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Executives

Leanne Marilley - Director of IR

Charles W. Moorman - Chairman, President and CEO

Donald W. Seale - EVP and Chief Marketing Officer

James A. Squires - EVP Finance and CFO

Analysts

Thomas Wadewitz - JPMorgan

John Barnes - BB&T Capital Markets

William Green - Morgan Stanley

Ken Hoexter - Merrill Lynch

David Feinberg - Goldman Sachs

Norfolk Southern Corp. (NSC) Q1 FY08 Earnings Call April 23, 2008 9:00 AM ET

Operator

Greetings and welcome to the Norfolk Southern Corporation's First Quarter Earnings Conference Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow up formal presentation. Questions will be taken first from those who are attendant at the meeting and then from those participating over the phone. [Operator Instructions]. As a reminder this conference is being recorded.

It is now my pleasure to introduce Norfolk Southern's Director of Investor Relations, Leanne Marilley. Thank you, you may begin.

Leanne Marilley - Director of Investor Relations

Thank you and good morning. Before we begin today's call I would like to mention a few items. First, we'd like to welcome you to our first quarter earnings conference call. We remind our listeners and Internet participants that the slide of the presenters are available for your convenience on our website at nscorp.com in the Investor section. Additionally, MP3 downloads of today's meeting will be available on our website for your convenience. As usual transcripts of the meeting also will be posted on our website and will be available upon request from our corporate communications department.

At the end of the prepared portion of today's call we will conduct a question-and-answer session. At that time if you choose to ask a question an operator will instruct you how to do so from your telephone keypad. Please be advised that any forward-looking statement made during the course of this presentation represent our best good face judgment as to what may occur in the future.

Statements that are forward-looking can be identified by the use of words such as believe, expect, anticipate and project. Our actual results may differ materially from those projected and will be subject to a number of risks and uncertainties some of which maybe outside of our control. Please refer to our annual and quarterly report filed with the SEC for discussions of those risks and uncertainties we view as most important.

Now, it is my pleasure to introduce Norfolk Southern's Chairman, President and CEO

Wick Moorman.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Thank you, Leanne and welcome back. And good morning everyone, it's my privilege to welcome all of you to our first quarter 2008 analyst conference call. We have with us today several members of our management team, including our Vice Chairman and Chief Operating Officer, Steve Tobias, along with Don Seale, our Executive Vice President and Chief Marketing Officer, Jim Squires, our Executive Vice President-Finance and Chief Financial Officer and John Rathbone, our Executive Vice President of Administration. We are also joined by Rob Kesler, our Vice President of Taxation, Bill Romig, Vice President and Treasurer and Marta Stewart, our Vice President and Controller.

Turning to the first quarter, Norfolk Southern delivered strong financial performance recording the highest railway operating revenues in its history in spite of a less than robust economy. We are in record first quarter revenues of $2.5 billion which produced operating income of $578 million, an increase of 9% over first quarter of 2007, even with the increase in legal expenses related to the settlement of litigation tied to the Graniteville accident.

First quarter net income grew year-over-year to $291 million or $0.76 diluted earnings per share. Our results continue to validate our focus on delivering a higher value service product which allows us to maintain strong pricing across our commodity group. The economy is turning out to be a little softer than we had originally anticipated when we looked at it towards the end of 2007.

But Norfolk Southern's balanced business portfolio which is something you have heard us talk about a great deal in the past along with our service has helped offset the downturns in some of our consumer and housing related businesses. From an operation standpoint, the railroad is running smoothly and our services metrics improved year-over-year for the first quarter.

Capacity enhancements that we put in place and our continued focus on the reliability of our locomotive fleet and other assets or allowing our system to run more and more efficiently. Additionally, the inclusion of the composite performance measure in our compensation package which we talked about in last quarter's analyst meeting has sharpened our employee focus even more on our operations which translate directly into better service levels.

I'll talk more about this a little later, but it is worthwhile to note that recent Morgan Stanley shipper survey confirm the improvement in our already industry leading service. Finally, we continue to climb for the future, we believe that the factors that support long-term growth in rail freight demand remain in place, and we're confident that volumes will resume growing as the economy rebounds. When that happens we will be poised to capture and handle that growth just as we did in 2003.

Rickenbacker, global logistics part in Columbus, Ohio opened during the quarter and work is in progress on the tunnel clearances on the Heartland Corridor, which remains on schedule for completion in 2010. As you'll see in Don's presentation these improvements will provide a significant competitive advantage for Norfolk Southern as global trade patterns continue to shift towards these coast ports.

Additionally, we are continuing our dialogue with the federal and state governments about the win-win opportunities presented by the Crescent Corridor and work is already underway with support from the Commonwealth of Virginia to add capacity in this key domestic freight line.

I'll now turn the program over to Don Seale to walk you through our first quarter results from a revenue and volume perspective. Jim Squires will follow with the financial overview. And then I'll return with some closing comments before we take your questions. Don?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Thank you, Wick and good morning everyone. During the first quarter we continue to deal with the effects of a slow overall economy led by softness in housing related commodities and the automotive market. In spite, of these challenges I'm please to report that we generated record revenue in the quarter of $2.5 billion, up $253 million or 11% over the first quarter of 2007.

Merchandise revenue was up a $124 million in the quarter as new records were set in agriculture and chemicals. Coal revenue increased by a $105 million or 19% which also represented a new record high and intermodal revenue was up $24 million or 5% despite its excess trucking capacity and shifting global freight patterns.

