聯合太平洋集團 (UNP) 2018 Q1 法說會逐字稿

Greetings, and welcome to the Union Pacific's First Quarter Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded, and the slides for today's presentation are available on Union Pacific's website.

It's now my pleasure to introduce your host, Mr. Lance Fritz, Chairman, President and CEO for Union Pacific. Thank you, Mr. Fritz. You may now begin.

Thank you, and good morning, everybody, and welcome to Union Pacific's First Quarter Earnings Conference Call. With me here today in Omaha are Beth Whited, our Chief Operating Officer; Cameron Scott, the Chief Operating Officer; and Rob Knight, Chief Financial Officer.

This morning, Union Pacific is reporting net income of $1.3 billion for the first quarter of 2018 or a first quarter record $1.68 per share. This represents an increase of 22% and 27%, respectively, when compared to 2017. Total volume increased 2% in the quarter compared to 2017. Energy carloads increased 6%, primarily driven by frac sand shipments, while Industrial and Premium volume both increased 2%. Partially offsetting the volume increase was a decline in Agricultural Products, driven primarily by lower green carloadings. The quarterly operating ratio came in at 64.6%, which improved a little over 0.5 point from the first quarter of 2017.

Our solid first quarter results were a direct reflection of the tremendous effort put forth by our entire workforce. And had it not been for some network congestion, it would have even been better. I'm encouraged by the work we're doing to quickly regain superior levels of service and efficiency.

Our team will give you some more of the details on the first quarter starting with Beth.

Thank you, Lance, and good morning. For the first quarter, our volume was up 2% driven by Energy, Premium and Industrial, offset by Agricultural Products. We generated positive net core pricing of 2% in the quarter with continued pricing pressure in our core markets. The increase in volume and a 5% improvement in average revenue per car drove a 7% increase in freight revenue. Let's take a closer look at the performance of each business group.

Ag products revenue was flat on a 4% volume decrease with an offsetting 5% average revenue per car increase. Grain carloads were down 16% with continued weakness in grain exports due to high global supplies, partially offset by strength in long-haul domestic grain business. Grain products carloads were up 1% as growth in ethanol exports and other biofuels were partially offset by reduced meal shipments to the east due to a strong eastern crush. Fertilizer experienced a 10% increase due to robust export potash demand, coupled with increased demand for sulfur from both the mining and fertilizer markets.

Energy revenue increased 15% for the quarter on a 6% increase in volume and an 8% increase in average revenue per car. Coal and coke were down 3% driven primarily by a contract change, coupled with lower natural gas prices. Natural gas prices fell 7% versus first quarter 2017 and PRB coal inventories continue to be below the 5-year average. Sand carloads were up 52% due to increased crude production from major shale formations and favorable crude oil prices. Petroleum, LPG and renewables carloads increased 22% for the quarter, driven primarily by crude oil shipments.

Industrial revenue was up 6% on a 2% increase in volume and a 4% increase in average revenue per car during the quarter. Construction carloads decreased 6%, primarily driven by rock, due to the weather and service impacts in Texas. Metals volume increased 11% for the quarter, driven by strong OCTG pipe and line pipe shipments into West Texas and Oklahoma. Our specialized markets volume increased 10% overall, driven by military shipments due to continued strength in training rotations and deployments, as well as waste shipments due to remediation project growth.

Premium revenue was up 7% with a 2% increase in volume and a 5% increase in average revenue per car. Domestic intermodal volume increased 5%, driven by continued strength in parcel and stronger demand from tight truck capacity. Auto parts volume growth was driven by over-the-road conversions and growth in light truck demand, which minimized the impact of lower overall production levels.

International Intermodal volume was down 2%, driven by increased transloading and changing vessel ports of call. Finished vehicle shipments decreased 2% as a result of lower production levels and high inventories. These reductions were partially offset by new West Coast import traffic and strong truck and SUV shipments out of Mexico.

Looking ahead, for Agricultural Products, while we continue to face challenges in the export grain market from high global supplies, potential tariffs and a low-protein wheat crop, we are starting to see some positive indicators resulting from crop uncertainty in South America. We anticipate continued strength in ethanol exports. We also expect growth in food and beverage shipments due to Cold Connect penetration, tightened truck capacity and continued strength in import beer.

For Energy, we expect favorable crude oil spreads to drive positive results for petroleum products in 2018. We anticipate uncertainty in frac sand due to tougher year-over-year comps, in addition to continued concerns around the viability of local sand. We expect coal to continue to experience headwinds in the second quarter with natural gas prices. And as always for coal, weather conditions will be a key factor for demand.

For Industrial, looking forward, we anticipate strength in Plastics as new facilities and expansions come online, as well as continued strength in industrial production.

For Premium, over-the-road conversions from continued tightening in truck capacity will present new opportunities for domestic and auto parts growth. Despite challenges within the International Intermodal market, we anticipate year-over-year growth for the remainder of the year resulting from new business opportunity.

The U.S. light vehicle sales forecast for 2018 is 16.9 million units, down about 2% from 2017. Production shifts and new import business will create some opportunity to offset the weaker market demand.

With that, I'll turn it over to Cameron for an update on our operating performance.

Thanks, Beth, and good morning. Starting with safety performance, our reportable personal injury rate was 0.74, a 17% improvement compared to last year and a first quarter record. With regards to rail equipment incidents or derailments, our reportable rate improved 13% to 2.76.

In public safety, our grade crossing incident rate increased 38% versus 2017 to 3.05. This result is disappointing giving all the initiatives we have been progressing on. But we will continue our efforts to partner with communities using safety campaigns to reinforce public awareness and safe driver behavior.

