Norfolk Southern Corp (NSC) 2005 Q2 法說會逐字稿

Good morning to the tough and hardy few here.

Appreciate your coming out on a hot day.

Good morning, I'm David Goode, Chairman and Chief Executive Officer of Norfolk Southern, and I welcome everybody to our second-quarter analyst meeting.

As usual, I will remind everybody to take a microphone when you're speaking here and please identify yourself so that the folks or on the telephone can get it.

And I remind our listeners and Internet participants that the slides are available for your convenience on our website in the Investors section.

I will also read the following -- please be advised that any forward-looking statements made during the course of this presentation represent our best, good-faith judgment as to what may occur in the future.

Actual results may differ materially from those projected and will depend on a number of variables, some of which may be outside the control of the Company.

Please refer to our Annual Report or Form 10-Q for a discussion of those variables.

Additionally, keep in mind, and I would say particularly in this quarter, keep in mind that all references to reported results, excluding certain adjustments, have been reconciled on our website.

And this quarter we do have some adjustments that you'll hear about as the day goes on.

I think in the interest of time, I will not introduce our officers, who I think most of you know here.

I will take just a second -- there are two folks here in new roles.

Although you know Bill Galanko, he's now here as Vice President Financial Planning.

And next to him is Rob Kesler, who is a relatively newly elected Vice President Taxation, so these guys are here, along with the other folks, all of whom I think you know, for advice and consultation.

So please use them.

When we last met in April, I said that we were ready for a strong performance in the second quarter, although there were some growing concerns about the economy that were out there in the market.

I'm very pleased to report today that Norfolk Southern not only met but also exceeded expectations, even our own expectations, this quarter.

Our second-quarter results reflect strong growth, record revenues and earnings with an improved operating ratio and better returns for our shareholders.

We reported $1.04 in earnings per share, up 93%.

There's no getting around that this was a great quarter for our Company.

Now, let me quickly recognize that the quarter did benefit from the previously announced effect of settling two coal rate cases and also the favorable impact of tax law changes in Ohio, both of which we've previously announced through press releases.

These adjustments added a combined total of $0.29 per share to the quarter.

Even if we remove this static, and I recognize it's good static, but without that, net income would still have been $0.75 per diluted share.

That's up almost 40% from the $0.54 per share in the second quarter of 2004, a significant improvement.

Our second-quarter operating ratio of 72.5% was 4.1 percentage points better than the second quarter a year ago and 6.9 points better than the first quarter this year.

The favorable rate case settlements contributed 1.2 of the 4.1 points, but you will quickly recognize that that's still a significant improvement in operating ratio.

And our operating metrics improved through the quarter, even as we handled approximately 73,000 additional carloads.

So it's really hard to find -- hard for me to find things wrong this quarter.

I think the story of the quarter was our ability to handle continuing high volumes of business at service levels that met customer needs.

This enabled us to continue our valued pricing model and improved yields and at the same time realize improving efficiency in margins.

You will see this consistently throughout the presentations we have this morning.

We have every anticipation that we will continue to improve these numbers.

So our service improvements in the second quarter compared to the first were modest.

They were improvements, and to make sure we continue to be ready for growing business, we launched TOP 2.

Those of you who follow us know TOP, and we launched TOP 2 in July after the quarter ended.

That startup appears to be working well in the early stages and it should enable us to handle the strong fall business we expect efficiently at good margins.

We have ensured the Surface Transportation Board that we will be able to handle the fall peak.

As all of you who follow Norfolk Southern know, we focus on consistent incremental improvement in the operating ratio.

The year-over-year improvement this quarter shows we've plenty of room to go, and I'm confident we should be able to continue to improve our operating ratio in the future.

We've seen better numbers in the past on Norfolk Southern and they are good models for improvement, so I feel good about our ability to continue our improving operating ratio trend.

We've been watching carloadings carefully through July.

So far, they have shown continued traction with some continued weakness in autos and metals being offset by coal, intermodal and general carload strength.

For July, our overall carloadings are about even with last year, which you'll recall was a year when nobody took a vacation, and so we are about even with strong comparisons.

We are expecting upside as we move forward into the peak season.

As further indication that Norfolk Southern is moving on the right track, our Board increased our dividend again yesterday by $0.02 to a quarterly rate of $0.13, and, as we've said before, we expect to strive for a continued pattern of increases while simultaneously continuing to reduce debt and improve our balance sheet, which we also did in the quarter.

You will also have noted that Standard & Poor's increased our ratings last week.

In short, this was a fine quarter for us.

A lot of good things happened.

A lot of people made those good things happen.

I'm confident that Norfolk Southern will continue to leverage our momentum for the rest of the year, including our service quality and pushing new business and margin improvement as we do, reaffirming our position.

Now, I'm going to ask Hank to begin putting up a lot of numbers that we will show you now.

Hank will review our numbers, Ike will talk about the specifics of the market and then Wick will come in at the end and say a few words about plans and trends.

Steve does not have prepared remarks today, but as always, we will all be happy to take your questions.

And I will call on Hank for the financials.

Thank you, David, and good morning.

As I was starting the day today, I usually start the day with a walk for exercise.

And I was approached suddenly by a jogger who asked me if I had any spare change, and it turned out it was Wick Moorman.

So that tells you how hard we are at looking for those extra pennies.

As David indicated, I will be reviewing our financial results in detail, but before I do, I would like to remind you of two significant items which affected reported second-quarter earnings.

First, we entered into a settlement agreement with Duke Power and Carolina Power and Light, which resolved their rate cases before the Surface Transportation Board.

These statements -- settlements, rather, resulted in increased net income of $24 million or $0.06 per diluted share.

