Con-way Management Discusses Q3 2012 Results - Earnings Call Transcript

Nov. 1.12 | About: Con-Way Inc. (CNW)

Con-way (NYSE:CNW)

Q3 2012 Earnings Call

November 01, 2012 8:30 am ET

Executives

Patrick J. Fossenier - Vice President of Investor Relations

Douglas W. Stotlar - Chief Executive Officer, President and Director

Stephen L. Bruffett - Chief Financial Officer and Executive Vice President

Walter Gregory Lehmkuhl - Executive Vice President and President of Con-Way Freight Inc

Analysts

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

Jason H. Seidl - Dahlman Rose & Company, LLC, Research Division

Allison M. Landry - Crédit Suisse AG, Research Division

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

John L. Barnes - RBC Capital Markets, LLC, Research Division

Arthur W. Hatfield - Raymond James & Associates, Inc., Research Division

Scott H. Group - Wolfe Trahan & Co.

William J. Greene - Morgan Stanley, Research Division

Justin B. Yagerman - Deutsche Bank AG, Research Division

Christian Wetherbee - Citigroup Inc, Research Division

Operator

Good morning. My name is Brandy, and

[Audio Gap]

conference operator today. At this time, I would like to welcome everyone to Con-way Inc.'s Third Quarter Earnings Review Conference Call. [Operator Instructions] Thank you.

I would now like to turn the call over to Patrick Fossenier, Vice President of Investor Relations. Please go ahead, Sir.

Patrick J. Fossenier

Thank you, Brandy. Welcome to the Con-way Third Quarter 2012 Conference Call for shareholders and the investment community. In a minute, I'll turn it over to Con-way President and CEO, Doug Stotlar.

Before we get into the call, I'd like to offer a few reminders. First, certain statements in this conference, including statements regarding anticipated results of operation and financial condition, constitute forward-looking statements and are subject to a number of risks and uncertainties. Actual results of operation and financial condition might differ materially from those projected in such forward-looking statements, and no assurance can be given as to future results.

Additional information concerning factors that could cause actual results and other matters to differ materially from those in the forward-looking statements and the inherent limitations of such statements is contained in our Forms 10-K, 10-Q and other filings with the SEC.

Second, today's prepared remarks contain non-GAAP financial measures. Reconciliations of GAAP to non-GAAP financial measures are found within the financial tables of our earnings release, which is available on our website at con-way.com.

We understand that there are other industry calls today, so we'll be sure not to go over an hour on this call. I'd also like to note that we have a lot of people on this call, so we'd appreciate it if you'd limit yourself to a question or 2 then return to the queue.

Now, without further ado, I'm pleased to turn it over to Doug Stotlar.

Douglas W. Stotlar

Good morning, before we begin this morning, we want to extend our heartfelt thoughts and prayers to those who have been affected by Hurricane Sandy. For those of you with us on the call this morning from the Northeast, we hope that you and your families have come through these past few days without incident and are starting to get your lives back to normal.

On the call today, I'm joined by members of our senior leadership team, including Con-way's CFO, Steve Bruffett; Con-way Freight President, Greg Lehmkuhl; Menlo Logistics President, Bob Bianco; and Con-way Truckload President, Saul Gonzalez.

Steve will provide some commentary on our financial picture, and then in the Q&A portion of the call, Greg, Bob and Saul will be available to answer questions about their business units.

While we continue to be encouraged by the service performance and consistent operational execution of our businesses, operating income results for the third quarter of 2012 fell short of our expectations, a lower operating income was due in large part to higher than anticipated expenses for employee benefits, primarily healthcare costs at Con-way Freight and Menlo.

Results also were affected by investments in technology that support our 3-year continuous improvement roadmap for Con-way Freight. These investments are key to our strategy and are positioning Con-way Freight with the foundational capabilities for continuous operational improvement and progress toward net margin expansion.

Turning to our consolidated financial results for the third quarter of 2012, Con-way recorded consolidated revenues of $1.4 billion, a 2% increase over last year's third quarter revenues of $1.38 billion. Our operating income was $55.2 million in the 2012 third quarter, a 9.7% decrease from the $61.1 million earned in the prior-year period.

Diluted earnings per share were $0.45, compared to $0.52 per share in the third quarter last year.

Moving now to a review of our business segments, I'll start with Con-way Freight, our LTL operation and largest revenue segment. Con-way Freight posted third quarter operating income of $34.4 million, down 15.4% from the $40.7 million earned in the same period a year ago. Revenue was $858.3 million, a 1.8% increase over last year's third quarter revenue of $843.3 million. While improved yield contributed to the increased revenues, we did have to deal with the effect of one less workday in this year's third quarter compared to last year.

Con-way Freight's operating ratio this period was 96.0 compared to last year's third quarter operating ratio of 95.2. Third quarter revenue per hundredweight or yield increased 3.5% from the previous year third quarter. Excluding fuel surcharge, yield rose 3.4%, and when adjusted for length of haul and weight per shipment, yield ex fuel was up 3.5% in the third quarter compared to last year.

Tonnage per day for the 2012 third quarter decreased 0.2% from last year's third quarter. For the month of October, tonnage was down about 3% year-over-year prior to the effects of Hurricane Sandy. Given these volume trends, we expect the fourth quarter of 2012 to be challenging as well.

Over the past several quarters, we've talked about our multiyear strategy to improve our capabilities in ways that will enable us to drive margin expansion at Con-way Freight. This 3-year continuous improvement roadmap incorporates the implementation of lean principles, at both the grassroots level for local initiatives, and for systemwide projects, or we can utilize the more complex problem-solving tools for project management, prioritization and value stream mapping.

