Genesee & Wyoming's (GWR) CEO Jack Hellmann on Q2 2016 Results - Earnings Call Transcript

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Genesee & Wyoming, Inc. (NYSE:GWR) Q2 2016 Earnings Conference Call August 1, 2016 11:00 AM ET

Executives

Tom Savage - VP, Corporate Development & Treasurer

Jack Hellmann - President & CEO

T.J. Gallagher - CFO

David Brown - COO

Michael Miller - CCO, North America

Analysts

Prashant Rao - Citigroup

Alex Vecchio - Morgan Stanley

Allison Landry - Credit Suisse

Justin Long - Stephens Inc.

Rob Salmon - Deutsche Bank

Jason Seidl - Cowen and Company

Scott Group - Wolfe Research

Bascome Majors - Susquehanna

John Barnes - RBC Capital Markets

Ari Rosa - Bank of America Merrill Lynch

Jim Levesque - S&P Global Platts

Operator

Welcome to the Genesee & Wyoming Q2 Earnings Call. [Operator Instructions]. Today's conference call is being recorded. I would now like to turn the conference over to Tom Savage. Please go ahead.

Tom Savage

Good morning and thank you for joining us today on Genesee & Wyoming's Q2 2016 earnings call. Please note that we will be referring to a slide presentation during today's call. These slides are posted on the investors page of our website, www.gwrr.com. Reconciliations of non-GAAP measures disclosed on this conference call to the most directly comparable GAAP financial measure are likewise posted on the investors page of our website. We will start with the Safe Harbor statement and then proceed with the call. Some of the statements we will make during this call which represent our expectations or beliefs concerning future events, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 which provides a safe harbor for such statements.

Our use of words such as estimate, anticipate, plan, believe, could, expect, targeting, budgeting or similar expressions are intended to identify these statements and are subject to a number of risks, uncertainties and other factors that could cause actual results to differ materially from our current expectations including but not limited to factors we will discuss later and the factors set forth in our filings with the Securities and Exchange Commission.

Please refer to our SEC filings for a more detailed discussion of forward-looking statements and the risks and uncertainties of such statements. We cannot assure you that the forward-looking statements we will make will be realized. We do not undertake and expressly disclaim any duty to update any forward-looking statement whether as a result of new information, future events or otherwise except as required by law and you should recognize that this information is only accurate as of today's date. On the call today we have four speakers, our President and CEO Jack Hellmann, our Chief Financial Officer T.J. Gallagher, our Chief Operating Officer David Brown and our Chief Commercial Officer Michael Miller.

I will now turn the call over to our President and CEO Jack Hellmann.

Jack Hellmann

Thank you, Tom and good morning. Welcome to G&W's earnings call for the second quarter of 2016. As always we will start our call this morning with safety. On slide number 3 you will see that G&W's safety index was 0.58 injuries per 200,000 man-hours in the first six months of 2016. Meanwhile, our Freightliner Operations improved to a safety index of 1.02 in the first six months of this year, a significant improvement over 2015 and steadily approaching the performance of G&W overall.

Now let's turn to financial results for the second quarter of 2016 and slide number 4. Our adjusted diluted EPS were $0.93 which is roughly 20% better than the midpoint of our guidance. Our North American Operations performed well while our Australian and UK/European Operations were collectively in line with our guidance.

On slide number 5 you will see that our total revenue was roughly 2% better than expected and our adjusted operating income was around 12% better than expected. Our adjusted operating ratio of 81.2% was about 180 basis points better than outlook.

Please note that we recorded charges of $5 million in the second quarter which primarily related to the restructuring of our UK coal business. And we also had approximately $2.6 million of expense relating to the evaluation of acquisitions and investments. The bottom half of slide number 5 highlights our second quarter performance versus guidance by geographic segment. As you can see, North America performed well thanks to a favorable mix of revenues and solid cost controls. Australia was slightly ahead of plan and the UK/Europe was slightly behind plan due to weakness in Continental European intermodal and delayed aggregate shipments in Poland.

Now let's turn to slide number 6 which is the comparison of the second quarter of 2016 versus the second quarter of 2015 for our North American Operations. Overall, our revenue was down $6.4 million or 2% primarily due to weakness in utility coal, agricultural products and pulp and paper partially offset by petroleum products. Utility coal continued to be adversely impacted by cheap natural gas and high coal stockpiles.

Agricultural products continue to be impacted by low crop prices and the strong U.S. dollar. And pulp and paper continue to be impacted by truck competition and weaker demand. Despite the second quarter revenue decline our North American adjusted operating income increased around 5% in the second quarter and our adjusted operating ratio improved 170 basis points to 73.5%.

Now let's turn to slide number 7 which is a comparison of the second quarter of 2016 versus the second quarter of 2015 for Australian Operations. At a high level our Australian revenue was down 17% and our adjusted operating income was down 32% due to ongoing weakness in the mining sector. The main driver of the income decline in the second quarter was the loss of the fixed payment for Southern Iron which is on Arrium-owned iron ore mine that is in care and maintenance. Meanwhile, we continue to serve Arrium's iron ore business in the middle back range and the steelworks in Whyalla which are involuntary administration and expected to be sold in a process that starts in the near term. Also worth noting in the second quarter 2016 is that we had a one-off shipment of a manganese stockpile that will not recur unless the mine is reopened in the future.

Now let's turn to slide number 8 which is the review of our UK/European Operations. Overall, the second quarter represented an important transition period for our UK business as we successfully restructured the UK coal segment and continued to redeploy excess equipment to new customer contracts. Our second quarter revenues declined $22.9 million of which $5.1 million was lower coal revenue, primarily in the UK and $12.6 million was lower intermodal revenue in Continental Europe.

