Good morning, everyone. Welcome to day three of the virtual Laguna Conference. Lots of transportation content for you today, so let's get right to it with our first session hosting Norfolk Southern. Very excited to have with us Chairman, President, and CEO Jim Squires. Jim, welcome to the now Virtual Laguna Conference. Jim's going to take us through some slides and give us an update of what he's seeing out there, and I'll follow up with some questions for him. Again, a reminder to the audience, if you have any questions for me to ask Jim, please submit it through the webcast, and I can pass it on to Jim. Before we kick off, I have to note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press.
If you're a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Jim, the floor is yours.
Good morning, everyone, and thank you for hosting me today, Ravi. Before we kick off, allow me to remind everyone that forward-looking commentary today is subject to risks and uncertainties, and our annual and quarterly reports filed with the SEC provide a full discussion of the risks and uncertainties we consider to be most important. Lastly, please see the non-GAAP reconciliation posted on our website in conjunction with this event. Let's get started on slide three. I'm going to provide you today an update on our implementation of PSR. At its core, this is really a story of change. Over the past year, we've fundamentally changed the way we run our railroad to ensure the greatest efficiency across our operations.
Step change is hardly adequate to describe the pace at which we've reduced resources and assets, and yet we've dramatically improved the service we're providing to our customers and have created new capacity in the process. We remain committed to our goal of achieving a 60% operating ratio and strongly believe the best is yet to come. Let's dig in on slide four. Here you see the NS network map with our major classification yards highlighted. When we embarked on the implementation of our Top 21 plan last year, we operated 10 hump yards. By leveraging PSR, we've substantially reduced dependence on those major facilities, resulting in the idling of four more humps, two in the southern part of our network at Sheffield and Linwood, and two in the north at Allentown and Bellevue.
To put that in perspective, in the 16 years following the Conrail acquisition, we closed four humps, but in the past year alone, we closed four more, with the potential for even more of this type of structural change. An initial step towards accomplishing this occurred as we undertook clean sheeting efforts at yards across our network in order to reduce asset dwell and optimize terminal operations. In addition to clean sheeting, with the launch of the Top 21 operating plan, we began consolidating into larger trains with reduced circuity, ultimately enabling the idling of these four hump operations and driving additional resource reductions, which are highlighted on slide five. Turning to slide five , here you see a snapshot of the significant reductions to our headcount and active locomotives, which are down 24% and 27% respectively since the start of 2019.
2019 presented our industry with a challenging volume environment exacerbated by the onset of the pandemic earlier this year, but the story behind the charts on this slide is one of scaling to a much more efficient operating plan. From the start of 2019 through the current quarter to date, our train and engine personnel productivity has increased more than 20%, highlighting the outperformance of our resource adjustments versus volume. On the locomotive front, thanks to our more efficient operating plan, we're driving productivity while continuing to invest in our locomotive modernization program, which is taking end-of-life units and rebuilding them with state-of-the-art technology in a very capital-efficient manner. We've kept that program going even as we've reduced our capital expenditures budget by 25% from where it was the last couple of years.
These cost control efforts enabled us to produce record free cash flow in the first half of the year. Lastly, to give you a preview of numbers not shown on these charts, our third quarter resource levels are trending similarly to the second quarter levels you see here, while daily volume is trending up about 19%. We are seeing even more productivity and operating leverage. Moving to slide six, as we look ahead, we remain committed to achieving a 60% operating ratio and enhancing shareholder value while continually delivering superior service levels. We will continue to bring this powerful franchise to bear on markets across the Eastern United States while operating more efficiently and maintaining the trust and confidence of our customers. Slide seven shows fluidity metrics, train speed, and terminal dwell, which are substantially improved versus the pre-PSR range.
As I mentioned a moment ago, volume has ramped in the third quarter, and our operations team has done a great job bringing that traffic back onto the network while keeping the trains on schedule. Last quarter, due to COVID-19, we essentially shut down the entire automotive network. And recall, we serve more light vehicle origination points than anyone else, so it's a broad network. As that traffic has rebounded, we didn't simply turn the auto network back on. We seized the opportunity to rebuild the network to be more efficient and fully integrated into the merchandise and intermodal networks. As I mentioned, we idled two hump yards simultaneously. To come back to clean sheeting, it continues to be a big driver of the significantly improved dwell time that you see on the right side of the slide.
