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Executives

David Baggs - Asst VP, IR

Michael Ward - Chairman, President and CEO

Clarence Gooden - Chief Sales and Marketing Officer

David Brown - COO

Oscar Munoz - CFO

Analysts

Scott Group - Wolfe Trahan

Ken Hoexter - Bank of America Merrill Lynch

Tom Wadewitz - JPMC

Scott Flower - Macquarie Research Equities

Bill Greene - Morgan Stanley

Scott Malat - Goldman Sachs

Gary Chase - Barclays Global

Chris Ceraso - Credit Suisse

John Larkin - Stifel Nicolaus

Cherilyn Radbourne - TD Newcrest

Jason Seidl - Dahlman Rose

Walter Spracklin - RBC Capital Markets

John Mims - BB&T Capital Markets

CSX Corp. (CSX) Q3 2010 Earnings Call October 13, 2010 8:30 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the CSX Corporation third quarter 2010 earnings conference call. (Operator Instructions)

For opening remarks and introductions, I would like to turn the call over to Mr. David Baggs, Assistant Vice President of Investor Relations for CSX Corporation.

David Baggs

Good morning, everyone, and again welcome to our third quarter earnings call. The presentation material that we will 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; David Brown, Chief Operating Officer; and Oscar Munoz, Chief Financial Officer.

Now, before 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 carrying presentation on Slide 2. And again, as a reminder, the presentation slides are also available on our website. This disclosure identifies forward-looking statements and risks and uncertainties 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. With 28 analysts covering CSX, I would ask, as a courtesy to 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 Ward

Thank you, David, and good morning everyone. Last evening, we were pleased to report record third quarter results, supported by an economy that continues to improve and another strong performance by our employees.

Third quarter earnings per share were $1.08, up 48% from the same period last year. Revenues increased 16% to nearly $2.7 billion with approximately two-thirds of that increase coming from higher volumes. We adopted higher traffic levels profitably as our employees continued to improve safety and efficiency while delivering reliable service to our customers.

The combination of higher revenues and continued productivity resulted in a 39% increase in operating income from the prior period and a 490 basis point improvement in our operating ratio to 69.1, a significant milestone for the company.

This continued strong performance allows us to return value to our shareholders and we remain committed to delivering that value through our balanced approach.

You will recall that on September 29, CSX Board of Directors announced an 8% increase in our quarterly dividend on the company's common stock. This marked the eighth increase during the past five years. By the end of the first quarter of 2011, we also expect to complete the repurchase of nearly $650 million worth of shares, representing the remaining balance under the $3 billion buyback plan announced in March of 2008.

And finally, we are increasing our capital spending in 2010 from the previously announced $1.7 billion to approximately $1.8 billion for projects that will create competitive advantage for our customers, efficiently grow the business, create jobs and deliver shareholder value.

The leaders with me today are proud of what CSX is accomplishing and we are confident that we are doing the right things to create even more value for our customers and investors.

With that, let me turn it over to Clarence for an overview of our topline performance in the quarter.

Clarence Gooden

Thank you, Michael, and good morning everyone. In the third quarter of 2010, an improving economy helped almost all of the markets that we serve recover from the lows experienced during 2009.

As I did during our second quarter earnings call, let me share the latest results from two key business reports. As you can see in the chart over the left, the manufacturing sector expanded again in September, as reflected, and are reading 54.4 from the Institute for Supply Management's Manufacturing Purchasing Managers Index. Recall that a reading above 50 indicates growth. This is the 14th consecutive month that the index has reflected an expanding manufacturing sector.

At the same time, inventories remained below target levels. And the chart to the right, the September ISM report on Customer Inventories, which assesses manufacturers' views of the adequacies of inventories, yielded an index score of 42.5; where a score below 50 indicates that respondents believe that customers' inventories are too low.

As the economy and our traffic levels continue to improve, we are committed to delivering a safe and reliable service product and we remain focused on capturing the value of our services.

Now, let's look at the change in revenue for the third quarter on the next slide. CSX revenue increased 16% to nearly $2.7 billion due to volume growth, core pricing gains and the impact of higher fuel costs reflected in our fuel surcharge program. As you can see on the chart, volume increases drove $225 million of year-over-year revenue growth.

Also, the combined effect of rate and mix accounted for $114 million of the increase, reflecting yield gains across all markets as we continued to sell the value of rail transportation.

Finally, as you look further to the right, the impact of higher fuel cost increased our fuel recovery $38 million in the quarter.

Let's turn to the next slide and take a closer look at volume growth over the last few quarters. Total volume of 1.6 million units was up 10% versus the same period last year. As you will recall, the U.S. economy began growing again in the third quarter of 2009, and despite the tougher year-over-year comparison, overall volume growth in the third quarter remains strong.

You can also see on the chart that total carloads also grew sequentially versus the second quarter despite what is normally a lower volume quarter due to seasonality. Finally, as you will see in the slides later in my discussion, each of the major markets grew versus the prior year.

Now turning to Slide 10, revenue per unit increased by 6% driven by price and increased fuel recovery which were partially offset my mix changes. The largest component of the increase, same-store sales pricing, increased 6.6%. Recall that same-store sales are identified as shipments for the same customer, commodity and car type, and the margin and destination.

These shipments represent approximately 75% of our total traffic base. In addition, the increased fuel recovery accounted for approximately one-fourth of the change in revenue per unit. In addition, you will notice the higher revenue per unit, 2008; that resulted from much higher fuel prices than exist today.

Finally, partially offsetting these two drivers was the effective mix changes that resulted from strong growth and lower revenue per unit intermodal traffic and a continued impact from terminating a prior interline intermodal agreement.

Our improvement continues to reflect the unique value CSX is providing to our customers as well as the relative value of rail transportation. Looking forward, we continue to expect core price increases to exceed rail inflation on a sustainable basis.