The two primary drivers of the revenue increase across our markets in the first quarter were improved yield and fuel revenue. Of the total increase of $253 million in the quarter, a little more than half of the gain came from pure pricing while the balance attributed to higher fuel revenue. With respect to yield as shown in slide 3 revenue per unit reached an all time up a $166 or 14% over the same period last year. This was our 22nd, consecutive quarter at year-over-year ARPU growth and each of our major groups except automotive reached an all time high. Continued strength and pure pricing which averaged 7% for the quarter combined with higher fuel revenue generated these record results.

Now turning to volume on slide 4, you will note that we handle 1.8 million units in the quarter which was 2% a low last year, as weakened economic conditions continue to suppress rail freight transportation. Increases in agriculture, coal and metals traffic can not offset losses in our consumer driven and manufacturing related sectors. It's also worth noting that volume gains were posted in the first two months of the quarter which were offset in March as one last working day and the timing of the Easter holiday impacted loadings.

Finally, the continued weakness in the U.S dollar helped drive volume gains in export products such as coal, grain and machinery. Total export volumes surged by 14% in the quarter, while total import volumes declined by 7%.

Now, turning to our individual markets on slide 5, intermodal revenue reached $486 million for the quarter, up $24 million or 5% as higher average revenue per unit over came lower traffic volumes. Record revenue per unit of $656 was driven by more favorable traffic mix, improved pricing and fuel surcharge revenue. Hour rated [ph] intermodal marketing company, LTL and Triple Crown traffic grew while volumes and lower revenue per unit ocean and domestic containers declined.

Also, we handled fewer revenue empties for private equipment owners in the domestic market. Also during the quarter strong export demand converted empty ocean container movements to loads which also helped boost average revenue per unit. And finally Triple Crown benefited from additional long haul traffic in its business.

Within the individual market segments an intermodal is depicted on slide 6, our international volume fell 5% for he quarter driven primarily by a softer economy and resulting import weakness, as well as the ongoing reduction of inland rail movement of West Coast import containers. Higher inland transportation costs are prompting several major ocean carriers to restructure the way they are doing business in North America.

We continued to see ocean carriers placing more vessel capacity in the highly profitable Asian European freight and eliminating less profitable inland transportation service for certain markets in the U.S. In cases such as Maersk Line and others long haul transcontinental markets have been replaced with all water service to East Coast ports. As a result of this trend our total volumes associated with West Coast ports declined 16% in the quarter, while volumes through East Coast ports increased by 8%.

Slide 7, illustrates the changing nature of our international flows and the trends I just discussed. For the quarter total import volume fell by 8,000 loads while export volume increased by 8,300 loads. As part of this changing international landscape we saw a decline of 17,000 units in the movement of empty containers back to port locations during the first quarter. Many of these boxes which previously moved in empty revenue service are now being used to support our growth in exports. And as you can see from this slide over half of our international traffic in the first quarter moved over the East Coast ports.

As depicted on slide 8, our total domestic and truck load volumes decreased 5% for the quarter reflecting a softer economy and the loss of Schneider National's business into the Southeastern market. Internodal marketing company volumes grew 2% somewhat offsetting the decline in truck load in domestic segments. The increase reflects the relative efficiency of intermodal versus over the road transportation in today's high fuel cost environment.

Our premium business which includes partial and LTL carriers was down 2% as LTL conversions from the highway partially offset softer parcel and the empty trailer repositioning volumes. And Triple Crown was up 2% in the quarter due to expansion of our fleet and improved rail service over our network. With respect to intermodal demand during the quarter and ahead there are clear signs of escalating demand across our network and in particular within the Eastern half of our market. Trucking continues to grow more expensive and as we introduce new intermodal lanes and products and our service performance reaches new highs we are seeing additional opportunities.

And with respect to service as shown in slide 9, our strong performance is being recognized by our customers. During the quarter UPS recognized Norfolk Southern for our commitment and dedication to providing consistent and reliable service throughout our network. UPS requires strong service performance in support of its customers and we are proud to provide that level of service to UPS and to be recognized accordingly.

Now turning to slide 10, our merchandise business sector reached its second highest quarter ever at $1.35 billion, up a $124 million or 10% over the same period last year. Volume fell 3% as lower auto production and continued weakness in manufacturing impacted shipments. Revenue per unit reached a record $2,047 up $240 or 13% over first quarter last year. Rate increases and higher fuel revenue drove this performance.

Within the merchandise market segments as shown in slide 11 agricultural revenue reaches $299 million, up $58 million or 24% over last year. The 4% volume gain was driven by strong growth in ethanol to the Southeast along with higher export gain and feed volumes due to the weak U.S. dollar and high international demand for agricultural products.

Metals and construction revenue is shown on slide 12, was up 11% or $30 million for the quarter. Higher volume from new and increased business in metals, machinery and aggregates offset declines in housing related commodities. The new coil steel business and increased inter-mill volumes helped offset weaker demand from the Detroit three automotive manufacturers. Aggregate shipments increased as our electrical utilities scrubber stone network continues to ramp up and growth in machinery was driven by export shipments from the Midwest over the ports of Baltimore and Savannah.

Turning to the next slide, chemical revenue reached a record $305 million up $31 million despite a 3% decline in volume. Continued pricing improvements and higher fuel drove the increase in revenue. Volume declines were driven by lower plastics and feedstock carloads linked to housing construction declines. Additionally, propane carloads dropped due to lower seasonal demand.