From the beginning of this process, we targeted 2 core areas of the LTL business model that provide the greatest opportunity for unlocking value. The first area is pricing sophistication and the second area is line haul network design and optimization. We invested in and deployed the technologies to allow us -- to allow for this sophisticated data analysis necessary to gain a deeper understanding of the opportunities for improvement that exist within these complex and interwoven aspects of the business.

Over the past year, our teams have developed the framework and models to support implementation of lean-based pricing, in conjunction with dynamic linehaul optimization. This work has been laborious, but after a year in development, we believe we have transformed our capabilities.

The pilot test designed to verify the model's capability have produced intended results. We will continue to make enhancements as we learn more, but we are confident that we will able to achieve significant improvements in these focus areas.

Over the next 60 days, we will complete the steps necessary to prepare the field organization for implementation of the new models. Over the course of 2013, as we work through our account base during contract negotiations, we will incent customers to utilize our network, where we can test leverage or operating structure. Our new linehaul models will dynamically adjust to the freight loads as they change. We anticipate we will take the first quarter of 2013 to get the ball rolling and then we expect to see meaningful benefits as we progress through the year.

Having prepared the foundation during 2012, we are now ready to leverage lean, to develop tests and deploy networkwide process improvements and technology implementations. Another key tenant of lean is sustained. And this means not only having the foundation in place to implement improvements, but equally important, to have a lean process-oriented culture at the frontline to sustain and increase the gains after implementation.

We're excited about the future of our LTL company and are very focused on executing our strategic initiatives and remain confident in the benefits and competitive differentiation we expect these initiatives to deliver.

Now we'll move to our Logistics segment. For the 2012 third quarter, Menlo Worldwide Logistics, our global logistics and supply chain management company, recorded operating income of $11 million, a 13.3% decline from the $20.7 million earned in last year's third quarter. Revenue for the quarter was $427.8 million, an increase of 2.6% over the prior year revenue of $417.1 million.

Net revenue, or revenue less purchase transportation, came in at $159.8 million, a 3.3% increase over the $154.7 million generated in the previous year period.

Menlo's second quarter highlights included increased revenues and profits from transportation management services, offset somewhat by declines in warehouse management services. While we are seeing relatively good growth with international business, we are also experiencing some declines in domestic account volumes, particularly with our larger long-term customers due to the soft economy.

On the operating income side, lower operating income in the third quarter was due primarily to 3 factors. Higher healthcare costs, softer business levels from existing customers and changes in the timing of gain share awards from performance-based contracts. We also had higher costs from other operating expenses associated with certain warehouse management accounts.

Menlo has a solid position in the supply chain management market and is well-situated to take advantage of growth opportunities. Our logistic company's recognized leadership in lean provides clear value differentiation in the market. We have an excellent platform and a strong portfolio of services that is well aligned with our customer's needs. Our pipeline is robust, we are winning a good share of new projects and we are implementing and managing them successfully. We're confident and optimistic about Menlo's prospects and opportunities for growth.

Now, I'll review results at Con-way Truckload. For the 2012 third quarter, Con-way Truckload reported operating income of $11.3 million, a 43.3% improvement over the $7.9 million earned last year. The increase in third quarter operating income resulted largely from improved pricing and lower workers' compensation expense. Revenue increased 0.9% to $160.1 million over last year's second quarter revenues of $158.7 million. Revenue per loaded mile, excluding fuel surcharge, was down 2% from the previous year third quarter.

The operating ratio, ex fuel surcharge, improved to 90.9 from 93.6 in the year-ago period. Loaded miles were down 1.1% compared to the previous year's second quarter, while empty miles were essentially unchanged from last year at 9.5%.

Con-way Truckload has an excellent foundation in place. The year-over-year results achieved by our truckload company in the third quarter are a direct reflection of the strategic investments we've made in this business unit over the past 2 years. By refreshing the fleet, we've driven the average tractor age down to our target levels, that's enabling us to manage overall maintenance cost more effectively, improve fuel economy and realize advantages in driver recruiting.

Again, we focused on improving in the key operational areas of the truckload business that make a difference and present the highest potential for return. And with Con-way Truckload in the early stages of its lean journey, we are confident that we'll continue to make progress as we use lean tools to improve our processes and systems and engage our employees in continuous improvement initiatives.

Now, I'll turn it over to Steve Bruffett for some additional financial perspective.

Stephen L. Bruffett

Thanks, Doug, and good morning, everyone. I'll begin with our third quarter cash flows, and cash from operations was $68 million as compared to $50 million in the third quarter of last year. A good portion of the year-over-year increase was due to a lower pension funding during this third quarter, as compared to the 2011 third quarter.

On a year-to-date basis, cash from operations was $230 million this year as compared to $236 million last year. The more significant year-over-year changes were due to net income and cash taxes.

Through September, net income was up $27 million versus source of cash, income taxes for use of cash due in part to $7 million of taxes paid during 2012 versus $28 million of tax refunds in 2011.

Net capital expenditures were $64 million this quarter, as compared to $55 million in the third quarter of last year. Year-to-date, net CapEx was $200 million, that's up from $178 million in the first 9 months of 2011.

For the full year of 2012, we still expect net CapEx to be approximately $300 million. As such, we expect the fourth quarter of 2012 to put in about $100 million of net CapEx, and that's mostly for new drivers.

