Norfolk Southern Corporation (NSC) Earnings Call Transcript & Summary

All right. We'll go ahead and get started for those I haven't met. This is Justin Long. I cover rail intermodal and transportation equipment at Stephens. Our next fireside chat is with Norfolk Southern, sitting next to me is Alan Shaw, CEO. Alan, appreciate you being here and continuing to support this event. I look forward to the discussion. This will be a fireside chat format. So I'll start with some questions. I'll also open it up to any questions from the audience as well.

But with that, maybe, Alan, you could just start with a general update on the business so far this quarter. We're now about halfway through. So what are you seeing relative to expectations in terms of volumes, service, operational performance. Let's just start broad and then we'll dive into some more detailed questions.

Great. Thanks, Justin. It's -- I enjoy coming here. It's always a pleasure to sit down with you and thanks for hosting this event. Now I will make some forward-looking statements today, which, as you know, are subject to risks and uncertainties and I would invite your guests to take a look at those risks and uncertainties in our SEC filings and our website. As I think about where we are right now, we laid out a plan for the fourth quarter on our third quarter earnings call and we're delivering on that. We said we're going to improve service as we move through the fourth quarter and we are. We're about to start on peak season, which generally starts the Monday of -- and I'm talking about e-commerce peak, the Monday of Thanksgiving week and we're ready, and I expect to see continued improvements in service as we move into peak and we move through December. As a result of that, as a result of the continued improvement in service and that positive trajectory, we have the capacity to handle more business and we're attracting more business. And so the last 6, 7 weeks, our weekly volumes are at levels that we haven't seen for about 18 months. So that's positive for us as well. We continue to focus on productivity. A faster network is a less expensive network. And there are also some other things that we can do and some turns of the dial that we can make to enhance productivity on Norfolk Southern, which I'm sure will have an opportunity to talk about. So the fourth quarter is basically playing out like we told everyone to expect on the third quarter call.

Okay. Great. And I know one thing you talked about too is with the OR. I think Mark said third quarter would be the trough, so it sounds like you're still confident that's the case and you can see some sequential margin improvement here in the fourth quarter.

Yes, I'm very confident of that. We said that the fourth -- third quarter OR would be the most elevated of the year. I'm confident that, that will be the case. We're going to see some meaningful improvement in OR in the fourth quarter. And we understand that our commitment over the long term is to deliver industry competitive margins. We're intently focused on that with a sense of urgency.

And so maybe let's dive into that a little bit more. I know that's clearly a focus for the company. When you think about closing that gap versus peers are getting to competitive margins in the industry, how much of that is seeing the positive operating leverage associated with volume growth versus more of a kind of internal self-help productivity opportunity?

Yes, it's -- I'm going to do this. It's a combination of that. What we've talked about is a balanced plan service productivity and growth to help deliver those industry competitive markets. Certainly, volume growth will help productivity. And we expect volume growth in markets such as merchandise and intermodal, which candidly have -- we've got a lot of room on those trains, right? And so that's -- those will come with pretty strong incrementals. A faster network is a less expensive network. We're spending $40 million, $50 million a quarter on service recovery costs as service improves, those costs really start to go away. And as service stabilizes, we've got the opportunity to continue to iterate our operating plan for productivity and for service improvements, which should drive T&E productivity, fuel productivity, equipment rents and locomotive productivity as well.

Okay. And maybe we can build on the service-related costs that are starting to come down. You also have the investments and the resiliency of the business that are going up. On the latter piece, do you feel like we'll be at a peak in the fourth quarter in terms of some of those resiliency investments?

I like the way you frame it, it is an investment, right? It is an investment in the quality of our service product and our ability to handle growth and candidly to drive productivity. It is elevated as service improves, that's going to help -- it will be offset by the service recovery costs, there will be inflation next year. It basically is associated with elevated head count, it's associated with inflation, it's an association with quality of life issues with our craft colleagues. All of those over time, are going to create benefits for us.

Okay. And maybe we could focus on labor a bit and what you're seeing in terms of labor availability, attrition rates today? Have you seen any noticeable change on that front?

