CSX - Q2 2016

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to the CSX Corporation Second Quarter 2016 Earnings Call. As a reminder, today's call is being recorded. During this call, all participants will be in a listen-only mode. For opening remarks and introduction, I would like to turn the call over to Mr. David Baggs, Vice President, Treasurer, and Investor Relations Officer for CSX Corporation.

David Baggs (Head of Investor Relations)

Thank you, Prema, and good morning, everyone, and again, welcome to CSX Corporation's Second Quarter 2016 Earnings Presentation. The presentation material that we'll be reviewing this morning, along with our quarterly financial report and our safety and service measurements, are available on our website at csx.com under the Investors section. In addition, following the presentation, the webcast replay will be available on that same website. This morning, our presentation will be led by Michael Ward, the company's Chairman and Chief Executive Officer, and Frank Lonegro, our Chief Financial Officer. In addition, Cindy Sanborn, our Chief Operating Officer, and Fredrik Eliasson, our Chief Sales and Marketing Officer, will be available during the question-and-answer session. Now, before I turn the presentation over to Michael, let me remind everyone that the presentation and other statements made by the company contain forward-looking statements.

You are encouraged to review the company's disclosure in the accompanying presentation on slide two. The disclosure identifies Forward-Looking Statements, as well as the uncertainties and risks that could cause actual performance to differ materially from the results anticipated by these statements. In addition, at the end of the presentation, we will conduct a question-and-answer session with the research analysts. With nearly 30 analysts covering CSX, and out of respect for everyone's time, including our investors, I would ask as a courtesy for you to please limit your inquiries to one question and, if necessary, a clarifying question on the same topic. And with that, let me turn the presentation over to CSX Corporation's Chairman, Chief Executive Officer, Michael Ward. Michael?

Michael Ward (Chairman and CEO)

Well, thank you, David, and good morning, everyone. Yesterday, CSX reported second quarter earnings per share of $0.47, compared to $0.56 per share in the same period last year. Revenue declined 12% in the quarter, as strong pricing across nearly all markets was more than offset by the impact of a 9% volume decline, which included a 34% decline in coal, as well as negative mix and lower fuel recovery. Regarding operating performance, CSX continued to deliver strong safety performance, and service continued to meet and exceed customer expectations and drive further efficiency. In the quarter, CSX continued to aggressively and successfully reduce its cost structure throughout the network, recognizing that this company's long-term future is built on a fluid and efficient network, serving primarily intermodal and merchandise markets.

Despite these cost-saving actions, operating income declined $177 million-$840 million. At the same time, the operating ratio increased 210 basis points year-over-year to 68.9. Now I'll turn the presentation over to Frank, who will take us through the second quarter results and third quarter outlook in more detail. Frank?

Frank Lonegro (CFO)

Thank you, Michael, and good morning, everyone. Let me begin by providing more detail on our second quarter results. As Michael mentioned, revenue was down 12% or $360 million versus the prior year, driven primarily by lower volumes. Total volume decreased 9%, which impacted revenue by about $260 million. In addition, fuel recoveries declined $98 million. We continue to see strong core pricing from an improving service product, which for the second quarter was up 2.9% overall and 4.0% excluding coal. However, this was partially offset by negative business mix in the quarter. Other revenue decreased $29 million, driven mainly by lower incidental charges and coal-related revenue from affiliate railroads.

Expenses decreased 9% versus the prior year, driven mainly by $96 million in efficiency gains, $86 million in lower volume-related costs, and $56 million in lower fuel prices. Operating income was $840 million in the second quarter, down 17% from last year. Looking below the line, interest expense was up slightly from last year, with higher debt levels partially offset by lower rates, while other income was relatively flat to the prior year. And finally, income taxes were $262 million in the quarter, with an effective tax rate of about 37%. Overall, net earnings were $445 million, down 20% versus the prior year, and EPS was $0.47 per share, down 16% versus last year. Now let me turn to the market outlook for the third quarter.

Looking forward, we expect year-over-year volumes to decline in the third quarter in the mid- to high-single-digit range. Despite some markets growing, the majority of our markets will be down, with the most significant declines continuing to be concentrated in coal and crude oil. Automotive is again expected to grow as light vehicle production remains higher on a year-over-year basis. Minerals volume will be higher, with the continued ramp-up of new fly ash remediation business and ongoing strength in construction, which drives demand for aggregates. Agricultural products are expected to decline as the strong dollar and low commodity prices continue to pressure both domestic and export shipments. Chemicals will be down due to the continued declines in shale-related products, resulting from low crude oil and natural gas prices. We expect crude oil volume to be moderately lower on a sequential basis.

Domestic coal will continue to be unfavorably impacted by an excess supply of natural gas at a price point that favors gas burn over coal in the East. In addition, coal inventories remain high, and year-over-year volume declines will continue to be significant, although less severe than the second quarter due to softer comps in the back half of 2015. Export coal should be moderately lower in the second half of the year from the first half tonnage run rate, consistent with the seasonality we have seen in recent years. Despite modest improvements in the met and thermal benchmarks, the export market will remain pressured by the strong U.S. dollar and global oversupply. That said, we saw more spot moves than anticipated in the second quarter. As such, we now expect full-year export coal tonnage of around 20 million tons.

For the total coal market, we continue to expect full-year tonnage declines of around 25%, with third quarter coal tonnage roughly stable sequentially to what we have seen in the first half of this year, or approximately 22 million-23 million tons in the quarter. Intermodal is expected to be down as we continue to cycle prior competitive losses in international through the remainder of 2016. Domestic intermodal is anticipated to be roughly flat in light of difficult comps that reflected new business shifting to CSX in the third quarter of last year. Overall, our business continues to reflect a market environment driven by low crude oil, natural gas, and broader commodity prices, as well as continued strength in the U.S. dollar. Turning to the next slide, let me talk about our expectations for expenses in the third quarter.

Since last year, we have taken aggressive cost actions, which includes reducing headcount by about 4,500 versus the prior year. As a result, we have achieved about $230 million of efficiency gains in the first half of 2016, and now expect full-year productivity savings to approach $350 million. We expect third quarter expense to benefit on a year-over-year basis from our ongoing focus on driving efficiency gains and rightsizing resources. Looking first at labor and fringe, we expect third quarter average headcount to be down slightly on a sequential basis. In addition, we expect labor inflation to be around $30 million in the third quarter. Finally, we expect a headwind in the third quarter of $25 million-$30 million versus the prior year, driven by higher incentive compensation.

As a reminder, in 2015, we saw incentive compensation decrease in the second half of the year as market conditions drove CSX's financial results below our initial plan. Looking at MS&O expense, we expect efficiency gains and volume-related savings to more than offset inflation. As a result, MS&O costs are expected to be down moderately versus the prior year. Fuel expense in the third quarter will be driven by lower cost per gallon year over year, reflecting the current price environment, volume-related savings, and continued focus on fuel efficiency. We expect depreciation in the third quarter to increase around $20 million versus the prior year, reflecting the ongoing investment in the business.

Finally, equipment and other rents in the third quarter are expected to be relatively flat to the prior year, with the benefit of improved car cycle times offsetting higher freight car rates and the increase in volume-related costs associated with automotive growth. Now, let me wrap up on the next slide. CSX's second quarter results reflect success in a challenging freight environment, with macroeconomic and coal headwinds impacting most markets, resulting in a 9% volume decline this quarter. This success is driven by pricing for the relative value of rail service, driving efficiency gains, and aligning resources to the softer demand environment, which partially offset those substantial volume headwinds. Looking ahead, let me first provide an update on our 2016 capital investment.