Secondly, late in the quarter, the State of Ohio enacted changes in its tax laws which required us to reduce deferred income taxes and resulted in an increase in net income of $96 million or $0.23 per diluted share.

Our reported results establish new record highs for any quarter in railway operating revenues, income from railway operations, net income and earnings per share.

And I would emphasize, however, that even excluding the impact of the coal rate cases and the benefit of the changes in the Ohio tax laws, that our railway operating revenues, income from railway operations and net income and earnings per share before accounting changes, each establish new record highs for any quarter.

Railway operating revenues for the second quarter were 2.2 billion, up 341 million or 19%, and were the highest quarterly revenues in our history.

For the first six months, railway operating revenues were a record 4.1 billion, an increase of 609 million or 17%.

Second-quarter volume rose by 73,000 units or 4% compared with last year, driven by 54,000 or an 8% gain in intermodal units.

In addition, revenue per unit increased by 14%, reflecting higher rates, increased fuel surcharges and favorable settlements of the rate cases.

These settlements, the rate cases, were attributable to 3% of the 14% increase in revenue per unit.

For the first six months, volume growth of 179,000 units, or 5%, combined with a 12% increase in revenue per unit to produce a yield -- a 17% increase in railway operating revenues.

Ike Prillaman will provide you with the details of our revenues in just a moment.

Railway operating expenses for the second quarter were 1.6 billion, up 174 million or 13% compared with '04.

For the first six months, railway operating expenses were 3.1 billion, 385 million or 14% higher than '04.

The largest increase in railway operating expenses for the second quarter was in depreciation, up 64 million or 49%.

And as you'll recall, this was principally due to the effect of the divisive reorganization of Conrail last year, and you will note that there is an offsetting decline in Conrail rents and services.

The next-largest increase was in compensation of benefits expense, which rose 59 million or 10% compared with last year.

As we observed in January and again in April, when we reviewed our quarterly results, strong business growth combined with demographics of our workforce have caused us to hire new employees to ensure adequate levels of qualified train and engine employees and increased levels of mechanical people.

This chart shows railway employment levels for the past six quarters.

You can see year-over-year, second-quarter employee levels are up about 8%.

As you know, training for a railroad operating position take several months to complete.

Thus, based on our forecasting models, we have been hiring for the last three quarters to be well-staffed for the peak fall season.

As you can see, this hiring began in the third and fourth quarters of last year.

This increased hiring, combined with additional business volume being handled, produced an $18 million increase in additional train and engine employee hours.

About half of this increase is attributable to trainees.

Higher health and welfare benefits costs and lower pension income added 12 million to compensation and benefits costs.

Wage rates were up 11 million.

Costs for funding life insurance added 7 million, higher payroll taxes, 5 million and increased non-T&E hours increased compensation costs another 5 million.

Material services and rents rose by 57 million or 15% in the second quarter.

Within this category, volume-related purchased services increased by 20 million, particularly for intermodal services.

Increased maintenance activities added 20 million to material costs, including 13 million for locomotive overhauls and freight car repairs scheduled to handle the higher traffic volumes that we saw in the second quarter and expect throughout the balance of the year.

Equipment rents were up 14 million, reflecting higher traffic volume, as well as equipment leases from Conrail which were previously recorded or embedded in the line Conrail rents and services.

Diesel fuel expense for the second quarter was up 56 million, or 53% compared with last year.

As you can see, the average price per gallon of diesel fuel increased from $0.86 in the second quarter of '04 to $1.28 this year.

Consumption of approximately 127 million gallons was 3% higher in the quarter on a 4% increase in traffic volume.

Our average price per gallon would have been $1.59 absent the benefit of our fuel hedges.

During the second quarter, 52 million gallons of fuel were hedged at approximately $0.80 per gallon compared with almost 96 million gallons hedged at $0.79 in the second quarter of '04.

Even with the smaller percentage of fuel hedged, the dramatic increase in price resulted in an even greater hedged benefit -- 40 million this year compared with 26 million last year.

As you can see in the third quarter, our hedged position declines to 39.1 million gallons and again to 28.6 million gallons in the fourth quarter.

As a reminder, our hedged position for ‘06 is approximately 12% of projected consumption in the first quarter and 3% in the second quarter.

As our hedged position diminishes, absent a drop in diesel fuel prices, you can expect that our diesel fuel expense will rise.

Other expenses were 6 million, or 10% higher than last year, principally due to increased property taxes and higher sales and use taxes.

Casualties and other claims were up 2 million or 5% for the second quarter, primarily due to unfavorable claims development.

For the first six months, railway operating expenses were up 385 million or 14%.

As was the case in the second quarter, the largest increase in the year was in depreciation, combined with a corresponding decline in Conrail rents and services as a result of the Conrail reorganization and the accounting that flowed from that reorganization.

The second-largest increase was in material services and rents, which increased by 128 million or 17%.

The same costs that impacted the quarterly increase again contributed to this increase as well and included higher volume-related purchased services of 46 million, 33 million more in material related to the increased maintenance activities, including 26 million for locomotive and freight -- locomotive overhauls and freight car repairs, and higher volumes related to equipment rents, which were up 25 million.

For the first six months, compensation and benefits were $118 million higher than the same period last year.

The increase in compensation and benefits expense was the result of increased T&E hours that added 34 million; higher wage rates of 23 million; increased health and welfare benefits expenses and lower pension income, which collectively added 18 million; increased non-T&E hours that added 12 million; higher payroll taxes of 11 million; costs for funding life insurance benefits of 7 million; and a host of other miscellaneous items that totaled $13 million.

Diesel fuel expense was up 99 million or 46%, primarily due to the increased average price per gallon that rose to $1.20 for the first six months of '05 compared with $0.84 for the same period in '04.

Without the benefit of the fuel hedges, our average price per gallon for the first six months would have been $1.50.