Moving on to network performance. As reported to the AAR, velocity declined 4% and terminal dwell increased 8% compared to the first quarter of 2017. Multiple factors are affecting our network fluidity. We are experiencing record manifest volumes in our southern region. Also transportation plan execution at some of our key terminals has contributed to the degradation of our operating metrics. Sequentially, however, we are making improvement. Over the past several weeks, our velocity has consistently increased with all 3 regions showing meaningful improvement. Systemwide, terminal dwell has decreased by 5%.

Our total freight car inventory, as reported to the STB, is down 3%. More importantly, our operating inventory, which excludes cars that are stored or placed at customer facilities, is down over 25,000 cars or 11% since its high in the first quarter. We are intently focused on continuing to improve service levels and we're confident that we have solid plans in place to achieve better results.

Let me provide you with a high-level look at our service recovery initiatives. We are aggressively managing inventory to reduce terminal congestion. This is primarily targeted at the southern end of our railroad. We're closely monitoring car inventory levels at key terminals. Railcars with excessive dwell are being identified and prioritized for prompt handling. We also continue to adjust our transportation plan, or T-Plan, to route cars around congested areas to the extent possible. We are being more disciplined and running the T-Plan as scheduled, which helps locomotives and cruise remain balanced. We are shifting volume between some of our southern region terminals to more effectively balance car flows within our network.

And we are now complete with the T-Plan adjustments we piloted in the Pacific Northwest in Northern California. This resulted in the discontinuation of some aspects of that pilot, while maintaining the positive adjustments that we implemented, including more 7 day per week manifest [2] trains running on the network.

We are improving efficiency at our key terminals. This is the basic blocking and tackling of getting cars in and out of yards effectively. We have increased local train frequency to facilitate spotting cars at our customer facilities in a timely manner after they reached the local serving yard. This also enables us to quickly pull cars from customers once they are released. We have also added more yard jobs to support yard and terminal fluidity. These changes have enabled us to make significant progress in reducing freight car inventory over the past month. I am confident that going forward, we will continue to see steady improvements to our service and operating efficiency. When you add all this up, the decline in our operating metrics, coupled with service recovery plan we have put in place, has put some pressure on our resources.

On the locomotive front, we have reactivated approximately 650 high horsepower locomotives since mid-2017, including more than 250 high horsepower locomotives since early February. Currently, we have about 225 high horsepower road units remaining in storage, and we'll continue to bring stored locomotives into the active fleet as needed to support our service improvement efforts.

Additionally, we have entered into a short-term lease agreement for approximately 100 locomotives. These units will provide additional surge capacity in case of an unexpected event like a hurricane.

On the TE&Y front, we have recalled all furloughed employees back to service and continue to hire new employees to handle expected attrition. Our TE&Y workforce is up 8% when compared to the first quarter of 2017, primarily driven by an increase of approximately 800 employees in the training pipeline. We plan to graduate approximately 200 trainees per month between now and July. In some of the more challenging labor markets, we're currently offering signing bonuses to make these jobs more attractive, which is a tool we have used successfully in the past.

This does not mean, however, that we have given up on our productivity initiatives. Although the decline in our velocity and terminal dwell metrics are negatively impacting productivity in certain areas, we're still driving productivity elsewhere.

G55 + 0 continues to be an integral part of our daily fabric with respect to how we approach our work. For example, we are recovering -- while we are recovering our system fluidity, we were able to continue generating solid productivity in both our engineering and mechanical functions. We also achieved best-ever train size performance in our grain train category during the first quarter. The team also achieved first quarter train length records in our manifest, Automotive and Intermodal businesses.

Looking ahead, we expect network fluidity to return to more normalized levels as we continue our service recovery efforts. While there isn't a specific date that I can provide you before we reach normalized operations, please be assured that the entire company is working with a sense of urgency and teamwork as we continue making improvement.

Next, I would like to provide you an update on our progress with positive train control. PTC is already implemented on nearly 2/3 of Union Pacific's network, and we have a comprehensive plan for installation and implementation to complete PTC. As part of this plan, Union Pacific intends to file an alternative schedule with the Federal Railroad Administration in order to maintain the health of the railroad network. The remaining implementation schedule will be phased in over the next couple of years. So that additional problem solving and system testing can occur, while minimizing operational issues.

We do not anticipate the revised schedule will materially change the $2.9 billion estimate of investment required to install and implement PTC. But of course, as Rob had discussed on some previous occasions, there will be ongoing capital and operating expense required to maintain and enhance this system going forward.

So with that, I'll turn it over to Rob.

Thanks, and good morning. Let's start with the recap of our first quarter results. Operating revenue was $5.5 billion in the quarter, up 7% versus last year. Positive core price, increased fuel surcharge revenue and a 2% increase in volume were the primary drivers of the increase in revenue for the quarter. Operating expense totaled $3.5 billion, up 6% from 2017. Operating income totaled $1.9 billion, an 8% increase from last year.

Below the line, other income was a negative $42 million compared to a positive $72 million in 2017. And as we previously disclosed in an 8-K filing on April 6, other income was negatively impacted by a noncash, pretax charge of $85 million associated with an early bond redemption. Excluding the impact of the early bond redemption, other income would have totaled $43 million or about $29 million less than last year. But also keep in mind, we had a favorable pretax real estate gain totaling $26 million, which we recorded in last year's first quarter. So if you net out the large onetime items from both this year and last year, other income was essentially flat at $45 million.

