Norfolk Southern Corp (NSC) 2007 Q2 法說會逐字稿

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  • Operator

  • Good morning and welcome to the Norfolk Southern Corporation second quarter earnings conference call.

  • At this time I would like to pass the conference to Leanne Marilley, director of investor relations.

  • Thank you and have a good conference.

  • Go ahead, Ms.

  • Marilley.

  • You may begin.

  • Leanne Marilley - Director - Investor Relations

  • Good morning.

  • I'm Leanne Marilley, director of investor relations with the Norfolk Southern Corporation.

  • Before we begin today's meeting I would like to mention a few items.

  • First, we would like to welcome those who are listening by telephone and on the internet.

  • We remind our listeners and internet participants that the slides of the presenters are available for your convenience on our website in the investors section.

  • Additionally, MP3 downloads of today's meeting will be available on our website for your convenience.

  • As usual transcripts of the meeting will also be posted on our website and will be available in a few weeks upon request from our corporate communications department.

  • During the question-and-answer session please identify yourself before you ask a question so that everyone can hear you, including our satellite listeners.

  • 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.

  • Statements that are forward-looking can be identified by use of the words such as believe, expect, anticipate and project.

  • Our actual results may differ materially from those projected and will be subject to a number of risks and uncertainties, some of which may be outside of our control.

  • Please refer to our annual report filed with the SEC for a discussion of those risks and uncertainties we view most important.

  • Now it is my pleasure to introduce Norfolk Southern's Chairman, President and CEO, Wick Moorman.

  • Wick Moorman - Chairman, President & CEO

  • Thanks, Leanne, and good morning, everyone.

  • It's my privilege to welcome you to our second quarter 2007 analyst meeting.

  • Before we get started, I wanted to point out that we do have several members of our management team with us today, including Our Vice Chairman and Chief Operating Officer, Steve Tobias; along with Deb Butler, Executive Vice President, planning, and our Chief Information Officer; Don Seale, our Executive Vice President and Chief Marketing Officer; and Jim Squires, Executive Vice President of finance and our Chief Financial Officer.

  • We're also joined by Bob Fort, Vice President of corporate communications; Rob Kesler, Vice President, taxation; Bill Romig, Vice President and treasurer; Marta Stewart, Vice President and Controller; and Debbie Malbon, Jim Squires' assistant, way in the back.

  • Well, I'm pleased to report strong second quarter financial results, particularly during a quarter characterized by continued softness in certain segments of the economy.

  • Norfolk Southern produced a second quarter record for income from railway operations, reflecting the strength of the market for our transportation services, as well as our sustained focus on providing a higher-value service product.

  • Despite continued volume pressures in the automotive and housing sectors of the economy, along with some softness in our intermodal business, we produced improvement in revenue per unit.

  • Of equal importance, we were able to control operating costs, which declined 2%, and when combined with our nonoperating results resulted in a 5% increase in net income, or $0.98 diluted earnings per share for the quarter.

  • Particularly noteworthy is our second quarter operating ratio of 71.0%, down from 71.7% in the second quarter a year ago and the lowest for a second quarter since the Conrail integration.

  • For the first half of the year our operating ratio of 73.7% is the lowest six-month ratio post Conrail.

  • As a further indication that Norfolk Southern is on the right strategic track, our board increased our dividend 18% yesterday resulting in an annual dividend of $1.04.

  • As you will recall we also increased our dividend by 22% in January, as well, and we've now nearly tripled our dividend in the past three years.

  • Jim Squires, our CFO, will provide you with details of the financial results in just a moment.

  • Operationally we continue to safely and reliably handle very strong business demands, improve our infrastructure, and maintain strong service levels.

  • We continually strive to improve our service performance by intensively managing all of our assets; our people, track, equipment and information.

  • In that regard our board yesterday authorized an increase in the capital budget for the purchase of an additional 50 locomotives to begin delivery in the fourth quarter.

  • This additional power will aid us in continuing to improve our service performance, particularly in our unit train network, primarily on the coal side, where we're implementing a new service plan to increase velocity and reduce car requirements.

  • We're also keeping an eye on our long-term improvements.

  • This quarter we made significant progress in preparing for the Heartland Corridor clearance work and we should be working on nine tunnels on the route by October.

  • We also announced recently the creation of the Michigan Central, a joint venture with Watco Companies.

  • We believe that it creates a new model for such transactions, which will be a win-win proposition for both parties, and we're currently in the process of seeking approval for the transaction from the Surface Transportation Board.

  • I'm now going to turn the podium over to Don Seale, our Chief Marketing Officer who will walk you through our second quarter results from a traffic standpoint, Jim Squires will follow with the financial overview, and then I'll return with some closing comments before we take your questions.

  • Don?

  • Don Seale - Chief Marketing Officer

  • Thank you, Wick, and good morning, everyone.

  • Let's see if we can -- even though the economy rebounded somewhat in the second quarter, transportation services demand, which is the red line in this chart, has not returned to the robust level seen in 2006.

  • The primary constraint to GDP continues to be weak housing along with higher gas prices, which has contributed to a slow-down in consumer spending growth.

  • In view of softer demand and stronger comparisons the last year that reflected record volumes of over two million units, volume this quarter declined by 4% or 82,000 loads across five of our seven business groups.

