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CSX Corporation (NYSE:CSX)

Deutsche Bank Global Industrials and Basic Materials Conference Call

June 5, 2014 11:40 ET


Fredrik Eliasson - Chief Financial Officer


Rob Salmon - Deutsche Bank

Rob Salmon - Deutsche Bank

Thanks again for joining us this morning for the Deutsche Bank transportation track at the Industrials Conference. Joining me is CSX Corporation, their CFO Fredrik Eliasson. CSX is one of the major Eastern railroads in the U.S. It’s got about 21,000 route miles with the network that goes across 23 states east of the Mississippi. Without further ado, I will turn it over to Fredrik who will talk about quarter-to-date update as well as trends that CSX has seen.

Fredrik Eliasson - Chief Financial Officer

Thank you, Rob and thank you for that introduction. It’s a pleasure to be here this morning. Before we get started, as always, let me just quickly remind you about our forward-looking statements. Any forecast, any outlook that I might share with you today should be taken within the full context of these statements.

The way we have structured this presentation today is really around four key topics. First, a quick look back at how we have overcome the transition in energy markets over the last couple of years and we have been able to keep our earnings per share at record level despite pretty massive total headwind. Second, give you an update on what we are seeing on volumes here so far this year and the fact that volumes here in the second quarter has accelerated quite significantly and the fact that they have is impacting the speed of our operational recovery that probably even more gradual than we had originally anticipated. And the third, we will talk about our diverse portfolio of business and probably where we spend most of our time today to talk about some of the key drivers behind each of those markets to give you a sense of our bullishness in each of those markets and the fact that we have positive growth prospects for that to drive long-term sustained earnings growth. And at the end, we will transition out and just talk a little bit about our financial outlook that remains positive long-term.

So, let me start with giving you a quick look back at what has happened over the last couple of years. And as you can see on the left hand side of Slide 4 here, you can see our earnings per share in 2009 was $0.96 and last year it was $1.83, so almost doubled over this time period. We have been able to do that despite the fact that our utility coal tonnage has declined quite significantly from 150 million tons, down to 66 million tons last year, so a decline of 43%. And over the last two years alone, we have had a coal headwind overall at about $800 million. So, in addition to continued focus on productivity, the real story over the last couple of years has been the vibrancy of our non-coal business on merchandise and intermodal business that during this period of time grew $2.7 billion about evenly split between inflation plus pricing and volume growth, volume growth that significantly outpaced the overall economic activity in our country, in this country. And we have great expectations for this part of our business going forward as well and we have gotten off to a good start here in 2014 in terms of our volume performance.

If you look on Slide 5, you can see on the right hand side here that our volumes so far in the second quarter is up 9%, which compares to 3% in the first quarter and this is after eight weeks here in the second quarter. And clearly, some of that is pent-up demand from the first quarter, but we think the bigger driver here is continued good economic expansion and the fact that our domestic coal business has come back. If you go to the left hand side just looking at some of our markets high level, agriculture business at about 5% clip year-over-year versus 4% in the first quarter. Construction sector has recovered quite nicely from the impact of the winter in the first quarter, it’s about 8%. Industrial sector continues to do very strong at 11% quarter-to-date at this point clearly driven by continued strength in our energy related areas, such as crude by rail, LPG and frac sand, but also the fact that our automotive sector is doing better as well, which was impacted quite significantly by the weather in the first quarter. Intermodal 9% evenly split essentially between domestic and international. And then you can see our domestic coal business up 19% at this point as we now find it’s in transportation and utility coal more in line with underlying of consumption of utility coal as we now have certainly new path the inventory overhang as we would have shorter period of time.

And then export coal down about 14% so far quarter-to-date. So clearly based on the volume strength that we have seen at this point and we were pretty bullish on the volume going into the quarter we expected 83% of our volume to be favorable in this quarter where we had our earnings release in April. But clearly at this point we feel that there is more upside than downside to our original guidance to be flattish for the quarter, which is why we are now saying that flat to slightly up and as volume strength is a good place to be in terms of earnings per share growth year-over-year.