And now let's take a look at each of the major markets that we serve, starting with coal. Coal had third quarter revenue of $835 million, up 23% versus 2009. Revenue per unit increased on improvement in yield, higher fuel recovery and positive mix. Volume also increased 3%, driven by several factors:

First, export coal grew year-over-year as demand was strong for U.S. metallurgical coal to Asia and Europe. Second, in the industrial sector, North American metallurgical coal, coke and iron ore volumes grew on stronger steel production. Yet domestic utility demand remained lower year-over-year due to above-normal utility stockpiles.

These stockpile levels continued to moderate from their peak in 2009, helped by an increase in burn levels. Electrical generation increased nearly 9% in CSX-served territories during the quarter.

Turning to the next slide, let's look at the merchandise market. Merchandise had a third quarter revenue of over $1.4 billion, up 15% versus 2009, driven by a 7% increase in volume and 8% higher revenue per unit. As I discuss the quarter's results, let me provide you with a brief overview on this slide, followed by a more detailed discussion on the slide that follows.

First, we achieved growth in the agricultural sector, primarily driven by increased shipments of feed, fertilizers and ethanol. Next, the industrial sector experienced significant growth due increased auto sales and the improving economy. And finally, the housing and construction-related markets remain challenged when compared to historical levels.

Now turning to the next slide, let's look at each of these sectors in a little more detail. The merchandise market showed growth across all three sectors. For the agricultural sector, fertilizer, inventory replacement continued in the third quarter. Feed grains and wheat shipments also improved, as improved global demand led to new opportunities.

Finally, ethanol volumes grew 5% during the quarter on increased consumption. Within the industrial sector, the 54% growth in the automotive revenue was the primary driver of the 23% overall improvement in revenue. This increase in auto production as well as pipe and plate shipments for energy infrastructure drove the growth in metal shipments.

Lastly, in the chemicals market, plastics and chemical intermediates grew on a greater need for autos and consumer goods, while petroleum products and industrial sand markets also experienced gains in volume.

Finally, within the housing and construction sector, forest product volumes continued to be affected by weakness in construction and paper related markets. In our emerging markets, while shipments of aggregates were flat, volume growth was driven primarily by new shipments of limestone and cement.

Now turning to our intermodal results, intermodal had third quarter revenue of $318 million, up 6% versus 2009 driven by a 19% increase in volume which was partially offset by a 11% decline in revenue per unit. International volumes grew again this quarter, up 43% due to U.S. inventory replenishments and early pre-holiday shipping, as well as new volumes from international customers we gained because of our strong portfolio of service and network offerings.

As a result of this strong growth, international volumes represented half of CSX intermodal shipments for the quarter. Total domestic volumes grew 2% year-over-year.

During the quarter we saw strong highway freight conversions across the majority of our domestic customer base. However, we did experience a significant year-over-year decline in one of our largest private asset customers. Without the impact from that one customer, the domestic market would have grown at a double digit rate in the third quarter consistent with the growth we have seen earlier this year.

Turning to revenue per unit. While intermodal secured price increases in both its core businesses and had slightly higher fuel recoveries, this was more than offset by the impact from the revenue per unit associated with the termination of a prior purchased transportation agreement which is I discussed in detail last quarter.

Going forward, you should expect to continue seeing the revenue per unit mix impact for the next two quarters before we began cycling this event in the second quarter this year.

Now let's turn to the next slide and discuss our fourth quarter outlook.

Looking forward, we expect the ongoing economic recovery to continue driving growth. The chart that you see on the left is based on our outlook for line-haul revenue on a comparable basis which excludes the impact from fuel recovery. Our year-over-year fourth quarter revenue outlook is favorable in nine of our 10 markets and neutral in one.

In coal, we expect the strength in both the industrial sector and in exports to continue in the fourth quarter. With export tonnage still expected at about 30 million tons for the year. Utility demand in the fourth quarter is also expected to be favorable year-over-year. In our merchandise market, we expect growth during the fourth quarter across two of the three sectors that we serve.

Within the agricultural sector, volume growth is expected to continue being driven by increased shipments of fertilizer, feed and ethanol. Within the industrial sector, volume growth should continue to be driven by increased metals and chemicals shipments.

Finally, the housing and construction sector is expected to continue to show softness related to slow growth in the new housing starts and infrastructure projects. In addition, movements of military shipments is expected to slow year-over-year. These are the primary drivers in our neutral outlook for emerging markets.

Our intermodal revenue outlook is favorable after adjusting for the impact of terminating our prior interline agreement. The army impact of the agreement, we see opportunities for continued volume and price growth in both our international and domestic lines of intermodal business. We expect the pace of imports to remain strong. We expect to see continued strength in our rail asset domestic market segment from over the road freight conversions in the fourth quarter.

And consistent with our market-by-market outlook, U.S. industrial production is expected to grow 4.9% for the fourth quarter of 2010.

That said, our network is well positioned to handle the volume growth, as we have handled these higher volumes in the past. And we are well prepared to continue providing the service and reliability required by our customers.

At the same time, we continue working closely with our customers to develop new business opportunities. And we are making significant investments in our network such as the National Gateway Initiative. As you can see in the map on the right side of this chart, our year-to-date industrial development efforts have resulted in 83 new announcements or expansions across our network. Given what we are accomplishing, we remain confident that CSX stands out as a compelling value for customers especially as they see transportation providers that also offer environmental solutions.

Thank you, and now let me turn the presentation over to David to review our operating results.

David Brown

Thank you, Clarence, and good morning, everyone. As we have said before, leadership, discipline and execution continue to be the foundation of our company's strong operational and financial performance. During the third quarter, our operating team once again drove improved safety results, solid productivity and consistent network performance. We delivered another quarter of year-over-year improvement in FRA personal injury and train accident frequency as we continue to be a leader in one of the nation's safest industries.

Productivity gains contributed to record fiannaical results, including the operating ratio, which as Michael mentioned, improved 490 basis points to a record 69.1%.

Finally, our network remained fluid and key service measurements remain stable. Now let's look at some of the details.

