Norfolk Southern Corporation (NSC) Earnings Call Transcript & Summary

Everyone, welcome to day 3 of the virtual Laguna Conference, lots of transportation content for you today. So let's get right to it with our first session hosting Norfolk Southern. Very excited to have with us, Chairman, President and CEO, Jim Squires. Jim, welcome to the now virtual Laguna Conference. Jim is going to take us through some slides and give us an update on what he's seeing out there, and I'll follow up with some questions for him. And again, a reminder to the audience, if you have any questions for me to ask Jim, please submit it through the webcast, and I can pass it on to Jim. But before we kick off, I have to note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And with that, Jim, the floor yours.

Good morning, everyone, and thank you for hosting me today, Ravi. Before we kick off, allow me to remind everyone that forward-looking commentary today is subject to risks and uncertainties, and our annual and quarterly reports filed with the SEC provide a full discussion of the risks and uncertainties we consider to be most important. And lastly, please see the non-GAAP reconciliation posted on our website in conjunction with this event. So let's get started on Slide 3. I'm going to provide you today an update on our implementation of PSR. At its core, this is really a story of change. Over the past year, we've fundamentally changed the way we run our railroad to ensure the greatest efficiency across our operations. Step change is hardly adequate to describe the pace at which we've reduced resources and assets, and yet, we've dramatically improved the service we're providing to our customers and have created new capacity in the process. We remain committed to our goal of achieving a 60% operating ratio and strongly believe the best is yet to come. Let's dig in on Slide 4. Here, you see the NS network map with our major classification yards highlighted. When we embarked on the implementation of our TOP21 plan last year, we operated 10 hump yards. By leveraging PSR, we've substantially reduced dependence on those major facilities, resulting in the idling of 4 more humps, 2 in the Southern part of our network at Sheffield and Lynwood and 2 in the North at Allentown and Bellevue. To put that in perspective, in the 16 years following the Conrail acquisition, we closed 4 humps. But in the past year alone, we closed 4 more, with the potential for even more of this type of structural change. An initial step towards accomplishing this occurred as we undertook Clean Sheeting efforts at yards across our network in order to reduce asset dwell and to optimize terminal operations. In addition to Clean Sheeting, with the launch of the TOP21 operating plan, we began consolidating into larger trains with reduced circuity, ultimately, enabling the idling of these 4 hump operations and driving additional resource reductions, which are highlighted on Slide 5. Turning to Slide 5. Here, you see a snapshot of the significant reductions to our head count and active locomotives, which are down 24% and 27%, respectively, since the start of 2019. 2019 presented our industry with a challenging volume environment, exacerbated by the onset of the pandemic earlier this year. But the story behind the charts on this slide is one of scaling to a much more efficient operating plan. From the start of 2019 through the current quarter-to-date, our train and engine personnel productivity has increased more than 20%, highlighting the outperformance of our resource adjustments versus volume. On the locomotive front, thanks to our more efficient operating plan, we're driving productivity while continuing to invest in our locomotive modernization program, which is taking end-of-life units and rebuilding them with state-of-the-art technology in a very capital-efficient manner. We've kept that program going even as we've reduced our capital expenditures budget by 25% from where it was the last couple of years. These cost-control efforts enabled us to produce record free cash flow in the first half of the year. Lastly, to give you a preview of numbers not shown on these charts, our third quarter resource levels are trending similarly to the second quarter levels you see here, while daily volume is trending up about 19%. So we're seeing even more productivity and operating leverage. Moving to Slide 6. As we look ahead, we remain committed to achieving a 60% operating ratio and enhancing shareholder value while continually delivering superior service levels. We'll continue to bring this powerful franchise to bear on markets across the Eastern United States while operating more efficiently and maintaining the trust and confidence of our customers. Slide 7 shows fluidity metrics, train speed and terminal dwell, which are substantially improved versus the pre-PSR range. As I mentioned a moment ago, volume has ramped in the third quarter, and our operations team has done a great job bringing that traffic back on to the network while keeping the trains on schedule. Last quarter, due to COVID-19, we essentially shut down the entire Automotive network. And recall, we serve more light vehicle origination points than anyone else, so it's a broad network. As that traffic has rebounded, we didn't simply turn the auto network back on. We seized the opportunity to rebuild the network to be more efficient and fully integrated into the Merchandise and intermodal networks. And as I mentioned, we idled 2 hump yards simultaneously. So to come back to Clean Sheeting, it continues to be a big driver of the significantly improved dwell time that you see on the right side of the slide. I'm very proud of our ops team and also the collaboration with marketing and everyone within the organization to keep the steel wheels rolling. We are operating today more efficiently than ever, and we're excited about our strong prospects for further improvement. Our organization is energized and committed to achieving and surpassing our targets. Turning to Slide 8. Now that we've talked a bit about network configuration and the enhancements and resiliency of our network fluidity, I'd like to cover the train plan, particularly the continuous improvements we're making and will continue to make to drive strong free cash flow and superior returns for investors. Our TOP21 plan went live 14 months ago. And in that time, we reduced crew starts by 28% during the depth of the volume trough in May and the reduction stood at 19% last month. So the number of trains out on the network has been significantly reduced, but our ability to haul freight is stronger than ever before, creating a powerful formula. If you contrast these crew start reductions with the strong rebound in daily carloads, you see here, the result is solid productivity growth. While I've talked about big events like idling hump yards, the approach to continuous improvement is broad-based, driving efficiencies at smaller yards, local operations or mechanical footprint and more. The continuous improvement to the plan and the commitment of our team never stops, and this creates a lot of future value for our customers and shareholders. A robust service and more efficient network are the foundation from which we will continue to improve this plan as we move forward. The last item I want to hit on before we open the call to Q&A is the no-surprises approach we take with our customers. So turning to Slide 11. Prior to launching TOP21, we undertook an aggressive campaign of meeting with our customers out in the field with their local operations team as well as marketing representatives and had transparent conversations backed by data about the changes they would see with PSR before we proceeded on our initial implementation. As a result, our implementation of PSR thus far has been very successful and well received. At the onset of the pandemic, we demonstrated our agility, reacting quickly to changing market conditions by expediting critical shipments, rerouting products to keep plants open amid sporadic shutdowns and adjusting service intervals as shippers fought to keep their supply lines open. These are just a few examples of things our folks do every day to ensure Norfolk Southern is the transportation provider of choice in the geographies we serve. We wouldn't be afforded revenue per unit excluding fuel across growth -- across all 3 of our business units for 10 consecutive quarters if we weren't adding value to the economic lifeblood of our franchise, our customers. So in closing, I can tell you how excited I am about the opportunities ahead for our company as we work together to build a faster, more efficient railroad. With the capacity and operational momentum we have, our positioning with the best intermodal franchise in the East, 55 intermodal trailheads, a highly diversified and powerful merchandise portfolio with over 250 short line partners, the best channel partners in the business and the best people in the business, we're well positioned for continued growth and success. I can't thank our employees enough for their hard work and dedication to delivering each and every day for our shareholders and our customers around the world. In short, we've done an outstanding job of improving performance and creating value since we began our PSR journey, and we are committed to building on that progress to further enhance the financial and operational performance of our company going forward. Ravi, I'm happy to take your questions.