Our adjusted operating income from the UK/European segment was down U.S. $4.3 million in the second quarter as the cost-benefits of the recent UK coal restructuring weren't in effect until June. Meanwhile, our continental European intermodal traffic was lower than expected as we continue to reprice traffic, add commercial capabilities and redeploy assets to more profitable lanes. Overall we're pleased with how the UK management team has rapidly adjusted to the challenging business environment and the second half of 2016 should begin to show the fruits of their labor thanks to a lower cost structure in the UK. However, we're now focused on improving the underperformance of our intermodal business in Continental Europe which is expected to persist in the second half of 2016.

Finally, I'd like to discuss how Brexit may impact our UK business which I broadly think about in four categories. The first category is the impact of currency translation as our British pound-denominated profits are mathematically 10% lower than they used to be. The second category is the net impact of the weaker British pound on our intermodal traffic which remains uncertain. On one hand, the UK effectively just voted for a 10% decrease in consumer purchasing power for imported goods which should lower shipments of certain goods that travel in containers on our trains. On the other hand, certain exports that move in containers will become more globally cost competitive. The net impact on our traffic remains to be seen.

The third category of Brexit impact is the influence of UK monetary and fiscal policy on our heavy-haul business. To the extent that interest rates move lower and fiscal policy facilitates infrastructure projects, shipments of bulk commodities such as aggregates could actually be stimulated. And the fourth category of Brexit impact which is probably the toughest to predict, is simply how the macro structure of the UK economy will evolve in the years ahead. So we will certainly have much to reflect upon in the months and years to come.

Turning to slide number 9 I'd like to highlight our key priorities for the second half of 2016. At a corporate level we're focused on a strong finish to the year in safety and we're also actively evaluating acquisitions and investments across our global footprint.

Now turning to our three segments, in North America we're focused on staying close to our customers and managing costs carefully in an economy that is decidedly uneven. During the second quarter we initiated a consolidation process whereby we eliminated one operating region in North America as we divided the Ohio Valley region between the Northeast region and the Midwest region as part of our drive for cost efficiency. Also I should note that support for the U.S. Short Line Tax Credit has expanded to 43 cosponsors in the Senate and 179 in the House. So we're approaching our targeted support thresholds of over 50% in the House and the Senate.

In Australia I think it is still too early to call a bottom to our business but most commodity prices have improved. And we're now handling new business and bidding on new contracts. In the UK/Europe we're pursuing further cost efficiencies in the UK and are redeploying excess equipment for new business while at the same time our priority focus is on improving the performance of our intermodal operations on the continent. Overall, our second quarter results for 2016 were better than we expected and while economic uncertainty remains a global reality we expect to deliver similar financial results in the second half of 2016.

I would now like to turn the call over to our Chief Financial Officer, T.J. Gallagher. T.J.?

T.J. Gallagher

Thanks, Jack and good morning everyone. I will walk through the results of the quarter in a little greater detail by segment followed by updated guidance. We'll start with North American Operations on slide 10. Second quarter revenues in North America decreased $6.4 million or 2.1% primarily due to FX and lower fuel surcharges. Excluding these items revenues were relatively flat as the $6.8 million decline in coal revenues was offset by the net impact of several small items.

Slide 11 shows a comparison of North American carloads by commodity. Our utility coal traffic declined 17,000 carloads or 27% and represented roughly 60% of the total second quarter decline. Other commodities to highlight include agricultural products which were down approximately 4,400 carloads or 8% as volumes continued to be negatively impacted by low commodity prices and the strong dollar.

Our minerals and stone traffic was down approximately 4,000 carloads or 7%, weaker salt traffic due to the mild 2015 winter and lower frac sand shipments in our Northeast region were partially offset by stronger aggregates traffic in our central region. Last, pulp and paper volumes were down approximately 4,200 carloads or 9% primarily due to strong truck competition. In addition, consolidation in the paper industry last year resulted in the closure of certain facilities that we serve.

Now moving to slide 12. North American average revenues per carload increased 2.3%. Excluding the impact of changes in the mix of commodities, changes in fuel surcharges as well as currency, average revenues per carload increased 3.3%. Note that we had changes in customer mix within coal and minerals and stone that impacted average revenues per carload. And excluding these customer mix changes the core pricing increase in the second quarter was in the range of 3.5% to 4%.

Now moving to Australian Operations on slide 13, Australia revenues declined $11.5 million or 17.3% primarily due to the weaker Australian dollar and weaker Australian mining revenues. As Jack mentioned the decline in mining revenues was primarily related to Southern Iron fixed payments which ceased at the end of the first quarter. All other revenues combined decreased by $1 million.

Now slide 14. UK/Europe revenues declined $22.9 million or 13.9% primarily due to the weaker pound and euro, lower Continental Europe intermodal revenues and lower coal shipments. In addition to the expected decline in continental intermodal revenues as unprofitable routes were rationalized revenues were also impacted by lower utilization of scheduled intermodal services along certain routes. The decline in coal, however, was consistent with our expectations.

Turning to slide 15 and guidance. Let me refer you to our earlier Safe Harbor statement that noted that these statements are subject to a variety of factors that could cause actual results to differ from our current expectations. These statements represent management's expectations regarding future results as of today, August 1, 2016 and we do not undertake any occasion to update this information.

Now before we get into the specifics of our updated guidance for Q3 and Q4 let's start with a big picture for each of our operating segments regarding the second half of 2016 where I will highlight the changes from our prior guidance. In North America our guidance assumes core freight pricing increases in the 2% to 3% range in the second half of the year. Although we had achieved roughly 3.5% to 4% pricing in the first half, it is difficult to forecast the same performance for the rest of the year given low fuel prices and ample truck capacity. We expect pulp and paper and petroleum products traffic to be weaker in the second half of the year. In the case of pulp and paper this is due to truck competition and in the case of petroleum products this is due to lower NGL and LPG shipments given weaker market conditions for those commodities.

