Financial Analysts' Meeting
New York, NY - January 24, 2007
Questions and Answers
Thank you, Steve. You've been very patient, but I thought it was important that Steve get up and talk for a few minutes. You've heard us talk over the past few years about the investments we're making, the expenses we're incurring, as well as the capital.
We have been very, I think, prudent and systematic in terms of how we've looked at our property and how we continue to look at it and invest in it. But what I think the charts show and certainly what all of our internal metrics tell us is that the railroad is running very well these days, knock on wood, at volumes that, quite frankly, two or three years ago we would have had a very difficult time handling efficiently, and I think we're setting the stage for further business growth -- and not only to handle that growth, but to handle it at even higher service levels than we have in the past. I can tell you that we look at our service levels in a lot of different ways. We're never satisfied with them, but yet I would tell you that our numbers today reflect a railroad that runs about as well as it probably ever has. So thank you, Steve. And thank you all of you for listening.
I will say one other thing about the presentation before we open it up for questions.
Hank mentioned the FAS 123 charges, and the fact that the charge this year reflects not higher grant levels, but an aging work force. That was a euphemism for the fact that I and a number of my colleagues happen to turn 55 this year and we're retirement eligible, so though we have no intention of retiring, but under the accounting rules, we take the charge. But he was gracious enough not to point that out. Thank you, Hank.
All right, if we could take some questions I saw Scott raised his hand very quickly so.
(Question) Thanks Wick. Two questions. Scott Flower of Banc of America Securities. Two questions if I could for Don Seale. One would be if you could give us some sense of where your fuel surcharge coverage level is, in terms of the percentage that’s covered, and then secondly some sense of what you think that might improve in '07? And then I had one follow up.
(Mr. Moorman) If you want to answer that. Go ahead.
(Mr. Seale) Scott, we concluded 2006 with 91% coverage on our fuel surcharge program. And you will continue to see that change as time goes on, because as you know, we’re in the process of rebasing business as we go forward to reflect higher fuel prices that have been around for a long time now, so we're currently at 91% coverage. You will continue to see fuel surcharge revenue decline going forward as we rebase and also as we see fluctuations in oil prices that we're seeing today.
(Question) The second question relates to the domestic and premium and truckload intermodal markets -- that seems to be where we're seeing a little bit more of the shorter term pressures on supply, demand and balance relative to the domestic truckload industry. Is your sense that more of the pressures in the short run will be manifested by volume just coming off based on how customers are deciding and you're going to stay disciplined on price? Or will there also be some price pressures because that market may be more flexible in the short run, based on what is going on in the TL and LTL markets on pricing on that side?
(Mr. Seale) As I've mentioned, it is our view that the softer demand that we're seeing right now and excess capacity in trucking, as the economy firms up this year, we will not see that excess capacity being there long-term. So we don't see any real impact on our pricing model, the same pricing model that we saw in 2006. We're continuing on that basis and we see a good foundation for that going forward. So even on the IMC and domestic side of our intermodal business, we see this as a short-term phenomenon that we're facing with respect to truckload capacity.
(Mr. Moorman) Let me add that I think our intermodal team, as we've discussed in the past, has done a great job not only of bringing in growth, but bringing it in at good margins. We don't intend to change our philosophy on that and go out and do things in the marketplace from a pricing standpoint that would significantly alter the profitability of our intermodal traffic.
(Question) Tom Wadewitz, with JPMorgan. Another question for you on the intermodal side. When we look at the intermodal yields in fourth quarter they were down year-over-year, and I think that’s the first time since 2003 that we've seen that. It sounded like there were probably a number of mix factors within that as well as fuel surcharge and I was wondering if you could give us a sense maybe what pure price in intermodal was like in fourth quarter, and then a few thoughts about 2007. Intermodal yields, are they likely to be up? Or do these factors persist?
(Mr. Seale) Yes. The fourth quarter yield, Tom, was impacted by mix, as I mentioned. We saw our transcontinental international business decline. It was down 3% in the fourth quarter – that’s generally longer haul, gateway business, versus East Coast port business that may be shorter haul. Over time, we see some of this migrating to the East Coast ports that will actually go back as far as the gateway. So we will see Chicago freight, gateway freight coming through the East Coast ports, if this trend continues. So it was mix.
We continue to see good pricing and yield opportunities for 2007 on the international side of our business as well as the other components of intermodal. I mentioned that we concluded some new contracts late in 2006. We improved our pricing position reflecting today's market conditions in those contracts, and that included international business. Also, I will remind you that as we go forward, we will continue to convert traffic from trailers to containers. That conversion continues. And when we have that change, we have lower RPU for containers but a higher margin.
(Mr. Moorman) I think we saw a fair amount of the volume decrease in the fourth quarter, actually turned out to be trailer business, which is business that over the long term we're happy to supplant with containers.