Interest expense of $186 million was up 8% compared to the previous year. This reflects the impact of a higher total debt balance, partially offset by lower effective interest rate. Income tax expense decreased 35% to $401 million. The decrease was primarily driven by a lower tax rate as a result of corporate tax reform and was partially offset by higher pretax earnings. Our effective tax rate of 23.4% came in a little lower than the 25% rate that we were anticipating. In future periods, we would expect our effective tax rate to be in the 24% to 25% range.

Net income totaled $1.3 billion, up 22% versus last year. While the outstanding share balance declined 4% as a result of our continued share repurchase activity. These results combine to produce record first quarter earnings per share of $1.68. The operating ratio was 64.6%, an improvement of 0.6 percentage points from the first quarter last year. As we have footnoted in the financial handouts accompanying this earnings release, the first quarter 2017 operating ratio was adjusted upward 0.1 points to 65.2% for the retrospective adoption of the new pension accounting standard. Please reference the Investor section of the UP website for the 2017 full year restatement by quarter.

The combined impact of fuel price and our fuel surcharge lag had a 0.2 point negative impact on the operating ratio in the quarter compared to 2017. And fuel had $0.03 positive impact on earnings per share year-over-year.

Freight revenue of $5.1 billion was up 7% versus last year. Fuel surcharge revenue totaled $353 million, up $141 million when compared to 2017, and up $60 million versus the fourth quarter of last year. The business mix impact on freight revenue in the first quarter was slightly positive. Year-over-year growth in sand, petroleum products, metals and lumber shipments offset a decrease in grain carloadings and an increase in lower intermodal and auto parts shipments.

Core price was about 2% in the first quarter, up from the 1.75% we reported in the fourth quarter of last year. Coal and International Intermodal continue to be a challenge from a pricing perspective. However, if we set Coal and International Intermodal aside, our core price was about 2.75% in the first quarter.

For the full year, we still expect the total dollars that we generate from our pricing actions to well exceed our rail inflation costs.

Turning now to operating expenses. Slide 20 provides a summary of our operating expenses for the quarter. Compensation and benefits expense increased 1% to $1.3 billion versus 2017. The increase was driven primarily by volume-related costs, network inefficiencies and increased TE&Y training expenses incurred during the quarter, and partially offset by our G55 workforce productivity initiatives. For the full year, we still expect labor inflation and overall inflation to be under 2%.

Total workforce levels decreased about 1% in the first quarter versus last year. This was driven primarily by a 10% decrease of employees associated with capital projects. Employees not associated with capital projects were up about 1%. Our management employee account was down 600 employees, primarily driven by the workforce reduction program that we initiated last year.

Fuel expense totaled $589 million, up 28% when compared to last year. Higher diesel fuel prices and a 4% increase in gross ton-miles were the primary drivers of the increase in fuel expense for the quarter. Compared to the first quarter of last year, our fuel consumption rate increased about 2%, while our average fuel price increased 22% to $2.13 per gallon.

Purchased services and materials expense increased 6% to $599 million. This increase was primarily driven by volume-related costs, higher freight car repair expense related to the return of leased cars, and increased locomotive repair costs associated with a larger active locomotive fleet.

Turning to Slide 21. Depreciation expense was $543 million, up 4% compared to 2017. The increase is primarily driven by a higher depreciable asset base. For the full year 2018, we estimate that depreciation expense will increase about 5%.

Moving to equipment and other rents, this expense totaled $266 million in the quarter, which was down 4% compared to 2017. The decrease was primarily driven by lower locomotive and freight car lease expenses.

Other expenses came in at $266 million, up 2% versus last year. The primary driver was an increase in state and local taxes and other expenses, partially offset by a decrease in personal injury expense and reduced casualty costs.

For the full year 2018, we continue to expect other expense to increase around 10% versus 2017. On the productivity side, our G55 + 0 initiatives yielded approximately $35 million of productivity in the first quarter, net of the operational headwinds that we experienced during the quarter. This is well below what we anticipated coming into the year. We estimate that the impact of these operational challenges totaled about $40 million in the first quarter. The $40 million was spread evenly across the cash [corp] -- cost categories of comp and benefits, purchased services, equipment rents and, to a lesser extent, fuel.

While we are seeing some improvement in our operating metrics as Cam discussed a minute ago, our full year productivity will be less than our original goal of $300 million to $350 million given the current challenges.

Looking at our cash flow. Cash from operations for the first quarter totaled $1.9 billion, up slightly when compared to last year. Higher net income was mostly offset by payments made to our agreement workforce in accordance with the terms of the recently ratified labor contracts and the timing of tax payments.

Taking a look at adjusted debt levels. The all-in adjusted debt balance totaled about $20.1 billion at the end of the first quarter, up $570 million since year-end 2017.

We finished the first quarter with an adjusted debt-to-EBITDA ratio of around 1.9x. In light of the higher earnings and cash flow that we expect to generate from tax reform, we are in the process of reevaluating our target leverage ratio and optimal capital structure. As we have stated before, we believe tax reform enables greater debt capacity for Union Pacific, while still retaining a strong investment-grade credit rating. From a timing perspective, we will have an update for you at our Investor Day scheduled for May 31 in Omaha.

Dividend payments for the first quarter totaled $568 million, up from $492 million in 2017. This includes 2 recent 10% increases in our declared dividend per share. The first increase occurred in the fourth quarter of 2017 and the second increase was effective in the first quarter of this year. In addition to dividends, we bought back 9.3 million shares, totaling $1.2 billion during the first quarter of '18. This represents a 53% increase over 2017 in terms of dollars spent for share repurchases. Between our dividend payments and share repurchases, we returned about $1.7 billion to our shareholders in the first quarter, which represents a 132% of net income over the same period. This also represents a 39% increase in cash return to shareholders compared to the first quarter of 2017.