Yes. Attrition rates are down slightly, which is a positive for us. That tells me that we're doing the right things with our culture. We're doing the right things with hiring the right folks, we're doing the right things with employee engagement, right? Because it takes -- it costs $50,000 to recruit, hire and train a new employee. And typically, you're trying to do that during a period in which demand is elevated. And so you just don't -- you don't have the right resources in place to handle the volume that we're much better off if we can hold on to folks and use attrition, where needed in specific spots to address the head count to match demand and to match the outlook. Yes, we're continuing to see improvements in attrition. There are some areas in which head count, our resource level isn't where it needs to be, but we are so much closer to target than we were this time last year. And so as a result, again, we're doing exactly what we said we were going to do. The number of conductor trainees in the pipeline continues to decline. And that's a very important phase of the employee life cycle is training our employees. But when we're training them, they're not moving any freight, right? And so that really does impact our T&E productivity. And so as the conductor trainee ranks continue to decline because we're much closer to where we need to be. That in and of itself has got to enhance T&E productivity.

And it sounds like your expectation is the head count grow a bit sequentially as we move into the fourth quarter. At that point, do you feel like head count will be pretty close to targeted levels. And if we see volume growth next year, you can leverage that and not have to add at all the head count or not add a meaningful amount?

I'd say we are going to be really close. Our goal will be to use the leverage of our fixed operating network and the capacity on existing trains to secure that additional volume and bring the productivity that's inherent in that. I think we probably need some more fuel supervisors in a couple of areas. That's something that we identified last fall and we're continuing to hire there. But ultimately, our goal is to really moderate the growth in headcount.

Okay. I'll double back to a couple of questions on volumes, and then I'll open it up to the audience if there are questions. But we've seen an improvement in volumes recently, to your point, the highest levels we've seen in roughly 1.5 years, do you feel like any of this is just catch up from some of the operational headwinds and challenges you've dealt with this year? Or is it the market is getting better? How would you kind of pie chart what's driving the volume acceleration?

I don't know that I would call any of it catch up, alright? I think it's unhealthy for a railroad to assume that if it provides poor service, once service recovers, all of a sudden, that latent demand is going to come back. Those customers -- our customers are smart and they're going to look for alternatives. And so that -- I'm just going to assume that, that business moved one way or another, maybe in the spot truck market. I think that as our network fluidity has improved, our cycle times and our equipment are improved, so we're presenting more capacity to our customers. And look, people want to ship via rail. It's less costly. It's safer. It offers more capacity, it's more sustainable. There are a lot of reasons people want to ship via rail. The reason rail has ceded share to truck over the last 25 years is because of service, one reason and one reason only. That's what we're trying to take off the table with our better way forward at Norfolk Southern a new plan that we outlined where we're investing in the cycle and committed to providing a good service product through the cycle. I think as our network velocity improves, it also makes the -- our product more attractive to new entrants. With respect to markets, you've talked to some of our channel partners in the intermodal space. And I think they're seeing some opportunities for growth as we move into next year. And we've seen that in the domestic side over the last couple of weeks. We've seen volumes start to pick up. We continue to take share from truck and international intermodal metals and construction markets, basically anything associated with nonresidential construction is really strong. Our volumes in automotive are elevated year-over-year. On the converse, there's a lot of weakness in chemicals. There's weakness in domestic coal and energy markets. So it's -- I'd say it's -- we've got some things that are moving up, things that are moving down. There's a cloud due to the geopolitical uncertainty out there. And so we're not in a position right now to talk about what 2024 looks like.

Any commentary on peak season just since you brought up intermodal?

Yes. It seems to have like the right shape of the curve for us, but the amplitude might not be as high. We're tracking 80,000 units -- 81,000 units a week in intermodal. Ideally, we'd like to see that closer to 88,000 to 89,000. And then our e-commerce, our more premium product will start to elevate here in about a week.

Okay. I'll pause for a moment. Any questions from the audience? One over here.

[Audio Gap].