Financing activities used about $24 million of cash during the quarter, as compared to $14 million last year. The increase is mostly due to higher repayments of capital lease obligations.

As of September 30, our cash and marketable securities totaled $445 million, as compared to $451 million a year in 2011.

Moving to the consolidated income statement for the third quarter, revenue was up $27 million on a consolidated basis. We would normally expect to see some incremental growth in operating income as a result of the increase in revenue, however, our operating income was down $6 million when compared to the third quarter of 2011, and this is driven by a couple of notable cost variance. The first is, as been mentioned, with healthcare. After several quarters of falling for predictable trend, our third quarter 2012 healthcare expenses slide to over $55 million, this is $9 million higher than in the third quarter of last year.

For additional perspective, our healthcare cost for the first 9 months of 2012 were $144 million, as compared to $124 million in the same period of 2011. So nearly half of the year-to-date increase occurred during the third quarter.

We're actively pursuing ways to mitigate future increases, while still offering competitive business package to our employees. For example, we've made structural changes to our health plan options for 2013 and we plan to expand our existing wellness programs.

The second cost item is 401(k) expenses which were up nearly $4 million in the third quarter of 2011, this was mostly due to the fourth quarter 2011 restoration of certain declined contribution benefits that had been suspended during the economic downturn.

While we've obviously planned for these expenses, it still impacts the year-over-year comparisons. The third quarter was the last quarter that we'll have need for a year-over-year variance for this particular item.

I'd also like to bring your attention to an upcoming change in how we report income or expense related to our declining benefit pension plans. Our current practices is to allocate this income or expense to business units. Beginning 2013, we plan to retain pension-related items at the corporate level and report them in the other section of our financial statements. Our defined benefit plans are fully frozen, and therefore have no service costs associated with them. As such, the income or expense related to these plans is predominantly driven by long-term discount rates, and to a lesser degree, corporate decisions regarding pension funding and asset allocation. In other words, our legacy pension plans have little to do with the ongoing operating results of our business units.

During next quarter's earnings release cycle, early February 2013, we'll provide a schedule of historical quarterly information showing the amount of pension income or expense that's been allocated to the business units over the last couple of years, so that you have a full visibility to the impact of this change.

To summarize my comments on the consolidated income statement, I definitely have the sentiment that our third quarter results did not meet our expectations. In the near term, we have a sharp focus on adjusting variable cost to softer economic activity, and over the longer-term, our path to further enhance margins, particularly in Con-way Freight, involves step function improvements in fundamental areas such as how freight moves through the network. Making this type of change requires careful analysis, planning and testing. Much of this activity is taking place this year, which positions us to execute in 2013.

I would note that this path is not likely to be linear in nature, rather we expect to have periods of time in which we will make strides forward and then, we would allow some time to absorb the changes and ensure that they are sustainable before we move on to the next phase of improvement.

Overall, we're encouraged by the opportunities that's been identified and the foundation that is now in place, but we're focused on converting these opportunities into financial results as we move forward.

Before I turn it back over to Doug, I'd like to provide a few forward-looking guidance for your modeling purposes. For the full year of 2012, we expect depreciation and amortization expense to be approximately $215 million. We also anticipate our full-year effective tax rate, exclusive of discrete items, to be about 38.7%, and our fully diluted share count for the year should be $56.5 million.

So with that, I'll turn it back over to Doug.

Douglas W. Stotlar

Thanks, Steve. In summary, while the economy may help or hurt our overall results in 2013, we expect to deliver visible and notable progress from our lean-based initiatives. We're focused on the highest leverage parts of the business. We have proven our ability to impact the metrics using lean. And we have an engaged and energized team. We are confident about the future at Con-way.

With that operator, we'd like to open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Todd Fowler with KeyBanc Capital Markets.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

So on the network, can you talk a little bit about -- I mean, obviously, with the past couple of quarters, tonnage has been kind of in a van with that you've targeted. With the decline that you're seeing here in October, how do you think about adjusting the network on the cost side if tonnage is going to try and -- lower on a year-over-year basis? And what are some of the things that you're thinking about, from a variable cost standpoint, to adjust to a lower tonnage?

Douglas W. Stotlar

Well the big things you typically look at in an LTL network are, certainly, the variable costs associated with labor performing the services that you provide on the dock in the P&D environment and in-line while you moderate -- you're adjusting line haul schedules down. So we'll certainly look at all the logical leverage that we pulled in the past when tonnage levels declined.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

And so, I guess, just a follow-up to that. I mean, if you have enough flexibility at this point, I mean, if you see kind of low-single digit year-over-year declines in tonnage during the fourth quarter, can you still operate at a targeted level from a margin standpoint with what you've thought about historically?

Douglas W. Stotlar

We'll certainly going to pull every lever we have and we're going to continue to work on our focus initiative to drive margin expansion.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

Okay. And then just as a follow-up, on the investments in technology and what you're thinking about as far as improving the efficiencies in the margin. Do you have other costs that are coming in, in the fourth quarter into 2013 to affect some of the change, there is a lot of that -- and you encouraged here, during 2012, and as you move into 2013, a lot of that's -- you utilizing the systems that are in place?

Stephen L. Bruffett

Todd, this is Steve Bruffett. On the technology investments, there is an element of what we refer to as bubble costs being that they are temporary in nature and they involve either the implementation or start-up or termination of existing services. And then, there's another component of our technology cost that are going to step up as we go forward. In our run rate, those items that become part of the run rate, we wouldn't make those investments if we didn't believe that the return was there on these investments. So it's part of what's going on in the third quarter, we would anticipate an elevated level of IT expenses we've moved through the next couple of quarters that we're kind of at the apex of that investment as we've moved through the next couple of and we expect that, those bubble-type cost moderate as we move into the warmer months of 2013.