Now this is a quick reminder though this quarter we still have the fair amount of headwinds. We have about $36 million of real estate gains that we have to overcome. This is the last quarter we will have that year-over-year challenge. Our export coal rates which I will talk about a little bit more detail later on is also down 16% year-over-year and we do see operational challenges. We have yet to see our network performance get back to the place that we had going into the winter. And we are incurring – we are expecting about $30 million to $40 million of additional costs during this quarter because of the fact that we are still seeing elevated overtime additional re-crews and an asset utilization level that is not where we would like for it to be.

So let’s talk a little bit more on the next slide about our operational performance. And you can see here on the left hand side you can see the velocity on a weekly basis in the blue bars. And on the right hand side you can see our on-time originations in the blue bars. And in both graphs you see the volume performance that we had in addition to being up 9% year-over-year we are also up about 16% sequentially since the midpoint of the first quarter. So despite having over 10% more locomotives in service year-over-year, we have yet to get to the point where we see our assets turn time and service improve to the level that we expect from our self and certainly our customers should expect from us. We do think there is an opportunity as we get through the summer months here to get more of an asset turn time recovery as we see this normal sequential slowdown. And then from there we expect a gradual recovery through the rest of the year. So stronger than expected volume growth is hampering our ability to see the service recovery, but at the end it’s still good for the bottom line that’s the matter of fact of the two.

Now, let’s turn to the longer term and we do expect this solid volume environment to continue, this is probably the most bullish we had been about the top line opportunities for our portfolio business. There really are three key drivers to that. And what you can see on the left hand side of Slide 7 is our network that is one of the key drivers the fact that we have a network that is irreplaceable. We serve two-thirds of the U.S. population 21 states – 21,000 miles, 23 states. And we have a competitor advantage and that our market reach, which is all the way down into Florida and all the way up to Northeast even into Canada to take advantage of the growing assets. That’s one reason for our bullishness.

Second, in terms of the macro drivers that are out there that continues to push supply chain towards the rail based solution. We talked a long time about longer supply chains. We have talked about the trucking challenges that are out there and under investing in our highway system. And the third reason is really around the new energy environment. And I can only say that after having going through the last couple of years as we think about the new energy environment going forward, we think the net-net is a positive for CSX as we continue to capitalize not just short-term on crude by rail, frac sand and LPG opportunities, but then longer term about the (indiscernible) of the U.S. economy.

Now because of that transition that you are seeing in the energy environment and because of the strong growth that we have had in our portfolio and merchandise and intermodal, we probably now have the most diversified portfolio of business than we have ever had as a company. And you can see that on the right side where you can see our first quarter revenue breakdown, where our largest segment now is chemicals and is no longer coal. Our domestic coal is now our second largest market is at about 16% and then you can see intermodal at about 14% of overall revenue followed by both auto and agricultural at about 9%. So, we think not only do we have the most diverse portfolio in our company’s history, but we also have the most sustainable business going forward having them through this energy environment. And we think that we have an opportunity to mitigate a lot of different markets going up and down, because we are not beholding to any specific market in the way that we have been historically.

So now, let’s take a look at these markets in a little bit more detail over the next couple of slides starting with our domestic utility portfolio. And really two things has occurred here over the last couple of months. First of all, as you can see on the left hand side here, natural gas prices have returned to what we think is a more sustainable level around 450 or so. At that point, 70% of our book of business in the utility side is in the money, not only is Illinois Basin and Powder River Basin coal in the money, but so is our Northern Appalachian business. And we think that 70% over time will grow to larger number as we continue to see customers, especially in the south switch over from the Central Appalachian coal to Illinois Basin coal predominantly. This is one of the reasons why we said we are going to come out of this transition with albeit a smaller portfolio, but clearly a more resilient portfolio going forward at much more competitive and lower natural gas prices than we have been in the past.

The second story of this change is the inventory overhang. I spent the last two and a half years talking about the inventory overhang and I can officially say that we passed that at this point. And whether you look at tons on the ground that is down in the north 26% or in the south that is down 43% or you look at days burn, which perhaps is a better measure going forward. You can see now on the days burn side that we are down 30% to 50% year-over-year depending on looking north and the south and we are that below what we consider to be more normalized historical level that we took the average between 2006 and 2010. So, that is you finally are getting now as I said earlier, transportation and utility coal more in line with the underlying consumption. And having gone through this inventory overhang will allow us now to much more easily offset additional plant closures that we expect over next couple of years due to the new environmental regulations that are coming online here in 2015.

