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CSX Corporation (NYSE:CSX)

Q1 2014 Results Earnings Conference Call

April 16, 2014 08:30 AM ET

Executives

David Baggs - VP of Capital Markets and IR

Michael Ward - Chairman, President, and CEO

Clarence Gooden - Chief Sales and Marketing Officer

Oscar Munoz - Chief Operating Officer

Fredrik Eliasson - Chief Financial Officer

Analysts

Bill Greene - Morgan Stanley

Ken Hoexter - Merrill Lynch

Brandon Oglenski - Barclays

Chris Wetherbee - Citi

Allison Landry - Credit Suisse

Rob Salmon - Deutsche Bank

Bascome Majors - Susquehanna

Jeff Kauffman - Buckingham

Scott Group - Wolfe Research

Jason Seidl - Cowen & Company

Ben Hartford - Robert W. Baird

Cherilyn Radbourne - TD Securities

David Vernon - Bernstein

Walter Spracklin - RBC

Justin Long - Stephens

Keith Schoonmaker - Morningstar

Operator

Good morning, ladies and gentlemen and welcome to the CSX Corporation’s First Quarter 2014 Earnings Call. As a reminder, today’s call is being recorded. During this call, all participants will be in a listen-only mode.

For opening remarks and introduction, I would like to turn the call to Mr. David Baggs, Vice President of Capital Markets and Investor Relations for CSX Corporation. You may begin, sir.

David Baggs

Thank you and good morning everyone. And welcome again to CSX Corporation’s first quarter 2014 earnings presentation. Presentation material that we’ll be reviewing this morning along with our quarterly financial report and our safety and service measurements, are available on our website at csx.com under the Investors section. In addition, following the presentation, a webcast and podcast replay will be available on that same website.

Here representing CSX this morning are Michael Ward, the company’s Chairman, President, and Chief Executive Officer; Clarence Gooden, Chief Sales and Marketing Officer; Oscar Munoz, Chief Operating Officer; and Fredrik Eliasson, Chief Financial Officer.

Now, before we begin the formal part of our program, let me remind everyone that the presentation and other statements made by the company contain forward-looking statements. You are encouraged to review the company’s disclosure in the accompanying presentation on slide 2. This disclosure identifies forward-looking statements as well as the uncertainties and risks that could cause actual performance to differ materially from the results anticipated by these statements.

In addition, let me also remind everyone that at the end of the presentation, we will conduct a question-and-answer session with the research analysts. That said, with nearly 30 analysts covering CSX today, I would ask, as a courtesy for everyone, to please limit your inquiries to one primary and one follow-up question.

And with that, let me turn the presentation over to CSX Corporation’s Chairman, President, and Chief Executive Officer, Michael Ward. Michael?

Michael Ward

Thank you, David and good morning everyone. Last evening, CSX reported first quarter earnings per share of $0.40, down from $0.45 in the same period last year. These results reflect the challenging winter conditions faced by CSX and the broader transportation industry this quarter. In that regard, I would like to offer my sincere thanks to the talented and dedicated men and women of CSX who worked tirelessly to one of the worst winters on record to keep the network running as fluently as possible. I would also like to thank our customers for their patience and support as we work through the service impacts to meet their needs.

Looking at the quarterly results, revenue increased 2% to $3 billion on a 3% volume increase. The underlying economy remained strong supports continued gain in CSX’s intermodal and merchandise markets, which more than offset the decline in coal business. At the same time, as Oscar will discuss in more detail later, we took many steps during the quarter to keep service levels as high as possible in a challenging environment. Dealing with these challenges also had the effect of increasing costs. As a result, operating income decreased 16% to $739 million and the operating ratio increased 520 basis points to 75.5%.

As we look forward, we have the resources in place to support a gradual service recovery while also capitalizing on the market opportunities created by broad economic strength. We see the first quarter headwinds transitioning to longer-term positive momentum in the back half of the year as the economy drives additional growth in our merchandise and intermodal business coupled with an improving environment for domestic coal this year based on increased electrical demand, higher natural gas prices and reduced stockpiles across much of CSX’s service territory.

Given these opportunities, we will more than offset the challenges of this quarter. For that reason, our earnings fit to remain intact with modest growth expected for full year 2014.

Now I’ll turn the presentation over to Clarence, who will take us through the topline results in more detail. Clarence?

Clarence Gooden

Thank you, Michael and good morning. This was a challenging quarter with the impact of the severe winter masking the underlying strength of the economy and the strong demand for our service. As you can see on the left side of the chart, total volume grew 3% and surpassed 1.6 million loads in the quarter with growth in merchandise and intermodal more than offsetting the decline in coal. As a result, merchandise and intermodal now combine for 82% of CSX’s total volume.

Moving to the right, total revenue increased $49 million to over $3 billion in the quarter, reflecting overall volume growth and increased pricing across most markets. Here merchandise and intermodal now account for over three quarters of CSX’s overall revenue.

Next the average, revenue per unit was down slightly, the impact of core pricing gains and liquidated damages was offset by the unfavorable mix impact related to growth in intermodal versus the decline in coal.

Finally, coal pricing on a same-store sale basis remains solid across nearly all markets. Recall that same-store sales are defined as shipments with the same customer, commodity, and car type, and the same origin and destination. These shipments represented 75% of CSX’s traffic base for the quarter.

On this basis, all-in prices was 0.5% in the quarter, primarily reflecting continued rate pressure in the export coal market. Since we continued to have greater variability in both our export and domestic coal business reflecting global market conditions and our fixed variable contract structure and since our merchandise and intermodal markets are becoming a larger portion of our business, we have again provided you with the same-store sales pricing for these two markets on a combined basis.

At the bottom of this panel, you can see pricing for merchandise and intermodal averaged 2.6% for the quarter. This increase is less on a year-over-year basis, but still represents a solid spread over rail inflation. That said, we remain confident that the value created by our service product for our customers provides a solid foundation for growth and pricing above rail inflation over the long-term.

Now let’s look at the individual markets in more detail, starting with merchandise. Overall, merchandise revenue increased 4% to nearly $1.8 billion in the quarter. Volume in the agricultural sector was up 4%. Feed grain shipments, both domestic and export, increased sharply due to a strong 2013 harvest. In addition, ethanol shipments grew as lower corn prices resulted in higher ethanol production levels.

The construction sector declined 2% overall as weather-related challenges more than offset the continued recovery of the residential housing market. Finally, the industrial sector was up 3%, strength in energy-related commodities including crude oil and liquefied petroleum gas more than offset lower shipments in the metals and automotive markets impacted by the severe winter weather.

Moving to the next slide, let’s review the intermodal business. Intermodal revenue increased 4% to $421 million. Total intermodal volume grew 5%, setting a new first quarter record. Domestic volume was up 7% also setting a new first quarter record driven by continued highway to rail conversions.

International volume was up 3% year-over-year reflecting continued economic growth. Total intermodal revenue per unit declined 1% as continued core pricing gains and higher fuel recoveries were offset by unfavorable mix. Volume associated with our domestic door-to-door product, which has higher revenue per unit was more severely impacted by the weather.

Finally, we continued to focus on the intermodal product by adding new service offering and making strategic investments. These investments include the new terminal in Winter Haven, Florida, which opened early this month; the Montreal terminal, which will open later in the year and the ongoing expansion of the Northwest Ohio facility.

Moving to the next slide, let’s review the coal business. Coal revenue declined 9% in the quarter to $662 million. Export coal tonnage declined 15% as global market conditions for both thermal and metallurgical coals continued to soften. The API2 benchmark for thermal coal recently fell to $75 per ton, a level where U.S. coals were more challenged to compete. The Queensland metallurgical coal benchmark has also fallen to low levels of $120 per ton. Domestic coal tonnage increased 8% driven by increased northern utility shipments including a competitive gain. Finally, total revenue per unit was down 8% with lower export pricing and unfavorable domestic mix negatively impacting RPU.