I'm very proud of our ops team and also the collaboration with marketing and everyone within the organization to keep the steel wheels rolling. We are operating today more efficiently than ever, and we're excited about our strong prospects for further improvement. Our organization is energized and committed to achieving and surpassing our targets. Turning to slide eight, now that we've talked a bit about network configuration and the enhancements in resiliency of our network fluidity, I'd like to cover the train plan, particularly the continuous improvements we're making and will continue to make to drive strong free cash flow and superior returns for investors. Our Top 21 plan went live 14 months ago, and in that time, we reduced crew starts by 28% during the depth of the volume trough in May, and the reduction stood at 19% last month.
The number of trains out on the network has been significantly reduced, but our ability to haul freight is stronger than ever before, creating a powerful formula. If you contrast these crew start reductions with the strong rebound in daily carloads you see here, the result is solid productivity growth. While I've talked about big events like idling hump yards, the approach to continuous improvement is broad-based, driving efficiencies at smaller yards, local operations, our mechanical footprint, and more. The continuous improvement to the plan and the commitment of our team never stops, and this creates a lot of future value for our customers and shareholders. A robust service and more efficient network are the foundation from which we will continue to improve this plan as we move forward.
The last item I want to hit on before we open the call to Q&A is the no-surprises approach we take with our customers. Turning to slide 11, prior to launching Top 21, we undertook an aggressive campaign of meeting with our customers out in the field with their local operations team as well as marketing representatives and had transparent conversations backed by data about the changes they would see with PSR before we proceeded on our initial implementation. As a result, our implementation of PSR thus far has been very successful and well received. At the onset of the pandemic, we demonstrated our agility, reacting quickly to changing market conditions by expediting critical shipments, rerouting products to keep plants open amid sporadic shutdowns, and adjusting service intervals as shippers fought to keep their supply lines open.
These are just a few examples of things our folks do every day to ensure Norfolk Southern is the transportation provider of choice in the geographies we serve. We would not be afforded revenue per unit, excluding fuel, across growth across all three of our business units for 10 consecutive quarters if we were not adding value to the economic lifeblood of our franchise, our customers. In closing, I can tell you how excited I am about the opportunities ahead for our company as we work together to build a faster, more efficient railroad. With the capacity and operational momentum we have, our positioning with the best intermodal franchise in the East, 55 intermodal trailheads, a highly diversified and powerful merchandise portfolio with over 250 short-line partners, the best channel partners in the business, and the best people in the business. We are well positioned for continued growth and success.
I can't thank our employees enough for their hard work and dedication to delivering each and every day for our shareholders and our customers around the world. In short, we've done an outstanding job of improving performance and creating value since we began our PSR journey, and we are committed to building on that progress to further enhance the financial and operational performance of our company going forward. Ravi, I'm happy to take your questions.
Great. Jim, thank you so much for that update. Clearly, very impressive operating performance during a very challenging time. Maybe if I can start with some follow-ups to what you said, I just wanted to confirm that you said in 3 Q so far, you're seeing operating metrics similar to what you had in 2 Q, but with volumes up 19% off the bottom. Is that what you said? Were you referring to train starts, number of locomotives, employee count, kind of those are the kind of metrics you're referring to?
Right. Those are the basic resource classes that we keep a close eye on that drive productivity in the operation. Yes, in the third quarter to date, we have seen strong growth in volume off a pretty stable resource base in those areas, and that has obviously generated significant operating leverage.
Got it. I'll come back to the demand side in a second, but maybe just to stay on this topic, is that the roadmap for the near term? Try and hold the resource base where it is and try and squeeze as much of the volume recovery through it as possible until you have to start adding resources? Or are you also saying that, hey, we can target further improvement in that resource base?