Slide 18 shows FRA personal injury and train accident rates over the last four years. In the third quarter, the personal injury rate improved 8% versus the prior year to 1.06%. This marks the sixth consecutive quarter that we have registered year-over-year improvements. Looking at train accidents, the third quarter frequency rate improved 13% to 2.25%. This quarter's excellent safety results were achieved through affective leadership and a sustained effort by all of our employees. While we are pleased with this progress, we hold ourselves mutually accountable for continuous improvement. And our goal for personal injuries and train accidents is zero.

Now let's look at our service improvements on Slide 19.

Overall, the network ran well during the quarter. On the left side of the chart, On-Time Originations and Arrivals both declined year-over-year, but remained within the ranges experienced over the last several year. And they continued to support efficient and reliable train operations for our customers. On the right side of the chart, Train Velocity fell slightly and Dwell increased modestly, but the network remained stable as volumes continued to build in the quarter. although, overall performance is solid, we are focused on taking service reliability to even higher levels for our customers.

Moving to Slide 20, let's look at crew resource levels. This chart says the year-over-year change in the volume and crew starts, and reflects the operating leverage evident in our quarterly financial results. Here, the 10% volume increase in the third quarter is reflected in the gold bar on the chart.

Moving down the chart, road, local and yard crew starts did increase in the quarter but at a rate below the volume increase. When feasible, incremental volume was added to existing trains using available capacity and avoiding additional crew starts. As a result, total crew starts increased 6%, which is below the 10% increase in volume. This operating leverage was particularly evident in our intermodal road starts, or a 19% year-over-year increase in volume was handled with just a 10% increase in crew starts.

Moving to Slide 21, let's look at resource versus historic levels. This chart shows the number of active train and engine employees and locomotives deployed in the third quarter over the last five years. Resources have increased to support higher business levels in the quarter.

However, you can also see that they both remain well below the peak levels of 2006. As Clarence mentioned earlier, we have handled higher volumes in the past and we clearly have room to grow.

As the volume continues to build, we will take advantage of opportunities to drive further productivity, while at the same time managing resources closely to meet customer needs.

Let's move to Slide 22 and look at the record operating ratio improvement driven in part by effective resource management and productivity. Slide 22 shows the continuous improvement in our third quarter operating ratio over the last five years, ending with the record level achieved in 2010. This improvement is partially driven by effective management of resources, as volume returned to our network that we discussed earlier.

In addition, we continued to rely on our cross-functional process improvement teams to maintain and deliver a pipeline of productivity initiatives. We have also been successful in leveraging technology to drive productivity gains.

In 2010 alone we have installed automation technology in nearly 20 yard locations. Lastly, our Total Service Integration or TSI initiative that we have talked about periodically continues to drive efficiencies in unit train link.

As we progress our newer TSI carload phase, we would drive efficiencies in our local operations while providing customers with first and last mile service improvements. Let's take a look at some of the areas where we have invested in our network to gain efficiencies in 2010 on Slide 23.

The gold markers on this map indicate areas where we have invested in line and yard capacity to improve fluidity at key points on our network. The green marker and highlighted portion of our network represents the newly-opened Liberty Corridor Freightway.

As announced last week, this major public-private partnership enables double-stack intermodal freight to flow from the port of New York and New Jersey to inland destinations. The project will increase train capacity, improve service levels and expedite freight flows to and from inland ports. It will also help keep thousands of trucks off crowded highways each year.

The blue markers indicate yard locations where we have implemented automation technology in 2010 as I referenced in the previous slide. This technology, including remote control operations and automated switches, yield further productivity in the quarter.

As we prepare to handle future growth, we will continue to invest in projects like these that support capacity, fluidity and productivity. Now let's wrap up on Slide 24.

Looking forward, we will build on our safety performance as we pursue our ultimate goal of zero injuries and accidents. We will continue to drive productivity, control cost and manage resource levels closely as volumes grow.

Finally, the network will remain stable, fluid and efficient while providing more reliable service for our customers. Our employees continue to hold each other mutually accountable for providing reliable service safely and efficiently, which delivers value to both our customers and our shareholders.

Now let me turn the presentation over to Oscar to review the financials.

Oscar Munoz

Let's start with an overview of the quarter's results starting at the top of Slide 26. As Clarence discussed earlier, revenue improved 16% to nearly $2.7 billion. This, coupled with the continued strong cost management David and the operating teams delivered, yielded a 39% increase in operating income for a record $825 million.

As you look below the line, interest expense was favorable by $9 million, primarily the result of lower average debt balances, and income taxes were $288 million in the quarter, mostly the result of higher earnings.

Now while our normal effective tax rate is approximately 38%, this quarter's rate was about 41% due to a $22 million income tax charge, which is described in more detail in the quarterly financial report. All in, we finished the quarter with a reported EPS of $1.08, an improvement of 48% versus last year.

So with that as background, let's review our expenses in more detail, starting with labor.

Labor expense increased 12% or $78 million from last year. As mentioned in previous calls, CSX and the rail industry continue to face wage and healthcare costs that are well above inflation. The impact for CSX in this quarter was $34 million.

The second driver was an increase in incentive compensation of $30 million, driven by our strong earnings performance this year. You may recall that this program is available to management employees and the portion of our union workforce that have performance-based agreements.

Finally, we also incurred $14 million from cost associated with ongoing rules-based training over time and new hire training and development. Going forward, we expect headcount to increase by about 1% to 2% in the fourth quarter as we continue to hire ahead of attrition and support further volume growth.

Moving to Slide 28, MS&O expenses increased 2% or $9 million versus last year. If you look at the table on the right, the largest driver relates to the inland transportation costs, which were favorable by $44 million.

As Clarence reminded us earlier, this relates to the termination of a prior intermodal interline agreement and results in a quarterly reduction in revenue as well as a corresponding reduction in operating expense.

Going forward, you should expect to continue to see this impact for the next couple of quarters, and we'll begin to cycle this event in the second quarter of 2011.

The second driver in MS&O was a $24 million increase in volume-related expenses. And additionally, we are cycling about $18 million of prior year gains, including the settlement of legal disputes and favorable credit resolutions.