  • As in the first quarter, weak housing and domestic automotive production were the largest contributors to the softness in our overall volume.

  • The remaining losses were the result of moderating international trade, higher coal stockpiles and lower steel production.

  • Total revenue reached $2.378 billion and was our third highest quarter ever.

  • This quarterly result was $15 million less than record revenues set in the third quarter of 2006, and was achieved with 49,000 fewer carloads.

  • Compared to the second quarter of 2006, volume was down 82,000 loads while revenue was within $14 million or 1%, reflecting continued improvement in revenue yield.

  • Revenue per unit improved by 4% for the quarter, reaching $1,224, an increase of $42.

  • This was our 19th consecutive quarter of year-over-year revenue per unit growth and all of our business units produced gains for the quarter except automotive, which was flat.

  • Continued strength in pricing along with more favorable traffic mix drove the improvement for the quarter.

  • Turning to our individual markets, Coal revenue of $579 million was down 1% versus second quarter of last year.

  • Carloads declined 3% in the same period, while tons were down 2%, reflecting higher average per-car payloads.

  • Revenue per unit grew by 2% for the quarter, reaching $1,332 per car.

  • An increase in yield combined with declines in short-haul river traffic and improvement in tons per car boosted revenue per unit.

  • Turning to the segments in Coal, the utility market was down 6% in carloads in the quarter, electric generation has remained fairly strong in our service territory, up 3% but high stockpile levels weakened rail coal demand.

  • Utility stockpiles remained at or above normal levels, which allowed utilities to burn from their inventories during the spring months and transport less coal.

  • The summer cooling season has begun in earnest and inventory levels are declining, but remain above 2006 levels.

  • Export coal was strong in the second quarter, increasing 33% over the same period last year.

  • Demand for U.S.

  • coal is currently higher due to the weaker dollar, as well as vessel loading delays at Australian and Canadian coal ports.

  • Net coal, coke, and iron ore carloads were down 8% for the second quarter.

  • Furnace and coke battery outages caused by a softer steel market reduced demand for metallurgical coal and coke.

  • Industrial coal carloads were up 6% in the second quarter.

  • New business and stronger demand were the primary factors that drove growth in this market.

  • Turning to Merchandise, our Merchandise group reached its second highest quarter ever at $1.32 billion, up $9 million or 1% over the same period in 2006.

  • Volume was down 4% for the quarter, principally due to lower auto production and a weaker manufacturing economy.

  • In spite of the decline, this was the 14th consecutive quarter of year-over-year merchandise revenue per car growth, which was a record at $1,822 per car.

  • Positive traffic mix changes in the quarter with less lower rated short-haul business, the addition of some higher-rated import volumes, and favorable pricing across the commodities drove this performance.

  • Within the groups -- within the Merchandise group chemicals produced a new record for revenue per car in the quarter, principally driven by improved pricing.

  • Chemicals also produced its first year-over-year gain -- volume gain since the second quarter of 2005 prior to the Gulf storms.

  • Agricultural volumes also rebounded in the quarter, increasing by 2%.

  • While metals and construction faced tough comparisons to the all-time high volume of 223,000 carloads in the second quarter of 2006, volume in this quarter of nearly 210,000 cars was the third highest ever for this sector, in spite of lower steel production and soft residential construction markets.

  • This decline in metals and construction traffic, coupled with weaker paper and forest products carloads, were large components of the year-over-year decline in Merchandise.

  • Iron and steel shipments declined by 14% and coil steel volumes were down 10% as the slow down in auto production reduced our import and domestic slab trains handle.

  • Miscellaneous construction volumes were off by 13% due to the continued weakness in the housing sector.

  • Paper and forest product volume was down, due to lower paper production, coupled with a 17% reduction in lumber, as a result of lower housing starts.

  • Also, kale and clay shipments declined by 8%, due to reductions in paper production and the impact on pressures from Brazilian import clay.

  • On the plus side, several of our individual markets achieved strong growth for the quarter.

  • Our scrubber stone business for the utility industry continued to ramp up, increasing over 1,000 loads in the quarter.

  • We also saw higher volumes of aggregates associated with new highway construction projects.

  • Also, as I just mentioned, many of our agricultural markets performed well in the quarter.

  • International trade drove gains in export wheat, fertilizer volume was up 7% for the quarter due to increased corn acreage related to ethanol production, and ethanol volume increased by 13% in the quarter, as the market continues to ramp up.

  • And the 2% gain in chemicals was partially attributable to increased shipments of soda ash and higher volumes of plastics.

  • Automotive was the other major component of the decline in our Merchandise sector, with volume down 13,000 loads, or 8%.

  • Plant closures and production cuts at Ford, General Motors and Chrysler resulted in a volume decline of 12% for the quarter.

  • Shipments for the new domestics, such as Toyota, Honda and BMW , were up 2,400 loads or 8%.

  • As we previously advised, year-over-year comparisons will continue to be impacted by the Big Three plant closures and production cuts through the second half of 2007, and into early 2008.

  • Now, turning to Intermodal.

  • Intermodal revenue in the quarter of $479 million was down 4% versus 2006, as volume declined 5%.

  • Revenue per unit was up 1%, reflecting a combination of fuel surcharge increases and stronger traffic mix in international and Triple Crown.