Moving on to the next slide, let’s take a look at the macroeconomic environment. The underlying macro economy remains constructive for growth. The purchasing managers’ index increased to 53.7% in March. Rating above 50 indicates the manufacturing economy is expanding. This is the 10th consecutive month that PMI index has signaled expansion. Meanwhile, the customer inventories index declined to 42 in March. Rating below 50 indicates customer’s inventories are low. This is the lowest ratings since May of 2011 when the customers’ inventory index registered 39.5.

On the right side of the page, both the GDP and IDP projections remain strong and show continued growth throughout 2014. This is consistent with what we see in the marketplace and what we hear from our diverse customer base.

Now let me wrap up with the outlook for the second quarter. Looking forward, we expect the overall volume outlook for the second quarter to be positive with favorable conditions for 83% of our markets and stable conditions for the remaining 17%.

Looking at some of the key markets, agriculture is favorable with higher year-over-year crop yields supporting continued growth in grain shipments. We expect growth in chemicals as we continue to capture opportunities created by the expanding domestic oil and gas industry. The continued expansion of the U.S. housing and construction markets will drive growth in the forest products and mineral markets. Strong intermodal growth will continue as our strategic network investments and service reliability support highway to rail conversions.

We expect domestic coal volume will grow in the second quarter as inventory levels have normalized and gas prices have increased to levels where most coals are more competitive fuel source. Export coal volume is expected to be neutral in the second quarter and our best estimate of 2014 volume remains in the mid 30 million ton range, reflecting soft global market conditions particularly in the thermal market. At the same time, rail pricing will likely continue to reflect the weak global market conditions. The automotive market is stable with North American light vehicle production expected to grow 1% in the second quarter.

The U.S. economic expansion is expected to continue in 2014 with projected GDP and IDP growth of 2.9% and 3.2% respectively, producing a macroeconomic environment that supports growth. The value of the service we provide supports not only growth, but also pricing above rail inflation over the long-term.

Thank you. And now I’ll turn the presentation over to Oscar to review our operating results.

Oscar Munoz

Thank you, Clarence and good morning everyone. Well, as most of you know or heard by now, this past winter season was one of near historical portions in terms of the duration, the coal, the snow and ice and the corresponding impact on not only rail, but truck and airline transportation systems, their supply chain and frankly the overall economy was pretty significant.

We at CSX certainly felt the impact of the severe weather and despite the best efforts of our operating employees, lost and worked around the clock to ensure we were able to deliver freight even in the worst of conditions. CSX’s operating performance this quarter was not at the high levels we’ve all come to expect.

We assure you that the team is fully engaged to support both the gradual recovery and the strong demand that Clarence just discussed.

Now looking at the operating results in the first quarter and beginning with safety. While CSX still remains a leader amongst the class one railroads, we did experience an increase in both personal injuries and in train accidents. The personal injury rate was up to 0.6 and the train accident rate rose to 2.35, both up from near record low levels in the first quarter of last year. Adverse operating conditions were a factor of these results, but we remained focused on prevention with the specific emphasis on avoiding catastrophic injuries.

Let me now turn to the company’s service performance on the next slide. Our operating measures echo the challenges of the North American transportations we faced in the first quarter; originations, arrivals, velocity and dwell are all well off the record levels over the last two years. But as you’ll see later on in the presentation, service measures are stabilizing and beginning to improve.

Turning to slide 15, I will highlight some of the specific challenges we faced from the severe weather in the quarter. While the impact of CSX network was most keenly felt in the Midwest and Northeast, which is a network business and as you can see on the map on the left of the chart on-time originations were negatively impacted as far as South as the State of Georgia. Of course our Northern region clearly faced the worst of the storms, resulting an on-time performance for the quarter of just above 50%.

On the right side of the chart you can see heating degree day, an indicator of the severity of cold temperatures were up over 17% on a year-over-year basis. And snowfall was more than doubled prior year levels in most of our Northern service territory.

Now in a normal winter, when a storm approaches, we make adjustments to the operating plant, move development resources to the area to accommodate the disruption and then usually have a little time to return to normal operating plans after the weather has passed.

This year 25 storms came back to back over several months, which means the operating plant have to be constantly adjusted to serve customer needs. These adjustments require more resources and can also stress our line of road and [yard] capacity.

Now as the worse of the weather seems to be behind us and we are beginning to see fluidity recover, however given the duration of the storm season and the backlog of freight it created along with the increased demand we are seeing, our complete service recovery will be gradual.

Now let me turn to next slide and I will discuss the effects on the operating costs of business. Now while Fredric will provide more specifics on where these impacts were in the quarter and what to expect going forward, let me give you some details on key operational impact.

If you look at the chart and on the left, the number of relief starts doubled year-over-year and overtime across the entire operating department was up nearly 50%. Reposition maintenance of the way and signal employees around the clock along our critical routes to ensure traffic can move safely and efficiently through these effective areas.

Mechanical employees worked extra shifts to ensure locomotives and freight cars were available to help catch up and meet customer demand. In the transportation department labor to ensure terminals remain fluid and trains ran as close to schedule as possible.

Moving down the chart, average freight car cycle days were up 9% reflecting the additional time it took to move cars to and from customer facilities. We also placed additional locomotives into service; the result was a 7% increase in the average locomotive count. With this many additional locomotives and the harsh conditions, fuel efficiency was impacted. I am encouraged however that we only saw 2% set back in this measure as the underlying technology and processes we have in place to drive fuel savings are still yielding results.

Finally our active T&E Crew was flat on a year-over-year basis. Crews worked extra hard to run the network through this harsh winter and I am pleased to say that crew availability remains high and the team was able to support solid volume growth even through the operating challenges. To recapping maintaining network fluidity in these extreme conditions drove a significant short-term cost impact what was necessary to serve our customers.

Now let me turn to slide 17 and discuss our recent service trends. CSX is stabilized and is beginning to recover. A last of the significant storm systems came through about a month ago and as you see depicted on the chart on the left of the slide on-time originations is trending up and dwell is declining since that time, while with positive signs.

As Clarence reviewed, traffic levels are also increasing. In support of this growth, we expect our current high level of locomotives to remain in service for the foreseeable future and we have new crew members in training to meet this rising demand.

The recovery in Chicago specifically will likely take longer to meet the amount of interchange traffic with other railroads and the complexity of the rail network there. Nevertheless the rails are in close coordination and we’re beginning to see some [headways].

As we look forward, we remain confident in our progress. So, it is clear the recovery and related additional costs will extend through the second quarter with more meaningful improvement in the second half of the year.

Now let me wrap up on the last slide. As I discussed the effects from the winter storms were wide and significant driving an increase in cost and impacting service levels. Nevertheless, CSX is confident in the ability of this operating team to steadily return service to the levels our customers have come to expect. We’re adequately resourced recovery and our operating measures are headed in the right direction.

On a productivity perspective, while it’s too early to give you an update, estimate for the full year, it’s pretty clear we’re not going to be able to deliver our normal $130 million savings, but we’ll update you on that later on in the year.

So, at this point, let me echo Michael’s comments and thank each of our employees for the skill and dedication and safely and efficiently serving our customers through this challenging winter.

With that let me now turn the presentation over to Fred to review the financial.

Fredrik Eliasson

Thank you Oscar and good morning everyone. As Clarence mentioned earlier, revenue increased 2% in the first quarter as declines in coal revenue were more than offset by gains in merchandise, intermodal and other revenue.

In the quarter, other revenue included $55 million of liquidated damages, an increase of $22 million versus the prior year. Looking at the remainder of 2014, we expect liquidity damages to be about $10 million for each of the remaining quarters.