Our steel-related traffic and agricultural products traffic remain uncertain. While our steel-related traffic has outperformed our expectations for much of the year, our shipments in June and July month to date have been a bit weaker and our customers haven't provided clear visibility to the rest of the year. For agricultural products there are significant amounts of grain in storage and expectations for a good harvest but the timing of shipments remain difficult to predict.

We have also updated our fuel price assumptions and now expect approximately $5 million higher expense versus our prior guidance. In North America fuel prices are still below certain fuel surcharge program thresholds and therefore we do not expect this increase to be fully covered by fuel surcharges. In Australia our expectations for full-year revenue and operating income are unchanged from our prior guidance.

Now slide 16, UK/Europe. The British pound has devalued roughly 10% since the Brexit vote and our revenue impact is currently estimated at approximately $20 million in the second half of the year. As Jack noted we haven't seen any other direct impact of Brexit on our business yet other than currencies.

In the second half of 2016 we expect our UK Operations to perform in line with previous expectations, both for intermodal as well as the heavy-haul business. However, our overall outlook for UK/Europe operating income in the second half is about $6 million lower than our prior guidance. The three components are the weaker pound which is a $2 million million impact, the weaker continental intermodal business which is approximately $3 million weaker and approximately $1 million of non-cash expense from the accretion of the deferred consideration for the Freightliner acquisition.

With that context let's move to third quarter guidance on slide 17. We expect operating revenues of approximately $500 million and operating income in the range of $90 million to $95 million. Net interest expense in the third quarter should be approximately $17 million and we expect D&A of approximately $56 million. Our effective tax rate should be around 29% and diluted shares should be 58.1 million. The bottom line is that we're expecting third quarter diluted EPS in the range of $0.90 to $0.95. Also included in the slide you will see carload assumptions by segment as well as our assumptions for FX rates.

On slide 18 we show Q4 guidance. We expect our Q3 and Q4 results to be similar to Q2 in terms of EPS and therefore for the full year we expect diluted earnings per share to be at the midpoint of our prior guidance or $3.60 excluding the impact of severance and restructuring costs as well as the first quarter Australia write-down. The relatively lower second-half expectations can be attributed roughly 50/50 to North America and our UK/Europe segment.

I will close with our balance sheet on slide 19. Our net debt was $2.1 billion and our net debt to adjusted EBITDA was 3.6 times.

With that I will open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. And our first question comes from the line of Chris Wetherbee with Citi. Please go ahead.

Prashant Rao

This is Prashant in for Chris. I wanted to jump right into the guidance a little bit. First off, on the expense side it looks like labor expenses you guys did an impressive job. I wanted to get a little more color on the puts and takes there? And is this a new run rate and are there further levers not just in labor but on the expense side as you're managing the volumes this year and into 2017?

Jack Hellmann

Are you speaking to any particular segment when you refer to -- I mean there's initiatives in place in every single segment to reduce cost. You can see we've done a restructuring in North America that you will start feeling the impact of here in the back half of the year. We've done a restructuring in the UK in the second quarter that you'll feel in the back half of the year in Australia.

Given the changes in the business overall it has been in a perpetual state of reassessment and you'll see that flowing through the labor line. I wouldn't speak to it being a run rate, necessarily, because the mixes of business change over time, so that might be a little dangerous--

T.J. Gallagher

We did start our cost reductions in North America in Q3 last year. We talked about the second half of the year roughly $9 million from last year. So this is sort of the last quarter before we will grandfather that first round of cost cuts in North America in 2015.

Jack Hellmann

That's a good point. You're seeing in the second quarter results which are probably a little better than expected in North America from a cost standpoint, that's a full-blown -- it's a whole host of things. Part of it is mix of business which can't take which is just is what it is, it has nothing to do with management. Part of it is management of the cost structure that you're feeling the full impact of a year later.

And what was interesting about the quarter in North America, at least from an internal standpoint, was the fact that pinpointing one specific reason why the business did better in North America was actually quite difficult. There were a couple of things like steel shipments were a little better and that helps. But given the operating structure within North America, each one of our operating regions pulled their weight.

And if you've got 8 to 10 operating regions and each one of them tightens things up by $1 million you see a quarter like that we just had in North America. But actually which from my standpoint is a good thing. It points to how tightly each of our Senior Vice Presidents manage their regions in the quarter.

Prashant Rao

I guess another question on coal, we're starting to see some sequential movement overall in rail volumes. I just wanted to get a sense are you thinking about a tailwind in the second half of the year? And we have started to hear strategically more of a consensus collecting around not necessarily recovery but a reprieve in 2017 on coal given where nat gas prices are. I just wanted to get a sense of how you think about that and how that factors into the North American business for you guys?

Jack Hellmann

Why don't we have two people answer that to get different perspectives? T.J. can speak to how we're thinking about the carload trend and then Michael can talk commercially to what he has been seeing out there. Obviously Mother Nature has been extremely cooperative this summer and that's helping right now. But T.J., do you want to speak first to some of the carload trends?

T.J. Gallagher

Sure. Coal was a slight outperformer in Q2. You saw I think coal nationally tick up in May and June and we experienced the same positive uptrend. Right now when we look at the back half of the year versus our prior guidance we do see coal a little stronger. We've had a hot summer, it's still very hot right now but we will see how the weather goes for the second half of the year. But right now we're thinking that it's going to be a little bit better than what we thought before.

Jack Hellmann

Michael, do you want to speak a little bit to what you're seeing in the Midwest?

Michael Miller

Yes, we have a pretty good exposure to the PRB coal and we've seen inventories drop about 20% due to the hot weather. So hopefully we can continue a strong push in the summer. I think if you were to ask our Class I partners there is a sense that we've hit the bottom earlier this year before the summer kicked in.

So with the inventory levels moving down closer to something like historical levels we do feel like if weather can cooperate natural gas prices being pretty steady we feel like we'll see an okay outlook through the rest of the year and then hopefully 2017 will be a little bit better. It's all based upon getting inventory levels adjusted downward.