Projected capital investment has increased $300 million from our initial plan, as CSX now anticipates accelerating payments for locomotives delivered throughout 2016 under a long-term commitment. We originally intended to pay for these locomotives in 2017. As such, 2016 capital investment is now expected to be $2.7 billion. By completing our locomotive purchase commitment this year, we simultaneously clear the path in 2017 for CSX to begin returning to our long-term core capital investment guidance of around 16%-17% of revenue. As we think about market conditions for the remainder of the year, we expect macroeconomic and coal headwinds to continue. Low commodity prices and strength in the U.S. dollar will continue to impact many of CSX's merchandise markets, while natural gas prices below $3.50 and elevated stockpiles are driving significant headwinds in coal.

As a result, we continue to expect total coal tonnage to decline around 25% for the full year. Looking at our expectations for the third quarter and full year, we remain intensely focused on achieving strong pricing that reflects the value of CSX's service product, rightsizing resources with lower demand, and pursuing structural cost opportunities across the network. As a result of these initiatives, we now expect efficiency gains to approach $350 million in 2016. That said, the impact of current market conditions on CSX's volume, particularly in coal, is expected to outweigh our positive momentum. As a result, we continue to expect third quarter and full year 2016 Earnings Per Share to be down from last year. Furthermore, as a reminder, third quarter EPS is typically down sequentially from second quarter results, reflecting the seasonality of our business.

With that, let me turn the presentation back to Michael for his closing remarks.

Michael Ward (Chairman and CEO)

Thank you. As Frank discussed, it's clear this continues to be a challenging freight environment with plenty of macroeconomic headwinds.

Thanks to the extraordinary work of our employees, CSX is delivering record levels of efficiency and rightsizing resources to the business demand of today. Looking longer term, the company has a bright future as the men and women of CSX are simultaneously positioning the company for growth, where we have the resource flexibility to serve future demand. This will position CSX to maximize long-term opportunities in both our merchandise and intermodal markets. As a result, we continue to be enthusiastic about the core earning power of the company as the market headwinds subside. As we work to transform this company into the CSX of tomorrow, we must grow and make more profitable the merchandise and intermodal markets, which represent our future. At the same time, we will continue to preserve the business value of coal, recognizing that it will become a smaller but still important part of our company.

Our future involves leveraging a premier, highly efficient network that reaches diverse merchandise and intermodal markets and nearly 2/3 of the American consumers. It requires consistent, excellent service for customers, which in turn supports efficiency, profitable growth, and pricing that allows us to continue investing for the future, and includes technology solutions that drive an ever more safe, reliable, and efficient railroad. As we manage today's business environment to deliver on the future potential, we continue to focus on achieving a mid-60s operating ratio longer term to deliver compelling value for you, our shareholders. And now, we are pleased to take your questions.

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. Our first question comes from Rob Salmon of Deutsche Bank. Sir, your line is now open.

Frank Lonegro (CFO)

Good morning, Rob.

Robert Salmon (Analyst)

Hey, good morning, and thanks for taking the question. You know, Frank, I think on the last call, you'd indicated that with regard to the earnings cadence, you thought the decline in Q2 would be the largest for the year. As I think out to the back half of the year, with the puts and takes of coal being a little bit stronger than what you had anticipated in Q2, cost actions being a little bit more, how should I think about that earnings cadence as I look out?

Frank Lonegro (CFO)

Yeah, I think as, as we look at Q3 earnings on a year-over-year basis, you know, we've mentioned that they'll be down. We haven't sized that, as you know. We've got the challenging market environment that I know Fredrik will get into later in the call, impacting the top line. There are comps that begin to ease, as we get into the back half of the year, although, as we've mentioned, volumes in the third quarter will be down mid to high single digits, you know, with crude down, international intermodal losses and the coal, as we've mentioned, on a year-over-year basis, down as well. So we've got some negative mix. And then moderating productivity as we get throughout the year.

Obviously, we have delivered about $230 million in productivity in the first half, and that implies, you know, a certainly moderating productivity level as you get into the Q3 and Q4. And then we tried to give you some clarity in the third quarter remarks about where incentive comp might be, and certainly with fuel prices, where they're going, and cycling some of the fuel positives that we had in the third quarter of last year, we're gonna have a net fuel headwind as well.

So we've got some challenges looking ahead of us in the third quarter, but you know, as I'm sure Cindy will mention later in the call, everything's on the table on the productivity side, and pricing, you know, continues to be a favorable given the environment.

Robert Salmon (Analyst)

When I think about the mix, that feels like it'll be a little bit less bad in the third quarter. Fuel is probably gonna be a little bit tougher. Do those two net out, or does the fuel overwhelm the mix?

Frank Lonegro (CFO)

Well, let me, let me hit the fuel one, then Fredrik will hit the mix one. So when you look at fuel, we had about a, a $7 million in-quarter challenge in the second quarter. You know, you would anticipate, given where the forward curves are, that the in-quarter challenge will likely be a little bit more difficult sequentially, and then given the fact that we're cycling about a $20 million favorable in the third quarter of last year, you're looking at a pretty big obstacle there. Fredrik?

Robert Salmon (Analyst)

Got it.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah, in terms of the mix, I would say that obviously we're gonna continue to have the overarching mix change between coal going away and we're growing intermodal. We have indicated that we do think things will moderate in terms of overall volume decline as we move throughout the year. However, third quarter is still going to be a challenging quarter, and frankly, so will fourth quarter, but we do expect things to improve from a volume perspective as we move throughout the second half of the year.

Robert Salmon (Analyst)

Appreciate the time, guys, and I'm sure someone will also help hit on the efficiencies, but congrats on a good quarter.

Frank Lonegro (CFO)

Thank you.

Operator (participant)

Thank you. The next question comes from Ravi Shanker of Morgan Stanley. Sir, your line is now open.

Frank Lonegro (CFO)

Good morning, Ravi.

Ravi Shanker (Analyst)

Thanks, good morning, everyone. I will hit on the efficiencies. Obviously, a pretty impressive pace so far this year, and, and not surprised that you raised that target of $350 million. This then raises the natural question as to what innings we are in with the productivity gains here. Just how deep is that well that you can draw from?

Cindy Sanborn (COO)

Good morning, this is Cindy. I'll respond to that one. You know, I'll tell you, when we think about productivity, we've generated some in our network performance. As you've seen our service measurements improve. We think about it structurally and streamlining and process within initiatives. So those are the main categories that we look at. When we look at what we've done so far, clearly, we're lapping some of the big initiatives that we took late in 2015 and earlier this year. But we see we have a very long initiative base.

We've pulled some of those forward, but I think when we look out into the future, I think, we'll continue to drive results in both in the back half of the year, as Fredrik has, you know, as Frank has talked about, it'll be a little bit less in terms of quarterly numbers, but it's gonna be better than what we traditionally do on a quarterly basis. And as I look into 2017, I think we'll be able to overcome inflation. And I think a big part of what is gonna help us to do that is our CSX of Tomorrow initiatives around the Network of Tomorrow, as well as automation and technology is gonna allow us to continue to drive productivity.

And I would also want to mention that the actions that we are taking are not reactions, they are actual actions that are driving our decision-making relative to our coal portfolio getting much smaller, and the importance of providing a safe and reliable service product in the merchandise and intermodal portions of our business. And that is part of our core CSX of Tomorrow strategy, and we're executing on that, and will help us to be both service sensitive, more service-sensitive company, as well as a more efficient company.