Expenses increased 9% versus last year driven primarily by the adverse impact of winter weather that Oscar mentioned and the cycling of real estate gains, both of which I will discuss in more detail in the coming slides.

Operating income was $739 million, down 16% or $141 million versus the prior year. Looking below the line, interest expense was down $7 million versus last year driven by favorable interest rates on debt that was refinanced in 2013 and modestly lower debt levels.

Other income was $7 million and income taxes were $208 million in the quarter for an effective tax rate of approximately 34%. This included the stated legislative tax change, which benefited earnings by $0.02 per share. Without this change, the effective tax rate would have been 37.6%.

Overall, net earnings were $398 million and EPS was $0.40 per share, down from $462 million and $0.45 respectively from the prior year period.

Now before we move on, let me take a moment to summarize the total impact that weather had on our first quarter financial results. We estimate that weather impact on the first quarter expense was around $90 million or $0.06 per share. Revenue impact is more challenging to quantify, but we estimate there was about $0.02 to $0.03 per share in revenue contribution that we were not able to recover in the first quarter due to weather disruptions.

With that let’s turn to the next slide and briefly discuss how fuel lag impacted the quarter. On a year-over-year basis, the effect of the lag in our fuel surcharge program was $4 million unfavorable. This reflects $9 million of negative in-quarter lag during the first quarter of 2014 versus $5 million of negative in-quarter lag for the same period in the prior year. Based on the current forward curve, we expect the year-over-year fuel lag impact to be negative in the second quarter, similar to what we saw in the first quarter.

Turning to the next slide, let’s review our expenses. Overall expenses increased 9% in the quarter. I will talk about the top three expense items in more detail on the next slide, but let me first briefly speak to the bottom two on this chart. Depreciation was up 5% to $283 million due to the increase in the net asset base. Going forward, we expect depreciation to increase sequentially a few million dollars per quarter, reflecting the ongoing investments in our business. Equipment rent was up 6% to $101 million due to the weather’s impact on the network and higher locomotive lease expense as active fleet was increased to minimize service disruption.

Now turning to the next slide, let's discuss our other expenses. First, let me highlight the impacts that we have attributed to weather disruption across each of these expense categories. As I previously mentioned, we estimated first quarter weather impact on expense was $90 million. Of that, $35 million is attributable to labor and fringe driven primarily by overtime and relief crew starts. $35 million in MS&O due to an increase in active locomotives and higher utility expense, $15 million is in fuel driven by loss of efficiency and an increase in non-locomotive heating fuel. And finally, there was $5 million of weather impact in equipment and rent expense, which I covered on the previous slide.

Looking ahead at the second quarter, we expect to incur additional cost associated with recovering from the weather disruptions, although not to the same degree as seen in the first quarter.

That summarizes the weather impact on our first quarter expenses. Now let me discuss the other drivers for each of expense categories, beginning on the left with labor and fringe. Total labor and fringe increased 6% to $47 million versus last year and included $14 million of inflation. Going forward, we expect labor inflation to be around $15 million on a year-over-year basis for the remaining quarters in 2014.

At the same time, we expect headcount to remain roughly flat to our first quarter level, although as we have consistently demonstrated we will continue to adjust resources to reflect current volume levels and drive efficiency.

Moving to the right on the slide, MS&O expense increased 24% or $122 million versus last year. This included a cycling of $49 million of real estate gain, a $12 million increase in expenses related to train accidents and $9 million of inflation. In addition, there was $17 million increase in other MS&O, [setting] multiple items none of which were significantly by themselves.

Looking ahead, MS&O expense will continue to be impacted by this cycling of real estate gains, which as a reminder totaled $36 million in the second quarter of 2013. However, there are no further gains to be cycled in the second half. In addition, we continue to expect high year-over-year expenses in the remaining quarters related to inflation and volume growth.

Finally, fuel expense was essentially flat to last year as favorable price driven by a 5% decline in our fuel cost per gallon was offset by volume and weather headwinds.

That concludes the expense review for the first quarter. Turning to the next slide, I am pleased to announce that we’ll be increasing our dividend. CSX will pay a dividend of $0.16 per share starting in the second quarter, which reflects the 7% increase versus the prior year. While this results in a dividend payout ratio slightly above our target range of 30% to 35%, it is important to note that weather-related headwinds we experienced in the first quarter are not indicative of the core earnings power of the business. We expect our full year EPS to better reflect the [true] earnings power and to support a 30% to 35% dividend payout range in 2014.

Our second quarter dividend increased builds on the 11 increases we have made over the last 8 years representing a 20% CAGR in a dividend over that period.

Now let me wrap it up on the next slide. First, the core earnings power of our business remains strong. Despite the very challenging operating conditions that we faced, we delivered top-line revenue growth of 2% and grew volume by 3% in this first quarter. Across the portfolio, we generally have a positive outlook on the growth trajectory for our merchandise and intermodal market. In addition, we expect 2013 was the low point for domestic coal and that volume will grow this year, whereas the export coal market continues to be volatile.

Our near-term focus is to restore superior service levels across the network as quickly as possible. We experienced significant incremental operating expense in the first quarter from weather disruptions and expect some of these costs to continue into the second quarter. While we plan to recover a portion of this loss productivity during the remainder of the year, our first priority is to restore higher service levels.

For the full year 2014, we expect to see modest earnings growth despite first half headwinds from weather and the cycling of real estate gains.

We have visibility to 7 million new tons of utility coal as a result of the cold winter and higher natural gas prices, which will more than offset the incremental cost incurred in the first quarter.

Looking at 2015, it is still not clear whether projected 2015 growth rate will be strong enough to deliver 2 year EPS CAGR of 10% to 50% across 2014 and 2015 given the modest growth expectations we have for this year.

That said we feel confident that CSX can sustain double-digit EPS growth as we get through this year. That earnings growth which will be more balanced between volume, price and efficiency will also contribute to an improving operating ratio which we expect to be in the mid 60s longer term.

With that let me turn the presentation back to Michael for his closing remarks.

Michael Ward

Thank you, Fredrik. As you’ve heard this morning this first quarter was certainly more challenging than most. And again I thank our employees and customers for their perseverance and patience over these past few months.

As I look ahead, we have the right people and resources in place. And we’re working hard to return our network to the high levels of service and reliability that we have consistently produced for our customers while remaining a leader in one of the nation’s safest industries.

With that as a foundation, I’m confident in the company’s ability to deliver modest growth for the full year 2014 and become more effective serving broad markets that will put the company in a position to sustain positive earnings momentum over the long haul.

In that regard, we are particularly optimistic about the opportunities and plans to support increases in the intermodal and merchandise markets. Put another way, the underlying strength of our network and team coupled with a more stable domestic coal environment and a growing economy gives us confidence that in 2015 and beyond, CSX should again sustain margin expansion and double-digits earning growth.

With that, we’re pleased to take your questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions). Our first question comes from Bill Greene with Morgan Stanley. Your may ask your questions.

Michael Ward

Good morning Bill.

Bill Greene - Morgan Stanley

Yes. Hi, good morning. Fredrik, can I ask you for a little bit of clarification on your guidance commentary, particularly as it relates to ‘15, because I think most of us recognize there are some extraordinary events so far this year. And so there is not -- we don’t have the same kind of expectations for this year. But in ‘15, when you think about that double-digit growth rate, what kind of gives you confidence in it? Can you kind of maybe walk us through a little bit of the assumptions behind it maybe, because obviously there are still concerns about how long export coal could be weak and these sorts of things. So I think it would be helpful to know kind of what goes into that comment?

Fredrik Eliasson

Sure. So, just take a different year, so first of all, we said modest earnings growth for 2014. And while we feel strong and have good confidence in what we see for 2015 as the year by itself, we’re pretty bullish about the macro factors that we’re seeing, we’re pretty bullish about the fact as we get the network running better again, but 2015 by itself will be very strong year.

