Norfolk Southern Corporation (NSC) Earnings Call Transcript & Summary

Amazing. So well, that's loud. Welcome, everyone, to the 13th Annual Laguna Conference. For those who don't know me, I'm Ravi Shanker, Morgan Stanley's Transportation Airlines Analyst. And for the next 3 days, you guys are going to hear from the castings in industry across all industrial verticals, obviously, very important trend themes going on both macro and idiosyncratic.

So We're very pleased and excited to jump right into it with probably the hardest story, the hardest stock definitely in transports right now, maybe in all cyclicals, Norfolk Southern, very happy to have with us CEO, Mark George and CCO, Ed Elkins. Gentlemen, thanks so much for being here. Before we start, I should point out that for a research -- disclosure leading to Morgan Stanley's relationships, please read our latest research or go to morganstanley.com/researchdisclosures. With that, Mark, it was at Laguna last year, that he became CEO so congratulations on your 1-year anniversary. I'm sure it's been a really quiet and boring 12 months. I guess anything in particular going on?

It's been a very busy 12 months and it's been a very busy 50 days since we announced the proposed merger with Union Pacific. We're really excited by this. And we're really proud of this combination. I think when you look at it, this will go down, and you look back 5 years from now when the deals close, integration is large and complete, this will be as transformative as what Eisenhower did in the '50s when he built the interstate highway system when it comes to freight transportation. Ever since then, when that highway system was built, I think freight has started to navigate toward the highway and it's been hard for rail to recapture share. This is our opportunity to redefine rail's role in freight transportation. So I'm really excited by that. We've spent the past 50 days meeting with various constituencies, and we'll continue to do that, whether it's shippers, labor unions, people in the political world. And honestly, there's just a lot of optimism and positivity towards what we're doing, and we're really excited by that. In parallel, we're working on a lot of things that are due to a lot of deliverables. We've got to get the S-4 filed and go through our shareholder voting process. So that -- we're working on that real time. And at the same time, we're working on our STB application. And again, that needs to be filed within 3 to 6 months. And we're working as fast as we can because we want to move this along as quick as possible. And look, at the end of the day, windows opened up. We got, I think, a pretty good STB going from -- you look back to November last year, and there was a big change in the STB after the election. And we think that the members are pragmatist and they'll be open and receptive. And I think when you look at what's going on just in the past week with a lot of announcements, just the mere idea of having a transcontinental railroad has already enhanced competition in this space. And I think that's a very, very important point. Our argument is being made for us. But we're really excited.

Got it. That's a great overview. A few follow-ups on that. But before that, a little bit of a side bar, I'm watching the TV show The Gilded Age right now. And obviously, it's about a railroad baron who's trying to buy the Illinois Central and trying to build a transcontinental railroad and telling him, it's going to be impossible literally 100 years ago. So it's amazing how the more things change, the more they stay the same. So maybe kind of if you can give us -- so that's a very good overview. Maybe a little more color around genesis behind this kind of how it came together, kind of what triggered that opportunity for you when there's been a lot of talk about rail M&A kind of over the last several years, like not happening over the last several years. So like maybe why now?

Well -- look, I think I joined the industry just under 6 years ago. And I've been told for 6 years that it's just impossible. It can't happen. Because you always look at it and you say, "This is ridiculous when you look at the way the rail networks are partitioned in our country." You've got a couple of the east, you've got a couple in the West, you've got a couple in Canada who are transcontinental by the way. And then they dip down into the U.S. .

And into Mexico.

And into Mexico. So the way that the whole network has evolved after the decades of consolidation that happened in the '80s and '90s and then you put a hard freeze on it for understandable reasons. There were all sorts of integration challenges. The STB was freaking out at the time and said, all right, no more to protect shippers. I get that. I do. But it was a real inopportune time to put a freeze. Maybe it was appropriate at that time. But look, with the passage of 25 years, I think sentiment has changed. And I think you bring in new thinking to say, why not? Tell me why not? Nobody will tell me that it doesn't make sense. They just tell you that the hurdles are too great to get there. And I get that, too. My single biggest concern and when I started to talk to Jim about this was what do we do for 2 years, if it takes 2 years to get this thing through. How do we continue to run our business without disruption for 2 years when with Norfolk Southern, we're going to have employees, human beings who are uncertain. You'll have that even on the UP side, people who are uncertain about their future, right? So that was one of the considerations for sure. We had to make sure that we address that, and we did. But ultimately, why not now? And I do think that something happened in November with the STB following the election, and I think it's worth giving it a try.

