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CSX Corporation (NYSE:CSX)

Presentation at Deutsche Bank Global Industrials and Basic Materials Conference

June 12, 2013 9:40 a.m. ET

Executives

Fredrik Eliasson - CFO

Analysts

None

Unidentified Speaker

Without further ado, I’ll turn it over to Fredrik Eliasson, executive vice president and chief financial officer of CSX. Thanks.

Fredrik Eliasson

Thank you, Justin, and good morning everyone. Before we get started, as always, let me just quickly remind you about our forward looking statements. Any forecast or any outlook that I might share with you today should be taken within the full context of those statements.

Four topics that I’d like to cover today. First of all, talk a little bit about CSX’s proven track record to deliver even though we’ve seen some pretty significant challenges to the macro environment. Second, and really the foundation I guess in terms of our ability to deliver, is our network, talk about the fact that our network reaches two-thirds of the U.S. population.

Third topic is really about our diversified portfolio. Because of that network reach that we have, the fact that our domestic coal business has declined as much as it has and also our intermodal business has grown as fast as it has over the last few years, we probably have the most diversified portfolio of business that we’ve ever had.

And then the fourth topic is really around intermodal, to share with you a lot of details around our platform that we think is most definitely aligned for profitable growth long term and how we’re going to leverage some of the investments we have made and some of the investments we’re going to make.

Let me start with our track record. Let me talk a little bit about what has occurred here. Eight out of the last nine years, we have been able to deliver earnings growth. Nine out of the last nine years, we have been able to improve our margins.

And we’ve been doing that despite some of these challenges that we face. We have been able to deliver earnings in a freight recession that really started in 2006. We’ve been able to deliver earnings growth even through the financial crisis. And now also, through this transition to a new energy environment.

And how we’ve been able to do that is really through focusing on the things that we control the most. We are focused on CSX, around safety, service, efficiency, and inflation plus pricing. On the safety side, last year it was the safest in the history of CSX. We were the safest class one railroad.

We also last year, according to both external and internal measures, were the record performance in regard to service. In regard to efficiency, we were able to take out almost $200 million of cost last year. And we continue to push inflation plus pricing.

As you can look on this slide, you can see that since 2006, when the freight recession really started, we’ve been able to produce an operating income growth of about 8% CAGR. On the earnings per share side, we’ve been able to almost double our earnings per share at a 12% CAGR. And our operating ratio has improved 710 basis points to a record last year of 70.6%. We’ve been able to do that despite a very challenging macro-environment, which bodes well for the future.

So by executing well around the things that we control the most, we’ve been able to withstand this pretty significant shock to our overall macro-environment. So if you look on slide five, you can see what has occurred to our portfolio of business. On the left-hand side, you can see since 2006, when we had about 7.4 million units, overall volume on our system has declined about 950,000 units, last year coming in about 6.4 million units. So about a 13% decline.

You can see on those stacked bars that the blue area represents our merchandise business. As a percentage of overall business, merchandise has stayed essentially the same, but overall has declined about 600,000 units. And that’s predominantly because the housing and industrial sectors of the economy have yet to fully recover.

At the same time, our intermodal business has grown about 300,000 units, and intermodal is now up to about 38% of our overall business. And this is driven by the continued success of highway conversion and new customers.

And you can see our domestic haul business is now down to about 14% of our overall business, and that is the decline of 900,000 units that I talked about before. At the same time, our export coal business has increased significantly and is up to 6% of our overall portfolio. And that is driven by the secular trends that we talked about, where we believe that the U.S. producers of coal have a larger role to play long term in the world coal market.

So bottom line, we’ve been able to produce despite the significant challenging environment on the macro side. But going forward, and underlying the guidance that you can see there on slide six, we expect a little bit more stable environment for the next few years.

Underlying these financial targets are two basic assumptions. First, that the overall coal environment over the next two years is going to be stable, which is going to be a nice change. We expect that between our domestic and export coal portfolios, that overall volumes will be stable over the next two years, off the 2013 base.