Finally, there was an additional $11 million of other items which we do not expect to repeat.

Moving to Slide 29, total fuel cost increased $56 million or 25% versus last year. Look at the table on the right. Increased fuel prices accounted for $34 million of the year-over-year change, as CSX's average cost per gallon climbed to $2.17, an increase of about 15%. Higher volume accounted for $15 million of incremental expense, and non-locomotive fuel increased by an additional $3 million.

The chart to the left highlights fuel efficiency as measured by gallons per thousand gross ton miles. You can see fuel efficiency decreased 2%, which translates to a $4 million expense increase for the quarter.

Now we move to the next slide. We will review the remaining expenses.

Beginning with depreciation, these costs increased $5 million year-over-year, and the net increase in our asset base was partially offset by lower depreciation rates from the life studies completed in the fourth quarter of 2009.

Moving to graphs, expenses declined $2 million. Here, the higher costs associated with volume were more than offset by improved utilization of our fleet and the reduction of some long term freight car leases.

Now that we have reviewed our expense items in detail, I'd like to provide an update on dividends and share repurchase as we move to Slide 31.

With the increased earnings and an improving financial position, we remain committed to balanced deployment of cash for our share owners. As Michael mentioned earlier, we recently announced an increase in our quarterly dividends of $0.26 per share effective with the fourth quarter payout.

This is the eighth increase in our dividends since 2005 and represents a 35% compounded annual growth rate over the five-year period.

I would also like to update you on our share repurchase program. During the third quarter, we repurchased an additional $300 million or about 5.7 million shares of our common stock.

The year we repurchased over $1.1billion or more 21 million shares. Going forward, we expect to complete the current share repurchase program which is nearly $650 million remaining under our existing authority by the end of the first quarter of 2011.

Now I would like to talk a little bit about CapEx. As mentioned earlier, we expect our 2010 capital spending to increase from $1.7 billion to approximately $1.8 billion. These incremental investments leverage an improving economy and positions CSX for long term growth. This new capital is focused on strategic investment with the support of our strong growth in our intermodal business and investment in our rolling stock which helped further drive productivity.

With these investments, we will be able to more effectively serve the growing needs of our customer, improve efficiency and drive earnings growth in margin expansion. As such, we expect these investments to generate significant returns well above our cost of capital.

I have to wrap up. For the quarter, we continued to see growth in nearly all (technical difficulty). The underlying fundamentals of our business remain positive. And they are evident in the double digit volume growth that we delivered this quarter. Our operating team effectively handled this growth while maintaining service levels. And we will continue to bring back surplus resources to handle the additional growth.

Overall, we continue to produce solid results and are committed to our balance towards cash deployment. CSX's third quarter financial performance demonstrates our sustained focused on delivering value for our customers or our share owners.

Finally, and as a reminder, CSX follows a 52-53 fiscal reporting calendar. To maintain this type of reporting calendar every fifth or sixth year, an extra week is included in fourth quarter. 2010 is such a year and therefore we will report the quarter on fourteen weeks of activity and the fiscal year on 53 week basis.

The effect of this is to include an additional week so the year will end on December 31. This extra week is during the holiday period and is historically one of a lowest in both volume and a revenue perspective.

So with that, let me turn to the presentation back over to Michael.

Michael Ward

Well thank you, Oscar. For the past several years, CSX employees have been sharply focused on serving customers while delivering strong financial results by our share holders. As our markets continue to rebound, we're sticking to our game plan. And our excellent results in the third quarter reflect that commitment.

We see even greater opportunity for CSX as the country relies more and more on environmentally friendly railroads to handle its trade. Just last month, the Federal Railway Administration highlighted the incredible efficiencies freight railroads have produced since the Staggers Act was enacted thirty years ago and the savings that have been passed on to shippers.

Not surprisingly, hundreds of transportation experts and stakeholders who were consulted for the FRA report concluded that the freight system must not be harmed as a national rail policy is implemented.

Thirty years ago freight railroads were bankrupt, and lacked the investment to operate safely, efficiently or reliably. Today they are healthy enterprises that are investing record levels of capital into their networks, helping drive the nation's economic recovery, and employing more than 150,000 people with excellent pay and benefits.

Our customers and their customers have been the real winners as average adjusted rail rates have declined by half since the passage of the Staggers Act in 1980.

In today's economy, the nation should embrace these benefits. Policymakers should make certain that future legislative and regulatory actions do not in any way recreate the dysfunction of the pre-Staggers years.

We are committed to working to maintain a balanced regulatory environment that lets us create competitive advantage for our customers, good jobs for hardworking Americans and value for our shareholders.

A steady improvement in the economy will give us an even greater opportunity to demonstrate outstanding results and to further deploy our capital to enhance our network and reward shareholders.

We believe CSX delivers terrific value for investors. We provide a critical service to a wide range of customers. We have a cultural and a track record of results, and we are ideally positioned in the growing marketplace.

With that, we'll be pleased to take your questions.

Question-and-Answer Session

Operator

Thank you. We are now be conducting a question and answer session. Our first question comes from Ed Wolfe of Wolfe Trahan.

Scott Group - Wolfe Trahan

It's Scott Group in for Ed. First, Clarence, wanted to ask you about export coal. You talked about 30 million tons of coal for the year. At this point, what are you thinking about for 2011? Do you think it's up or down from that? And wondering if you think the coal that you sent to China this year and Asia, is that sustainable into 2011?

Clarence Gooden

We are not prepared today to give guidance for 2011.Our export market is still strong. We are on track as we said to reach the 30 million tons. The coal volume levels this year are in line. We're in the process now putting together that 2011 plan and as that becomes more clear, we'll give you that information.

Okay. And, Clarence, you talked about an early peak season in intermodal. Are you seeing any signs of an early end to peak season? Or do you think we stay strong through forth quarter? And then separately with the domestic intermodal, the lost contract, can you talk about the magnitude of that, and then the timing for when that grandfathers?