Jack Hellmann

Michael, any observations on train sets coming in and out of storage on coal?

Michael Miller

We certainly have seen additional train sets come online. We've seen coal volumes increase. Now obviously coal moves in shoulder months. This is certainly peak time for coal sets to come online. But based upon what we're seeing with the weather forecast it should continue to see additional coal sets move between now and the fall weather kicking in.

Operator

And next we will go to the line of Alex Vecchio with Morgan Stanley. Please go ahead.

Alex Vecchio

I wanted to touch base again on the volume guidance, specifically in the third quarter. The context is the Class I rails have broadly guided to their year-over-year declines in the third quarter to moderate sequentially versus 2Q to varying degrees, obviously, but broadly seeing those declines moderate. Your guidance implies a little bit of actually a deterioration on the year-over-year trend despite actually having a little bit of an easier come. And just given what you noted on coal it sounds like there might be some maybe optionality to the upside on grain.

Can you just help a think about what is maybe accounting for the disconnect between what you guys are expecting in the third quarter versus the Class I rails? Is there anything Company-specific that might account for it? Just a little bit more color on the puts and takes would be helpful.

Jack Hellmann

I don't think there's any -- the world has been uneven for some time and we've done our best to quantify what we see happening. Even the Class Is aren't going to be -- things like steel markets, the forward visibility of those markets is very difficult. So for example, T.J. just talked to you about steel. Our steel fell off pretty sharply in early July and then picked up significantly at the back end of July. So trying to forecast this stuff is extremely difficult. And at the plant level, but the macro set up for it is obviously much better now than it was a year ago.

So hopefully that plays out in our favor as it did in the first half of the year. But I wouldn't say there's nothing unique that's going on in our business relative to others. Our relative out-performance in this quarter is because our traffic fell off a bit sooner than the Class Is. And that's why we're doing better than most in this quarter. If you just look at our core North American results we're doing just fine. And the only trends that you see sequentially being any different are the ones we highlighted. Yes, you're right, maybe we'll do a little better in coal but you've got pressure on pulp and paper just like the Class Is do.

Petroleum products, that may be a little bit more unique to us in terms of our natural gas liquids outlook is slightly moderated from where it was. It's still good but it's tempered somewhat. Putting money down on ag products is always a tough one because we've had some uplifts in shipments, we've had some nice shipment periods in South Dakota and then they've fallen back down to earth. And so it's hard to forecast. Maybe with ag, Michael you want to elaborate a little bit more on agricultural products? Because that's a real wildcard and that's a lot of volume.

Michael Miller

Yes, I mean we have seen over the four-week average grain carloads increase. I think the ag crop report, progress report comes out today at 4 o'clock and the hope is we'll have a really good harvest. There is a lot of grain stored. It's very unlikely additional storage will be constructed, so grain is going to have to move. The question is when. We're seeing, as Jack mentioned we've seen a couple of good weeks coming out of South Dakota, we're starting to see some pickup in Kansas.

So we're hopeful but you have a strong dollar and you're trading a commodity that's low-priced on a global platform. So South America harvest comes in weak or the outlook looks a little bit weaker we expect to ship more. Right now we feel pretty positive but it is an uncertain market and it all depends on the harvest.

Alex Vecchio

And just switching gears to pricing, you got 3.5% to 4% in the second quarter in North America and that came in a bit higher than your prior guidance for the 2.5% to 3%. You are reiterating the expectation for the back half to decelerate towards 2% to 3%. And I guess I'm wondering why would it decelerate now? I realize you cited fuel and truck markets, but I guess I'd argue that on the truck side we've actually been hearing a little bit of incremental positive commentary in terms of tightening conditions through June and at least through the first part of July from the carriers for the first time in a while.

And fuel has been coming up. Granted oil is now trending back down, so it's tough to call. So I guess what's really maybe the difference here versus last quarter that now pricing actually should decelerate in the back half after it held up pretty well here in the second quarter.

T.J. Gallagher

Well I mean you're exactly right. I think I would say our outlook is conservative rather than predicting a deceleration. We've outperformed year to date both our budget and our guidance. But this is a really tough market with ample truck capacity and relatively low diesel prices. And so we're just a little cautious about how much strength you can continue to project.

Our marketing team has been doing a great job negotiating contracts one by one. But again it's a tough market out there. I don't know if, Michael, you have any other color to add?

Michael Miller

The other thing I would just throw in here is the first half of the year we did have a few legacy contracts that came due and we did a really good job getting those legacy agreements back up to market price. And that's reflected in the first half of the year, as well which we don't have those coming up in the back half.

Alex Vecchio

So maybe a little bit conservative but we also have to consider those legacy contracts that helped the front half. Okay, thanks very much for the time.

Jack Hellmann

You know, the big picture is there are very few people that give guidance like we do for good reason. There is a lot of uncertainty in this world. And so this is the best information we have based on all of the internal reviews that we do. We've been wrong a lot over probably the last six quarters. Thankfully most recently we've been wrong on the light side and we've outperformed.

But forecasting an uncertainty is very difficult and it's sort of independent of actually running the business. As you can see from the cost structure, we're managing the costs like crazy and then the volume will do what it will do. And if it's a little better than we expect you'll see results fall to the bottom line like they did in the second quarter.

Operator

And next we move to the line of Allison Landry with Credit Suisse. Please go ahead.

Allison Landry

In terms of the categories that you outlined for how you're thinking about Brexit, clearly a lot of unknowns that will materialize over time. But as we think specifically about the second-half volume guidance for Europe/UK it seem like there's a pretty decent inflection in the fourth quarter. So I just wanted to get a sense for how we can marry up that guidance with your commentary and how we can maybe handicap the potential downside?

