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Con-way (NYSE:CNW)

Q3 2013 Earnings Call

October 31, 2013 8:30 am ET

Executives

Patrick J. Fossenier - Vice President of Investor Relations

Douglas W. Stotlar - Chief Executive Officer, President and Director

Stephen L. Bruffett - Chief Financial Officer and Executive Vice President

Walter Gregory Lehmkuhl - Executive Vice President and President of Con-Way Freight Inc

Robert L. Bianco - Executive Vice President and President of Menlo Worldwide LLC

Analysts

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

Christian Wetherbee - Citigroup Inc, Research Division

Ken Hoexter - BofA Merrill Lynch, Research Division

A. Brad Delco - Stephens Inc., Research Division

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

Anthony P. Gallo - Wells Fargo Securities, LLC, Research Division

Matthew Troy - Susquehanna Financial Group, LLLP, Research Division

Allison M. Landry - Crédit Suisse AG, Research Division

Justin B. Yagerman - Deutsche Bank AG, Research Division

Thomas Kim - Goldman Sachs Group Inc., Research Division

Thomas R. Wadewitz - JP Morgan Chase & Co, Research Division

Operator

Good morning. My name is Stephanie, and I will be your conference operator today. At this time, I would like to welcome everyone to Con-way Inc. Third Quarter 2013 Earnings Release Conference Call. [Operator Instructions] Thank you.

I would now like to turn the conference over to Patrick Fossenier, Vice President of Investor Relations.

Patrick J. Fossenier

Thank you, Stephanie. Welcome to the Con-way third quarter 2013 conference call for shareholders and the investment community. In a minute, I'll turn it over to Con-way President and CEO, Doug Stotlar.

Before we get into the call, I would like to offer a few reminders. First, certain statements in this conference, including statements regarding anticipated results of operation and financial condition, constitute forward-looking statements and are subject to a number of risks and uncertainties. Actual results of operations and financial condition might differ materially from those projected in such forward-looking statements, and no assurance can be given as to future results.

Additional information concerning factors that could cause actual results and other matters to differ materially from those in the forward-looking statement and the inherent limitations of such statements is contained in our forms 10-K, 10-Q and other filings with the SEC.

Second, today's prepared remarks contain non-GAAP financial measures. Reconciliations of GAAP to non-GAAP financial measures are found within the financial tables of our earnings release, which is available on our website at con-way.com.

Also, certain financial and operating statistics of the company can be found in the Investors section of our website. [Operator Instructions]

Now without further ado, I'm pleased to turn it over to Doug Stotlar.

Douglas W. Stotlar

Good morning. On the call today, I'm joined by members of our senior leadership team, including Con-way CFO, Steve Bruffett; Con-way Freight President, Greg Lehmkuhl; Menlo Logistics President, Bob Bianco; and Con-way Truckload President, Saul Gonzalez. Steve will provide some commentary on our financial picture and Greg, Bob and Saul will participate in the Q&A portion of the call.

Our third quarter performance reflected continued emphasis on our key strategies we've discussed in recent quarters. Con-way Freight has entered the second half of its 3-year improvement plan and is achieving the expected results. We have confidence that our less-than-truckload company will continue to improve in the areas of revenue management and operational efficiency. Menlo Worldwide Logistics continued to experience lower operating income, as it implemented several large and complex new projects. While these have contributed to growth in net revenue, they have also had an adverse effect on operating income. As these projects become fully operational, we expect their negative impact on near-term operating results to subside. Con-way Truckload recorded a slight increase in year-over-year revenues but saw operating income in the quarter decline. Truckload's results were impacted by an inconsistent demand environment that hampered our ability to secure rate increases sufficient to keep up with rising cost.

Moving to the third quarter's financials. I'll first provide an overview of our combined results. Our consolidated revenues were $1.4 billion, the same as the year ago. On an operating income basis, we earned $67.7 million this quarter, an increase of 22.6% over the $55.2 million earned in the third quarter last year. Diluted earnings per share were $0.53 compared to $0.45 in the prior year period.

On a non-GAAP basis, earnings per diluted share were $0.58 compared to $0.45 in last year's third quarter, with the non-GAAP items consisting solely of tax related adjustments, mostly in the 2013 third quarter.

Turning to our business segments, I'll start with a review of our less-than-truckload company. Con-way Freight had third quarter revenue of $899.3 million, a 4.8% increase from last year's revenue of $858.3 million. Higher yield and tonnage, along with longer length of haul, all contributed to the increased revenues.

Operating income was $51.6 million, a 49.7% increase from last year's third quarter operating income of $34.4 million. The higher operating income was driven primarily by gains from pricing and efficiency initiatives and by lower employee benefits expense. These employee benefits items were largely offset by higher claims activity and, to a lesser extent, IT expense. Con-way Freight's operating ratio this period was 94.3, an improvement over last year's third quarter operating ratio of 96.0. Revenue per hundredweight or yield increased 2.5% in the quarter compared to the prior year. Excluding fuel surcharge, yield would grow 2.4%.

For the third quarter this year compared to the same period last year, daily tonnage was up 1% and total tonnage was up 1.8%. As a reminder, for July, the tonnage growth was calculated with July 5 as a half workday. If we counted it as a full workday, the per-day tonnage comparison is up 0.2%. The point here is that per-day tonnage levels were relatively stable during the quarter.

With respect to tonnage per day on a sequential basis, July was up 2.3% and about flat, with July 5th counted as a full day. August was up 1.4% while September was down 0.8%. For October, while we don't have final numbers yet, we expect tonnage per day to be up slightly as compared to October of 2012.