So, to illustrate that a little bit more, if you look on the left hand side of Slide 9, you can see our utility plants that we started totaled 62 plants today. The green dots represent utilities that we expect to remain open, 45 of those. Yellow dots represent plants that are going to have partial closure,, those are 5. And then plants started for closures are about 12. So, if you look on the right hand side, you can see in the blue bars are the coal to those plants that we expect to remain open, the 45 plus the 5 that we are going to have partial shutdowns. I mean, you can see that we have gone from 87 million tons in those plants to 59 million tons last year, so a decline of 32%. And that’s really a function of we have moved from being the base load as prices not come up, there is an opportunity to see increased volume at those plants in addition to the fact that the inventory overhang is behind those.

The purple line reflects tonnage that is going into plants that are going to close. And you can see that’s down 83% from 41 million tons to 7 million tons last year. So, that’s why we were confident to say that the vast majority of the pain from the environmental regulations in 2015 is behind us. And then the gold bar just reflect that first quarter at an annualized pace, which is why we are comfortable that we are going to grow our domestic coal business here this year. And we think that based on the pace during the second quarter, it’s probably upside to this annualized number as well. And not only do we think we are going to be able to grow in 2014, we think we are going to be able to grow our domestic portfolio in 2015 as well.

So, let’s turn to the export market and that’s one market we do feel challenge going forward as well. On the left hand side, you can see down the line commodity indexes and you can see that both domestic coal, which is indicated by the Queensland Index and the thermal coal, API-2 has declined quite significantly since the beginning of 2012, has declined somewhere between 40% or 25% for Queensland and 25% for API-2. And even though the forward curve points towards the second quarter as the trough, it’s not going to come back anywhere close to where it was at the beginning of 2012. As a result of the decline that we have seen over the last couple of years here, you can also see in the right hand side at the top, our tonnage in 2012 was a record year. In terms of tonnage, it was 48 million tons and then declined to 44 million tons last year. And our guidance this year is the mid 30s and it seems to be the right place to be in terms of overall tonnage for 2014.

Part of the reason why the tonnage is staying up as much as it is, is because we are accommodating on price here. As you can see at the bottom, you can see we are down here second quarter, about 16% as I said earlier year-over-year in terms of revenue per ton in the export market and 33% since the first quarter of 2012. So, we have done this because obviously we are going to optimize our bottom line, but also strategically try to do what we can with a reason to keep these producers in the business during this very difficult time.

Now, let’s turn to the rest of the business and let’s start with our agricultural business. So, if you add the agriculture business with our food and consumer and our phosphate business, that’s about 15% of our revenue. And the story here is pretty simple. Over time, we expect this market to go about 2.5% or so between corn and soybean, those are two major crops. And clearly, here in 2013 we are benefiting year-over-year by the low crop in 2012 and we expect that favorable comps throughout the second quarter and the third quarter this year as we continue to refill the grain supply pipeline. Initial look at 2014 crop looks favorable. We think that even though acreage is down slightly we think on the corn side, soybean acreage is up and the yield is expected to be high, but obviously until you get to August and September, you know the rainfall that is still just an estimate. And the lower corn price is not helping some of other businesses as well, which is interesting. We see several new ethanol plants coming back online as they have been shutdown. And we are also seeing an increase in the pull-through production, because of the fact that the corn prices are now lower.

Now, turning to the other sector in our merchandise business, our construction sector, which is about 11% of revenue. You can see that housing start is still well below the historical average about 1.5 million units per year even after the expected growth rate this year that is about 12% based on global inside expectations. But we are still going to be about 30% below that historical average. And housing starts directly drives about 6% of our business between our lumber, aggregates, metals and appliance businesses. So, we think this area of our business has a great opportunity to grow for several more years at a very, very attractive pace as we get back to a more normalized level of housing starts.