The question is, will it be strong enough to make up for the fact that we’re only making modest gains this year. And that’s left to be seen. Clearly the domestic market on the coal side has gone stronger over the last few months. But at the same time, we continue to see the export coal market deteriorate. So it’s a little hard at this point to be too bullish about that part of the market.

And so, instead of getting into individual component, what I have said throughout the quarter has been, so I am overseeing things right now for 2015, we are going to need some help as we think about this thing from a bottoms up perspective. And that help in coming different forms are going to come in terms of export market firming up, a little bit more domestic coal, little bit better pricing, more productivity, we just don’t know. But overall 2015 by itself would be very strong year and it’s just not sure it’s going to be as strong enough to make up for the modest earnings growth we are seeing here in 2014.

Bill Greene - Morgan Stanley

Yes. One point of clarification there, another comment you have made in the past I think on ‘15 has been sub-70 OR so a high 60s OR in 2015, are you walking away from that?

Fredrik Eliasson

I think the same thing holds true there in order to get to that sub 70 offering ratio, we are going to also need some help from where we are seeing things today. It doesn’t mean we can’t get there, we certainly going to -- we certainly target it, we are trying to get there but we are going to need some help from where we are seeing things today.

Bill Greene - Morgan Stanley

Does the change to fix variable cost do anything to pricing there, if the domestic coal comes back, does this make pricing sort of weaker and does that effect of you?

Fredrik Eliasson

It doesn’t really impact the overall trajectory.

Bill Greene - Morgan Stanley

Okay, alright. Thank you for the time.

Operator

Thank you. Our next question comes from Ken Hoexter with Merrill Lynch. You may ask your question.

Michael Ward

Good morning, Ken.

Ken Hoexter - Merrill Lynch

Good morning. Michael, you mentioned a couple of times that you are prepared for a gradual recovery, Oscar mentioned a little bit about maybe not hitting the $130 million recovery this year because some costs are coming in. What if we -- I mean we have seen volumes already up 11% quarter-to-date, what if we get a little bit of a sharper recovery in terms of volumes, what does that do in order to flex the network and stress test, what your infrastructure is?

Oscar Munoz

Ken, so that was a couple of questions, specifically your -- restate your question a little bit if you could?

Ken Hoexter - Merrill Lynch

I am just wondering because you mentioned, Michael mentioned a couple of times and I think as did you in terms of a gradual recovery you are prepared for that. What if we see, I mean you have already seen volumes up 11% starting off second quarter pretty robust, what -- how are you prepared if the recovery is a little bit stronger than that? Does that mean you’re fearful that if we get too much volume, it’s going to stress the network too much and you would be prepared just because you mentioned the word gradual recovery so many times?

Oscar Munoz

Yes. Thank you, Ken. I appreciate that. So, the gradual recovery is based upon exactly the volume that we are seeing, so both backlog as well as the increased demand and again, our balance between productivity and ensuring superior service levels. And so we’re making sure that everyone understands that we -- our balance is geared towards our customer. And the volume that we’re seeing today is if you think of our sort of annual peak periods weeks 9 through week 23 is kind of at the peak of it. So right now we’re probably in the highest point of workload we’re going to have in the course of the year and we’re slightly improving. So we feel pretty confident around that.

Now given that fact we’re bringing on some more locomotives, we continue to bring crews out of training and of course doing the hiring if required. But now the volume is a very welcome event for us after a couple of years of being in relatively dry.

Michael Ward

Ken, it is Michael. The other thing I’d add to that is obviously with that demand which I think we’re doing a reasonable job of handling, it does slow your ability to recover. And I think the other thing I would point out, the Chicago as you know is a key interchange. And I think all the major carriers have issues around Chicago and those will take time to work through. And it does have a cascading impact on the rest of the network. So, we will continue to improve.

I think the reason we used gradual several times, because we don’t think this is going to snap back immediately and that’s [to] try to make people understand that.

Ken Hoexter - Merrill Lynch

But I guess if we see a little bit stronger, is that something that you need to then reengage that, the one plan from years ago, is it evolutionary? I am just trying to understand is that something that could make this look even a worse if you get a little bit faster growth?

Michael Ward

Well, we used our reengaging one plan, we still use the one plan to run our railroad, but I’m not overly concerned. I think the demand levels we’re seeing out there we can handle, we will work through. So I don’t see that as a major risk. I think it really adds more like as Oscar said, it’s an opportunity for us to help regain some of that lost earnings in the first quarter.

Ken Hoexter - Merrill Lynch

Wonderful and then just a follow-up on kind of Bill’s question there on the coal RPU. If you exclude the liquidated damages, how should we think about coal yields for the rest of the year? Fred, is that something we’re going to see accelerate on the declines given the change in contract structures or maybe you could just walk us through your thoughts a little bit on that?

Clarence Gooden

Ken this is Clarence. I think you will see the coal RPUs will be very similar to what you saw in the first quarter. Our utility north business was up about 22% in the first quarter and that tends to carry a lower RPU; our southern utility was down about 6% in the first quarter and our rates on our export coal as we mentioned were slightly down. So that mix that particular mix will tend to carry through here in the second quarter, so you will see something very similar on the RPU going forward.

Ken Hoexter - Merrill Lynch

Great, I appreciate the insight and time. Thank you.

Operator

Thank you. Our next question comes from Brandon Oglenski with Barclays. You may ask your question.

Michael Ward

Good morning Brandon.

Brandon Oglenski - Barclays

Yes, good morning everyone. And it’s still snowing in New Jersey by the way, so it’s a pretty tough spring as well.

Michael Ward

Never ending.

Brandon Oglenski - Barclays

I just want to ask a longer term question, Michael. I mean coal revenue used to be 30 plus percent of your mix, it’s down to close to 23%, 22% this quarter. We’ve seen your non-coal volume expand 3% to 4% for the last few years. What are some of the impediments that keeps that non-coal growth from driving better operational margins and I know you’ve been talking about the quarter, but just thinking longer term, how do you get that base of revenue to drive better margins and better earnings growth looking forward?

Michael Ward

Well, as Fred alluded to one, obviously the coal is a high margin business and our portfolio has changed. But we’re very optimistic, if we look at our intermodal and merchandise growth, it is good margin business. And we think as we go forward, if you look at our value creation we drove in the decade prior to this, it was about two-thirds price and one-third productivity. As we look at the company going forward, we still see strong value creation opportunities that are being more balanced, not exactly a third; a third; a third, but it’s going to be continued productivity, continued pricing above rail inflation and adding the element of growth.

The intermodal margins are very nice now that we have basically double stack economics and the density of lanes and the other business we’re growing the crude by rail, the growth in our other merchandise businesses are all good margin businesses that will help drive us to that mid 60s operating ratio long-term.

Brandon Oglenski - Barclays

Okay. I mean at what point though, do you need still coal revenue stabilization in order to just overall expand margins for the business; is that what we’re hearing today?

Michael Ward

Well, we do need the coal to stabilize and we think we’re getting fairly close to that point now. This cold winter, the early blessing of this cold winter is a big drawdown to the stockpiles. Actually as Clarence alluded to, the demand in the north is very strong and actually the stockpiles are below where they ideally would like to have them. And the overhang we’ve been living within the south for the last couple of years, about three quarters of that was eliminated here. So, we really do see that domestic is very strong…

Oscar Munoz

Yes. Just to add to that that Brandon also, in terms of the underlying core earnings power of our company over the last two years, it’s been pretty strong. I mean we’re still thinking of double-digit earnings range. The issue has been $800 million of coal revenue that has gone away. And in this year we are still seeing some headwinds in coal, which is why we only feel that we are going to have modest earnings growth. But we are pretty confident as I said once we get through this transition that we are going to return to the more normalized earnings growth going forward.

Brandon Oglenski - Barclays

Okay, appreciate it guys. Thank you.