That's a great question. I'm going to caveat that really broadly because obviously, it's dependent upon the specific train, the location. But when you -- you think about the mix of business. If you were to add additional coal, you're absolutely going to have to add additional trains, right? Because each coal train, each green train is effectively running at capacity. When you look at the markets where we think there are growth opportunities, right, in that single car network in automotive, we don't run a lot of strictly automotive trains. Certainly, in intermodal, there you're adding additional boxes, additional multilevels and really increasing the revenue density and the productivity of existing trains.

Maybe we could go back to the resiliency cost. So based on the annual run rate now, it's $200-plus million of resiliency and I use the word investments. I'll use that again annually. When you think about getting a return on those investments, how long do you think that takes in terms of the volume and pricing benefits that should eventually come from that.

It's a pretty short turnaround on the investment quick payback. Number one, service continues to improve because of these investments and resiliency. Service recovery costs over time, recrews, equipment rents. Those all start to come tax expenses. Those will come out, right? We'll also see the additional opportunity for price. We are and continue to lean into price. And as the quality of our product improves, as a double coupon, there's more demand for the product. That's a goodness. So volume gets up, but the value of the product increases, too. So we can charge more for it and we fully intend to do that. So pricing will help offset that as well.

And so when you think about the year-over-year change in pricing today versus what it could look like in the next 12 months, do you feel like the setup would support an acceleration of pricing in the next year as service improves? Or does the macro backdrop make that difficult?

We'll just set coal -- export coal aside. Right?

Sure. Unique animal.

Yes. It is. And you understand as well as I do what the drivers are, right? So I think in merchandise, yes, there is absolutely is the opportunity for continued strength there. And frankly, we're above our plan this year on our pricing and our merchandise network. The intermodal space is going to be dependent upon what's going on with the truck market and with truck pricing. But again, as our service quality improves, it's going to attract more business for us and more business for our channel partners.

Okay. I think there was a question over here.

[Audio Gap].

Yes. So the question, I think, is inflation was super heated for a while. The pricing was not able to keep up with that as inflation in the rail space cools. And there's some forecast that inflation will be in the rail space relatively flat next year. Can you catch up on that gap? That's absolutely correct. That's absolutely what we think will happen. The average duration of our contracts is about 2.5 years. And so if inflation spikes in any given year, we're not necessarily going to be able to fully incorporate that into all of our contracts. I'll make it really clear. We don't do inflation plus pricing, right? We don't do cost plus pricing. We price to the value of our product. And over time, that kind of mindset has allowed us to secure price in excess and inflation. I know that's a key component of the investment in rails and we're fully committed to that. And that's the right thing to do.

[Audio Gap].

Well, I'm referring to ALF all-inclusive less fuel, which is an industry guide for rail inflation. It's included in some contracts. I think there's productivity that can help us offset that.

Maybe we could double back to some of the truckload conversion commentary. One of the questions I get a lot is when rail service gets better, how long does it take for a shipper to decide that they're going to pull the trigger on converting from truck to rail. Is it weeks? Is it months? Is it quarters? I know it's going to depend on the situation and the customer. But generally speaking, when do you feel like you can hit that inflection point?

Yes. I think including the merchandise business and the automotive business, I think it's -- it's relatively quickly. I think for some customers, it's going to take longer. They frankly need to see rail service at targeted levels through an economic cycle. There are a lot of customers right now who just would really want to ship more with us today if we could present the capacity to them because of those inherent advantages to rail that I talked about. So yes, we're seeing it right now as volumes have picked up, as services picked up, but I know there's a lot more out there as we demonstrate and continue to demonstrate our ability to deliver good service through an economic cycle. And that's a lot of the stuff that we're working on with our channel partners is going after a different type of product that's out there. Right now, a lot of intermodal business is just -- it's the same customers and -- it's the same shippers to themselves, right. What we want to do is get to the place where we can pick up business from customer A to customer B because of the confidence that customer A has in our service product. That's a much bigger pie in the intermodal space than what rail participates in right now.

And just given the momentum in service and the opportunity for conversions that it sounds like they're starting to materialize. As we look into next year, do you feel like that secular theme, is it enough to support an outlook for volume growth, how confident, without getting into specifics, obviously, how confident are you can grow volumes next year?