Now as shown in slide 14, our forest products revenue of $215 million for the quarter exceeded first quarter of last year by $4 million or 1%. Volume decreases were driven by the decline in housing, lower volumes of paper and delayed increases in waste shipments to selected disposal sites due to EPA and permitting issues. These declines were partially offset by stronger export, pulp board shipments.

And finally, automotive revenue on the next slide reached $228 million for the quarter, flat versus the same period last year despite a 10% decline in volume. Rate increases and better fuel coverage applied in the second half of 2007 and renegotiation of a major parts contract in the first quarter of '08 drove the improvement in revenue. Volume was negatively impacted by a reduction in North American vehicle production to 3.6 million units which was down 9% compared to the first quarter of 2007. This was coupled with the impact of the ongoing American Axle strike in Detroit.

Increases associated with BMW traffic in the U.S. markets along with developing export vehicle traffic from domestic producers to Europe partially offset volume declines.

Now turning to slide 16, despite the challenges in the current automotive market, we continue to maintain the highest level of service to our automotive customers which builds well for business ahead. During the quarter Toyota which holds its carriers to vigorous standards of performance awarded Norfolk Southern with its 2007 President's Award for overall logistics excellence among rail carriers. This is its highest recognition given to a logistic provider. This award is based on overall customer service, on time performance and quality. We are pleased that this is the fifth President's Award that is been presented to Norfolk Southern since Toyota implemented its program in 1996, and we are proud to be a Toyota preferred carrier.

Now turning to slide 17, and concluding with our strongest performer for the quarter, coal revenue reached $662 million up 19% over the first quarter of last year. Revenue per unit increased $225 per car or 17% due primarily to pricing gains and higher fuel revenue. Volume increased by 2% versus the same period last year, driven by strong export demand, reductions in the other market sectors stem primarily from coal availability and sourcing changes.

Turning to the individual coal markets on the next slide, export volume was up 64% over the first quarter last year and reached its highest toll of volumes since the second quarter of 1998. Carloads through Lamberts Point increased by 16,000 units or 60%, the dynamics of the export market continued to be in our favor as U.S. producers see increased demand for coal in [ph] Europe and Asia. The weaker U.S. dollar along with tight worldwide coal supply are driving the surge in demand. With respect to domestic coal utility volume in the northern half of our service network increased by 1,700 loads or 1%. During the quarter longer haul, higher rated spot movements were handled from the West due to higher demand and tight coal supply in our service territory.

But these gains were not offset... enough to offset a 11,000 carload or 7% decline to Southern based utilities. Volume in our domestic net coal market was 3% for the first quarter last year, coal supply issues due impart to the strong export market reduced domestic metallurgical volume while coal sourcing drove the decline in coke shipments. New shipments of domestic and import coke helped offset part of this decline. And industrial coal volume fell 20% driven by the shut down of the Wabash, Indiana mine and shipment delays due to coal sourcing and availability.

Now turning to slide 19, looking ahead for the remaining three quarters of the year we will face yield softness in the housing and automotive sectors of the economy along with a lot of puts and takes in the other market sectors. Despite this uncertainty, we expect coal volumes and revenues to be robust as export demand remain strong and domestic utilities move more aggressively to supplement stock piles in the face of tighter coal supply. Coal supply and Norfolk Southern mines will improve for the remaining three quarters of this year as the reopening of Kansas, [indiscernible] the start up Massey's new mammoth operation this month near Charleston, West Virginia and the first quarter start of Trinity Coal's [indiscernible] West Virginia all in combination will generate an additional 6.5 million tons of coal over the next three quarters versus the corresponding period of 2007.

And in intermodal and merchandise project growth is progressing as planned which will bolster volumes over the remainder of the year. Stronger exports throughout both sectors will supplement these project gains and with higher fuel prices combined with very solid service performance across our real network, we believe truck to rail conversions should accelerate as the year progresses.

And finally, the pricing environment for our high quality transportation service remain solid. And we remain on track to realize a minimum 4% pure pricing improvement for the year as a whole.

Thank you very much and now I will turn the mike over to Jim Squires who will represent our financial report. Jim?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

Thank you, Don and good morning everyone. I will now provide a review of our overall financial results for the first quarter.

Slide 2, is a snap shot of our operating results, as Don described record railway operating revenues were up 11% from last year. Operating expenses rose 12% resulting in $50 million or 9% improvement in operating income. The railway operating ratio for the quarter was 76.9 compared with 76.5 last year an increase of 0.4 percentage points.

The next slide depicts first quarter operating results for the past five years. As you can see, 2008 was a record first quarter with a 9% increase in operating income despite the effects of a legal settlement reached earlier this month.

Turning to our operating expense detail slide 4, shows the year-over-year change by major expense category. As you would expect the largest increase was in fuel, which rose a $156 million or 63%.

The next slide illustrates the components of the fuel increase, higher prices resulted in an additional $155 million of costs. Our average price per gallon of diesel fuel was $2.75, a 65% increase compared with 2007. There was a slight increase in consumption related to the mix of traffic.

Turning back to our expense categories, materials and other rose $26 million or 12%, the two primary components are listed on the next slide. As described in our April 7th, press release we reached a legal settlement related to the January 2005 Granitville accident. This settlement and offsetting favorable personal injury and environmental claims development combined to result in a $13 million year-over-year expense increase which reduced diluted earnings per share by $0.02. The other component of the increase was in materials costs which was $12 million related to locomotive and car repair materials. Nearly half of this increase was a direct result of higher prices for raw materials such as steel. Additionally, while our internal usage of car repair materials is up, you will see in a couple of slides that we had fewer third party car repairs.

