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Executives

Fredrik Eliasson - EVP and CFO

David Baggs – VP, IR and Capital Markets

Analysts

Thomas Wadewitz – JPMorgan

CSX Corporation (CSX) JPMorgan Aviation, Transportation and Defense Conference March 6, 2013 8:00 AM ET

Thomas Wadewitz – JPMorgan

If I can ask everybody come on in and take a seat. My name is Tom Wadewitz. I cover the freight transport, so I think a lot of you or most of you know me but anyways, thanks for joining us in today, it’s our pleasure to have CSX to kick things off. We have the Chief Financial Officer Fredrik Eliasson and I am sure most of you know David Baggs, Vice President of Investor Relations and Capital Markets.

Last year CSX had a pretty strong presentation. I think they gave us some interesting things that you think about and I am not sure if I know – recall exactly how the stock did last year but I think there might have been a mildly positive response. But anyways Fredrik, thanks for joining us. Go ahead and take things away and look forward to your comments.

Fredrik Eliasson

Thank you Tom for that introduction and thank you all for being here this morning. Really appreciate the opportunity on behalf of CSX to be here. Before we get started, as always, let me just quickly remind you about our forward-looking statements. Any forecasts or projections that we might share with you today should be taken within the full context of those statements.

What I’d like to do today and the way that I have structured this presentation is really around four key points. And to Tom's point earlier, the first point I’d like to cover is around how we’re effectively dealing with this secular business shift that we’re seeing in our domestic coal business. If you recall for those who were down here last year, I laid out a stress case scenario for CSX that said that even in an environment where domestic coal business would be down 30% for the year, we’ll still be able to deliver record earnings and margin expansion for our shareholders.

The best news is unfortunately that stress case came true. Our domestic coal business was down 30% last year, but we were able to deliver on that promise of earnings growth and margin expansion. So that’s the first topic I’d like to dive in a little bit into. Secondly, as we now are about eight weeks into the quarter, I'll give you an update on what we’re seeing so far both from a volume view and also revenue. Third, clearly because of the headwinds that we are facing in our coal business this year, this is going to be another year of transition for CSX, but we’ll continue to focus on the things that are within our control to effect, which is really around safety, service, efficiency and continue to drive inflation plus pricing. And then [third], talk a little bit about 80% of our business that has absolutely nothing to do with coal and talk about how we very quietly over the last couple of years have grown that business about $2.2 billion and then highlight two sectors in that portfolio business, the housing and automotive markets where we now finally are seeing the housing market also at work in tandem and in favor of an economic recovery.

So let me start on slide four and just remind all of you that over last nine years we've been able to deliver earnings growth eight of those years, and nine out of nine years we’ve been able to deliver margin expansion. If you look since 2006, and 2006 was the beginning of the transportation recession, the freight recession and also the peak year for our domestic coal business. We’ve been able to deliver 8% CAGR in operating income and an earnings per share growth of about 12%.

At the same time we’ve also been able to drive out over 700 basis points in terms of our operating ratio. And we’ve been able to do that despite some pretty significant headwind on the topline. Our volume has declined during this period of time by close to 950,000 carloads. If you look on slide five, you can see on the bars on the left that in 2006 we were about 7.4 million units and in 2012 we were about 6.4 million, so of that 950,000 units of decline, 900,000 of that is domestic coal.

If you look at the blue area on those bars, you can see that our merchandise business is about the same percentage as we saw it to be in 2006, somewhere around 40% and – but overall we've lost about 600,000 loads in that market as industrial economy and the housing sector hasn't fully recovered yet.

On intermodal side, we’ve been able to grow about 300,000 units during this period of time. And as a percentage of our overall business intermodal business has grown from 30% to 38%. And then the domestic coal business has as said earlier grown from 24% to about 14% and that's a decline of about 900,000 units that we've seen there. And then on the export coal side, consistent with this secular trend that we talked about where we think that the U.S. producers are going to play a larger part in the overall global trade of coal, our export coal business have gone from 2% to about 6% here in 2012 and a growth of about 300,000 units. And we think there is more likely to grow over the long term in that part of our business. So despite this volume decline and this pretty significant mix change that we’ve seen we have been able to produce continued strong cash deployment and continue a balanced approach to cash deployment.