Clarence Gooden

Well, first question there on peak intermodal season, we actually saw it started in a traditional timeframe. This year, it started in August, stayed strong in September. Continued strong in October and traditionally, Scott, as you know it tails off towards thanksgiving. And then our premium intermodal services start to kick in for their fall peak from thanksgiving into Christmas.

So, we see that moving along those lines very well. As you know, we don't give particular information out on a single customer other than this case to say that customers decline, we would have been in double digits in our domestic intermodal growth.

Operator

Ken Hoexter of Bank of America Merrill Lynch, you may ask your questions.

Ken Hoexter - Bank of America Merrill Lynch

Great job on the incremental margin, so let me dig into that a little bit, because I know, Oscar, last quarter you had talked about how strong you thought you were going to see that continue through the end of the year. So when you think about this capacity out on the sideline, how do you think about that as you bring on equipment?

And I guess, I had there because it looked like on one of the slides that Dave was talking about, it looked like you are starting to get some lower fuel efficiency, is that because you are adding some lower efficient locomotives? If you can just talk a little bit about the incrementals?

Oscar Munoz

First, on the fuel efficiency, that is correct. It's a little bit of the old equipment coming on board. But let me answer the broader question of incremental margin and what if that continues? The answers absolutely, unequivocally, yes. We'll be able to maintain that strong over the near term. And we'll provide kind of a longer term view early next year. But again, strong showing for us.

Ken Hoexter - Bank of America Merrill Lynch

I guess maybe more to Mr. Brown on the service side, it looked like your numbers were starting to come in because the volumes are increasing. At what point does that start to concern you in terms of what Oscar's talking about on the incremental margins continuing? Where should we start looking and then saying well the volumes are driving that boat, but we got to start getting concerned because there's more congestion?

David Brown

That's really not at the level we are today, concerned. I mean we feel we're like in a solid range in terms of those measurements, and our performance overall. So as we see volume come back where it is at this point, it's really at a level where we see it at a very sustainable high level of service.

Operator

Tom Wadewitz of JPMC, you may ask your question.

Tom Wadewitz - JPMC

I guess I wanted to get your view in terms of insights on pricing for next year. I know you've maintained this inflation plus view. But I don't know if you can compare what you are seeing in contracts to what you would have seen in the last couple of years or any additional insight in terms of what the contract repricing looks like at this point for 2011?

Clarence Gooden

We expect economy to have good slow steady growth in 2011. And we expect our pricing will remain above rail inflation.

Tom Wadewitz - JPMC

Perhaps, a question on a different topic. You said you don't want to give guidance on export coal. Can you directionally talk about utility coal in 2011? If you're at target stockpiles now, is there pretty good chance that you see some growth in utility volumes as you look to 2011?

Clarence Gooden

Again, we are in the process putting together the 2011 plan at a very high level. Stockpiles will begin to build in the shorter period as we're going through now. Having said that, it's going to be weather dependent on what happens in 2011 and we hope for a cold winter.

Operator

Scott Flower of Macquarie Research Equities, you may ask your questions.

Scott Flower - Macquarie Research Equities

Maybe, this is one for Clarence and following up to Tom's question. Stockpiles have come of their peaks from '09. But, still, if you look over the last over years in aggregate, there're still at fairly high level versus what they were mid decade. And obviously, you have more granularly in what you think your customers stockpiles are.

How do you customers view what the right level of stockpiles are? So although they're down from '09, that seemed to be a zenith level. And I am just wondering how do they view what's the right level of stockpile?

Clarence Gooden

Scott, it varies from utility-to-utility based upon their philosophy, is the first point. The second point in there is, is that if you look at where the stockpiles are currently, they're really at about 2008, late 2007 levels. And the third factor that comes in is the contractual commitments that the utilities had to take and to receive coal.

Scott Flower - Macquarie Research Equities

What I was wondering is, did they think '07-'08 is the right level? Or is earlier the right level? I am just trying to get a sense of do they want a higher level of inventories than where they've been, perhaps, in the middle part of the last decade?

Clarence Gooden

I think the answer would be that, by and large, the broad base would be like a higher level of inventories that they had had in the middle of the decade.

Scott Flower - Macquarie research Equities

And then one very quick follow up, I know you don't talk about specific customers, but the blip with that one asset base is that work its way through or is that going to continue into the fourth quarter?

Clarence Gooden

It could be possibly in the early part of the fourth quarter before it fully cycles itself.

Operator

Bill Greene of Morgan Stanley, you may ask your questions.

Bill Greene - Morgan Stanley

Oscar, back in 2008 I think you said at the investor day you'd get to sub-70 OR. And we're there and we're talking about strong incremental margins from here. So how do we think about a sustainable margin level as you look out a few years? How much better can it get?

Oscar Munoz

Well, we're always trying to build on our great results as you know, and in this quarter it's certainly consistent with that. And so in the near term, we'll continue to focus on the fundamentals that have been driving us. And we're not going really project too much of a ratio. But having said that, longer-term, this railroad can and will operate below 70% on a consistent basis.

Bill Greene - Morgan Stanley

Clarence, just a couple of clarifications on pricing. Can you remind us, at this point in the year I think you usually have a fair amount of the business locked in already. Is that the case this year? And I have in my notes that you did start a little bit of legacy re-pricing, but has that all been taken care of now or is there anything left?

Clarence Gooden

Bill, it's very negligible number on legacy pricing left and most of that's in out years, 2012, 2013. And we have about 75% of our pricing for next year locked up at this point, which is about typical for this time of the year.

Operator

Scott Malat of Goldman Sachs, you may ask your question.

Scott Malat - Goldman Sachs

You gave a very good positive outlook for coal. I just wanted to understand natural gas substitution impacts. As net gas prices have come down, it seems like electricity demand is up. So maybe that helps you out, and maybe won't be as much of an impact as you've seen before. But why don't you comment on that?

Clarence Gooden

Well, in the fourth quarter we don't expect it to have a lot of material impact on what our utility coal is going to be, again because of the contractual commitments that our utilities have as well as the fact that the burn in our region is up. Now having said that going forward is going to be dependent on how much natural gas will replace the baseload coal.

