Kansas City Southern (NYSE:KSU)
Q3 2016 Earnings Conference Call
October 18, 2016 08:45 AM ET
Patrick Ottensmeyer - President and CEO
Jeff Songer - EVP and COO
Brian Hancock - Chief Marketing Officer
Mike Upchurch - EVP and CFO
Jose Zozaya - President and Executive Representative, Kansas City Southern de Mexico
Ravi Shanker - Morgan Stanley
Tom Wadewitz - UBS
Brandon Oglenski - Barclays
Chris Wetherbee - Citigroup
Jason Seidl - Cowen
Scott Group - Wolfe Research
Ken Hoexter - Merrill Lynch
Brian Konigsberg - Vertical Research
Danny Schuster - Credit Suisse
Bascome Majors - Susquehanna
Justin Long - Stephens
Brian Ossenbeck - JP Morgan
Scott Schneeberger - Oppenheimer
David Lipschitz - CLSA
Greetings, and welcome to the Kansas City Southern Third Quarter 2016 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation [Operator Instructions]. As a reminder, this conference is being recorded.
This presentation includes statements concerning potential future events involving the Company, which could materially differ from events that actually occur. The differences could be caused by a number of factors, including those factors identified in the Risk Factors section of the Company’s Form 10-K of the year ended December 31, 2015, filed with the SEC. The Company is not obligated to update any forward-looking statements in this presentation to reflect future events or developments. All reconciliations to GAAP could be found on the KCS Web site, www.kcsouthern.com.
It is now my pleasure to introduce your host, Pat Ottensmeyer, President and Chief Executive Officer for Kansas City Southern. Mr. Ottensmeyer, you may begin.
Thank you and good morning everyone. Welcome to our third quarter 2016 earnings call. If you look at page four, you’ll see the line-up, which I think is familiar to everyone. Jeff Songer, Brian Hancock, Mike Upchurch and Jose Zozaya, is on the phone as well this morning.
Let me begin my comments with slide five. As you saw in our press release from earlier this morning, we reported diluted earnings per share for the third quarter of $1.12, which compares to $1.20 per share last year, which represents a 7% decline from 2015. Revenues were $604.5 million, a 4% decline from last year. Excluding the impact of lower U.S. fuel prices on fuel surcharge revenue and the further weakening of the Mexican Peso, our revenues for the quarter would have been about 1% lower than last year. Volumes were down by 4% from last year.
Our reported operating ratio for the quarter was 56.9, which is 170 basis points higher than last year. However, this includes the impacts of some one-time cost events, including higher detour expenses due to flooding in South Texas and service disruptions in Mexico, which, as we’ve stated in our press release, had an adverse impact on revenues.
In addition, those disruptions had a negative impact on cost performance during the quarter as well. In spite of this deterioration in quarterly operating ratio, we feel very good about our overall cost performance during the quarter.
Later in the presentation, Jeff Songer, will talk about some of the efficiency initiatives that are underway, and Mike Upchurch, will get into more detail about what we’ll refer to as our normalized cost performance. Just to give you a bit of a preview, this normalized cost performance is demonstrated by looking at our year-to-date operating ratio, which as you can see from the last point on slide five, improved by 230 basis points from the adjusted or comparable operating ratio last year to 65%.
Among other things, this year-to-date view shows our operating ratio performance on a basis, which smooth out the impact of timing or events that would have a more pronounced impact on the results in any given quarter. Again, Mike, will walk you through this in greater detail in a few moments.
Moving onto slide six, I wanted to briefly remind you of the recent guidance which we previously provided, and show you that we are on track with that guidance. Last quarter, we told you that we expected to see sequential revenue growth from the first half to the second half of 2016 and we are confirming that view at this point; and that we expectd to see mid-single-digits sequential revenue growth in the third quarter of 2016.
As you saw on the previous slide, we generated sequential volume growth of 5%, which led to revenues growing by 6.4%, sequentially. We are also confirming our previous guidance regarding second half 2016 automotive volume growth and our overall capital spending targets for 2016.
With that, I will turn the presentation over to Jeff Songer.
Thank you, Pat, and good morning. Beginning with slide eight, velocity for the quarter of 27.8 miles-per-hour improved 10% over prior year, while Dwell for the quarter of 24.1 increased 6% versus prior year. Factors impacting Dwell were the July bridge outage in Rosenberg, Texas, which restricted cross-border traffic flow. The border terminals of Sanchez in Nuevo Laredo and Laredo were impacted by this event.
Compounding this outage were service disruptions in Mexico during the month of July, which caused multiple days of outages across the network. All major terminals in Mexico were impacted, while terminals in Sanchez, Nuevo Laredo and Laredo, already congested by the earlier Texas Bridge Outage were affected further. Current Dwell has shown improvement from the elevated levels that we saw between late-July through mid-September, and we look for this metric to return to more normal levels through Q4.
Moving to the operations overview on slide nine, focus continues on our biggest cost drivers of labor and fuel. Currently, 5% of the U.S. T&E workforce is in furlough status. Overall headcount for the quarter was down 1% versus prior year, as Mike will review in later slides. 12% of our locomotives across the system are in storage.
Fuel management programs, as outlined in prior earnings discussions continue and we have gained another million dollars in fuel efficiency during Q3. Year-to-date, we are about 75% complete with the technology installations in the U.S. with Mexico installation work, slated for 2017.
Effective recrew management continues with year-to-date reductions of 49%, while over-time management provided an additional $2.4 million in savings for the quarter versus prior year. One other item to note is the completion of a mechanical in-sourcing effort that was finalized during the quarter and went into effect on October 1st. This represents an approximate $5 million in ongoing annual cost savings. We will recognize these benefits starting in Q4.
Moving on to capital project highlights. I would like to provide a quick update on PTC. First, I would like to acknowledge the tremendous ongoing effort by all of the groups involve in this project. We plan to have a first operating sub-division in PTC revenue service in Q4, and have an aggressive implementation schedule in 2017 and 2018. 2017 will be another heavy investment year for PTC and capital spend will begin to reduce thereafter.