If you look on the left hand side, you can see that over the last few years we continued to reinvest in our business. We have taken up our capital investment, which is our first priority in terms of cash application by about 30%. Last year we invested $2.2 billion overall in our capital, and we continue to believe that about 16% to 17% of revenue is a good place to be in terms of guidance going forward with an overlay for PTC, so that’s 16% to 17% is our core capital with an overlay for that -- to completing the PTC investment that required to do.

Our second priority is dividends. Our dividend per share during this period of time since 2009 has increased almost 90%, $0.54 last year, and we are continuing to effectively look at a range of 30% to 35% of trailing 12 months earnings-per-share as we size our dividend. And we reevaluate that each and every second quarter.

And the third priority is our share repurchase program, and we continue to believe that most of our share repurchase program should be driven by a cash generation but also not opposed to use some debt capacity going forward. As you can see over the last couple of years we've been able to – we spent close to $4 billion in share repurchases and last year we completed our existing program of $2 billion program and we spent about $700 million last year to complete the program. And we will announce any new program later this spring.

So now let me shift gear and talk a little bit about what we’re seeing here in the first quarter. So we are eight weeks through the quarter, and our volume overall at this point is down about 2%. And if you look at the different markets, you can see that our intermodal business is down about 4%, our industrial sector is flat, and construction and agricultural sector is down slightly. And then on the coal side our export coal so far is down 6% and then on the domestic coal side we are down 17% and so we will continue to see a moderation in decline that we've seen over the last three quarters. We continue to see a slight improvement as we're going through this secular shift.

So let me talk a little bit more about each of these markets in more detail. I would say though that overall at this point we’re probably a percent or so behind where we would've thought we would be, predominantly because of what we are seeing in the domestic coal markets.

So look at slide eight, you can see that our coal revenue so far this quarter is down about 16% and combined between export and domestic our volume is down 14% with revenue per unit being down 3%. Starting with domestic coal, as you saw earlier volume is down 17% and if 2012 was the year of switching as more and more utilities switched their electricity generation away from coal towards natural gas where they had an option to do so, 2013 is clearly the year of switching. And at this point we continue to see high stockpiles especially in the south. Heating degree days have improved somewhat here in February, but overall we still see that this winter has been warmer than the five-year average.

Our guidance has been that we think that this – the inventory overhang is going to be with us clearly through the third quarter and probably well into the fourth quarter as well. And overall volume guidance has been that we think that volume should be 5% to 10% down for this year, and I would say at this point we think probably that –we’re probably going to be towards the high end of that range.

On the export coal side, our volumes are down 6% quarter to date. We had indicated that we think that overall volume will be 40 million tons this year. We think that's still a good forecast, that is down from last year, we were about 48 million tons, so about a 16% decline. We do think that overall as we get through the second quarter that the year-over-year comparison is going to be a lot more difficult because the second quarter was a very, very strong quarter for us last year.

And then on the RPU side it’s down 8% -- 3% so far, and I would say that we’re still very comfortable with our guidance that our RPU for our overall coal business should be flat for the full year as comparisons will ease as we go through the year.

So let me turn to our merchandise markets. Starting overall you can see that our revenue is up 1% at this point. Volume is down 2% and with continued push on inflation plus pricing our revenue per unit is up 3%. If you look at the different sectors that we have in our merchandise business, if we start with industrial side, which is really our chemicals and metals and auto business, our chemicals volumes are doing very well. We’re up about 11% so far, clearly driven by our crew by rail initiatives, we’ve taken advantage of our premier high-speed route into the Northeast and we’re continuing to work with several of the big players that you hear in the news in terms of developing a rail based solution to grow that business over the next few years.

On a negative side in our industrial sector is the metals business. The metals business has been weak year over year so far, but we are seeing signs that, that part of our business is recovering as well. Last week the steel mill utilization reached such an eight-month high of 77% and we think that will help that part of our business going forward as well. And then on the automotive side, we are down about 2% so far year-to-date predominantly because we have some very difficult year over year comps and also one piece of business that we lost to another railroad earlier last year.

On the agricultural side, our volumes are down 3%. Our phosphate and fertilizer business is doing very well so far, up 7% that I think bodes well for the crop size later on this year. However the agricultural business itself is struggling as we said previously because of the crop size that we saw in 2012 and that is going to be with us clearly through the second-quarter and probably well into the third quarter before we start seeing some improvements in terms of the year over year comps.