Operator

Thank you. Our next question comes from Chris Wetherbee with Citi. You may ask your question.

Michael Ward

Good morning, Chris.

Chris Wetherbee - Citi

Hey, good morning, guys. Clarence, could I just ask for a little bit of clarification on your comments around the export coal market? I think you included it in the neutral category in the outlook. And I just want to get a rough sense of how you think about that relative to the sort of full year target. I think you still said in the mid 30 million ton range. Should we expect a bit of an absolute tonnage step up in the second quarter which I guess would be a little bit more neutral or is that still going to be a little bit under pressure on a year-over-year basis?

Clarence Gooden

Well, it’s a little too soon Chris to sort of see what this export coal business going to do. Frankly it’s a lot stronger this first quarter than I anticipated that it would be. So, we are sticking with sort of mid 30s throughout the year. We have got in the second quarter right now about 80% of what we project for the quarter is tied up under contracts. And that’s obviously subject to market conditions.

We think we have hit pretty much the bottom of where the global price of coal is going to be. The thermal is very low right now in Europe; the metallurgical prices are very low over in Queensland right now. So, as we move towards the middle of the year, we expect to see a more firming in the rate structure, and we can tell you a little bit more towards the middle of the year what it looks like. But right now, we are sticking pretty much to the mid 30 ton, mid 30s in the export market.

Chris Wetherbee - Citi

Okay, that’s helpful. I appreciate that. And then Fred, I think three months ago, you sort of mentioned that the first half of the year when we thought about 2014 was going to be the where you were lapping some of the real-estate gains and other stuff yet in 2013. When you look at the second quarter with the volumes bouncing back with still some cost lingering, is that still the right way to think about the first half is going to sort of be a bit, sort of flat to downish on a year-over-year basis and then maybe you get a little bit of upside, is that sort of how your plan is building as you think about 2014 showing modest growth?

Fredrik Eliasson

Yes. I would say that probably flattish is a good way to think about the second quarter. I think we feel very good about the top-line. I think that you have still those things to cycle that you talked about real estate gains based on that what I said earlier liquidated damage probably down a little bit in the second quarter as well.

And then we will have some lingering cost there for a period of time because of the fact that our network is not running as well, but offsetting that is a more vibrant top-line especially in the coal side and we expect it. So I think flattish is probably good place in the second quarter and then from there, we have to produce earnings growth for the rest of the year to get into that modest earnings growth for the year.

Chris Wetherbee - Citi

Do you think you mostly cut up on volume by the end of the second quarter, is that how the plan would sort of trend?

Fredrik Eliasson

I would think that based on what you’ve seen here in the last few weeks where volumes are up double-digit that that would be a good assumption.

Chris Wetherbee - Citi

Okay. Thanks very much for the time. I appreciate it.

Operator

Thank you. Your next question comes from Allison Landry with Credit Suisse. You may ask your question.

Michael Ward

Good morning Allison.

Allison Landry - Credit Suisse

Good morning. Thank you for taking my question. So, I wanted to ask the question about core operating margins. And if I am adjusting both this quarter and the prior year for all the unusual items including weather or liquidated damages, real estate gains, the fuel lag et cetera, it doesn’t appear that there was very much operating leverage on the 3% volume growth during the quarter. So, I wanted to ask how we should think about contribution margins for the balance of the year, considering both the rate cuts on the export coal side and the fact that you plan to bring on additional locomotive and people.

Fredrik Eliasson

Yes. So obviously it was a noisy quarter in terms of the ins and outs. But I think you are right, if you do adjust for the real estate gains in both the years, you adjust for the fact that you did have weather impact here, and you will see that you had modest earnings growth year-over-year. And now that’s an even factor in also the fact that we had taken our export rate down quite significantly. So once you adjust for all these things, we as I said in my previous answers, the core earnings growth of our company and margin expansion is still very healthy, we’re just dealing with a lot of factors right now that we have to cycle through. And as we get through this, real estate gains will be behind us here as we get through the second quarter where the tail end I think of what we reasonably can do on the export side; and the rest of the business is doing good; coal on the domestic side is coming back. We feel we’re going to return back to normal incremental margins going forward. But it’s just a lot of noise right now that prevents us from coming down to the bottom line.

Allison Landry - Credit Suisse

Okay. And a follow-up question on the tax rate benefit during the quarter. I did notice that there was a comment in the earnings review that the future corporate tax rate would be reduced. I mean should we expect sort of a similar tax rate as we saw in 1Q or is there any sort of prior period catch up?

Fredrik Eliasson

No, we had a -- this is a state legislative tax change that impacted our earnings by $0.02 here in this quarter that made effective tax rate 34%. If you just ask for that, we were right at 37.6%. So, our guidance has always been somewhere around 38%, that’s very conservative place to be and then we think that we should be the place going forward as well.

Allison Landry - Credit Suisse

Okay. So, I guess in terms of the comment that said that this will reduce the future corporate income tax rate, is that…

Fredrik Eliasson

I don’t know about that comment.

Allison Landry - Credit Suisse

Okay.

Fredrik Eliasson

So maybe David will talk about it later, but there is -- nothing has changed in terms of our overall tax and we would like to of course have a lower tax rate. But nothing is imminent around that.

Allison Landry - Credit Suisse

Perfect. Okay. Thank you so much.

Operator

Thank you. Your next question comes from Rob Salmon with Deutsche Bank. You may ask your question.

Michael Ward

Good morning Rob.

Rob Salmon - Deutsche Bank

Hey, good morning guys. Thanks for taking my question. Fred you had called out about 7 million incremental utility coal counts you guys are going to be taking on that you have got now line of sight into the back half of the year. How should we think about this as we look out to 2015 as well? Does this give you guys conviction that we’re going to see utility coal point that we stabilize to growth as we look out even in spite of some of the, I think the 4 million tons that you’re expecting to go in ‘14 and ‘15 from some plant closures?

Fredrik Eliasson

Well, a couple of things there in your question just to clarify. So first of all, we do see several million tons of incremental demand here this year, because of the cold winter. Then I think your question was around 2015 and beyond the impact of map. And what we have said is that as we look at the movement of coal for 2013 into plants that we expect to be close, because of map, we have identified 7 million tons that we think is going to come out between ‘14 through ‘18 essentially. 4 million of those tons we think is going to come out in ‘14 and ‘15 and the remaining 3 million in the years beyond that between ‘16, ‘17 and ’18. Does that answer your question?

Rob Salmon - Deutsche Bank

That answers that question with regard to the several million tons that are coming out in the back half of the year. Will we have continued -- are you expecting that, do you have line of sight in terms of that traffic looking out ‘15 as well where you have got a lot of conviction that utility coal volumes, how that be stabilized and are growing as we look out over the next several years?

Clarence Gooden

Well Rob, this is Clarence. We expect that our growth in coal continues in through 2015. In fact the growth for the rest of this year in utility coal will be in the mid to the high single digits as a lot of those plants that Fredrik has talked about is that will be closed in those years in terms of tons, the other plants that will remain open will simply run harder to absorb those tonnage.

Rob Salmon - Deutsche Bank

Thanks, appreciate the color.

Operator

Thank you. Our next question comes from Bascome Majors with Susquehanna. You may ask your question.

Michael Ward

Good morning.

Bascome Majors - Susquehanna

Good morning, guys. One for Clarence here, we’ve talked pretty extensively about export coal pricing pressure over the last couple of years. And you said again today that you kind of [have been] to what you can do to help incentivize your customer’s competitiveness in that market. If my math is right, it looks like that yields have come down a bit on domestic side of business over the last few quarters as well. I know you called out mix earlier but can you directionally kind of walk us through what’s driving that drop in domestic yields between mix and any pricing or fuel that’s in there as well?