Ravi Shanker (Analyst)

Got it. So just to clarify, the run rate that you expect to see for the second half of this year, is that a run rate to think of going into 2017?

Frank Lonegro (CFO)

Hey, Ravi, it's Frank. I think what the numbers would imply in the second half would be about $60 million a quarter. It never works out perfectly, as you know, but- But that's a general run rate in the second half of the year. As we get closer to the end of the year, we'll be able to give you a little bit more guidance on 2017. But I think Cindy mentioned, and I'll reiterate, our goal is always to, to offset inflation with productivity. And, depending on how those numbers play out, as you get into forecasting next year's inflation numbers, you should see us have confidence in our ability to continue to do that in 2017.

Ravi Shanker (Analyst)

Great. Thank you.

Operator (participant)

Thank you. The next question comes from Ken Hoexter of Merrill Lynch. Sir, your line is now open.

Frank Lonegro (CFO)

Morning, Ken.

Kenneth Scott Hoexter (Managing Director)

Hey, good morning. Just wanted to follow up on Frank's comment on the increasing CapEx and accelerating locomotives purchasing. Just wondering why you're accelerating the CapEx? Did you get better pricing on equipment, and does that change your thoughts on cash flow buybacks and use of capital as we move forward?

Frank Lonegro (CFO)

Hey, Ken. Honestly, it was the avoidance of seller financing charges that we would have incurred if we had stuck with the original deal to pay off the engines next year. So, it's just a timing over a couple of months. No impact on, you know, cash flow. It's kind of a one-time thing, switch between 2017 and 2016.

Kenneth Scott Hoexter (Managing Director)

So it's not a commentary on what you thought on pace of volumes or anything else, just financing to accelerate in a declining volume environment?

Frank Lonegro (CFO)

Well, we either pay the financing charges or avoid them by pulling it forward. And as Cindy is mentioning, you know, every dollar is on the table, and that seemed like a good way to save a little bit of money as we look forward into 2017.

Kenneth Scott Hoexter (Managing Director)

All right, great. Thank you.

Operator (participant)

Thank you. The next question comes from Brandon Oglenski of Barclays. Your line is now open.

Frank Lonegro (CFO)

Morning, Brandon.

Brandon Oglenski (Director)

Yes. Good morning, everyone. So I want to follow up from Ken's question on CapEx. So you talked about the ability in 2017 to get back towards a core investment around 16%-17% of revenue, but I'm assuming that excludes spending on things like PTC. So you might not be willing to tell us right now what you think the non-core items might be in 17%, but maybe if you could give us some context on what non-core investment has been for the past couple of years.

Frank Lonegro (CFO)

Sure. So the only thing that we exclude from core investment is positive train control. If you look at what we're doing this year, our all-in number of $2.7 billion has the $300 million increase for the engines that I just mentioned. It has $300 million for positive train control, which gets you down to the $2.1 billion of core capital that we had started the year talking about. And as you might remember, that was a decline of over $100 million in core capital from 2015. You'll continue to see us focus hard on core capital and making sure that we're making the right decisions in terms of infrastructure, equipment, and return-seeking investments.

As you think about PTC going into 2017, that number should decline some from the levels that you see here in 2016. It should step down a little bit, and then again between 2017 and 2018, as we set our sights toward being compliant with the FRA's and Congress's mandate that we'd be hardware complete by the end of 2018, and then it should leg down even further between 2018 and 2019. And then hopefully, all of that will go away as we get to full implementation in 2020, and then you won't see us carry a positive train control CapEx line after that. It'll just become embedded within the broader capital plan.

Brandon Oglenski (Director)

Okay, I appreciate that.

Operator (participant)

Thank you. The next question comes from Brian Ossenbeck of J.P. Morgan Chase. Your line is now open.

Frank Lonegro (CFO)

Morning, Brian.

Brian Ossenbeck (Managing Director)

Hey, good morning, everyone. Thanks for taking my question. ... so I was wondering if you could give us an update on the CCX project. You know what, you can talk about CapEx, what type of CapEx you're expecting there? Is that something we can do a public-private partnership? And, you know, how close are you to scoping out and finding a site for that, you know, for that investment?

Michael Ward (Chairman and CEO)

Yeah, this is Michael. We're very excited about the CCX opportunity. We're finding that we're getting great cooperation from the state and local officials. We're very encouraged that we will be able to work cooperatively with them. As you mentioned, it's a public-private partnership, with the state providing about half of the funds and us providing the other half of the funds. We think it's going to be a tremendous economic development opportunity for the state of North Carolina, and we're very excited about the progress we're making on it. The exact location hasn't been finally determined at this point, but we're continuing to make good progress.

Brian Ossenbeck (Managing Director)

Okay. Can you just remind me of the timing and the size of the expense, the expenditure?

Michael Ward (Chairman and CEO)

It's going to be roughly $150 million of ours, which is in part of the long-term capital plan that Frank evaluated, and the state is putting up close to a similar amount for the facility.

Brian Ossenbeck (Managing Director)

Okay, thanks for your time.

Operator (participant)

Thank you. The next question comes from Allison Landry of Credit Suisse. Your line is now open.

Michael Ward (Chairman and CEO)

Good morning, Allison.

Allison Landry (Analyst)

Good morning. Thanks. I was wondering if you could talk a little bit about the mix during the quarter. In particular, it looks like maybe there was some positive mix within the coal segment. So just wanted to see if you could help us understand if that was on the domestic side or export, what drove that, and if that's something we should expect to persist in the third quarter.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah. So, Allison, on the coal RPU specifically, we did have some positive mix. Obviously, we also had the help of our fixed variable contracts, and continued pricing on the domestic side. Offsetting that is, of course, fuel surcharge revenue coming down and then the actions that we've taken on the export coal market. I do think that, you know, it changes from quarter to quarter, but it is a sustainable level, and there will be quarters when it will be up, and there will be quarters when down. The focus on our part is to make sure that we continue to do core pricing appropriately, and then let fuel and mix fall wherever it's gonna fall.

Allison Landry (Analyst)

Okay. And then were there any contracts on the domestic side that came up for renewal in the second quarter that maybe boosted that a little bit?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Nothing specifically. We have about a quarter, 20%-25% of our contracts coming up here by the end of the year, but nothing specifically here in the second quarter that would have changed the RPU number.

Allison Landry (Analyst)

Okay, great. Thank you.

Operator (participant)

Thank you. The next question comes from Chris Wetherbee of Citi. Your line is now open.

Michael Ward (Chairman and CEO)

Good morning, Chris.

Christian Wetherbee (Analyst)

Morning, guys. Wanted to follow up on the CapEx side and just kind of talk a little bit about locomotive spend. So you pulled some forward into 2016. How should we think about the change in locomotive spend as we go into 2017 and 2018?

Frank Lonegro (CFO)

Sure. So if you take just a year or two view of that, and you look at where we are from a locomotive storage perspective, we've got about 350 engines in storage. And then as you look toward the back half of the year, as Cindy gets the deliveries of about 60%-65% of the remaining engines from the purchase commitment that we had started in 2014, I mean, I think you should expect in the volume environment that we'll continue to store engines through that period. As you look forward into 2017 and 2018, assuming volumes stay essentially where they are, I doubt you would see us in the market for new locomotives.

At the same time, we do believe that continuing to reinvest in our four-axle, so our yard and switcher engines, is the long-term right thing to do, so you might see a little bit of capital going toward rebuilding the four-axle engines. But again, no, probably no big purchases in that time period. Cindy, anything you want to add to that?