And in the last sector is the construction sector, our volumes are down 2% at this point. We are seeing positive signs because of increased housing starts especially in our lumber business but that is being offset in the short-term by weakness in movement of transportation equipment and also in our paper business segment.

Looking at our intermodal so far our revenue is up 6%, year-over-year volume 4% and revenue per unit 2%. The domestic volume is up 7% as we continue to see this highway to rail conversion success that we talked about for an extended period of time. We think the addressable market here is very large, probably close to 9 million loads that we over time feel that we can convert over to an intermodal based product. Continue to work on the strategic partnership with all of the truckload carriers and IMCs, continued improvement in our service product and service offerings and continued sales penetration will drive the success of this opportunity.

Our international business is up 1% so far. We are being negatively impacted by some diversion away from the port of New York from especially one customer, but we think over time that will normalize. And then clearly we’re seeing the benefits of our investments that we made in this area over the last few years both obviously in capturing the growth but also more fluid operations both in the line of road and also in the terminals themselves, and we continue to work in the double stack clearances, we’re at about 82% cleared at this point, and in two years we believe we will be about 90% cleared in our intermodal business.

So clearly 2013 is a transition year for CSX, significant amount of headwinds that we are facing because of the coal businesses, both on the domestic side and on the export side. As I said earlier this year in our earnings release it is too early to tell whether or not we will be able to produce earnings growth and margin expansion that you've been accustomed to for CSX to produce. However our focus continues to be that we need to focus on the things that we control the most. We continue to focus on safety, service, efficiency and inflation plus pricing. We believe by focusing on these things we will be able to come out of this transition in an even stronger position than we were going into it.

So let me talk a little bit more about each of these areas going forward. So first of all, let me talk about safety, and safety is really about making sure that our employees have the ability to go home safely to their families each and every day. Clearly there is a financial positive aspect of this, but the biggest thing is to make sure that our employees are safe. It is impossible for employees to focus on service and efficiency if they're not safe, and as you can see we made tremendous progress in this area over the last two years and in fact, last year we were the safest railroad in the industry. This year so far in the first quarter we have improved 24% year-over-year.

On the train accident side you can also see a significant improvement year-over-year of about 33%. And this is really a result of continued efforts on our side to hardening our infrastructure and to put technology in place that will prevent a lot of accidents and proactively identify potential issues well in advance of ever becoming an incident.

On the service side as you can see so far this year, we have gone off to a very good start. Our on-time originations in our schedule network, which we use as a proxy for several other measurements that we use in terms of service levels continues to be at a very high level 89% last year, up to 91% on-time originations in our schedule network. The big story though this year is the fact that our on-time arrivals are continuing to improve quite significantly, and we're now close to 86% quarter to date on-time arrival in our schedule network. And we are doing this with much more difficult environment in regards to the weather versus what we have last year.

Perhaps more important is also the fact that we’re providing this service with 4% less crews than we had last year and 8% less locomotives. This is really a testament to what we have been saying for an extended period of time now that a more service-oriented railroad is not just good for volume growth and inflation plus pricing but is also good from an efficiency perspective.

Let’s talk a little bit about efficiency on slide 14. As you can see over the last five years we've been able to take out about $833 million of costs in our network, about 167 or so a year. This year again we’re targeting a $130 million of productivity, and I would say that we've gone off to a very good start so far in terms of getting to that $130 million. Last year we targeted $130 million as well, but we ended up with close to $200 million predominantly because of this improvement, the step function change that we saw in the service product which really drove a lot of incremental improvements in asset utilization.

The last area that we think is in the most of our control is inflation plus pricing. As you can see on the chart on the left here, you can see that overall our inflation – our pricing last year was about 1.6%. However if you exclude export coal, our overall pricing is 4% in the fourth quarter. We believe that export coal is a very unique market to CSX, where us being very responsive on the pricing side can create incremental demand. And so that's why you saw us take the action that we did twice last year to make sure that we keep the U.S. producers competitive in the worldwide market, and the fact that we were able to produce 48 million tons last year and we’re still comfortable with a 40 million ton range that we laid out in the first-quarter earnings release I think is a good testament to that fact.