Todd C. Fowler - KeyBanc Capital Markets Inc., Research Division

And Steve, can you put some -- can you quantify or give us, kind of directionally, the magnitude that you talked those costs to be? And if I hear you correctly, it sounds like fourth quarter and then maybe the first half of '13, is that the right way to think about the timing?

Stephen L. Bruffett

Correct. As we indicated in the third quarter, roughly $4 million of year-over-year increase in IT expenses have occurred at Con-way Freight for these reasons. And about -- it's about half and half, the run rate versus the bubble cost I referred to. But as we move forward, there will be new bubble costs for new different types of projects and expenses. We expect that to continue for the next couple of quarters. So somewhere in this zip code, that's where we are in the third quarter.

Operator

Your next question comes from the line of Jason Seidl with Dahlman Rose.

Jason H. Seidl - Dahlman Rose & Company, LLC, Research Division

Steve, and I want to close in on a comment you made. You talked about next year, especially seeing sort of a step function in some of the benefits from some of the IT stuff and the leans that these guys are doing today. Can you talk to us about the magnitude that you're talking about on the step function in terms of what we should look for in the OR?

Stephen L. Bruffett

So Jason as you know, we are trying to avoid giving specific financial guidance along the way. The area of most impact is the linehaul network, which is our biggest single cost item. And we're already, by our traditional metrics operating at levels of efficiency that we've never encountered in our past, that we want to move that up significantly through the opportunities that we've identified in that -- in line haul modeling and so on. So it is a sizable increase that we're targeting in 2013, particularly that area.

Jason H. Seidl - Dahlman Rose & Company, LLC, Research Division

Okay. All right. That’s good comment there. And when we're starting to think about, maybe in more near-term stuff like the fourth quarter, you do pick up a working day per bill, [ph] but it looks like the economy is slowing. How should we look at maybe the effects of this East Coast storm, the disruption to your network, extra expenses?

Douglas W. Stotlar

But we certainly don't understand, at this point Jason, how much economic activity will be generated as a result of the hurricane. But when we look at -- we were running about 3% down year-over-year through the beginning of October pre the effects of Sandy, and it looks like our volumes have been down on a per day basis after the storm had hit, or during the storm, to appraise impact of the storm about 9% to 10%. So you have to be seen -- obviously, we're only through a 1/3 of this quarter, so we don't know what is still ahead or how prolonged the economic softness is going to persist.

Operator

Your next question comes from the line of Chris Ceraso with Credit Suisse.

Allison M. Landry - Crédit Suisse AG, Research Division

It's Allison Landry in for Chris. I was wondering if you could talk about the line haul optimization tools a little bit. And you've mentioned that you're going to start rolling it out and incenting customers to start using this in the first quarter. Are you expecting that to be a pretty smooth transition, or could there be any disruptions? What kind of impacts could we see from that?

Douglas W. Stotlar

Allison, it's a good question, and I'm going to turn it over to Greg and ask him to be, perhaps, give a little more comprehensive in his response so you can think about all the pieces in totality.

Walter Gregory Lehmkuhl

Sure. Thanks, Doug. So the simple answer is we don't anticipate any interruption to customers. The line haul models are something we deploy internally and really don't touch the customers in the way they interface with us. But I'll provide a little more color on the line haul initiatives we are focused on. So as Doug and Steve both mentioned, the line hauls are single biggest cost in the freight business, about 45% of our total expense. We're focused on 2 key areas in improving our line haul efficiency. The first one is cube-based planning, meaning planning to the space of the trailer versus the weight of the trailer. And about 90% of our trailers in our line haul network cube-out before they weighed-out. So in the second quarter this year, we began collecting cube information, we've been working since on the processes to plan and load based on cube versus based on weight. And the pilots using this new process is we're seeing meaningful improvements. Steve mentioned, we're already at our highest line haul efficiency we've ever seen in the third quarter, and we really feel we barely scratched the surface. So we'll start to deploy these new processes networkwide starting this month and they'll be fully implemented in the first quarter of 2013. The second key area of focus in linehaul is optimization models. And simply, optimization models just determine the weight freight will flow through our network. And honestly, [ph] there's nothing simple about how freight flows through an LTL network and we've been working for, literally more than 2 years to get to the point where we have these new models developed and tested. A simple example of how of the type of changes the models make isn't how it passed us. [ph] We previously routed freight destined for the Midwest from the San Antonio market through our service center in Houston. When we deployed the new model, it identified cubic capacity on existing equipment running through Austin instead of running through Houston giving us the opportunity to better leverage our company assets and eliminate miles. In this one lean, we saw linehaul efficiency increase 5% overnight. And we know we're going to get that much in every lean, but we're confident that the new models, combined with the other lean projects and our focus on cube, will result in meaningful improvement in 2013. And these new models will be implemented in the beginning of '13 and the yields -- and will yield increasing benefits as '13 progresses.

Allison M. Landry - Crédit Suisse AG, Research Division

And then just as a follow-up question on pricing, are you seeing any pockets of aggressive behavior or increased competitiveness by any of your peers given the weak demand environment?

Walter Gregory Lehmkuhl

Okay. So, this is Greg. I would say, in general, no. The pricing environment feels very stable. It feels like supply and demand are close to equilibrium and it's always a competitive environment, but no significant change at all.

