very encouraging.
Great. Thanks. And just as a quick follow-up On the comp and employee issue, it looked like on a per average employee basis the year over year change is just under about 2%, which kind of thinking about that and going forward through the year on a year over year basis how to think about that line item. Are there offsets to the headwinds? And sort of what are some of the initiatives that you guys see on the table maybe in terms of combating some of the headwinds you pointed out in the slides?
Well, if you look at our comp right now, obviously, and we've discussed this before, we have the labor agreements which cover about 85% of our workforce. We had the effectively an early pay increase as a result of the last round of negotiations that kicked in January rather than As we look at overall headcount, we're clearly we're focused right now on getting the right number of people in our train and engine service workforce to handle the traffic without delay. I will say that as these numbers and Mark showed you the conductors and engineers we expect to bring on in the next couple of months, most of them are included in the headcount today because they're trainees at the end of the Q1. As they come on, they come off training status in which they're effectively paid a salary and start to be paid on a trip rate. So that will then be proportional to our operations.
And then on the non agreement side and in particular the G and A side as Marta mentioned, we're always looking at ways to do everything we need to do with a lower headcount. And the Roanoke closure will help precipitate some of that. We will continue to look at that and try and drive those costs down wherever we can.
Let me just add a footnote to the Roanoke office closure question. Having spent a lot of time with our marketing team in the last couple of months, I am really, really excited about having all of our sales and marketing team under one roof here in Norfolk. That is going to allow us to produce a much more focused and consistent approach to growing our top line. And we'll have an opportunity to move people around between jobs that they might not have been able to move around between in the past. And there will be similar synergies
from a
workforce standpoint across all of the functions that are currently in RONA today, our IT and accounting departments, for example.
And then on the operations side, what I would add is, average headcount, which was up sequentially from the Q4 by 500. And what we're projecting for the remainder of the year is another 500 increase. Most of that will occur by the end of the Q3 and that is almost exclusively in the operating area. So by the end of the year, we think we'll be up about.
Thank you. Our next question comes from the line of Brian Ossenbeck with JPMorgan. Please go ahead with your question.
Hey, good morning. Thanks for taking my call. So just two quick ones. Jim, you mentioned a lot of the headwinds of the strong dollar and some of the disruptive imports that we're seeing in this deal. But you also mentioned that we're seeing in this deal.
But you also mentioned you expect ethanol and soybeans to be up. So maybe if you could just summarize why you think those are moving? And overall, you think that the strong dollar is a positive factor or a negative excluding coal for the rest of the business if the strong dollar is a positive or a negative?
Well, most of our business is U. S. Domestic economy focused. So there are certainly pockets of resistance in the revenue based on the stronger dollar, and we highlighted a few of them. The most prominent of them would be export coal and pockets elsewhere as well.
But I don't see an overall dampening effect on total revenue necessarily outside export coal from the much stronger dollar. In certain pockets of our business, it will be an additional challenge. But we have enough drivers of revenue growth within the U. S. Domestic economy to push the top line higher based on our portfolio even with the strong
dollar. Okay. And then just one follow-up on the export coal side. You mentioned you're pretty confident in the thermal side. Now that looks for the rest of the year.
But I know the mix has kind of bounced around a little bit. Could you just give us a refresh on what the mix was in the Q1 and perhaps what you expect for the rest of the year? Thanks.
In the Q1 of this year, 64% of the export tons we handled was metallurgical and 36 percent was thermal. And that compares to last year's 69% met, 31% So we had a relatively high proportion of thermal coal in the Q1 this year. We think that will revert in the balance of the year to more of the 70 fivetwenty 5 type of split. Now going back, we were almost all metallurgical gold. But the last couple of years kind of 70% to 80% met and the rest thermal has been kind of the common split.