Cindy Sanborn (COO)

No, I would say, as we look ahead and the engines that we have stored, the 350 that Frank mentions, are readily able to be brought back to service if we need them. In addition to that, we have, as we've taken locomotives out, this year, some have gone into a recommended retire status, which would not be in that stored count. So when you look at GTMs down about 10%, our active fleet is also down about 10%. And going forward, I would echo Frank's comments.

Christian Wetherbee (Analyst)

So, so is that the right way to think about it on a GTM basis? I guess it's a tough question because of mix, but when you think about potential volume growth, how much sort of latent capacity you have on the locomotive side for the next year or two? Is it roughly 10% when you think about it in GTM terms?

Cindy Sanborn (COO)

Well, when I think about it, GTM is how we think about our workload demands. But we're obviously cycling a very different type of commodity mix, with coal being reduced and lesser GTM-intensive business growing, hopefully. So we will look at GTMs in terms of workload, but when I think about what's available to bring back, it's really in what's in our stored status, not in the total that we have taken out this year. We're gonna recommend to retire some of the locomotives that we've taken out this year. And there's also leases that we've returned to, I might add.

Christian Wetherbee (Analyst)

Okay. So probably a little less than that number, I guess, ultimately, is what you're saying.

Cindy Sanborn (COO)

Less than 10% is what's available to bring back.

Christian Wetherbee (Analyst)

Okay, that's helpful. Thank you very much for the time.

Operator (participant)

Thank you. The next question comes from Thomas Wadewitz of UBS. Your line is now open.

Michael Ward (Chairman and CEO)

Good morning, Tom.

Thomas Wadewitz (Analyst)

Good morning. Wanted to ask a question. I think it's for Fredrik. It's on the domestic intermodal side. You guys have done a good job of realizing volume growth despite a, you know, a difficult market, difficult backdrop in truck. And I think you were up 5% in second quarter domestic intermodal, but then you're saying flat in third. Is that just the kind of impact from that one contract, or is there some slowing that you're seeing in the market? So I just wonder if you could talk on the domestic intermodal a bit. Thanks.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Sure, Tom. No, it really is impact from the fact that last year, in the third quarter, we had a significant ramp up in our domestic intermodal business. And as we move in here to the third quarter, we're going to start lapping that, which is going to make the volume comparison a lot more difficult than it's been in the first part of the year. And that's really the key driver. The market out there obviously continues to be challenged with a fair amount of excess capacity. From our perspective, though, the intermodal story is broader than that, and we continue to have good success in converting traffic off from the highway in partnership with the trucking industry.

We also continue to get some pricing, even in this tough environment, which bodes well for long term.

Thomas Wadewitz (Analyst)

Do you have any thought on inventories and whether high inventories are coming down somewhat, or is that still an issue that you hear from shippers?

Fredrik Eliasson (Chief Sales and Marketing Officer)

You know, inventory is still at a high level. It's been a sequential decline just a little bit, but it's still high versus historical basis. So that's certainly impacting the international part of our intermodal business more perhaps than it does on the domestic side, which is also why you're seeing the steamship line continue to struggle quite significantly, and demand on that side is very weak at the moment.

Thomas Wadewitz (Analyst)

Right. Okay. Thank you.

Operator (participant)

Thank you. The next question comes from Jeff Kauffman of Buckingham Research. Your line is now open.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Good morning, Jeff.

Jeffrey Kauffman (Director)

Hey, good morning, Mike. Congratulations.

Michael Ward (Chairman and CEO)

Thank you.

Jeffrey Kauffman (Director)

Question for Frank. Frank, there's been a lot asked about the CapEx, and I understand what you're doing with the locomotive CapEx, but that is going to create a little bit more of a cash shortfall. Since it's just really borrowing from 2017, do we fund that shortfall with debt and continue repurchasing shares at these levels, or do we focus on maintaining cash and maybe slow the repurchase until the cash flow gets a little bigger next year?

Frank Lonegro (CFO)

Hey, thanks, Jeff. In terms of the buybacks, you know, we're in the midst of the two-year, $2 billion program that we announced in April of last year. You've seen us essentially ratably buy throughout the period, about $1.2 billion that we've repurchased so far, throughout that program, about $800 million or so left. I think absent a recession, you should see us continue to do that ratably from now through the end of the first quarter of next year, and then reevaluate where we are from a, you know, a cash and a ratings perspective, as well as what the forward view of earnings might be at that time.

Jeffrey Kauffman (Director)

Okay, thank you. One detail follow-up. You never mentioned where are coal inventory days in your northern and southern service regions?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Sure. So, right now, where we are, we are in the South, and we use an external source for this. We're at about 98 days on forward burn in the South and about 71% in the North. And just to give you kind of the average benchmark, I think we've given in the past, in the South, we expect the average to be about 70%, and in the North, 55%. So whether you look at days burn or tons, we're up about 5% year-over-year using that same source. So we're still at a pretty elevated level as we sit here today. Clearly, the warm weather is helping, but it's highly unlikely that by the end of the year, we'll get to normalized level. It is our best prediction at this point.

Jeffrey Kauffman (Director)

Okay. Thank you, everyone.

Operator (participant)

Thank you. The next question comes from Scott Group of Wolfe Research. Your line is now open.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Good morning, Scott.

Scott H. Group (Analyst)

Hey, thanks. Morning, guys. So wanted to ask one more on the CapEx. You know, if we're not buying locomotives for a few years and PTP spending starting to come down, and you know, it feels like just given volume, but maybe the growth CapEx in general should be coming down. I would think that there's an opportunity to cut the CapEx kind of below that historical 16%-17% of revenue, and then you guys can really get a good free cash flow story going, which I think would probably help the multiple here. How do you think about that, and is that a realistic opportunity?

Frank Lonegro (CFO)

Hey, Scott, it's Frank. Certainly, we, we're in our planning process for 2017. It's really too early for us to comment on what we think next year's core CapEx is going to be. I think what you're hearing us say is that we're committed to returning to that about 16%-17% of revenue from a CapEx perspective. Within that, in any given year, there's going to be differences between how much is in infrastructure, how much is in equipment, how much is in return-seeking investments. And as I think I've mentioned in the conferences back in June, we're also committed to making sure that the CSX of Tomorrow initiatives are part of that capital guidance. So it, it's not something that you're going to see us take that guidance up because of the CSX of Tomorrow initiatives.

We're going to make all the right trade-offs within that, within that framework in order to be able to deliver, on the CSX of Tomorrow, which is a very important part of our future, as Michael mentioned in his remarks.

Scott H. Group (Analyst)

Yeah, I guess I'm just thinking, though, like, if historical, that 16%-17% of revenue historically has included locomotives, so if we're not buying as many locomotives, I would think that there's an opportunity to get below that historical level, or is that realistic, or are you saying not?

Frank Lonegro (CFO)

I'm not commenting one way or another, to be honest, Scott. I'm telling you that we'll give you some guidance on 2017, as we get closer to the end of the year. And then, as we begin to talk about the CSX of tomorrow and the associated financial parameters of that, we'll give you some guidance longer term.

Scott H. Group (Analyst)

Okay. And then if I can just ask one more, just kind of a detailed question. Just on coal, can you give us the mix of your coal by basin, App coal, Illinois, and PRB, and where do you see the switching points?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Sure. So here in the second quarter, we saw an increase in Illinois Basin coal up to about 37% of our overall utility portfolio. And really, that's what's relevant, I think, just looking at the utility portfolio. So 37%, thereabouts, was Illinois, PRB about 20%. So we had about 57% of our coal was either Illinois Basin or Powder River Basin, and the rest was Appalachia. And that is up a little bit from what we saw in the first quarter. And frankly, we expect Illinois Basin to continue to do well longer term as part of our utility mix.