That's a good way to frame it, instead of why now, the question is why not now? You touched upon this in your opening remarks, but can you remind us again what the next catalyst path is and kind of what the time line looks like?

Well, the time line is simple. I mean, we've got to get the S-4 filed and we got to go through kind of -- I think of it as we've got 3 paths right now. We got to get the S-4 filed and pursue shareholder approval. And I believe that, that will all happen depending on the SEC's interest and review, it should happen by the end of the year for the shareholder votes. And then in parallel, so we're well along that way. In parallel, we're working on the STB application. That's a monster. But we got a lot of people involved in that. We've got great game charts and good planning. I'm really proud of the collaboration between the NS team and the UP team. We are working extremely well and extremely close, and it speaks to why I think the combination of UP and NS makes the most sense. There's a cultural fit. We have very similar value systems, a very similar culture. And we're working really well together. Just the way Jim and I worked variable together since we started this conversation to now our teams. That process is playing out. Again, the application is a monster. It's a bear. And we want to make sure that it's comprehensive because you don't want to submit something that is missing things and you have kind of a restart and that extends the whole duration. But that said, we want to be fulsome, but we want to move fast. So I'm not going to put time lines out just yet, but I can say that we're pushing the team to be on the earlier side of the 3- to 6-month window. But we'll see where that goes. And then the third stream -- process stream really is kind of integration planning. And those -- the good news, if there is any good news about having this longer review process within STB as opposed to FTC DOJ process is that it gives us time to plan and as I mentioned before, I mean, we cannot have integration issues. And Jim and I are aligned on that. We're going to do everything possible to ensure that we have a seamless integration. We're going to learn from the mistakes of the past. And if it takes a little longer to make sure that it's smooth from a systems perspective, then it will take a little bit longer. But we can start the planning now to some degree without crossing lines or boundaries, I think what we're going to do, particularly on the system side, is just for our benchmarking. What systems do you have, what systems do we have and start thinking about where we would end up migrating to and start building plans for that. We do the same thing on the operations side. But again, we've got to do it in a very measured way. And that right now is not the focus. Right now, it's about -- we don't want anything to get in the way of getting the application in.

Got it. Last question on this topic, at least from me. Again, you touched on this in your opening remarks, but in these few weeks you've had since the announcement, any surprises, positive or negative with either the process or the feedback you've got from various constituents or kind of what any surprises?

Yes. The feedback has been good, especially as I talk to customers, as I talk to members of the administration as well. The feedback has been good. People see the value that we're creating for America. As we rebuild and reindustrialize America, they understand and see it. So I'm favorably surprised that we don't have to do a lot of convincing. It's intuitive to everybody. So that's a good surprise. And I think the other good surprise is just that everybody is making the case now that this is enhancing competition. We're seeing announcements from other roads, and I think that's great.

Got it. So let's move on to fundamentals there, right? So -- and the market environment and maybe Ed, we can get you in here so can you just update us on kind of recent demand trends, I think 3Q looks like it's setting up to be a little bit better than 2Q was. And there's a lot of focus on the handoff between 2Q and 3Q. So how are you seeing the volume in moment right now?

Well, we actually have 2 or 3 different things going on in that macro economy. And I'm guessing based on our discussion before and people in this room are going to fall on maybe one side or the other, no one in the middle in terms of...

It's very polarized out there...

In terms of outlook, the industrial economy for us, that is our industrial products, our merchandise business is generally on track with what we expected, which is a pretty good growth trajectory on those commodities. There's some tariff distortions, I'd put it that way, and we can set that aside for a second. And we're seeing a real -- I was talking to Mark earlier, there's a couple of stories out there that are maybe getting covered up by tariffs. The first one is this demand for energy going forward. And we're seeing a lot of inventory replenishment on the utility side for our coal burning customers in the U.S. That has been overshadowed to a degree by the weak export markets, whether it's commodity pricing or actual demand for the export product. But you look at our industrial fundamentals frac sand and NGLs are 2 of the real bright spots for us right now. So there's clearly -- clearly, I would call it, developing story when it comes to the long-term energy demand inside this country. And then now let's go back to tariffs and probably intermodal.