The other assumptions that underlie these economic forecasts or the guidance is also the fact that we expect the economy to continue to expand, albeit at a relatively slow pace. So if you look at the top, you can see EPS growth we expect 10-15% earnings per share growth through 2015, off the 2013 base.

And we expect 2013 to be flat to slightly down to our performance last year. We’ve been very vocal about the challenges that we’re facing this year. First of all, the fact that we have to reset our export coal rates. Second, we have said our domestic coal volumes will be down 5% to 10% for the full year. And, we also see our export coal volume going from the 48 million tons last year to about 40 million tons this year, a decline of about 16%.

On the expense side, the challenges we are facing this year are between cycling real estate gains of about $60 million we had last year and also resetting our incentive comp plans, which now has a broader participation, to include a portion focus on our union workforce - also about $60 million. So combined, about $120 million of expense challenges really playing out here starting in the second quarter.

And I should also mention operating ratio, the fact that we’re targeting operating ration now by 2015 in the high 60s, and longer term in the mid-60s. But reflecting the confidence in our guidance is the fact that our investments remain the same, about $2.3 billion for this year. Longer term, we are looking at 16% to 17% of revenue with an overlay of PTC.

Our quarterly dividend increased 7% during the second quarter, to $0.15 per share. We also issued a new share repurchase program of $1 billion that we should complete in the next 24 months. And we’re doing this within the context of an improved credit profile.

So our ability to deliver over the last few years and our ability to deliver this guidance really starts with our network reach. Our network connects all of the five mega-regions east of the Mississippi River. All of the major population centers. We serve, through our network, over two-thirds of the U.S. population and almost an equal amount of the overall consumption in this country.

In addition to connecting to the major population centers, we are also connecting a significant portion of the manufacturing capability in this country, and a significant portion of the natural resources in the country, to the global market through the connectivity, over 70 [unintelligible].

We also think that our network has superior market reach. We cover all of Florida, including all the way down to Miami and the Panhandle. We’re also connecting all of the Northeast, all the way up to Boston, and into Montreal, taking advantage of the growing NAFTA trade.

Because of this network reach, we now probably have the most diversified portfolio of business that we’ve ever had as a company. If you look on slide eight, you can see that our intermodal business now, as I said earlier, is close to 38% of our overall volume. It is evenly split between our domestic intermodal and our international intermodal.

In addition to that, we have our industrial segment. Our industrial segment consists of chemicals, automotive, and metals. And that’s about 18% of our overall portfolio of business. Our agricultural sector is about 13% of the business, and that includes also phosphate and food to consumer, in addition to the agricultural business.

And then the last section, before we get to coal, is our housing and construction market. And our housing and construction market is about 11%, which is forest products, minerals, and waste and equipment. And that’s the 80% of our business that has absolutely nothing to do with coal. The remaining 20% is our export and domestic business. Export is about 6%, as you saw earlier, and domestic is about 14%. Of that domestic, about two-thirds is utilities.

Overall, our portfolio of business now, 90% has nothing to do with utility coal. So let’s take a look at how this portfolio of business has done here over the last few weeks since our earnings release in the first quarter.

So, over the first nine weeks, our overall volume is up about 1%. And that compares to about a 2% decline in the first quarter. Overall, I would say that our volume is about what we had expected going into the quarter at this point.

Our intermodal volumes are up about 2%. Our domestic part of that business is up 4%, continued good vibrancy in that part of the market, and on the international side, we’re only up about 1% as we are negatively impacted by a port shift of one of our steamship line partners.

On the industrial segment, you can see our volumes have sequentially improved slightly. We’re up about 4%. That continues to be driven by strong growth in our chemical business, led by crude by rail and frack sand.

On the construction side, you can see that sequentially we improved about 3 points. We’re up about 2% now in the second quarter. And that is predominantly driven by stronger aggregate volume here in the second quarter as we’re starting to see some improvements related to greenfield developments in our service area.