However inflation plus pricing was achieved in the rest of our business and clearly long-term we want the whole portfolio to be able to achieve inflation plus pricing. And the service product that we’re currently are seeing should significantly aid that as we continue to renegotiate contracts with our customers not just this year but for the next few years.

The one area that is in less of control of ours is of course the topline and we clearly have spent a lot of time over the last two years talk about -- talking about our domestic coal business and our export coal business, that 20% of our business is clearly yielding a lot of interest. We fully recognize that during this secular shift that, that is what we wanted to. However long-term we truly believe that at 80% of our business that has absolutely nothing to do with coal is what’s going to create value and long-term sustained value creation for our shareholders.

If you look at the left-hand side of this slide you can see our portfolio business. And I would say at this point we probably have never had a more balanced and diverse portfolio business than what we have today. And as you can see that portfolio business has done very well over the last few years. Now the key driver behind that diversity in our portfolio is really our network. Our network reaches two-thirds of the U.S. population and even greater percentage of the overall consumption it reaches out to all of the major population centers east of the Mississippi River and it touches over 70 ports, all of the major natural resource areas and the vast majority of the U.S. industrial economy. That is the core assets that drives that diversity.

And if you look on the right hand side on the slide you can see that we have very quietly over the last few years grown this business significantly, almost $2.2 billion over the last year and $500 billion -- $500 million last year alone. And the key to that is our continued focus around profitable growth. One of the things that you would expect any good company to do is in periods where demand is not where you want it to be is to continue to focus on making sure that your resources match the demand levels. And as I think for those of you who follow us we are relentless about making sure that we’re taking costs out of the system to match whatever demand levels we’re seeing. We are not going to sacrifice price to create artificial demand or to try to fill out the network, because we think the long-term that's a recipe for disaster and we’ve seen this industry done those for several years until just the last decade, and we think that continue to focus on profitable growth, making sure that everything that we carry is at reinvestable levels is a good thing for us, is a good thing for our customers as we'd be able to sustain the service product and service improvements and we’re able to capture even more growth going forward.

So let me highlight two sectors of this --- of our merchandise intermodal business, and let me talk about the housing and the automotive sector. Both of these two sectors are now finally starting to move in the right direction. Automotive clearly has for a period of time but we are now starting to see the housing sector also moving in the right direction. And for those of you who follow history the empirical evidence are pretty clear that you cannot have a full recovery without both of those two sectors working in tandem.

So automotive production as you can see on slide 17, North American light vehicle production has gone from about 8.6 million units in 2009 and last year up to 15.4 million units, that’s about 80% increase and there is a very, very high correlation between that and our volumes. This year we expect growth of about 3% based on the latest forecast and we expect continued growth going forward for three reasons: continued population growth obviously but we also look at the vehicle fleet in United States based on the latest data that we have is still about two years older than both what the European age is, and the age in Canada. We think that should be a positive driver going forward.

The third driver is really the broader point about the re-industrialization of our country as we’re now seeing automotive production actually outpacing sales, and we’re hearing more and more from some of these producers that the U.S. is becoming a more favorite place to produce vehicles both because of a lower energy cost but also because of the relative efficiency of the U.S. workforce.

And as you can see on the sheet, about 9% of our volumes are tied to the automotive business. And clearly you can see that in output in terms of the passenger cars and the trucks but also in terms of lot of different inputs that goes into both on the part side but also to some of the raw materials.

And now finally as I said we’re also starting to see the improvements in the housing sector. If you look on slide 18 you can see that we've been very consistent as a country over the last five decades that we've been right around 1.5 million housing starts per year. So far this decade we’re less than 700,000 housing starts and even at the run rate that we saw here in January little bit less than 900,000 housing starts. We have a 65% growth that is there just to get back up to that average, so that we think is a significant opportunity for us going toward and we think about 6% or so of our overall business is tied to housing if you look at the different market segments as we analyze that.

So let me wrap up on the next slide and then turn it over to questions. So clearly first of all, 2013 is going to be another transition year for CSX as we continue to deal effectively with some of the headwinds that we're facing and the secular change that we've seen in our domestic coal business.