And we think we'll get back to something like that split. I will say though that the demand feels firmer on the thermal side of the franchise right now and Northern App Producers were able to jump on some metallurgical coal moving predominantly over Lambert's Point. And by the way, as you probably know, most of the metallurgical coal we handle moves over Lambert's Point and most of the thermal coal moves over Baltimore. If there's a potential downside in our assumptions of roughly 4 5000000 to 5000000 tons per quarter for export coal, it would be on the metallurgical coal, which in our case is coming out of Central App. And because of all of the factors we mentioned, the very small dollar, the global oversupply of coal, Queensland at $109 and spot coals moving forward prices below that.
Because of low very low bulk dry shipping rates, it's just an extremely difficult environment for central app producers in particular right now.
Great. Okay. Thanks for your time.
Our next question is coming from the line of Justin Long with Stephens. Please
I wanted to ask a question about PTC. As you've continued to roll out this technology, how much of a disruption is this causing to the network? Is this a contributor congestion in the rail network today? Or would you say it's not a significant needle mover when you think about fluidity?
It's something we're paying a whole lot of attention to and it has everything to do with how well we plan it. Those PTC cutovers take place on a regular basis each month. And the good thing is that our signal and communication group are doing a very good job of reducing the amount of disruption that takes place with each of the events. And case in point, when we started this out and we've been doing it for a while now, but when we started these out, the outages were in the neighborhood of disruption. As we've gone along here, outages have gone to 8 hours and now in more cases down to 6 hours.
We've got some things going on where we think we can reduce them even below 6, some of them down to as little as 4 hours. So a lot of planning and schedule workarounds. So the disruption factor will be minimized going forward, but still something we do a lot of planning around.
No, I'll add one thing to that, which we I think it's very good question, which and we have not talked about that in any detail nor have the other railroads. But I will say that we got a lot of the really problematic areas on the railroad in terms of traffic disruption done last year. We still have some more to go. And my analogy for it last year is it was we were almost it was almost like we were constantly running a low grade fever. We had a lot of work to do out there and a lot of significant disruption that as Mark said, we disruption that as Mark said, we planned around it.
We did everything we could. But nonetheless, it was disruptive and it's something that we as Mark has described we continue to work on. And in fact it's a real point of focus for us right now as we look at restoring our network velocity.
Okay, great. That's helpful color. And I'll just sneak one more in on intermodal. I was curious, are you getting a lot of pushback from your customers and your IMCs on the intermodal price increases you're going out with today? And also as of today, how much of book of business in intermodal has been repriced at higher levels, call it that mid single digit range over the past
year? We are not getting a lot of pushback on price increases. We are aligned with our intermodal partners in a view of the marketplace and in desire to take prices higher at this point.
If you look at
our equipment by line of business as an indicator of where we have the opportunity to lean into price most. E and P is about 70% of the total book by volume. And that's where that's the rail owned fleet, rail equipment owned fleet is that's where we have the most ability to take prices up on a spot basis. So and that's and also on the Triple Crown side of things at 10% of our total book by volume, we lean into rate there as well.
Okay, great. Very helpful. Thanks for the time.
Our next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.
Well, good morning, everyone, and thanks for getting my question in here in the second hour of the call. Look, Jim, welcome to the hot seat. And as you guys know, we've been supportive of the stock here. So I'm going to try to be constructive with these questions. But I do think it's worth it for your shareholders to ask some of the difficult questions here though too.
And granted, I've never run a train, we just live in Excel models. So please tell us where we're wrong. But this quarter volume was up 2%, yet 3% growth in merchandise, intermodal is up 5%. And yet earnings are down 15% on what was a pretty easy comp from last year given all the weather disruptions. So I mean that's a lot of the frustration I think with your shareholders.
And if I listen to the strategy to drive improvement going forward, it's getting price above inflation, which we got this quarter. It's getting growth in those intermodal merchandise segments and Wick said it in the past, coal is a very profitable segment for you. But where are the margins and returns on intermodal merchandise? And is that going to be enough to drive future earnings growth for this company? Do we have all these continual cost pressures and fuel surcharge headwinds where we're just not going to be able to see a lot of earnings expansion even with those pretty robust growth rates outside of coal.