Our fuel hedges have produced $80 million in diesel fuel savings for us in the first half of the year.

Casualties and other claims expense was 40 million or 51% higher in the first six months of '05.

This increase was primarily driven by the costs associated with the Graniteville accident in the first quarter, which added $37 million in expenses.

Other expenses were up 9 million or 8%, again reflecting higher taxes for property taxes and higher sales and use taxes.

The railway operating ratio for the second quarter was 72.5%, 4.1 percentage points better than the 76.1% operating ratio in the second quarter of '04.

The settlement of the rate cases contributed 1.2 percentage points to this improvement.

For the first six months, the operating ratio was 75.8% compared with 78% for the same period last year.

This represents an improvement of 3% over '04.

Second-quarter income from operations was a record 592 million, up 167 million or 39% over the 425 million produced last year.

For the first six months, income from railway operations was also a record at 995 million, up 224 million or 29%.

Total other income and expense for the second quarter was an expense of 117 million, compared with an expense of 121 million in '04.

And although the total change is relatively small, you can see on this graphic a number of individual variances.

Expenses related to tax credit investments were 17 million higher this year.

As you may recall, in the second quarter of '04, we entered into a synthetic fuel investment that produced other expense, but at the same time generates tax credits under Section 29 that are reflected in the income tax line.

Gains on sales of property and investments were 8 million higher than last year, and coal royalties were up 4 million.

There was an additional 8 million in equity earnings of Conrail, and as you will recall, this was recorded in Conrail rents and services for reporting periods prior to the reorganization.

All other was an increase in income of 6 million, which reflects primarily some additional interest income on cash balances that we had.

Interest expense on debt was 5 million higher than last year, reflecting the interest on the Conrail debt assumed as part of the Conrail reorganization and now included as Norfolk Southern debt.

For the first six months, total other income and expense was an expense of 243 million, compared with an expense of 232 million in '04.

Expenses related to the tax credit investments were 40 million higher than last year.

Gains on sales of property and investments were 14 million higher and coal royalties increased by 7 million.

Equity earnings in Conrail added another 14 million.

All other was an increase of 6 million, which included the additional interest income of 11 million.

Interest expense on debt for the first six months was 12 million higher than last year, again, largely due to the interest on the Conrail debt that was assumed as part of the reorganization.

Second-quarter income before income taxes was 475 million, compared with 304 million last year, a 56% increase for the first six months.

Income before income taxes was 752 million, up 40% compared with 539 million in '04.

Income taxes for the second quarter were significantly affected by the $96 million non-cash tax benefit associated with the changes in the Ohio tax laws.

Because of this, total tax expense was only 51 million for the quarter compared with 91 million in the second quarter of '04.

The effective tax rate for this quarter was 10.7%, compared with 29.9% last year.

For the first six months, the provision for income taxes was 134 million, compared with 168 million last year, and the effective tax rate was 17.8%, compared with 31.2% in '04.

Second-quarter net income was 424 million, which is 211 million or 99% higher than the 213 million earned in '04.

For the first six months, net income was 618 million, compared with 371 million last year, an increase of 247 million or 67%.

Diluted earnings per share for the second quarter are reported at $1.04, compared with $0.54 per share last year, a 93% increase.

For the first six months, diluted earnings per share were $1.51, which was 61% above the $0.94 per share earned a year ago.

Excluding the effects of the change in the Ohio tax laws, and the settlement for the rate cases, second-quarter income would have been a record 304 million, which is $91 million or 43% higher than the 213 million earned in '04.

And for the first six months, net income would have been 498 million, compared with 371 million last year, an increase of 127 million or 34%.

Diluted earnings per share for the second quarter excluding the rate case settlements and the change in Ohio tax law, would have been a record $0.75, compared with $0.54 per share last year, a 39% increase.

And for the first six months, diluted earnings per share would have been $1.22, which was 30% above the $0.94 per share earned a year ago.

This slide reconciles the income and earnings per share for the second quarter and first six months of '05, excluding the Ohio tax legislation and the two rate cases, to our reported net income and earnings per share.

And this reconciliation is posted on our website and available for your use at that location.

At this time, I would like to thank you for your attention and turn the program over to Ike Prillaman, who's going to give you an in-depth report on our revenues, and Ike is going to be followed by Wick Moorman.

Thank you, Hank, and good morning.

I will begin this morning with a few comments about the overall economy, which, along with U.S. rail volumes, continued to grow during the quarter despite increasing oil prices.

The ISM manufacturing index was up more than 2 points in June, and perhaps more encouraging was that the index for new orders reached its strongest reading this year.

And as reported in the Wall Street Journal last week, and from my point of view contrary to most thinking, manufacturing production now stands 3% above the height of the last business cycle.

So, our manufacturing sector is looking very positive.

Looking for trends of our markets, intermodal continued growing, albeit at a more moderate 8% rate versus 10% for the six months, while coal volumes increased at a consistent 3% for the quarter and year to date.

Merchandise volume for industrial markets increased 1% for both the quarter as well as for the first six months, and that was in spite of declines of our auto and metals business, which are our two largest industrial markets.

This decline was more than offset by gains from our paper, chemicals and ag business, which supports our opinion that we do have a well-balanced portfolio of business.

As Hank indicated, Norfolk Southern achieved record revenue for the quarter and exceeded 2 billion for the first time ever.

This is an increase of 19% over the second quarter of 2004.

This was the seventh successive quarter of reporting record revenues.

And I should note that our quarterly revenues of 2.154 billion includes 55 million for the settlement of the coal rate cases.

For intermodal, it was the second-best quarter for both volume and revenue.

Revenue reached 428 million for the quarter, up 18% over the same period last year, and for the six months, revenue of 836 million is 21% over 2004.