Looking ahead to 2018, we still expect full year volumes to be up in the low single-digit range. As Beth just commented, we're optimistic with several of our business categories, but have some uncertainty in other areas. Positive full year volume and positive core price should lead to solid improvements in the top line for 2018.

On the expense side of the equation, our current operational challenges will be a headwind to operating expense in the near term. Our goal is to still achieve an improved full year operating ratio in 2018. And with respect to our targeted 60% operating ratio, plus or minus, on a full year basis by 2019, we have clearly lost some time given the current service challenges that we are experiencing. And it is now unlikely that we will achieve that target next year. We are still committed to achieving a 60% operating ratio, just not likely next year and ultimately, a 55% operating ratio.

We will provide you with more details on our outlook at our upcoming Investor Day at the end of May.

So with that, I'll turn it back over to Lance.

Thank you, Rob. As we discussed today, we delivered solid first quarter results, despite experiencing operational difficulties. We're pleased with the improvement we've seen in recent weeks and we are confident in the plan we have in place to continue building on the progress that we've already made. With the economy favoring a number of our market segments, we're well positioned to benefit from another year of positive volume growth and solid core pricing gains.

With that, let's open up the line for your questions.

(Operator Instructions) And our first question comes from the line of Allison Landry with Crédit Suisse.

So I wanted to start with price and I know you don't give guidance, but hoping that you could help to frame for us directionally, if we should be thinking about another step up in that core pricing number in Q2 or the second half and then some of the drivers behind that. And then, if you think about what's happening with truck pricing, do you think ultimately that could translate into pricing gains that are above what you've seen in prior cycles, of course, adjusted for legacy?

Beth, do you want to handle it?

Sure. Allison, we -- we continue to be very encouraged by what we're seeing in the truck market and the opportunities that, that gives us both for -- as you indicate, pricing gains, but also volume gains, bringing more volume on to the railroad. We will continue to feel like we have opportunities in all of our truck competitive markets. Where we're really seeing pressure continues to be in places like International Intermodal and in the core markets.

Okay. And maybe just switching to the plastics opportunity that you highlighted. Do you think there's more opportunity to capture export traffic than perhaps you initially thought? Again, given the tight trucking market and equipment constraints, and even thinking about the rebuild activity in Texas and the competition for labor, how do you see that playing out versus your expectations maybe 3 or 6 months ago?

I think that we've always been pretty optimistic that we were going to handle the plastics business to a significant degree. Some of it will be packaged on site at the original producer, in which case Union Pacific won't have an opportunity to participate. But for those producers that are intentionally using hopper cars as their first means of warehousing, if you will, and then going to a plastics packager for their export shipments, we hope we'll certainly participate at least on that first move. But we do believe there will be a substantial percentage of this plastics that, that's produced in the Gulf that will end up taking a West Coast exit from the United States. And we think that packaging facilities like the one we're developing in Dallas, right adjacent to our intermodal facility, will give us a great opportunity to participate in that. And we are still on track to open that facility with our partner, Katoen, in the third quarter -- late third quarter of this year.

The next question comes from the line of Chris Wetherbee with Citigroup.

Wanted to come back to some of the network challenges and your thoughts around productivity, I guess, for the year. When you think about the $40 million from the first quarter, can you give us some rough estimates of maybe what those -- that number might look like as the year progresses? I think you said that it's going to diminish but it's probably going to be there to a degree?

Let me start and then I'm going to turn it over to Rob to fill in some detail. So from the standpoint of the network challenges, we mentioned that those had really started in the second half of last year and there are a myriad of reasons. Ultimately that culminated in us having too many operating cars. The operating car inventory on us for the amount of carloads that we are generating, which exacerbated the problem, made it worse. We've spent a good part of the first quarter and coming now into the second quarter in getting that right. There's still more work to be done there. And Rob mentioned that in terms of we're still going to face a headwind as we move into the year with excess resources deployed, so that we can get our service product right. Rob, you want to...

Yes, Chris, I would just add -- I'm not going to give a fine point number on the -- what do we think that congestion cost is going to be in the second quarter, I would just tell you that recall Cam's slides where we are making improvements. We've seen sequential improvement on the one hand and that's all good. But we are bringing on those additional locomotives that we highlighted there. So when you add it all up, we're focused as all can be on getting back, if you will. But in terms of exactly what that dollar amount might turn out in the second quarter, we'll just have to stay tuned. We're aggressively looking to reduce that. And I would also add that even with those -- that $40 million of challenges, that we faced in the first quarter, our total productivity was still a positive at that $35 million that I reported.

Okay. So the net benefit was still there. That's helpful.

That's right.

And when you think about the full year OR, I think the goal now to [approach], maybe it's a little less sort of a statement, I guess, than previously. How do you think about sort of some of the puts and takes? There, it seems like pricing has maybe gotten a bit better at least from a core perspective? And volume has been okay. So what are the dynamics there that, that might move the needle sort of one way or another that may be are different now than they were previously? Just trying to get a sense of maybe if there's a different feeling around the OR improvement potential this year?

Yes. Chris, I would say, it's the same levers that, that were there before and that is positive volume, which we feel pretty good about; positive price, which as Beth talked about, we still feel pretty good about; and then productivity. So yes, the margin, if you will, of improvement might have gotten a little bit more challenged with what we're facing on the congestion cost. But the levers are, frankly, the same. And we are fixated and convicted around improving that operating ratio this year.