Frank Lonegro (CFO)

Thank you, Scott.

Operator (participant)

Thank you. The next question comes-

Scott H. Group (Analyst)

Thank you, guys.

Operator (participant)

Thank you. The next question comes from Jason Seidl of Cowen. Your line is now open.

Frank Lonegro (CFO)

Morning, Jason.

Jason Seidl (Managing Director)

Morning, Michael. Good morning, team. I wanna focus a little bit on the mineral line. Obviously, the new fly ash contract is ramping up, and that's distorting the yields a little bit here. How should we look at yields going forward for the remainder of the year as the contract ramps up?

Fredrik Eliasson (Chief Sales and Marketing Officer)

You, are you talking about yields overall or specifically in minerals?

Jason Seidl (Managing Director)

Specifically in minerals.

Fredrik Eliasson (Chief Sales and Marketing Officer)

I mean, I think overall, it's I don't think you're gonna see a much different picture in terms of the yields. Clearly, the fly ash is a big initiative on our side. We're also seeing strength in other parts of our minerals business. But I don't think that RPU is significantly different than any other part of our minerals business. So I think those drivers are similar within the other parts of that portfolio as well.

Jason Seidl (Managing Director)

Okay. And just a follow-up question on coal. You know, you, you guys talked about, you know, being 98 days in the south, 71 days in the north. You know, how should we think about burning that through? If we get sort of a normalized summer and, you know, a normal winter, you know, at what point are we gonna get back to sort of that, those levels you talked about, you know, 70 days in the south and 55 days in the north?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Well, most of the external sources we use, and also discussions with utilities, would indicate, on average, that we'll get there sometime in 2017, hopefully in the first part of 2017. Clearly, as I said earlier, this summer is helping. Clearly, there are utilities that are below where they wanna be, and frankly, we have seen additional calls here over the last month or so. And that's a pretty low bar because the phone certainly wasn't ringing for several months. But it is helping. But you have some of our utilities that we serve have an awful lot of coal on the ground at this point, and it's going to take more than just a really hot summer to get it back to where it needs on average.

Jason Seidl (Managing Director)

And so as we think about coal for next year, I'm assuming we should think at least the first half should be still continue to be pressured.

Fredrik Eliasson (Chief Sales and Marketing Officer)

I think that there is a high likelihood of that. As I said, we will have a much better feel for that as we get through here this summer to see where we end up. Usually, not just in coal, but in all of our markets, we go out and really work closely with our customers to get a sense of what the plan for 2017 should look like. And at that point, as we get into third quarter and definitely the fourth quarter, our initial release, we have a much better sense of where we are. But, you know, overall, I think it's important to say two things.

One, what is happening here right now, in coal, in terms of the hot weather and the fact that natural gas prices have recovered a little bit, is really more of an impact for 2017 than it is short term in 2016. And then I think it's also important, and we've been probably the most vocal on this, from our perspective right now, we're planning for a secular decline in our coal business. We would love to be wrong about that, but in terms of how we approach our business and how we approach our planning, we continue to see a secular decline. Doesn't mean that you can't have a year or so where it goes up, but overall, we think that the trend is pretty clear where it's heading.

Jason Seidl (Managing Director)

Well, Fredrik, that's fantastic color. Listen, Fredrik, Michael, team, I appreciate the time as always.

Frank Lonegro (CFO)

Thank you.

Operator (participant)

Thank you. The next question comes from Ben Hartford of Robert W. Baird. Your line is now open.

Frank Lonegro (CFO)

Morning, Ben.

Benjamin Hartford (Analyst)

Hey, good morning, guys. Cindy, just some perspective on current service levels. You know, kind of pick your measure, whether it's dwell time or velocity. Those measures have somewhat stagnated over the past few quarters, still above 2013's peak levels. Any thought or hope of being able to return those measures back to 2013 levels? Or should we, for the time being, kind of ignore what you're able to do in 2013 and look for improvement, but the likelihood of returning those levels are low? I'd be interested in any perspective there.

Cindy Sanborn (COO)

Okay, well, Ben, we've improved our service levels both sequentially and year-over-year, as you can see from the charts. We were actually a little ahead of where we had planned to be for this year. And obviously, improved network performance does provide some efficiency gains for us. And we are committed to provide a service product that meets or exceeds our customers' expectations, helps Fredrik, you know, price for the value of the service that we provide. We have to balance that always, though, with some, you know, efficiency initiatives, and I think we're doing that. I think we're pretty happy with where we are. Where there's always opportunity to improve, and we will do that.

I think I've also highlighted before, and you, and you've probably heard Frank talk about it before, where we've installed our Train Length Initiative that is more problematic for us in terms of of velocity, let's say, is on the southern part of our network, which is mostly single track. So, we think that's the right mix. We've made the right decision there. We're seeing, overtime down, recrews down and other measures that give us, confidence that, we are improving, but, but it's, it, you know, I think we're, we're pleased with where we are, and we will work to improve. And Frank, Frank,

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah, let me just speak from a sales and marketing perspective. I would say that the effort here this year has been to really focus on the most service-sensitive part of our business, specifically in the intermodal business, to drive that service up, and that's where we made the most gains, and it is markedly different, and it's really helping our pricing efforts. Also, one of the key things for us is to reduce the span around the mean, and that is also improving significantly, because as also, as we look at a broader portfolio, it is about being able to be there each and every day at a reliable way. Our local service has improved significantly as well.

Really, as we look at the customer-facing measurements, not so much the measurements that you're seeing in terms of what we disclose externally, has improved significantly as well. From our perspective, I think we're making the right trade-offs between productivity and service, and as Cindy says, on the productivity side, we're never done, and the same thing holds true on the service side. We always wanna do better for our customers, and I think we're seeing that cooperation from operations, and we feel very good about where we are.

Benjamin Hartford (Analyst)

Okay, that makes sense. So but from the metrics that we can see, you know, that 2013 high water mark, are those targets that are credible? Do you feel like that you can get back to those levels over time and potentially exceed them?

Cindy Sanborn (COO)

Yeah, I think everything is on the table. You know, in terms of the pace and cadence of which we may get there, it's probably a longer-term type of aspiration. But again, you know, there's nothing that we're satisfied with. I'm not satisfied with the service measurements nor the efficiencies, and we will continue to work on both. But I think that's a longer term initiative.

Benjamin Hartford (Analyst)

Okay, thank you.

Operator (participant)

Thank you. The next question comes from Cherilyn Radbourne of TD Securities. Your line is now open.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Good morning, Cherilyn.

Cherilyn Radbourne (Managing Director)

Thanks very much, and good morning. Wanted to ask a question on productivity, which I think was a highlight again this quarter, and you always do a very good job of disclosing productivity versus the volume-related cost reductions. I just wonder if you could talk about the rigor with which you track that internally and make sure that you're holding people accountable.

Frank Lonegro (CFO)

Hey, Cherilyn, it's Frank, and absolutely, we have a lot of rigor within the finance organization, which in some respects is the scorekeeper here. What we do in terms of tracking productivity, we make sure that we normalize for volume first. So to the extent that there are volume variable expenses, then those don't count toward productivity. And what you've seen this year is that in the first half, we're about $150 million of what we call right-sizing or volume variable cost reductions, and then $230 million of structural cost efficiencies. There is a lot of accountability around productivity, and again, that is, you know, the way that we take costs out long term. Let me give you just a simplistic example that may help illustrate it.