International volume was up 14% for the quarter and 15% for the year to date, and increased NS business from East Coast all-water service along with the continued growth of transcontinental traffic contributed to these volume gains.

Truckload volume grew 6% for the quarter and 11% for the year, while domestic IMC volume was down 3% for the quarter.

Freight that had traditionally been transloaded into a domestic box and shipped via truck or an IMC has remained in the steamship containers to the inland ports, and during the quarter, this created truckload capacity in the marketplace, specifically in the Midwest and West Coast, and did moderate the first-quarter growth rates for both truckload and IMC.

Triple Crown volume continued to increase with a larger road rail or fleet, as well as expanded markets.

Volumes were up 9% for the quarter and 8% for the year.

And looking ahead, the international ship lines continue to project a 10 to 12% year-over-year increase for the second half of 2005, and it's also expected that truck capacity will again tighten this fall, and we believe that will provide another opportunity for increased volume and pricing.

Looking at coal, volume increased 12,000 carloads or 2.9% and reached its highest carload quarter since the Y2K concerns during the fourth quarter of 1999.

More importantly, it was our highest tonnage quarter ever, which increased 3.4%, and you will note that tons are up more than carloads as our efforts to have more coal loaded into cars are beginning to positively affect the metrics.

Utility carloads increased 4% for the quarter and 3% year to date as stockpile levels were replenished and demand continues at a sustained level, as natural gas prices are projected to remain very high into 2006.

Several utilities have told us that marginal generation will probably go the coal route -- not probably, will, as opposed to choice of gas.

Coal availability we believe will remain tight.

Our export volume declined by 4700 carloads or 11% for the quarter, but it's still ahead 3% for the six months.

Lamberts Point traffic was down due to coal supply problems caused principally by the Buchanan mine closure, which has now reopened.

Even with cutbacks in European steel production, the worldwide availability of metallurgical coal remains tight, and which I believe will sustain the demand for U.S. coals.

Export volumes were also affected by the U.S. domestic metallurgical markets, where demand was particularly strong during the quarter, which increased 14%, and 12% for the six months.

And volume was driven by higher production of domestic coke for the integrative steel producers.

The U.S. coke production increased during the quarter as new coke batteries came online, and I would add that the Chinese government announced last week that coke exports would be cut back, and this I believe will also supports the demand for U.S. coals going forward -- net coals.

Our industrial coal market, as you see, did turn around in the second quarter, and this was after several year-over-year declines.

On the merchandise side, it reached the highest revenue quarter as revenues for both the second quarter and six months are up 12% on a 1% increase in volume.

Paper, chemicals and ag markets, our volume growth exceeded the rail industry averages for the quarter.

Our paper and wood products revenue of 197 million for the quarter was the highest ever and was up 17%.

This was the highest volume achieved since the first quarter of 2001.

Revenue was up for all of our paper market groups.

Chemical markets also produced record revenues and were up 15% for the quarter and 14% for the year to date.

This was the highest-volume quarter, which exceeded the record volumes of 2000.

And our ag business also had its highest volume and revenue quarter as well.

These gains are attributable to the strong exports as well as processing plants returning to full production and the continued ramp-up of new feed mills.

Metals and construction revenues were up 16%, reaching a record 243 million for the quarter in spite of a decline in volume.

For the six months, revenues are up 75 million or 19%, and this is the largest increase of any of our industrial carloads sector.

Rate increases and changes in mix more than offset the revenue loss from the decline in volume.

And I would add that demand for coals, steel and scrap metal has dropped, while steel plate production remains high, and of course that's related to the continued construction underway in this country.

Even with the 4% volume decline, automotive revenue reached a record 263 million for the quarter.

The increase in revenue was the result of higher pricing from renegotiated auto parts and vehicle contracts.

In addition to production cutbacks at Ford and GM, DaimlerChrysler volume was down for the second quarter as a result of downtime at two assembly plants, and several weeks of downtime were taken at certain Ford plants and GM closed three assembly plants during the quarter.

The transplant volumes and revenues continue to grow.

Full production at Honda's second plant at Lincoln, Alabama and increases from the Mercedes, Alabama plant expansions along with Toyota's strong results, partially offset the Big Three cutbacks.

Looking ahead, total North American vehicle production for 2005 is projected to be down 1.3% versus '04.

However, I would add that it would be up slightly for the second half.

With the exception of intermodal and metals and construction, all of our market groups experienced record revenues per unit for the quarter.

Service improvements, price of energy and an ongoing shortage of trucking capacity continued to produce a favorable pricing environment for rate increases.

Traffic mix, longer haul business and broader coverage of fuel surcharges also contributed to the increases of revenue per unit.

For the quarter and year to date, increases in fuel surcharges represented about one-third of the gain in revenue per unit.

Coal revenue per car is up $322 for the quarter and $229 for the six months, which includes $126 and the $64, respectively, for the effect of the rate case.

We also have had improved pricing across the board for all of our coal markets.

Export rates at Baltimore were increased $2.5 per ton, and that was effective January 1.

Prices at Lamberts Point were increased $5.00 per ton on April 1.

Fuel surcharges also contributed to the gain.

Our merchandise groups also achieved significant improvements in their revenue per unit.

Market-based pricing, our truck pricing with continued emphasis on modal conversion and fuel surcharges were the main drivers.

Intermodal revenue per unit gain of $48 or 9% resulted from yield improvements, which was offset by a mix change due to an increase of shorter haul business that continues to grow as a result of the container ship lines all-water service to the East Coast.

To summarize or conclude, Norfolk Southern has recorded revenue growth of 1.14 billion the last four quarters, and it is also positive to see our industrial market volumes approaching our 2000 levels.

The market outlook for the remainder of the year I believe is optimistic.