Talk about auto, too.

Yes, that's true. Before I leave the merchandise space, we've had multiple monthly records so far this year in our automotive space. And that's really -- we're the #1 railroad in terms of originating autos. And what I would call our success is really defined by is our service product, which is allowing us to deliver the capacity that our customers need right now. And that really comes down to enhancing the velocity of the fleet so that we can make those cycles happen. And really and truly, we're feeling really good about that. Our automotive customers are also feeling really, really good about our capability to deliver value for them in that space.

And we're taking share from the highway because of that service product.

That's right. Share that over the years has gone back to the highway because they couldn't trust the rail industry to deliver that capacity. So on the merchandise side, feeling pretty good. On the coal side, it's sort of a 2-edged story, right? Exports weak, but domestic utility quite strong. Then on the intermodal side, I think one thing that probably everyone in this room would agree with and maybe everyone in the U.S. is we probably underestimated as an industry, how much pull ahead inventory there was earlier in the year ahead of the old tariff story. And what that has caused is a number of distortions in the economic environment. I think we're still actually burning off some of that inventory buildup that happened in the year earlier. And that manifests itself as pretty weak volumes, both on the import side, but also on the domestic transload which for us is sort of an idiosyncratic story in and of itself and that we have some great partnerships on the TransCon side for a domestic product. And so we've seen that show up in terms of weakness on the domestic side as well. And we're in what, the fourth year of a freight recession in the U.S. for trucking. And certainly, we haven't seen prices get weaker on the truck side, but they're sort of bouncing right along the bottom. And our service product is what is allowing us to be as successful as we are right now because our channel partners can go out and deliver that value to their customers, be very confident in it. And I think we're -- I've said before, we're setting up as sort of a coiled spring when it comes to that demand on the intermodal side, we're going to be really well positioned to take advantage of it when that demand comes back. And eventually, it will.

Absolutely. Thanks for that overview. Just a couple of follow-ups there. You mentioned kind of we may have underestimated the pull forward. Do you have a sense of the magnitude of that pull forward? Is it going to take a couple more months to burn it off quarters, obviously not years, but kind of how long does that take to normalize you think.

I think it's like everything else, it depends. On the consumer side, I think we're probably I think the trajectory we're on now is sort of normal for a peak season, right? But we didn't see that anticipated import surge that was supposed to happen in July and August. And I think that is a testament to that inventory pull ahead, which let the consumer continue to consume even without that big surge. On the industrial side, I've talked to a number of customers, and some of them are actually now at the very end of those inventory buildups that they had, whether it's in commodities like steel or aluminum or copper, et cetera, et cetera. So we'll see what plays out there. But again, we're seeing some of that strength and some of those distortions in those markets like metals, where intuitively, we would say, well, there must be a whole bunch of demand out there. Auto is doing great and prices are up, right? But it's -- there's a whole lot of puts and takes. And I call those really tariff distortions, which will settle themselves out over time as the economy to use the Secretary Bessent's words, realign. And that will happen, I think. But -- so it's a different story based on different commodities. But all in all, I think we'll settle out this year.

Got it. Just on that note, you guys put in place early and forward-looking demurrage going into July kind of almost expecting kind of a big surge, right? So can you just talk about the reasons behind that decision? I think is it fair to say that, that was like not triggered kind of with the volume environment that we saw?

Yes. Well, look, we know what a good running network looks like. We have one, so we really wanted to protect it. And we've seen in the post-Covid era a number of instances where that unexpected demand sort of knocks the whole world off kilter. And before you know it, all the railroads are running poorly because of that bullwhip effect of inventory distortions. And so we didn't want to jeopardize the good service that we're producing out there, whether it's on the intermodal side or on the carload side. And so we preemptively sort of looked at what the economy was telling us, what our port partners were telling us, what our steamship line customers were telling us. And everyone was really anticipating this big surge of imports in July and into August and so we Drink our own Kool-Aid and put our -- and put some rules in place to protect the network, and it turns out we really didn't need to do that. And so what we've done is roll those back off again. And what we want to make sure that we're always doing is being, number one, sort of highly protective of the service products that we're able to deliver, but number two, that we're responding to the market at the same time.