So let's use coal, just 'cause coal volumes have come down. So if a coal train ran last year but doesn't run this year, then the cost associated with locomotives and crews and fuel and car costs would come out of volume variable expenses, and so you'd hear us talk about those in terms of right-sizing. If, for example, and we have instances of this, where you know, you have two coal trains that ran last year, and this year, through the Train Length Initiative and network routing, we've actually put those two trains together and run a 200-car train instead of two 100-car trains. The efficiencies associated with less locomotive intensity, crew intensity, fuel intensity, etc, would be allocated toward productivity.

Cherilyn Radbourne (Managing Director)

Great. That's helpful. Thank you. That's all for me.

Operator (participant)

Thank you. The next question comes from David Vernon of Bernstein. Your line is now open.

Frank Lonegro (CFO)

Good morning, David.

David Vernon (Managing Director)

Oh, great. Thanks for taking the question. Frank, this is kind of a great setup to what I wanted to ask you in terms of, you know, the size of the absolute productivity number. As we've gotten through the year, it does seem like that number is growing at the same time that our expectations for forward volume are getting worse. Is it right to believe that you guys are finding more opportunities to drive that productivity because there's less traffic on the network, and that that productivity pool is kind of expanding in relation to the volume decline? That's kind of the first question I wanted to ask you.

Frank Lonegro (CFO)

You know, I think what you'll see us do in an environment like this, where we realize that the revenue portfolio is in transition and the volume, especially on the coal side, is coming down, you know, we turn over every rock. And you've heard Cindy talk a lot about all the things that she's doing on the operating side, and not to the exclusion of the G&A side. I mean, the G&A side, every department is also looking for ways to challenge every cost dollar. So I think what you're doing—what you're seeing is really an across-the-board focus in our company to be disciplined on cost. We've always been disciplined on cost. We've always tried to offset inflation with productivity, but just given where we know the business is going-

we're really looking at the structural things, in a way to reduce the overall cost intensity of the business. And when volumes inflect positively, obviously, we'll be able to grow with that, both on the earnings and the margin side. And to the extent the growth comes in, you know, the batch merchandise business or the intermodal business or the automotive business, you should see us grow with healthy incremental margins. So, I think what you're seeing is the company focused on cost, given the environment.

David Vernon (Managing Director)

I guess, and then the second part of the question is, you know, as you're sort of taking that in your example, the 200-car trains and making it a 200-car train, I guess, you know, when volume does inflect, how do you think the cost structure will react? Do you think that the variable cost might go up, and you should probably just shouldn't care because the contribution is so high? Or do you think you can actually sustain this lower level of variable unit cost that you've been able to engineer, given the extra space on the network?

Frank Lonegro (CFO)

Sure. It depends in large part on how the volumes come back and where the volumes come back. We have engineered a lot of flexibility into the network through the train length and variable scheduling initiatives that you've heard us talk about. Again, as I mentioned, if volumes come back in class traffic and part of the scheduled network, you should see us be able to grow volumes without adding back variable costs. If the volumes come back in bulk traffic, where you're adding a new train start for a new bulk train, then you should see us bring that back. But again, the resource is back. But again, that would be at a nice margin, so you would want us to do that.

David Vernon (Managing Director)

Yeah, no, that's kind of what it seems like. Well, those are my two. Thanks very much for the time.

Frank Lonegro (CFO)

Thanks, David.

Operator (participant)

Thank you. The next question comes from John Larkin of Stifel. Your line is now open.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Good morning, John.

John Larkin (Analyst)

Hey, good morning, and thanks for taking the question. Just wanted to see how much granularity on the accelerated productivity targets you're willing to share with us. There are a lot of initiatives obviously underway, coal network rationalization, longer trains, closing down some excess facilities, eliminating duplicate overhead. All of those are very admirable initiatives. Are there any two or three of those that have really been the primary reason why you've almost achieved your entire former productivity target in the first six months that had originally been established for the entire year?

Cindy Sanborn (COO)

Well, John, I think, you know, some of what we've been able to do is put a series of initiatives together, mostly structural, with the closure of facilities late last year in the coal network, and moving forward into this year, where we also closed Russell Yard, and also consolidated our Huntington division headquarters. But it's not just in the coal space. We've also, you know, announced publicly, and you've probably read it, where we've consolidated facilities in central Florida with Winston Yard and Tampa. A consolidation actually in Tampa, and also streamlining some of our mechanical facilities and shops that are aligned more with our outer triangle and the core network that we have.

Our job is to really become less resource intensive, so between train length and the density of the train, as well as the density of the route that we route the train, has also allowed us significant savings across the board. So, I think there's really no one thing, I think, that we've accelerated that would really answer your question. But we are able—as we're able to put initiatives in place, we are doing so and continually looking for more. We have great momentum here. Everyone is over-delivering, and I think, you know, technology is a big help for us, and also some of our working with our labor organization is also a big help for us.

John Larkin (Analyst)

Thank you for that, very detailed answer. And then maybe as a follow-on, I understand that there's a fairly big initiative internally, given that intermodal is gonna be a bigger part of the puzzle going forward, to make intermodal more consistently profitable, going forward. And it occurs to me that some of the initiatives to achieve that goal come from the marketing side. And I was wondering if Fredrik could talk about some of the initiatives that perhaps sales and marketing has underway within intermodal to sort of normalize the volume so that you're running full trains every day of the week, every week of the year.

That's an obviously very difficult mountain to climb, but can you talk a little bit about what you're doing there, perhaps in working with third parties to fill all the trains up every day to really leverage that productivity?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah, there's a variety of things there that we are working on. That's absolutely right, John, and some of them are, I think, at this point, ready for public consumption. Some of them are not. But overall, you're absolutely right. In an environment where the RPU is so much lower, one of the key things that you can do to drive up margins is to make sure that you have a much more leveled workload, and the team is certainly working on that and thinking through how we can do that longer term. That is a pretty significant structural change. In the meantime, what we're trying to do is work on terminal productivity. We have a variety of initiatives in place there that has yielded a lot of a lot of results here.

We continue to work on train lengths in our intermodal space to make sure, just as we do elsewhere in our business, to allow for the leverage that occurs there. Of course, double stack clearances is important. You know where we are with Virginia Avenue Tunnel. By the end of this year, we should be able to be double stack clear there as well. And then the hub-and-spoke strategy that we've lined out for all of you for a long time has allowed for a significant amount of efficiency, being able to penetrate some of these smaller markets with a lot more density than we otherwise could, and of course, overall speed up the network itself.

which I alluded to before, which has been a priority as we think about the service improvements here in 2016, because the turn time on the v-, on the equipment is critical. And then to your point, and this is a little bit, a little more longer term, how do you structurally ensure that the day of the week balancing is a little bit better than what it is today? But that is, I think, a little bit of a longer term, initiative from our perspective.

John Larkin (Analyst)

Got it. Thanks very much.

Operator (participant)

Thank you. The next question comes from Bascome Majors of Susquehanna. Your line is now open.

Michael Ward (Chairman and CEO)

Good morning, Bascome.

Bascome Majors (Analyst)

Good morning. You know, we talk a lot about rising truck competition and its impact on the intermodal, but I wanted to focus on how it's hit your carload merchandise business. Do you have a sense of how much share loss to truck has been a drag on overall volumes? And I guess more importantly, when you begin to cycle the worst of that drag on what's called a year-over-year basis.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah, you know, one of the key things that we are focused on right now within our sales and marketing team is to sell through this cycle of excess capacity. And there is excess capacity in the truck market, and that is probably impacting our volume to some degree. But one of the key things for us is to continue to be able to reinvest in our business, and not necessarily chase that down too much when we see these temporary changes, because we do have to be able to be there for our customers day in and day out.