I'm not really going to talk too much about next year because of that geopolitical uncertainty that's out there. We're working on our plan right now for next year. But volume -- volume levels right now, would create the opportunity for growth next year if you map that out.

And since you brought up the economy and geopolitical changes, what's your kind of view on the state of the economy today and next year? What's the feedback you're hearing from your customers? I think it's a finger in the wind exercise for everyone, but would love to just get some real-time feedback from you.

As we moved into this year, there's a lot of pessimism on the economy. I did a lot of forecasts for a recession. The chances of the recession continue to go down, I think, because of the macro outlook certainly that's what most of the banks are saying. So I think that the economy is not super heated, although GTB was 4.9% in the third quarter. So there are some aspects that are going well. I think it's performing better than what we would have thought. I think the long-term prospects for it are really strong. We're in what I call a manufacturing super cycle. You look at investments in new factories in the United States, and it's 3x what it was on average in the decade of 2010 through 2020. And Justin, most of that's in our service region, right? Those are coming in the Southeast and in the Midwest. And we've got a best-in-class industrial development team. So it's probably going to have an outsized positive impact on us. You just -- you look at the EV market, there have been $70 billion of EV investment announced in all of North America and about $30 billion of that's on our lines. So we're in a great spot for long-term growth in manufacturing and also in consumer markets because in the consumer space because of our geography where we serve 60% of the consumption in the United States and also because of our powerful intermodal franchise in the East.

And maybe we can build on that a bit more because the other rails have talked about the industrial development pipeline and the momentum there despite the fact that real-time volumes have been under pressure. Is there a way to frame up what that industrial pipeline looks like for Norfolk today versus a year ago? And how much of a contributor to growth that could be in future years?

Yes. I think Elkins, our CMO, talked on our call about how -- just the stuff that's recently been announced is about [indiscernible] car loads a year for us, primarily in merchandise. If you look at our network 9 of the top 10 states for doing business as identified by Site Selection magazine are on our network. We serve the Southeast and the Midwest. That's a great opportunity for growth. And Ed likes to talk about battery built, which is kind of like Indiana, Kentucky, Tennessee, into the Southeast. That's our network, right? And so there's -- I'm really confident that we're going to have a lot of strength in our merchandise franchise going forward because of onshoring.

Okay. Great. I'll take a quick pause. Any questions from the audience? If not, maybe we can talk about coal. Obviously, a unique animal. But what are you seeing as we kind of move through the fourth quarter in both the domestic coal market and the export market relative to what you were expecting.

So in the export market, the met prices and the API too have started to slide a little bit, but they're still at really elevated levels. So I think low-vol premium is at $300 a metric ton. It was at like $343. I think API 2 is hovering around $120, which is still really strong that will ultimately have an impact on coal RPU, but demand remains really high. And our coal volumes are pretty strong right now, which is good for us. On the utility side, we're seeing the North plants come back into the market. And while we're really, really happy to have that business, and it's certainly accretive to the bottom line, it does come with a lower RPU for us.

Okay. So it sounds like moving into the fourth quarter, reasonable to expect some sequential pressure in coal RPU.

Yes. But strength in volumes.

Strength in volumes. Okay. 2024 is some of the third-party projections for coal are fairly pessimistic. Are there items within the Norfolk network new business mix shift changes you alluded to that could help offset some of the broader pressure we could see in the coal market.

Yes. I think we've got a really strong export market. And so NS has got a good balance between utility, domestic utility and export and a good balance in the export markets between metallurgical and thermal. So we've got a pretty diverse portfolio there.

Okay. Question over here.

Just a follow-up on the [indiscernible].

We're seeing, as I noted, a little bit more strength in that in the merchant market, which is where I think we were going to see a lot of some of the disclosures. Ultimately, it's still going to be a secular decline and I don't think it would be prudent for us to plan otherwise.

As met prices have rebounded, and I know there's been a lot of volatility, but it feels like you've increased some of your minimums in those contracts is; one, is that true? And two, if so, is the downside protection with export coal pricing better as we move into next year than it's been historically? Is there a way you can help us think about that?

