CSX - Q2 2017

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to the CSX Corporation Q2 2017 Earnings Call. As a reminder, today's call is being recorded. During this call, all participants will be in a listen-only mode. Following the presentation, we will be conducting a Q&A session. To ask a question, please press star one. For opening remarks and introductions, 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, Marcella, and good morning, everyone. On behalf of the management team, I'd like to welcome you to our quarterly earnings call and also thank you for your interest in CSX Corporation. Our presentation, our quarterly financial report, and our press release, which conveyed our results, expanded buyback program, and reaffirmed 2017 guidance, are all available on our website at csx.com in the Investor section. In addition, later today, our webcast replay of this presentation, as well as our 10-Q, will be posted on that same website. This morning, CSX is being represented by Chief Executive Officer, Hunter Harrison, our Chief Operating Officer, Cindy Sanborn, our Chief Marketing Officer, Fredrik Eliasson, and our Chief Financial Officer, Frank Lonegro. On Slide two is our forward-looking disclosure. Any statements about the future made during the presentation or during Q&A should be taken in the full context of this disclosure.

Turning to Slide 3 is our non-GAAP disclosure, and while CSX files all of its financials in accordance with U.S. GAAP, we are providing certain non-GAAP measures to give you a more wholesome understanding of the business. These measures should be taken in the full context of this disclosure and with the understanding that they are not a substitute for GAAP. Finally, with close to 30 analysts covering CSX, I would encourage everyone to limit their question to one primary and one secondary question. With that, it is my great pleasure and privilege to introduce our President and Chief Executive Officer, Hunter Harrison. Hunter?

E. Hunter Harrison (CEO)

Thank you, David. Welcome, everyone. It's nice to be here with you from beautiful downtown Jacksonville. I'm gonna limit my opening remarks this morning, and let Frank and Fred and Cindy take the heavy load initially, and I'm sure we're gonna have a vigorous Q&A session, and I'll make most of my remarks or observations during that period. I would say this: I trust that you read the press release. I hope we were reading the same one. I thought we had a hell of a quarter. Four months we've been after this, and a lot has been done, a lot has been accomplished, directionally.

I'm very pleased with the direction the organization has taken, although I think maybe certainly in some quarters, and I understand that your expectations were pretty high. What used to be an all-star performance, you don't even make the cut anymore. So, I'm gonna be interested, obviously, in some of the Q&A. And I do think that as a result of this, to some degree, I think we're gonna change the format of how we announce earnings in the future. And I think we'll go more to the conventional approach of releasing the earnings and having the call effectively simultaneously.

Because I think it does create some awkwardness, in that some of you see numbers the night before, you have questions, we're not able to respond to some of those questions, or in my case, all of them. I mean, I don't, you know, didn't talk to anybody last night. I just kind of mopped the tears up a little bit and moved on. So I think it'll put us in a situation where you're not having to make observations in the dark, and it'll make all our work here much easier, and in distributing this information to the shareholder, which is really the important thing we're dealing with here. So with that said, let me let me turn this over to conductor Frank, and and let him proceed with the with the presentation.

Frank Lonegro (CFO)

Good. Thanks. Good morning, everyone. Thanks, Hunter. Slide seven reviews our safety service and efficiency performance year-over-year. As you can see, our train accident performance improved slightly, while our personal injury frequency index rose to 1.14, reflecting a slight increase in injuries and a significant fewer number of man-hours. The safety of our employees is paramount, and our commitment to them is unwavering.

Cindy Sanborn (COO)

Let me jump in, Frank. You know, even though we express injury performance in numerical terms on the slide, safety is always about returning employees home at the end of their tour of duty. Tragically, we had two employees who were killed in an accident that occurred in Washington, D.C., in the quarter. Our condolences go out to the family of Stephen Deal and Jake LaFave as we mourn the loss of two of our colleagues.

It is a stark reminder that even though railroads are one of the safest industries in North America, they can also be very unforgiving ones, and our commitment to safety remains.

Frank Lonegro (CFO)

Thank you, Cindy. Service and efficiency measures are trending well year-over-year. Q2 train length reflects two initiatives that offset one another in the quarter. Both are integral to Precision Scheduled Railroading. The first is balance. We have expanded the days of service on most trains to seven days per week, which is instrumental to improving cycle time and asset utilization, but negatively impacts train length. The second is unit train conversions into the scheduled merchandise network, which reduces both asset and resource intensity and increases train length. Going forward, you should see train length increase sequentially. Dwell and velocity are both improved and reflect the early success of Precision Scheduled Railroading. These improvements are particularly noteworthy given the rapid pace of change we are driving.