The next largest expense increase was in compensation and benefits which rose $24 million or 4%. Slide 9, lists the two main reasons for the increase. First, a stock-based compensation rose $14 million due to this year's stock price increase and the combination of a higher earn out in 2008 and a lower earn out in 2007. Second, higher wage rates added $10 million to compensation costs.

Continuing on in our expense categories, the next slide shows the $9 million or 2% decrease in purchase services and rents. This was due to lower equipment rents related to the decline in traffic volume and also to fewer third party freight car repairs.

Now let's turn to our non-operating items. As you will recall the synthetic fuel tax credits expired at the end of 2007, therefore we no longer have this expense as a component of non-operating items and we no longer have the tax benefits associated with these credits. The second non-operating item with a significant variance is corporate owned life insurance which decreased $21 million. As you are aware the underlying investment returns can be volatile in this area, the $18 million net expense from corporate owned life insurance this quarter resulted in a $0.04 reduction to diluted earnings per share. And finally interest income declined $10 million as a result of lower cash balances.

The combination of the $50 million increase in income from railway operations and $6 million decrease in interest expense resulted in first quarter income before taxes of $476 million, which was $56 million or 13% above last year. Total income taxes for the quarter were $185 million compared with $135 million last year. The higher effective tax rate of nearly 39% compared with a rate of 32% in 2007 was driven primarily by the absence of the synthetic fuel tax credits.

As shown in slide 14, net income for the quarter was $291 million an increase of $6 million or 2% compared with the $285 million earned in the first quarter of last year, diluted earnings per share for the quarter was $0.76 which was $0.05 or 7 % more than last year.

Turning to the next slide you can see that these earning resulted in strong cash flows for the quarter. Operating cash flows exceeded $600 million and set a first quarter record. As depicted on slide 16, a portion of these strong cash flows was used to repurchase stock. In the first quarter of 2008, we brought back 5.6 million shares for $276 million and this brings our total purchases since inception to 51 million shares at a cost of $2.4 billion.

Thank you for your attention and I will now turn the program back to Wick.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Thank you, Jim. Well as you heard the first quarter was another very strong quarter for our company, even in the face of some economic head-wins, substantially higher fuel prices and some unanticipated legal expenses, it's worth noting that our operating ratio for the quarter would have been lower year-over-year but for those legal expenses. Our results continued to showcase our superior service products and our ability to recognize value from those products and they also showed the strength of our balanced portfolio of businesses.

Before, turning to you questions let me talk a little more about our operations and service levels for the quarter. Last quarter we discussed the composite performance measure that we have incorporated into our bonus calculation. You will recall that it is comprised of three key internal performance measures, how well we adhere to our Thoroughbred Operating Plan, how well we do and making the right connections in our terminal and the on time performance of all of our trains, measured within tight performance standards.

We put this measure into place in an effort to more closely align the interest of our employees in the field with the service goals of our company. It's been in place since the first of the year, and we are already seeing benefits of this approach in our operations. For the first quarter the composite metric improved 7% as compared to first quarter 2007, driven by improvement in all three of the internal performance metrics, TOP adherence, connection performance and train performance. Practically that means that we are doing an even better job of running our trains according to plan, moving cars more efficiently through our yards and then our trains are running on time, not to early and not too late.

You can also see the results in our public performance metric, as you would expect average terminal dwell time which is directly correlated with these three metrics has decreased year-over-year for the quarter. Both average train speed and cars online improved as well. You would expect to see cars online go down given lower volumes and better network connectivity. But the velocity improvement is particularly noteworthy given changes in the mix of trains that we're running. As faster intermodal and automotive trains are rationalized due to softening demand, our average theoretical system velocity actually decreases and the effect is magnified by the addition of unit trains on the coal and grain side.

However, as Steve Tobias, described in our last meeting, we're now in the process of scheduling our unit train network and the benefit in terms of asset velocity and utilization not to mention improved customer service are substantial with more to come. Looking at the rest of 2008, we know that we'll be facing some challenging economic conditions. Despite, the fact that I have spend a lot of time recently talking about whether railroads service the harbinger of the overall economy I can tell you that my crystal ball is no better than any of yours.

However, the good news for all of us at Norfolk Southern is that the project driven growth which we discussed at our last meeting and Don just mentioned is still in place and coming online. And we expect that the strength that we see in key part of business will continue. In the current economic environment, we'll continue to operate our business in a prudent and nimble manner, which will allow us to react as necessary to whatever the economy throws our way. At the same time, we will not lose sight of or stop planning for the opportunities that will exist for us as the economy strengthens.

Thank you and I will now turn the program over to the operator, so that we can begin the Q&A session.

Question And Answer

Operator

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from Tom Wadewitz with JPMorgan. Please state your question.

Thomas Wadewitz - JPMorgan

Yes, good morning. Ahead of time here I apologize if I am asking something that you might have mentioned there was a little overlap in your call with another conference call. But in any case on the pricing and in the yield side... wanted to see if you could give a little further comment on what drove up the same-store price I think you said it was 7%? And then also if you could maybe give the breakdown in the total yield the 13.9 between price fuel and whether there was any meaningful mix impact we should consider.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Don?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

With respect to the last part of your question, the mix was negligible in the quarter. So, no impact to speak off from mix. The yield of 7% was a timing issue with respect to increases that we took in the first quarter that will apply through subsequent quarters over the year. So... and then of course the remainder were some of the index increases that were taken in existing contracts, which is part of the ongoing escalation in contracts that have been negotiated.