As I noted earlier, we have surpassed the halfway point in our 3-year plan at Con-way Freight. In 2013, this plan has been focused primarily on 2 major initiatives: lane-based pricing and linehaul optimization. Regarding lane-based pricing, we are on target to having completed negotiations with 268 of our 360 largest accounts. We continue to track and analyze the profitability of these renegotiated accounts and to date, the results are in line with our expectations.

At the same time, the cumulative effect on national account tonnage is becoming more evident. So far, we have been able to offset this tonnage decline with increases in local account tonnage, and we are comfortable with these trends in our national account tonnage as our primary focus is on margin expansion. In the fourth quarter, we'll finish up the remaining accounts that have yet to be renegotiated. Then we will continue to process in 2014 and expand the scope to include additional accounts.

With respect to our linehaul optimization initiative, the early phases are fully implemented and our linehaul productivity has improved. As measured by load factor, our utilization is up 3.5% compared to last year's third quarter. We recently launched the next phase of this linehaul initiative and we have additional phases lined up for 2014. As we continue to make investments in these key initiatives, we expect additional network efficiencies.

Now, I'll move to our logistics segment. In the third quarter, Menlo recorded a decrease in revenues yet achieved an increase in net revenues. Revenue was $380.5 million, down 11% from last year's third quarter revenue of $427.8 million. Net revenue, or revenue minus purchased transportation, was $172.8 million, an 8.2% increase over last year's net revenue of $159.8 million. Business mix drove this result, as growth in warehouse services was partially offset by a decline in transportation management business. The growth resulting from additional warehouse business is an overall positive for Menlo, although these services typically come with a lower margin than transportation management. Given the array of supply chain services offered by Menlo, changes in the mix of these services can impact overall margins.

Menlo's operating income this period was $8.2 million compared to $11 million in last year's third quarter, while operating income declined compared with third quarter of 2012. It improved sequentially from the second quarter of 2013.

Menlo is implementing several large new projects at the same time, which is further demonstrating Menlo's depth and ability to deliver efficient customized solutions for some of the most complex supply chains. In addition, some of these projects are in new industries for Menlo. This, coupled with the already solid sales pipeline, provides Menlo with good prospects for longer-term revenue growth.

Now, I'll review results at our truckload segment. In the third quarter, Con-way Truckload reported revenues of $162.2 million, a 1.3% increase over last year's revenues of $160.1 million. Top line results benefited from a 1.2% increase in loaded miles, a slight increase in revenue per loaded mile and lower empty miles. Truckload's operating income was $9.0 million in the third quarter compared to $11.3 million earned in the prior year. The operating ratio, excluding fuel surcharge, was 92.9 compared to 90.9 in last year's third quarter.

Results were adversely affected by weak demand and a challenging rate environment. In addition, truckload experienced higher expenses due to regulatory changes, along with increased maintenance and depreciation. These items were partially offset by lower employee benefits expense, primarily health care. In response to this challenging operating environment, Con-way Truckload is focused on improving its mix of freight and asset allocation, both with the objective of improving network density.

Now, I'll turn it over to Steve Bruffett for some additional financial perspective.

Stephen L. Bruffett

Thanks, Doug, and good morning, everyone.

I'll begin with an overview of our year-to-date cash flows. Through September of 2013, our cash provided from operating activities was $260 million as compared to $230 million in the same period of 2012. A variety of factors were involved in this increase of $30 million but at a high level, working capital improvements more than offset higher pension funding.

Net capital expenditures through September 30 were $205 million as compared to $200 million at this point last year. For the full year of 2013, we still expect net CapEx to be around $275 million.

Year-to-date financing activities used $10 million of cash in 2013 compared to $42 million in 2012. These activities reflect the net effect of capital lease payments, common dividend payments, stock option activity. And last year's third quarter was higher due to accelerated repayments of capital lease obligations.

In total, these activities resulted in a cash and equivalents balance of $478 million at September 30, which compared to $433 million at December 31, 2012.

Moving to the consolidated income statement, I'd like to provide some color on a couple of notable items. First item is health care. In the third quarter, health care expenses did not seasonally spike as we've experienced over the past couple of years. This is primarily due to fewer high-value claims during the quarter and also to the plan design changes that we implemented for 2013. As a result, third quarter health care expense was $42 million, as compared to a very high $55 million in the third quarter of 2012.

While our quarterly expenses for health care have been more stable this year, we still could experience quarterly volatility going forward. Over the longer term, we continue to take prudent steps to manage this cost item while still providing competitive benefits for our employees.

While we had favorable results for health care during the third quarter, we also had items that went in the other direction. Those items primarily include higher claims activity and IT expense. So there was a mixture of items; some good, some not so good. They're reflected in our consolidated operating income. And that leads us to the other notable item on the income statement, which is our tax rate.

For the third quarter, our tax rate was 42.8%, well above the 38% that we have guided to. The difference between these 2 percentages, which amounts to $0.05 of EPS, was driven by the combination of discrete items and a true-up of the full year effective rate. The largest contributor to the true-up relates to Menlo's international startups. The projected cost in 2013 for a portion of these activities produced foreign net operating losses for which we cannot claim a current tax benefit. As such, the reduction in our pretax income for these losses does not coincide with the reduction in our tax expense, and this drives up the effective rate. However, as these Menlo projects become operational, we expect the negative impact of these activities on our tax rate to subside.

Looking ahead, we want to provide some context on our near-term expectations per business unit performance.

Starting with Con-way Freight. Our stated target for the full year of 2013 remains the same, which is to offset a soft first quarter and still produce year-over-year margin improvement. Given that year-to-date results through September are virtually identical, at $122 million, it follows that we expect to earn more in the fourth quarter of 2013 than we did in the fourth quarter of 2012. But we expect the percentage improvement in operating income to be in a range similar to what was achieved in the third quarter year-over-year.