T.J. Gallagher

What's shown in Q4 versus Q3 I mean that's just normal seasonality. Q3 is strong from an intermodal standpoint and its strong through most of Q4 but then it falls off in the December time frame. Our aggregate shipments fall off in December as winter weather kicks in, so that's really what's going on. There's nothing about Brexit there. That's simple normal seasonality of the business.

Allison Landry

Okay. And then just back to the grain question in North America. Could you remind us what the exposure is to grain versus other ag products since I know that there's a bunch of different things in that category?

Jack Hellmann

Sure. Michael, do you want to -- the trick to that question is that we serve so many ag markets in so many different states that it's tough to generalize perfectly. But why don't you pick, Michael, do you want to pick a few of our bigger markets and talk about ratios between soy and wheat and corn?

Michael Miller

Yes, we're by far more heavily weighted towards the grain side than we're the ag products side which ag products is a function of both ethanol with the DDGs and then soy crushing facilities that we have. I would say with respect to the ag products side there's a couple of ports where we send ag products, soy mill out particularly. As long as there is a good harvest we will continue to see that.

But most of our exposure is on the grain side which will be predicated on a good harvest. Ethanol we feel good about, DDGs we feel good about, as long as we're burning gasoline the ethanol will be produced. So I would say if you want to look at our business and exposure is primarily on the grain side, not necessarily the grain products.

Operator

And next we go to the line of Justin Long with Stephens. Please go ahead.

Justin Long

I had a couple of questions on Freightliner. Now that the coal restructuring seems to be wrapped up, how should we think about the average incremental margin for this business going forward? Secondly, Jack, you mentioned some of the puts and takes with Brexit, but are you managing that business any differently in response to Brexit?

Jack Hellmann

Well, the latter question is, yes, there's been a significant restructuring of the business on the UK coal side. Not in response to Brexit but just in terms of normal drives for efficiency we're looking at the UK market with the diminution of coal contribution and seeing what we can do better throughout the business from a cost standpoint and so that's what I was highlighting in terms of priorities for the back half of the year.

So I wouldn't call that derivative of Brexit itself and so I wouldn't say we're managing anything differently yet based on anything new that we've seen. But that was underway as it is. But we're looking with interest to how infrastructure projects might unfold in terms of stimulus depending on what the government decides to do in an effort to shore-up the British economy because to the extent that major infrastructure projects transpire, whether they be rail-related specifically or merely projects that consume aggregates, that typically moves by rail.

So yes, anyway that's how we're thinking about that. In terms of the incremental margins I wouldn't -- we haven't provided commentary on that before. But I would say because you can see based on incremental cars going on the back of any train tends to be very positive. But you run shorter trains in the UK than you do in the U.S. and so they won't be -- to the extent that on average you're thinking about 50% incremental margins in North America, it will be less than that overseas. Not because the last car on the train won't have that same margin but you have to add train starts more quickly because the trains are shorter. So I think if you divide by two what happens in North America you won't be that far off.

Justin Long

Secondly, it sounds like the acquisition pipeline has picked up recently. So I was wondering if you could provide some more color on just what you're seeing out there? And has the level of activity in the market changed how you're thinking about a targeted leverage ratio for the business as you think about these potential opportunities?

Jack Hellmann

You know, I think on the last call I mentioned, sorry, I'm getting old, I'm losing track of time, but I think on the last call I mentioned things had begun to pick up about three or four months ago in a whole host of different acquisition and investment markets across the footprint. That has continued. You can see based on our -- it's fairly obvious based on our spending, because we called it out, that we're spending money related to due diligence on a variety of opportunities.

Those opportunities are both small and large. There's a whole range of things across our footprint that we're looking at. In terms of leverage as I've said before we continue in certain opportunities we may look at them with financial sponsors and other smaller tuck-in transactions we'll fold into our balance sheet right now as you can see that we can absorb that as we have continued to delever.

Justin Long

Okay, but would you feel comfortable generally speaking taking the business to call it 4, 4.5 times leverage for the right deal? Or would that be a little bit above what you'd feel comfortable with?

Jack Hellmann

That's above where we typically go. You've seen us do transactions historically where we were willing to take it up to 4 and then delever quickly and you've never seen us go higher than that as a public company.

Operator

And next we go to the line of Rob Salmon with Deutsche Bank. Please go ahead.

Rob Salmon

I guess to go back to the ag products but thinking about it in a little bit differently within North America, from a cost perspective in the second-half guidance, how much headcount are you assuming you're maintaining given the uncertainty? Because my understanding has been to date you've maintained higher headcount because you've got uncertain volume there. So this is basically all tying into how should we think about operating leverage to the extent the volumes are either stronger or a little bit weaker than what we're anticipating.

Jack Hellmann

Dave Brown, do you want to talk a little bit to how we've been maintaining headcount in South Dakota and some other places and just talk a little bit about that?

David Brown

And just in general terms we did maintain headcount through the light shipping period that we experienced in the early part of the year and through the summer. We've seen some increase in volumes and the headcount is being put to work in those situations. We have constant attrition, though, so we manage our headcount just by how we stage our hiring around attrition because our workforce continues to try it out as a fairly significant percentage. We can manage our headcount because we always have people going into retirement.

So throughout the seasonal periods of the year we can delay our hiring or at least stage our hiring to have the people, the newer people that we bring in to the railroads prepared and ready for the volumes that we expect to come even if it's going to be down the road.

Rob Salmon

I guess, Jack, if I'm thinking about it relative to the 50% incremental margins that you achieved across the North American franchise, is it fair to think it would be a little bit higher than that?

Jack Hellmann

The answer is yes, that could very well be the case but it depends on the nature of the traffic. There's different types of unit trains versus single carload traffic and so that is a generally safe generalization, but the pattern of traffic can affect it. Michael, is that a comfortable statement?