Yes. I really don't want to talk about pricing and contract structures for a number of reasons. I'm sure you can appreciate that. I would say that at the inherent commodity price levels that we just talked about, we're in good shape.

Okay. Is there anything else just broadly looking at the business from a mix perspective that we should be mindful of going forward. I know in intermodal, it seems like that's probably leading the charge on volume growth going forward or at least over the long term based on your Investor Day last year, but I know there's mix within mix. You mentioned some things in coal, but anything else that comes to mind?

Yes, that's a good question. So when I think about RPU and I think about it a lot, I look for a couple of things. I look at the mix within coal between export and domestic and within export met and thermal. Thermal typically has a lower RPU, Met is typically higher. The stuff moving in the north, it tends to be shorter haul than the stuff moving in the south. So that's an issue for us. You got to pay attention to. Within intermodal, domestic has a higher RPU than international. And that's one of the things that's really pressured our intermodal RPU less fuel this year is that international has performed much better than domestic. That's not normally the case. Overall, I think over the long term, we're going to see more strength and more growth at a higher rate than in domestic than we do in international. And then this year because of some of the issues with some of the Canadian ports, there were more evacuation of empties moving on our network, which further pressured our overall RPU and intermodal. And then you move on to merchandise, I'm always happy to see chemicals business. That's been pretty weak this year because of the energy markets.

Okay. So it sounds like within coal, let's say, export outperforms domestic, that's a good thing.

That's goodness.

If you look at intermodal, say domestic intermodal starts outperforming international, kind of see a reversal, that's good, maybe nothing too major the changes in merchandise. So generally speaking, mix should be stable to better going into next year? Is that how you're thinking about it?

As our velocity improves, and we're able to handle more metals business, that will certainly help RPU and that will create more of a positive mix within merchandise. Again, we're ahead of our plan and price and merchandise. So that will help too moving into next year.

Okay. Maybe we could shift to the CSR acquisition. It was recently approved. Any update on the timing of when you would expect that to close? And maybe you could just go over the rationale for that transaction again?

Sure. So that's a line about 360 miles on the core of our network that links Chicago and Atlanta, pretty important for us. We've been leasing it since about 1880 and under various long-term leases, each time we renegotiate the lease, we take a rate increase. It was an opportunity for us to purchase this and candidly take no longer have operating lease expenses. I'll tell you when I -- when we executed this and got the deal signed, the 3 preceding CEOs at Norfolk Southern all reached out to me and congratulations. So that tells you how long we've been working on trying to acquire this property. It goes all the way back to [indiscernible]. We expect to close on that in the middle of March and we expect to have that be funded by free cash flow and by debt.

Okay. And if I look at where leverage is today, it's kind of at or above targeted levels slightly. That's a pretty big check that will have to be written. Will that influence the level of buybacks we see next year? And would it fair to say that we can see a pause in buyback activities for the most part in 2024?

So as you think about our capital distribution, right, it certainly is investments and safety and resiliency and growth and productivity, then it's dividends and then it's share buybacks. As we write that big check, yes, it certainly would -- it's reasonable to expect that it's going to impact the level of share buybacks.

Okay. And with [ East Palestine ] costs as well, any change to your thoughts around what you could see in the next couple of quarters or so?

Yes. We -- right now, we've accrued about $900 million in costs. Those are the costs that are estimable for us right now. That can certainly increase with additional environmental costs with fines I will tell you that we have exited the most intense phase of the environmental remediation. We did that about 3 weeks ago. That's really good for us. It's really good for the community. That will help the cost structure. . We started to receive insurance checks, right? And so that will help offset that going forward. That $900 million does not include insurance or third-party claims, which we're in the process of. So there'll be a lot of puts and takes on that. The environmental remediation is in a really good shape for us.

Okay. Good to hear. From a CapEx perspective, are you anticipating any major changes going forward?