And that's one of the things that we sell with our customers, that we gotta work through the downturn that we're seeing right now, and we want to be able to be there for you, not just today, but also tomorrow when capacity is tighter. So we are seeing in certain of the markets beyond intermodal, where there has been probably some share loss to truck. We look at that each and every deal as a marketplace, and we always try to estimate what the second-best alternative is and try to match that. And in certain places where that is below what we think is long-term reinvestable for us, and at that point, we probably don't participate, because we don't want to do anything artificially. The pricing lever is critical.

With the service improvements that we've gotten here, we've been able to sustain and allow customers to see the long-term value that access to our network provides. But in certain places, we have seen some traffic go way back to truck.

Bascome Majors (Analyst)

Understood. And I just had a quick housekeeping one on one of your expense guidance items. You know, on MS&O, it implies what you guided, that it could be up as much as 10% sequentially from the second quarter in 3Q. You know, looking back, it's been eight or nine years since we've seen a magnitude of that rise from 2Q-3Q. Can you just give us a little color on what's driving that expectation of that big increase?

Frank Lonegro (CFO)

Yeah, Bascom, it's Frank, and not commenting on the numbers that you threw out there. As you know, MS&O is awfully difficult to predict in any given year, in any given quarter. I think what we said was that it would be down moderately versus the prior year, which does have some implications sequentially. I think what you're gonna see is we had the timing item on the $10 million casualty reserve, so that's generally what we do in the second quarter and the fourth quarter of each year. We relook at the probability and severity of casualty, and, you know, we had a favorable one-time item. You shouldn't, you know, think about that on a sequential basis in the third quarter.

And then in any given quarter, again, you have, you have timing items and some small one-time items, that are gonna impact the, the sequential comparisons. You know, so I think, I think you're, you're directionally accurate, although, again, not commenting on your numbers specifically.

Cherilyn Radbourne (Managing Director)

Thank you for the time this morning.

Operator (participant)

Thank you. The next question comes from Justin Long of Stephens. Your line is now open.

Michael Ward (Chairman and CEO)

Good morning, Justin.

Justin Long (Managing Director)

Thanks. Good morning. So I wanted to start by asking about the Point-to-Point Pricing initiative in coal. Could you provide an update on how far along you are in that process? And do you think this will be a tailwind or a headwind to the core price numbers you're putting out today?

Fredrik Eliasson (Chief Sales and Marketing Officer)

So we have implemented the point-to-point pricing across our coal network. Overall, I would say the process has gone very well. The reason for doing that is to make sure we better match the true cost of service some of the locations that are further away from so-called our core routes, to reflect the maintenance cost and operating costs that is associated with moving that. I don't think that will be material in any way, shape, or form to our same-store sales measure.

As I said, it really is more about ensuring that as we try to rationalize the infrastructure in the coal fields, that we, from a sales and marketing perspective, help operations to do that by truly reflecting what it costs to move some coal from certain other mines that are further away from some of our core routes. That's really all it's about. It's not so much about the same-store sales changing because of it, even though I think overall, I would say probably it's slightly helpful.

Michael Ward (Chairman and CEO)

Fredrik, you've put it in place on the tariffs, but it'll take some time to go through all the contracts.

Fredrik Eliasson (Chief Sales and Marketing Officer)

That is correct as well. We put it in place in terms of the tariffs. We have adjusted one or two contracts, but it will probably take, you know, one or two or three years, frankly, to get it completely implemented across our whole book of business.

Justin Long (Managing Director)

Got it. That's helpful. And maybe as a quick follow-up, so the 4% increase in core price, excluding coal, is a pretty strong number in this environment. It's also above what we've seen from some of the other rails here to date. Do you think this level of price increases is sustainable as we get into the back half of the year, or is there risk we see some moderation, given truckload capacity is pretty loose right now?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Well, so first of all, a great testament to both what our sales and marketing team has done in this tough environment, to your point about the strong results, and also, clearly, a critical part of this has been the service improvements that we have seen. You know, we don't really forecast what pricing will do over time. We will obviously disclose it each and every quarter in terms of our quarterly flash. But I think you know from our statements before, on one hand, we know value creation for CSX, pricing is a critical component of that. But I've also alluded to the fact that I think short term, meaning for the next 12 months or so, we see a period of excess capacity out there that certainly is impacting things.

But overall, you'll have a chance to see it where it comes each and every quarter.

Justin Long (Managing Director)

Okay, I'll leave it at that. Thanks so much for the time.

Operator (participant)

Thank you. The next question comes from Donald Broughton of Avondale Partners. Your line is now open.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Good morning, Donald.

Donald Broughton (Managing Director and Chief Market Strategist)

Well, good morning. Good morning. Thank you for taking the call, or the question, gentlemen. Help me think about this strategically, or help me understand how you think. I understand how the strength of the U.S. dollar is affecting negatively ag exports and the exports of other commodities. I understand that's why crude being under $70 is affecting negatively chemical volume and everything related to fracking. And nat gas, obviously under 4, is gonna continue to be a headwind for coal. So what's your crystal ball? Not that your crystal ball is any better than anyone else's, but how do you. You have to have a plan. What do you plan? Do you expect the dollar to stay strong, crude to stay under $70, and nat gas to stay under four for the foreseeable future?

Is that your expectation, or are you planning for the dollar to get weaker, for crude to go back up and nat gas to go back up?

Frank Lonegro (CFO)

You know, that's where the flexibility, I think, in our resource planning is critical because, to your point earlier, there's a lot of crystal balls out there, but I'm not sure which crystal ball is better than the other. What we do, as I said earlier, we do go out to our customers in the fall to try to get a sense of what they're seeing in the different markets that we serve. And then from there, we take their best input and triangulate with other things to put together our perspective on 2017. And it, you know, it is a very volatile marketplace right now, where it's very hard to predict.

We have laid out that overall, from a coal perspective, we do think that there's a secular decline that we're heading towards, and certainly we've seen the vast majority of that already. The U.S. dollar, you know, it is impossible for me to sit here and predict what the U.S. dollar is. Probably much better to look at a forward curve than me speculating on that. But the key thing for us is that we continue to have flexibility in our resource planning, and right now, the best predictor of tomorrow is today. The dollar is strong, and the low commodity prices are there. So that's kind of how we approach it.

Michael Ward (Chairman and CEO)

So Donald, what, what does your crystal ball say? My crystal ball says that crude is gonna stay under $70, and nat gas is gonna stay under $4 for the foreseeable future, and that there's nothing to indicate that the US dollar is gonna get weaker anytime soon. But, again, whose, whose crystal ball is better than the other? I just wondered what you're planning against, what's your best guess, and because obviously, I understand what, triangulating your expectations to your customers, but, you have to have your own internal gauges of where you're going as well.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah, and then I, I think that goes back to the point of flexibility. It, it is so hard to plan these days, and I think Cindy and team has done a fabulous job with really variabilizing our cost structure. We've talked about that for a long time. And then we do whatever we can to forecast, even on a monthly basis, and try to flow that around the network, so we can make very timely changes to our network based on the best information we have. But it's hard to see much beyond a month to three months at this point.

Donald Broughton (Managing Director and Chief Market Strategist)

Very good. Very fair. Thank you, gentlemen.

Operator (participant)

Thank you. The next question comes from John Barnes of RBC Capital. Your line is now open.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Good morning, John.