  • Within the market segments, international volume was down 5% for the quarter, as imports to the U.S.

  • continued to soften compared to last year.

  • Despite slower imports, our volume was primarily affected by a reduction in empty containers handled compared to last year, while loaded container volume remained virtually unchanged.

  • With weaker demand in the Far East for empty equipment, the shipping lines are opting to move empties that are on the east coast via east coast vessel services rather than expedite them moving them westbound by rail.

  • We also saw increased storage of empty containers in the U.S.

  • during the quarter, again reflecting declining demand for empties in Asia.

  • As the mix of loaded and empty containers has changed, so, too, has the mix between our east coast and west coast traffic.

  • An 11% increase in east coast volume was more than offset by a 15% reduction in west coast volume.

  • The west coast continues to be challenged by the impact of inland transportation cost increases, incurred by a large portion of the customer base.

  • As a result, the shipping lines are terminating cargo at west coast ports and requiring the beneficial owners to book and route their cargo inland using a third party, as opposed to inland service provided by the steamship lines.

  • In turn, this has encouraged customers to use all water service to east coast ports.

  • In the combined truckload and domestic IMC segments, volume decreased 7% for the quarter.

  • Domestic IMC traffic continued to lag behind 2006 levels in the face of softer demand and higher capacity in the marketplace.

  • Truckload shipments were also down for the quarter due to the same demand capacity factors, but this decline was somewhat mitigated by the continued conversion of over-the-road business to intermodal by a couple of our large asset owners such as JB Hunt.

  • Our premium intermodal volume was up 5%.

  • Within the premium sector growth was due primarily to increased activity with UPS.

  • Finally, even though we've seen increased demand for our Triple Crown business as the year has progressed, volume continued to be impacted in the second quarter by production cuts at automotive plants and softness in the housing and consumer products markets.

  • Now, looking ahead, Intermodal comparisons to 2006 become easier in the second half of this year.

  • While trucking capacity relative to demand remains somewhat high, increased fuel costs and projections for improvements in manufacturing and economic output should bolster second half volumes.

  • Additionally, we hope to see a more normalized Intermodal peak season this year, which as you know, did not materialize in 2006.

  • Also on the horizon, two preliminary phases of the Heartland Corridor will be completed later this year, as we begin new service at our new Rickenbacker Terminal in Columbus, Ohio, late in the fourth quarter and A.P.

  • Moller opens its new $450 million marine terminal at Port of Hampton Roads later this month.

  • In the Coal sector utility stockpiles are declining but remain above 2006 levels.

  • We're seeing some signs that utilities may be interested in additional coal shipments in the second half of 2007, as continued strong electricity demand forces them to run their coal plants at maximum capacity.

  • In the export market, Australia's coal port congestion is not improving and we expect to continue to see stronger export coal demand for the remainder of the year.

  • In the met market, two primary coke batteries have resumed operations, which should improve inbound coal volumes.

  • We expect fewer furnace outages, which should stabilize volumes for the remainder of the year.

  • And finally, we expect industrial coal to remain strong for the balance of the year, with increased economic activity and industrial production.

  • In our Merchandise markets, we should see increasing volume growth in several segments.

  • Metal shipments are projected to improve, particularly in the fourth quarter when steel capacity utilization is forecasted to be higher.

  • In the construction sector housing starts are likely to remain soft, but regional highway projects, commercial construction, and scrubber stone markets for the electrical utility industry are slated to drive volume and revenue growth.

  • As we shared with many of you at our investor conference on June 6, there is significant project and industrial development-related growth on the horizon.

  • Later this year we expect to begin shipping soy beans to the new Dreyfus 80-million gallon biodiesel plant at Claypool, Indiana, near Fort Wayne.

  • This facility presents opportunities for outbound biodiesel transportation to selective markets, in addition to inbound soy beans.

  • Four additional NS-served ethanol production facilities are scheduled to open in the Midwest in the second half.

  • These facilities will total approximately 330 million gallons of additional production capacity.

  • These new plants will generate nearly 7,000 carloads of corn, ethanol and DDG feed supplements.

  • Our challenges will continue to be the housing impact on lumber and increased truck competition in our paper and consumer product markets.

  • But on the lumber side we will benefit from new business to a new distribution center and truss plant scheduled to open in August at Holiday City, Ohio.

  • In automotive we will continue to see the impact of Ford and GM plant closures in 2006, but year-over-year comparisons should be easier in the second half of the year, as new business is added to our network.

  • And finally, across all groups, we see ongoing opportunity for improved pricing and yield, as expiring contracts and quotes are repriced in the second half.

  • In sum, we're well positioned to see improvements in yield and volume across our business, as economic activity improves here in the U.S.

  • and global volumes pick up this fall.

  • Our continuing focus is to provide our customers with the best possible service in a safe and efficient manner, while fully realizing the increasing value of our service in today's changing transportation market.

  • Now, thank you, and Jim Squires will now review our financial

  • Jim Squires - CFO

  • Thank you, Don and good morning, everyone.

  • I'll now provide a review of our overall financial results for the second quarter.

  • Here we go.

  • Net income for the quarter was $394 million, an increase of $19 million or 5% 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 $0.98, which was $0.09 per share or 10% more than last year.