On the agricultural side, you can see we improved quite significantly here from the first quarter performance, and that is predominantly driven by the phosphate and fertilizer business. Our phosphate and fertilizer business continues to be very strong, which I think bodes well for the fall harvest.

And then on the domestic coal side, you can see a big shift here from the first quarter to what we’re seeing here in the second quarter. We’re up about 3% in the second quarter, first nine weeks. And that is what we had expected. And that is predominantly because we have easier year over year comps here in the second quarter.

Likewise, on the export coal side, we’re down 16% after only being down 3% year over year in the first quarter. And that’s also as expected, as we’re facing a very difficult year over year comparison.

So let me talk a little bit more about our coal business first here on the next two slides. On the left-hand side, you can really see the two-year story. So 2012 was the year of switching, and this year is really the year of inventory overhang. You can see natural gas prices depicted in the blue area on this chart, and you can see last year natural gas prices declined by May or June. They actually came in below $2. And since then, they’ve come back up and been around $4. Right now around $3.80 or so.

Overlaid on top of that are the different coal basins that we serve. And you can see that the [Powder] River Basin coal is in the green line, and the yellow line is the Illinois Basin coal. We’ve seen a lot of growth over the last few years in our Illinois Basin Coal. It’s gone from about 12% in 2010 to about 29% here in the first quarter of this year.

And overall, we have now a little bit less than 50% of overall utility coal volumes are from one of those two basins. And at about $3.80 natural gas, we believe both of those two basins are in the money, so to speak. Our Northern Appalachian coal is about 20% of overall utility coal, and on the blue line you can see the Central Appalachian coal is about $5 in difference points to natural gas.

So overall, we feel that our utility coal portfolio has become a little bit more resilient over the last few years as we’ve seen more and more shift over to the Illinois Basin coal.

On the right hand side, you can see our volumes for the first nine weeks in the blue bars, and then the red line depicts our average weekly run rate in the first quarter. And you can see we’re up sequentially, about 7% versus the volume we were doing in the first quarter.

However, the green line also depicts the run rate in the third quarter, and the fourth quarter is relatively similar to that. And once we get to the third and the fourth quarter, even though we’re up here at 3% year over year in the second quarter, we still expect to be down in the second half of the year on the domestic coal business, because of this inventory overhang, and because of more difficult year over year comps in the second half.

But overall, we are still comfortable with the guidance that we’ve given out. We expect our domestic coal business to be down 5% to 10% for the full year. So let me then turn to the export coal business, and as you can see on the left-hand side, you can see the underlying commodity indexes. You can see the Queensland Index, and then you see the API2. Queensland is a good proxy for the [unintelligible] commodity prices, then API2 for the steam coal market internationally.

And you can see both of those two have declined here over the last few months. But nevertheless, our export coal business is holding on very nicely here in the second quarter. Once again, the red line depicts where we were in the first quarter on the average weekly basis. And so far, the first nine weeks of this quarter you can see that we’re only down about 2% versus where we were in the first quarter, sequentially.

But the green line shows where we were last year at this time, and obviously that is the reason why we’re 16% down year over year. And as we get through June, I would expect that 16% declines actually get even worse, because June was really the record month for us last year.

But overall, we’re still comfortable with that guidance of about 40 million tons. And we also take the fact that we’re moving as much coal export in a depressed market like this as a very good proof point around the long term thesis that we’ve laid out that we think that the U.S. producers can be much more competitive than they’ve been historically in the world markets.

So let me turn to the 80% of our business that has nothing to do with coal. And let me start with our merchandise and intermodal, and kind of a historical perspective of what we’ve done over the last three years.

So on slide 12, you can see that we’ve been able to grow our merchandise and intermodal business, that 80% of the business that has nothing to do with coal, $2.2 billion over the last three years. The foundation for that, as I said before, is the network reach that we have, the diversified portfolio, and also the service that we’re currently providing for our customers.