We clearly expect our merchandise and intermodal business to grow above GDP and as we go through the year we do expect our overall coal volumes to decline to moderate. CSX however will continue to be focused on the things that we control the most, which goes back to safety, service, efficiency and continue to drive inflation plus pricing. And then in regards to what we’re seeing here in the first quarter volumes are down about 2%, but overall we still expect volume growth for the full year clearly driven by the merchandise and intermodal segments, but also as I said earlier as we expect our coal volumes to moderate as we move out through the year.

And now in that 80% of our business that very quietly has grown $2.2 billion over the last three years. We are now finally seeing both the auto and the housing sectors supporting economic growth and we think overall that supports about 15% of our business. So we're very excited about the fact that both of those two are going to work in tandem to drive growth for us going forward.

So with that, Tom. Thank you for your attention. I will open it up to questions.

Question-and-Answer Session

Thomas Wadewitz – JPMorgan

Great. I am going to give Fredrik two questions to work with and then we will turn it over to the audience here. We have time for a couple of audience questions as well. First on the pricing environment, Fredrik, I think you’ve obviously seen weakness in utility coal and some volatility in export coal weakness in the second half of last year. How would you characterize the pricing environment in the East broadly? Has it changed materially versus last couple of years or is it pretty consistent with what you’ve seen in the past?

Fredrik Eliasson

Well I think that overall I think the pricing environment continues to be in favour of railroads and I think that there are pieces of business that perhaps where we are making sure that we continue to put rates out there that are at reinvestable levels. That is a strategy that we have been very focused on over the last 10 years and we’re going to continue to focus on that because we think that, that has driven significant amount of value not just for CSX but for the industry. So I wouldn’t say they changed significantly but obviously in an environment where you see large portions of your business decline as much as it is, it is tempting to start filling out the network as I said earlier. But our philosophy is that the right course of action is to make sure that you focus on the expense side and take down your resources and that way produce earnings growth for your shareholders, versus trying to artificially create demand.

Thomas Wadewitz – JPMorgan

So have you seen I guess somewhat of a change versus your rail competitor in terms of focus on volume versus price or would you say that, that’s pretty stable as well?

Fredrik Eliasson

I think that you've got to look at what the data says in regards to what we’re looking at and in regards to the numbers that we’re producing both on the revenue and the volume side, the implied RPU and compare that to what other railroads are doing. So from our perspective we just got to continue to do what we do best which is to make sure we match resources with whatever volume environment that is out there.

Thomas Wadewitz – JPMorgan

Okay, one more from me and then I will turn it over. Let's see the crew by Rail Star obviously a lot of excitement about that for the industry, you I believe that in the Buckeye Partners terminal in Albany you guys have seen about a train a day something on that magnitude develop from probably November-December, would you expect another step up later this year as additional terminals come on or perhaps additional business at the Buckeye Partners facility?

Fredrik Eliasson

I don’t like to get into specific customers but I would say that our forecast is we indicated in our first-quarter earnings release is that, that business would grow significantly this year. And it is truly a step function change as different terminals come online and there are at least two major terminals that we are working on currently that we expect to come online in 2013 that will drive that growth.

Thomas Wadewitz – JPMorgan

Would those be second half, you’d start to see that in the second half or is it later in the year?

Fredrik Eliasson

Well for those of you who follow this part of our business you know that a different constraint that has to be solved in order for actually movement to occur. So we do think that the infrastructure will be finished in one place in the second quarter and probably in the second location sometime in the third quarter. But then you also do have some ramp up periods and you do want to make sure that those receivers can secure the actual production and we have less visibility into that than the actual infrastructure being built.

Thomas Wadewitz – JPMorgan

Okay, fair enough. We have a couple in the audience maybe start in the front here and then we’ve got one in the middle of the room as well.

Unidentified Analyst

I see one of your competitors is exploring using natural gas instead of diesel for the railroad locomotives, what’s your plans for that and also what about your speed on the system, is your speed moving up over time of the year and how do you feel about your continued subsidy for truckers with a very low gasoline tax?