  • The larger increase in earnings per share reflects the impact of our share repurchases, which I will update you on in a few minutes.

  • Let's start with an overview of our operating results.

  • As Don described, railway operating revenues declined 1% from last year, as lower traffic volumes were largely offset by higher average revenues.

  • Operating expenses, however, declined by a larger amount, resulting in $13 million or 2% increase in operating income.

  • The operating ratio improved to 71 compared with 71.7 in the second quarter of last year.

  • Now, let's take a look at the operating expenses in detail.

  • 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%.

  • This decrease is largely attributable to lower derailment-related lading costs and equipment costs and to lower personal injury costs.

  • As you know, these types of costs are correlated with train incidents, and this slide illustrates our industry-leading low accident rate, and this slide depicts our own year-over-year improvement.

  • Returning to our results, the next largest expense decrease was for diesel fuel, which was down $11 million or 4%.

  • The absence of any hedge benefits, which reduced last year's second quarter expenses by $5 million, was entirely offset by a 4% drop in the average price per gallon that lowered diesel fuel costs by $8 million.

  • Also, decreased consumption saved an additional $8 million.

  • Compensation and benefits decreased $8 million, or 1% in the second quarter, compared to last year.

  • While this is a modest change, there are some offsetting items I'd like to point out.

  • 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.

  • Material services and rents declined $6 million or 1% in the second quarter compared with last year, as lower volume-related equipment rents and purchased services more than offset higher maintenance 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, and early replacement does not get the full benefit from each rail wheel.

  • Based on research and analysis, they have identified cars for wheel replacement and that accounted for much of this expense increase.

  • This is an example of where we are spending money now to save more money later.

  • Other operating expenses increased by $7 million or 10% primarily due to higher sales and use and property taxes.

  • And, finally, depreciation expense increased by $10 million or 5%, which reflected continuing investment in our network and equipment.

  • 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.

  • And now I'd like to provide some detail concerning our synthetic fuel investments.

  • This slide shows amounts recognized during the second quarter related to our synthetic fuel investments, which as you know, have a pretax 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 expect the net benefit to be like the first half of the year; however, we are increasing our synthetic fuel investments.

  • NS recently purchased one facility -- and we expect to shortly purchase another -- that produce synthetic fuel from coal.

  • Assuming the same 18% 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% 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.

  • 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% above last year.

  • Income taxes for the second quarter were $206 million compared with $214 million last year.

  • The effective tax rate of 34.3% compared with a rate of 36.3% 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%, which reflects the impact of the new synthetic fuel investments.

  • And I want to reiterate that this projection is based on an 18% phase-out, which will be affected by changes in oil prices.

  • Now, I'll update you on our share repurchase program.

  • This slide shows quarterly purchases since the inception of the program.

  • 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 over to Wick.

  • Wick Moorman - Chairman, President & CEO

  • Thank you, Jim.

  • Well, as you've seen, the second quarter did pose some challenges for us, not like what we experienced -- not unlike, I should say, what we experienced in the first quarter, in that for only the third time in three years we saw volumes decline on a year-over-year basis.

  • However, as I said earlier, even in the face of that decline we were able to realize an improvement in both revenue per unit and our operating ratio, which speaks to our commitment to value-based pricing and our focus on operating efficiency and cost control.

  • As we look to the balance of the year, we do expect the resumption of volume growth, although those expectations are tempered by the continued pressure in the automotive and particularly the housing sectors.

  • What remains important to note here, though, is that our current volumes remain at historically high levels, even what is clearly a softer freight transportation environment.

  • In fact, with the exception of a couple of brief periods, our traffic levels have been at or above our 2005 traffic levels, which were very strong.

  • Despite some near-term economic uncertainty, we're confident that the structural factors that have driven our growth over the past few years are still in place, and that long-term demand for our transportation services will continue to grow.

  • We're committed to strategically investing in safety, capacity and new technology to capture that growth.

  • Our goal is to offer a premium level of service to our customers across our network -- excuse me -- and all facets of our enterprise served to support that goal.

  • In terms of our service metrics, as you can see from the public metrics of cars on line, velocity and terminal dwell, the second quarter was improved over the first quarter of this year, and we saw some improvements year over year, as well, in terms of some of our internal metrics.

  • While our service is judged to be good by our customers, we know we can improve even further and that remains our primary focus.

  • The recently approved purchase of additional locomotives and our wheel replacement program that Jim mentioned, are but two examples of this focused effort, along with initiatives in locomotive and car maintenance and infrastructure improvements that we've already discussed with you.

  • We strongly believe that our continued investments, both on the capital side and the expense side, will enable us to drive further operating efficiencies and deliver solid financial results for our shareholders.

  • On the financial front, in addition to our first priority of investing in the business, we remain committed to increasing shareholder distributions.

  • Our dividend increase is a strong indicator of that commitment.

  • We're also committed to continued share repurchases on an opportunistic basis, and you'll see us acting on that commitment when market conditions are right.

  • I hope we've illustrated to you all today the progress that we're making on all fronts.

  • As you've heard me say before, superior service is the catalyst for improved profitability and free cash flow, which creates long-term value for our owners.

  • As we move into the balance of the year, Norfolk Southern will continue to leverage our operating momentum to improve service quality, pursue new business and margin improvement opportunities.