Got it. So just on that note, kind of -- obviously, as you said, we're in the fourth year of a freight recession and kind of there was this expected improvement and you guys put in place demurrage and surcharges, is there any risk or concern that if we do see this prolonged up cycle kind of kick in at some point that it may strain the network or put at risk that service product you have built out. How do you make sure that, that is sustained through the up cycle without having to put in place these fees?

So look, I think our service product right now is as good as it's ever been. And with John Orr what he's done and the team he brought in, what they're doing, it's -- we've never seen it and certainly in my 6 years because it's just been crisis after crisis -- service crisis after service crisis. But even I think Ed will tell you that we go back to 2019 levels, which were kind of considered our benchmark. And we're driving incredible productivity while providing as good, if not better service than we were back then at that benchmark. Now the reality is we have got a real lot of capacity to move volumes, a real lot of capacity to move volumes. So we are not worried. And the mindset, fortunately, that John has, is bring it on. He wants volume. He understands an entire P&L. He's not just focused on trying to keep his network running smooth with light volumes, and then he stays out of trouble. That's not John like bring it on, I want the challenge. But it's actually fairly easy in the sense that we've got all this capacity. We've moved more than double digit in the past higher volumes than we are now. So we're -- what we have right now truly is a volume revenue problem. We've done great things on the cost side. And it is about volume, and we're not worried about a potential disruption of our service product.

And probably the most important thing that we're doing right now, and we do it every single day pretty much is John's team and my team every morning 8:00, get together talks about what's going on. And that sort of a dynamic ongoing conversation is really what protects the network, number one. But then allows us to resource up in those very specific places where we have opportunities, right? And so we're not really -- we're responding to what the market is giving us, but we're not responding in a way that I would say is too late. And so it's a pretty dynamic process, but we're very, very dedicated to it in terms of making sure that we're capturing every single opportunity and we're protecting the network and service.

Got it. So to put a bow on this, when you look at this kind of mixed volume environment, how is it tracking relative to expectations for both your 3Q revenue commentary, which you said might be slightly pressured and also the full year guide, you said it was plus 2% to 3%.

Yes. Look, we're behind the curve. Year-to-date now, including through early part of September, we're only up about 1 point in volume. So that translates to revenue that's behind the curve, too. So we had put guidance out there of 2% to 3% and in order to get there, we're going to need kind of a real -- the bounce-back scenario in the balance of the year to get there. Something like 5% growth in the last 3.5 months of the year. Probably unlikely that we're going to see that but it is possible because this has been a very unpredictable environment and very polarized based on people's projections. So I think it definitely puts that at risk.

Got it. Just kind of -- so the next question would be, you guys obviously have shown tremendous improvement in the OR, a lot of it on the cost side with John's initiatives on the network and the service, but you just said which we also believe that you probably have a revenue issue now, not a cost issue because of the progress you've made. So when you think of that 100, 150 basis point improvement in OR, kind of how much of that could potentially be at risk because of these volume issues as well versus how much internal initiatives do you still have.

Yes. Look, I think we've got this temporary challenge right now. You can't really respond that quickly. And we've already taken out a real lot of expense. John is a year ahead of schedule pretty much on the multiyear cost takeout. And so we're actually beating our cost targets. But the OR is a simple equation. And so we're kind of on target ahead of target on the cost part of that equation. But when revenue is off by that much, it's going to have a mathematical effect on the OR. That's going to be meaningful.

Got it. Maybe kind of just 1 more for me before I turn it over to the audience to see if there is any questions. But just given all your extensive experience kind of in this industry and kind of talking to like basically everybody in the economy, what, in your view, is the bottleneck? Do you think rate cuts might help unlock this kind of 4-year down cycle? Or do we just need more tariff clarity or what happens from here?

I think it's a combination of a few things, and I'll let Ed our amateur economist plan as well.