Operator

Your next question comes from the line of Ben Hartford with Baird.

Benjamin J. Hartford - Robert W. Baird & Co. Incorporated, Research Division

Could you talk a little bit about the expectation for healthcare expenses in the fourth quarter, maybe provide what the 4Q '11 comp was, and whether the third quarter run rate should be a number into the fourth quarter? And then, as you think about these changes in the plans in 2013, can you provide some direction in terms of what you believe the '13 expense is going to be? I know it's early, but is it the opportunity to return to 2011 levels as it relates to some of these health care expense changes?

Stephen L. Bruffett

This is Steve. I'll tackle that one. Regarding the expectations for the fourth quarter health care expense, obviously, it's difficult for us to pin down. We currently estimate about $51 million of health care expense in the fourth quarter. To provide some perspective, at this time of year last year, third quarter was $46.5 million of expense and the fourth quarter was $48.5 million. And this third quarter was $55.5 million. And given the order of magnitude in which it spiked up in the third quarter, we didn't -- we don't expect that level to continue into the fourth quarter. We would hope that it moderates a bit, but we will have to see as we finish up the year. If that $51 million forecast for the fourth quarter holds up, that would translate into nearly $195 million of expense for the full year, that would be up a little over $20 million for the full year. Regarding 2013, our expectations would be that with the structural changes and other items that -- other actions that we're taking in healthcare space, that we'll be able to slow the rate of increase with healthcare expenses. But I don't believe that's a realistic expectation, to get back to 2011 levels. What we would try to do more realistically is to mitigate the amount of increase that occurs in 2013 and bring that percentage down to the low-single digits as opposed to the upper-single digits.

Operator

Your next question comes from the line of John Barnes with RBC Capital Markets.

John L. Barnes - RBC Capital Markets, LLC, Research Division

Doug, you talked about some of the lean initiatives that are going into play. Is there any place where these new initiatives are going to give you better visibility into your cost structure than you currently have today? I mean, will it allow you to better plan for better labor needs based on variable volume trends or something like that? Is there any benefit you're picking up from that?

Douglas W. Stotlar

I'll let Greg address that one.

Walter Gregory Lehmkuhl

So absolutely. I mean, that's right in the crosshairs of what we're doing with lean. One example that's in our line haul -- our cube modeling. So in the past, we would plan trailers every night based on weight of the shipments. And as you know, weight of shipments can -- it can be a very small heavy thing or it can be a very large light thing. And so the number of trailers that we would move from any origin to any destination at night versus what our models said we would move, we would see significant areas in ad-up, [ph] that number and that makes it difficult to plan ad-up. [ph] So with the new models, using purely cube to plan those trailers, we found that we can be far more precise in how much labor we need to deploy to get the job done on a nightly basis.

John L. Barnes - RBC Capital Markets, LLC, Research Division

Okay. All right. And then Steve, if I go back and look, I mean, healthcare has kind of been a thorn for a while now. Is there -- and it just seems like we've heard it more from Con-way than we've heard it from others, and I know it's an issue. I know everybody battles the rising healthcare costs. Is there something with your labor base, your employee make up? Is there something that's causing this beyond what's under your control by picking plans and that type of thing?

Stephen L. Bruffett

That's a good question, John, and this has been a thorn in our side and we fully acknowledge that. And we have been doing a series of analytical work with outside parties to help us understand how we look compared to other industries or companies within our industry and so on, and have adjusted miles accordingly for that. I'm not aware of anything particularly unique about our employee population or our incidents rate. I do think that given part of our legacy, our plans were a bit richer than market and as such, many dependents were on our plans as oppose to a spouse's planned option. I think we've made adjustments over time that should help moderate that as we go forward. It takes some time for some choices to be made as we go forward. But overall, we're not aware of anything particularly unique to us, but we have had batches of both severity and volume of healthcare claims through our network. And as we go through the last 3 years, in particular, it has created this lumpy pattern and we're working to, at minimum, smooth that out, and as I indicated earlier, lower the amount of increases that we incur on a year-over-year basis.

Operator

Your next question comes from the line of Art Hatfield with Raymond James.

Arthur W. Hatfield - Raymond James & Associates, Inc., Research Division

Doug, as I think about lean, and I got a couple of questions related to that and as you implement that. First, how is your approach to this? Are you on a do-it-yourself basis, or have you hired people who are experts in lean to come in and kind of help educate the company on how to do this? And secondly, do you implement -- my thought process on lean always is it makes the company more efficient, and this goes together with your network optimization. It should make you a better competitor and allow you to grow the business, i.e. take market share because you have better service than your competitors. Can you talk a little bit about that and how you see this giving you an opportunity to grow the business, which I would think gives you the best opportunity to hit more consistency in your results?

Douglas W. Stotlar

Sure. So to answer your first question on lean. We have a center of excellence in lean, which really started with Menlo as their 8 years into their lean journey. And we pulled some of their best and brightest out, like Greg and several people on our lean team, from Menlo. So we have the demonstrable capabilities and understanding of how to put these things in place. But that being said, I'm not trying to do this completely alone. We've hired outside experts where we need some additional horsepower and that can help jumpstart these efforts and move them a little bit faster. And so, it's a combination of those 2 things. But at the grassroots level, it's really all internal EP [ph] initiatives. The experts have more come in on the project-type level to help us improve our processes and develop a deeper and faster understanding of our key drivers. We certainly expect, John, that as we're able to optimize the line haul network, utilizing the cube-based planning systems and optimization, in conjunction with our lean weight-based pricing initiatives, we're going to be a more efficient organization. We're going to find additional capacity in our network and have the ability to sell into that capacity as we go forward, because we're going identify many opportunities. We already have. And so, we definitely believe it's going to provide us the opportunity to drive growth in the future as we -- through the existing assets. So allowing us to return a higher rate of return on our existing assets because we're making better and more efficient use of them.