  • Thanks very much for your attention, and we'll now be happy to take your questions.

  • Wick Moorman - Chairman, President & CEO

  • And the hands are going up.

  • We'll start (inaudible)

  • Bill Greene - Analyst

  • Bill Greene, Morgan Stanley.

  • On the locomotive fleet, the fact that you're growing it, I would have thought that you would have had some excess [locomotive] power, given what's happened with the volumes, so are there implications about how we should be thinking about 2008 CapEx from this?

  • Are you trying to pull forward some spending to invest, given the opportunities you see in '08?

  • Wick Moorman - Chairman, President & CEO

  • What I would say is we clearly haven't decided on the 2008 total capital budget for locomotives.

  • Some of these locomotives that -- the 50 locomotives that we've received authorization for will, in fact, be delivered in the first quarter of 2008.

  • But this -- the locomotives are largely aimed at new service plans that we've developed, which will greatly increase the velocity of our unit train network, both on the grain and the coal side.

  • As you know, we're looking at the prospect of buying a significant number of new coal cars over the next seven or eight years.

  • We think these plans and this ability to increase our velocity will substantially reduce the requirements for new coal cars and we'll talk to you more about that, as time goes by.

  • But we think this is a very efficient use of capital to start reducing our equipment requirements today and in the future.

  • Bill Greene - Analyst

  • Okay.

  • And then can we just get a sense for two things.

  • On pricing, in terms of just core pricing, how was it for the quarter ex-fuel and mix?

  • And secondly, was the payroll tax benefit one time?

  • Wick Moorman - Chairman, President & CEO

  • The answer to the second question is the payroll tax benefit was a one-time item.

  • But Don, why don't you talk for a minute about pricing?

  • Don Seale - Chief Marketing Officer

  • We -- Bill, we continue to see pricing in line with what we saw in the first quarter.

  • We saw 4% in the first quarter, another 4% in the second quarter.

  • Mix, while it was modestly favorable, I'll tell you it was only 0.3% of a percent, so essentially it was flat.

  • The 4% RPU reflects the continuity in our pricing.

  • Tom Wadewitz - Analyst

  • Yes, good morning.

  • It's Tom Wadewitz.

  • Wanted to -- actually I was thinking maybe I'd catch Don still up there, but I guess I'll --

  • Wick Moorman - Chairman, President & CEO

  • He can come back up here.

  • Tom Wadewitz - Analyst

  • Sure.

  • How should we think about intermodal sensitivity to the truckload market?

  • If the truckload market remains weak for a sustained period of time, is it still possible to really see your intermodal volumes pick up, or is that a significant enough headwind that we should really pay attention to what that truckload market looks like when we think about your growth in Intermodal?

  • Wick Moorman - Chairman, President & CEO

  • You want to try that and I'll --

  • Don Seale - Chief Marketing Officer

  • Well, Tom, as you know, the truckload market is comprised of a lot of different segments and we're seeing a portion of that truckload market, like our large asset-based participants, like JB Hunt, continue to grow with us.

  • We're seeing others protect driver pools and actually take some freight and put it back on the highway, so we're seeing a mixed bag.

  • I think ahead, though, if we continue to see fuel prices go up -- and the forward curve on oil indicates that that may happen -- we're optimistic that intermodal volumes on the truckload side will continue to improve.

  • UPS is stong with us and JB Hunt continues to be strong.

  • On the international side of the business, we do expect to see some semblance of a peak season this year compared to no semblance of a peak last year.

  • And as I also mentioned our comps on volume this second half, compared to last year, are easier comps than the first half.

  • Tom Wadewitz - Analyst

  • Okay, I'd follow up on intermodal.

  • On the international side, is east coast business good or bad versus west coast, and can you give me a sense of the difference in length of haul between those two?

  • Don Seale - Chief Marketing Officer

  • About 50% of our international business is now east coast.

  • If you go back five years ago it was only 20%, so we have seen a migration of all water service that we're about 50% off the west coast now and 50% off the east coast.

  • A haul from one of the east coast ports back into Ohio or back to Memphis, those are good hauls compared to the hauls that we have coming from the west.

  • So we're indifferent with respect to the east versus west.

  • We're working with all parties for both coasts and all ports.

  • Tom Wadewitz - Analyst

  • Okay, great.

  • One last one just for -- maybe for Wick.

  • How do we think about the -- speeding up the bulk network in terms of what that does?

  • Do you go from three locomotives to four per train?

  • Does your -- how do we think about that?

  • Does your fuel consumption go -- change a lot if you speed it up?

  • And just what's the logic behind that?

  • Is it to address track and [screen], or it's just purely the car issue you're talking about?

  • I'm trying to understand --

  • Wick Moorman - Chairman, President & CEO

  • It's really --

  • Tom Wadewitz - Analyst

  • -- the (inaudible) and the impact.

  • Wick Moorman - Chairman, President & CEO

  • It's really not on the expense side an impact.

  • You're really -- you're hauling the same amount of tons the same distance, so the fuel requirements are the same.

  • The crew requirements are largely the same.

  • It's really has to do with how we fit the unit train network into our already-scheduled top network, to -- and increase the velocity by keeping power assigned in a different way, really almost allocating power to the unit train network and keeping it there, rather than trying to use power between the top network and the unit train network.