And Rob, I think, it's important to note that -- the fact that we're masking some of the productivity improvements that we have the ability to make through these excess resources to get the network right that, that has not in any way diminished both the game plan and the confidence around the game plan of what productivity opportunity we have.

Next question is from the line of Justin Long with Stephens.

I appreciate the way you report core pricing is different than others. So I wanted to ask about renewals. Would you be willing to share the average renewal rate this quarter? And how that compares to what you saw on the prior quarter?

You know we don't really comment on that, Justin. What I would just tell you is, we are encouraged, again, by the tightening truck capacity and we feel good about our opportunity to get pricing in those truck competitive markets.

Okay. And then maybe following up on some of the OR commentary. There was the change in language and I just want to clarify that we are not reading too much into this. Is it fair to say that improvement the OR this year could be a little bit more challenging relative to what you thought back in January? And I guess to follow-up on that, what's your confidence that the OR can improve in the back half, has that changed at all?

Let me take the front half of that question then I'll give Rob the opportunity to deal with the back half. In terms of confidence in improving OR, we are confident in improving our OR this year. Clearly, we would have liked to have made more progress in the first quarter. And we mentioned that in our comments that, that we had a solid quarter. I'm proud of the financials, and they could have been better. And when we see that, it's a little bit of a disappointment on our side, but it's also a confidence boost, knowing what we're capable of achieving. Rob?

Yes. Justin, I mean, as you know we don't give quarterly guidance on the OR, but remember last year the reported OR was 63%, of course, you get the pension adjustment that affects that. So that's the marker. And yes, I think it's fair to say that the room for error, if you will, to make improvement is a little bit more challenging this year given the costs that we just talked about than it might have been had we not incurred those costs. But we're still focused on making that improvement year-over-year.

Our next question is from the line of Amit Mehrotra with Deutsche Bank.

I guess, I'm a bit surprised by the OR commentary relative to the targets you guys laid out, given the backdrop, at least, prospectively probably couldn't be better. So I guess the real question is really around incremental margins, which obviously have been lowered in the mid to near term. And I just want to understand that a little bit better. It's really a piggyback to Chris' question, but certainly service levels are getting better prospectively, volumes and pricing are good, pricing is actually accelerating in the quarter. You're also adding costs. I understand, there are some puts and takes there. But relative to that 50% to 60% incremental margin target that you guys have targeted at least over the next several quarters or 1.5 years, what's the right incremental margin expectation now given those puts and takes?

Yes, Amit. I would say that the incremental margin is still a fair way of looking at it. We still need the average, call it in the 50% to 60% range. I mean, we -- on a fuel adjusted basis, I think in the first quarter was like in the mid-50s. Absolute all reported was closer to 40-ish. But we have to get back to that 50% to 60% and we -- over the long term, we're focused on doing that. And I guess, I would just say that if you're calling [out surprise] around the OR commentary, you might -- I assume you're referring to the 60-plus/minus by next year. What we're basically saying there is, that in our mind is a 60%. I mean that was the guidance that we are taking down. And again we're going to revisit that when we meet in the end of May. But that -- to achieve a 60% OR from where we are today by next year, we're just saying that's unlikely at this time. We're not giving up on our focus, but that's just unlikely to get a 60% between now and next year.

Okay. And then just one follow-up question, if I could, on the revaluation of the -- reevaluating of optimal capital structure, sorry. Can you -- I know I don't want to -- I know I'm sure you're going to discuss this in length at the May-end Analyst Day. But can you just help us now, give us a little bit of preview in terms of how you're thinking about it? Because you are retiring -- you got some high-cost debt out there that's trading a big premium to par, so probably doesn't make sense to buy that back. So when I think about optimizing your capital structure, I'm really thinking about, correct me if I'm wrong, is leveraging up the balance sheet in a very prudent way to buy back a disproportionate amount of stock, just like Norfolk announced that they're going to start doing in terms of accelerating their share repurchase. CSX is certainly doing it. So is that the right playbook in terms of how to think about how you're approaching this analysis from a balance sheet capacity perspective?

Yes. I mean and I said this publically previous, and we -- you're right, we are going to get into this in more detail at the May Investor Conference. But the way we're thinking about it, I mean, we think we have additional capacity both as a result of our ongoing strong cash from operations and then turbocharged, if you will, by the tax reform. And our guiding light is a solid investment grade rating. And we're working with the rating agencies around that, but more to come on that, but we think that gives us additional capacity.

I mean you're 4 or 5 notches above investment grade, well on investment grade territory. Is it safe to say that you may be even wanting to go 1 or 2 notches below, but still stay well into investment grade territory. How do we think about that?

More to come on that. I mean, again, I'm not going to get into the details here, but again, a solid investment grade rating is sort of that guiding light. And you're right, we're well above that today.

The next question comes from the line of Scott Group with Wolfe Research.

So I want to try and take a step back, big picture. How did we get to this place? Volumes are only up 2%, they were up 2% last year. You've got [tiny] headcount up 8%. Why are we having these service issues? It doesn't feel like there is that much volume growth that should be pressuring the network?