Well, let me just add, we appreciate the candor. And by all means, ask the tough questions. And we demonstrated last year that we can drop the operating ratio significantly based on solid general merchandise volume growth and intermodal volume growth even with coal headwinds. Now when you're talking about coal volumes down 7% overall in a quarter, that's a pretty strong headwind and that is more difficult and we lost ground this quarter, no doubt about it. But that will stabilize.
We will see a bottom on coal volumes. And as we've discussed on this call, we think we may be there already. And then we have the opportunity to see continued growth in many areas of our merchandise franchise and in our intermodal franchise. Put on top of that significant price increases and you do have a recipe for growing earnings. It's essential that we get the network back up to speed.
We have a plan to do that. We have the resources coming online. There will be some cost headwinds to get from here to there in the short term. But once the network is back up to 2012, 2013 service levels, we will see significant cost dropout as well. So it's the combination of that basic efficiency and the cost reduction that comes from running a faster network, bottoming out of coal volumes and the combination of volume growth and price in our general merchandise and intermodal businesses.
Okay. Well, I mean, you're not the only railroad to see some pretty challenging coal numbers. And I do agree with Wick's assessment that there's differences between the East, the West and Canada. But there are some similarities between the West and Canada, at least in terms of achieving mid to low 60s OR for a lot of these carriers with public targets to get there. And if I'm hearing you correctly, Jim, it sounds like we need to have stability in coal before we can get any real traction on the operating ratio.
But I think there'd be a lot of skeptics on the buy side at least or your investor base, where if we look at natural gas being sub $5 in the future, there's still some incremental gas capacity in the East. And on top of it, the export market doesn't look all that solid as you've confirmed on this call. So can Norfolk get traction on margins even if coal continues to be maybe a modest headwind heading forward?
I think we can. I really do. This is going to be a tough year. We're going to we will start to see the top line grow again in the Q4 we think based on our current forecast. Until we get the top line moving, it will be difficult for us to make a lot of improvement.
That's coming. That's coming. These mix effects that you saw in the Q1 are somewhat transitory. Hole volumes will bottom out. Now we cannot say with total assurance that
we have hit bottom in
terms of coal volume today. But we've studied our utility franchise pretty carefully. And we do believe gas substitution becomes more difficult at this point with gas plants running full out. Now the export side of things, there are headwinds there, but there are opportunities as well, particularly on the thermal side of that franchise. So we think we can do it.
We've got a couple of tough quarters ahead of us with the fuel surcharge headwind, with some additional costs out there to get service back up. But once we're there on the service, once we see coal volumes stabilize and we get past this fuel surcharge headwind, we're in great shape to improve our financial performance.
Thank you.
Our next question is from the line of Ken Hoexter with Bank of America. Please proceed with your question.
Great. Good morning. Thanks for the time. I'm going to take a little bit of a different tact on some of the same questions there. But it looks like service starting to show some improvement still the mid-70s operating ratio for the quarter.
Why such a contrast, maybe if I could address this to Mark between your need to add 6.50 employees between the conductors and engineers, the 200 some odd locomotives. And when you look at Canadian Pacific's plan to cut resources, which creates a lot of capacity, maybe Mark, can you just describe maybe a little bit of the differences in the operations or how you're running it, so we can understand why we can see such a great contrast between one creating capacity and the ability to move more versus what how you're structuring the operations?
Well, as far as the resources that we're adding, we know that when we're in the process of ramping up, you need it's almost like you can't have enough locomotives. You need a certain number of locomotives just to spin your storing locomotives before long storing locomotives before long. In fact, we'll probably get into that by May and give ourselves a surge fleet of we'll see how far we go, 100 to 200 locomotives. And same thing on the people side, I mean, need a certain number of people to ban your trains and it is activity based. We pay them when they work.
So we need to take on more people. We will stabilize on the people side by the end of the second quarter. And from there on, we are essentially outside of business growth opportunities.
As we
get into the second half, we're going to be leveled off on people and we'll be hiring for attrition. So we don't see ourselves doing anything particularly differently than what the other railroads do as far as that goes.