Thomas Wadewitz - JPMorgan

So, essentially it's of the 13.9, it's 7% price and 6.9% fuel that's the right way to look at it?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

That's a good way to look at it.

Thomas Wadewitz - JPMorgan

Okay. And you think the 7% that continue to that level through the year, you have got --

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Tom, as I mentioned, you might have missed the last comment that I made in my remarks.

Thomas Wadewitz - JPMorgan

Right.

Donald W. Seale - Executive Vice President and Chief Marketing Officer

That we feel; we are on track, as we mentioned to you in the fourth quarter of last year. We are on track for '08 to come in at a minimum of 4% for the year as a whole.

Thomas Wadewitz - JPMorgan

So, how do I resolve the difference between, I mean you are expecting it to really tail off quite a bit later in the year or is the 4% just a conservative number because that's quite a bit below the 7% that you are talking about in first quarter?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Well as we have mentioned in the past the quarters it's not ratable quarter-to-quarter. So we may have some quarters that are stronger, some quarters that are not from a timing perspective. But we are still comfortable with the minimum of 4% for the year as a whole, taking into account the timing as we go quarter-to-quarter.

Thomas Wadewitz - JPMorgan

Okay. And in terms of the impact of export coal, the export coal price is obviously getting dramatic increase and my understanding is you have repriced your... the transport price for export coal on an annual basis starting April 1st. Is there a potential that we would see a further acceleration in your reported yield, when we get into second quarter and when you have got the impact of export coal pricing coming in as well?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Well, the export coal market is very dynamic, as I have discussed and most of our coal is in contract which is confidential with respect to the terms. But you will continue to see us look at that very closely with respect to the demand equation and the supply equation with respect to transportation. We will continue to move the needle on pricing with export coal but I cannot comment beyond that, because it's... they are in contracts.

Thomas Wadewitz - JPMorgan

I mean we are not talking about specific contracts is that, logic that coal prices are up a lot so you can take advantage and have some increase in your transport contract. Is that a fair way to look at it or I am missing something?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

I don't want to comment on our pricing strategy, with respect to exports but the world wide coal market is tight and with the devaluation of the dollar we have got some very strong demand in Europe and in Asia for U.S. coals. And we are supporting that with our coal shippers and as we negotiate our contracts we take all of that into account because we do price to the market.

Thomas Wadewitz - JPMorgan

Okay. And then the last one I'll turn over to someone else. On the purchased services, there is a meaningful improvement as a percent of revenue in that line, again I apologize if you have already mentioned this but can you tell us what the driver was and whether we should be that is an impact it would likely continue over the next couple of quarters?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

Yes, Tom this is Jim I will cover that. The biggest factor there in the combined purchased services and rents was first lower equipment rents and then on the services side, we had fewer third party freight cargo repairs that was offset by increased materials expense on the materials and other side. But then in addition we have lower traffic volumes and the reserve volume metric element to the purchased services as well for example, intermodal lifts. So that was the reason for the decrease there.

Charles W. Moorman - Chairman, President and Chief Executive Officer

And Tom to give you a little more color just on the freight car repair side, and the material side we are looking across the year at freight car programs that are about the same as last year's. We don't have any increases remember [ph] we do plan on maintaining the fleet. We clearly have some inflation built into that and as you heard we saw some of that in the first quarter. So it will be a little bit it won't be purely ratable in terms of third party repairs or material purchases. But we are looking at programs particularly on the car side that look about like last year's.

Thomas Wadewitz - JPMorgan

Okay, good. Well, thank you for the time I appreciate it.

Operator

Thank you. Our next question comes from [indiscernible].Please state your question.

Unidentified Analyst

Thanks, good morning, guys.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Good morning, Ed.

Unidentified Analyst

Couple of things first just a lit bit more clarity on the 7% pricing in the quarter versus the guidance for 4% I just don't understand how if you are getting pricing on that amount of your business right now, why that would change quarter-over-quarter so quickly? Could you give just a little bit more flavor on that?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Well, good morning Ed, this is Don. As you recall into fourth quarter, we had a 9% increase in RPU with 8% after backing out the item for automotives. So, basically we are gone from 8% RPU to 14% RPU, fuel was higher and fuel was about half of the 14% gain in RPU and 7% pure price and the price was related to the timing of some coal reprising but also some pricing in automotive contracts that I mentioned in my prepared remarks. Some other activities where the timing of those increases are applying and going forward.

Now we may see in subsequent quarters and for the rest of the year where we will be above the 4% or we might be down comparable to it. But we are still comfortable with the overall minimum afford [ph] could be little higher than that, it could be close to being right on that number.

Unidentified Analyst

And Don if you have got coal contracts that repriced in the first quarter, why wouldn't those say repriced with the year-over-year comp and be up severance [ph] charges is that?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

They will stay for the balance of the year but we have got some other mix since some other activities that take place in the subsequent quarters that may not drive the number quite as high as 7% going forward.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Ed, you will recall that last year from quarter-to-quarter, we had some variability in that and in fact we had one quarter in which our underlying pricing seemed to be below 4% and we have got a lot of questions about that. But we can't always give you a ratable number quarter-to-quarter. But I think we're comfortable with what we're saying right now that we may have a few ups and downs but for the year we are comfortable that we'll get a minimum of 4% and if economic conditions in the markets co-operate hopefully we'll do better.