Now if you recall our Investor Day in December of last year, we said that we're going to invest through the cycle and we're going to do it a lot more ratable level, right? And key strategic assets that I know we're going to need 5 to 7 years from now. And that's locomotives that's intermodal terminals, it's freight cars to help us compete with truck, it's track infrastructure and it's technology and it's our people. And so what the desire there, Justin, was as you as you're a lot more consistent, you're not always approaching the market when demand for that type of locomotives or cars or chassis is wicked high, right, which means the prices are higher. So that helps you control costs and control productivity. It also makes it a lot more consistent. So it's easier for Mark George to include into our cash flow projections. And so as I think about next year, if it does go up, it's only going to be modest.

Okay. And can we unpack the locomotive strategy a bit more locomotive investments going forward, do you anticipate being in the market for new locomotives anytime soon?

Well, this year, we went out and acquired a handful of used locomotives. As you know, for Norfolk Southern, most of our locomotive capacity investment has been converting, let's say, dated DC units to effectively new AC units. We'll continue to do that. We've got about 240 more left to go on that. So that's going to create a big boost in capacity and productivity for us. We expect that we'll be at about 70% penetration of D.C. unit -- pardon me, AC units, 75% penetration of distributed power. That's a big productivity, that's a big service. That's a big capacity advantage for us.

So that 240 units, once you're done with that, is there a runway beyond to continue these rebuilds?

We'll look into the market to see we can find older units available. But that would pretty much chew up what's available for us in our current inventory.

Okay. And it sounds like new locomotives will just kind of see on how the demand environment.....

Yes, we'll see on the demand environment and our own productivity as well.

Okay. And maybe same question for rail cars. If we think about your investment levels this year versus what they could look over the next several years, would you expect that to be pretty ratable as you mentioned for overall CapEX.

Yes, that's the intent, right? I don't want to get ahead of the curve. I certainly don't want to get behind the curve.

Okay. One thing that's come up a lot is technology and I feel like the rail space, to be frank, is lagged a lot of other subsectors within transportation. And that's been one of the issues when you think about capitalizing on this truck to rail conversion opportunity, what are some of the things Norfolk is doing to change that?

Yes. Look, I agree with you. It really is about -- you're talking about it from an external facing environment, right?

Right.

So it really is about ease of doing business. I know that the truck market has -- right now has got a better digital interface with customers generally than the rail market. One of the things that we just did is we acquired right now, pretty minimal investment, but that basically is a technology company that's going to help us interface with our customers. We know that the drayage costs are a pretty significant component of that end-to-end cost for our customers, particularly in the intermodal space, but also there's a merchandise component, too, because we do a lot of transload stuff, too. So that's going to help us improve the visibility. That's going to help us improve productivity. We were the leader. We're the ones who launched RailPulse, which is an industry-wide effort to enhance visibility on our rail cars and ultimately equip the entire North American Railcar fleet. Our goal is to combine that simplicity of truck with the efficiency of rail. We got a better cost structure if we can provide a competitive service product, we're safer, offer more capacity. That's -- we'll win. That's the goal.

Okay. Any final questions from the audience? If not, I'll end with the last one. I feel like the rail industry as a whole has started to collaborate a lot more and we've seen management changes that might be helping with that. When you think about the opportunity for Norfolk specifically to collaborate better with some of the Class I rails. Where do you see the most opportunity going forward from things that have either been announced or things that could be on the horizon?

Well, you've seen some recent announcements from us, right, with the FEC, with CN. I continue to -- we continue to work closely, particularly with our Western partners. 50% of our business originates or terminates offline. We hired Stefan Loeb, former Chief Marketing Officer of a short line company that work specifically with us on first mile, last mile and collaborate with short lines. We partner with over 260 short lines, which is the most of any Class I railroad in America. So yes, there's a lot of opportunity. And again, it's kind of that thought process that led us to do RailPulse. We have to think of ourselves as competing in the supply chain ecosystem. And if all we're doing is throwing cost over the fence at a customer or another short line partner, then that end-to-end solution probably isn't going to be effective and it's probably not going to win versus truck. We got to partner with them to make that interface much more efficient. That's ultimately how we'll win.

Okay. Well, we'll wrap it there. But Alan, thank you so much for the time and support and great to see you.

Justin, it's a pleasure to be here. Thank you.

Thanks. Thanks, everybody.