Yes, Scott. So it's not an aggregate issue. It's a kind of a more targeted issue. So for us, if you go back to the second half of last year, there were a number of things that we've highlighted that started us down the road of a congested network, specifically in the southern region. Part of that congestion was visited in other parts of the network in part with our implementation of positive train control and unintended stops. We've done some tremendous work on reducing that occurrence. And that we feel very good and confident about squeezing that out. We did a couple of other things in terms of experimenting with our T-Plan, specifically up in the Pacific Northwest. And that created a little bit of congestion in dwell. We've deconstructed that. We're keeping the piece that we thought was most productive. And then when you get down south, basically in our most constrained part of our network, we've seen significant manifest carload growth, which is the type of product that consumes our terminal and yard capacity. So when you put that all together, the way to get out of that as inventory -- operating car inventory increased because of that congestion is to over resource the network so you can run on demand, that you don't wait for cruise and you don't wait for locomotives. And as Cameron pointed out, we changed our transportation plan, so that we actually added starts in order to move cars out of our terminals and in toward customers and in toward interchange. All of that is paying dividends. We see that as we mentioned with a $25,000 or 11% reduction in our operating car inventory, and an improvement in dwell and an improvement in velocity. There's more work to be done there, but that's why you get more locomotives than you would need steady state, more cruise than you would need steady state. And once we achieve steady state or as we approach it, you should start seeing us put locomotives back in the storage and our appetite for TE&Y is also going to reduce.

Okay. I guess that make sense. And then wanted to ask you one other just, again on the operating ratio side, I guess. So and if we go back a year ago, when we first had the management changes at CSX and we asked all the rails about it. I think what you said is, "Hey, we're watching, maybe we'll replicate some things that they're doing. And I'm sure, they're going to want to replicate some things that we're doing well." I guess, a year later and it's just a quarter, but they now have the best operating ratio for a quarter of any rail. So it seems to be working there. I guess, I'm asking, are there things that they are doing that you see that, hey, that works and that applies to us as well like demurrage or hump yards or what that you think about wanting to replicate so you can get back to having best award winning U.S. rail?

Yes. So unpacking that, the short answer is, yes. We do see both the CSX and other railroads and other businesses candidly, other industrial businesses doing things that we can learn from. We experiment with that learning like we did in the Pacific Northwest. Some elements that worked, some elements didn't and we'll continue to innovate and experiment so that we continue to drive operating ratio. We're very proud of -- and I think can stand on our record of improving operating ratio over the long term, while providing a sound and excellent service product and being able to find areas of the market that we can grow into and generate attractive profit return. And we're going to keep that up. So nothing has really fundamentally changed for us in terms of how we're looking at the business or running the business, and what we're holding ourselves accountable for, and what our shareholders and communities and customers and employees are holding us accountable for.

Our next question is from the line of Ken Hoexter with Merrill Lynch.

Lance, if I could just maybe follow-up on that a bit. You know if I look at some of the yard service issues, Cam talked about adding locomotives and cruise that you kind of just highlighted. In 2000, I guess, was it 4, 5 when you launched the unified plan, it took that network overhaul. Does this require a network overhaul, so you don't just push problems from 1 yard to another as you did back in the early days of the 2000s, so you can get the fluidity running on the network? Or is this really just that southwest and if we can fix that area with the oversupply that you talked about then it neutralizes itself?

Yes, Ken. I think it really is about getting the mix right of the right transportation plan, getting the inventory right and making sure that we have the right amount of fixed capacity available to handle it. You saw us announce earlier in the year that we were firing up Brazos, which is a large, modern network terminal in the middle of Texas, that's a key component of making sure that we have the right capacity to handle our business in Texas. We have other capital investments that we're making down in that area, that will increase the fluidity and the ability to handle carloads in that area of our network. I don't think we have to deconstruct entirely and reconstruct entirely the game plan. We don't see that. But clearly, we see opportunity to continue to find productivity, both in how we manage over the road and how we manage in our terminals, and Cameron and team are all over that.

So if I can just get my follow-up then on -- do you -- would you then view this low 60% range? Would've gone from the 90s to the 80s now to getting to the low 60s. Is this the peak? I mean, is this maybe where the rail network needs to run and operate, so you don't have to keep over hiring and bring on resources? Or is this just kind of a slow bleed, whether it's pricing or technology that gets rolled out that, that can continue to improve those operations, just in order to handle the rebounding growth as it comes?

Yes. We do not believe that there is a choice that you have to make to identify a low watermark that you stand on in terms of operating ratio. We think that we can run this business in a way that we'll continually look for opportunities to reduce our operating ratio, and we think there is still opportunity for that. The other thing to notice, we don't manage the business solely with the focus on one metric, right. I mean, operating ratio is a very important metric for how efficiently we're running the network. Return on invested capitals is a very important measure that we use to make sure that we're making prudent investment decisions. We look at our service KPIs and our quality KPIs, and of course, our safety KPIs. So we believe we can accomplish all of that at the same time. We did a fair job of that in the first quarter of this year. I mean, we've shown operating ratio improvement, record EPS, solid increase in operating income, and we think there's more of that to be had and some of that was masked in the first quarter because we had excess resources in the network to get back to a great service product.

Our next question comes from the line of Bascome Majors with Susquehanna.

We spent a lot of time on the OR. I was curious, I mean, officially your volume guidance is unchanged from what you put out in January a low single digits. I'm just -- do you feel better, worse about kind of how volumes are going to shape out this year with 1 quarter under your belt? And can you maybe point to any upside or downside risk outside of frac sand which you already highlighted that we should think about there?

You know, Bascome, I would say that the economy feels pretty good to us. Industrial production was very strong in the first quarter. It looks to stay strong as we progress throughout the year. We've had some wins that are public on the International Intermodal side that makes us feel good. We do have some uncertainty, I'd say, and what happens with coal, the ag markets globally are always a little bit of a question mark for us. And there were something also I was going to say which slipped my mind. Oh, frac sand is still, like you indicated, uncertain just because of all the capacity that's coming on locally. So our guidance has been kind of low single digits. We're not changing that at this point. But certainly, we're optimistic about having a nice volume year.