So if you look at the green bars there, you can see our gain in revenue is evenly split between rate and mix. First of all, for about a billion dollars, and that is a testament to our commitment to inflation plus pricing. And then the other half is volume, and overall volumes during this period of time, we’ve been able to grow our non-coal volume at about a 6% CAGR during this period of time.

So profitable growth is clearly a long term focus of ours, and we think that between focusing on organic growth that fits our network and continued inflation plus pricing, that we have a lot of opportunities going forward.

So let me talk a little bit more about probably the most meaningful growth opportunity that we have long term for profitable growth, which is our intermodal network, and our intermodal platform.

On slide 13, you can see on the right hand side, what we’ve been able to do over the last three years. And over the last three years, we have been able to grow our intermodal business 32%. We’ve gone from 1.9 million units to about 2.5 million units last year.

On the left-hand side, you can see those metropolitan regions, the population centers east of the Mississippi River, and on top of that, you can see the terminal network, 45 terminals that we have in our intermodal network. And obviously no surprise, those terminals fit well into those population centers.

Then, you can also see, in blue, our Northwest Ohio terminal. This is a terminal we opened in 2011, and it’s probably one of the most transformational investments that we have ever made as a company, and really has created a first hub and spoke system in the intermodal world, I would say at this point. And that is an investment that has allowed us, similar to airlines, to penetrate markets that otherwise economically wouldn’t make sense.

We run about 35 trains through that terminal on a daily basis, and because of the fact that we can consolidate volume into that facility, we have been able to open up about 50 new lanes that otherwise, economically, just wouldn’t make any sense.

Because of the growth that we’ve had, and also the growth that we expect going forward, we are expanding several terminals on our network. You can see that in the beautiful pink. You can see that this year we’re expanding in Atlanta, Columbus, Boston area, Detroit, Louisville, and overall, we’re adding about 500,000 units of lift capacity to our intermodal network this year alone.

In addition to expanding existing terminals, we’re also building new terminals and right now we’re in the process of building two new terminals, one up in Montreal that we announced a week ago, that we had a groundbreaking on. And we expect that terminal to be up and running at the end of 2014.

In addition to that, we’re also working on Winter Haven to serve Orlando in the Florida market, which are obviously growing and very exciting markets for us. And that we expect to be up by the end of 2014. We also are in the planning stages of opening terminals, both in Baltimore and in Pittsburgh.

The other part of our investment in our intermodal network is really around double stacked clearance. And our double stacked clearance today, as we stand here in the second quarter, is 90%. Ninety percent of all the volume that we’re moving in our intermodal network is moving in double stacked cleared lanes.

In addition to that, as we finish our national gateway initiative, that you can see there in yellow, we are going to be close to 93% as we work through the Virginia Avenue tunnel process over the next two years.

So overall, we feel that our intermodal network here in the East, between the fact that we have an incredible market reach, we have a really transformational service product, and especially with our Northwest Ohio terminal, and with the double stacked clearance now approaching close to 100%, we have an incredible platform for long term profitable growth within our intermodal network.

So now let me talk a little bit more about the two submarkets within intermodal. First of all, let me talk briefly about our international markets. On the left-hand side, you can see some of the customers that we are aligned with.

Obviously this market is a much more mature market, but even though it’s mature, you can see on the right hand side that continued global trade is expected, based on the forecasts that we’re getting, to grow about 3% to 5%. So you take a mature market, you’re growing at 3% to 5%, and you continue to get solid pricing in that. That’s a pretty nice place to be, and once again, the fact that we’re serving two-thirds of the U.S. population really gives us a good opportunity to capture a significant portion of that growth.

But clearly, the most vibrant part of our intermodal business is our domestic intermodal business. And our domestic intermodal business, as you can see here on slide 15, really is something very special for us to be able to capture over the next couple of years. We believe that there is about 9 million units of freight that is moving by truck today, that is moving between orders and destinations where we have terminals, and it’s moving at least 550 miles.