Arthur W. Hatfield - Raymond James & Associates, Inc., Research Division

As a quick follow-up to that, is it that being able to do that or are you still highly reliant on the economy getting better to get some consistency in your results ultimately?

Douglas W. Stotlar

Certainly, we're going to work at stability and consistency in our results. But I'll just give you an example. For next year, we're modeling a flat economy and we're modeling a pricing environment that is going to be moderating. Still gets price increases, but at more modest levels than what we've experienced in 2012. And even in a flat economy, we're confident that our internal initiatives are going to allow us to make margin improvement and progress in all the key foundational areas that we've discussed on the call. And so, we've identified the biggest impact areas being line haul optimization and pricing sophistication. The pilots that we've done are proving out that the -- it's there, and we're proving out that these tools are effective and working for us. And so, our job now is to execute, be relentlessly focused on the initiatives we have in place and keep executing against our plan. And with that, we believe we're going to be able to move the needle in 2013.

Operator

Your next question comes from the line of Scott Group with Wolfe Trahan.

Scott H. Group - Wolfe Trahan & Co.

So I hear line haul efficiency at all-time records and that there's a lot more to improve, but margins are going the wrong direction and well off past peak levels. So it feels like there's either a structural cost or yield issue, despite having a really good line haul efficiency. So maybe can you give us a color of what those issues are and how do you plan to fix that?

Douglas W. Stotlar

Scott, I think that brings us around to the whole concept of the pricing sophistication in lean-based pricing. And so I'm going to kick it over to Greg and let him explain more about that project.

Walter Gregory Lehmkuhl

Yes, let me provide color on the cost headwinds of freight in the third quarter to start with. I mean, obviously, after 6 quarters of margin expansion, we weren't proud to report the third quarter results. But if you look at what those cost headwinds are, they're pretty easy to identify. The core business, the core operating metrics for which me manage this company by, are all in very good territory, that our teams around the country are executing exceptionally well, and at all time best levels in most areas. The cost headwinds are pretty easy to identify a rate. [ph] Healthcare was almost $7 million Q-over-Q versus last year. And if we look at -- just to provide a little more color on the healthcare, going into this year after employees had suffered pretty bad through the recession and we didn't pass on any amount or inflation to our employees for 2012. And if you look at how those expenses hit throughout the year, and pretty hard in Q3, Steve already talked about structural changes going into next year. One example, a big one in freight, above 30% or about 1/3 of our people are in the HMO plan which is a very high-cost plan and the rate of healthcare inflation in that plan that we're experiencing is 25% to 30% year-over-year. So going into next year, we've just incented that plan in a big way by increasing the cost of it to our employees. So we are taking fairly bold action to get that under control going forward. Other areas of cost headwinds in the third quarter, if you look at our DB and DC expenses at freight, it's $5 million versus third quarter last year. The majority of that, almost 70% of that, is defined contribution of our 401(k) that we've restored starting in the fourth quarter last year, and this is the last quarter that we'll be comparing to a quarter that did impact that expense on our base. So when you combine those pretty major items with some investments we're making in continuous improvement, it's easy to see how the cost headwinds were a little bit at risk this quarter. Doug wanted me to talk a little bit about our pricing sophistication, and I think this also goes to the prior question of growth in the LTL segment. So we talked about lean-based pricing, let me explain what that means. We traditionally look at customer's fit into our network by moving an older business and primarily just looking at the customers operating ratio as a whole. And so, for example, when it comes the time to renegotiate, we'll go for an X percent increase with that customers across the board. And this process works pretty well until 2 things fundamentally changed in the LTL business. And that -- those 2 things are TMS systems for large customers and brokers for small customers. And what TMS systems and brokers enable customers to do is load different carrier rates and service level into their system and choose the carriers on a dynamic basis based on the rate in each individual range for each individual shift. And so, this gives customers the opportunity to effectively share-effect the best rate from a variety of carriers based on their individual tariff or discounts against those tariffs, their fuel, their astutorial [ph] schedules, and there's such a wide variance between carriers to give customers a big opportunity to be surgical and dynamically choose carriers on a day-to-day basis. So knowing this, we've been focused really on lean-based pricing where we're leveraging our business intelligence systems and all the advancements we've been making in understanding our own shipment cost internally, and we've developed a model that looks at all aspects of the customer shipments and allows us to price them in a way to better leverage our operating cost, while staying competitive for customers and ultimately, maximizing profits. So the lean-based algorithms, they model multiple variables of customer shipments, they're proprietary and they're effectively our answer to the modern TMS and brokerage models. So we can be surgical about what's breaking now, where we put it in our network and make sure we get the shipments that best leverage our network for profitability. So for example, we have a large account that we recently used as a model on during negotiations, and instead of increasing the price for the customer, the standard 4% to 6% or whatever it was, to improve and ultimately, improving the profitability on that account by that same amount, we were able to deploy this model, be much more surgical in which business we wanted to keep, which business we wanted to grow, which business we wanted to give back. And we were able to improve the profitability on the account more than twice that much. So we see -- it's not necessarily about growth for us, it's about growth in the right range, so we can leverage our asset base and become more profitable.