Great. Jim, thank you so much for that update. Clearly, very impressive operating performance during a very challenging time. Maybe if I can start with some follow-ups to what you said. I just wanted to confirm that you said in 3Q so far, you're seeing operating metrics similar to what you had in 2Q, but with volumes up 19% off the bottom. Is that what you said? And were you referring to train starts, number of locomotives, employee count, kind of -- those are the kind of metrics you're referring to?

Right. So those are the basic resource classes that we keep a close eye on and that drive productivity in the operation. And so yes, in the third quarter-to-date, we have seen strong growth in volume off a pretty stable resource base in those areas. And that has obviously generated significant operating leverage.

Got it. I'll come back to the demand side in a second, but maybe just to stay on this topic. Is that the road map for the near term, try and hold the resource base where it is and try and squeeze as much of the volume recovery through it as possible until you start adding resources? Or are you also saying that hey, we can't target further improvement in that resource base?

We will certainly continue to preserve structural cost reductions and improvements in our cost structure in all of the areas you outlined and in other areas as well. So the goal is certainly to handle the volume growth that we have experienced with the existing resource base or less over time. Now obviously, there will be the need for additional resources in some areas where volume growth is particularly strong. But in general, yes, the idea is keep the resource base stable and declining.

Got it. And just kind of on that note, kind of in your analysis and in your team study of the network, how much of that initial volume recovery can you absorb without bringing on additional resources before you guys are -- fully utilize the network stretch? And at that point, do the resources come back 1:1 versus the volumes?

Well, as I said, in the third quarter-to-date, the leverage has been very, very strong. The incrementals have been very strong, as you would expect, with that kind of sequential volume growth and an essentially flat resource base. So -- and going forward, we would expect to continue to pursue that objective. That's really -- that's the key in the growth phase of the economic cycle in our industry is to maximize absorption of the volume with a stable or declining resource base. Now at some point, you do begin to need to add back train starts, employees, but I don't think we're close to that point. Our intent is to continue to drive the growth through the network using the existing assets.