Unidentified Analyst

All right, thanks. In terms of repricing of contracts in '08 can you go through how many contracts... what percent of contracts you're going to reprice and which one's haven't repriced since '04 and if any of those took place in first quarter?

Charles W. Moorman - Chairman, President and Chief Executive Officer

Yes, as we've mentioned in the past, we've got about two-thirds of our total book of revenue under contract about 67%, 68%. And the average duration of those contracts now have stopped selling the rates [ph] three years. So we have approximately a third of those contracts that will be repriced each year. The actual number for 2008 exactly Ed is 28% of our contracts.

Unidentified Analyst

And what percent of that 28 repriced in the first quarter already?

Charles W. Moorman - Chairman, President and Chief Executive Officer

We had in the first quarter about half of that 28%.

Unidentified Analyst

Jim as to the fourth quarter's operating expenses excluding fuel being down, we saw a 2% increase in first quarter, implement the Granitville settlement. Were there any unusual one time costs in there how should we think about operating expenses going forward?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

Well we highlighted the $0.02 from the legal settlement net of favorability and claims. Other operating expense changes in the quarter, we would not characterize this unusual or one-off. But I think we expect to see a somewhat lower rate of increase in the materials expense column for the rest of the year.

We would expect to see, depending on volumes, contingent favorability in purchased services and rents. Now on comp and benefits the story there was twofold. On the on hand, we had a rise in our stock price in the quarter and that affects the stock-based compensation piece of things. And then in addition, we had higher earn outs, the adjustments to stock-based compensation accruals to reflect higher earn outs and that was again really driven by the increase in our stock price in the quarter versus the benchmark S&P 500 upon which we base our total shareholder return component of long term comp.

And then lastly we did have wage rate increases in the quarter the majority of which were scheduled graded increases and that added to the compensation expense increase as well.

Unidentified Analyst

But what was the stock-based comp impact in this?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

I am sorry.

Unidentified Analyst

What was the stock-based comp in dollars impact this quarter versus a year ago?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

It was $14 million, it went to $65 million from $51 million in the first quarter of 2007 and that was a combination as I mentioned of earn out and stock price increase about 50-50 and then a small adjustment for other stock-based compensation and then we had $10 million increase in wage rates.

Unidentified Analyst

All right. Is 39% as good as any for a tax rate going forward?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

Well, I think we're going to see an effective rate throughout the year in the high 30s, probably 38%, 39% somewhere in that vicinity for the rest of the year would be our expectation.

Unidentified Analyst

Okay. And the $18 million, the corporate owned life insurance that's a one-time event or does some of that carry forward?

James A. Squires - Executive Vice President Finance and Chief Financial Officer

See, well what you saw there were changes in the value of marketable securities which constitute the underlying collie [ph] investments. Those have to be mark-to-market each quarter and because in the quarter, we saw roughly 5% decline in the value of the collie investments, is that along with some other adjustments in the collie net number created the unfavorable variance. And it is above little item because of the mark-to-market accounting for it and so if you look back it has fluctuated over the years.

Charles W. Moorman - Chairman, President and Chief Executive Officer

A little bigger fluctuation in the first quarter than normal and another thing in this has a slight effect on the text rate that does not have tax shield so we had a custom to seeing a little movement every year... every quarter in the collie depending on what underlying securities do this one, with larger than we are accustomed to seeing. But we don't expect... we don't know what the markets will do in general. But this is... it's certainly not something we are expecting to see on a continuing basis.

James A. Squires - Executive Vice President Finance and Chief Financial Officer

The other moving part and other income that was the lower interest income as well that declined $10 million and that is a reflection of much lower cash balances this year than we had at this time last year.

Unidentified Analyst

Okay, one last question for Don, on the coal side, how sustainable is this 64% growth in export coal I mean you are on the run-rate I think of 23 million ton?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Ed, obviously, demand where the dollar is coal supply is a big part of this as well we have handled more coal than this obviously in the past, and we have got the capacity at our peer at peer six and peer five t land at this point [ph] is point ramp up additional capacity. At one point we handled as much is 40 millions tons over that but it's a function of where the dollar is, where other International production is namely Australians, South Americans as well as the Russians, and then the... then just the overall ongoing demand. I don't anticipate that run-rate continuing into the future for coals, obviously we have some coal supply constraints that I don't believe will support that type of volume increase.

Unidentified Analyst

The other question is... assuming the demand is there, do you think the supply chain can handle... how much can they handle do you think... not just you but the whole?

Unidentified Company Representative

I'm comfortable with the supply chain with respect to our capabilities and our port capacity, obviously we would have to ramp up some additional capacity that's been more call [ph]. But we have that capability of doing that... and I don't know if you saw the New York Times, this morning Ed, that the front page has the headline its 50 additional new cold fired utility plants being built in Europe, because of concern of short falls in electrical generation capability and the fact that natural gas is now need to be less dependable and very, very expensive in Europe. So, that's somewhat of a change when we see that type of activity that's being documented.

So... we could see demand in Europe for U.S. coal on the steam side as well as the metallurgical side for steel making, change and we are in the midst of that change right now.

Unidentified Analyst

: I thank all of you for all your time. Thank you its all very helpful.

Unidentified Company Representative

Thank you Ed.

Operator

Thank You. Our next question comes from John Barnes with BB&T Capital Markets. Please say the question.