And Lance, maybe one for you. At a high level, I mean, you and Rob have talked about being able to sustain more leverage on the balance sheet. But certainly makes sense from a return on equity standpoint, but it also probably reduces your balance sheet optionality, if we do get into another round of rail consolidation down the road. I was just thinking about -- at a board level, is that a conversation your peers have? And how do you think about the tradeoffs from that?

Yes. Bascome, so we constantly discuss our capital structure. You know, looking at us now and historically, we're pretty conservative in our capital structure. We make sure that we have our powder dry for the what-ifs as we look into the future. So not disclosing anything we discussed at board level, I would tell you that's a constant discussion. Right now, we think both our ability to generate incremental operating income and cash and tax reform gives us the opportunity to, in aggregate, increase leverage and also to reevaluate the amount of leverage we have.

Our next question comes from the line of David Vernon with Bernstein.

Rob, I just wanted to talk a little bit, again, about the sort of the same issue here, right. If we're sort of walking back off of the '19 targets, how do you get confident that there's enough operating leverage in the business to get to that 55% number?

Yes, I mean, as you know and others know, we haven't put a finite date on that 55%. But as Lance and Cam have commented throughout this morning, we continue to believe, while we've hit this little speed bump, if you will, that doesn't change our conviction and our belief that there's a lot more to be gained here. And we have -- we don't just pull numbers out of thin air, we've got real action plans behind as you've heard me speak too many times. Real action plans behind getting to that 55%. And yes, we need the economy to cooperate, we need to be performing at a high level, we need to continue to get price above inflation to get there, but we're confident in our ability to ultimately drive to a 55%.

But I mean, I guess, the primary controversy or the primary issue here is when the market sort of hears the 55%, it's connecting those dots. Like how do you -- is this going to be part of the Investor Day agenda? Is this sort of in May? Like how do you help give confidence around that, that margin potential inside of the business?

Yes. Certainly, David, and I would envision that we will be talking to this at our Investor Conference in May. And I get the push back. I mean, I understand. I mean, we've hit a little speed bump here in the road and we're going to clear that as soon as we possibly can and sort of get back on track. But I hear the message that we need to rebuild that confidence in the investor base.

The next question comes from the line of Matt Reustle with Goldman Sachs.

Just one quick one again on leverage capacity. I just want to make sure. It sounds like you're referencing specifically that you see more debt capacity from tax reform. I mean, it also seems like you would have some additional capacity to match where your peer group is? Are you considering both of those opportunities or you're specifically looking at where you are and the opportunity from tax reform and still wanting to kind of keep a better balance sheet than a lot of your peers?

Yes. Matt, again, this is Rob. We'll talk more detail at the Investor Conference. But I would say directionally, it's both. I mean, we think -- you're right. We think we have debt capacity and then that is turbocharged by the benefits from the tax package. So really it's a -- we're looking at it as a combination of those things and that's what we're working through with rating agencies.

The next question comes from the line of Tom Wadewitz with UBS.

I apologize if you've covered this already, with just overlapping conference call with UBS. But I guess, pricing topic is pretty further ground so I'm sure there's room to talk about it. How do you think about kind of stability you've seen in core price? And any potential changes in that? I think from other railroads, we have seen pretty good evidence of acceleration in price? So how do you think about that in terms of the dynamics in your business? And whether that's changing and how big the effect is from Coal and International Intermodal where you have for a while identified a little more market pressure, market challenges?

Yes. You're right, Tom. We've had a couple price questions already and they are somewhat similar, but -- yes, we continue to see pressure in Coal and International Intermodal. We are very optimistic and encouraged by the truck tightening and -- that -- and certainly in our truck competitive markets, we're seeing strong pricing. Rob talked about that earlier. If you took Coal and International Intermodal out, we're at about 2.75% pricing. So there is opportunity out there in the truck competitive markets and we'll be going after it strong.

So is it reasonable to think that the -- there is room for acceleration in what you're seeing? Or do you think what you're seeing in the first quarter results is kind of representative of what might be the case looking forward?

We don't like to try to predict what's going to happen in the future. All I can really tell you is that we will take advantage of every opportunity to not only go after pricing, but to try to convert that highway business to rail while we see the truck tightening and the opportunity for us to provide value.

Okay. So do you still have a fair bit of the book left to reprice this year? Is there still opportunity to get rates up on business this year?

Yes. We are partway through bid season on the intermodal side, and we always are converting over about a 1/3 of our business every year and we'll have pricing opportunities as the year progresses.

Next question comes from the line of Walter Spracklin with RBC Capital Markets.

I'm going to limit to just one question, I guess, maybe directed mostly at Lance or Cameron. Really looking at our capacity and we've seen other railroads see some capacity issues. So you pulled back all your furloughed workers. You've brought in 650 locomotives or reactivated them. Can you touch on -- is that all of the locomotives that you have in storage now? Or do you still have some remaining? Can you touch a little bit on network capacity in addition to your, kind of, capacity on the employment side and on the locomotive side? And where any surge capacity is? I know you touched on that on your prepared remarks, but given some of the issues, some of the other rails have had, what confidence can you give that you're prepared for any surges if we should see them?

Cam, do you want to start?

Sure. Our western region and northern regions are in excellent shape when you look at rail network capacity. Truly is, as Lance mentioned, a southern region story from a network capacity perspective, and it's a good one, that we're experiencing growth. And we're responding appropriately with capacity investment to tackle that growth. From a locomotive standpoint, we still have 225 locomotives in storage, and we will evaluate bringing those back in as our network picks up steam. On the employee side, we don't have anybody furloughed anymore and we are hiring. And the pipeline is full. It's about 200 employees a month through July that will be landing in full service and we'll be evaluating, hiring going forward preparing for the fall.