We will certainly continue to pursue structural cost reductions and improvements in our cost structure in all of the areas you outlined and in other areas as well. The goal is certainly to handle the volume growth that we have experienced with the existing resource base or less over time. Now, obviously, there will be the need for additional resources in some areas where volume growth is particularly strong, but in general, yes, the idea is keep the resource base stable and declining.
Got it. Just kind of on that note, kind of in your analysis and in your team's study of the network, how much of that initial volume recovery can you absorb without bringing on additional resources before you guys are fully utilized and network stretched? At that point, do the resources come back one-to-one versus the volumes?
As I said, in the third quarter to date, the leverage has been very, very strong. The incrementals have been very strong, as you would expect with that kind of sequential volume growth and an essentially flat resource base. In going forward, we would expect to continue to pursue that objective. That is really the key in the growth phase of the economic cycle in our industry, to maximize absorption of the volume with a stable or declining resource base. At some point, you do begin to need to add back train starts, employees, but I do not think we are close to that point. Our intent is to continue to drive the growth through the network using the existing assets.
Got it. Just not to belabor the point too much, but obviously, this is a very important topic and probably the single biggest focus area for investors with Norfolk Southern, which is your incremental margins and way back up again because clearly kind of that really drives the numbers higher. Obviously, you are seeing very strong incrementals in 3 Q so far. I think historically, you've done 65%, 70% incrementals in periods of strong growth in the past and up cycles. Are we looking at that kind of incremental margin kind of in the back half of 2020? Can we do better than that? How do you see that continuing in 2021 and 2022 as volumes start normalizing?
Given the structural cost reductions we have made, I think investors can reasonably expect incrementals to be stronger than average in a growth phase of the cycle like we're in right now. Now, going forward, we would eventually expect, I think, incrementals to return to a more normalized level, but that's some ways out. We believe that we can handle growth with the resources that we have while we continue to pursue additional structural cost reductions and absorb growth with that resource base.
Got it. Maybe shifting gears a little bit and kind of going away from big near-term stuff and talking more structurally at a higher level, you've obviously made very good progress on the operations and cost side so far with implementing PSR, but you've also had some turnover on your PSR and operating team recently. Mike left and Cindy is now a COO. What does that mean for the PSR program? What does that mean for the way these gains continue in the near- term and medium- term? Does that signal a shift in your PSR strategy or a transition from one phase to another?
Every member of our management team from the C-suite through field operations is fully committed to precision scheduled railroading because we have seen the success that is possible with PSR. We intend to continue to follow the PSR model and to continue to drive the types of structural cost improvements that are possible while we also continue to communicate with our customers, the no-surprises approach I mentioned in my prepared remarks, so that we have the platform for growth as well.
Got it. Maybe last question on PSR before we switch to other topics. Clearly, kind of at the Analyst Day, you guys had laid out both the cost improvement plan, Top 21, as well as the yield-up strategy. Obviously, we've seen a lot of traction on the cost and operations side so far. How's the yield-up strategy going? Kind of how would you describe the current yield environment? At what point does the PSR kind of transition from the cost side towards the revenue side?
Yield-up is a fundamentally sound strategy for managing the top line in our view because it seeks to obtain value for the services that we provide and the value that we generate for our customers. We are intent on serving our customers well, creating value for them, and generating in return increases in shareholder value for our shareholders as well. That is the essence of the yield-up strategy, and it has been very successful. As I mentioned, the trend in revenue, the revenue per unit component, and the pricing component of our top line in my prepared remarks, the strategy is intact. It is working, and we are very confident that with yield-up, we are producing an optimized top line for our company.
Got it. Let's shift gears a little bit and talk about the demand environment, kind of what you're seeing out there. Clearly, kind of there's been unmistakable improvement off the bottom. The sequential gains have been pretty strong, but for you and the rest of the rail space, volumes overall are still down year-over-year. What's your marketing team telling you? Kind of what visibility do they have? When do they see overall carloads start to turn positive on a consistent basis and kind of stay meaningfully positive for a while? Is that a second half 2020 event, or is that a 2021 event?