(Mr. Seale) Yes, Tom, that conversion from trailers to containers will continue. In fact, you probably recall that we predicted that we would be out of the trailer business much sooner than we really are. It has stayed with us longer than we thought it would, but there is a very, very clear trend of going from trailers to domestic containers and international containers.
(Question) And I just got two more. I’ll give you one for Don and one for Wick, short questions. On the UP-NS, the new service on intermodal, is that really primarily a change in flow of traffic from Memphis to Shreveport so you can provide better service? Or is it really a new market opportunity that you see where you would drive additional traffic, either from CSX or from the truckload market? And then for Wick, just thoughts on share repurchase in '07. Thank you.
(Mr. Seale) The answer to the first question is both. The announcement that we made -- we operate the Blue Streak service today, as you know, and we've been operating that for some five years now with UP, over Memphis, a very dependable service to Atlanta and to the Southeast. We will build on that. We adjusted the schedule for availability -- the train will run the same, but availability will be improved by 12 hours to fourth afternoon service starting in February. We’ll also add a new train over Memphis that we will build volume on. And then about July, or August, the beginning of the third quarter, we plan to migrate those trains to the Shreveport gateway using the added capacity on the Speedway, our joint venture with KCS, using that added capacity which will be completed by then, and that will reduce the UP Memphis-NS route by 150 miles and it will reduce the through mileage compared to the competitive route to Atlanta, by 300 miles.
(Mr. Moorman) The Shreveport route, as we told you before, in terms of the speedway, is the shortest, straightest, we believe best route from L.A. to the Southeast. And this is service that will take advantage of that route.
Share repurchase. We have an ongoing share repurchase program, we were -- I think it is fair to say -- probably aggressive, possibly, in terms of our share repurchases last year. We certainly, as you know, made a substantial number of share repurchases. We did that obviously on what I would describe as somewhat an opportunistic basis in terms of what we saw with our share price, and how we feel about the long-term value of our stock. This year, we will continue to repurchase shares. The volumes I think at which we do that will be determinant upon a number of factors, one of which will be share price, but we will also look our hand over in terms of, you know, what we're doing with our cash in general. I think the significant dividend increase that we announced yesterday is certainly part of our plan to return shareholder value, too. Hank, is that a reasonable answer? I check with Hank on my answers here. Let me go there, then there, then there, then there.
(Question) Tony Hatch. Just to follow up again on intermodal, when you migrate that business over to the Meridian Speedway, if you can make an apples-to-apples comparison, will the volume be up versus what you had been doing before? In other words, are you really replacing the volume?
(Mr. Moorman) I don't know that we want to speculate on that right now, Tony. That’s a competitive marketplace. We think it’s a new service. We think it is a great service that’ll have a lot of appeal to customers who are in that route today, and new customers as well. But we've got some plans and projections that I don't want to speculate on it right now.
(Question) Another way to look at what is happening in intermodal also is what percent of your business really can move directly back to the highway, and might have in the fourth quarter, and what percentage of your business can move rail to rail. How much have you locked up and how much is it a rail to rail competitive situation going on as well as a slowing economy? Or are you really just seeing lower volumes because your customers are seeing lower volumes?
(Mr. Moorman) You're talking about in terms of our fourth quarter volumes?
(Question) Yes, I’ve been trying to look at that for the future, but yes.
(Mr. Moorman) And looking at it, I would say, Don, correct me if I'm wrong, but what we're really seeing right now, in our opinion, is a direct result of that index that Don showed you. And all of the reading we do from a lot of you who follow the truckload industry, in terms of what is happening to trucking volumes, and we're seeing a reflection of that, and as Don said, we think that that, over the course of this year, will tend to reverse itself. And we’ll go back, and we're not -- to the extent that you have trucking competitors that go out and when their volumes get very soft do things in the marketplace in terms of pricing or whatever to take some volume away, we -- as I stated earlier, are not going to necessarily follow that, just to keep volume. That's not our business strategy.
Don, is that a fair way to put it? Right here, sir.
(Question) Thank you. Jason Seidl, Credit Suisse. A question for Don. You said about half your book of business will roll over again in '07. What percent of the business has not been repriced under the rail renaissance? Can you give a number?
(Mr. Seale) Jason, we have most of our business now rotating on about a three-year cycle. And as we've mentioned in the past, about two-thirds of our business is under contract, the average duration being three years. So we have a third of that two-thirds expiring each year. And then the balance of those rate instruments are in private quotes or public quotes, and it gives us an opportunity to reprice each year. So we have some legacy contracts that are left that have not been treated, but I will tell you that that is a shrinking percentage.
(Mr. Moorman) And clearly, as Don has told you many times before, as we run into those longer-term legacy contracts, our intent is to generally drive them to a three-year duration, to not extend legacy contracts in that sense.