Now, let’s turn to the industrial side of our merchandise market, last of emerging markets, but also the largest of the merchandise markets. It’s about 31% of revenue when you combine chemicals, metals and auto. And you can see there that the story is pretty simple, right now, the key drivers are chemical business. And our crude by rail business here this year could double in 2014. With originally going into the year expecting about 50% growth, it looks like we are going to be growing that little bit faster than we originally expected. It’s about 2.5 to 3 trains a day versus the 1.2 or so that we were last year, so more growth than we had originally expected.

The other part of the chemical renaissance is also very favorable between frac sand and LPG as well. The metals markets is forecasted to grow 5% and we expect to take our part of that as well, continued strength of course in oil and gas area, but also helped by continued strength in the automotive sector as well, where we see on the automotive side we expect North America light vehicle production to once again outpace the economy as a whole as we continue to see our fleet being relatively old and the fact that the U.S. is a very attractive place to manufacture vehicles and we see that in our export business on the automotive side as well.

Now, key to sustained long-term growth is industrial development and our industrial development effort is second to none. We have 20 people out there on a daily basis working with customers to locate their businesses adjacent to CSX’s track to take advantage of the strategic opportunity to use rail-based transportation solution for their cargo.

In the left hand side, you can see the investments in 2013, which was about a 120 of those, where customers either look at new facilities or expanded facilities on our track and over the last five years that’s almost 600 new facilities, which represents over that five-year period 620,000 new opportunities to either create new growth opportunities for us or to offset natural churn. The project pipeline had probably never been healthier in our company’s history. As we look at this thing, clearly a lot of this is driven by substantial chemical-related and energy-related opportunities, but also in the right to work state in the south, we are seeing a fair amount of industrial production opportunities as well, which is very welcoming. And overall, our customers have invested $15 billion adjacent to our track over the last few years.

I wanted to just touch on the last part of our business, which is probably the part of our business, where we think we can grow the fastest for a long period of time. And if you can see here on the left hand side, you can see our intermodal network. We have carried about 2.6 million intermodal loads last year. And traditionally, when you think about an intermodal network, you really think about a corridor strategy. You think about a corridor strategy where you have a major population side on each side and then you have to pickup and setup maybe one or two or three times along the way. That’s the way we thought about our business traditionally. That’s the way the other railroads have thought about the business traditionally. What we have done over the last couple of years and we have spent a fair amount of capital strategically here between double-stack clearances and terminal expansion opportunities, but probably the most strategic and most transformational investment has been our Northwest Ohio hub.

And what the Northwest Ohio hub does is similar to what UPS and FedEx does, it allows us to connect order from destinations pair in a much more economical way and really give us an opportunity to grow our business in a different way than we have had in the past. The Northwest Ohio facility has opened up a 125 new lanes over the last few years and total growth coming from that is 20% in total growth that we have seen as a company on the intermodal side. And Northwest Ohio has been so successful frankly that we are actually going to expand it with adding an additional 50% capacity later on this year, which continues to support our growth opportunities going forward. So, we are clearly bullish in this market, but this is not a build it, they will come strategy.

Just very briefly, if you look on the Slide 16, you can see what our domestic intermodal market has done since 2006. We are up almost 70% in terms of average weaker domestic volume while the American Trucking Association tonnage is up only 13%. That is the best proof point you can possibly see in terms of the vibrancy in this market. And while the path has been great, we think the future frankly is even greater. We think there is 9 million loads out there in our service territory that reflects movement of cargo 550 miles or greater between origins and destinations, where we have terminals. And we think a significant majority of that can overlay very nicely to our network. This is why we think over time we can grow this market at 5% to 10%.

And we have clearly recognized that they have to be capital investment associated with this, but we think they are scalable and that they will fit nicely into our already 16% to 17% capital guidance. And the greatest news is this is not just about the top line, this is also about the bottom line, because of what we have done over the last couple of years in terms of double-stack clearances, tonnage productivity, longer train length and pricing discipline, the margins in this business now is at par with the rest of our business with the exception of chemicals and coal.