So moving to Menlo. We still expect to have startup costs in the fourth quarter, though not to the extent of what we experienced in the third quarter. As such, we expect some sequential improvement in operating income, which should result in a year-over-year improvement in the fourth quarter. As we look into 2014, there are a couple of items that will likely impact the rate at which Menlo is able to grow operating income next year. Given the size and relative certainty of these items, we want to provide visibility to them well in advance.

The first and largest item is annual incentive compensation. Given the series of events this year, including the startup cost previously mentioned, Menlo will fall short of the operating income threshold required to earn bonus payments. And as a result, no expenses have been accrued in 2013 for the group of Menlo's supply chain professionals who are eligible for these bonuses. In 2014, we expect Menlo to earn a more typical bonus payout. And as a result, this will likely create a year-over-year hurdle for their operating income growth.

The second item involves IT investments. And while there are numerous IT-related projects planned at Menlo for 2014, the one with the largest impact is an enterprise-driven one. We're making investments to modernize and expand the capabilities of our data and voice networks. And this investment will involve implementation and other costs in 2014. So while this project will have an impact on Con-way Freight as well, the relative impact on Menlo is greater. So that will create an additional hurdle for Menlo's 2014 operating income.

Moving on to Con-way Truckload. We expect a continuation of the challenging operating environment and this will likely lead to a modest decline in operating income, as compared to the fourth quarter of 2012.

Lastly, here are further items at the consolidated level for your modeling purposes. First, we expect depreciation and amortization expense to be approximately $235 million. That's up from $216 million in 2012. Also, we expect that our 2013 effective tax rate, excluding discrete items, will now be approximately 39%.

And moving to our share count, we expect our fully diluted shares for 2013 to be 57.2 million.

And with that, I'll turn it back over to Doug for closing comments.

Douglas W. Stotlar

Thanks, Steve.

We're always confronted with challenges in the sectors where we operate, and this quarter was no different. Employing lean methodologies, our business units continued to develop capabilities to address these challenges, and are making significant investments in people, processes and technologies, that position us for a successful future. These capabilities are clearly on display at Con-way Freight and we remain confident in our ability to continue to expand margins. Those -- that concludes our prepared remarks. And operator, we're ready now to open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Todd Fowler with KeyBanc Capital.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

Steve, I just want to make sure I got your comment right on your expectations for the freight operating income for the fourth quarter. Basically, what you're saying there is that the amount of year-over-year improvement should be similar to what you saw in the third quarter, so around 50% or so?

Stephen L. Bruffett

It's obviously a range, but, yes, that's what I said. Yes.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

Okay. And then, I guess, Doug, thinking about where you're at with the 3-year plan, what would be some of the things that would drive the rate of improvement in margins for 2014? I mean, some of the things that you think about that you could show greater improvement versus what you've seen to date and versus what you've seen so far this year?

Douglas W. Stotlar

Well, I think the single biggest thing that could impact the rate of improvement would be an improving demand environment which, obviously, is beyond our control. So we're certainly planning all of our initiatives around the fact that the economy remains at a relatively unrobust level, somewhere around 2% GDP-type growth, and that we're going to have to create our own lift through our improvement initiatives. But the single biggest thing that could improve our ability to accelerate that rate, I believe, would be an economic demand -- improving economic demand environment.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

But I mean, if we're still in a similar environment into 2014, would your expectation be that you see a similar rate of margin improvement that you saw -- or that you're going to experience this year in 2013? Or could you see something better or worse than that?

Douglas W. Stotlar

Hard to say. I think we have several projects certainly planned for 2014 on the docket. Further linehaul improvement initiatives. We know we're going to go back through our accounts with lane-based pricing and increase the number of accounts that we're going to be adding to our lane-based pricing pool. We also know that we're making investments in IT systems to allow us to continue to improve efficiencies. And we are retiring some technical debt from old legacy systems, as we rebuild some of our underlying IT systems. So we do expect our IT expenses to increase next year. And so we don't have -- we certainly don't have our 2014 plan, at this point, locked down. So it would be hard for me to speculate right now. Greg, do you want to add some color to that?

Walter Gregory Lehmkuhl

Sure. So I think the bottom line is that our plan is working. If you look at the balance of the year, we continue to implement the lane-based pricing and linehaul initiatives. The next significant linehaul initiatives will roll out this quarter and will help us further improve optimization. It's very focused on lane balance, purchased transportation and improved shipment routing. We're pretty excited about how these will translate into further cost reductions in linehaul in 2014. In addition, this quarter, we're implementing what we call drive safe systems, which is a combination of electronic onboard recorders and 2-way cameras in the tractors. We'll have these technologies installed in the entire fleet by year-end. So going into '14, we will have the safest fleet in the LTL industry and new capabilities to manage our fuel economy. We're seeing our fuel economy improve more than 4% on the installed units and we know we can do better, as our training and technology reinforces the right behavior with our drivers. So looking forward, we remain confident and upbeat about our ability to drive profit improvement. And we're not giving a target for 2014, but we certainly expect continued improvement, as in all the areas where we're focused, we're seeing the expected results and the plans working.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

Okay. The last one I have and I'll turn it over. Steve, the $42 million of health care expense here in the quarter, roughly what percentage of that flows through the Freight segment of the P&L?

Stephen L. Bruffett

It's, obviously, a large percentage. I believe it is 70% to 75% of it anyway.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

And it would have been a similar percentage last year in the third quarter?

Stephen L. Bruffett

Yes.

Operator

Your next question comes from the line of Chris Wetherbee with Citi.

Christian Wetherbee - Citigroup Inc, Research Division

I wonder if I could ask about the national versus the local trends. I think you commented that national was down. And, obviously, given volumes were up, local's probably up. Could you give us a little bit of a -- more granularity on sort of how that has been trending? I think we got some numbers in the second quarter. Just curious how that trend looks into the third quarter, through the third quarter.