Fredrik Eliasson

Some nice softballs there. So in regards to the first part of your question on LNG, clearly the industry is moving in tandem. There are some players who started testing some engines quicker than other players. We expect to start testing here later this year and parts of our business as well. The economics I think at this point where we are kind of past, we think it’s pretty compelling proposition because of what we’re seeing in natural gas industry. We’ve got to make sure the technology is there. We think that the protracted effort is there, but we do – we’re also seeing some new designs that will allow us to perhaps have more of a hybrid both between diesel and LNG. But so we're really testing that technology and once that we’re confirmed I think you’re then starting to go to how are you actually going to implement this, at what scale, at what timeframe but this will happen mostly likely over the next three years, but it is a massive investment and -- but I think we’re more and more convinced that the economics actually make sense.

In regards to the last part of your question in terms of the fuel tax, I would say that clearly one way to deal with this is to move over to LNG. Clearly we are working with a lot of these truckload carriers as partners, and we think that's a bigger driver than differential on the tax side in terms of the fuel tax. And so I don't think that's going to be whether or not that changes, I am not sure that’s going to be a big driver for us. Ultimately that strategic shift that we’re seeing a lot of truckload carriers who are really changing their business model to have an intermodal solution is a much bigger driver. I am trying to recall the middle part of your question. Oh, the speed in terms of – velocity is up significantly year-over-year despite that winter weather and we’re continuing to focus on that, it’s clearly part of our efficiency play making sure that asset utilization continue to improve. Speed is one component of that and certainly we’re focusing on that as well.

Unidentified Analyst

Fredrik, it feels like there are number of factors pushing up the cost of trucking, and I was wondering if you could share your view of the rate at which trucking costs will rise over the next three to five years. And it seems pretty obviously how that will impact you in your intermodal segment. I was wondering if you could talk a little bit about how that might impact your pricing power in segments outside of intermodal.

Fredrik Eliasson

Sure and really it depends market by market, customer by customer in terms of their opportunities, with truck versus rail versus barge, the length of haul but clearly there has been a favorable environment in regards our relative position to the trucking industry. And we've seen that to play out really for the last eight or nine years as first fuel prices came up but then the regulatory changes in terms of our service CSX’s 2010 and a lot of drivers that have been working in our favour. Clearly we have had our challenges as well during this period of time. But what we’re seeing as a result of this is what I alluded to before is the strategic partnership, where the truckload carriers more and more are embracing the model that one of them had embraced for a long time and really lean on the railroads to provide the long haul and then gearing their infrastructure to the pickup and delivery. That solved a lot of their strategic challenges, including the driver retention fees because the quality of life for their employees improved significantly.

There is still a discount between what we are charging our customers, versus what a truck move would charge. There are certain places where that is less than it has been but overall there is still a significant discount that we think over time we should be able to capture more and more of as we continue to improve the strategic alliance between us and the truckload partners and we’re continuing to improve our service offerings and getting more and more density in our network.

Thomas Wadewitz – JPMorgan

I think we have time for one last quick one if there is. If not, okay I will I guess pose one last quick one for you. On export coal I think you said you’re keeping the 40 million tons view, do you have more conviction that the market is bottoming and what do you see on the met side of export coal?

Fredrik Eliasson

Yeah we still feel comfortable with the 40 million tons. We think that's the right place to be. We've said that we have good visibility into the steam side of things. We have contracts in place for the vast, vast majority of the 20 million tons that we’re going to move there. On the met side, we've seen that that the Queensland index is what I usually look at has improved slightly from where it was just a few months ago, and that's a good sign. It is not at the point yet where we think we’re going to be able to recapture some of the rate reductions that we did last year. But we do think that's a good sign to be able to get to the 40 million tons. So I do think just a very fact that we are down 6% only at this point is a good sign and a good validation that we are in a good place in terms of our guidance for the full year.

Thomas Wadewitz – JPMorgan

Is that 6% little better than you would have expected or is it too short a period of time to really –

Fredrik Eliasson

I think it’s too short a period of time. You will see the year over year numbers significantly change as you move through the second quarter. We had one heck of a second quarter last year and so that decline will be significantly higher as we move through there. But we are having some good conversation and the secular thesis that we talked about for a long time I think even at this very depressed API 2 and Queensland index rates, the U.S. producers are competitive. There's no reason why they wouldn't participate in the market if they weren't competitive at this point. So this secular change where we think there's many more room, a lot more opportunities to grow that part of our business we clearly think it's being validated in this environment.

Thomas Wadewitz – JPMorgan

Very good. All right. Fredrik, David, thank you for the presentation and your time.

Fredrik Eliasson

Thank you.

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