So I guess maybe just to keep digging into there to take a step further, is it the network resets you've done a few times over the long weekends or is it changing the operating plan which creates that extra capacity?
No. It's the we said last year that depending on the severity of the winter that we would do as we typically do as we come out of these winter events. These are big network systems and they ramp up on a gradual basis. That is what has been happening ever see you see our cars online going down, you see our bad order ratio going down, our train performance is improving, our connection performance improves. The number of locomotives available improves.
All that drives overall network velocity, but it happens in a gradual way. And we'll see that we will continue day in and day out see that gradual improvement take place through May, through June. And I think by the end of June, we'll see
some pretty darn good numbers. Just in the overall theme, let me say one more thing about that. And it goes back to this idea, every franchise is different, every railroad is different. And the Eastern carriers obviously are as all of you know shorter haul complex networks and that's fine. For one thing we live where all the people are and we think that has a lot of positives in terms of growing.
But the overall belief that I think everyone in the railroad industry shares is that velocity creates capacity go up, as Mark mentioned, cars online go down, our terminals get more and more fluid and that's what then drives further operating and cost improvement. And that's the path we're on. And if you look at some of the things we've done in the past here, we've done a lot of work on our terminals in terms of we've closed 2 significant yards. We've expanded 1 to make up for that and to make up for changes in our traffic base. So the patterns may look somewhat different based on the franchise, but the theme is always the same in terms of constantly improving the velocity of your railroad no matter whose railroad it is in order to efficiencies and create further capacity.
Wonderful. And if I could get the follow-up, I guess, Jim, as you prepare to take over in 2 months or so, what are your thoughts on M and A? Obviously, we've heard Wick's kind of thesis in the past. I'm just wondering how you view the world. And obviously given the discussions that we've heard from some of the Canadians and maybe your peer on the East in the past, just want to get your insight and whether you think it's possible, whether and if not, why not?
And then if not now, does that mean something could happen in the future? Maybe just some thoughts on that.
Sure. Well, I'll share a few thoughts and then I'll invite Wick to chime in as well. First of all, let me say
We'll see how well I've trained you.
Let me start by saying that we are a public company. We're obviously here to serve our shareholders. So there are no categorical answers in that regard. On the other hand, we do see significant challenges associated with further consolidation. The regulatory review process for consolidations in this industry is very, very time consuming, onerous and risky.
And I say that as one who practically lived at the Surface Transportation Board for 1.5 years or so as we were going through Conrail. It's a very unpredictable process and it is a very costly and risky process as well. And there are relatively few synergies to be achieved in exchange for those risks as well. The remaining combinations in this industry are end to end and by definition fewer synergies available. So we don't think it's a good idea.
And we think we have a great business plan to run this company on a standalone basis. And that what we can do with this company is better than anything that could be achieved in
the combinations. Jim and I agree completely about this. But I think Jim's first caveat obviously is important. We're a publicly traded company. We are interested in long term welfare benefits to our shareholders.
That is our job and we understand that very clearly. But I think that what is sometimes really underestimated by those who don't live or immerse themselves in the regulatory environment in the way that we do is just how hard it would be, A, to have any kind of transaction approved, particularly under the new merger rules where a by definition it has to be pro competitive, whatever that and no one has defined that. And second, the enormous risks that the conditions imposed, if you are even able to get a merger approved by the STP would negate any and all benefits and beyond of the transaction itself. And there would be an enormous amount of resistance on the certain parts of our customer base. We just think that you never say never and the time may well come, but right now not a time where trying to do a transaction of any size makes any sense.
Appreciate everybody's insight and takeaways. Thanks guys.
Thanks Steve.
The next question comes from the line of Jeff Kauffman with Buckingham Research. Please proceed with your question.
Hey, everybody. Thanks for getting me in at the end here.
