Remarks by:
James A. Squires
Executive Vice President Finance and Chief Financial Officer
Norfolk Southern Corporation
Thank you Don. I’ll now provide a review of our overall financial results for the second quarter.
Net Income and Diluted Earnings per Share
Net income for the quarter was $394 million, an increase of $19 million, or 5 percent, compared with the $375 million earned in the second quarter last year. As you will see, the improvement resulted from higher operating income, lower interest expense and lower income taxes.
Diluted earnings per share for the second quarter were 98 cents, which was nine cents per share, or 10 percent, more than last year. The larger increase in earnings per share reflects the impact of our share repurchase program, which I will update you on in a few minutes.
Let’s start with an overview of our operating results.
Income from Railway Operations
As Don described, railway operating revenues declined 1 percent from last year as lower traffic volumes were largely offset by higher average revenues. Operating expenses however declined by a larger amount resulting in a $13 million, or 2 percent, increase in operating income.
The operating ratio improved to 71.0 compared with 71.7 in the second quarter last year.
Now, let’s take a look at the operating expenses in detail.
Railway Operating Expense Analysis
With the reduced traffic volume, most of our expense categories were down. The largest reduction was in casualties and other claims, which declined $19 million, or 29 percent. This decrease is largely attributable to lower derailment-related lading and equipment costs and to lower personal injury costs.
Class I Train Accident Rate 2006
As you know, these types of costs are correlated with train incidents. This slide illustrates our industry-leading low accident rate.
Norfolk Southern Train Accident Rate
And this slide depicts our own year-over-year improvement.
Railway Operating Expense Analysis
Returning to our results, the next largest expense decrease was for diesel fuel, which was down $11 million, or 4 percent.
Diesel Fuel Cost Analysis
The absence of any hedge benefits, which reduced last year’s second quarter expenses by $5 million, was entirely offset by a 4 percent drop in the average price per gallon that lowered diesel fuel costs by $8 million. Also, decreased consumption saved an additional $8 million.
Railway Operating Expense Analysis
Compensation and benefits decreased $8 million, or 1 percent, in the second quarter compared with last year. While this is a modest change, there are some offsetting items I would like to point out.
Compensation and Benefits Analysis
First, incentive compensation decreased $15 million reflecting the higher bar set for our bonus calculation. Second, there was a $9 million favorable settlement of a payroll tax refund claim related to former Conrail employees that came to NS on Split Day in 1999. These decreases were partially offset by increases of $9 million for health and welfare benefits and $8 million of higher wage rates.
Railway Operating Expense Analysis
Materials, services and rents declined $6 million, or 1 percent, in the second quarter compared with last year, as lower volume-related equipment rents and purchased services more than offset higher maintenance costs.
Materials Costs
The primary component of these higher maintenance costs was in mechanical material. Steve and his folks have been making a concerted effort to detect and replace rail wheels at the optimum time. A late replacement of a wheel could result in it exerting too much force on the rail and wears it down more quickly. An early replacement does not get the full benefit from each rail wheel. Based on research and analysis, they identified cars for wheel replacement and that accounted for much of this expense increase. This is an example where we are spending money now to save more money later.
Railway Operating Expense Analysis
Other operating expenses increased by $7 million, or 10 percent, primarily due to higher sales and use and property taxes.
And finally, depreciation expense increased by $10 million, or 5 percent, reflecting continuing investment in our network and equipment.
Non-operating Items
Now let’s turn to our non-operating items.
Other income - net for the quarter was $21 million compared with $33 million last year, a decline of $12 million.
Most of this decrease resulted from expenses related to our synthetic fuel investments, which rose $14 million over last year reflecting a lower expected phase-out in 2007 compared with 2006. Interest income decreased $10 million as a result of lower cash balances and returns from corporate owned life insurance rose $6 million primarily due to improved stock market performance.
Interest expense on debt was $10 million lower than last year, largely due to less outstanding debt.
Now I’d like to provide some detail concerning our synthetic fuel investments.
Synthetic Fuel Investments
This slide shows amounts recognized during the second quarter related to our synthetic fuel investments which, as you know, have a pre-tax and an after-tax component. The net benefit from these investments in the second quarter was $6 million. You will recall the net benefit for the first quarter of this year was comparable at $7 million. Given a similar phase-out for the second half of the year, you might be expecting the net benefit to be like the first half of the year. However, we are increasing our synthetic fuel investments.
Expected Synthetic Fuel Effects
NS recently purchased one facility, and we expect to shortly purchase another, that produce synthetic fuel from coal. Assuming the same 18 percent phase-out that was projected as of quarter end, it is expected that these investments will result in an additional $31 million of net benefit in the second half of 2007. Because of the ramp up of production, about one third of this benefit would be expected in the third quarter with the remainder in the fourth quarter. Combined with the expected net benefit of $16 million from our original synthetic fuel investments, we are projecting a total net benefit of $47 million for the second half of 2007.
Please remember that these credits are subject to reduction as oil prices rise and are also dependent on production levels at the facilities. The 18 percent phase-out equates to a NYMEX per barrel average price for the last half of the year of about $71. Each dollar variability in that average price affects the net benefit by approximately $3 million. This rule of thumb holds true from an average price of $65, where there would be no phase-out, to about $80. Above this price level, curtailment or cessation of production of synfuel may occur resulting in a more drastic reduction to the net benefit.
Income Before Income Taxes
Turning back to our results, the combination of the $13 million increase in income from railway operations and the $2 million decrease in nonoperating items resulted in second quarter income before income taxes of $600 million, which was $11 million, or 2 percent, above last year.
Income Taxes
Income taxes for the second quarter were $206 million compared with $214 million last year. The effective tax rate of 34.3 percent compared with a rate of 36.3 percent in 2006. The decline resulted from the lower expected phase-out of the synthetic fuel tax credits.
We expect our full year effective tax rate to be around 31 percent, which reflects the impact of the new synthetic fuel investments. I want to reiterate that this projection is based on an 18 percent phase-out, and will be affected by changes in oil prices.
And now I will update you on our Share Repurchase Program.
Share Repurchase Program
This slide shows quarterly purchases since inception. During the second quarter of 2007, we bought back 2.8 million shares of stock at a cost of $151 million. In total, we have purchased and retired 30.2 million shares for $1.4 billion, at an average price of $46.05 per share.
Thank you for your attention and I will now turn the program back to Wick.
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