Michael Miller


That is very comfortable. In grain we have a very good mix that swings between single car and unit train traffic. So it really depends. I would add to Dave's comment we had weeks in the last month or two where we've handled volumes that were close to two-year ago levels and we handled them really quite easily with the staffing we had. So I think as we look going into the harvest we feel comfortable we've got the staff in place to move the product.

Rob Salmon

I guess Jack, my second question and you might not be able to answer this one is when you're thinking about M&A and you guys are a service provider, does that change the economics and how a deal potentially looks? I'm cognizant if you don't win out in a bid and you're the service provider that contract will last until it expires. But I'd be curious to get some context in terms of how you think about that.

Jack Hellmann

Can you repeat the question? I think it was very nuanced and it went right over my head.

Rob Salmon

So if you're a service provider and the customer is looking to potentially divest some assets, obviously you've read what's going on in the news. So does that change how you think about the equation from a financial or from a strategic standpoint? To the extent that you're willing to comment on that, any color would be appreciated.

Jack Hellmann

Well, no. If in those instances -- the only thing I would say is the obvious, if there is instances where we've signed up for a contract for a specific duration that's the duration we expect to operate that contract. And if the structure of the ownership or the desires of the customer change with the passage of time we'll alter our positioning accordingly, including not providing that service any longer if we're not desired. So it's pretty simple, we honor our contracts for their duration and if the world changes the world changes.

Operator

And next we go to the line of Jason Seidl with Cowen and Company. Please go ahead.

Jason Seidl

A couple of quick questions here. Number one, your outlook for Australia in the third and fourth quarter, those are some fairly big ranges in terms of your carloading guidance. Can you walk us through the best-case scenario versus the worst-case scenario?

T.J. Gallagher

Well I think the wildcard is going to be grain. The metallic ore shipments that we have are fairly steady, the minerals and stone is very steady, the intermodal follows a typical cyclical pattern increasing third quarter to fourth quarter and falling off late in the year. So the wildcard is going to be the grain.

Jason Seidl

That's fair enough.

T.J. Gallagher

I mean the percentages are big but the amount of absolute number of carloads is relatively small.

Jason Seidl

Right, okay, understood. When we look at your yields on your coal business, obviously there's a lot going on. You had a restructuring. Should we look at your second quarter yields as a go-forward basis now that the restructuring is complete? Or is there just something going on, that was a one-off in the quarter in terms of revenue per carload?

T.J. Gallagher

Are you talking UK/Europe?

Jason Seidl

Yes.

Jack Hellmann

You know what, I would guess that the best estimate you could make would be what we just did in the second quarter in terms of from a modeling standpoint. I don't think I could give you a better assumption than that.

Jason Seidl

Jack, you gave a pretty good update in terms of where you are with support for the Short Line Tax Credit bill. Is this something that we can finally get into a multiyear bill or are we going to still be going year by year by year by year?

Jack Hellmann

We will see. The version of the bill that I'm alluding to with those sponsorship numbers is a permanent bill and the politics of permanence versus it being another two- or three-year extension is something that will play itself out either in a lame-duck session in 2016 or in 2017, but there is as you can see in the numbers, the congressional support is unwavering.

I think we just passed, there was some, I saw a press release go out with something I didn't know but we just hit our 2,000th co-sponsor over the past decade within Congress. So it truly has strong bipartisan support, but whether it becomes permanent or we have to do this two-year dance remains to be seen. But I think there's an understanding in Congress that when you're making infrastructure funding and you've heard every presidential candidate talk about infrastructure funding, having some certainty with the basis on which you're going to be investing is very constructive and the congressional leadership understands that.

Operator

And next we go to the line of Scott Group with Wolfe Research. Please go ahead.

Scott Group

So let's see, I know there's been a couple of questions on the guidance. They're still just one thing I'm just not so clear on. We pretty much always see margin improvement in earnings growth from the second quarter to third quarter and I know that's what you were expecting but now you're expecting margins to get worse 2Q to 3Q. I'm just not sure why.

T.J. Gallagher

In North America one thing that's changing is fuel. So we expect you saw in our guidance roughly we expect roughly $0.20 higher diesel costs. And since we're in a lot of our fuel surcharge programs were below the threshold, right now I'd say would a third covered, a third are not applicable to fuel surcharge and a third of our programs we're below the threshold. So we're going to eat to some extent this next $5 million worth of expense and that's one difference quarter to quarter. And then there's always some mix shift in traffic. But the fuel is one thing that's definitely different from Q2 to Q3.

Jack Hellmann

Scott, the way I think about it is the way the world feels right now and we could be wrong, there are puts and takes as we look ahead. First of all, while things are uneven it actually feels reasonably stable after a long period of instability. But sequentially North America we're looking at revenue and EBIT in Q3 and Q4 that are pretty consistent with what we did in Q2 and we're absorbing this fuel increase but we're offsetting it by some other measures --

T.J. Gallagher

Higher traffic actually.

Jack Hellmann

Some higher traffic and other mix. And so we're is not getting ahead of ourselves.

Scott Group

So on the M&A side, just two things I wanted to follow up on. One, Jack, you mentioned financial sponsors if you were to do a larger deal, are you ruling out going to the equity markets or is that potentially an option? And then there's obviously this one kind of larger deal in the public domain. Anything you can share with us in terms of timing or anything else on that?

Jack Hellmann

With respect to specific transactions, for the past 16 years I've never commented on one. And so we're not going to -- I won't go there right now. The first question was financial sponsors--

T.J. Gallagher

And issuing equity.

Jack Hellmann

And issuing equity. The intent right now based on if you look at our free cash flow relative to our share price is we don't love the prospect of issuing equity. And so that is why we're working with financial sponsors. And so it is very fact pattern specific on any given transaction as to what the right solution is for shareholders. And you can just rest assured that we will use good judgment in assessing what that right structure of transaction is to maximize shareholder value.