Scott H. Group - Wolfe Trahan & Co.

Greg, that’s really good color. But maybe just another way of thinking about it, if your goal is to get to a $90 million or about $50 million in light of an operating income this quarter give or take, how much of that $50 million is what you're talking about on the pricing side, and how much of that is on the cost side?

Walter Gregory Lehmkuhl

I would say, maybe split down the middle over the next couple of years.

Scott H. Group - Wolfe Trahan & Co.

Okay. So you still think $90 million OR is the place you can get to 2 or 3 years from now?

Walter Gregory Lehmkuhl

I think -- I'm confident we can get there. The timetable is not something we're disclosing.

Scott H. Group - Wolfe Trahan & Co.

Okay. And then just this last thing if I can, the 3% tonnage decline in October, before Sandy, that implies a pretty big sequential drop-off from third quarter. And we're hearing things are soft from other companies, but I haven't heard of that big of a sequential drop for most, in October. What are you seeing that's so much different or feels a little bit worse than what other companies are seeing?

Walter Gregory Lehmkuhl

So first of all, I'm fairly confident that we're not losing market share. We just got our market share report, I had blogged [ph] into me, we just got it for September and we've seen 2 months of substantial market share gain on the lean freight. So we're -- we pushed rate out of our network last year. We're now seeing year-over-year gains in 2 straight months of very strong market share gains. So our customers are appreciating the best service and the fastest service we've ever provided, and it's allowing us to gain business while we're still pushing yields up, at least with our peers. So I would be shocked if we find -- well, we won't find that this is a Con-way specific issue. We have -- I talked about the customer meetings we have every 2 weeks with 20-plus customers, what we're hearing is that they're not hiring, they're not investing right now, waiting for election results and waiting for some more stability in the political and fiscal policies. So no prediction, but hopefully, after the election. And with the dealing of the fiscal cliff that the -- that our customers will feel more confident in investing in their businesses.

Douglas W. Stotlar

And Scott, if I could point one more data point here. We saw a consistent softening at all 3 of our business units. So it wasn't just an LTL-specific thing. We saw load count go down at truckload and we also saw a moderating from the large domestic accounts at Menlo in the volumes due to warehouses.

Operator

Your next question comes from the line of Bill Greene with Morgan Stanley.

William J. Greene - Morgan Stanley, Research Division

Could you just to share with us how the tonnage is trending by month, just following up on the question you hear about the sequential change, October versus September. Because it doesn't feel like the market shrinking at 3% or more, so the market share comment is puzzling. Maybe I misunderstood the context for it?

Stephen L. Bruffett

This is Steve. I can provide you the tonnage trend as we moved through the third quarter compared to 2011. July was up 0.2% on a per day basis. August was down 0.5%. September was up 0.1%. And then October, as we've noted in the release prior to the effects of Sandy, was down about 3%. We've just gotten the full month down 3.2%, all in, counting the effects of Sandy and the last few days of the month.

William J. Greene - Morgan Stanley, Research Division

Okay. When you look at the impact of having one fewer operating day, and then I think you have one extra here, relative to last year, in the fourth. Can you maybe help us think about the fixed versus variable breakdown of your cost structure so we can think about how that might have affected the margins?

Stephen L. Bruffett

Typically, and this is the Steve, again. In LTL, you think of 75% or so of your cost being variable. Over the course of time, however shorter bursts of time there is a much higher fixed component to the cost of that. And so, part of that's what we experience with things move fairly quickly that we experience 50% or a greater percent of our cost being fixed, because it takes a little time to adjust those. I hope that helps provide context. It's a matter of timing as to how variable costs are.

William J. Greene - Morgan Stanley, Research Division

Yes. I was just trying to think about the impact of having one fewer day, how much of an impact of margin that might have been. So if I use 50%, you think that's the fair starting point?

Stephen L. Bruffett

It's in the range, yes. And especially with the way this quarter unfolded and how the days in the week fell.

Operator

Your next question comes from the line of Justin Yagerman with Deutsche Bank.

Justin B. Yagerman - Deutsche Bank AG, Research Division

So Doug, I think you talked about 2013 expectations being for a flat economy. Am I reading that as a 0% GDP or kind of a 2%-is which is flat in terms of the same level of growth? And you said price moderating, but still some margin improvements. I just want to make sure I've got those right, and then I've got a follow-up to that. So what did you mean about flat economy?

Stephen L. Bruffett

This is Steve again. I'll jump in here. What we mean by that is we basically look at the consensus expectations for GDP growth, which are, right now, around 2% or slightly less. And that typically translates into something south of that for overall tonnage growth rate space. So that's what we're assuming as 0.5% to 1% tonnage growth in the space. So relatively flat tonnage growth is what we're talking about.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Okay. So within that context though, we're still talking about margin improvement. So I guess Scott was talking about a long-term goal of getting to 90%, I guess I'm more concerned about what we'll see over the next few quarters. You guys have been talking for a while now about company-specific margin improvement efforts and it sounds like Q1, hopefully, is a culmination of some of that with the technology that you're putting in place and should be fully implemented. So is it appropriate to think that you guys can do a 95% or better in 2013? I mean, is that a -- it doesn't sound like a very high hurdle to get past, but right now, it's been a pretty big stumbling block. So is 95% a big goal? Can we get something that you guys are willing to stick to?