And as we’ve taken that data and overlaid it onto our network, we see that a significant portion of that traffic really fits our network very well. On the left-hand side, you can see how that traffic will flow on our network, and the thickness of the lines depict the density in those lanes. And then the size of the pie really shows the opportunity from those population centers.

The yellow part of the pie shows terminations, and the blue shows originations. And no surprise, generally in the Northeast, and also here in Chicago, it’s predominantly a consumption market. So you have a lot more terminations that originations, but in the Southeast, you have the opposite, more originations than you have terminations.

We believe that our strategy here is going to allow us to capture a significant portion of this over time, in a profitable way. We’re not going to grow just to grow. We’re going to make sure that what we add to our network makes sense economically. Our strategy for that is first of all to have a service product that can compete with trucks.

Second, to make sure we continue to work with our partnership, with our truckload partners, and with IMCs. Third, which is something we’ve started here very recently, is to go out and continue to educate beneficial cargo owners through what we call the H2R Initiative. We are making sure that the beneficial cargo owners have a better understanding of the virtue of moving their product with an intermodal based service.

And then the last step, of course, is to continue to invest in this network to make sure that we have the capacity to be able to handle this growth. The good news is that while we are investing in some new terminals, most of this is going to be able to be handled with our existing network.

And because of some of the technology that we’re putting in place right now, we think this is very much scalable, doesn’t really include a lot of additional land that needs to be acquired. It’s really about putting more throughput through these terminals with better technology and also using wide-span crane technology that we’ve started to implement in several of our terminals as we’re expanding those.

So we think clearly this is a great opportunity for us long term, to provide very profitable growth for CSX onto our network in a market that is significant from what we are doing today. To put the 9 million units in perspective, currently our domestic market is a little bit over 1.2 million units.

So let me wrap up on the next slide. We have a long term, proven track record of success. We’ve been able to deliver for our shareholders despite some pretty significant challenges in the macroeconomic environment over the last few years. And we’ve been doing that by focusing on the things that we control: safety, service, efficiency, and continued inflation plus pricing.

Our merchandise and intermodal business, which is the 80% of our business that has nothing to do with coal, has very quietly grown $2.2 billion over the last few years, and has been to a large degree unnoticed because of course the offset that we’ve seen in our domestic coal business.

But as we sit here today, we think that the new energy environment is a positive thing for CSX, and we’re looking forward to being able to grow this business going forward. We think our network is very well positioned for long term growth, once again serving two-thirds of the U.S. population, having these sorts of opportunities as we’re seeing on the intermodal side to be able to convert truckload traffic.

We’re seeing crude by rail, frack sand. We’re seeing the housing market starting to recover, and also hopefully, as we get into the fourth quarter, having a much more normal crop size, we think that there’s significant volume opportunities for us, both short term, medium term, and long term. And clearly, our intermodal platform is one of the most critical pieces of that strategy going forward.

So thank you for being here this morning. I appreciate your attention, and I’ll turn it back over to Justin.

Question-and-Answer Session

Justin

Thanks, Richard. I’ll start with a question on the pricing side of the business. We went through a stretch where legacy pricing was something we all talked about in the rail industry in a big way, and it obviously was very fortuitous in carrying you guys through a tougher economic time as well. When you think about the duration of those contracts resigned during that period, and the repricing opportunity that comes up now through the next several years, how do you think about approaching those contracts and the pricing opportunities that are there? Is that another opportunity in terms of the duration of where we are right now?

Fredrik Eliasson

Are you talking about coal, specifically?

Justin

Not just coal, but across the business. And we’ll get into the coal, because you have a big chunk at the end of this year.

Fredrik Eliasson

I think we’re going to continue to push value pricing. And the way we define that is that we think we should be able to get some spread over our internal inflation. We had a lot of legacy contracts for a period of time, really starting in 2004 and 2005. We don’t have legacy contracts anymore. But I think with the service product that we’re providing our customers today, there are opportunities to continue to price at a very good pace going forward as well.