John Barnes (SVP and Financial Advisor)

Hey, good morning. Thanks for taking my question. Hey, two things. One, you indicated that you saw more spot load activity on coal volumes in the quarter. Fredrik, I think you alluded to a few more phone calls. Do you have a sense for how much volume moved in the quarter was on a spot basis versus, you know, kind of on a normal contractual basis?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Oh, on the export side?

Benjamin Hartford (Analyst)

Was there-

Fredrik Eliasson (Chief Sales and Marketing Officer)

Or overall?

John Barnes (SVP and Financial Advisor)

- domestic. Overall.

Fredrik Eliasson (Chief Sales and Marketing Officer)

Overall. You know, as you well know, on the export side, pretty much everything is spot these days.

John Barnes (SVP and Financial Advisor)

Yeah.

Fredrik Eliasson (Chief Sales and Marketing Officer)

So also, that's a great example in the previous question around that, you know, things change very fast in terms of how much we move. And we did see a pickup on the export side in the second quarter beyond what we had originally anticipated, which is why we increased the guidance on the export side to about 20 million tons for the year. On the domestic side, really the calls that we've received has really come in here over the last, I would say, 3-4 weeks. And so we really haven't had a chance to move a lot of that yet, but we do expect a little bit of a sequential uptick on the domestic coal, which is embedded in the guidance.

As we expect export coal to be weaker in the second half, we expect our domestic coal to be slightly stronger within that $22 million-$23 million , 22 million-23 million tons for the quarter.

John Barnes (SVP and Financial Advisor)

Okay. All right. And then my second question, and this is a little bit longer term, more strategic in nature. I recognize both of these things have only occurred since, you know, kind of July first, but... You've got the, the expanded Panama Canal is now open. The bookings are pretty solid thus far, and then you had the SOLAS rules go into, to effect on January, or July first as well. You know, have you seen any impact of either, and, and what do you think are the, the, the longer term impacts? I mean, what, what do you think it means? Is there a stairstep in volume as a result of one or both, or is this just moving, is this just changing where the freight, you know, how the freight gets to you, but no real stairstep?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah. On the SOLAS, first of all, we really haven't seen any impact at all. And we've spoken to our international customers, and it seems like the capabilities have been there, either by the port or some of the other freight forwarders or somebody else providing that information that is required. So we have not heard anything or, and we don't anticipate any impact on our international volumes because of SOLAS. In terms of Panama Canal, obviously, it is very recent, and it's a little too early to tell. We have said this for a while, that there are so many different drivers that comes into play here that is very difficult to predict exactly what's gonna happen. The good news is that we have a flexible network.

We will be able to handle additional volume coming into the East Coast if that happens. We are working very closely, both with international customers and with the ports, to make sure we have the capability that we need if it is a bigger shift than what we're currently anticipating.

John Barnes (SVP and Financial Advisor)

Very good. Are the ports—how far behind are the ports in being prepared for this?

Fredrik Eliasson (Chief Sales and Marketing Officer)

I don't think that it's my place to comment, John. I think overall, we work very well with the ports. Certain of the ports have better infrastructure than others, of course, but overall, it's a great relationship, and I think they, the East Coast ports are certainly seeing this as an opportunity and have spent a fair amount of capital over the last decade to prepare for this, so.

John Barnes (SVP and Financial Advisor)

Okay. All right, thanks for the time. I appreciate it.

Operator (participant)

Thank you. The next question comes from Keith Schoonmaker of Morningstar. Your line is now open.

Michael Ward (Chairman and CEO)

Good morning, Keith.

Keith Schoonmaker (Director)

Good morning, Michael. And, this is probably a question for Fredrik related to your last answer. Could you comment on the possibility that significant potential Panama Canal diversions from the historical land bridge route could be simply truckable when they arrive by ship?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Yeah, so, so our view of this has been, is that as you, if you do see a major shift over to the East Coast ports, what we will, we might lose some traffic that goes into the coastal regions that would be trucked to those markets. However, we also see then the opportunity to pick up some traffic into the Ohio Valley, into more kind of the Southeast that is further away from the ports, including potentially also going all the way back up to Chicago. And, you know, we've seen a fair amount of shift already as the Suez Canal has taken up a bigger shift. We've seen, as production in Asia has moved to more to the Southeast, that we've seen additional volume coming into the ports.

So, you know, we have the capability, but it, and it could be a little bit of a mixed change, but overall, we feel that we are very well positioned to capture whatever happens.

Keith Schoonmaker (Director)

Okay, thanks. Maybe just one more on truck competition. In the commentary, I think that was issued last night, if I'm remembering correctly, there was a remark about forest products experiencing some competition from trucking, and yet you managed to grow domestic intermodal an impressive 5%. It's sort of a contrast there, losing in one area. Is this just pretty route specific with the forestry?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Well, the reason why the intermodal domestic has been as strong as it has been has been the fact that we onboarded a significant amount of new traffic from one specific customer last fall, and we are starting to lap up here as we get to the third quarter, hence the guidance for not the same sort of growth and probably close to flat on the domestic side as we get to the third quarter. And obviously, long term, we think we're we can grow the domestic intermodal business kind of 5%-10%.

But we are in a period here on the domestic side and on the merchandise side, where we see some temporary weakness because of excess capacity, but we do fully expect that to be worked out over time and allow us to get back to more normalized growth rate as we move into, hopefully, the second half of 2017 or so.

Keith Schoonmaker (Director)

Okay, great. Thank you, Fredrik.

Operator (participant)

Thank you. The last question comes from Scott Schneeberger of Oppenheimer. Sir, your line is now open.

Michael Ward (Chairman and CEO)

Morning, Scott.

Scott Schneeberger (Managing Director)

Hey, good morning, thanks. I was gonna ask on a couple smaller segments since we're at the end here, but with regard to metals, could you give us an update on what you're seeing there, particularly with steel, and is there a chance that could swing to positive volume growth, you know, within a matter of quarters?

Fredrik Eliasson (Chief Sales and Marketing Officer)

Well, I think steel production year to date is relatively flat year over year. Part of what has helped that has been that the countervailing tariffs and so forth has been very helpful to stem the flow of imports into the United States. Our volumes are down a little bit more than that, and the reason for that is, on one hand, mill closures that has affected us specifically. We have one mill that we both have inbound and outbound to, that has closed down, and it's really a big driver for our volume decline. We also are seeing the impact on the metal side from a little bit more truck competition than we've seen before. So as we think about the second half, I think it's a little too early.

I think we're gonna have some of these specific, you know, specific CSX-related issues that is going to hurt us as we get into the second half of the year. So I think the second half will be pretty challenging still. But the key thing for us is to continue to work with our customers on the steel side, provide a better service product, and continue to make sure we can reinvest in the business, and that's what we're focusing on.

Scott Schneeberger (Managing Director)

Great, thanks. And, and just as a follow-up, and again, a small segment, but wasting equipment, a nice lift from Revenue Per Unit in the quarter. Is that something that's gonna persist, or was that a one-time act, event?

Fredrik Eliasson (Chief Sales and Marketing Officer)

There's a lot of changes, depending on what you move in that, because a lot of that equipment are some high wides that are, have very high revenue per unit because it's a very specific service, specific unit trains. And so that varies quite a lot from quarter to quarter, but overall, positive pricing continues and, but you will probably see more volatility in that line item than any of the other line items.

Scott Schneeberger (Managing Director)

Okay, thanks again, and congratulations.

Michael Ward (Chairman and CEO)

Thank you. Thank everyone for joining us, and we will talk to you again next quarter. Thank you.

Operator (participant)

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