Construction work at the previously announced WTC/Watco SLP fluids terminal both ground during the quarter. Design work for support facilities for the Ford and BMW automotive plants at SLP is underway. Work at the Sasol support yard facility continues and is on schedule for our late 2017 completion.
Finally, Sanchez Yard classification tracks are on schedule to complete by year-end. This will allow additional handling of trains at Sanchez and will ease some pressure on other terminals in the network, while continuing to facilitate cross-border traffic. Additional classification tracks and mechanical facilities at Sanchez will be complete by the end of 2017.
I will now turn the presentation over to our Chief Marketing Officer, Brian Hancock.
Thanks, Jeff, and good morning, everyone. I'll start on page 11, where you can see, our year-over-year revenue was down 4% and up 1% excluding currency and the fuel. Our carloads were also down 4% for the quarter versus last year.
Our Chemicals & Petroleum business had a record quarter with 1% year-over-year growth in revenue. Our carloads in this segment were up 4%, primarily due to shipments of fuel oil as a customer in Mexico had a disruption in production, which was partially offset by strong growth in our plastic segment. We continue to see strength in this line of business as the plastics manufacturers in the Gulf region grow their shipments globally.
Our Industrial & Consumer business remain slow with year-over-year decreases of 6% volume and 6% revenue, with half of the revenue decline driven by fuel and the foreign exchange. This business segment continues to be negatively impacted by softness in our metals and paper segments. These businesses are experiencing stiff global competition impacted by currency fluctuations and low truck pricing, which we believe to be unsustainable in the long-term. This weakness was somewhat offset by strength in our other carload segment.
During Q3, our Ag and Mineral business saw decrease of 1% in carloads and revenue growth of 3%, driven by strength in grain and food products, particularly in the cross-border business. We continue to see the benefit of the additional equipment serving this important business unit.
Our overall cross-border business showed strong growth of 7% for the quarter being led by a record breaking quarter in our automotive business and solid growth in cross-border Ag and Minerals, and the Chemical and Petroleum business. More details on our cross-border franchise are included in the appendixes on page 31 and 32.
Our energy business continued to be negatively impacted by volatility in crude and frac sand. Our coal business had lapped some of the lowest numbers from last year and slightly higher in Q3. Overall, energy carloads were down 7% and revenue was down 15% versus prior year.
Intermodal volumes were down 5% with revenue decreasing 7% in the quarter, primarily driven by our Lázaro cross-border and Lázaro inter-Mexico business. We’re seeing good growth in our cross-border franchise and non-franchise business, which more than offsets any general weakness in the overall U.S. market. The intermodal business was also negatively impacted by the service interruptions earlier in the quarter as customers made the decision to use trucks that augment their third quarter shipping capacity.
We are optimistic that these lines will return as the current improved service bolsters customer confidence, moving into 2017. With all of the automotive plants being back online, our automotive volume increased 14% but was impacted by a negative mix, which kept our revenue growth adjusted for fuel and FX at 4%.
One note is the impact of a new move we are now making from railroad to Corpus Christi area, which is driving down RPU. This is a very good piece of business with good overall length of halt. But given the way we account for the move, it has a negative impact on RPU.
In Q4, we’ll see one new facility come up to full production and another facility begin production in November. We’re also seeing strong volumes at the ports, both import and export volumes. And KCS is well positioned to serve our automotive customers as they grow their business in this important segment.
From a pricing perspective, we continue to see renewals close at the positive rate, myear-over-year. Excluding the large customer contract from last year, which will remain unchanged in 2016, our overall core pricing came in at mid-single digit levels. Intermodal remains that market segment most impacted by truck competition, but we’re confident in the value we’re providing and the customers will continue to return to the railroad as we move into 2017.
On slide 12, we have provided a fourth quarter year-over-year outlook for each of the industry segments. As you can see, we have a favorable or unchanged volume projection for about 90% of the business. This includes normal seasonal shipping in the Intermodal as well as the return to some of our automotive parts business versus 2015. We’re seeing slightly higher coal shipments year-over-year as we discussed on our last call. And the Mexico Energy Reform continues to be a focus area for investment.
We’re already seeing increased shipments of LPGs into Mexico. And KCS believes we’ll start to see the refined products business ramp-up beginning in Q1 2017. We are meeting with our customer to ensure that our plants meet their expectation as the law begins to be implemented. We’re also seeing some market volatility as refineries in Mexico have maintenance windows, which may impact volume in the month ahead. And we’ll continue to provide updates as we know more about the expected roll-out and implementation of the new law.
The automotive business we expected to grow as our customers continue to ask us to do more in creating solutions to support their global manufacturing footprint. As we’ve mentioned before, by 2020, Mexico will provide over 5.3 million vehicles and import another 900,000. Over 50% of this production will be added between the years 2016 to 2020. We’re investing in those projects that will enhance the fluidity and capacity to effectively service this important segment.
The Ag and Minerals business should have a good quarter based on record harvest we’re experiencing this year. And we believe our Industrial and Consumer segments will continue to see fierce competition, in both paper and steel into 2017. Overall, we’re upbeat about the opportunities in front of us. As Jeff mentioned, we’ll continue to make strategic investments, focus on providing our customers with a consistent product that has reliability they can count on as they create their shipping plans into next year.
We continue to focus our efforts in adding reliable capacity and fluidity for all of the growing businesses. I’ll now turn the call over to our CFO, Mike Upchurch.
Thanks, Brian, and good morning everyone. I am going to start my comments on slide 14. As Brian just reviewed a few minutes ago, both third quarter volumes and revenues declined 4%. The peso depreciation had a $12 million negative impact on revenues while declining U.S. fuel prices negatively impacted revenues by $7 million. Fuel surcharge revenues declined $32 million due to lower fuel prices and from rebasing customer contracts.