Stephen L. Bruffett

Absolutely. So we're definitely seeing downward pressure on the national account side, as we work through the lane-based pricing process, but we're seeing strong growth and welcomed growth in local. So in the third quarter, our total national account tonnage was down 3% but entirely offset, and then some from local accounts growing more than 10%.

Christian Wetherbee - Citigroup Inc, Research Division

Okay. So that's relatively consistent with the type of phase that we saw in the second quarter?

Stephen L. Bruffett

Very consistent, yes.

Christian Wetherbee - Citigroup Inc, Research Division

Okay. And when you think about the October pace of activity, sort of slight positive tonnage growth in October. It feels like that was your easier comp from the months of the fourth quarter. When you think about sort of what's going on in the economy, was it -- the government shutdown have any impact on that? Or how do you think about sort of the next couple of months? It seems like maybe the performance there was a little bit weaker than we were expecting.

Douglas W. Stotlar

Well, Chris, it's really hard to quantify the impact of the government shutdown. We certainly believe there's probably something there, but it's hard for us to understand it. If you recall last year, we also had some political gridlock that was making some noise in the economy. But when we track the tonnage per day, particularly of freight through the month of October -- and you're correct, last year, we saw a decline in our tonnage per day on a sequential basis in October, we saw the exact same thing occur this year. So it's really hard for us to determine is this a new seasonality, or is it the effect of similar confluence of events around political gridlock that's happen to cause the same impact in our businesses? We don't know the answer to that at this point.

Stephen L. Bruffett

And this is Steve. I want to jump in very quick here and clarify my answer on the previous health care question. Freight is about 80% of the total health care. So now, we can move on to the next question.

Operator

Your next question comes from Ken Hoexter from Merrill Lynch.

Ken Hoexter - BofA Merrill Lynch, Research Division

I just want to maybe revisit this. You talked about doing tech investments going forward. I thought we had done that -- you had done that last year? And then I guess, in that same vein, I just wonder if you're trying to do too much at the same time, if you're -- you're volleying back and forth, given the volatility in Menlo. And it seems like, going back to the Emery days, this segment has always had really large swings. And while you're in the midst of a large turnaround at LTL, are you -- do you feel like it's getting stretched too thin in terms of where the focus can line in terms of catching up to show that progress? Because I'm kind of surprised by the outlook for the LTL segment. So I guess it all is -- I guess based on the tech investments, and I thought we already made those, is this getting a little stretched in terms of the number of things that need to be worked on here?

Stephen L. Bruffett

This is Steve. I think from a technology standpoint, we in fact have -- we do have a fair number of things on the plate, we acknowledge that. But I think they've been very prudently prioritized, and the business and financial rationale behind them has been thoroughly scrubbed. So the cost items themselves get trapped in 1 line on the income statement but the benefits from those investments accrue in other parts of the income statement, if that makes sense. So we think that the investments that we make or have made and will continue to make, make sense and are an important reason why we're able to move the ball down the field, particularly at Con-way Freight. So I would see that rate of investment continuing into next year and, perhaps, the next, as we retool what we are as a company and how we go about doing our business.

Ken Hoexter - BofA Merrill Lynch, Research Division

And, Doug, do you want to revisit your thoughts on Menlo as part of the organization, and I guess, the synergies you see versus the difficulty of integration there?

Douglas W. Stotlar

Well, I think the one point we need to make about Menlo is don't forget that Menlo is project-based. And by the very nature of a project-based business, you have big projects that roll off and you can be adversely impacted by big projects as you implement them and bring them on. And so, we're certainly in the middle right now of a pretty major startup of very large, complex warehousing projects that are on a global basis, that have consumed a lot of bandwidth and certainly consumed resources and financial resources while we're in the startup phase. Depending on how the contracts are structured, we have to make the investments and bringing on the buildings and the employees before -- and bringing and staffing the facilities and filling the facilities before we can start to ship product and are to generate revenue. And so we're in the middle of that phase right now. And depending on what we -- what's in the sales pipeline and our ability to land different types of projects also have an impact on the mix of business that we have going through and the margin composition of that business. I think it's -- I still believe it's a good business. It provides -- it's high rates of return on invested capital. It doesn't require big capital investments on our behalf on an annual basis. And so -- but it does provide some level of volatility that is inherent in that business model.

Ken Hoexter - BofA Merrill Lynch, Research Division

I guess that's what's missing. Maybe if there's a possibility -- since we don't get statistics, like you do on Truckload and the LTL side, is there any way to kind of pinpoint the number of -- maybe when you talk about manufacturing, the number of warehousing facilities or the size of the startup costs and the pace with which they're going to roll in to give some better visibility on that unit, and how you see that panning out?

Unknown Executive

Ken, I'll add a little bit color to that and hopefully, that'll answer what you're getting at. So since June, we've had to add over 2,000 employees worldwide. We've added over 2 million square feet to our global footprint of warehouse space and we've had to integrate our supply chain execution systems into several new customers in several new industries. So all that activity, obviously, consumes a lot of bandwidth that our employees are doing an unbelievable job right now. So on behalf of our customers onboarding these projects. But it -- each contract is different, right? And the way we recognize revenue during the startup period is different. So oftentimes, when you have to get these -- you have to outfit these buildings with material handling equipment, training the employees and get the operation to a ready state before you're seeing the full effect of revenue recognition. So the expenses will hit first and then we'll see the revenue later, and that's what's happening and has been happening. And these projects are very large and they -- we onboarded them at the same time this year, which is uncommon in past years. And that's what's driving a lot of the volatility.

Ken Hoexter - BofA Merrill Lynch, Research Division

Just my follow-up, a quick clarification, I guess. Did you describe the claims activity on the LTL side? Was that -- is there a specific incident or anything there?