The recent forecast for continued economic growth and positive reports about the rebound of the manufacturing economy, as well as the projected 10% growth in international trade, is encouraging for the second half of 2005.

Now, obviously, I am bullish about the markets, and that is in spite of difficult comparisons against last year that -- the oncoming difficult comparisons against last year, and that's particularly in automotive and metals.

Thank you.

And Wick will now share some additional analysis of our results and a view of our efforts going forward.

Thank you, Ike.

It is true that I went for a run this morning, and as I came back, I saw this fellow walking down the street and I approached him for some spare change.

The reason, though, I went to Hank for spare change is the reason -- well, he's talking, he went to the bank.

So I know where the money is.

So it didn't work out.

I couldn't get anything.

Thanks, Ike.

It obviously was a great quarter for us in almost every respect.

And I thought I would wrap things up briefly by talking a little bit about how we're looking at the future in terms of continuing to drive operational and financial performance.

First, though, I want to acknowledge the fact that our employees earned an unprecedented 16th consecutive E.H.

Harriman gold medal for employee safety in 2004.

For 16 years now, Norfolk Southern has been the safest Class I railroad and has reduced accidents and injuries to an extent that would have been thought impossible just two decades ago.

It really is a Lance Armstrong kind of performance, I think.

And it's particularly important, I think, in today's conversation because in the same way that we have woven continuous safety improvement into the fabric of everything that we do, Steve Tobias, a smart man, and their teams are now also continuing to build into our fabric a culture of continuing improvement in service performance and service delivery.

Now, our service metrics remained stable in the second quarter of 2005, even as you've just seen our volumes continued to increase to a record level of about 1.95 million loads.

And in fact, we handled this 4% increase in volume with about 2.5% increase in crew starts, which demonstrates continuing leverage of our system.

While our second-quarter key operating metrics were not quite as strong as they should have been on a year-over-year basis, they did improve considerably compared with the first quarter of the year, and we expect that improvement to continue for the balance of the year.

It is clear in terms of service in the second quarter that we did offer service products that met if not exceeded the needs of our customers, and that is evidenced by the continuing strong demand in most of our business segments and our ability, as you saw, to continue to realize value-based pricing gains.

But, and I will tell you that it's a big but, all of us at Norfolk Southern know that there is still a lot of room for improvement in our operating efficiencies and our service deliveries, and we are really focused and committed to making those improvements.

We're confident that if we remain relentlessly focused on making those improvements that we can continue to not only improve the demand for our products and continue to grow the topline, but we can also drive a lot more operating efficiencies into our system and take out money on the operating side, and that's our plan for driving our operating ratio down.

Well, how are we going to do that?

Well, as David mentioned, we've got a lot of initiatives underway.

The first, obviously, is TOP 2, which we think will be a significant catalyst for the improvement of our network.

As you will recall, TOP 2 accommodate the changes in our business since we implemented TOP 1.

It also, in addition to incorporating our general merchandise traffic, adds our intermodal network and to some extent our coal and grain unit train networks.

Now, the first benefit that we expect to see when TOP 2 is completely rolled out, which is in the mid-August time-frame, are continued -- are improved performance in our yards in terms of connections and improved train performance on our general merchandise network, and we should then see that as improvement in some of the metrics you look at, particularly the terminal dwell and the average train speed.

The integration of these networks that I mentioned makes a lot of strategic sense for us as well as the networks obviously share the same locomotive power and share the same crews and offer us opportunities to realize further efficiencies, which we expect to when everything is in place.

TOP 2 is really all about service performance and resource utilization.

At the same time, we do expect it to add more capacity for future growth opportunities.

We're also continuing to make prudent investments in the other drivers of capacity on our network -- crews, power and physical infrastructure.

As I mentioned last time we met, we're taking more delivery -- delivery of more locomotives in the fourth quarter, as we've announced, and we're making investments, as you've seen, in our people, our locomotive and freight car fleets, so we can keep our operating standards and service levels high.

On the locomotive front, we take delivery, as I said, of 102 new locomotives in the fourth quarter, with more coming online in the first half of 2006.

We are continuing our accelerated locomotive overhaul programs.

They will help us improve the reliability of our fleet and they will also improve the longevity of our fleet, which clearly has important implications for CapEx in the years to come -- positive implications, that is.

In the second quarter, to give you some numbers, we overhauled 135 locomotives, and that compares with 84 in the same period of last year, a 61% increase.

And additionally in our car programs, to help ensure that we have the right car at the right time for all of our customers, we've accelerated the program -- we spent about almost $8 million in freight car repairs and programmed freight car repairs in the second quarter of 2005, and that compares with about $3.5 million in the second quarter of 2004.

On the employment side, and you saw the numbers in Hank's presentation, we do continue to invest in hiring additional train and engine crews to meet growing business demands as well as meet the expected attrition that we're looking at in the next few years.

As Hank mentioned, it takes awhile -- it takes six months to train a conductor.

It takes a year to train an engineer.

And we've got to get people in the pipeline well in advance of our attrition needs and our additional business needs to make sure that we have the service levels that are required to handle that business.

We are continuing to closely monitor, though, I will tell you, our employment levels to make sure that we have the right people in the pipeline, the right number of people -- not too few, but in addition, not too many.

And finally, in terms of capacity, we're also continuing to invest on a very targeted basis in physical infrastructure, identifying pinch points in the system and addressing them as quickly as we can.

Looking ahead, we remain committed to careful strategic investment in the business and to moving the network to ever-higher levels of efficiency.

Our goal, all stated, is to offer a premium level of service to all of our customers across the network.

We believe that the results that we've shown you today and have shown you in the past few quarters continue to validate the strategy of providing an ever-higher value transportation product along with exemplary operating efficiency to drive ever-improving results, and I am confident that that will continue.