Well. We all are closet economists.

Yes. But certainly, there's a strong correlation in the rail space with housing. So seeing housing come back with starts will be helpful because that drives a lot of other moves, including people wanting to fill their houses with new stuff that comes on the intermodal side. So it's not just the lumber and other things. So housing, it would be -- rate cuts, obviously, will prompt that. And so we would be certainly encouraged by that. I think ending this 4-year freight recession, which is -- the end has been imminent for a couple of years now, and it remains imminent. But will rate cuts help that. Potentially, it's hard to predict. But certainly, that is -- that's a big 1 for us. And I think export coal is another thing where we've seen dramatic reduction in export coal prices that have certainly hurt our top line. So if we see some normalization in the overall trade environment, clarity on tariffs, that start to rebalance the demand for some of our exports, it's going to help us in multiple ways. So those are what I think we're waiting to see. So does a 25 or 0.5 point cut start to trigger things, I think certainly that will be helpful, but I think clarity on trade will also be enormously helpful, just finality so people who were frozen, they don't know how to act can just start to plan now. Right now, I think it's just because we're still in a period of uncertainty, there's some paralysis in the market that's causing some of the volume pressures we have. But ultimately, I also think just share recapture from the highway is partly in our own control, and I think we're making good progress there. And I think the proposed TransCon over the long term is going to dramatically help that. But go ahead, Ed.

Well, I think mortgage rates follow interest rates down that's going to be a really important phenomenon. I think at 1 point in the past, we had estimated that every new house construction start is worth 7 or 8 truckloads might be dated on that. But it's more than 0. And what we have is we still have a, what I would call a U.S. freight environment, particularly when it comes to truck that is oversupplied, really as a lingering distortion of the post COVID environment where sort of everybody in their brother jumped into the truck in the industry and there was just a whole bunch of capacity added, which has still not come out, quite frankly. And you look at the cash rate index, which is something I kind of paid attention to, it's negative year-over-year. So there's still a headwind when it comes to total freight demand in this country with an oversupply of trucks. And it's just going to -- we have to get further and further away from COVID for that to sort of normalize itself an interest rate cut, which then manifests itself as lower interest rate for mortgages will certainly help that. I truly believe that. And I'm very bullish overall on the U.S. economy at large, which really our transaction is about, it's about bullishness in the outlook for the U.S. economy in the long term. I think as this country reindustrializes, we're going to see more and more opportunities and whether it's in our industrial development pipeline or in our business levels, what we're going to see, I really believe, is more demand for high-quality transportation, not only of truckload replacement business in intermodal but also in the carload business. And when I think about things like the demand for energy in this country, I think I feel very good about some of our prospects and then where we're positioned in those markets.

Any questions from the audience? One back there?

[ Guilherme from Tarpon ] here. I'd like to hear your thoughts from a broader looking back, why do you think the industry as a whole failed to capture volume growth whether there was too much focus on pricing perhaps or not? And what structurally the industry needs to do to have more volume.

So I'll start and say that when we look back, I think our industry has been too volatile with the service product that we offer unreliable with service crises that have really disrupted our ability to deliver reliable and consistent service to our customers. So over time, customers have built out alternatives with trucking and even though maybe it's more expensive than rail, at least it was more reliable. We went through a decade where service crisis -- more than a decade where service crisis happened every couple of years.

For the whole industry.

For the whole industry, I'm talking about, right? And so that has conditioned the customer base, the shipper base to be prepared with alternatives. And frankly, we've just come out of one as an industry post COVID, only a short while ago. But I think there is -- as an industry as a whole now, an acknowledgment that we've got to stop that. We've got to stop being short-term focused and induce these service crisis. And I'm really happy to see that overall right now, the network is running really well. And we care about that. We're not competing on somebody else's misfortunes or crisis because it creates a problem for all of us. We have to interchange with each other. Half of our freight interchanges with another carrier. So if they're not running well, it impacts our service, too. We want everybody to be running good. And right now, everybody is so I think the biggest impediment in the past, which was service crisis at one or more railroad is -- doesn't exist today. So I think this is good for the industry. And I'm hopeful that all of us collectively in North America can start taking share back from the highway.