Walter Gregory Lehmkuhl

Okay. So, sure. This is Greg. So this quarter, we had a couple of very unfortunate, severe and infrequent events that drove vehicular claims to unusual levels in Q3. We also saw some increased rehandle in our linehaul network, which led to higher freight claims. On the freight claims side, we quickly put countermeasures in place, and now claims are trending back to a more normal level. Vehicular is also at a more normal level here in Q4. Regarding the IT expense, we expect it to remain at an elevated level going forward as we continue to invest in both applications and infrastructure. But that was all part of our plan, and I want to reinforce the point Steve made.

We plan to put more in IT. And the cost will come out in the other line of the income statement. But without those investments, for example, we wouldn't have gotten 3.5% improvement in linehaul, which translates to over $30 million in cost out a year. The same is true with the EOBRs. We're putting quite a bit of IT investment this quarter and will -- that will flow over into first quarter in the EOBRs. But we expect to get 4% to 7% fuel economy improvement out of that investment on a $350-plus million spend. And so, yes, IT is up but that was all planned long ago and is a -- are very solid investment.

Operator

Your next question comes from Brad Delco with Stephens, Inc.

A. Brad Delco - Stephens Inc., Research Division

I guess, maybe just to follow up on that last one. Can you quantify maybe what the unusually high claims or vehicular claims were this quarter versus last?

Stephen L. Bruffett

Without getting into a lot of details, Brad, this is Steve. I'd say that those activities explain well more than half of the year-over-year variance in that line item on the income statement that's labeled other operating income expenses.

A. Brad Delco - Stephens Inc., Research Division

Okay. So that's roughly $5 million?

Stephen L. Bruffett

Well over half, so...

A. Brad Delco - Stephens Inc., Research Division

Okay. Well, I guess, where I'm getting at and what I'm kind of confused at and I think what a lot of investors want to know, you guys touting a lot of progress on the lane-based pricing initiative. And we've seen other carriers do this and we've seen it evidenced in yields and we've seen yields consolidate from first quarter to third quarter despite you guys rolling out more to your national accounts. I guess, 3/4 are done. And then when I look at a comment earlier, you said that freight was 80% of your health care cost and the delta between last year and this year is $13 million, $10 million of which would be from freight. So if you exclude that, your OR would have been about 50 basis points better versus 170. So I'm trying to figure out where exactly can we see the evidence of all these pieces in driving margin improvement?

Walter Gregory Lehmkuhl

Sure. So the health care good guys were very largely offset by unusual bad guys in the areas that we talked about. So we got some -- we didn't have the spike like we had last year in health care but we did have some major spikes in some areas where we don't expect those areas, those spikes, to continue in Q4 or next year.

On the yield front, I just want to be clear that we don't target any specific length of haul, yield level or freight type. Each account is different and we make the decisions based on the commodity, the pricing in the lane, the lane characteristics and how that individual set of shipments fits into our network. There's so many variables that go into the yield calculation: length of haul, weight per shipment, density, fuel cost, price, accessorials. And it's difficult to say how the yield -- and we've said this over the last couple of quarters, how the yield will trend, especially when we're materially changing the mix in our national accounts and seeing a significant growth in local. And so the yield in a downtown area is going to be more than a yield in a rural area. And the yield in California is more than it is in Florida. So as we make each one of these lane decisions, it can impact the yield. But that's -- it's really not how we think about it. We think about it in terms of profit improvement, by lane, by customer. And from that lens, we're getting exactly what we thought we would. And if you think about the health care and these unusual claims as largely offsetting, I believe that the operating income improvement in the third quarter versus last year, at almost 50%, is very reflective of what we've done in lane-based pricing and in linehaul. And if you -- and you heard what Steve said about the fourth quarter. We expect operating improvement year-over-year to be very similar in Q4 and we're feeling very good about next year and we think our progress will continue. And so in all areas that we can measure, our plan is working.

A. Brad Delco - Stephens Inc., Research Division

Yes. And I mean, and I hear you on that. So when I look at, specifically, your fourth quarter comment, let's just say you can make some top line assumptions. If you see that similar 50% improvement in operating income, it suggests roughly 190 basis points of sequential degradation in OR. And if you look over the recent history, normal seasonality would suggest roughly 170. So you're basically in line or slightly worse than normal seasonality. So I don't know why wouldn't it be better, given all the work that you guys are doing on freight right now?

Walter Gregory Lehmkuhl

Sure. So we're not sure what normal seasonality means anymore, and we haven't even gotten October's results yet. And so it's early in the quarter. Tonnage is very, very similar to last year. We are making investments this quarter. And we, at freight, we're not a 1-quarter story. We are a multiyear retooling of this company and we expect to see continued improvement going forward and it's -- and again, it's not going to be a 1-quarter story.

Operator

Your next question comes from Ben Hartford with Baird.

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

Greg, I guess, just continuing that point. I want to look beyond '14. Because it does sound like there are going to be some expenses from IT and others that might be incremental, at least relative to investors' expectations. But you talked about making progress. You talk about this being more than a 1-quarter story. But at the same time, moving beyond the halfway point in terms of this 3-year project and understanding that there are some terminal operations to come in terms of productivity opportunities in 2015 and beyond. But if we can look beyond the near term, if we can look beyond 2014 and think about 2015, how do we think about the pace of progress relative to your expectations within Freight? And in the context of your conviction in the past as it relates to being able to return this business to prior peak margins, can you provide some context there?