Balancing the train plan, merging unit trains into the scheduled network, and converting to flat switching has reduced handlings, improved transit times, improved velocity, and allowed us to idle 26,000 freight cars and 900 engines. Hunter and Cindy can certainly provide more color during the Q&A on those items. Fuel efficiency has also improved year-over-year, with 900 fewer engines in service and a more fuel-efficient active fleet. Turning to Slide 8, we're encouraged by the financial results driven by the early implementation of Precision Scheduled Railroading. Revenue was up 8%, driven primarily by coal pricing gains of 3.7% all in, and 2.2%, excluding coal, volume growth of 2%, and higher fuel recoveries. We also had liquidated damages of $58 million in the quarter, which reflects the resolution of a long-standing dispute.

It is recorded in the other revenue line and drives the year-over-year variance. GAAP expenses were up 6%, but down slightly, excluding the restructuring charge. Efficiency savings of $90 million more than offset the impact of inflation in the quarter. Looking at the details, labor and fringe was favorable, reflecting 2,200 fewer resources. As Hunter discussed on the Q1 call, we have also begun to address the size of our contractor workforce, with savings flowing through the MS&O line. On that line, we also concluded a decade-plus condemnation proceeding, resulting in $55 million of favorability. Fuel expense was higher, reflecting a 15% price increase. Strong revenue gains combined with cost control drove very strong incremental margins. Reported EPS was $0.55, with a 67.4 operating ratio.

Adjusting for the restructuring charge, EPS was $0.64 with a 63.2% operating ratio. The reconciliation of GAAP to non-GAAP is in the appendix of these materials. Slide 9 illustrates that our free cash flow generation continues to improve, driven in large part by three things: strong top-line gains, cost control, and reduced capital intensity. Our success in generating free cash flow has enabled us to increase our shareholder distributions year-over-year, with over $750 million of share buybacks year to date, including nearly $500 million in quarter two. You can also see the effect of our recent 2-cent dividend increase. The company's improved financial performance is reflected in our trailing twelve-month ROIC of 10%, nearly a full point better than, better than, last year.

Finally, our debt-to-EBITDA ratio remains stable as higher earnings offset the impact of additional debt. Turning to Slide 10, the Q3 volume outlook shows nearly three-quarters of our business is expected to be favorable or neutral. Export coal demand remains strong, and we now expect to ship around 30 million tons for the year, though revenue per unit will moderate sequentially as the global benchmarks come down. Consumer sentiment remains positive, driving intermodal growth in the Q3. As a reminder, in August, we will cycle the short-haul domestic interchange loss we've mentioned previously. We expect continued economic growth as well as a tightening truck market, which should support growth in several of our merchandise markets. On the other ledger, a few of our markets will experience year-over-year volume declines in the Q3 due to market-specific headwinds you are very familiar with.

Auto shipments will be impacted by softening production, as reflected in the forward views of North American light vehicle production. Crude oil trains have essentially gone to zero, more than offsetting the growth we expect in the core chemicals markets. Domestic coal remains challenged, due in large part to the impact of the short-haul competitive loss as of January 1. Before I wrap up on Slide 11, two housekeeping items. One, our FY will now tie to the calendar. As a result, the Q3 of 2017 will have one more day than the Q3 of 2016, and the Q4 of 2017 will have one more day than the comparable 13-week Q4 of 2016.

Also, as a result of a recent state tax law change, our effective tax rate for the Q3 will be between 39% and 40% as we reevaluate the deferred tax liability for that particular state. Now to Slide 11. We're off to a good start to 2017. Our H1 performance provides this team with continued confidence in our full year expectations, and we are reaffirming that guidance today. Excluding restructuring and assuming no economic or coal-related disruptions, we are on track to deliver a mid-60s operating ratio, record efficiency gains, EPS growth of around 25%, and free cash flow of around $1.5 billion. With that backdrop, the CSX Board of Directors has authorized a $500 million increase to the share repurchase program, bringing the total authorized program to $1.5 billion.