John Barnes - BB&T Capital Markets

Hey good morning guys you guys did a phenomenal job on the coal side. I mean all the 40 basis points are overall degradation year-over-year, when you had fuel go up, at the pace it did, I am curious as to as volumes begin to rebound and these are models that have always done a little better when you push them a little bit more a little bit more volume to the system, and I guess... I don't mean to be longwinded. But the nalcomma [ph] company had been, you kind of reached a low 70s award and it seemed like that was always the hurdle it was stuff to get through and get lowered than kind of that 72 and 71.5 some were in that ball park.

Do you feel like the cost that you took out this quarter and your ability to really perform well in the margin side in the phase of higher fuel cost translates into a much lower overall as volumes begin to recover. Can we see something in a better economy? Can we see a high 60s award at Norfolk?

Unidentified Company Representative

Well, John, you know how we have stayed focused on our OR [ph] for a long time in this company and I think you put your finger on an important point. As we have improved our service, added physical capacities and networking and really brought our assets up to a level of maintenance, this allows us to provide the service we do we think that we have the ability now as volumes continue to... as volumes comeback and grow, to add additional services and services that are higher level, without a significant impact in our cost structure and I think that sets the stage, that kind of operating leverage sets the stage.

As our growth resumes and economic condition is down pointed out may drive traffic to the rails even before the rest of the economy starts to comeback and that is going to allow us... we hope and plan to do some significant things with our operating ratio. It is... it's tougher the lower you get, there is just know question about that, but we have not lost sight of that and, I will tell you our goal is to have an operating ratio of... with a six in front of it and we are going to keep working hard to get to that goal and I think that we have got the company and Steven, his folks have gotten our operations in to a very good place to do that.

John Barnes - BB&T Capital Markets

Okay, al right very good. In terms of some of the market opportunities that are out there, there is export coal and I think I read some place that they are starting to put a fair amount of investment back in the things, like Lamberts Point again. How do you balance, export coal looks really attractive right now given, the dynamics in the market place weak U.S. dollars and things like that.

But how do you balance making the necessary investments to support things like export coal, where you just, you don't have a good read in to a longer term. I mean, I think at the peak you are at, what that the peak you do in twice or maybe three times as much export coal as you are doing today or a year ago. So how do you balance making those CapEx decisions out with some uncertainty as to what the long term benefit could be?

Unidentified Company Representative

Well that's is a great question. If you look at our facility and you are right, we peaked out through Lamberts Point at something north of 40 million tons a year. It's still a great facility. Its in a very good state of our repair and we can add capacity there as Dan said very easily, its really more a question of kind of ramping up the train service and the cruise in the facility rather than having to make significant investments in CapEx.

Having said that we still have to make investment, we still have to plan ahead, we still had to think about hiring. But one of the things that we've been trying Dan and his team have been trying to do is to really get a handle on what's this export market look like for the longer term, and I have to say that what we're hearing from a lot of folks in the coal industry is that this is going to be with us for awhile. And what they are looking at are things like the new coal plant is being built in Europe.

They are looking at the fact that China is not exporting coal anymore. As all couple of other formerly called coal exporting nations. They are looking at the issues and these maybe shorter term but they have been there for awhile with getting some of the Australian coal lot of Australia. And they are also looking at things like bulk shipping rates, so, the more we go into this export boom, the more we think that this really has legs, for not just one or two years but for multiple years, and that will as we think about investment.

John Barnes - BB&T Capital Markets

Okay, very good, guys nice quarter, thank you for your time.

Unidentified Company Representative

Thank you.

Operator

Our next question comes from William Green with Morgan Stanley, please state your question.

William Green - Morgan Stanley

Yes, Dan I'm sorry to bring this up one more time, but just in terms the pricing, is it... that you have some fuel rebasing in there as well?

Unidentified Company Representative

In terms of the 7% and I mentioned it is pure prize.

William Green - Morgan Stanley

Okay, and then... with regard to utility stock piles in your region, how do they look at this point?

Unidentified Company Representative

Well, could you repeat that please, I didn't catch it.

William Green - Morgan Stanley

Oh sorry, I said in terms of utility stock piles in your region how do they look?

Unidentified Company Representative

Yes... we have got the Northern utilities that generally the stock piles are lower and as I mentioned in our... in our end remarks that business was up in the first quarter, we even move some traffic some coal from the west to stop the coal supply, in the south the utility stock piles had been higher, but I can tell you that we have the information that those are beginning to come down and we have some indications that those utilities are coming into the market... seeking coal very aggressively, because coal supply later this year could be a very real issue... for all utilities as they worked to plenty of stock piles so I think we are beginning see... the northern utilities for [indiscernible] to replenish already lower stock piles and our southern utilities take a more aggressive approach to... seeking sourcing to stock replenishing theirs.

William Green - Morgan Stanley

Okay, and then in terms of... if you exclude coal and you have looked the merchandize and automotive traffic and what not what gives you confidence that you can actually grow volumes for the remainder of the year, because it seems to me that lot of your other sort of freight competitors [ph] are sort of suggesting that... that will be tough... given the economic environment?

Unidentified Company Representative

Well it starts... starts with our projects that are coming on stream and we have mentioned those specific projects that we have in our budgets which we know will generate business. But we are also seeing, even in April our volumes trend up we are up about 1% intermodal has trended positive... we have got some positive indicators on the steel markets business is still year-over-year.

Our aggregates business where I mentioned the scrubber stone going to utility plants that's ramping up so we have got new project driven volumes that are in the network that we feel will generate the type of year-over-year growth that we are talking about and then the wild card here is the conversion from highway, taking into account $4.25 diesel cost on highway. And we are seeing some of our intermodal truck load segments within the eastern half of our market in particular and this is the intermodal service back in single line areas within the east. Beginning to get traction with respect to new business. That's being converted from highway to rail. So, you put all that together and we still see some uplift in volume this year.