Adjusted operating ratio increased 1.7 points to 66.9, primarily due to incremental costs incurred during the quarter that relate to year-to-date true-ups for incentive compensation and expenses related to flooding and service interruptions during the quarter. I’ll discuss those details in the next few slides.
Third quarter 2016 reported EPS of $1.12 per share was down 7% from last year, while adjusted EPS was also $1.12 and down 7%. More details on the reconciliation of reported to adjusted EPS can be found on slide 27 in the appendix.
On slide 15, for the nine months period ended September 30, 2016, carloads declined 3% and revenues 5%, mostly from foreign exchange impacts and lower fuel prices. Reported operating ratio improved 290 basis-points. Despite a challenging operating environment requiring us to manage a number of extraneous events, adjusted operating ratio improved to healthy 230 basis-points, largely the benefit of $50 million in fuel excise tax credits, more than offsetting and incremental $14 million in higher incentive compensation. Reported EPS increased 4%, while adjusted EPS increased 3%.
Turning to slide 16, not only as 2016 been a challenging year from a carload and revenue perspective, but we have experienced increases in out of pocket costs related to various flooding related events in all three quarters, increased environmental expense, and higher incentive compensation expense.
Higher incentive compensation expense for all management employees caused $14 million increase from the targeted 100% payout level to a higher projected payout for the full year 2016. Including, both the $9 million true-up for the first-half of 2016 and $5 million in period, increased in the third quarter. Despite those increased costs, we have improved our adjusted operating ratio by 230 basis points in the nine month period ending September 30, 2016.
On slide 17, this reflects foreign exchange and U.S. fuel rates for the first three quarters of 2016, and projections for the remainder of the year. As you can see, we continue to expect significant downward pressure on revenues as a result of peso depreciation, currently expected to be 13% below 2015 levels during the fourth quarter.
As a reminder, we saw similar depreciation of the peso during the third quarter, which negatively impacted our revenues by $12 million. Fuel prices are expected to be approximately the same year-over-year, and thus fourth quarter could be the first quarter we haven't seen negative fuel impacts on revenue in quite some time.
Turning to slide 18, third quarter operating expenses declined $7 million or 2%. Key drivers of the decline and expense included the excise tax credit, the benefit from the depreciating peso, lower headcount and better labor productivity. Offsetting those declines were higher incentive compensation, depreciation, detour costs from flooding, and higher environmental expenses.
Let me provide a little bit more color on the excise tax credit. During the quarter, we generated $16 million fuel exercise tax credit; a continuation of the credit we began realizing during the second quarter. As we indicated last quarter, this credit was established for qualifying transportation companies in Mexico and represents the beginning of transition to world market prices, which we still expect to occur in 2018, and perhaps earlier.
While we still don’t know whether the credit will be available in 2017, the good news is the 2017 draft budget proposal presented to the Mexican Congress does reflect continuation of the credit in 2017. Congress is expected to approve the budget sometime during the fourth quarter.
As a reminder, we include this credit and operating expense as it directly relates to our fuel expense, which includes the applicable excise taxes we have always paid on fuel purchases. And accordingly, is included in the operating expense section of the P&L.
We have included the credit as a separate line item in operating expense to provide investors transparency and clearly see the year-over-year impact of the credit rather than netting it with fuel expense. We actively manage fuel purchases on a daily basis on our cross-border traffic to ensure we are purchasing fuel in the most economical way to produce the lowest possible operating costs.
Our ability to utilize the credit is dependent on a variety of factors that include having sufficient taxable income and sufficient withholding and income tax liabilities to utilize the credit as there is no carry-forward provision available to us. We currently expect to generate approximately $15 million in additional credits during the fourth quarter.
Turning to slide 19, compensation and benefits expense went up $15 million, largely due to $16 million of increased incentive compensation. During the quarter, we increased our accruals for incentive comp to higher payout percentages. The $7 million increase is due to 2015 payout percentages being accrued at 50%, and increasing the payout to higher achievement levels in third quarter 2016.
When increasing the projected payout in 3Q, we also recorded true-up adjustments for the first six months to increase our accruals to the higher payout percentage, which contributed an additional $9 million year-over-year increase. For the fourth quarter, to give you a little guidance, we currently expect incentive compensation to be $7 million higher than the fourth quarter 2015. And again, we were accrued at a 50% payout level in the fourth quarter of 2015.
Wage inflation is still running in the 3% to 4% range, and contributed to another $4 million year-over-year increase in compensation expense. And as you can see in the bar chart, headcount continued to decline by 1%, contributing to $4 million of savings, along with various other productivity improvements.
As Jeff mentioned, we continue to have crews per load in the U.S., resulting in year-over-year savings. And we experienced a slight reduction in overall headcount.
Turning to slide 20, fuel expense declined $11 million, primarily due to peso depreciation, lower fuel prices, lower volumes, and better efficiency. As you can see in the bar chart, fuel price declines, both in the U.S. and Mexico, and our average consolidated price per gallon declined from $2.24 in the third quarter last year to $1.99 in the third quarter this year.
And finally on slide 21, our capital structure priorities continue to focus on investing in the business to generate the best growth in the rail sector. In fact, despite the downturn in the industrial economy the past 18 months, we have grown third quarter volumes 19% since 2007, while the rest of the Class Is have experienced declining third quarter volumes on an aggregate basis of about 6%.
We will continue to focus on reinvesting our cash flow back into growing our business for the long run. And projected capital expenditures, as Pat mentioned for 2016, continue to be in the range of $580 million to $590 million. Finally, in May of 2015, our Board of Directors authorized a $500 million share repurchase program. And a little more than halfway through the life of the program, we have repurchased about 60% of the authorized amount at an average of $89.63 per share. We will continue to monitor economic and business conditions to determine future levels of share repurchases.
And with that, I’ll turn the call back over to Pat.
Okay. Thanks Mike. I’ll just close with a few comments to provide an overall assessment for the quarter. Obviously, we continue to be in a challenging business environment as evidenced by our year-over-year declines in overall volumes. While the weakness is most evident in energy related business, we did experienced year-over-year volume decreases in five of our six major business lines during the quarter.