(Question) Good morning. It is Ken Hoexter from Merrill Lynch. Actually I'm just going to do a quick wrap-up on intermodal before I get to some of my other questions, but I just wanted to clarify, the West Coast volume, the ports were very strong. Are you saying it came from the middle of the country and then trucks increasingly got competitive and you don't expect that competition to slow down going into the first half of the year? Is that -- I'm just trying to understand because I think Tony's question was are you seeing more rail competition, are you seeing volumes overall. It sounded like you, Wick, were saying volumes overall were slowing but West Coast ports are very strong. So I'm wondering why that didn't flow over to the East Coast.
(Mr. Seale) Ken, we saw our intermodal volume this past year, July, and August, really represent more of a peak than we saw in October. So I think it was a couple things at work there. The supply chain is elongated. We've got more retailers now taking inventory earlier in the year for the holidays. So we saw that.
The second thing is that there have been some fairly significant price increases from the West Coast coming to the East Coast. And we're seeing that convert some maritime trade to the East Coast ports, and that cuts both ways. We gain on that. It’s an added opportunity, but for traffic that’s close to the port of entry, like New York, we don't get a haul on that. So it is a two-way street on this. So we're seeing some dynamics there that came into play in the second half of this past year. Now, we're also seeing the truckers a little more aggressive with respect to gateway hauls as well. We don't expect that will continue longer term. It might be four months, five months, six months, but not a longer-term trend in our view.
(Question) Thanks, Don. It’s kind of odd, just because it seems like the West Coast ports are remaining strong but the East Coast are kind of flat. So, you're saying you're seeing a little bit of the opposite.
Hank, I think you've gotten off a little too easily this morning. I just want to clarify two things-- you said $0.10 stock expense in the first quarter. Is that a $0.10 expense or is that an increase of $0.10 year on year?
(Mr. Wolf) That is a $0.10 expense. When you add up all of the moving parts last year, it came to probably $0.09 so it’s only going to be slightly higher than it was last year, and that is because so many of my colleagues are joining the club, that I have loved to belong to now for almost 10 years.
(Question) I just want to -- we've had a lot of this fuel volatility on the synfuel tax credits. It looks like at the end of the year, a full year now, you had, after all of the expenses and everything, it looked like you showed an $18 million gain. If I'm right, you know, on $1.481 billion of net income, you're talking about 1% of your net income for something that has fluctuated, your earnings and stock, in such a great way during this past year.
(Mr. Wolf) Every 18 million counts.
(Question) Okay. That ultimately was where I was heading with this just because …
(Mr. Wolf) We love it.
(Question) Okay. Now, explain this going into '07 then. Is this something -- does it run out in '06-'07? Any chance that you’d be interested in selling this? If fuel is pulling back, does that give you a better benefit now that we're at lower prices?
(Mr. Wolf) Right now, the provisions under section 29 will expire at the end of this year.
(Mr. Wolf) That’s right. So, we have at least one more year of potential benefit. With fuel prices where they are today, and one would expect that if they continued at that level, we would get a higher benefit for the year '07 than we had in '06. But until we know what the fuel prices are, we can't give you that number. What we do internally is make a projection or an estimate for the year and then each quarter we true up.
And so to the extent there were wide fluctuations in fuel prices in '06, you not only had an impact on the individual quarter that you were accounting for, but you had a true-up for the prior part of the year.
I think a good place to start in terms of your model would be to say, okay, what do you think the effective tax rate is going to be? Because the effective tax rate takes this into account. And I'm going to break a cardinal rule that I've had all this time, and that is, I don't give you forecast numbers or budget numbers, but our budget number for effective tax rate is 34% for the year.
(Question) Last one I have, while you're up there, is on fuel surcharges; I'm sorry, on pricing, actually. If fuel surcharge ends up coming down, I think Don was talking about it, and you might have some negative comps, is there a point where Norfolk Southern considers breaking out pure pricing and fuel surcharge -- especially if we're going to see a negative comp which we could end up seeing a negative average revenue per comp?
(Mr. Wolf) Well, I’m going to let Don answer that question, but I think that really and truly, at least from our perspective, we would be reluctant to break out all of that information, because that’s really competitive information. We have competitors in the marketplace and to the extent they have a greater knowledge or understanding of the sensitivities of our pricing approach -- that works to our disadvantage.
But Don, do you want to add something to that?
(Mr. Moorman) And then I’ll answer.
(Mr. Seale) As I mentioned, we are actively rebasing as we go forward with respect to pricing, market-based pricing. And we're converting to the new fuel surcharge level at $64 a barrel. We've got about 10% of our book of business already converted. We're continuing to move on that. Oil prices have dipped recently. Oil went back up to $55 a barrel yesterday. I think if we have normalized weather patterns for the rest of the winter, and demand picks back up in the spring, I'm not sure we see too many folks that feel that the forward curve is too far off, which is $63 a barrel for 2007. So we will continue to work the rebasing effort, and we think that’s the right way to go and have the new fuel surcharge set at $64 for traffic going forward.