I want to ask a question on a different aspect
of the coal franchise. Given that most U. S.-based calls are well out of the money globally And given that the utility inventories remain quite high, I think up till now everybody's focused mainly on the volume aspect of the coal franchise. But I guess the question becomes at what point do either the coal producers or utility customers say if we want to keep the coal moving we need a pound of flesh and let's revisit the pricing so that we can keep coal competitive and keep coal moving. When we look at your contracts, won't have this new leg down this fall when these contracts or next year go to reprice?
We believe we continue to have a compelling value proposition in our ability to deliver coal from various basins and various ways to our utility and export customers. And we're going to price that on a value basis. So on the export side, there just isn't that much we could do unfortunately. Our major customers are finding it very difficult to place coals into the global market, particularly on the metallurgical side. So our goal, as is the case across our franchise, is to obtain the maximum value for the dollar for the value that we provide our customers and we'll continue to do that in the coal business as elsewhere throughout our financials.
Okay. And domestic?
Same story. The as I said, we think natural gas substitution, which has been the driving factor in the decline in utility volumes has largely run its course. And we are in position to continue to deliver goals to our utility customers. Now a normal summer weather is critical to our assumptions in that regard though. Another very cool summer and we could see further declines.
But provided we have a normal summer, we think we're in good shape to manage a pretty consistent run rate on utility coal this year.
Okay. It's been a long call. Thank you for your answer.
Thanks.
Our next question is from the line of Jason Seidl of Cowen and Company. Please proceed with your
question. Thank
you. And guys, thank you for getting me in here. Two quick ones. One, can you talk a little bit about your ability to price as your service levels start coming up? Because clearly you're getting price now and services well let's call it less than optimal.
Is there any relation between rail service and pricing? Or should we not look at it that way?
Clearly there is. And our pricing potential will only improve with better service levels in the long run. You have to give the customer something more in order to obtain price increases. And that's one of the big reasons we are spending now to get service back up, so that we will be able to grow volumes, but also so that in the long run we'll be able to take prices up for a better and better product delivered to the customer.
Okay. And I guess my follow-up and I apologize if you guys already covered this because there was some overlap in calls this morning. We haven't seen any announcements
out there in terms
of getting Don's position filled. I was wondering where you guys are out there? And are you reviewing outside candidates as well as inside?
We are reviewing both internal and outside candidates. We've been running a process. We expect to complete that process and make an announcement within a matter of a few weeks.
A few weeks. Okay. Thank you for the update guys. Appreciate the time.
Our next question is from the line of David Vernon with Bernstein. Please proceed with your question.
All
right. Good morning. Hey, Marta, first question for you. How much additional borrowing capacity do you have? And have you gotten more comfortable raising the overall borrowing and leverage profile of the business going forward?
Yes. We have quite a bit of additional borrowing capacity. As I mentioned earlier and as I'm sure you know, we didn't issue any debt last year. So we are planning to issue debt this year and we're comfortable bringing up our leverage levels but staying within our current credit ratings band BBB plus BAA1.
Is there like a target level of coverage that you're shooting for?
Well, as
long as well, the target is to stay within the credit ratings band because last year we did issue. We floated down a little bit from within the band. We're still within the band, but floated down a bit. So we're comfortable ramping up towards the upper end of that band, but staying within it.
All right. Thanks. And then maybe just as a quick follow-up, Jim or Mark. I guess, have
you guys given any thought into how much
of the service related costs you guys are pouring into the network right now actually do come down? I mean I get the velocity driven improvements allow you to pull some costs down, but I would also think that the change in freight flows across your network are requiring a different level of resourcing than you've had in the past? Is it changing length of haul, longer haul intermodal, less short haul coal, that kind
of stuff? I mean, how
much of the extra investment you're putting in should we expect to actually come out?
Well, we're expecting the $42,000,000 that we highlighted in the Q1, we think is going to moderate to $25,000,000 in roughly the same categories that I outlined, a little bit less percentagewise in compensation because the compensation part in the Q1 had a transportation part and maintenance away part related to the weather. So percentage wise, the comp part will come down a little bit and the total will be $25,000,000 And then we believe if we get up to the train speed levels that Mark described in the second half, we think we will not have service. So that $1,000,000 in other words would go away in the 3rd and 4th quarters.