At this point, I will be happy to turn it back to David to answer all of your questions.

Thank you, Wick.

I will be moderator and we will now take questions.

Jason Seidl, CSFB.

Given that we're seeing some of the shippers plan better here in '05 for the peak season and that you just implemented TOP 2, can we expect to see some improvement in your service metrics actually in the third quarter in terms of greater improvement for year over year than we saw in the second quarter?

We certainly expect that you will.

It may be a good opportunity for Steve to say just a couple of words on how he feels about our service metrics.

Well, as you all know that I'm not prone to offer too many predictions, but I think I will stand on our past records of our focus on service metrics, dwell, velocity -- they are all key aspects of some of the measurements that we focus on from an operational standpoint that, as Wick has spoken more specifically to TOP 2, we are very confident that TOP 2's product in a review of the 5000 different blocks we make on our system -- the 367 train routes that we operate on a daily basis that we have not only built capacity into the train network, but we've also built capacity into our switching network to handle different levels of volumes than we've experienced in the past.

So, the question about creating capacity is still very prevalent in our minds -- optimism, if you will -- I'm looking forward at the economy and continued growth.

Metrics are important.

They drive utilization, particularly speed and dwell.

They bring greater levels of assets and human resource to the table.

The better we do, the easier it gets to do it.

And I think that would be the thought that I would try to leave you with.

Second question is probably for Ike.

Can you guys discuss a little bit about the impacts of the PRB disruptions and if you expect any sort of a spike in '06 or pent-up demand and delay to the E Stream total test runs (ph).

Ike, do you want to do that?

I will try that.

I think that has minimally affected us.

We have several large plants that do receive PRB coal, but for the most part, maybe a shortfall of five trains a month based on a 90 expected, which has not really affected the stock costs.

We watch that carefully, naturally, as you would expect.

We work closely with our Western partners to make sure that the utilities that are using Power River Basin coal are okay, and we -- as you can imagine, we are in very close touch on an ongoing basis with our big utility customers in the East to monitor their inventories and work with them at times where coal supply is very tight.

So, I think we've established very close relationships with our customers to make sure that the utilities are taken care of, be that with Power River Basin coal or Eastern coal, whichever they can use, and we work with them in making sure that they've got supply.

And we're pretty confident we can continue to do that.

At the same time, we're managing it very carefully in cooperation with both of the Western railroads that we work with.

We feel pretty good about that.

Yes, Tom.

It's Tom Roderick from J.P. Morgan.

I've got two questions, I guess one for Ike and then maybe one for David or Rick.

The first question here, Ike, you started to mention some things on fuel surcharge, and I was wondering if you could -- given that you've gone down that path a little bit, if maybe you could give us a sense of where you think you are today, maybe percent of the portfolio that has a good fuel surcharge mechanism on it, and what kind of a pace we can expect in terms of ramping up to get to further coverage.

The word coverage is the key term, and our coverage does continue to grow.

And as Hank pointed out, we are planning on having full coverage to take care of the hedge as it disappears.

But as I mentioned, it's about 33% of our increase in revenue per car, and that varies between the three major markets between 25% to close to 40%.

So a really -- because it is negotiated, I cannot make a broad-based statement of (multiple speakers).

I would say we have about 80% coverage now in some form.

Now some of that is not covered directly by the fuel surcharge chart or matrix that we have out there, but as contracts are renewed or renegotiated, we plan to get everyone on the same highway.

Is that something that can ramp up pretty quickly, or is it you've got a bunch of long-term contracts that it's really kind of a slow ratcheting up from here?

I guess I would say that it has been -- it has taken some time to ratchet up.

We've now been -- pretty well got it ratcheted up.

As contracts come due, we are including fuel surcharges in the renewals of them if we possibly can, and we've had good success at doing that, because I look at fuel surcharges, as all of our pricing is market-based pricing, and in today's environment, there's a pretty good understanding that fuel surcharges are a necessary part of the component.

So, we have pretty good acceptance of the need for that from our customers and we are implementing it and we fully realize that we are a little more cautious at disclosing the details of these surcharges than some other folks are, and that's because we think they are market-based and competitively driven numbers, but Ike gives you this -- a sense of what you see in the numbers this quarter and that third is a pretty good index.

And the second question I guess just considering two historical benchmarks, if you will.

In the past, you've been active in share repurchase.

I know that was a while ago, but I'm wondering if that's something that given some strong performance if you can quickly get back into a mode of doing that.

And in terms of historical peak hours, I think, you know, in 1997 at 71.3 hours, any reason that we can't get back towards that type of level?

It seems like you are approaching that relatively quickly.

I will answer the second first.

Certainly, the comments that I've made and Wick made indicate that we have our eye pretty firmly on that ball.

I don't know how many years you and I have been talking about this, Tom, but in all of my years as CEO, one of the things that I always talk about is the need for us to continually focus on improving that operating ratio and improving our margins, and we've had good historic success doing it.

Certainly, we've had good recent success.

We think we -- we certainly have to keep as an index our own previous best, and we are focused on getting there, but we're focused on getting beyond that.

Because frankly, we know others have gotten beyond that and we think we can achieve a lot of leverage yet on that.

We don't -- as with some other things, we don't make absolutely specific predictions, but you see what the focus has done on it, and we're pretty confident we could continuously improve that.

On the share repurchase question, what we've said is that our philosophy has been to continuously reduce our debt, repay it.

We've done that.

Hank, we've paid off 500 million this year?

About 500 (multiple speakers) including the debt exchange, we've paid down net of 500 million of debt this year.

Second leg of the stool is dividend increases.

Our Board has done that as recently as yesterday.

And so you see that we're focused on that.