  • But it is purely a play to increase the velocity of the equipment.

  • It won't have any other significant impact, other than we will be able to and, in fact, are looking at, in some cases, turning back leased equipment, particularly on the grain side, that we have today, and being able to reduce in the future our -- on the capital side by not having to replace as many coal cars.

  • But we want to get the improvement started right away.

  • Let me say, the other really significant piece of this -- and we've already seen this because we've started down this road already, particularly on the grain side -- is as our velocities increase, our customers on the grain and the coal side are really seeing that improvement already and commenting very favorably on it, so it has a strong -- very strong service component, as well.

  • Ken Hoexter - Analyst

  • By the way, Wick -- It's Ken Hoexter, I like the new white background on the slides.

  • After the years of the black background, it lets us take notes.

  • Thank you.

  • Wick Moorman - Chairman, President & CEO

  • We listened to people's comments about that.

  • Ken Hoexter - Analyst

  • Just a quick follow-up on Tom's question and for Don.

  • Is there a long-term benefit if these vessels are sailing east?

  • In other words, on the -- I guess what percentage is now that port to inland, Ohio, Memphis, versus to now really being really truck competitive from the short-haul moves.

  • Wick Moorman - Chairman, President & CEO

  • Well, that -- let me try it on and then -- that's still somewhat in flux because we're really seeing this shift happen and we're trying to understand it to some extent ourselves.

  • It is clearly something where there're going to be some service -- some inland -- or some east coast containers that move very short distances, whereas if they moved across the country it was a rail haul, but we think that is offset by the traffic that would be moving a very short distance from the middle of the country into the Midwest and is a long haul.

  • To give you an example of traffic that we think is good traffic that is absolutely booming, our Savannah to Atlanta intermodal traffic is skyrocketing.

  • The Port of Savannah is having a lot of growth and we see that as good business and we're running the train service and we intend to capture that business, so it is really a situation where I think the world is changing.

  • The really important point I would make to you is that, as business moves to the east coast, and to the biggest ports on the east coast -- in addition to the New York-New Jersey port, Norfolk, which is a great port and has seeing just explosive growth and investment, and Savannah, Charleston, all of the -- Jacksonville, the ports up and down the east coast -- if you look at our network, and you look at the investments we're making in that network, such as the Heartland Corridor, we think we are going to be extraordinarily well positioned to capture that intermodal traffic that wants to move into the interior part of the country, be it Atlanta, Columbus, Rickenbacker, Chicago or whatever.

  • So we think that over the long term this is going to be a good thing for us.

  • Ken Hoexter - Analyst

  • Are you constrained near term by any need for, I guess, raising tunnels or--?

  • Wick Moorman - Chairman, President & CEO

  • Clearly the Heartland Corridor is the big project we have.

  • We are looking at some -- in fact we've authorized, I think, one reasonably small project on the Savannah side.

  • We've added some sidings already on the Charleston line coming out of Charleston.

  • So we're targeting the infrastructure on a -- kind of a build it as the traffic gets there basis, and that's part of our ongoing study to look at infrastructure across the Company and add it selectively as we need it.

  • Ken Hoexter - Analyst

  • Just a couple of quick -- no, that's fine.

  • Just a couple of quick technical ones.

  • Was there any catch-up in the casualty line item?

  • Is there any accruals that were made up in that line item?

  • Wick Moorman - Chairman, President & CEO

  • I don't--

  • Jim Squires - CFO

  • Yes, we did have a favorable variance in PI as well as the derailment costs that I mentioned in the quarter, but that was not due to any actuarial adjustment.

  • It was the usual ups and downs in PI.

  • Nothing particularly significant there.

  • Ken Hoexter - Analyst

  • Great performance then.

  • Jim, while you're up there, are you increasing the CapEx budget at all for these 50 locomotives or is it --?

  • Jim Squires - CFO

  • Yes, there will be an addition to the capital budget for that purpose.

  • Ken Hoexter - Analyst

  • In '07.

  • Jim Squires - CFO

  • Yes.

  • Ken Hoexter - Analyst

  • Care to quantify that?

  • Jim Squires - CFO

  • Sure.

  • That's going to be a $93 million dollar addition to the capital budget, some of which will actually be spent --

  • Wick Moorman - Chairman, President & CEO

  • Spent in '08.

  • Jim Squires - CFO

  • -- $65 million of that will fall in '07 and the rest will fall in '08.

  • Wick Moorman - Chairman, President & CEO

  • One of the reasons, as well, that we looked at the locomotive side, talking about '08, is we looked at when locomotives were going to be available in term of production line scheduling and versus our needs.

  • And in order to fit them in to when we thought the traffic justified it, it made a lot of sense to get some space that remained in the fourth quarter on into the first quarter, otherwise we were looking at a significant time delay before we could get the locomotives.

  • So it was a timing issue, to some extent.

  • Ken Hoexter - Analyst

  • So just to clarify, your net CapEx budget actually is going up just because we're seeing a lot of other companies in the transport sector as a whole actually reduce CapEx because of the negative volumes right now, but you're actually net increase?

  • Jim Squires - CFO

  • That's correct.

  • Don Seale - Chief Marketing Officer

  • That is because we see financial benefit from making the investment, as Wick went through, especially with respect to unit train efficiencies.