I would remind folks, those of you who don’t follow the industry very well, if you adjust our prices today for inflation, in 1980, if it was $1 then, it’s $0.60 on the dollar today. So as we moved through the deregulation in 1980 and the Staggers Act was passed, most of the efficiency gains this industry created was passed on to our customers. It isn’t really until the last decade we’ve been able to recapture some of that. But still, on an inflation adjusted basis, overall pricing in our industry is about $0.60 on the dollar versus 1980.

Justin

And when you think about the coal contracts at the end of this year, you’re obviously in a different volume environment than we were when you probably broached those last. How do you think about that pricing conversation with your customers?

Fredrik Eliasson

I think overall, we’re still committed to inflation plus pricing, but I think that each and every customer is going to be unique in terms of that negotiation. And so we’re going to have to see what makes the most sense for them and makes the most sense for us from a bottom line perspective. And as I said, we’re going to look at each and every contract. But overall, I think inflation plus pricing is still what we’re targeting.

Justin

So there’s flexibility, in other words, where it makes sense, if length of haul changes, but overall, for the portfolio, you’d be targeting inflation plus?

Fredrik Eliasson

You know, what we have seen over the last couple of years is we have seen more Illinois Basin coal coming into our network. We have created a more resilient portfolio. So the number one thing we want to do right now is to make sure that we make good money on it, but also make sure that our portfolio continues to be more resilient.

So if somebody is putting up incremental tons that they think they can move by rail, by lowering their cost structure, and they need something from us, then we can think through that. But ultimately, as a portfolio, we still think the right place to be is inflation plus.

Justin

And then on the export coal side, we’ve recently heard about some mine closures and decreases in production, more on the [met] side than the steam side. How do you think about that in terms of impacting that 40 million ton goal that you have for this year?

Fredrik Eliasson

Well, you know, as I said, we are pleasantly surprised by the fact that our volumes are as strong as they are in the second quarter. We clearly think that the fact that the indexes are coming down is not necessarily a good thing for our ability longer term, but we also take it as a good sign, as I said earlier, the fact that the U.S. producers are still out there, and are competitive, even at these lower rates.

There is more capacity coming online on the met side. There’s also things that are being closed. We actually, because of the fact that we serve five different port facilities through our network, we have ground stores in all our facilities, and we have a relatively diverse portfolio, even on the met side, between Southern Appalachian coal, central [Ap] coal, high-[vol], low-[vol]. So we feel we have a relatively diverse portfolio. But clearly, as we get into the second half of this year, we’ll get a lot better sense of what these lower commodity prices do to our volume going forward.

Justin

And maybe just for a second here on the productivity side, that’s somewhere where you guys have continued to gain traction, maybe talk a little bit about where you think we are for this year, and if there’s upside to that number? The $130 million is what you’ve thrown out as kind of a run rate, but the last couple of years you’ve been able to do better than that.

Fredrik Eliasson

Right. So last year we were able to do close to $200 million. This year we’ve once again targeted $130 million, and we feel comfortable that we’re going to exceed $150 million. And just to put this in perspective, over the last eight or nine years we’ve been able to average about $150 million annually. So we continue to have great vibrancy in regards to our efficiency gains, and for the next two years, in this guidance period, we’ve said that we’re going to target $130 million annually as well.

Justin

With 47 seconds left, maybe you can talk about crude by rail here for a second. [laughter]

Fredrik Eliasson

In 41 seconds? So crude by rail, we’re doing seven to nine trains right now a week. That’s up from zero a year ago. We see a significant amount of investment being made by other people on our network. If we add that up, it could add up to a lot of growth going forward. And we do expect a lot of growth there over the next two years or so. But it also is going to be constrained by the actual production in the Bakken area. So how much we’re actually going to move is still unclear, but clearly this is a great growth opportunity for us going forward.

Justin

That’s as close to a just in time performance as I think we’re going to get. Thank you so much, Fredrik. Appreciate the time.

Fredrick Eliasson

Thank you.

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