Scott Malat - Goldman Sachs

At these prices, are we at the point now where it starts to have an effect or does it to have to go lower from here?

Clarence Gooden

You're at a point now where it will have some impact.

Scott Malat - Goldman Sachs

And then just another question I just had on CapEx. If you can give a little more specifics, anything you can give us on intermodal investments you found that are incremental, and then maybe something on the number of locomotives you expect to purchase. That'd be helpful. Thanks.

Oscar Munoz

On the intermodal side, it's a sort of broad-based investment from facilities, from yard expansions, from technology, from containers. So it's across those areas. We are not purchasing any new locomotives this year, 2010. We will purchase about 50 of them next year.

Operator

Gary Chase of Barclays Global, you may ask your questions.

Gary Chase - Barclays Global

If I could ask Oscar or David or maybe some combination to maybe just step back and walk us conceptually through what you think is enabling you to generate the cost outcomes that seem to be coming during the course of this year. And I think more importantly to me, the question I have is, is it really contingent on further volume gains? Or might we think even in a flattish volume environment, the kinds of productivity initiatives you're describing could actually drive unit costs down and you could relate it to inflation without having incremental volume on the network.

Oscar Munoz

Those are a lot of questions. So let me stick with the broad-based question which is, what is contributing to our strong cost management that's there.

Gary Chase - Barclays Global

I mean, just what's the conceptual driver outside the mix in the line items. What is it broadly that's enabling you to generate this outcome?

Oscar Munoz

This will sound trite, but it is a growing and great culture around running a great sound, efficient and safe business. And we've been doing that for a long period of time. And starting with Tony and continuing with David Brown, the culture around these cross-functional initiatives that David Brown mentioned in his talk, the levels of work that are going on, buying, areas of efficiency and asset utilization along with productivity are just throughout our entire system, and they are finding a ton of places to go find cost. And that just continues everyday and it's just a culture that we have. And that's something that's new over the last few years for this company. That's the fundamental driver.

Gary Chase - Barclays Global

As I hear you describe that though Oscar, it just kind of occurs to me that that doesn't necessarily require volume growth. I mean, is that a fair statement? So volumes are not that impressive; might we think you could continue to drive unit costs down?

Michael Ward

I guess Gary, I would point to 2009 where our volumes were down 15%. And we got not only our normal productivity, but additional extraordinary productivity. So I think we've shown that in a down period we can drive the productivity and in an up period we can drive the productivity, and we will continue to do so.

Oscar Munoz

And then even as a further reminder, back to 2008, before the financial meltdown, we gave you guidance of sub-70 by the end of 2010. And we said then very specifically that it was not necessarily predicated on lots of volume growth. And so it's certainly part of the equation, and we love to have it. And we love to grow our business organically. But cost management and the culture is all about being efficient and productive, regardless.

Operator

Chris Ceraso of Credit Suisse, you may ask your questions.

Chris Ceraso - Credit Suisse

First, the intermodal business was one where you did see very strong incremental margins. Can you give us a feel for how much extra capacity you have left in that network in particular?

Clarence Gooden

We are seeing that as we bring on additional business there, we still want to stick with about 15% to 20% more additional capacity available for productivity in our existing train network. And we're seeing that we can absorb these additional volumes very easily.

Chris Ceraso - Credit Suisse

Okay. And then maybe a little bit longer term, you did mention that in the near term you expect about a 1% to 2% increase in headcount.

But if you look at it over the next three years or so, what's the expected attrition rate? And how many of those, may be as a percentage do you have to replace? Can you replace less than 100% because you improved productivity, you take advantage of technology and so forth that we can kind of net shrink the headcount over the next few years.

Michael Ward

I would think, if we look at it a little bit, as you know, in our industry at age 60 with 30 years of service, one can retire, and many of our employees choose that option. So we expect probably attrition in the 6% to 7% range over the next several years. And obviously, we'll have to hire some of that back, but not fully, because Dave's going to continue to improve productivity and find better ways to run.

So we're going to have strong attrition, do some strong hiring. This year actually, we're going to end up hiring about 2,000 people to replace that attrition. And next year, we may be more in the range of 3,000. So we do have a changing work force.

Operator

Justin Yagerman of Deutsche Bank, you may ask your questions.

Unidentified Analyst

This is (Rob) on for Justin. One of the things which jumped out to us is an increased CapEx to $1.8 billion. Could you give us a sense if we can read more into your decision to increase CapEx by $100 million and if this has any implications on the rail regulatory backdrop?

I know Michael had alluded to kind of the regulatory environment briefly in his prepared comments. And we're also curious what else you're hearing right now?

Michael Ward

Well, Rob, I think if we look at it, obviously we're very pleased with the results here. And as you know, we continue to have a balanced approach. We took up our dividend; we're increasing our buyback or completing our buybacks really. And we think investing in the business is pretty important. So we've told the policymakers all along as we make more, we'll invest more.

Because there is a great future for our industry and for our company, and we have the cash flows to support it. On the broader aspect around potential regulation, we really do believe that policymakers are going to understand the importance of the railroads to this economy. Because if we are, in effect, hindered in our ability to invest, we're going to stop building, it'll stop job creation, it will be negative for the environment and really take away the competitive edge that some American companies have. Because we do have the best freight system in the world, great rail system in the world.

So we have, when it's all said and done, the policymakers will understand that. So this is just consistent with what we've been doing all along which is, as we earn more, we invest more, and we return to our shareholders.

Unidentified Analyst

Shifting gears to intermodal. Certainly, we've got the headwind from the contract change. But looking sequentially from Q2, the intermodal yield declined modestly, I think this is primarily a business mix thing, given the increase in international car loads.

Could you give us a sense how you balance the pricing improvement? And on international, with kind of getting longer term volume visibility?

Clarence Gooden

Let me make sure I understand the question correctly. How do we balance what now?

Unidentified Analyst

I guess, how are you guys balancing the longer term volume visibility that you guys can get with getting new international contracts versus looking kind of near term to the pricing improvement? And how do you guys balance this, use dynamics?