The good news is we are seeing sequential improvements and once we cycle through some dramatic reduction in coal and crude oil revenues that began in early 2015, we should start to see some volume growth returning.
In spite of some unusual cost items, which occurred during the third quarter, we feel very good about our overall expense management and productivity trends. We feel that the year-to-date view of operating ratio improvement is a more meaningful indicator of those trends.
Jeff detailed a few of the specific areas of focus, but there are many more that we are working on across all departments in the Company that will make us more cost efficient and productive in the years ahead.
I gave a presentation at a recent rail shippers conference at which I described the near-term business outlook as tepid which literally means lukewarm or lacking enthusiasm. When volume growth returns, and we are confident that it will at some point, the expense controls and efficiency initiatives we are currently working on should put us in great condition to begin using terms like incremental margins; again, which have been noticeably absent from our vocabulary for the past few quarters.
Finally, we continue to be very optimistic about our long-term growth outlook based on the key growth drivers that we see impacting the KCS network in the years ahead. You’ve heard us talk about these growth drivers before. But just to reiterate; there are new auto plants in Mexico; new petrochemical facilities being built in the U.S. Gulf Coast; growth and capacity at Lázaro Cárdenas; and continued growth and market share gains in the cross-border intermodal markets will be the primary catalyst for KCS in the years ahead.
So with that, I’ll open the mic for Q&A.
Thank you. We’ll now be conducting a question-and-answer session [Operator Instructions]. Our first question is coming from the line of Ravi Shanker with Morgan Stanley. Please proceed with your question.
Thanks. Good morning, everyone. Couple of regular questions for you. Pat, you said that the budget for the excise tax credit looks like it's going to be approved in the fourth quarter. Does that mean that there is no chance of going to market pricing on fuel in 2017 itself? And also, do you have an update on the antitrust investigation that new regulator has been conducting? I think we should be coming till the end of the window by ways they should be showing at work?
I’ll answer the second question; first, no update, still ongoing. The first question, we don’t know. At this point in time, there is nothing that we can say with certainty about acceleration of market price movements. But as we’ve described in great detail last couple of quarters, this movement in excise tax is a way to effectively get us to, we think, get us to the same outcome. And we expect that to continue in 2017 as well.
As a follow-up, I think you’ve mentioned mid-single-digit price increases. I think the last couple of quarters you had mentioned something in the order of just shy or 4%. Is that a similar level for this quarter as well?
Ravi, this is Brian. We feel very comfortable with the mid-single-digit range that we’ve talked about over the last few quarters. So, we’re pretty much in the same range.
Our next question is from the line of Tom Wadewitz with UBS. Please proceed with your question.
So, I wanted to ask you about the broader volume outlook. If you’ve had, obviously, you’ve had noise in the past couple of quarters with weather issues, teacher strikes, things that would be presumably hard to anticipate. But it seems that there is maybe been a bit of loss of momentum in the Intermodal side, or I guess lots of visibility to the growth in that segment. And so I just wanted to see if you could comment on impact of weak peso and how big an issue that is? How you think we might transition, how much volume growth you might get maybe in 2017 in the Intermodal segment?
Absolutely, this is Brian. What I would tell you is we feel very comfortable with the Intermodal space. As we’ve discussed over the last couple of quarters, one other big shipping company has made a decision to move to an all vessel water solution, out of the Pacific into Houston area. And so, that impacted our Lázaro cross-border and Lázaro inter-Mexico business. That’s primarily the decline you see from an Intermodal perspective.
All the other segments are growing and we feel very comfortable that we competing well. As we said before, we will not chase the lower trucking pricing that’s out there. We’re going to continue to provide the value that we do, both in security and in reliability of those shipments. What I would tell you is across the board though, we feel very comfortable that sequentially we’re going to continue to grow. It’s just slower than, I think, everyone would like it to be. But it’s above what we expect. And we’re continuing to manage the cost structure and the infrastructure investments according to that.
So obviously, the investments in supporting the additional automotive continue; the investments in the energy segment; the refine products, all those pieces are still in place. So the story is, it's pretty much the same except for that one Intermodal move that took a rail move and made it into a lot of move into these areas.
So, I mean, is there any reason to think that move would -- some of that business would come back eventually, or is that simply Panama Canal driven, and wider canal you don’t get it back. And then, I guess, I don’t know if you have any broad thought on what ballpark we enter volume year-over-year in fourth quarter, or even in looking into even 2017. Obviously, you’re not going to know exactly. But what’s the right ballpark for volume growth in fourth quarter next year?
Yes, I’ll answer the first one. We believe that it's very difficult for the shipping companies to maintain the pricing that they have put in place, which is below variable costs on that move into Houston. And so, we feel very comfortable that, at some point, that’s going to find the right solution as the best task into Mexico, and into the U.S. From an overall guidance perspective, on revenues, obviously we’re not give any guidance, but we continue to staying with the point that we’re going to continue to see growth in all of the segments, and we’ll continue to move forward with that.
Our next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.
Okay. Good morning, everyone, and thanks for taking my question. So, Brian, I want to come back to comment you made about your automotive growth, because your units were up quite a bit. But adjusted for FX, I think we’re seeing top-line expansion of about 4% for automotive. So, can you talk to us a little bit more about that mix impact? And I think you alluded to some accounting issues there too.
Yes, it’s a -- thanks Brandon, that’s a good question. What we have is we’ve added a couple of short haul moves. One of those includes an overall length of haul that’s very, very good for the business. But there is a piece of the business in the U.S. that goes from the border into the Corpus Christi area that is a short haul piece that have a pretty significant impact on length of haul. And as length of haul is shorter on the KIA business in Monterrey that also has an impact.
And so what I would tell you is some of this business that we’re changing from long haul deeper into Mexico into a long haul move that spreads across both railroads, you see that impact on length of haul in the U.S. side. The KIA business from Monterrey continues to be -- is always going to be a short haul. And that impacts RPU but is very good source from an overall perspective on profitability.