Scott Group

Okay. And then just lastly on the reciprocal switching proposal, I think the short lines are exempt if I'm understanding it correctly but are you comfortable enough with that exemption that this is a non-event for you? Or do you or the industry have the view on this proposal?

Jack Hellmann

We're still reviewing the proposal but there's probably three thoughts worth communicating. First, yes, we're pleased that the Board acknowledged the concerns of the Class II and IIIs and they limited the applicability of proposed regulations to movements involving Class I. So the fact that there was that recognition is important, but we still think there needs to be initial analysis on the impact of the proposed regulations on the industry overall and that there needs to be more clarity in the regulations themselves before we'll have a full understanding what the ramifications could be long term.

And I guess third, I'd just say you can rest assured we'll be involved in the comment period and we will be watching closely as these evolve over the coming years. So I think that's all I would comment on at this time.

Operator

And next we go to the line of Bascome Majors with Susquehanna. Please go ahead.

Bascome Majors

Thinking about a large deal that you've already alluded to, the desire not to issue equity and partnering with the financial sponsor, not having seen you do that before from a very high level as we think about the economics of what a larger transaction might look like, can you throw out some kind of structures or just roughly speaking what's in your head?

Jack Hellmann

You know, I really can't because you're asking a specific -- I can tell you hypothetically over the years we've looked at other transactions. So I'm going to wind back the clock a decade. A decade ago we entertained transactions, for example, where we had participating equity ownership at the side of a financial sponsor and charged a management fee.

We had other bids that are in the public domain where we bid on publicly-traded entities where we formed joint ventures with financial sponsors. The menu of options when you're thinking about corporate financing is -- there's a whole host of ways you can do it in a way that's value additive for shareholders. And so all of those would be on the table as we're entertaining a larger deal.

Bascome Majors

One more kind of on a similar angle. The Australian business press is saying that Glencore is seeking a valuation that is at least as high as what any publicly traded North American or Australian railroad is trading at right now. I know you can't talk about the process, but you already operate this business for Glencore today. I was hoping could you shed some light on if there is anything specific that makes this asset uniquely valuable?

Jack Hellmann

We can't comment on a specific transaction. It just wouldn't be appropriate.

Operator

And next we go to the line of John Barnes with RBC Capital Markets. Please go ahead.

John Barnes

First, on the balance sheet outlook, T.J., could you talk a little bit about you gave a nice slide in there, but where do you think you will be given free cash flow generation this year on that net debt to EBITDA? Is there a chance of being close to 3 or is it still going to be a little bit elevated from there?

T.J. Gallagher

I think we finished the quarter at 3.6 and we're going to be slightly lower than that by year-end. But we're not going to get down to 3 times.

John Barnes

All right. So that's still really the limiting factor--

T.J. Gallagher

We're moving in the right direction.

John Barnes

Okay, all right. So it's going in the right direction but that's still the limiting factor. You still would be less than 1 time, one turn of leverage available to you if you want to stick to that 4 times goal, correct?

T.J. Gallagher

I'm sorry, repeat your question?

John Barnes

I guess what I'm saying is Jack, you indicated your comfort level was kind of 4 times EBITDA. And so you're saying--

Jack Hellmann

I've said, yes, for a specific transaction as high as we have gone historically hypothetically, because it was a hypothetical question, was as high as 4 times. And what's unusual about the present is the fact that we're levered at 3.6 and we haven't and we're not anticipating being down as low as 3 by year-end. And that's why we're entertaining these other conversations.

John Barnes

And secondly, from a more of a medium- to longer term outlook on the petroleum side, you've all of a sudden got rig count beginning to creep back up, natural gas prices have crept back up. There have been a number of companies on the drilling side that have come out in the last couple of weeks talking about just how low their production costs have gotten and how much improved their extraction process is.

From more of a medium- to longer term outlook now that it feels like maybe we're beginning to reach bottom. What's the outlook for that business for you going forward? I know it's kind of unique. You talked about the liquid natural gas. I know you serve in a couple of different shales than maybe some of the Class Is. But what's your view of that business now that maybe we're starting to see some stability?

Jack Hellmann

I think why don't we have both T.J. and Michael come at it from a couple of different perspectives.

T.J. Gallagher

I will start. So John, we have got a great position in Eastern Ohio and Western Pennsylvania with respect to both the Marcellus and Utica shale formations. And there have been a number of significant fractionation plants that have been built and these are rail served and that's what's really been behind the growth of our petroleum products business over the past couple of years. So drilling counts have a fallen over the past year and a half.

To the extent that they come up with more drilling that, again, that's just more supply, a product that's going to be feeding these fractionation plants. So we like our position. With respect to frac sand you know that's down to virtually nothing today from a significant part of our minerals and stone just a year and a half ago. So again this is a cyclical business, we're at a cyclical low, we were at a cyclical high a few years ago and so, yes, we do see it coming back. But how high it gets that is going to depend on future petroleum prices. Michael?

Michael Miller

I agree with you, T.J. Our frac sand and our pipe business is pretty much at the bottom. So it's all upside. We have a unique geography that we serve. There's infrastructure in place, fractionators we serve. So as more drilling comes online for us we view it long term as upside opportunity.

John Barnes

Are you getting any indications yet that there is more drilling kind of in the near term pipeline? Or are we still just bouncing along the bottom here?

Michael Miller

I would say for us we're bouncing along at the bottom. Prices have come up but they need to stay up in order to get people in for the long term.

Operator

And next we go to the line of Ari Rosa with Bank of America. Please go ahead.

Ari Rosa

Just wanted to get a little bit of color. Obviously core pricing looked pretty solid but we saw a decline from the average revenue per car. And you mentioned mix being a little bit of a pressure point. Could you give some sort of ratio on what the balance is between mix versus fuel and specifically digging into that what are the mix effects? So is it shorter length of haul, is it type of freight that's being carried, what's really going on there?