Clarence Gooden

Well as I said earlier on the mix side, the [plus point] preponderantly in the mix, the utility coal which carries a much lower rate than those, the northern utility coal which carries a much lower rate than the southern utility coal is up about 22% this year. The southern utility coal which carries a considerably higher rate due to the much longer length of haul was down about 6% then when you put it in the export coal which we said has been slightly down in terms of rates. Those three combinations that put down have led to the lower RPU, very little of that has been driven at all by the fixed variable charges in our coal rates. So, that’s the principle preponderant drive.

Bascome Majors - Susquehanna

Okay. And a bit more broadly on the similar theme, you talked about competitive gains helping your domestic coal volumes this quarter. What’s the competitive dynamic like in that business today and has the volatility we’ve seen over the last couple of years given you more opportunities to go after your competitors’ business and vice versa than after yours?

Clarence Gooden

Not really, it was a single account in the north that the customers put up more competitive bid and involved the one-time issue. So, we really haven’t had many opportunities in that area at all.

Bascome Majors - Susquehanna

Is there any way to quantify how much of that is driving your domestic gain which you talked about in the previous question?

Clarence Gooden

Very little is driving our domestic gain in that area, most of it has been a result of a burn in the northern utilities and their stockpile depletion.

Bascome Majors - Susquehanna

All right. Thanks for the time this morning.

Operator

Thanks. Your next question comes from Jeff Kauffman with Buckingham. You may ask your question.

Michael Ward

Good morning, Jeff

Jeff Kauffman - Buckingham

Hey, good morning everybody. Thank you very much. I think the point on the weather has been well made. But I have a question concerning some of the noise we’ve been hearing on the regulatory side. And I don’t know if you’re prepared to comment, but there recently were hearings on the competitive switching, they’ve put out some requests for recommendations on the revenue adequacy questions. How do you view the regulatory environment right now? And what are your thoughts out there on some of the discussions?

Michael Ward

Yes Jeff, this is Michael. So, on the export of 7/11 which is the [met leave] proposal as you’re well aware, we did testify at the March 26th hearing opposing that proposal, because it basically provides no public benefit at all.

The early possible beneficiaries -- and you may recall there is a study commissioned by the STB a number of years ago by the Christensen Group is that very few shippers would benefit to the detriment of everyone else and we think that’s still true. It would degrade service, it would introduce uncertainty in the marketplace, disrupt our plans for growth and capital investments, strain prior investments.

And if you think about it, our witness Cressey Brown that day at the hearing did say that you could introduce a perpetual winter like we’ve just seen because you’ve been putting unnatural moves in there. So, we’re hopeful that the STB in its wisdom will not do anything to disrupt what is working quite well today for our customers.

On the side of the revenue adequacy piece, we actually welcome that examination. As you know, that’s an issue that’s I think right for examination in that, no time of the past [leveraging] but anywhere close to revenue adequacy. Some of us are approaching that, but those issues around what is sustained revenue adequacy, how many years do you have to be doing it through a business cycle, what is the appropriate criteria. And we really welcomed that examination to try to bring better clarity to what will happen as the railroads continue to grow in their financial health.

And you’d like to bring a question of replacement cost into that equation, because we do have to replace old assets with new dower. So, we think that’s really right one and we’re glad that they call for it.

Jeff Kauffman - Buckingham

Okay. Well, thank you very much and congratulations.

Michael Ward

Thank you.

Operator

Thank you. Our next question comes from Scott Group with Wolfe Research. Your may ask your question.

Michael Ward

Good morning Scott.

Scott Group - Wolfe Research

Hey, thanks. Good morning guys. Just want to clarify one think Clarence, did you guys have to take the export rates down further in 2Q as the new benchmark kicked in?

Clarence Gooden

Scott we did in a couple of lines with a couple of customers to make them competitive, yes.

Scott Group - Wolfe Research

Okay. On the intermodal side so nice volume growth, but still some pressure on the yields and wondering if that's a pricing thing, is that mix. I wouldn’t think it's mix just with domestic growing faster than international, but maybe it's mix. And then with the truckload pricing that's really starting to get better, should we start to think about your intermodal pricing getting better going forward?

Clarence Gooden

Two answers, it was definitely and specifically weather related, it was definitely a mix, it was in our door-to-door product, it had almost 2.5% impact, it was in the spot market where we couldn't price because of the weather-related issues this quarter. The other pricing, the other areas was positive. Yes, we are seeing a firming in the spot market with truck capacity tightening up in the U.S. in just about every regional area that we serve. So, you are seeing a more firming in the truck pricing.

Scott Group - Wolfe Research

Okay, great. And then just last thing maybe for Oscar or Michael, you guys have done such a great job taking resources out of the network following ‘08, ‘09 after a winter like this and maybe with volumes getting better. Are there longer term implications or do you need to spend more capital or bring back on a more sustainable basis more people or equipment?

Oscar Munoz

Yes. Hi Scott, it's Oscar. Seeing the operations no longer the financial guy can always use a little more capital here and there. But generally we had adequate level of resources; it’s just that the winter conditions were harsher than in a long, long period of time, which created a little bit of a log jam. I think there is a high level of learnings we’ve had operationally that we’ll obviously include, but we went into the year, into the start of the year with low locomotives, we’ve done a lot of the work on the plan of road over the course of time.

And so from a long-term perspective, there are places that we will strategically sort of review with the coming thing, but nothing immediately evident that would have been that helpful. Chicago land terminal, which as you know is the interchange between all of the different railroads that’s where the [create] project is really making a lot of that investment. And I think continuing that is probably the biggest investment the industry can make to make that fluidity in that location better.

Scott Group - Wolfe Research

So, any implications on capital, it sounds like not really?

Oscar Munoz

Not now.

Scott Group - Wolfe Research

From CSX’s perspective. Okay. All right, thanks for the time guys.

Operator

Thank you. Our next question comes from Jason Seidl with Cowen & Company. You may ask your question.

Michael Ward

Good morning, Jason.

Jason Seidl - Cowen & Company

Good morning, guys. Two quick questions here. One for Oscar, I’m sorry one for Clarence. Clarence you mentioned you guys had to bring down some of the export rates due to the benchmark weakening a bit. If the benchmark starts recovering, how quickly can you bring those rates back up?

Clarence Gooden

Within a quarter.

Jason Seidl - Cowen & Company

Within a quarter. Okay. And the last question is for Michael. Michael I have done this a while and Chicago has always been a major interchange issue for the rail industry. It should have improved I guess over the last 10 years with (inaudible) [EJ and E&N] and taking some pressure off of sort of that downtown area? What’s the need in going forward in terms of capital investments by the railroads maybe as jointly or with some help from the government because it’s pretty much still sort of playing after all these years?

Michael Ward

Two things; one, you’re certainly correct that we need to put some better infrastructure and that is the create project which we’re in the process of working and there is money from the railroads, from the state of Illinois and federal money to improve the fluidity in Chicago. But I will remind you though, friendly we looked at the statistics in Chicago going back to I think it was 1871, they kept records from then. Normally you can have a cold winter or you can a snowy winter, you’d rarely have both. This was the third snowiest winter in Chicago, the third coldest winter in Chicago. I think they had 32 snow days, they closed schools in Chicago, which is really rare. So, this is an extraordinarily tough winter that exacerbated some of the natural challenges in Chicago.

So yes, as an industry we are putting more capital in there, but I think we do need to put the context of how severe this winter was when we think of what happened this year.

Jason Seidl - Cowen & Company

And what happened this year, maybe accelerate some of the industry’s plans to pick Chicago?

Michael Ward

Well, quite frankly the railroad piece, the money for the railroad elements of it because create not only helps the rail freight infrastructure; it also helps the commuters, it also helps the interface at [gray] crossings and those sorts of things. The money related to the rail freight infrastructure is being provided by the rails today. The federal and state money for the other aspects, the commuter and the interface, crossings et cetera is coming a little bit slower just because of some of the budget challenges in those states comparatively. So, that’s moving at a slower pace, but the freight piece is moving forward faster.