Brandon this is Mike. Just to clarify that. I mean when we do the carloads, we’ll report them separately for Mexico and separately for the U.S. So, what Brian is referring to here is we picked up some north bound into the U.S. that picks up as one carload as well to the Mexican carload. And it's great business for us because we extended the length of haul.
Okay, appreciate the clarification. And Pat, you brought it upfront incremental margins. As we look into ’17, if things remain tepid, what can you guys do from an operational standpoint, or maybe this is a good question for Jeff. Should we be thinking that there is still margin potential in the cost structure?
I’ll take that one, this is Jeff. I’ve tried to outline a couple of things, and gave visibility around fuel, for example, on the initiatives. We’re not able to complete with the installs in the U.S., and we have the whole Mexico network to install fuel technology. And I’ve provided some numbers on savings on fuels throughout the year here. So, I view those things are going to continue.
And I am confident that they will continue, I think, on the headcount side. You’re continuing to see productivity. The noise we saw in the quarter with the disruptions, as mentioned, certainly drive some additional operating expense. And so on a more normalized quarter, I think you’re going to continue to see those improvements.
Headcount for me as we’ve talked with all the hiring in 2015, you’re starting to see us kind of lapse that comps. So, I think in Q4, you’ll continue to see the trends that we saw here in Q3. The one outlier in headcount would be the in-source effort I talked about, so very good financial move for us. But I think that will add about 250 and 300 hedge to our internal numbers, so that will skew just the outlook. But that’s the reason that you’ll see that in Q4.
But, all in all, very pleased with how things are progressing. I feel that we’re still fairly early in the productivity improvements, especially in Mexico as we’ve got the headcount right sized. We’ve got the growth opportunities ahead of us. So, I think the productivity focus will be there for us.
And I’ll just add to that. Again, we don’t normally talk a lot about year-to-date results on a quarterly earnings call. But if you look at the year-to-date operating ratio performance, given flooding we had in the first quarter, flooding we had in the third quarter, some unusual expense headwind in the absence of volume growth, a 230 basis point improvement in operating ratio, really says a lot about the success we’ve had.
And then just on the operating side but across the Company in expense controls. And we will get back to a period when we talk about volume growth again, and I am certain that we will. I don’t know when. But if you go back to your notes around a couple of years ago, not just us but all the railroads, we’re talking about incremental margins; again, a term that’s lost its relevance here lately. But the focus on expense control and operating efficiency, I think, will really pay-off when we start to see volume growth.
Our next question comes from the line of Chris Wetherbee with Citigroup. Please proceed with your questions.
Mike may be a question for you on the tax credit, just wanted to get some color. I am guessing you guys probably have internal target of what you think the benefit might be based on what’s in the language in the budget for next year. Just want to get a sense. Should we be thinking about it in the rough order of magnitude of what we saw in ’16? Or does it change materially?
Well, I mean, we have to cross the first hurdle, which is obviously formal approval, while it’s in the draft budget. We need Congress to approve that to be certain of it. And then it’s going to depend on the volume of business from the volume of business and the volume of fuel that we end up purchasing. But all things being equal, you could expect something of similar nature if your volumes were the same that you have in 2016.
And is it, so it is volume variable on a scenario where you had volume growth due to auto or maybe Intermodal, bouncing back as it could has some variability, up or down, I guess?
Yes, so if business grows, then there is an opportunity for that credit to grow. And I was just trying to give you a year-over-year, if things were flat in terms of gallons of fuel that we purchased, then you would expect the similar credit, and that could go up or down, depending on what happens with volume.
And then just a quick follow-up on the peso. Just wanted to get a sense. When you talk to customers in Mexico and we’ve seen some significant volatility in the peso over the course for the last quarter. Do you get any sense of longer term changes in behavior from customers in Mexico? Just wanted to get a rough sense of what this shorter term volatility original volatility, of causing or maybe not causing with customers attitude to how they do business in Mexico?
Chris, this is Brian. I would tell you that for the customers in Mexico, as they look at the peso, that impacts them significantly. And many of them have asked us price in peso and we have done over the last 18 months. There is still a significant portion of our businesses that is priced in dollars because it’s more of a global basis. But we watch that as they do as well. And we’ve tried to do everything we can to make sure that each other understand where the peso is, how it’s impacting the business.
And overall, I would say there is an awareness, I would say there is no one out there saying, boy, I want to take action in this way or that way. As has been suggested in other places around surcharges and things like that, that’s really not the space that we’re in. I would tell you that customers are very aware of the impact as the peso devalues or increases in value. So, it's just one of the things we stayed very close with them on. But most of the other business that’s in dollars is going to stay that way simply because of its global nature.
And just to add-on to that, Chris. What we haven’t seen, and I’ll use the grain business maybe as the best example. And I think this is maybe what you’re getting at. We haven’t seen customers shift sourcing decisions because of the weak peso.
Okay, that’s exactly -- that’s very helpful. Thanks very much for the time guys, I appreciate it.
Thank you. Our next question comes from the line of Jason Seidl with Cowen. Please go ahead with your questions.
Pat, we’re not going to let you off that easy.
I didn’t think so…
My first question, I think Tom touched on the top-line so I’ll touch on more on the bottom-line look at things. How should we think about the operating ratio as we go to the fourth quarter, because you guys soon to be getting hit with everything this year, and every quarter, whether it was, weather or just the flooding, or bridges being out or comp catch up. It seems like 4Q is going to be a cleaner number as I knock on, what is I’m saying then here. How should we think about that when we’re looking on sequential basis?
Well, we’re not going to be specific about guidance, as you know. But I think the thing that we want to emphasize and may clear to you guys is that we’re working really hard to try to continue to develop this cost initiatives, efficiency, productivity initiatives. And we think there is room for further improvement in operating ratio, even in the absence of volume growth. We’re not going to get specific about guidance. But as you said, we knock on woods that we don’t have extraneous events, like floods and other things that are totally outside of our control.