100% agree. I think the equation for growth is pretty simple, deliver service that you can count on from people that you can trust. And that's what we're really working on every single day. And it's not good enough to just deliver good service yesterday. You have to have a track record of it. You have to have really a runway of good service so that customers can make those adjustments in their supply chain to get themselves unwound from those higher cost and more expensive options and really reap the benefits of using rail transportation over time. So that's what we're focused on, and that's why we're so protective of the network and the service that we're...

You go back several decades and I'll give you 1 industry paper, right? There's no product that's more tailor-made to move on trains than paper, very heavy, very bulky. And frankly, rail had largely 100% share in the paper industry. Fast forward today through various crises over time, going back to the '70s, '80s, '90s, 2000s, they all have built out trucking, shipping docks out of their factories and facilities. And over time, our share has shifted dramatically toward more like the 40%, 50% range because they have to have options, right? If we were more consistent delivering service as an integrated freight rail network, that's an area where you can see significant share recapture from the highway. And it's not just paper. There's plenty of other examples like that.

Yes. Just a quick follow-up. What were the root causes of the service problems? Is it the PSR implementation?

Well, I would say this. I think over time, and I'm looking at the rail industry, written large, right? Generally, crises and service emanate from a couple of different places. Usually, it's a mismatch of resources and demand somewhere, and that starts to ripple through the economy. I can't lay it at PSR per se. It's a network business, and we just have to be very responsive to what's going on in the environment and make sure that we're resourced appropriately. And that's what I know Mark and Jim both talked about, we have to have a buffer of resources so that we can absorb those supply chain shocks that are inevitable. You want to talk about that?

Yes. No, that's exactly right. And you'll hear Jim talk about it. We have the same philosophy, right? You have to have to combat this mismatch of resources you may have to make sure you have a buffer. So oftentimes, the trigger to these crises might be weather, right? Well, what does weather do? It slows you down. It creates an imbalance in your network that you can only dig yourself out of if you have appropriate resources in place. That's kind of the buffer. When you're too thin on resources, you can't respond, and it takes you not just months, it takes you quarters to catch up and to rebalance yourself. So you have to make sure that you have the buffers in place. So some people might say, well, weather was the cause of that service crisis or some other network change was a cause. It's usually a mismatch of resource. You don't have enough locomotives or people as a buffer to help dig you out quickly and avoid a prolonged crisis. I think it's hard to point to PSR and say, "Oh, it's PSR." That is certainly a narrative I've heard in the past. There is -- PSR is the most logical approach to railroading, there is. It's the application of it that has maybe been a challenge in the past where maybe we've gone a little bit too far or too aggressive in trimming resources, leaving yourself no buffer. So when one of these external influences happen, you can't respond or you can't react.

So you need to be less aggressive on margins and financial management and more focused on operations going forward as an industry, I mean.

Yes. I mean, I think we need to be financially focused too and financially responsible too so I think you can do it all in a well-balanced way. And I think the industry is doing it right now. And I'm really proud of where we are.

Any other questions. Anyone else? So maybe just to wrap, obviously, a lot going on. And I hope you can use the next 24 hours at going to relax a little bit and get some sleep. But -- yes. So what can we look forward? Like -- so how much are you spending? Like what's management time split like between fundamentals versus the deal and kind of where your resource is going?

Well, I think we're allocating management time and resources. I've got certain key members that are disproportionately allocated towards fulfilling our deal-related obligations while trying not to distract the remainder of management who's focused on running the business. And so that's part of my job is to make sure that Ed is not distracted. And Ed's team is not distracted. They've got to try to find volume and be creative in responding to some of the new competitive threats that are out there. Same thing with John and the operating team. It's like we got to focus. We cannot have a service setback at all during this application period or forever, frankly. So we don't want that team distracted. But we've got core leaders, Jason Zampi, Jason Morris, are heavily focused on making sure that we fulfill our deal-related obligation. So it's a delicate balance, but it's very much top of mind.

Great. Thank you for bringing a really interesting story to the transportation space at the time when we're still waiting for the cycle. But Mark, Ed, thanks so much for being here, and I wish you all the best.

Ravi, thank you very much.

Thank you.

Take care.