Douglas W. Stotlar

Justin, we're not going to throw a specific goal out there. I do need to correct one thing. We won't be fully-implemented. We'll be using the new tools in Q1, but we won't be fully-implemented by the end of Q1 with every -- with all the initiatives along this line. Because as we mentioned earlier, it's going to take the full year to get through our entire account base, particularly with lean-based pricing which is a big portion of this combination of efforts that we're taking on. But we're very confident in the work that we've done. We're very confident in the data, and what the pilot projects have produced with us so far. And so, we're confident on our ability to execute. And the example that I wanted to give concerning the economic backdrop in which we believe we can continue to expand margins was to make sure that everyone understood that even in an environment that feels kind of like the environment we've been through this past year, around a 2% GDP, and a moderating pricing environment, that we believe we can still move the needle on margin expansion.

Justin B. Yagerman - Deutsche Bank AG, Research Division

I mean, so a 95% should be something you can commit to then? Because we'll be somewhere above there, but not too far above there, assuming that the Q4 environment doesn't completely fall apart. And that would imply some modest margin improvements. So is it fair to say that a 95% should be the hurdle rate for next year?

Douglas W. Stotlar

We'll update our progress as we go through the year.

Justin B. Yagerman - Deutsche Bank AG, Research Division

Okay. And when you guys are looking at the tonnage environment right now, you said you're still taking market share. So how do you think about that pricing mix? Where are you guys right now in terms of how you think your pricing relates to the rest of the industry? Are you still premium product for a premium price? Or are you still -- or have you moderated off of that in terms of how you got to go to market and think about your positioning when your pricing, relative to competitors?

Stephen L. Bruffett

Yes, I think it depends on the business. I think, overall, we still command a price premium, not nearly what we commanded 10 years ago, certainly. And I think right now, we can be competitive in the marketplace on the account that we want to penetrate, which is specific leans and national accounts and most local business, and we can compete profitably with anybody out there. So we're always going for a premium price. People do pay more for Con-way service. And we're always trying to command that premium. But even in a very low premium, we'd compete with anybody out there.

Justin B. Yagerman - Deutsche Bank AG, Research Division

And then, Greg, I may have missed it earlier, but did you give an update in terms of the service centers that you guys have rolled out leaning to within the freight network? I think you said 50-something last time we had a conference call, so just curious if that's been rolled out to more and how successful it's been as we've progressed here for the last 3 months.

Walter Gregory Lehmkuhl

Yes. I couldn't be more excited about the great lean average that are going on at the grassroots levels of our service centers. We'll have about 75 -- over 75 toward the end of year. So far we have 18 that are Brawn [ph] certified, meaning they've reached an additional hurdle of sophistication in lean, and that's increasing every week.

Justin B. Yagerman - Deutsche Bank AG, Research Division

And is that a good kind of pace at 25 a quarter as we get the full network rolled out? Is that how we should think about this thing?

Walter Gregory Lehmkuhl

Yes, I think that's pretty close.

Operator

We have time for one last question. Our question is from Chris Wetherbee with Citi.

Christian Wetherbee - Citigroup Inc, Research Division

Maybe a question on the pricing side. Just wanted to get a sense of how the progression of pricing played out through the quarter and maybe an update on how the October pricing environment looked like for freight.

Stephen L. Bruffett

I would say stable. I really would. I mean, it's -- we're continuing to get low to mid- single-digit increases. Most of our major customers aren't bidding out the business, they're negotiating with us, hanging on a high multi-tier deal. The pricing environment feels very stable.

Christian Wetherbee - Citigroup Inc, Research Division

Okay. And that's consistent even into -- even into October with the tonnage declines that we're seeing?

Stephen L. Bruffett

Yes.

Christian Wetherbee - Citigroup Inc, Research Division

Okay. That’s helpful. And then, Doug, you mentioned getting some of the benefits -- or I guess, a combination of some of the initiatives in the first quarter then started to see them bear fruit going forward. Can you just give us roughly, a sense -- I mean, is it a normal, kind of maybe 25% progression per quarter for 2013 as you're going through line haul initiatives and implementing pricing in trying to touch a lot of those customers as you need to, through that process? I just want to get a rough sense of maybe how to think about the progress of that in 2013?

Douglas W. Stotlar

I think most of the progress you're going to see coming in the second half of the year is we get a compounding effect on these initiatives. Because again, we're starting -- just starting now with the lean-based pricing. Some individual accounts will be really working at an earnest as we hit the beginning of the year, and our contract renegotiations, renewals come due. And so, it's going to take some while to get this attraction. But as we ramp up these models and get the field organization trained in implementing the planning and the line haul planning around density and then the optimization tools, we expect this to be a cumulative benefit. So -- but I don't think you can think about it linearly. I think there's going to be an inflection point where we'll really start to get some more leverage, and it generates faster improvements.

Christian Wetherbee - Citigroup Inc, Research Division

Okay. And a way to think about that is more likely second half of '13.

Douglas W. Stotlar

That would be my guess.

Douglas W. Stotlar

I want to thank all of you for joining us this morning. We've covered a lot of detail in today's call, which I hope gave you some context for a better understanding of our key strategic initiatives and activities that we believe will improve our company, particularly at Con-way Freight. While this quarter's results were disappointing, we're moving ahead. We have focused initiatives in place to improve the key areas of our business and we expect better results. We're poised for progress, and with an engaged and energized team, we're confident about our future. Thanks again.

Operator

Thank you for participating in Con-way Inc.'s Third Quarter Earnings Review Conference Call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!