If we see a quarter where we don’t have those kinds of influences, then we think we can see some continued benefit of these initiatives. Jeff mentioned the in-sourcing of the mechanical function in Mexico which will create a bump in headcount for the quarter. But net effect on operating income and profitability will be positive. We’ll start to see that in the fourth quarter. And in the absence of events that we don’t control, we think there is room to improve the operating ratio in the fourth quarter and beyond.
I guess my follow-up is going to be on Mexican Energy Reform. You mentioned that the Watco fluid facility broke ground here in the quarter. When do you think that’s going to be up and running and fully functional? And can you give us any insight for other facilities that are similar to that that might follow around the energy reform?
Yes, this is Brian. I would tell you that the facility broke ground this last quarter. We expected to be up in running by the second quarter, probably by the end of second quarter 2017. But I would tell you the Howard facility, actually came on line this week. And so it is now connected to the railroad. We’re not shipping there. They’re not able to receive shipments. But the fact that it is on line, means that they will be prepared to start. We’re seeing products here over the next quarter, so, probably first of 2017. There are number of other facilities, primarily in the variable space, where we will pull a railcar in, it will go direct to truck that are being contemplated and being considered. But overall, people are focused on that that center of the country area. And those are the two primary facilities, other than temporary facilities, that might be from rail to truck.
Thank you [Operator Instructions]. The next question today is from the line of Scott Group with Wolfe Research. Please proceed with your question.
So Mike, I wanted to just try, just on the near term outlook again. So, I know last quarter, you provided some sequential revenue guidance. Are you not able to give us any sequential or year-over-year revenue guidance for fourth quarter?
No, I think, Brian gave some visibility as to what we expect on the revenue side by segment. And we did give some cost information around year-over-year increases in incentives. And you can probably draw a quarterly savings from what Jeff talked about with respect to the maintenance in-sourcing. So, that’s where we’re going to keep our commentary at those three levels.
And I think going back to what I said earlier, Scott, second-half, we’ve said in the second quarter, second half would be better than the first half. Obviously, we’ve got a good start with the third quarter. I think sequentially stronger. But generally there is some seasonality in this business that shows the fourth quarter coming off the third quarter pacing?
And then on the coal side, so we typically, at least the last few years, we’ve seen a big drop off in coal volumes for you guys, third quarter to fourth quarter. Just given where NATGAS prices are and the weather that we’re seeing in Texas, right now. Can coal stay stronger for longer into the fourth quarter? And do you have any update on the long-term plans of those Texas plants?
Second part of the question, we do not have any indication on the long-term liability of plants. You’ll have to work with our customers on that. We do believe that the coal volume right now is kind of stabilized. We don’t see a large inventory build, like we saw in the past where people had really taken their coal reserves down to zero, and we had to replenish that.
So, we’re cautiously optimistic that we’ll stay where we’re at, and continue to move effectively with the facilities that we do support. But I don’t think there is going to be any wild swings down or up at least that we can see in the near-term future. Obviously, it’s hot in Texas and that’s good. These are facilities that come on from a variable kilowattage perspective. So, we think that’s going to continue. But, overall, we don’t see a big surge in demand over the next quarter.
So just unclear, at 330, give or take NATGAS, you don’t think these plants run more full-year, you think it's going to stay more just seasonal?
Yes, that’s what we’ve been told by our customers. And so that would be the way we would look at it.
Thank you. Our next question comes from the line of Ken Hoexter with Merrill Lynch. Please proceed with your question.
Good morning. Just I guess I’ll start with my clarifying one. Is the incentive comp increase tied solely to the stock moves, or is it related to performance? Just wondering what drives that $7 million increase going forward, and is that a sustainable $7 million?
Ken this is Mike. The increase in incentives is almost entirely our annual short-term incentive plan that covers all management employees. And that measure is operating ratio.
Again, so just is that a good placeholder to $7 million, or is that…
Well, I think I gave some guidance that we would expect to see $7 million increase in 4Q incentives in ’16 over ’15.
Which was 50%, right, last year and this is now. And then just, if I -- returning to I guess my question on Intermodal and an update on Lázaro is the second concession open and maybe can you maybe delve into the impact of the strike that you mentioned there was still some backlog. How long does it take to clean up? And what’s the leverage there as you move forward?
Yes, I would tell you the most important piece about Lázaro is that the facility will operationally be ready in Q4. I think they are planning to open operations in Q1 of 2017. So, the facility is ready to go. There is continued volume that comes in there that we move on a daily basis. I wouldn’t say there is congestion there right now I would just say that it's continued, operations it's the third time of the year, it's the holiday and high retail time of the year. So there is a lot of freight moving into that right now.
But that is the area that we talked about the Lázaro inter-Mexico and Lázaro cross-border piece of business that has been off, this year primarily due to the decision of one of our customers to move that freight completely by vessel up into the Houston area. And so that volume is not moving at all through the port. So if it were to move back, obviously, that would be beneficial to us. But again that’s -- they’ll decide that in the coming months and years, how they want to move that freight on an overall long-term basis. But right now, the concession is done. The operations will be ready to move in Q4. And we expect to move volume out of the new APMT terminal in Q1 of 2017.
Our next question is from the line of Brian Konigsberg with Vertical Research. Please proceed with your question.
Maybe can you just talk, just one point clarification. Just as far as the service disruptions. So you’re completely clear at this point, and there should be zero carryover from costs into the quarter. So, it should be clean. Is that’s the view at this point?
Yes, that’s the view at this point.
There are no further disruptions.
And maybe can you give an update on the port of Veracruz. So I know you’re connecting your tracks. Where are you, as far as marketing to customers, and do you see that providing some incremental tailwinds?
The port of Veracruz is, we believe that all construction and the bypass would be completed by the end of 2017. So, we are seeing more and more business into Veracruz. We’re selling specifically into the automotive space. And we feel very comfortable that we have a good product there right now. We have to hand that over to a partner railroad as we get closer to the port, very close inside the port. But we feel that once that bypass is completed at the end of 2017, we will have a great product for our customers to move into the Atlantic as well, so, very comfortable with the way that’s proceeding, right now. And right now all signs are that that will be completed in December of 2017.