  • Ken Hoexter - Analyst

  • Okay.

  • And then my last technical question is, on your synthetics -- synthetic tax credits, you said you bought one and you're buying another.

  • Is there a cash outlay that you're making for this and is there a capital cost --?

  • Jim Squires - CFO

  • There is a relatively modest initial up-front investment coupled with ongoing operating costs for the duration of the year for those, yes.

  • We've closed on one and we will be closing on the other in August, probably.

  • And the net benefits you'll see we gave you today and you'll see further explanation in MD&A in our upcoming Q of the effects of these investments.

  • So hopefully it will be relatively easy for you to follow [this and sensitize] as we go through the year.

  • Ken Hoexter - Analyst

  • Okay, can you qualify what you're spending on these?

  • Jim Squires - CFO

  • The expenses are as shown as projected in the slide, so just take a look at the slide and you'll see the -- we gave it to you for the second half of the year, the additional expense.

  • Ken Hoexter - Analyst

  • No, no, there is no cash outlay to acquire this?

  • Jim Squires - CFO

  • There is.

  • There is a cash outlay, yes.

  • Ken Hoexter - Analyst

  • But it's --

  • Jim Squires - CFO

  • It's included in the expense.

  • Ken Hoexter - Analyst

  • Oh, in the expense.

  • Wick Moorman - Chairman, President & CEO

  • There's no addition to CapEx?

  • Jim Squires - CFO

  • In other words -- no, in other income that is all there.

  • Ken Hoexter - Analyst

  • And just to clarify, do you want fuel to go -- oil to go up or down to get that benefit?

  • Jim Squires - CFO

  • To get the benefit from the synfuel investments?

  • Ken Hoexter - Analyst

  • I think you said $71 was the base price.

  • Jim Squires - CFO

  • From the synfuel investments lower fuel prices are better from the standpoint of maximizing the -- the net benefit from the synfuel investments, but --

  • Ken Hoexter - Analyst

  • So each $1 that oil goes down you get that $3 million benefit.

  • Jim Squires - CFO

  • Correct.

  • Wick Moorman - Chairman, President & CEO

  • But I should -- down but up to a maximum, which is -- I guess you would compute it by -- look at -- the current benefit is based on 18% phase-out, so if the phase-out went to zero, that would be the maximum benefit you would get.

  • And we haven't quantified that, but you could back into that, I think, fairly easily.

  • Ken Hoexter - Analyst

  • Okay, that makes sense.

  • Wick Moorman - Chairman, President & CEO

  • And, I mean, if oil goes to $20, we're not going to get -- we don't get the benefit all the way, if that makes sense.

  • Ken Hoexter - Analyst

  • -- stop at $65.

  • Wick Moorman - Chairman, President & CEO

  • Yes, something like that, that's right.

  • Ken Hoexter - Analyst

  • Okay.

  • And then my last question is just on the auto and housing, I just want to clarify, it was only 1.5% of the 4.1% decrease in carloads?

  • I was surprised it was that light of a percentage on the reason for carloads being down.

  • Yes, it's more a Don question.

  • Don Seale - Chief Marketing Officer

  • We -- Ken, we estimate that auto and housing was about 38% of the decline.

  • Ken Hoexter - Analyst

  • 38%.

  • Don Seale - Chief Marketing Officer

  • Yes.

  • Ken Hoexter - Analyst

  • Okay.

  • Don Seale - Chief Marketing Officer

  • And that's compared to the first quarter, it was almost half, so we saw some diminished component --

  • Ken Hoexter - Analyst

  • Okay.

  • Don Seale - Chief Marketing Officer

  • -- in the second quarter, and we expect that to continue to probably diminish as the comps change as the second half progresses.

  • Wick Moorman - Chairman, President & CEO

  • We do our very best in this analysis to try and figure out housing, but -- and we do it on kind of a customer-by-customer basis, because as you saw it cuts across a lot of our commodity groups.

  • But, do we capture all of the inbound ex -- inbound containers that had housing-related products in them that are now not being sold because of the downturn in housing, I'm not sure we capture it all.

  • This is just our best attempt to figure out what those two sectors are doing, if that makes sense.

  • All right.

  • Scott Flower - Analyst

  • Scott Flower, B of A Securities.

  • Maybe some questions also for Don.

  • Help us -- you talked a little bit about a hope for peak, and I just wanted to get a little more color around how you manifesting that hope.

  • Is it conversation with the customers, is it last year's decline was so precipitous versus normal seasonality?

  • Help me understand how much of this is just expecting normal seasonality versus dialog with your customers, or that you're seeing things on the early side of peak that are making you more positive as you look toward third and fourth quarter on that front?

  • Don Seale - Chief Marketing Officer

  • Scott, I would say that it's a combination of what you just described.

  • It's conversations with the retailers, meetings with the retailers, but also a large part of it is exactly what you just stated was -- is the comps from last year.

  • We saw our intermodal business start getting soft last October, which traditionally is the height of the peak -- peak season.

  • We expect to do better than that this year, just based on what we see, the input we've gotten from retailers, and also our own projections with respect to truckload, as well as international business.

  • Scott Flower - Analyst

  • And then actually a couple more for you.

  • You often told us that about a third of your business is touchable in any one year as a round figure.