(Mr. Moorman) Ken, you asked some good questions. You did something which actually I have a very difficult time doing which is pry something out of Hank. But you also raised a point and I want to make one editorial comment about, and that is the fact that we are in this -- the tax credits -- it is in some sense a relatively modest amount of money, but it does, in fact, add some volatility to our earnings. The fairly wide swings in fuel prices, which we're seeing these days, can also add some volatility, particularly just on the pure revenue side, keeping in mind as well that fuel surcharges typically trail oil prices by 60 days. So that adds even more variability into all of this.
But the fact of the matter is that we come here and report on a quarterly basis, and tell you how we're doing, but we try and manage on a long-term basis, and any opportunity that we have to make more money, to increase shareholder value, we're going to take that opportunity even if it somehow makes our earnings a little more volatile, in terms of breaking things out. If we see radical differences in fuel prices and things like that, we’ll certainly try to explain them to you in the very best way that we can, but still keeping in mind our positions on what we do and that we think is competitive versus what we do that can be open information. But that's our general philosophy. You saw it in the fourth quarter where we had some big material and purchased service charges. They were really the result of some timing on year-long maintenance programs that we have, but we're not going to go in, and for the basis of the quarter, stop a maintenance program. That doesn't make good economic sense to us.
In the back.
(Question) Sal Vitalely with Calyon Securities. I was just hoping that you could provide some more granularity on the cap ex budget for '07, of $1.34 billion, on as few dimensions as possible, in terms of what is growth, versus what is cap ex, and what is maintenance, rather -- and additionally, the growth cap ex, what sectors or what segments of your business is that earmarked for?
(Mr. Moorman) We don't break that out very well, because there is a fair amount of cap ex that you can argue is both. I’ll give you the granularity and then you can think about how it breaks down. As Steve mentioned, we have obviously a base amount that is rail crossties and ballast and programs, signal work that’s in order to maintain the railroad and renew the assets on the railroad, that is a substantial number, which I want to say this year, Steve, do you recall, 500? Hank? 550, 580 -- that kind of number. And then we have other capital that we build on top of that in terms of required projects. And I.T., things like that.
If you look at the growth components, we always have a fair amount of money. The breakdown exists, and it’s in our press release for new intermodal terminals, certainly new capacity. We have budgeted this year about 50 million for the kind of siding and capacity work that Steve talked about. A significant component of our capital budget this year, which you will see on an ongoing basis for a number of years -- you saw an early piece of it last year -- is renewal of our coal car fleet. We're buying 1,300 coal cars this year. That is -- oh, gosh, north of 100 -- slightly north of $100 million in cap ex just for coal. And we're doing rebuilding as well. We always kind of try to do a lot of I.T. work, which we count as capacity development, because we run the railroad better with that. What am I leaving out? We will get to the breakdown, but I would say that this year, if I looked at the budget, in terms of what is setting the stage for new business and better service, and we link the two very closely, the higher our service levels, the more business we're going to develop. Somewhere between 25% and a third of the capital budget is oriented towards better service and new business development, versus kind of keeping the railroad in good running order.
(Question) Sure. Thank you very much. And then in terms of that portion that is growth cap ex, I mean would you say that a fair portion of that is in coal and terminal combined than rather than some of the other segments?
(Mr. Moorman) No, I wouldn't break it down like that, for the following reason. You know, intermodal terminals are clearly an intermodal play, coal cars are clearly -- new better coal cars are clearly coal play. But we look at the business from a network standpoint. And if you look at the maps that Steve showed you about where we're putting infrastructure, and you think about new locomotives and you think about new systems, all of that benefits the entire network. And it improves the use of all of our assets. It may be a heavily intermodal quarter that we're investing in, but if we get the velocities up there, we're going to see positive impacts on our entire locomotive fleet which helps us turn the merchandise fleet better and move more coal cars. So we don't try to, in general, break that out as finely as that.
(Question) Okay. Thank you.
(Mr. Moorman) Tony? One more?
(Question) Sort of related to intermodal and cap ex there, can you tell us what is going on and what stage you're in for the Heartland Corridor building and also with Rickenbacker, and what their impacts might be on business levels this year?
(Mr. Moorman) The ground’s been broken at Rickenbacker and that work is moving ahead. All of the money there is committed and ready to go. We have actually completed now all of the paperwork and approval processes, other than environmental, on the Heartland Corridor on the tunnel clearance program. The FHWA, which will administer the federal funds, is signed off and is on board. We expect that work to begin in mid-year.
Well, listen, thank you very much for your patience. It’s good to see all of you as usual. And we look forward to seeing you for the next report.