And if I could sneak one last quick one in. Just on CapEx. So, it looks like it’ll tick-up just a little bit in Q4. Is the preliminary view that ’17 is going to be fairly flat given PTC remains simply elevated, and then initially the sizeable drop-off in ’18, that’s the initial plan?
Yes, I think that’s a fair assessment there are on a flattish and a dollar perspective. We’ve got Sasol continuing. We’ve got PTC, as I mentioned there, one more heavy. And then it will start winding down a bit after that. So, I think the flattish is a good expectation.
Brian that was a pretty sleek how you sneaked in three questions.
All right. Thanks guys.
Our next question comes from the line of Allison Landry with Credit Suisse. Please proceed with your question.
Good morning. This is the Danny Schuster on for Allison. Thank you for taking my question, and congratulations on achieving your auto volume guidance thus far this year. Just wanted to dig in a little bit more on that. So, given that you have two new autos facilities that are ramping production in Q4 and Q1. How should we think about auto volumes now in Q4 versus Q3?
I think you’ll, Danny, I think you’ll continue to see the auto volumes move as they have been, as we kind of laid it out. Obviously, the KIA facility will be coming on full swing at the end of the year. So, they’re already producing, but both will continue to ramp up. And then we’ll see another facility come on in November. Obviously, that’s the slow ramp-up, but we’ve described the other facilities. But right now, we feel like our automotive business is doing very well. We’re very comfortable that we have the security and the right type of fluidity and capacity to support them. As Jeff mentioned, we’re going to continue to invest in that space. But not only Q4 but into 2017 and over the next few years, we feel very good about the way the automotive volume is coming forward.
And just to clarify from the modeling perspective, in Q4. Are there any carryover costs from environmental and flooding expenses that you experienced in Q3, that we should also expect to see in Q4?
This is Mike. No, you shouldn’t see any carry-over impact on either those events those are behind us.
Our next question is from the line of Bascome Majors with Susquehanna. Please go ahead with your question.
Thank you. Cost pressures and incentive comps true-up, they drove your earnings down Q-over-Q this quarter, and that’s typically, you’ll see a seasonal rise. So that was a bit of typical on the downside there. Just thinking into 4Q with 3Q as a base, do you expect that 4Q will break with the flat to down quarter-over-quarter trajectory you’ve seen over the recent years from an earnings perspective?
Well, I think we gave some guidance around fourth quarter that you should expect to see about a $7 million increase over what we had in 4Q of 2015. And again, we were accrued at 50% levels in third quarter and fourth quarter a year ago, and obviously stepped those accruals this year.
I was asking more so, just from a very high level on EPS basis, 3Q was well below typical seasonality in the trend from 2Q. I am just curious if we should look at that as a base and maybe see some above seasonal uptick versus the flat to down trajectory you see in EPS typically in the fourth quarter?
We’re not giving any EPS guidance. So I think we’ll stick with the commentary we gave about fourth quarter. I guess, I’d just go back to looking at the year-to-date results as opposed to the quarter, because the quarter did include some things, some catch up things, some unusual things that going back to your comment about normal seasonality that you wouldn’t expect to see in a normal third quarter.
Just to follow up to try to put a closer number to some of the incentive comp expectations as we go into next year. I mean, can you tell us in dollar terms, what a 100% target payout for cash you would look like on incentive comp? And maybe percentage terms, how far you are tracking above normal for the payout this year, now as you true things up?
No, we’re not going to really get into all those details. And we’ll leave commentary as we provided it on the slides.
Our next question is from the line of Justin Long with Stephens. Please proceed with your question.
So, first question was on 2017. I know you’re not going to provide specifics today. But, Pat, in your closing comments, you expressed your continued optimism about the long-term growth in the business. And so I was just wondering, from a high level, especially when you think about lapping some of the irregular cost items that you’ve outlined this year. What’s your confidence the business that we’re in a position to return to double-digit earnings growth that we’ve seen historically?
Wow. You kind of knocked that one in there. You’re seeing that we’re paying attention here. It’s really going to depend on when we see volume recover. So we keep thinking that we’re lapping and going through the cycle on some of the coal and crude oil movements, and they should start to look better. And that just haven’t happened. I think we’re not going to give guidance about timing of when we expect the volume growth to return. But we think it’s going to happen.
When you see the investments, new plants, the market share opportunity that we have in the Intermodal, the new terminal at Lázaro, the petrochemicals, autos, all the things you’ve heard us talk about, we will see volume growth return. And when that happens, I think you’ll see the benefit of the cost and efficiency work that we’re doing right now. But is that going to happen in 2017? I don’t know.
Okay, fair enough….
So, not a very satisfying answer, but that’s our answer.
I had to try. And then as a quick follow-up, I wanted to ask about the competitive dynamic of Lázaro versus Manzanillo, right now. Could you just speak to how the two compare in terms of service and trends at times? And how do you think that opening of the second concession at Lázaro could change that competitive dynamic?
Yes, this is Brian, Justin. I mean, I think the most important piece, when you think about the competitive dynamics of Manzanillo and Lázaro. Lázaro was the only port that has a direct rail connection into the U.S. and into the rest of North America. So, the addition of the APMT terminal is going to be pretty significant. If you look at what the government has said, they’re looking to double the initial size of the facility. They want to double the capacity of the port. We feel very, very comfortable. But that port is going to continue to grow.
Now, when you think about competitiveness into the inter-Mexico area, that’s what we see the competition right now, the truckers and the low price. There is about, when you think about the difference between rail and truck, there is about 60% of the volume goes truck, about 40% goes rail. We’re hoping that that continues to improve as people look at the security of the rail, the number of places we can get to on the fluidity. Obviously, Jeff talked about the big investments that we’re making. It is important when you have an Intermodal product to be fluid and consistent, and that’s where we have to management team, we’re spending all of our time, because we realized that the growth opportunity there is significant, not only out of Lázaro but into the U.S.