So, let me wrap it up here on the next slide, we continue to expect broad-based strength to drive long-term growth. We feel very bullish about our portfolio going forward. We think as I said earlier, network reach that we have that is unique. The macro environment and the new energy environment is really going to provide a boost from the volume perspective going forward. This year is the last year of the coal transition. We clearly expect the domestic coal business to grow going forward. However, the export business will remain challenged both in terms of volume and price. And then we expect double digit EPS growth beginning 2015. We have said modest earnings growth here for 2014 and then longer term as we go through this energy transition, we will assume our path towards mid 60s operating ratio as we move through this year.

So, with that, thank you for your attention. And I am sure Rob has some questions for me.

Question-and-Answer Session

Rob Salmon - Deutsche Bank

Yes, thanks Fredrik. With the updated guidance you gave for the second quarter, traditionally with accelerating domestic utility coal volume growth as well as accelerating overall volume growth, we think about strong operating leverage to the bottom line and frankly we would typically expect a little bit faster earnings growth. There are some different puts and takes, which are unique to CSX given lapping of real estate gains as well as – but I think you called out $30 million to $40 million of costs related to service. How should we be thinking about the service metrics getting to where they need to be for CSX or where we will start to see the operating leverage translate to the bottom line?

Fredrik Eliasson

Well, first of all obviously we are sort of volume environment is very positive problem for us to have, is the fact that we haven’t been able to get the network to run as efficiently as we would like to because of the sequential growth in volume, whereas it’s over 10% more volume and locomotives out there to and try to handle this incremental growth. But net-net from the incremental margins perspective is still a very good thing is just not as good as we would like it. And coupling that with challenges that we had in terms of cycling both the real estate gain of $36 million and the fact that we had export coal rates as low as they are and with these additional $30 million to $40 million sub and related costs and extra overtime and reduced asset utilization it is not as exiting as it should. But we are pretty comfortable as we get through the rest of this year especially having gone through the summer months we will start getting this network floated it back up to better level. We get delivered better service product for our customers and at that point you will see some of those $30 million to $40 million coming out going forward.

Rob Salmon - Deutsche Bank

And when we are looking at the service metrics, are there certain kind of what I would call as green lights for the network, where we should be watching for if velocity gets back toward the upper 20s like how should we be thinking about the terminal dwelling velocity, which is indicative of a CSX network, where we are seeing a lot of operating leverage?

Fredrik Eliasson

Yes, I think those are the two big measures. Those are the public measures. Obviously, there is other things that we look at as well in terms of on-time originations. There are certain things in the dwells that obviously doesn’t count, because we don’t dwell unit trains for example. So, the story is a little bit more complex than that, but it’s not about proxy to look at where we are from an asset utilization perspective, but it’s clear in the fact that we are not churning the assets as quickly as we would like for them to turn, it’s impacting the cost structure. There is no doubt. But net-net, as I have said in my presentation, this is a good problem to have. We have lot of volume out there and net-net it is a positive thing.

Rob Salmon - Deutsche Bank

I just want to think of a lot of transportation demand using the marketplace traditionally that’s when we get volume growth which really good from an incremental margin standpoint, but to what means there is less capacity to handle it. And traditionally I would expect cost metrics accelerate under that environment, can you give us a sense of what’s different from your customers as you are going back about the pricing opportunity today versus service challenges precludes you from getting better pricing or there is the tight truck marketplace allow you to offset that actually to accelerate the coal price?

Fredrik Eliasson

Yes. We are really hitting on the two issues. On one hand capacity is being tighter which allows us to do more things from a pricing perspective, but on the other hand obviously service products is not as solid as it’s been in the previous two years. So net-net but I think net – I think overall we are thinking about business and opportunity to capture the value that’s being created in the trucking market meaning that we should be able to raise our rates as well going forward. And we are as committed as we always been through continued inflation plus pricing.

Rob Salmon - Deutsche Bank

And when you are thinking about that how much kind of spare capacity is on your merchandise as well as intermodal network to capture that with regard train length expansion?