Do you get like the $42,000,000 or the $25,000,000 back next year? Or do you think there's going to be some of that cost that's just going to be in the network?
No. I think those costs are the costs that we view as they're purely transitory in nature. And the answer to your other question is that, yes, as we see business mix change, we can see some shifting in resource requirements, particularly in terms of maybe where we need trained crews. But net net, I don't think that those changes are material in terms of overall crew requirements or train operating costs.
Even with the difference in length of haul on coal, you'd think that would just take more labor hours, but
Well, you're looking at length of haul on coal changing as basins change. As Illinois Basin coal comes on, We have we haul the coal longer or farther as the mix changes within coal. In intermodal, we've done a pretty good job and expect to continue to really not necessarily running a lot more trains, but just getting more and more containers on each one of the trains through stacking and additional train length. So as I say, Mark, I don't think net net that amounts to a whole lot. No, no.
Yes.
All right. Thank you.
Thanks.
The next question is from the line of Cleo Zagreen with Macquarie. Please go ahead with your question.
Good morning and thank you for your time. My first question relates to coal. So I appreciate that we may be looking at a stabilization in quarterly run rates on the domestic and maybe the, I guess, export front as well. But still this year, we're looking to, it sounds like 10% decline in the domestic volume and maybe mid teens in exports. So what does coal alone do to your operating margin or to the operating ratio this year in terms of the headwind?
It unquestionably is a headwind. When we see the kind of year over year declines that we experienced in the Q1 of 2015 and projecting for the balance of the year. So yes, we think a steadier run rate in both utility and export coal tonnage. But the comparisons are difficult. Q2 of 2014 was our peak quarter for utility coal volume.
And so we are comping that very difficult comparison. And similarly in the 3rd quarter, we as utilities rebuild stockpiles into the 3rd quarter, we're facing some difficult comps. Now by the time we get to the 4th quarter, it gets a little bit easier. And we would expect to see lesser year over year volume declines. The on the export side of the franchise as we've discussed, the comparisons really get easier in the second half, beginning in the second half.
And again, particularly in the Q4 of 2014, total export tonnage was 4.8 $1,000,000 so a drop below $5,000,000 by the Q4 of last year. So tough middle part of the year, tough couple of quarters coming. By the Q4, we start to see growth in Brazil.
Can you say maybe if you face specific challenges in your franchise compared to your eastern tier and how we can think about the operating ratio impact?
No. We don't think we face peculiar or particular challenges relative to our Eastern competitor in this regard. Okay.
And also on the operating ratio, if you would like to quantify or maybe just say that you're not prepared to maybe assess the impact of coal, that's fine. But on the ex coal and ex fuel surcharge hit this year, would you comment as to whether you see mix just below the top line being a tailwind or a headwind on the operating income level? I mean, we're focusing so much on the top line, but surely there must be benefit in growing intermodal and merchandise, right? If you can help frame that for us that would be very helpful.
Absolutely. And we've said in the past and it's still true today that our general merchandise businesses, particularly volume moving in our scheduled network are our highest incremental margin businesses. You layer it on top of the natural spontaneous favorable economics of volume growth in those businesses, significant core price increases and that's really a key driver of improvement for us. Now much of this unfortunately will be masked in the middle part of the year by the fuel surcharge headwind, which will be significant. And with the kinds of deltas to last year we're talking about in the top line from fuel surcharge alone, we will probably see margin pressure in the second and third quarter, unlike in the Q1 where the decline in fuel expense actually exceeded the decline in fuels for direct revenue.
That will flip most likely given the magnitude of the fuel surcharge revenue
Thank you. At this time, I will turn the floor back to Rick Morman for closing comments.
Well, thanks everyone for bearing with us on what has been a somewhat long haul, but hopefully we have given you a lot of data and a lot of color on what we're doing. We appreciate your time and
we look forward to talking to you next quarter.
This concludes today's teleconference. You may disconnect your lines at this time and we thank you for your participation.