Clarence Gooden

First off, we were able this year to get pricing in both our international business as well as in our core business. And what we look at with the longer term contracts on our international traffic is the overall value it can bring not only to our sale, but to our customers. And with the network improvements we're making in our infrastructure, the National Gateway, for example being one, our Northwest Ohio terminal facility which we'll have completed in the first quarter of next year is giving us opportunities to get into markets that are very profitable to us, very attractive to us.

And a density that is being created there has produced very strong economic results for us. So the bottomline for us is we feel very positive of that direction that intermodal is moving in.

Operator

John Larkin of Stifel Nicolaus, you may ask your questions.

John Larkin - Stifel Nicolaus

I wanted to get a little more color on you thinking regarding the potential for a public policy here. A couple of weeks ago, Senator Rockefeller held a hearing and continued to suggest that he was going to push for a legislative adjustment here. If he couldn't get it done in this Congress he is going to push again in the next Congress. And sort of the suggestion was that if a legislative remedy wasn't possible he was going to suggest that perhaps the STB Commissioners' led by President Obama's appointee Dan Elliot would perhaps make some of these changes administratively within the STB.

Is that a real worry? Is that something that the STB has the potential to do in terms of addressing issues like paper barriers, bottlenecks, terminal access, reciprocal switching, those sorts of complicated competitive issues?

David Brown

Well, John, they address both issues. On the legislative side, we continue to be willing to work with Senator Rockefeller in the Congress Committee to see if there is a Bill that's possible that allows some of those desires to be met and still allows us to earn sufficient returns to continue to invest. And Senator Rockefeller himself has said he realized the importance of the rails making enough to make those investments for the long term.

So we are still in a position as an industry where we are willing to engage in that dialogue and it probably will continue next year in the next Congress.

On the regulatory side, I think we've seen over the last several years that the STB has been very balanced in how they work through these issues. As you know there have been a number of rate cases where their mediation process has worked extremely well in resolving some of these issues where the railroads and their customers have different points of view.

Obviously they have the ability to look at issues like competitive access and exceptions and those sorts of things. I think Chairman Elliot did indicate that he would consider doing some of that next year. We do need to remember though that the Staggers Act, one of the key components of that is to ensure the revenue adequacy of the railroads. So that's going to have to be the overall backdrop in which those deliberations are made. And I think we obviously will be very well against an industry to make inputs into any proceeding that Chairman Elliot would initiate.

John Larkin - Stifel Nicolaus

Thanks for the answer. Just maybe one follow-on; keeping with the theme of government's interference, if that's the right word, on the TGC mandate, I've gotten the impression from some of the equipment manufacturers that they are not there yet with respect to sort of flushing out the complete plan in terms of meeting the requirements.

Any thoughts on the timetable of the spending levels required to meet the requirements and whether the technology will be there to meet the requirements by 2015?

Oscar Munoz

You are correct. There is a bit of delay across a couple of different areas with the development of the actual software and applications that are required for this.

At this point in time we will make up the time; the mandate is out there, the deadline is out there, and we're focused on spending the money in that appropriate fashion. But, yes, in the near term, there's a little bit of delay.

Operator

Cherilyn Radbourne of TD Newcrest, you may ask your questions.

Cherilyn Radbourne - TD Newcrest

Want to ask a question on train starts. Your road crew starts in the quarter were up 8% year-over-year versus the 10% volume gain, which makes sense if we start to lap more difficult comps. But on the local and your crew starts, those are still very well-contained. So I wondered if you could just talk about some of the initiatives you have underway at the local level and in your yards to contain those costs.

Clarence Gooden

Certainly, Cherilyn. We are looking closely at our starts and how we add additional service as customers grow their business and have needs for additional service. So we're looking at a very granular level and a very responsive level to particular customer needs, and that allows us to contain, especially in the local and the yard network where we serve customers on a carload basis, as well as contain those starts within the additional capacity we have within our existing local and yard network. So you see the results of that in the measurements.

Cherilyn Radbourne - TD Newcrest

And my second question, there was a bit of a year-over-year increase in the other revenue category, and I wonder if you could just indicate whether there was anything special going on in that line?

Oscar Munoz

It's liquidated damages in a sense that is driving that up a little bit.

Operator

Jason Seidl of Dahlman Rose, you may ask your question.

Jason Seidl - Dahlman Rose

A quick question, Oscar. Very impressive on the FRA personal injury and FRA train accidents that keep going down. Can you talk to us about expectations for maybe actuarial studies sort of lowering some cost going forward and when your next study is going to come up?

Oscar Munoz

Yes, thanks Jason, and thank you for noticing that. We are very pleased with the safety trends that we do continue to improve. As you know, we do that adjustment process that you refer to twice a year, excellent, being in this fourth quarter, and that is currently being reviewed by our third party actuaries. So we'll provide an update on that as we finish through that in the fourth quarter call.

Jason Seidl - Dahlman Rose

Well, based on the trends though, we would assume that it's not going to be just upwards based on these rates?

Oscar Munoz

Again, that would be a layman's assumption, but actuaries are what they are. But yes, I think what we focus on is the safety trends improving. That's the most important thing. The accounting will take care of itself.

Jason Seidl - Dahlman Rose

Okay. That's good. And my follow-up, Clarence, in relations to the North Ohio intermodal terminal and to the new markets that can open up, can you give us a little more color? I mean I know you guys are taking out a lot of time in intermodal into New England, but how big of a market could that be for you guys?

Clarence Gooden

I think it could be extremely a big and important market for us, because what Northwest Ohio will allow us to do eastbound is overhead Chicago with much bigger and longer trains going into Northwest Ohio. And then we can serve both the entire Ohio valley, the Upper Midwest over to the mid-Atlantic and into the New England areas out of that. And conversely, on the reverse side of that as we come out of those same areas going back west, it allows us to consolidate freight back at the Northwest Ohio terminal and then overhead the Chicago lanes which will improve both in terms of capacity utilization as well as longer and better trains.