William Green - Morgan Stanley

How far or below do you think your intermodal rates are versus the road?

Unidentified Company Representative

That is a moving target Bill as you know because the truck cost move that gap widens it varies depending upon the market segment that's something we are watching very carefully. And we are going to continue to price our intermodal service through that market.

William Green - Morgan Stanley

Al right, thank you for your help.

Operator

Thank you, our next question comes from Ken Hoexter with Merrill Lynch, please state your question.

Ken Hoexter - Merrill Lynch

Hi good morning. You did a great job on controlling cost this quarters. Just want to understand you have lowered your employee count in two quarter in a row, can you talk a bit about what kind of target is as far as continuing that trend?

Unidentified Company Representative

Yes, good morning Ken employees count have come down a little bit we are watching that very carefully as we have discussed before we have a significant attrition issue facing us over the next few years due to demographics of our work force and we have been hiring aggressively as you know for a awhile but we have some very good model which take traffic levels into account and as we've seen traffic soften we really started to moderate on our hiring and work that into our plans. If you actually look at our numbers year-over-year, they would be even lower were it not for the fact that our numbers are up on our non-agreement side, our management side because we brought in a significant number of management trainees year-over-year. And I think that's a smart thing for us to do.

I think looking forward in the year depending again on traffic levels, we hope that we'll see the numbers continue to moderate slightly, we don't think we're over sized right now and we're trying to just kind of make sure that we've got the right number of people to run the trains and have enough people to run them on time. And that's the way we're going to continue to manage.

Ken Hoexter - Merrill Lynch

All right. And if something over your fuel surcharge for a second, can you talk about what the change to the mileage based program I know that was for a small part but... and then on the coal fuel surcharge how much is WTI versus on highway diesel based method?

Charles W. Moorman - Chairman, President and Chief Executive Officer

Don?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Ken as you might know and we have no fuel surcharge in place on our public prices. Everything else is in contract and I cannot talk about the structure of what we have in our contracts because of the confidentially. But all our originated public prices, we are using market based pricing to cover up the all of the components of our cost plus the market.

Ken Hoexter - Merrill Lynch

So you can't even... I am not asking a specific contract in generally or you can just say if most of your contracts are based on WTI or are you exposed to crack spreads or?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

No, no. In terms of our basic proxy that we are using we continue to use West Texas and Armenia crude oil.

Ken Hoexter - Merrill Lynch

So then you are exposed to crack spreads as they have widened?

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Yes.

Ken Hoexter - Merrill Lynch

Okay, all right, great. Thank you very much.

James A. Squires - Executive Vice President Finance and Chief Financial Officer

Thanks. Ken.

Operator

Our next question comes from David Feinberg with Goldman Sachs. Please state your question.

David Feinberg - Goldman Sachs

Good morning, gentlemen. I think you touch on this earlier but I just want to make sure I covered with regard to your intermodal and merchandize business, where you talked about the rest of the year lying on projects coming on stream, one of the answers to your earlier question you mentioned steel and scrubber stone was there anything else that we should bear in mind as we look throughout the year?

Charles W. Moorman - Chairman, President and Chief Executive Officer

Well certainly, I mentioned exports and exports we're continue to see some new business opportunities emerged from that almost monthly. We're seeing new finished vehicles produced in the U.S. being exported to Eastern Europe. And the market is growing in Eastern Europe with respect to that demand. Machinery is another commodity where we are seeing very, very strong demand in Europe for exports and we are participating in that. So, the exports in general I think for intermodal as well as the merchandize column [ph] business, where another commodity that I haven't talked about is grain in carload business another commodity that I haven't talked about is grain and containers that are being exported over East Coast ports. That's another growth opportunity.

David Feinberg - Goldman Sachs

And, in order to see that come through is that just existing business that will be shifting or do we actually need to see change in your facilities or things like Rickenbaker coming online?

Charles W. Moorman - Chairman, President and Chief Executive Officer

No, actually, we have a lot of the infrastructure already in place that enables us to participate in these projects. The scrubber stone is a good example we have the, the equipment generally is private equipment that's leased by a private supplier not leased by Norfolk Southern. So those arrangements are already in place certainly as we open new facilities like Rickenbaker it will have a positive impact with respect to our capacity and our ability to grow intermodal traffic in Ohio valley. So those types of projects which are in our plan as we open those, it enables us to handle more volume.

David Feinberg - Goldman Sachs

Right. And then one follow-up question with regards to legal settlement I imagine in any given quarter you will host legal settlements that you may or may not be making. As we look forward are there any other large cases that are pending, we should keep an eye on that may affect results as they did this quarter.

Charles W. Moorman - Chairman, President and Chief Executive Officer

We wouldn't anticipate anything, the magnitude of the Granitville issues, you never know but this... on a regular run-rate basis we don't see these kinds of things.

Donald W. Seale - Executive Vice President and Chief Marketing Officer

Great, thank you.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Okay.

Operator

Thank you. There are no further questions at this time. I will turn the conference back over to Mr. Moorman for the closing comments.

Charles W. Moorman - Chairman, President and Chief Executive Officer

Well, thank you very much everyone for listening in. We appreciate all of your questions and we look forward to talking to you again in the near future. Thanks.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you all for your participation.

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Source: Norfolk Southern Corp. Q1 2008 Earnings Call Transcript
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