Walter, part of the answer is, again, when a network business like a railroad gets congested, you can either gut it out and that takes a long, long time. And usually, it means volume goes away. And then finally, you get enough spare capacity to be able to make the improvements you need to get back to where your plan was or you can overload the network, so that you can run volume whenever you want. We have a physical capacity that is a rail capacity issue just in a few spots in the south, in some terminals and some parts for the line of road. But what we don't want to do is also have that plus a locomotive capacity issue, plus a crew capacity issue. So we've over resourced those areas in the first quarter, clearly. We do have some more powder that's dry in locomotives. And as Cameron says, our hiring pipeline is full. I fully expect as Cameron and team continue to improve our service product in the south that we're going to be in a place where we start storing locomotives again, and slowing down that hiring pipeline. Where that happens exactly, when it happens exactly? We can't tell. But what we can tell is as we make improvement, we've got an eye towards being able to do that because those are the costs that are getting in the way of us demonstrating the $300 million to $350 million of productivity that know we can get this year.

And did you touch on your workforce that you expect in the year end, the workforce level?

No, we've not.

Do you have an estimate around there?

Walter, our view as you heard us saying many times on that, it has not changed. And that is it will move up and down with whatever volume is. That being, we are projecting that volume is going to be on the positive side of the ledger but it will be one-to-one. We still expect to achieve productivity as we look at the headcount.

So the 200 per month is a gross number, I guess, you will be attriting there, so it won't be to that extent, obviously?

That's right. That's right.

Okay. And then just one final question, more of a housekeeping. I don't know if you mentioned the other expense move around by shifting it from labor into that below the line item. Did you give guidance on that with regards to what we can expect on a quarterly [guidance] going forward?

On the pension?

Yes.

It's like 0.1% impact on the OR.

Our next question comes from the line of Brandon Oglenski with Barclays.

So I'll just leave that one, but Lance or Rob or Beth, you guys, I think if we look back a few years, have underperformed in the industry in terms of volume growth and your top line really maxed out maybe looking back at like 2014. So and I don't want to steal any thunder from the analyst meeting, but what can you talk about from a growth perspective, maybe at a very high level, where maybe the last decade you weren't able to expand with the market, but looking forward you really want to leverage this unique network that you have and really take advantage of that economics versus the highway. Because we've been hearing about that a long time, but the growth just hasn't really materialized specifically for your company.

Yes. Brandon, I'll start by saying what we really focus on is generating industry-best operating income and cash, which we do. And some part of whether or not we can get that from the top line volume is predicated on what's happening in the market and what's available to us at what we would consider appropriate and attractive return. But with that, I'll turn it over to Beth and Rob.

Yes. I wholeheartedly agree with Lance's comments. We're -- but what you are seeing I think from us this year, in particular, is pretty -- we had some questions earlier about growth, but I think it's going to be a solid year for us. We do -- we are having some wins in International Intermodal that are, like I said, public. The markets feel good to us. We have great exposure to the growth that's happening in the Gulf Coast in Industrial, Chemicals and Plastics. So just echoing Lance's comments, our focus is very much on getting value for the service that we provide, so that we do provide industry-leading margins and returns. And my team is really focused on doing that. We've a great business development pipeline. And we're going to continue to ensure that we put up good numbers in that regard.

Our next question is from the line of Brian Ossenbeck with JPMorgan.

So Beth, you mentioned earlier in the call about petroleum and LPG were pretty strong because of crude oil but I want to see if you could comment further on the opportunity to export refine products into Mexico, given all the changes with energy reform and the gateways that you serve into the country?

Yes. We have been participating in that Mexico energy reform market. It started first for us with pretty significant LPG volumes. And then last year and into the first quarter, we did see solid finished fuels, gasoline and diesel shipments. It's a nice growth opportunity. I wouldn't call it a substantial carload potential over the long term. But we are participating in that market and we'll continue to pursue opportunities from those -- the refinery complex that we serve in the Gulf Coast, down into the key consuming markets in Mexico in partnership with both KCSM and FXE.

The follow-up was -- and you talked about the operations already but maybe a little more specifically on the freight car inventory. For Cam, is there anything to read into the mix of private cars on the system, it's been pretty high across the -- most of the North American network. I understand how that relates to the type of volume and freight that you're moving. But did that add to any of the complications when you're trying to get through some of these pinch points? And do you think it'll have any effect after you reset the network if that does continue from here on and out?

I think both Beth and the operating team and the customers are working together very well to try and rationalize that very topic of private freight car inventory. We're making good progress and we expect to continuing that progress throughout the remainder of the year.

Okay. Just a quick follow-up on that, are you able to incentivize with the [lower rates] or potentially even to merge? Or is it just in everybody's best interest to keep -- to get the fluidity up and to keep it that way?

You know customers are really motivated to do the same thing that, that we are, which is make money and move their product, right. So we see very rational behavior from customers in terms of adding freight cars to the network based on the cycle times that they see. So as we slow down, we did have some customers that added additional freight cars. I feel like our conversations with those customers about the improvements that we're making and the increased cycle time are then causing them to make rational decisions which is pull freight cars back off the network. So I don't see that being any sort of a long-term systemic issue for us.

This concludes the question-and-answer session. I will now turn the call back over to Lance Fritz for closing comments.

Yes, thank you. Thank you all for your questions. And we look forward to talking with you at our Investor Day in Omaha on May 31. Thanks.

Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. And you may now disconnect your lines at this time, and have a wonderful day.