  • When we think of through the year, is it ratable, is it more skewed toward the early part of the year?

  • Obviously it may change year by year, but how should I think about this year what you may have been able to touch versus what is in the second half?

  • Don Seale - Chief Marketing Officer

  • The timing of expiration of contracts and quotes, unfortunately it's not ratable.

  • It's not a ratable process, and it is skewed, as you go through the year and you get a partial benefit, obviously, if you reprice something December 15th or December 1st, you get the full benefit the following year.

  • When we look at our coal business, a smaller percentage of our coal business is being repriced this year.

  • I think we shared that with you previously.

  • On the Merchandise side of our business and industrial products it's about 45%, 50%.

  • But it's not a ratable quarter-to-quarter process.

  • Scott Flower - Analyst

  • Has more of that for this year been touched in the first half or will you see more open in the second half in general?

  • Don Seale - Chief Marketing Officer

  • In terms of timing we're going to see more fourth quarter.

  • Scott Flower - Analyst

  • And then last question I just had, how much -- where are you on fuel surcharge coverage in terms of proportion of your business, and did fuel surcharge -- was it negligible in the quarter in terms of what it did up and down?

  • That seems to be what most of the other railroads have been saying, but I just wanted to get a sense --

  • Don Seale - Chief Marketing Officer

  • It was negligible.

  • Obviously with 82,000 less loads there was an impact from a revenue component there.

  • Our coverage is around 93%, 94%, in that range.

  • We feel we've gotten fuel coverage up to the point that it matches the available contracts and quotes.

  • We're now awaiting for contracts to turn over that we can get fuel on that doesn't have fuel, so it is a timing issue.

  • Scott Flower - Analyst

  • Great, thanks.

  • Tony Hatch - Analyst

  • Hi, Wick -- excuse me -- it's Tony Hatch, I just wanted to ask two quick ones, Don, if you could just give a little more color on the pricing issues, specifically to intermodal, what we saw on the quarter and what you expect in those various categories?

  • And Wick, for you.

  • Can you talk a little bit about what is going on in Washington?

  • It seems to be busier than ever these days and there are a lot of positive and negative things swirling around and there's still the UTU unsigned.

  • Can you sum that up for us and see what you -- what we should be expecting this year and next year out of Capitol Hill?

  • Wick Moorman - Chairman, President & CEO

  • I'll try that and then Don will talk a little bit about Intermodal pricing.

  • As to what we expect, my crystal ball is not particularly good, as you know, but there certainly is a lot of activity.

  • There's a lot of legislation that's been proposed, particularly on the House side, that we think would have a detrimental effect to our industry.

  • As you know, there's -- although people choose to call it things, there's essentially a rereg bill that's floating out there.

  • There is a another bill under the moniker of safety that has some things that we think are not good for our industry and don't really have anything to do with safety, either.

  • So there's a lot of discussion about that legislation and a lot of activity.

  • I think all of the -- all the rail carriers in the AAR are involved and Norfolk Southern certainly is involved in that.

  • I am an optimist in terms of thinking that ultimately reason prevails and the many, many people on Capitol Hill, on both sides of the aisle, who understand that a strong rail industry with the ability to invest and build infrastructure is one of the most important things that this country needs, if we're going to continue to grow and be competitive in the world marketplace.

  • And, of course, relating to that, we have, as you know, an investment tax credit proposal that's starting to get some traction and I think will continue to get traction.

  • And I'm not sure when it'll get done, but -- or if it'll get done, but I'm optimistic about it.

  • So from that standpoint there's a lot of activity and we'll just have to work hard to present our story, and make sure that people understand the importance of our business.

  • On the labor side, I guess the only thing I would say is I think it's -- as you know the TCU and the carmen have now tentatively -- they've signed the agreement and it's out for ratification.

  • I guess we'll know mid-September or thereabouts.

  • That's 80% of our work force that will be covered by an agreement and 12 of the 13 unions.

  • I think it's a good agreement that everyone signed.

  • I think it's good for the industry.

  • I think it's good for the folks who work for our industry.

  • And I'm very optimistic that ultimately the UTU will sign the same agreement.

  • I've been puzzled, I will say, by some of their positions and their comments during this latest round of negotiations, but ultimately I think that this'll be resolved and hopefully resolved fairly quickly, because I think that's the best thing for both the members of the UTU and for the rail industry.

  • Oh, yes, Don.

  • Don Seale - Chief Marketing Officer

  • Tony, with respect to intermodal pricing, as you noted, the RPU was up 1%.

  • We do not see a material change in our pricing philosophy with respect to intermodal.

  • We have some activity on repricing in the second half, but it's a small percentage of the total book of business.

  • We continue to, as we renew contracts, bring in that portion of the contracts that I mentioned earlier that did not have fuel.

  • And that's a couple of remaining intermodal contracts, which we'll be working on or modified fuel, bringing them to more of a standard fuel provision for us.

  • But we're not planning to take price and use it as a lever for additional volume.

  • We're going to maintain our pricing at Intermodal and we think the value of the service speaks for itself, and with rising energy prices we'll fare well with that approach.

  • Wick Moorman - Chairman, President & CEO

  • Anyone else?

  • Well, thanks for attending.

  • You've been very patient and we look forward to seeing you again.