So, from a competitive perspective, we know the value that we bring. We understand how the price is. We believe that it's going to continue to -- the tailwinds are going to our way as we continue to improve our fluidity. But right now, we feel like we’re very, very competitive in the space that we’re at. But there is also this dynamic of the vessel operators that we’re still dealing with and it’s a global issue. It’s not just Mexico. It's not just North America. And so, as the vessel operators sort out probably over next 12 to 18 months, I think we’ll continue to see that at Lázaro.
Our next question comes from the line of Brian Ossenbeck with JP Morgan. Please proceed with your question.
Thanks for getting me on here, just two quick ones, both for Brian. So you mentioned Veracruz, December 2017. Feel like it’s going to go forward at point in time. We’ve heard a lot of back and forth in terms of the progress. It seems like land ownership there that was a pretty big hurdle. This is reasonably positive update. I was just hoping if you could give us more clarity as to, as anything have happened to get this moving forward, because you do seem to be pretty positive about this being complete at end the next year?
You’re absolutely right, Brian. Land acquisition was a key. There was a particular piece of property. But we knew that this would probably be a question that would be asked. And so we did some research just prior to the call over the last week and half just to make sure we understood how it is progressing. And we continue to feel very comfortable they’ll be completed and we’ll have access to that line at the end of next year. So, you know everything that we know. But we feel very comfortable with the land acquisition issue that was there on that last four kilometers has been cured.
Other quick one was just on metals. Primary metal volumes have been down more each quarter as you go through this year. I would thought, we’d see some relief by now given all the favorable steel trade cases of the past year, is this really tied to any specific plants that’s been shutdown as a more destocking? I think Brian you actually mentioned this was not in area you saw of particular strength through this year -- end of this year and into next.
Yes, I would agree with that. What I would tell you is, the steel industry continues to be under a ton of global pressure. There is inventory in a number of areas, not only within Mexico but also in the U.S., and the rest of North America. We do see one ray of light is that the amount of high grade steel necessary in Mexico and the plants able to support that could potentially help us maybe into the last part of next year. But again people are looking at that industry and it is extremely competitive. And we just haven’t seen the fall-out that you would particularly expect seeing all the court cases that are out there, but I think that we’re going to hold our own. Our customers seem to be investing. And so we think it’s going to end up being a very positive space. But right now, we just don’t see any relief over the next or while.
Okay. And those would be high strength steel plants in the U.S. going cross-border?
Potentially, and also potentially coming inside of Mexico. So, I mean, both sides.
Thank you. Our next question is from the line of Scott Schneeberger with Oppenheimer. Please proceed with your question.
Just curious, your comments, in mid-September Ford announced shift of U.S. small cars production to Mexico. Just curious how you’re thinking about that and how that maybe incremental to opportunities you’re looking at in the coming years? Thanks.
It’s certainly a great opportunity. We are, as Jeff mentioned in his comments, we’re in the design phase of that facility. Those small cars are good for us. We’re able to move them, both south and north, because they export them, not only into the U.S. and Canada but also around the globe. So, you’ll see those cars go both into the Atlantic-Pacific. We feel that’s very positive, and we’re heavily engaged in that facility and its construction there in San Luis Potosi.
And just on the slide 12, Intermodal, as far as -- you have a new comment on there, incremental growth through the new service. I’m clear have we touched on this call or is there something that hasn’t been covered?
No, we’re just continuing to see other opportunities for ourselves and our customers out of Mexico, and also into Mexico, primarily driven by the manufacturing and the retail environment in Mexico, which seems to be doing very well. So we feel very comfortable with both north and south and out of the port of Lázaro that we’re going to continue see growth. And we’re looking at providing different services for those customers. But they would be normal Intermodal services, nothing exceptional.
Thanks for the clarification, appreciate it.
Our next question is from the line of David Lipschitz with CLSA. Please proceed with your question.
Just a couple of quickies. Ford announced that its idling one of their -- couple of their Mexico facilities. Is that going to impact to you at all? Or are you worried that others might do the same with auto sort of seeking out?
Thank you, Dave for the question. We do not believe that the impact of those particular facilities, we don’t service those facilities right now. So, we don’t think it’s going to have an impact on us. But, we do see Ford as a continuing customer over the next two years. As I just said that they will continue to grow. As to whether the volumes, from a North America perspective, are going to stay where they’re at, or if we’re going to see some of the other automotive companies tail-off production in Mexico.
We use the publicly available data and the data that our customers give to us. And right now we feel very comfortable that we’re still on the trajectory that we laid out over the last couple of quarters. And by the end of 2020, I mean, we see the facilities coming on next year. In Agulhas, the facility is coming onto next year with Ford and then BMW the next year. So, right now, we continue to see all of those facilities coming on at the same pace that they said, that they have announced. And we’re spending our capital dollars in preparing for that as we’ve said in the past.
Just one quick follow-up. The environmental charge, what was that for?
Yes, that was an ongoing environmental remediation clean up that we had -- we continue to work on and have over the past few years. With the work we’ve done, we discovered a little incremental remediation work needed. So, we’re booking to that anticipated remediation charge.
Thank you. There are no further questions at this time. Mr. Ottensmeyer, I’d like to turn the floor back over to you for closing comments.
Okay, just a couple of quick comments. I realize this was a bit of a noisy quarter. But you guys will write the headlines that I think the headline that we have in mind is this fuel excise tax situation is a good thing. For us, it accelerates the benefits of deregulation and then makes us I think more competitive long-term with truck, particularly Intermodal. The focus on cost control and efficiency is we’re very, very pleased with that and that is producing real productivity improvements that we’re seeing today. And when volume growth returns, I think that will put us in great position. And have to close with the long-term growth drivers are still very much intact. And finally, I know Tony Hans that is out there. I really like Jake Arrieta against Rich Hill tonight. So we’ll close with Go Cubs. We’ll talk to you in 90 days.
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