And then the third leg of that stool that we keep our eye on is share repurchases, and I guess the best way to say that is that we have our eye on that third balanced stool as well, and you'll certainly be the first to hear when we announce something.

Okay.

Great.

Thanks.

Congratulations on a good quarter.

Thank you.

Yes, go ahead, Gary, and then I'll get to you, Tony.

Gary, you had one on polyphones (ph)?

Just to clarify a few things.

I think, Ike, you had mentioned on the coal yields a number of $126 per unit.

Is that effectively the impact of the rate case on a per-unit basis in the second quarter?

I wasn't sure.

I'm not sure I completely understood that.

Ike, did you get that? (multiple speakers)

Well, I think you said 126 or maybe I transcribed it wrong.

I want to make sure I understand what that number represents.

Revenue per unit is up $322, and the change in revenue for coal is 153 million.

And fuel, excluding the rate cases and to give you a little better hint at coal, fuel surcharges is about 18% of the revenue per car or the revenue increase in coal.

Let me back up and see if we've got -- I'm not sure we got the question right.

(inaudible -- microphone inaccessible)

That's the increase in revenue (multiple speakers)

That's the increase in revenue car per car just due to the (multiple speakers)

Yes, you restate it.

You need that number, which includes 126 and 64 for the --

Okay.

Can you talk a little bit more about the export coal business and maybe on Buchanan, how much did it hurt you, how much does it help you coming back?

And just exports maybe over the course of the next year?

It all depends on availability of metallurgical coal, and certainly on the export side, how the European steel industry will -- at what rate they will be producing.

It is my belief that oil supplies will remain tight, which means that the price of Australian coal is still going to support a demand for U.S. export coals.

With the higher demand for domestic metallurgical coals, I would put those two points together and say that the price I think will remain high -- perhaps not $120 a ton that we continue to read about.

But I think the demand will be very high.

And I would think that export will come back.

The decline that we had was principally due to the fire at the Buchanan mine, and we believe that we would have been generally flat, and I would again say flat only because of the lack of availability.

There is some possible investment in additional net coming onto the market.

There are always the possibility of conversions of the high vol back into the market.

But, it looks very good.

We love the export market, as you well know, and work with our customers to try to find supply for them in that market.

In some cases, we're seeing coal that would otherwise be moving in that market that are reflected in other places in the numbers.

So to some extent, the kind of the story is all the coal that can be mined is being mined and we're moving every kind of coal that comes out of the ground, and it changes somewhat from traditional sources as to where it is used.

But we do think that -- we do expect the rest of the year that metallurgical coal will be more like it was in the earlier part of the year, and that second quarter is kind of an aberration.

But, we're cautious on that because we can't necessarily control that supply of coal.

If I could just sneak in one more with Hank, talking about just the relationship of CapEx to sales.

It's been, I don't know, 12, 13, 14%.

With operations improved and with pricing environment better, can we see that ratio start to move down over the course of the next two, three, four years?

Well, I don't know the answer two, three, four years out.

Last year, we had CapEx that was a little bit over $1 billion -- maybe 1.40 billion.

Right now, I think this year we're looking at about 1.50 billion.

We have 182 or 183 locomotives on order already for 2006, and I want to try and work very closely with Steve and his team to try to keep CapEx next year at about the same level that it has been last year and this year, if at all possible.

But until we actually sit down, go through the process, find out what the needs are, it's impossible to put that kind of a precise number on it that you're looking for, Gary.

And I would say to you that the first thing that we want to do in the environment that we are in right now is make the investment that we need to make in order to not only capture the traffic, but also to provide that traffic with service levels that we need to provide for those customers.

One thing we've learned -- I'll just make I guess a philosophical comment -- one thing we've learned is that to make money in the business, you've got to be able to move the trains and handle the service and do it.

And we have a pretty good track record of when we are able to provide acceptable service levels to our customers.

And we continue to try to get better and better, and we know we don't reach our customers' expectations yet.

But what we've learned is that we can do that.

We can provide returns and we need to keep our eye firmly on that ball.

At the same time, we also understand the capital intensity of our business, and we've talked to you many times about wanting to get acceptable returns on investment for our shareholders, so we've got that in mind.

We think that our record of capital expenditures over the last several years shows that we can, by carefully targeting our capital expenditures, achieve capacity improvements and in some ways by doing other things, like TOP 1 and TOP 2 and some of the other operational efficiencies that we do, and by doing that, improve the ratio constantly that you talk about, Gary.

And I guess the best way to answer it is we're about to go into capital budgets, into our final stages of capital budget planning for next year.

We're doing that looking at some pretty strong volumes in this business.

But at the same time, we're pretty optimistic that we came get capacity improvements in some other ways and keep that capital spending line where I think everybody would like to see it.

Yes, thanks.

Tony?

Related to Gary's question, and I've got two.

One is, do you think you can earn your cost of capital this year, given that the returns you are doing?

And the second bid is given the changing mix within intermodal, you know, short haul intermodal growing, especially in the international side, and Triple Crown growing pretty well, etc., given all those mix changes -- all those moving parts, where are the returns and the margins within intermodal?

You know, we saw what the yields are, but how are the returns going this year, year over year, and where do you expect that to go?

On the cost of capital question, you could -- you know that when we do that, we will be the first to brag about it.

It's clearly objective; it is clearly shaping up as a very good year for us.

But I never -- there are nine innings, and if you are a baseball fan, and there are nine innings and sometimes extra innings in a game, and you never count that lead until you see it.

But certainly, I think we have made very good progress towards that and we continue to keep our eye on that.

On the intermodal business, Ike, do you want to -- or Wick, do you want to make some comments on that?

Tony, I guess we will never be content with margins in any line of business, but I can tell you that margins on the intermodal side are higher than they've ever been.