Walter Gregory Lehmkuhl

Sure, and great questions. So we remain confident that we can get back to peak margins. The biggest thing, when we think about beyond 2014, is understanding the network at a new level between operations and pricing, and being able to sell into specific lanes to further improve our network efficiency and density. And so we've made a ton of progress on linehaul and we've made a ton of progress on pricing. But the models we're working on behind the scenes that will deploy in mid-'14 through the end of, call it, the first quarter of '15, really bring these 2 concepts together in a way that we've never been able to do before. And so when I think about long-term, we're going to continue to drive efficiencies, we're going to get P&D productivity, we're going to get further linehaul efficiency next year, we're going to move down our fuel cost with mpg, and we're going to get better at lane-based pricing than we are -- than we were this year. And we're already better than where we were, starting the year. But really when these 2 major flows come together into the new models that we're creating, that tie in together, that's where I see a big change in our operating income. But in the meantime, we're going to continue to make progress. I mean, we understand what our cost headwinds are and we understand exactly how we need to move the needle on the local side, on the national side, on P&D, on dock and linehaul, and we -- those projects are underway and we're getting the results that we expect.

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

Okay. So it sounds like the inflection ought to come in a more meaningful way in early 2015, as the 2 concepts: lane-based pricing and linehaul optimization, come together with some of the terminal productivity opportunities. Is that right?

Walter Gregory Lehmkuhl

Yes. It's not a linear path. We're going to see improvement next year and we'll see improvement again in '15. And I would expect '15 to certainly be a very good year but it's not -- we're not -- we're certainly not looking past 2014.

Douglas W. Stotlar

Yes. And, Ben, we're not predicting an inflection point. I think you need to think about our story as continuous improvement. And while we've talked about a 3-year plan, because I think that was something we needed to do to be able to sequence events within the company, as well as communicate it externally, we're going to stop talking about a 3-year plan. Because we have a continuous improvement plan now. We already have 2015 projects already on the slate, already lined up. By midyear next year, we'll already have some of them in pilot. So this -- it will just be continuous improvement effort and, believe me, there's no shortage of opportunities.

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

Right. And then one last one to clarify, and then I'll turn it over to somebody else. Clearly, we're in a 2%-type GDP growth environment and industry pricing, whether it's truck or LTL, has been pressured here in 2013, very few signs of reaccelerating growth. So Greg, when you talk about the ability to get back to previous peak margins, is it in the context of kind of a continued sluggish demand environment or does it require a better macro to achieve those goals?

Walter Gregory Lehmkuhl

I think we can do that in a sluggish demand environment. Obviously, the economy moving either way really just shifts the curve. We're going to make continuous improvement either way. It's going to be easier if we have a good tailwind, and it's going to be harder if we had a headwind. But in the current economic environment, we believe we can do it.

Operator

Your next question comes from the line of Anthony Gallo with Wells Fargo.

Anthony P. Gallo - Wells Fargo Securities, LLC, Research Division

I'm wondering if you can, maybe, frame for us 2014 expense inflation relative to repricing efforts. And I'm wondering, does the top 360 success offset expense inflation with the so-called bottom half of the customer base and maybe GRI, along with some productivity provides a margin expansion? Is that the right way to frame expense inflation versus some of the repricing efforts?

Walter Gregory Lehmkuhl

It's difficult to break all this down into one question. But I would say 60% of the increase in -- or the benefit next year will come from pricing, 60%, 65%, and the balance will come from operating efficiencies. I mean, you can think of it that way. And when I say pricing, I mean GRI, lane-based pricing in the top 360. But also, we'll be expanding that lane-based pricing program to another couple thousand accounts next year. And we expect that to be beneficial. So when you think about offsetting our cost headwinds and increasing our operating income, you can think 65-35 with revenue management and efficiency activities.

Anthony P. Gallo - Wells Fargo Securities, LLC, Research Division

Okay. And then I'm wondering if on Menlo, there's obviously a lot of things going on there. The new business that you added, could you maybe bucket it for us? How much of it is the more complex warehouse management? How much of it is transportation management? And then, is there a way to give us an idea of what the margin should look like, once they normalize? Will it be more like a 2011 Menlo, a 2012 Menlo? I know the '13 is not the benchmark. Any color there would be helpful.

Robert L. Bianco

Well, this is Bob. Virtually all of the business that we've won this year has been warehouse management. And that, traditionally, those margins are about half what we normally see in transportation management accounts. It's very hard for us to predict going forward because we're project-based and it could change next month. We could win a couple large transportation management projects and that mix can swing. So it's very difficult to answer what we project that margin would look like in the future.

Anthony P. Gallo - Wells Fargo Securities, LLC, Research Division

And are we talking operating margins or net revenue margins? Or is that operating margin?

Stephen L. Bruffett

We typically talk in terms of net revenue margins. We pay little attention internally to what we call gross revenue or top line revenue. It's net revenue at Menlo that is our key metric. So when we talk about margins, it's off of that application.

Anthony P. Gallo - Wells Fargo Securities, LLC, Research Division

I didn't think you were going to give me the operating margin, but I had to ask.

Operator

Your next question comes from the line of Matt Troy with Susquehanna.

Matthew Troy - Susquehanna Financial Group, LLLP, Research Division

I have a question, now that you're at 268 of the 360 largest accounts renegotiated, I'm just trying to get a relative sense of sizing. That 360, I mean, how much of it -- of that is your revenue base? And as you talk about cascading that down into smaller customers next year, how do you parse or segment out? Or what's your definition for the next tier, if you will?

Walter Gregory Lehmkuhl

So the top 360 is about $1.8 billion of our revenue base and, call it the next set of accounts is about $600 million. But it's important to note that we will continue the process on the top 360 next year, and we think there's plenty of opportunity left on that $1.8 billion base, again, in '14.