Jason Seidl - Dahlman Rose

And the opening date on the terminal's at mid-2011?

Clarence Gooden

It's end of first quarter 2011.

Operator

Art Hatfield of Morgan Keegan, you may ask your questions.

Unidentified Analyst

This is (Derek Riabian) for Art. I just want to look real quick at your rolling stock. Could you kind of talk about where you stand on your storage levels? Also, do you see any need for particular car types in the near term, and if so are those mainly still on the coal side?

Clarence Gooden

On the cars that we have stored, we have about 2000 box cars that are still in the storage. But they are mostly Class C box cars which would be good for brick loading and bulk type loading. All of our Class As are out and being utilized. And the same is true in our multi-level fleet. There are a couple of thousand cars in the automotive fleet stored, but they tend to be bi-level cars as opposed to tri-level cars that are all in use.

Then we have some gones and coal metal cars still under storage, but not as many as they were. That's driven mainly by the fact that steel capacity utilization's in the low to mid-70s. And the biggest number of cars we have still in the storage is centerbeam lumber cars as a result of the construction business being down. I guess the second part of your question was what are our car needs going forward.

Unidentified Analyst

Yes, both on a short-term and long-term basis.

Clarence Gooden

We're looking at replenishing some of our coal fleet in the near term. We're making some plans right now to go back and do some rework on our automotive cars. We're acquiring some box cars through TTX's national fleet to help us improve in our Class A box car side of the house. That's principally and preponderantly where those numbers are. And our jumbo covered hoppers, we're adding in a new 286 short wheelbase capacity covered hoppers.

Operator

Walter Spracklin of RBC Capital Markets, you may ask your questions.

Walter Spracklin - RBC Capital Markets

The first question here is for Clarence. You are pretty optimistic, in your 10 segments there you've got is favorable, and the shippers we've been talking to, not that they're much less optimistic, it's just their crystal balls are lot more cloudy. I am just curious, are you getting some insights from your investors, perhaps more recently as to how the volume, the demand level is going to be developing into 2011 that gives you (occasion) for optimism?

Clarence Gooden

Yes Walter, before we do a forecast of the type that you're seeing here on an internal basis, we canvas all of our customers to see what they see in the short term as well as longer term. And the customer base we're dealing with has been very positive to us in the growth and just in all of those segments that we've mentioned there.

As you know the automotive market is still strong for us. Our intermodal business is strong for us right now. In fact last week in our intermodal business we almost had a record week; we were very close in terms of volume in doing that. And we're still very optimistic in both our export coal and our utility coal.

Walter Spracklin - RBC Capital Markets

Switching gears, Oscar, obviously debt rates on cost of debt is certainly dropping and quite low here. Just curious how this might have affected your view on what CSX's optimal capital structure is? Is it possible that we see that a return to sort of a debt financed share buyback or raising debt to increase your share buyback in 2011?

Oscar Munoz

As you know, our capital deployment over the last few years has been sort of sourced by two things, our strong operating cash flow and of course our even stronger balance sheet. So I think as we go forward, we'll continue that same approach and always stay in investment grade. So we'll always look at all those options.

Operator

Jeff Kauffman of Sterne, Agee & Leach, you may ask your questions.

Unidentified Analyst

Hi, it's actually (inaudible) in for Jeff Kauffman. I had a quick question on the labor side. Were there any sort of accruals that helped labor expense? I guess you were surprised to see your incremental margins go from a 45% range in Q1 and Q2 up to 60%?

Oscar Munoz

No. Nothing in particular. We actually increased expense in there because of incentive comp. And so that's I guess a reserve adjustment. But we're negative.

Unidentified Analyst

And then on the coal side, I guess we're kind of curious if you could provide some more color on the 20% increase in the RPU and how much the length of how it might have boosted that?

Clarence Gooden

Well there were three primary drivers that drove the positive revenue per unit not coal. First and principal was in our pricing itself. Second was in our favorable mix both with long haul southern utility coal as well as in our expert coal which carries one of our higher rates. And the third was our fuel recovery, although that was to a lesser extent.

Operator

And our last question, John Mims of BB&T Capital Markets.

John Mims - BB&T Capital Markets

First, what percentage of the exports is the low ball Southern App coal versus higher volume Central App?

Clarence Gooden

I don't know off the top of my head. Are you talking about the ones that are coming out of Birmingham versus the ones coming off the Pittsburgh (inaudible)?

John Mims - BB&T Capital Markets

Right.

Clarence Gooden

I just don't know off the top of my head.

Michael Ward

We'll get back to you with the exact answer.

John Mims - BB&T Capital Markets

No, that's fine. We have just been hearing from out of China that there is more demand for that higher quality, lower vol stuff that were coming out of the south. So was just curious to know what kind of market share is there. What percentage are you all shipping directly to China versus kind of back filling other areas?

Clarence Gooden

We have three major markets that we are serving right now in a very broad sense now, the very high level. And they are the Ukraine, China and Brazil.

John Mims - BB&T Capital Markets

And percentages on this?

Clarence Gooden

I don't know the percentages of the top in my head. Brazil will probably end up being one of the larger though.

John Mims - BB&T Capital Markets

And then just as a follow-up, just final question. We're seeing kind of this fuzzy trends out of China and just kind of global demand in the near-term on the net coal. So I am curious what's really behind your bullish stance on this 30 million ton target? I mean because that would imply a 20% sequential increase over this quarter which seemed to be pretty strong, but in my indication my thoughts were that export trends have sequentially slowed throughout the third quarter. So curious to know what's really driving the, call it 8 million tons for Q4?

Clarence Gooden

A couple of factors in there. Number one, as I mentioned, our coal is going to three major markets. So China is not the only driver in that market is number one. And number two is that we base this forecast at this time on the vessel lineup that's lined up to come in the (forced) projection of the shippers on when the vessels will arrive.

Michael Ward

Thank you everyone for joining us.

Operator

This concludes today's teleconference. Thank you for your participation in today's call. You may disconnect your line.

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