Got it. And just kind of not to belabor the point too much, but obviously, this is a very important topic and probably the single biggest focus area for investors with Norfolk Southern, which is your incremental margins are way back up again because clearly, kind of that really drive the numbers higher. Obviously, you are seeing very strong incrementals in 3Q so far. I think historically, you've done 65%, 70% incrementals in periods of strong growth in the past and past up cycles. Are we looking at that kind of incremental margin kind of in the back half of 2020? Can we do better than that? And kind of how do you see that continuing in 2021 and '22 as volumes start normalizing?

Given the structural cost reductions we have made, I think investors can reasonably expect incrementals to be strong, stronger than average in a growth phase of the cycle like we're in right now. Now going forward, we would eventually expect, I think, incrementals to return to a more normalized level, but that's some ways out. We believe that we can handle growth with the resources that we have while we continue to pursue additional structural cost reductions and absorb growth with that resource base.

Got it. Maybe shifting gears a little bit and kind of going away from being near-term stuff and talking more structurally at a higher level. You've obviously made very good progress on the operations and cost side so far with implementing PSR. But you've also had some turnover on your PSR operating team recently. Mike left, and Cindy is now a COO. What does that mean for the PSR program? What does that mean for the way this -- these games continue in the near term and medium term? Does that signal a shift in your PSR strategy or a transition from one phase to another?

Every member of our management team from the C-suite through field operations is fully committed to precision scheduled railroading because we have seen success that is possible with PSR. And so we intend to continue to follow the PSR model and to continue to drive the types of structural cost improvements that are possible. While we also continue to communicate with our customers, the no-surprises approach I mentioned in my prepared remarks, so that we have the platform for growth as well.

Got it. And maybe last question on PSR before we speak to other topics. Clearly, kind of at the Analyst Day, you guys had laid out both the cost-improvement plan, TOP21, as well as the yield-up strategy. Obviously, you've seen a lot of traction on the cost and operations side so far. How is the yield-up strategy going? Kind of how would you describe the current yield environment? And kind of at what point does the PSR kind of transition from the cost side towards the revenue side?

Yield-up is a fundamentally sound strategy for managing the top line in our view because it seeks to obtain value for the services that we provide and the value that we generate for our customers. We are intent on serving our customers well and creating value for them and generating, in return, increases in shareholder value for our shareholders as well. And that's the essence of the yield-up strategy, and it's been very successful. As I mentioned, the trend in revenue -- the revenue per unit component and the pricing component of our top line in my prepared remarks, the strategy is intact. It's working. And we are very confident that with yield-up, we are producing an optimized top line for our company.

Got it. Let's shift gears a little bit and talk about the demand environment, kind of what you're seeing out there. Clearly, kind of there has been unmistakable improvement off the bottom. The sequential gains have been pretty strong. But for you and the rest of the rail space, volumes overall are still down year-over-year. What's your marketing team telling you? Kind of what visibility do they have? When do they see overall carloads start to turn positive on a consistent basis and kind of stay meaningfully positive for a while? Is that a second half '20 event? Or is that a 2021 event?

Not surprisingly, our carload trend mirrors what's going on in the broader economy. So we're seeing strength in consumer-oriented products. Our intermodal volumes are tracking very well. And in some of the subsegments within intermodal, volume is up -- already up year-over-year in our premium intermodal segment, for example, we're seeing strong growth year-over-year. Now in other parts of the franchise then, we continue to see weakness. Energy-related commodities have lagged overall trends in the economy, and the same is true in our car loadings. Although even there, we're starting to see a little bit of a pickup as inventory replenishment really gets underway, manufacturing is kicking in some, and we're seeing more demand for basic products. But still, energy products are the weak spot with consumer-oriented products leading the growth.

Got it. Just maybe to dig a little bit deeper there. On the intermodal side, what's been driving that improvement in volumes? I mean clearly, the comps are easy, but also fundamentally, it looks like things are getting stronger. Is that a function of just a tight truck market? Is that a function of, obviously, e-commerce being robust? Is that a restocking thing? Kind of what would you say are the biggest drivers of that intermodal improvement?

I think inventory is being very low. The inventory sales ratio having hit all-time lows a couple of months ago and continuing in August. We're seeing a lot of restocking of consumer products, and that's driving the strength in the intermodal franchise to a significant degree. I think we're also seeing a continued migration to e-commerce-related volumes within our network. That was well underway even before the pandemic hit, and I think, as we all know, it's accelerated during the pandemic. So those are some of the drivers of growth in the intermodal segment, in particular, but we're seeing a little bit of that in carload as well.