Jack Hellmann

If you go to slide 12 of the presentation I think that sets it up pretty well for you. I don't know if you want to add any additional color on intra -- I mean there's always--

T.J. Gallagher

Yes, so again if you just refer to slide 12 you see the reported number of, this is North America we're talking about up, of 2.3%. And then you can see the change in commodity mix which means relatively less coal, more petroleum products, etcetera. And just following through the math with the fuel surcharge and the currency and you see the 3.3% that's mathematically pulling out those factors. We know we have customer mix within a couple, significant mix within a couple of commodities which I highlighted, coal and minerals and stone, one moving average revenue is down, one moving them up. So the best way to think about it is that 3.5% to 4% range is how I see the quarter.

Ari Rosa

And any comment on length of haul effects?

T.J. Gallagher

It's going to vary. Each commodity is different. There's new business. There is significant mix shift year over year this past 12 months if you think about how much of our business has changed, so --

Jack Hellmann

I wouldn't describe it -- in this particular, there have been periods where I would have ascribed some to length of haul, but not this one.

T.J. Gallagher

Yes.

Ari Rosa

And then just my second question, I wanted to ask about some of the savings that you guys have been seeing, is there a way to put a number on how much of that is volume related versus sustainable efficiency gains? I know you mentioned within ag products doing more with lower headcount. But if you could just talk more broadly about some of the different product groups? And as we go forward and hopefully see a little bit of a volume uptick what can be sustained there?

Jack Hellmann

The way I would think of it probably isn't by commodity group. I think about it by railroad. We run 120 railroads. What I can tell you is that we're running -- we have 5% of our active fleet parked. We're running short -- almost without exception we're running short trains right now. And so it's almost like coming out of the global financial crisis.

If you're running 25 car trains and you could be running 40 those incremental 15 cars is extremely -- there's a lot of leverage to that. So that's where we're in most places. Don't know, Dave or Michael, do you want to -- is that generalization about right?

David Brown

I think just real quick on the cost side of it, certainly and every railroad is a little bit different and Michael I'm sure we'll talk about the commodities that nuance that. But at the same time, over time we have redesigned and worked on our service design plans to try to be as efficient as possible. But also with the expectation that we will have incremental volumes over time that will be very beneficial to operating a little bit bigger train as we see volume come back.

Ari Rosa

Okay and so is it reasonable to say and I'm not trying to peg you guys to a number, but as some volume returns then maybe we're looking at system-wide sub-80% operating ratios? Is that fair to say? I mean talking about 25 trains to 40 trains with relatively little incremental cost it sounds like a pretty big efficiency gain.

Jack Hellmann

Well, the way to look at it is you look at North America overall, so what you're talking about is North America which we ran at probably 73.5% operating ratio in this last quarter. And to the extent that we get some volume back, yes, you'll see the operating ratio drop with those incremental carloads. There's no question. I have to go back and look back maybe seven, eight quarters but I think we were approaching 70 or below before we started losing all the coal traffic. And so you can see there is another path to get there, it's just going to take some time. And we're hard at it.

Operator

Next we go to a question from the line of Jim Levesque with S&P Global Platts. Please go ahead.

Jim Levesque

A quick question going back to U.S. coal and North American coal, in your second quarter mix is there any -- could you give a little color on the breakdown by basin and historically if that's a trending away from what you've normally seen? And maybe with stockpiles, as we've heard they've gone down, where you're seeing different parts of the country what stockpiles are at today maybe compared to a few months ago?

Jack Hellmann

Michael, do you want to talk coal for a little bit just on broadbrush terms? It's a little tricky to answer because it's very railroad, utility specific and we serve a lot of them but maybe make some broadbrush comments, Michael?

Michael Miller

Yes, if I had to just broadbrush, put a number out there, probably 60% of our carloadings for coal is going to be PRB-based when you look at the utilities we serve. And we do have some exposure to Northern App and then some exposure to the Illinois Basin. But we've not really seen any significant shifts between basins. It's just been really the utilities we served burning more coal, so the volume has picked up.

Jim Levesque

Okay and what about where you're seeing stockpiles now today?

Michael Miller

Stockpiles are still probably it depends on the utility but they are probably still running 30% higher than they have been in the historical five-year average. So there's still probably 20 or 30 days of inventory that needs to come out to get it back to where it needs to be. We're starting to see that slowly decline. It all depends on weather but it is dropping.

Operator

And that will come as a follow-up from Alex Vecchio with Morgan Stanley. Please go ahead.

Alex Vecchio

T.J., I just wanted to clarify, when you report core pricing, is that a same-store sales metric or is that a metric that just reflects the pricing you get on contracts that are renewed in that specific quarter?

T.J. Gallagher

Isn't it the same thing? It is the same railroad, so to the extent that we have acquisitions in the period that haven't been grandfathered we would strip out that impact. So, yes, it's a result of --

Jack Hellmann

It is the same railroad.

Alex Vecchio

Okay, because you guys noted that you had some legacy contracts repriced in the first half that may boost the first-half pricing versus the second half. But wouldn't, I'm assuming you moved those volumes in the back half, wouldn't that carry through core pricing through the back half as well?

T.J. Gallagher

Sure.

Jack Hellmann

That sliver would, yes.

Jack Hellmann

Okay, thank you very much for joining us today. And we will look forward to speaking again on the third quarter call.

Operator

Thank you. Ladies and gentlemen, this conference is available for digitized replay starting today August 1 after 1 p.m. Eastern Time through September 1 at midnight. You may access the digitized replay service at any time by dialing 1-800-475-6701 and enter the access code of 372877. International participants may dial 320-365-3844. Again, those numbers are 1-800-475-6701 and 320-365-3844 with the access code of 372877. And it is available for replay after 1 p.m. Eastern Time today through September 1 at midnight.

That does conclude your conference for today. Thank you for your participation and you may now disconnect.

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