Jason Seidl - Cowen & Company

Okay. Gentlemen thank you for the time.

Operator

Thank you. Our next question comes from Ben Hartford with Robert W. Baird. You may ask your question.

Michael Ward

Good morning Ben.

Ben Hartford - Robert W. Baird

Hey, good morning guys. Just want to circle back Fredrik, we addressed this earlier in the Q&A but in terms of abandoning that sub-70 OR target for 2015. I want to understand the reasons I believe it’s on the export coal side, specifically on the pricing side, but Clarence I think you as well have made a comment about volumes frankly in the first quarter being slightly stronger than you guys had anticipated and we know that the settlement prices are lower here on the margin in the second quarter. So Fredrik maybe if you could provide just some context into really what is driving the lack of confidence there for 2015, in terms of that line of sight to the sub-70 OR and when you say that you will need some help, is it simply on the export coal pricing front or are there other opportunities even at current pricing levels in the export market that would allow you that would provide for that help to get back into that sub-70 OR for 2015?

Fredrik Eliasson

Sure. And I won’t say we have abandoned it, what we said is that we need some help from where we see things today. As we do a bottoms up view of thing, we are going to need some help and that help can come from different places, it doesn’t have to be from export coal, but particular to that while Clarence up, you are right, our export coal market has done better than we’ve thought from a volume perspective, as you also heard, we will continue to make adjustments on the right side to make sure we optimize our bottom line and of course try to do what we can to keep the U.S. producers in the business.

At these low levels in terms of underlying commodity prices, it is unknown to us or it’s difficult for us to predict, how long this would be able to sustain, how long will the producers be able to be competitive in marketplace. So until we see some sort of an uptick there, it’s hard to be too bullish on 2015 in terms of what our overall volumes will do. But it's not defined to that, if we can as I said earlier get help from other places as well in terms of more price, more productivity, the economy is doing well. And so we continue to target, we continue to think that that's where we want to be. At the same time, one of the things that we try to do as a company is to be very transparent about how we see things and that's really I think pretty consistent with the two public appearance I had in the quarter in terms of saying what we need in order to be able to get there.

We certainly haven't given up volume, we certainly haven't abandoned it.

Ben Hartford - Robert W. Baird

Of course, okay. And then if I can ask a follow-on in terms of the mid 60s OR target longer term. Do you have comfort that at current global segment prices on the export coal market that you can -- that this mid 30 million tons run rate is an appropriate run rate going forward. And that with the component of productivity gains and volume growth and coal price growth, you have visibility overtime to be able to get to that mid 60s OR that how we should look at that longer term target?

Fredrik Eliasson

Yes, we think about pulling the three levers that we have, price, volume, productivity, so we do a long-term modeling. We still feel comfortable that we will be able to get that mid 60s level, obviously it’s taken longer than we expected for that, because of the fact that we have lost $800 million from coal revenue in two years alone here and we still have some headwinds, we're facing this year. But even at the current levels as we model things out, we will get there overtime, it’s just look at longer than we had anticipated originally.

Ben Hartford - Robert W. Baird

Perfect. Thank you.

Operator

Thanks. Our next question comes from Cherilyn Radbourne with TD Securities. Your may ask your questions.

Michael Ward

Good morning Cherilyn.

Cherilyn Radbourne - TD Securities

Thanks very much and good morning. In your testimony before the STB last week I think I heard Cressey Brown indicate that you had recently acquired a new route through Chicago. And just given all of the focus on Chicago currently, I just wondered if you could give a bit of color on that and how it might be strategic to you going forward?

Michael Ward

Yes Cherilyn, this is Michael. We acquired the Elliston sub of this Canadian National in our swap ratio. When they acquired the EJ&E, they didn’t need that route any more. So, we acquired that from them and we are currently once this weather is broken we are making improvements to that route to allow additional fluidity in the Chicago area.

Cherilyn Radbourne - TD Securities

And how long would you expect those investments to take before you start seeing some benefits?

Oscar Munoz

Those are -- Cherilyn, this is Oscar. By mid-year, let’s say July we should be fully operational.

Cherilyn Radbourne - TD Securities

Okay. And then just one last quick question; in terms of the double-digit volume growth that we’ve seen over the last couple weeks in your carloads, do you have any feel for how much of that is pent-up demand versus real organic traffic growth?

Oscar Munoz

I think a lot of that is pent-up demand, but at the same time though we still feel that the economy, as I said in prepared remarks, continues to be very vibrant and we are also seeing our coal business now finally is picking up. So the underlying volume trend is also very positive, but there is no doubt that there is a fair amount of that double-digit volume growth that is related to just catching up of things we didn’t move in the first quarter.

Michael Ward

But I would add to that, the economy is forecast to grow let’s call roughly 3%. We think our merchandise and intermodal business we can grow faster than that rate as we did last year, we will do this year as well. So we will be some amount above what that economy is doing with the great service product we’ve been providing. So, we do need to temper down a little bit, because it is pent-up demand, but it’s also a strong demand in the base business.

Cherilyn Radbourne - TD Securities

Great, thank you. That’s all from me.

Operator

Thank you. Our next question comes from David Vernon with Bernstein. You may ask your question.

Michael Ward

Hi David.

David Vernon - Bernstein

It’s David Vernon with Bernstein.

Michael Ward

Hi David.

David Vernon - Bernstein

Hey good morning. Just maybe a higher level of question, if you think about the slower rate of operating margin development and keeping CapEx is higher, is there a point where you need to start thinking about the capital budget a little bit differently just to ensure overall returns are kind of getting to an upward trajectory?

Michael Ward

David, this is Michael. One, I think what I think is the slower operating margin growth; I don’t know that I’d necessary agree to that base premise. I mean if we look at our business and strip out the effect of the loss of that coal business over the last couple of years, we are in the high single to low double-digits growth on the other businesses, and once we get through this transition, we will produce that kind of growth.

Now to do that we have to make the investments necessary to support it, so that 16% to 17% of revenues that we’ve held with the last few years, we still think that is the appropriate level. We do need to make strategic investments in our intermodal as we’re going to capture that growth opportunity, we think there are 9 million truckloads out there that we can go after and we have to make the investments necessary to do so. So we still think the 16 to 17 is the appropriate level and it will produce value for our shareholders as we grow the business and the margins.

David Vernon - Bernstein

You don’t get concerned at all about the asset turns created by the mix headwind towards lower revenue intermodal?

Michael Ward

No, because of lots of lower revenue doesn’t mean it’s a lower margin. So if we look at the margins on the intermodal business it’s as good as our other margins for our merchandise businesses. So, as good margin business it’s lower RPU, but what we get paid for doing is producing margin not necessarily revenue per unit. So we think it’s good business and we’ll lower the overall RPU, but we’ll increase our profitability, which is what we really need to do.

David Vernon - Bernstein

All right, I appreciate the time.

Operator

Thank you. Our next question comes from Walter Spracklin with RBC. You may ask your question.

Michael Ward

Good morning Walter

Walter Spracklin - RBC

Good morning. Thanks for taking my call here. I just have two follow-up questions really, one is for Clarence on the export coal side and the guidance that you provided with regards to the neutral on the second quarter, I know Chris kind of asked this. But just to clarify, if we reflect in -- you did 11.5 million tons last year, you did 10.5 last quarter even though we do say 10.5 this quarter it would imply a step down of over 20% in the back half of the year to get to about 36 million tons. So I just -- is that what you are guiding or are we just giving a little bit more room for upside in the case that’s the back half turns out to be better than we are expecting?