Not surprisingly, our carload trend mirrors what's going on in the broader economy. We are seeing strength in consumer-oriented products. Our intermodal volumes are tracking very well, and in some of the subsegments within intermodal, volume is already up year-over-year. In our premium intermodal segment, for example, we are seeing strong growth year-over-year. In other parts of the franchise, we continue to see weakness. Energy-related commodities have lagged overall trends in the economy, and the same is true in our car loadings. Although even there, we are starting to see a little bit of a pickup as inventory replenishment really gets underway. Manufacturing is kicking in some, and we are seeing more demand for basic products. Still, energy products are the weak spot with consumer-oriented products leading the growth.
Got it. Just maybe to dig a little bit deeper there. On the intermodal side, what's been driving that improvement in volumes? I mean, clearly, the comps are easy, but also fundamentally, it looks like things are getting stronger. Is that a function of just the tight truck market? Is that a function of obviously e-commerce being robust? Is that a restocking thing? Kind of what would you say are the biggest drivers of that intermodal improvement?
I think inventory is being very low. The inventory sales ratio having hit all-time lows a couple of months ago and continuing in August, we're seeing a lot of restocking of consumer products, and that's driving the strength in the intermodal franchise to a significant degree. I think we're also seeing a continued migration to e-commerce-related volumes within our network. That was well underway even before the pandemic hit, and I think, as we all know, it's accelerated during the pandemic. Those are some of the drivers of growth in the intermodal segment in particular, but we're seeing a little bit of that in carload as well.
Got it. Just looking out a few months, obviously, one of the big topics of discussion, big focus areas at the Laguna Conference so far has been the truck market, which is already at record levels of tightness, and it looks like the demand side of things hasn't really come back yet. How closely are you monitoring that? Kind of what's your outlook for the spillover into intermodal in the back half of the year? What's going to be your market approach to that? If that does happen, are you happy to take those volumes, or will you be more selective and kind of maybe push you a little bit higher?
We'll work closely with our channel partners who are the best channel partners in the industry to take the growth on favorable terms for both of us. That will be the key to our market approach. We're experiencing very high volumes now, peak season-like volumes already in certain parts of the intermodal network, as I've said. We want to continue to grow that business, but obviously, we need to make sure that we do so on favorable terms and that it is accretive to the bottom line. That's a big part of yield-up, which applies equally in this area as well. We're confident that we can continue to absorb the volume growth. We're obviously coordinating very closely with our key channel partners, folks like J.B. Hunt and the Hub Group and UPS, FedEx, and our other valued channel partners in the intermodal space.
Got it. I think there's obviously a lot of focus on the overall carload volumes, but as you said, it's kind of been a tale of two halves, where intermodal has come back really strongly and kind of commodities and certain parts of merchandise have lagged. Does that feel like a structural shift to you where obviously coal and energy and some of those commodity markets probably never come back, but you have a permanent increase in intermodal volume to replace that? Kind of is this mix that you're seeing right now the new normal for Norfolk Southern?
I think that in some segments of our energy business, utility coal, for example, we are in a secular decline, and there's no doubt about that. Our utility partners are shifting away from coal. We remain committed to hauling coal as and when they need it, but that part of the energy franchise is certainly in decline, and the numbers tell the tale there. With that said, we're seeing a slight rebound in utility coal even as we speak. That is most welcome. Longer term, that part of the energy franchise is in decline. Other parts of the energy-related franchise, I think, will prove to be more cyclical over a long period. As commodity prices recover, then we will see a corresponding step up in volumes on our network as well.
Got it. We have a few minutes left. A reminder to the audience to send in your question to webcast. I already have a couple in here. Before I go to that, maybe I'll ask you kind of one question on the balance sheet. I mean, clearly, you guys have been very tight with your CapEx spending the last couple of years, tighter still now with what's happening with COVID. How do you see kind of capital allocation evolving over the next couple of years? Is there any kind of CapEx you need to catch up on in 2021? How do we think about return of cash to shareholders?
Let me start with CapEx. We have made some pretty steep reductions in capital spending this year, and that was the right move. We have done so, we believe, without creating a bow wave of any sort in future years. I would characterize the reductions that we made as semi-structural cost reductions in the capital spending arena as well. Now, going forward, we will pace ourselves. We will be sure to replenish the core assets of the railroad consistently and sustainably. Growth projects included in the capital budgets will depend on the returns that we think we can generate from those projects. We have the benefit of significantly reduced spending on positive train control. That is helping overall this year's budget and budgets going forward as well. We are getting a little bit of a dividend within capital spending for that.