I would also suggest that no matter how much all-water service increases in the East, it's not going to make a big difference, because there is the capacity -- the finite capacity on the East Coast.

Most -- we will continue to see transcontinental shipments of international imports.

And when you throw in the 10 to 12% growth factor, I would suggest both the West Coast and the East Coast will always have the capacity issues.

It's a very changing world.

But I think the high energy prices, the issues with the trucking industry -- the trucking industry working and choosing to work with the railroads has given us certainly a better spread to work with as far as opportunity for pricing, both on the international scene and domestic.

You know, looking ahead in the future on the intermodal business, we think our job is to provide capacity and make ourselves the mode of choice for moving export and import freight.

And we are planning to do that thinking that their port capacity is going to be stretched in every port in the country, including in the Eastern ports.

So, we are working to make sure that we do everything we can to have the capacity available in the Eastern ports to handle the business that we think will come in.

At the same time, we're working with our Western partners to make sure that the transcontinental business is fully protected from a capacity standpoint, too.

Steve has a further comment on that.

I would like to add, but then I will go back to Gary's point.

One of the things that you may not be putting your finger on here is the robust nature of TOP.

When we first put TOP in, we viewed TOP as a bit of an advantage from the standpoint of being able to analyze our system in a matter of weeks -- to rejigger our schedules, to keep up with the mix and change in flows.

With TOP 2 and our operating plan developer that supports TOP 2, that several weeks is reduced to several hours.

We're not only able to manage the mix in a much more efficient fashion from a change standpoint, but we're also able to do the what-ifs from a planning -- the impact of ports, the change in flows as it relates to water versus rail.

There is a significant dynamic that attends that.

And all of those things underpin our ability to ratchet efficiency out of what we do.

And when I make the comment, the better we get, the easier it gets, easier translates to more economical it gets, and I think that plays into both of those points.

Hi, it's Ken Hoexter from Merrill Lynch.

I'm just still a little surprised that you guys are talking about fuel surcharges, so I just want to come back to that for a second.

On the 80%, was that percent of contracts, percent of revenues or percent of total coverage?

That was percentage of contracts.

I think Ike was referring to percent of our contract that have some form of fuel surcharge in them.

Obviously, our goal in that is 100%, and we will work towards it.

But the point is we've had pretty good success as we've renewed contracts over the last couple of years in including fuel surcharges.

Can you translate that to percent of revenues?

I don't think I can translate what percent of our revenues have a fuel surcharge on it.

I don't think I can give you that number.

It would be a pretty high number.

Our -- as we've said, the way we manage fuel surcharges is through a combination of fuel surcharges and hedging, where appropriate, and where we can do it to try to cover as much as we can of the increase in fuel costs over the last couple of years.

And we feel that we're getting to the point where we've had pretty good success in doing that.

But not knowing in the future what increases are going to be means that you have to have a pretty robust fuel surcharge program in order to achieve that coverage, and it's kind of a shifting target.

So, if we look at it, I guess there's only three quarters left of the hedge.

Do you presume that you will be 100% covered by the surcharge in early '06, or is there always going to be a (multiple speakers)

Well, you're reading the message on that.

That's something we look at on a regular basis to see how we feel we're going to be on it.

And obviously, as the hedge declines, it says that we think we've increased the coverage of the surcharge.

If we knew what fuel prices were going to be two years from now, we've got to be able to answer your question.

But obviously, none of us do.

What we do is just try to manage it on an ongoing basis to do the best we can, and as the quarter shows, we've had so far good success in doing that.

And just a quick question to the follow-up discussion on the whole intermodal kind of shift to the East Coast ports, where we've seen a huge growth rate at a couple of the ports.

Is that -- are we going to need to see expansion in some of the yards, building new yards, or is that built into the annual CapEx budget already, or should we be looking for additional capital?

I think we will be making investments.

I think that if there's anything out of the norm, we will announce it and tell you on that.

I think that we always -- our CapEx budget for the last five years has always had in it intermodal improvements, and I would expect that it would continue to do that.

But if there are big numbers that we're going to spend, and obviously for capacity improvements like that, we work with a combination of the states and the federal -- and federal programs and the port authorities and everybody works in order to try to get the most efficient money to make those investments, and part of that is ours.

You saw us announce the intermodal facility at -- Ricken -- at Columbus, the Rickenbacker facility -- Wick and Don Seale and I cut the ribbon on that yesterday, I guess -- or day before yesterday.

And it's likely that the investment by us of about 30 million, which was in last year's capital budget.

And so we always have -- we'll always have those, but I think if there's anything out of the ordinary on that, you will see us announce it specifically.

And my last one is on the coal contracts.

Obviously, phenomenal pricing on a year-over-year basis, excluding the settlement gain.

Are there additional contracts coming up?

Has everything basically been repriced since you started this increased pricing and fuel surcharge campaign, or shall we see this kind of growth sustained over the next few years?

Or is this -- do we settle down in normal rate increases?

Obviously, it's been an extraordinary period in the coal business, where our coal pricing -- coal prices have gone up, and have gone up dramatically, and at the same time with natural gas prices being where they are, every utility wants to use coal wherever they can.

So the environment obviously has pricing opportunities in it for us, and you've seen that achieved, and we expect that to continue.

There are contracts always coming up.

I think we don't want to talk about it in any specificity, but where contracts are coming due, we will reflect that.

We have signed a couple of large utility contracts.

We have settled a couple of rate cases, as you've just seen, and so a lot of that is behind us, but there's more in the future.

Any other questions?

You have been a very patient group.

I know there's more activity yet today that you will be interested in, so thank you for being here.

It was a strong quarter, we feel, and we're proud of it, but we think there's a lot more to be done.

So thank you and we'll look forward to seeing you next quarter.