Clarence Gooden

Walter I guess someone was to hint me up (inaudible) what are you really guiding? I’m guiding that this market is very volatile that has a $120 a ton in Queensland, you will get there, your guess is as good as mine, it is extremely volatile. With thermal coal sale in Europe between $75 and $79 a ton, some of the things we’ve seen in the first quarter really defy what has been historical norm. It’s highly speculative, we’ve worked with our producers to try to stay in the marketplace right now and it’s just too soon for us to bid on. So we’ve got a fairly clear line of sight of what the next two, three months look like, but to tell you what the third and fourth quarter looks like is just going way out in the [lamp].

Walter Spracklin - RBC

Okay, all right. That makes a lot of sense. Okay. I appreciate that color. Staying with you Clarence here on intermodal pricing, again a clarification question, lot of moving parts in the last few quarters with regards to fuel recapture or quite the opposite of lower fuel surcharge, firming truckload market or trucking market. If we strip all that out now on a base level going forward, we do see average RPU in intermodal flat or up going forward?

Clarence Gooden

Up.

Walter Spracklin - RBC

Okay. That's all my questions. Thanks very much.

Operator

Thank you. Your next question comes from Justin Long with Stephens. You may ask your question.

Michael Ward

Good morning.

Justin Long - Stephens

Good morning. Thanks for taking my questions, first one I had was on core pricing. You talked about overall core pricing being up about 50 basis points year-over-year, but could you talk about the headwind this number saw from the lower level of rail inflation. I'm just trying to understand the overall core pricing environment absent any changes in inflationary mechanisms. Would you describe it as stable or are you seeing some type of moderation?

Clarence Gooden

Well, you saw core inflation was around 1.4% from global insight. When you took coal out of the mix, we were about 2.6% that was down from what it was a year ago, which was around 3.3% in the merchandise and the intermodal markets.

So, we are pricing above rail inflation in our basic markets. The coal markets are being mainly impacted and influenced what's happening in the global coal market. So I would tell you that we are seeing stability in our general freight, in our general merchandise markets. As we are seeing capacity demands as just witnessed by the previous questions, we think that will firm up through the year as we go forward from where we are today. Depending on what happens to these coal markets, we think we have seen the near bottom start to approach in global markets in coal. So, the trend should be upward in the future in there.

Justin Long - Stephens

Okay, thank you. That’s helpful. And as a follow up, I was wondering if you could talk about the industrial development opportunity and your current pipeline of projects seems to be pretty robust, is there any possible way to quantify how much this could contribute to volume growth in 2014.

Michael Ward

I don’t have that number right off the top of my head. I am sorry.

Justin Long - Stephens

Okay, that’s fine. Maybe you could just provide some color on some of the opportunities as far as industrial development and what you are seeing and just kind of how that pipeline looks in general?

Michael Ward

Well one of the things that we are seeing as a result of the expansion in the oil and the gas industry is a lot of the development is happening in the Marcellus area with fractionators either located on CSX or on the short lines that be into CSX. We have 5 new fractionating facilities located on. So each one of those are producing between 15 and 20 cars a day of byproducts of the gas industry that are coming on to CSX. That’s positive for us. We have 2 new ethylene crackers that have been announced on CSX as a result of that. So those tend to be for lack better phrase, [annuities] going forward for us on CSX. So you are seeing a lot of developments in those areas.

In the last I guess 18 months we have seen a lot of activity in general in industrial development as economies begin to expand with new industries on CSX. I think last year we announced almost $1.5 billion, $2 billion worth of new industries that are locating on CSX. So you are seeing a lot of economic activity now as economy is getting to expand.

Justin Long - Stephens

Okay, great. That’s helpful. I’ll leave it at that. I appreciate the time.

Michael Ward

Thank you.

Operator

Thank you. Our next question comes from Keith Schoonmaker with Morningstar. You may ask your question.

Michael Ward

Good morning Keith.

Keith Schoonmaker - Morningstar

Yes, thanks. I am in Chicago and actually calling you from an igloo this morning. I’d appreciate those comments on uncertainty of export coal demand and wanted turn to domestic with a couple of quick questions. Fredrik mentioned expectations of 2015 was probably the midyear and domestic coal volumes. I know there is no crystal ball, but I just want to clarify for your thinking that based on current information you expect domestic coal will be flat or up from here on say indefinitely next 3 to 5 years?

Fredrik Eliasson

No, no, we expect growth in the mid to high single-digits for the rest of this year in 2014 in domestic coal.

Keith Schoonmaker - Morningstar

And then beyond the current year?

Fredrik Eliasson

Well I expect 2015 also be -- I don’t see much beyond 2015 right now at this point.

Keith Schoonmaker - Morningstar

Okay. And then if I recall correctly, Illinois and Powder River Basins constitute about half of your recent utility carloads. And I’d like to ask about your expectations for next same time period 2 to 3 years from now?

Fredrik Eliasson

2 to 3 years, right now you’re right; it’s running just slightly above 50% in both of those markets. So, we expect to see growth continuing in both, particularly in the Illinois Basin coals.

Michael Ward

We’re actually making capital investments on that line near Illinois Basin to allow us to muster those unit trains more efficiently. When is that expected to be done, Oscar?

Oscar Munoz

Again probably third quarter of this year.

Michael Ward

So we’re putting infrastructure in because we do think that Illinois Basin is going to be a continual growing market for us.

Keith Schoonmaker - Morningstar

You did that infrastructure’s track?

Michael Ward

It’s (inaudible) to be able to assemble unit trains and move them more efficiently.

Keith Schoonmaker - Morningstar

Thank you.

Operator

Thank you. Our final question comes from (inaudible) Macquarie Capital. You may ask your question.

Unidentified Analyst

Good morning. And thank you for your patience. My first question relates to again the outlook for the export coal market. Could you help us understand your leverage to recovery in met-coal across your book of business contracted and spot and also what your assumptions are with regards to this market in your guidance or double-digit EPS growth for next year?

Michael Ward

The leverage in met-coal, is that your question?

Clarence Gooden

The rebound, what kind of leverage…

Unidentified Analyst

Yes, how fast can you benefit from recovery in pricing? And then on volumes given that you have mix of contracted and spot business and if you could also clarify how much of your contracted business is up for renewal this year, that will also help?

Michael Ward

Okay. Our export coal business is priced on quarterly basis. So our ability to leverage and to response to the marketplace, we would be able to do so on a quarterly basis.

Clarence Gooden

So bid upticks, we can move…

Michael Ward

And this fall within the quarter.

Unidentified Analyst

All right. And with regards to your guidance for ‘15, what kind of outlook do you have embedded for export coal?

Oscar Munoz

I think what we have said is that, that is one market that we are concerned about in terms of how long we can see the sort of positive volume despite having the underlying commodity markets as weak as they are, but we haven’t given a specific number in terms of what we are assuming for 2015.

Unidentified Analyst

Thank you. And my follow-up is really regards to the past to your mid 60s operating ratio long term, can you help or shed some light on to, into what you mean by long term and the main drivers especially from the hurdle put by this hard winter?

Oscar Munoz

Well, in terms of the mid 60s, we’ve talked about earlier on the call today. And we -- because of the fact that we’ve lost so much momentum in the $800 million of coal revenue that’s gone away, it has been pushed out longer than we have originally anticipated, we are going to have to get there little differently than our original plans, but we are still confident and as we look at our long-term modeling, as we look at our pricing, productivity and volume opportunities that we will get there, we are not going to put a timeframe on it today, but clearly that we need to be long term in order to be able to reinvest in the business the way we wanted to be able to do.

Unidentified Analyst

So, it could be [3 or 5] I guess?

Oscar Munoz

We have not put a timeframe on that.

Unidentified Analyst

Thank you very much.

Michael Ward

Well, everyone thank you for your attendance, interest in the company. And we’ll talk to you again next quarter.

Operator

Thank you. And this concludes today’s teleconference. Thank you for your participation in today’s call. You may disconnect your lines.

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