On the other hand, it's certainly the case that we're spending more on technology. You put it all together, and we've been able to take significant reductions in capital spending this year, and we'll try to keep it productive but tight going forward as well. Turning to other aspects of capital allocation, our strategy has been to maintain a dividend with a long-term payout ratio target of about 1/3 of income. The remainder of free cash flow we generate and any borrowing capacity that we have as our balance sheet expands goes to share buybacks. We're proud of the fact that we have maintained our share repurchase program throughout this year, including in second quarter, when we bought back more shares in dollar terms than the rest of the industry combined. We have stayed on pace with share buybacks in third quarter.
We view that as a very important mechanism for distributing capital back to shareholders along with the dividend.
Got it. Maybe I'll go to the audience questions here. The first one is, where are you on train length and weight today, and how much more can you expand on these from here? I think you touched on those briefly in your slides, but maybe you can kind of tell us what's the target, maybe even a couple of years out on train length and kind of how much room there is to expand there?
Let me focus on weights because that's the metric that we really look at. On a tonnage basis, our average tonnage is running at around 7,000 tons across the entire network. Coincidentally, that corresponds roughly to train lengths as well, but in feet. That feels like a good place to be right now. That's a significant uptick as we have consolidated trains on the network versus a year ago, 6% up year-over-year in terms of train weight and with train lengths actually up 11%. We have continued to lean heavily into increased train sizes, whether measured by weight or length. That will continue to be important. We have already achieved our three-year plan goal for train weights as of where we stand in 2020. There's more room to go. I think, obviously, the constraint is siding capacity on the network.
I think that we have some additional room to run with train weights and train lengths on certain corridors. In other parts of the network where we're constrained in terms of sidings and double track, we will have less flexibility to increase train sizes. Understand that's a key productivity metric and outcome, and we'll continue to push on that.
Got it. The next question is, can you elaborate on the comment about seeing some restocking type activity in basic products going into manufacturing? Is that auto-related or something else?
I would say that's reflected in some of the pockets of growth or improvement that we have seen in our industrial products franchise. For instance, we've seen metals start to come back some. A rebound there clearly would be tied to auto manufacturing and other finished products that consume basic commodities like steel. Finished vehicles inventory is down 26% year-over-year. That's going to pull more product into our manufacturing customers' pipelines. For that reason, we're starting to see plastics pick up a little bit as well, and as I mentioned, steel in particular.
Got it. I think we have just about a minute left. Maybe the last question is, how are you thinking about the puts and takes to pricing in the second half? How should 3Q and 4Q compare to the first half of the year?
As I remind investors that in the second quarter, we did see revenue, overall revenue underperform volume by about three points. Revenue per unit was a downdraft in terms of overall revenue, and that's mix- related. This quarter, we would expect that pattern to continue. We will continue to see revenue, overall revenue underperform volume a little bit more even, perhaps, given the mix within certain subsegments, coal, for example. That will be driven sequentially by pressures on coal RPU, mix within coal. That will continue to pull down revenue. Behind the scenes, within that negative overall RPU trend, we are still seeing strong pricing, and we remain committed to pricing as part of our yield-up strategy.
Got it. When it comes back to the dynamic of customers coming to you kind of in this environment, we heard from trucking that you've had some customers come to them and basically offer price increases to try and guarantee supply. Are you seeing similar trends from your shippers as well?
You have to remember that our pricing is largely contract-based. We do have some exposure to spot markets and spot pricing opportunities, and where we have the ability to take advantage of very tight conditions, we do so. In the main, our top line is contract-based with our customers and other channel partners and would not tend to pivot immediately based on spot market conditions.
Got it. Sounds like a pretty good rebound off the bottom. Jim, thanks so much for joining us with this update today, and we'll speak soon during the 3Q call.
Okay. Thank you, Ravi.
Thanks, Jim. Bye.