Matthew Troy - Susquehanna Financial Group, LLLP, Research Division

And if you could talk about your experience in retention with the 268 so far. When you're going -- and you're doing the lane-based pricing and the optimization with these folks, they obviously give you some freight that may not be compensatory to you. But in their mind, as a customer perhaps they expect you to carry both the good and bad freight as part of comp or balance, and hey, it all averages out in the end. And I understand what you're doing intellectually, you're saying, "Well, we need to make money on what we do." How does that translate when you talk about the differentials in growth between your large customers and the small customers? Are you seeing a significant portion of the larger customers when you go through this exercise? Just simply walk and say, "Hey, if we want to play ball, you've got to move it all." Or are they relatively amenable and letting you keep the good stuff and walking with the bad? I'm just trying to understand that experience because it can be a tightrope to walk.

Walter Gregory Lehmkuhl

Oh, there's no doubt it can be. And so the vast majority we're allowed to price -- the price in a way that allows us to pick and choose. We had less than 10 customers just get up and walk away. I think you have to think about it in terms of how they operate their network. So they either have 3PLs or they have transportation management systems and, on average, we only handle about 1/3 of the shipments. So in general, people are using us when they need superior quality. And so we're not as interchangeable as some other carriers would be because they need our service. And so because they have other options in their TMS and, for freight, it's not compensatory. And if they don't need our service, they can switch us out. But then there's other freight that we find that they do need our service on and we can be more competitive on to grow those other lanes. And so it's been a good process. We give our customers 120 days to work through this with us. And so we're way out in front of it. We provide multiple scenarios, multiple options but all of which yield the profit improvement that we have in our goals by account.

Operator

Your next question comes from Allison Landry with Crédit Suisse.

Allison M. Landry - Crédit Suisse AG, Research Division

So I just wanted to ask about CapEx. And you talked a lot about continuing IT investments into next year. But now that you've mostly refreshed the fleet at both Truckload and Freight, what are your initial thoughts on capital spending in 2014, at least from a directional perspective?

Stephen L. Bruffett

Sure, Allison. This is Steve. We're still in our planning phase for 2014 and our early view would be that our CapEx will be in a similar range as '13, or slightly higher, not due to fleet investments but more in the IT space and, perhaps, some around the edges on real estate in very defined situations around the country. But a very consistent type of investment in tractors and trailers and if we experienced an increase, it would be around the edges with the capitalized IT projects as well as real estate.

Allison M. Landry - Crédit Suisse AG, Research Division

And I guess, just drilling down a little bit on some of the IT. You did mention the enterprise system. But are there any other specific initiatives that you're doing at Freight or Menlo that you could maybe quantify that for us a little bit, outside of just the normal enterprise-wide system?

Stephen L. Bruffett

One of the larger projects at Freight is the EOBRs, some of which translates into direct operating expense. Other portions of those assets are capitalized and flow through depreciation. And so that is part of the IT investment that I'm referring to for 2014.

Walter Gregory Lehmkuhl

And secondly, maybe the linehaul investments we're making to reconfigure the systems to support those initiatives.

Operator

Your next question comes from the line of Justin Yagerman with Deutsche Bank.

Justin B. Yagerman - Deutsche Bank AG, Research Division

So I'm just trying to put a period at the end of the sentence on what the real margin was at Freight in this quarter. I mean it sounded like, Steve, you were implying that maybe things were, on an ongoing basis, about 100 basis points better than where you guys actually came in, in the quarter?

Stephen L. Bruffett

I don't recall that line of discussion and I don't believe that's what we were trying to say.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Well, you said that insurance, in terms of onetime stuff, was much more than half of the roughly $11 million of elevated operating expenses. Just doing the math, you kind of get to like 80 to 100 bps.

Stephen L. Bruffett

Yes. And at the same time, we're trying to say that while health care is inherently volatile, we have purposely taken steps that managed a portion of that expense as we've gone through 2013, as well. So in aggregate, when you put everything together, we're trying to send the message that we think our operating income overall paints a pretty fair picture of operating performance this quarter.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Okay. So when thinking about the fourth quarter, it's just the same level of improvement in EBIT, is what you guys are forecasting, as you look out and think about the relative pace of things here going forward? And it's off of kind of the reported numbers not off of some kind of adjustment based on those onetime insurance items?

Stephen L. Bruffett

Yes, it's based off the GAAP number in the fourth quarter of 2012.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Okay. And so on the Menlo side of things, I'm trying to understand. It sounds like this transport -- the warehouse management business that you've onboarded, obviously, has a negative mix profile from a margin standpoint. How do you think about managing that mix as you take that business on? Because as we look at the results, obviously, they've been impacted here and it sounds like maybe the pace of improvement going forward could be slowed because of the mix of business. So just trying to get a sense of how you think about the balance of the business going forward?

Robert L. Bianco

So, Justin, this is Bob. What we do is we want to sign up a project with the customer. And whether it's on the warehouse management side or the transportation management side, it really doesn't matter too much. Because through our lean culture and our continuous improvement, we drive an increase in the scope of activity once we're with that customer. So -- and we can't control what type of projects come to us. But what we can control is, once we get in there, we prove our value to the customer. We prove that we can drive competitive advantage for them. And through that, we're able to expand the scope. And eventually, provide a wider array of supply chain services to them.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Okay. So the idea is, when you're going in first with warehouse management that, hopefully, it will expand to a broader scope, right?

Robert L. Bianco

Correct, yes. So we don't care which door we enter in.

Douglas W. Stotlar

But we also don't control the customer's flow of opportunities. In this case, many of the large complex warehousing opportunities we got this year, we really hunted those the entire year of '12 and they were pulled off the table late in the year because of seasonal issues. And they didn't come back to -- into the marketplace until early this year, and we won those. So these have been in the pipeline for quite some time. They all happened to hit at the same time and we don't control that flow of opportunity.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Okay. Steve, you' got a lot of cash that's been on the balance sheet. I think I've asked you about this several times. Just kind of curious in terms of thought process here of returning some of that to shareholders, either through buybacks or dividends. Where are you guys in that process? How should we think about that in the next -- as we head into 2014?