Fredrik Eliasson

Yes, so we have said that 15% to 20% of additional capacity in existing intermodal network and probably 10% to 15% in our merchandise network. The constraining factor right now is really around locomotives, which is hard to get more than what we currently have. And there is a lead time in getting additional crews. We do expect over the next four to five months to add about another 5% year-over-year. By the end of 2014 we should have about 4% to 5% more crews in service and that should be helpful as well. But there is always a little bit lead time I am making sure that the crews get trained and qualified.

Rob Salmon - Deutsche Bank

Now if there are questions in the audience, please raise your hand and we will be happy to kind of bring the mic across. With regard to that 4% to 5% crude growth, is this to primarily accommodate expected traffic growth or is this just a kind of drive enhanced search performance across the network?

Fredrik Eliasson

It is the combination of both. Clearly, right now, we have a lot of training engine folks out there working a lot of over time and trying to keep the network as good as we possibly can. And over time, we need to make sure we had additional manpower just to handle existing, but as I said earlier, we also are very bullish about the growth opportunities across our markets with really the exceptional export coal. So, it’s a combination of both.

Rob Salmon - Deutsche Bank

Yes, at the industrials conference we have heard a lot about the new crackers that are coming on particularly the petrochem opportunity, could you talk a little bit about what the speeds for CSX longer term from just overall volumes I think it can provide to the network?

Fredrik Eliasson

Sure. There are five factionators that have come online over the last couple of years, the last year really, you can ask the short line partners that really are producing good incremental volume predominantly on the LPG side. Longer term what we are seeing in terms of crackers are two that it’s been announced up in the kind of the Marcellus shale, Utica region and both of them are located on CSX. We will see if both of them gets build we certainly hope that they will. That will be a huge incremental volume opportunity for us at that point. I think the earliest they will be coming online will be 2017, but I think the bigger picture here continues to be the vibrancy we are seeing not just in the chemical business as a whole, but in the industrial sector as a whole because of the fact that we are so competitive internationally now from an energy perspective and frankly from the labor cost perspective as well. So, I think that’s the bigger story. We haven’t seen it play out in the numbers yet, but as I said in my earlier remarks about the pipeline of businesses that we have that is willing to locate next to CSX’s track that has probably never been as vibrant it is today, but I think as a reflection of our longer term trend, it’s really going to be beneficial not just in CSX, but the industry as a whole.

Rob Salmon - Deutsche Bank

Right, certainly. Volume is always railroads friend as we look out. Can you talk a little bit more about the intermodal growth that we have seen quarter-to-date? I think you had mentioned it was roughly balanced between domestic and international. From the international side, is this kind of do you think it’s pull forward from potential uncertainty on the West Coast port side and domestically it is new customer wins, it is just overall model changes that we are seeing take place?

Fredrik Eliasson

We don’t think the pull forward is that big of an issue at this point. On the domestic side and frankly on the international side, there has not been a lot of contracts that have been going back and forth between us and our competition. Domestic side is really just the story around moving stuff off the highway over to rail base solution, in conjunction with the tuck-in partners. And we grew that business 7% over last two years of our domestic intermodal business and we expect that we are probably in that same range this year and for many years to come. We think that is that sort of an opportunity for us to really partner with the trucking companies solving some other strategic challenges and in the meantime obviously capitalizing on that economically ourselves.

Rob Salmon - Deutsche Bank

And we have been hearing a lot from the trucking partners that truck pricing is going up. Can you remind us that the opportunities for CSX looking out into the back half to reprice some of the intermodal?

Fredrik Eliasson

Yes. We don’t see the same sort of swings that the trucking industry was seeing, because we do have generally annual contracts, but obviously as the rates come up, their index is in place to capture that over time. And so we have known that this is going to have, they have to come, because of the driver turnovers and some of the degradation of productivity that they are seeing because of regulation and we don’t – we think this is a longer term trend, not just the first quarter as we clearly was accelerated because of the capacity constraint in the first quarter, but fundamentally we think rates have to come up and we are seeing the benefits of that not just intermodal business, but frankly some of our other markets as well.

Rob Salmon - Deutsche Bank

It makes sense. Well, thank you so much for the time.

Fredrik Eliasson - Chief Financial Officer

Thank you.

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