Stephen L. Bruffett

You are correct that you've asked that several times and I have responded in a similar fashion several times. So I'll provide that context again. We are making good progress on pension funding and the age of fleet concerns that we have in years prior. So those are becoming less of a use of cash as we move forward, relatively speaking. The third leg of the stool is improved margins, particularly at Freight and that is moving along nicely. We would like to get a little further into that trajectory. At which time, we are having dialogue and analysis and considerations about what is the best use of that excess cash. And we will consider that at the appropriate time, but we're not quite there yet.

Operator

Your next question comes from the line of Thomas Kim with Goldman Sachs.

Thomas Kim - Goldman Sachs Group Inc., Research Division

I have a couple of questions, one on Freight and the other on Menlo. Just with regard to the Freight side, if we compare your pricing gains versus your peers in the third quarter, it seems that you're pretty much right in the middle of the pack. I'm just kind of wondering is there any reason why your pricing growth shouldn't actually exceed your peers. In particular, given the mix shift change between national and local, and then also, just given the lane-based pricing initiatives?

Walter Gregory Lehmkuhl

So Tom, this is Greg. Good question. And I kind of adjusted or addressed it before. The way we approach this is, every lane for every customer, and we're seeing significant changes in our mix. And so, with so many lanes and so many customers changing, the aggregate yield number really doesn't become the bellwether for how we're doing it, the profit by account, and ultimately, our operating income. And so I don't think you can take our yield, compare it quarter-over-quarter or year-over-year, and say, that's the price change because we know it's not, as we build it up from the lane and customer level. Yield is just such a compound metric that when things change in the network, as fast as ours right now and have all year, it just -- it becomes less relevant, frankly.

Thomas Kim - Goldman Sachs Group Inc., Research Division

Okay, and on the Menlo side, it's a 2-part question and they're both related to cost. So if we look at purchased transportation, can you help us understand what's driving the sharp year-on-year declines, let's say, versus the revenue, the top line revenue growth? Like how much of that is due to lower buying rates versus the transition in the customer base?

Robert L. Bianco

So the decline in purchased transportation is just due to scope change within the projects. If you recall, in the past, we had mentioned we had exited from a large transportation management contract, because the risk profile didn't align to what we like. And so that had an impact in -- so you're seeing a year-over-year decline there. That's the primary driver.

Thomas Kim - Goldman Sachs Group Inc., Research Division

Okay. So just a follow-up on that, and then just the second part of my question on the Menlo cost. When does that lap? And then the second question is with regard to the start-up cost, you talked about rents and purchased labor have ramped up in the third quarter. Actually, they ramped up in Q2 and then again, in 3Q. Is the rate of increase we've seen Q-on-Q sort of what we should be anticipating for the next couple of quarters? And when should these lap? Should they lap basically in Q2 of next year?

Stephen L. Bruffett

We're probably in the sixth or seventh inning of the ramp-up of those costs to meet the start-up activities. So it will probably be sooner than that when those costs level out. And more appropriately stated, the revenue catches up to the costs already being incurred. And so, I think we're probably 2 quarters away from that position.

Operator

Your last question comes from the line of Tom Wadewitz with JPMorgan.

Thomas R. Wadewitz - JP Morgan Chase & Co, Research Division

I have 2 questions also here. So first on the Menlo, I know you get a lot of questions on the nature of these new contracts. But, Bob, I wonder if you could comment about, are these big WMS contracts in a dedicated warehouse? Are there some that are shared warehouse? What is the -- what does the length of the contract look like? Is it something where the start-up's kind of long but the profitability is attractive and you keep it for a long time? Just kind of parameters like that. And whether those are kind of different from what you've seen in WMS contracts in the past?

Robert L. Bianco

Okay. They're different in that they're very, very large. When we're through the start-up, as far as warehousing, we will have our largest warehouse fully ramped up in the world, and then, probably, our second and third largest warehouse. And so that's a major difference. And they're also in new industries. But they are all dedicated to the customer, every single one. And the contract terms are multiyear. And so when we run our pricing models, we obviously take into account the expected investment we're going to have to make during start-up phase and we calculate an IRR and make sure that we're returning value to our shareholders. So -- and we do that throughout the -- we will see that throughout the length of these contracts.

Thomas R. Wadewitz - JP Morgan Chase & Co, Research Division

And when you say they're multiyear, are they the same kind of -- is it average historical length of contract? They're like 3-year contracts? Or because they're so large, are they longer-term, more like a 5-year deal?

Robert L. Bianco

They vary by region of the world, but they're average. They're not any longer than we expect them to be. So they're more in the range of about 3 years.

Thomas R. Wadewitz - JP Morgan Chase & Co, Research Division

Okay. And then a quick one for you, Steve. Just I guess, when you look at the pace of underlying inflation, so obviously not considering the productivity that you expect to gain, but whether it's wage inflation or other drivers, and I guess, I'm thinking in terms of the Freight division in particular, how would you look at underlying inflation in 2014, relative to maybe what you've seen in the last couple of years?

Stephen L. Bruffett

I think it would be in a similar range, maybe slightly higher, particularly on the wage side. So we've been in the range of 2% to 2.5% and that might start to look more like 2.5% to 3% in '14. And we're still in the process of doing our 2014 planning but that would be a preliminary view of that.

Thomas R. Wadewitz - JP Morgan Chase & Co, Research Division

And that's just the stronger wage increase or are there other factors within that?

Stephen L. Bruffett

It's primarily wage increase but that has not been finalized to date.

Patrick J. Fossenier

Thanks, operator. I think we're done.

Operator

Thank you. This concludes today's conference. You may now disconnect.

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