We are continuing to evaluate the optimal capital structure and cash deployment strategy for the company and are committed to an investment-grade profile. We are excited to host our 2017 Investor Conference on October 29 and 30 in Palm Beach, and look forward to sharing with you our multiyear strategy and associated financial targets. With that, we'd be delighted to take your questions.

Operator (participant)

Thank you. We will now begin conducting a questions and answer session. Our first question. One moment. Our first question will be from Brian Ossenbeck of J.P. Morgan.

Brian Ossenbeck (Analyst)

Hey, good morning. Thanks for taking my question.

Frank Lonegro (CFO)

Yes, good morning, Brian.

Brian Ossenbeck (Analyst)

So you mentioned in the press release that there's some impairments on PTC, about $10 million or so. So I just wanted to use this opportunity to talk more broadly about that system, how you stand right now, if you're seeing any implementation effects, you know, why you took the impairment, and, you know, overall, what, what sort of OpEx you're running through the P&L this year, and how you expect that to progress over the next couple of years?

Frank Lonegro (CFO)

Sure. Hey, Brian, Frank, thanks. In terms of the impairments, about half of the $10 million impairments were in Positive Train Control. The others were in literally a smattering of technology projects that aren't necessarily consistent with Precision Scheduled Railroading, and so we've stopped those. Back to the PTC half of the equation, that was really divided into two parts. As we've reduced the locomotive fleets and don't have plans to bring those back, some of the labor side work that we did on those engines for PTC won't be necessary, and therefore, we had to pull it out of the capital plan and roll it through the P&L.

The other part was some signal design work that we did on portions of the railroad, based on the traffic flows that we anticipate, as well as the TIH flows that we anticipate. We won't necessarily be upgrading those to PTC, so we had to roll those through as well. You know, we'll continue to look at things. Obviously, impairments are somewhat unusual. We don't have those on a routine basis, but as we look at the capital plan going forward and as we look at the PTC footprint going forward, I mean, there may be some. I don't know of any right now, but there may be some. In terms of your OpEx question, I know there's been a lot of commentary on that recently based on some statements by the CN and the UP.

Let me tell you where we are from an OpEx perspective. Our OpEx on PTC has been ramping up for several years. Our full year 2017 will be $150 million. Now, that is the cumulative impact of a ramp up since about 2009 on the OpEx side. And the cash piece of that is about one third. The depreciation piece of that is about two thirds. When you look at the cash piece, it's really as the, I'll call it, the phone bill goes up because it's a very heavy communications-type system. You know, that phone bill keeps going up. So, you know, we've got some piece of that, and then the hardware, software, maintenance, and support, as we go forward, would be the other part of the cash piece.

We likely will have a terminal run rate in 2020 of around $200 million-$250 million. And again, I think that split between depreciation and cash expenses will be roughly the same. And Cindy can talk about where we are on the project.

Cindy Sanborn (COO)

We're about 40% of our PTC miles are in service at this point. We feel very comfortable that we'll be, have a majority of our well, certainly our commitment to, by 2018, to be hardware complete and continue the implementation of subdivisions as we progress from 2018 this year and next year and on into 2020.

Brian Ossenbeck (Analyst)

Okay. Thanks, Frank. I know you spent a lot of time on PTC in that prior role, so just to confirm, it's 200-250 kind of annual run rate split between OpEx and CapEx, so it's kind of an all-in expense, cost to run the network,

Frank Lonegro (CFO)

Brian, just that's kind of a terminal run rate in, like, 2020 or 2021.

Brian Ossenbeck (Analyst)

Right. Great. And then just a quick follow-up on the high-level market view. We've seen the US dollar on a trade-weighted basis basically decline ever since the beginning of the year. I think it's down almost 7 or 8%, as we stand right now year to date. So, Fredrik, what are you seeing in terms of the various puts and takes outside of the obvious in export coal? When does that decline start to become more of a benefit and start to show up in perhaps some more exports and probably fewer disruptive imports?

Fredrik J. Eliasson (CMO)

I think we've been encouraged this year by the fact that IDP, to begin with, is showing a little bit of a strength versus what we've seen in the last couple of years. And clearly, part of that is also the dollar has helped some of the U.S. exporters. You hit on the export coal side. Clearly, a weaker dollar is helpful there, and I think as we look at some of the other markets, we will see some of those benefits. I don't think we've seen a lot of it yet, but anytime we have a little bit of weaker dollar, it does help them. So I do expect to see that as we move forward.

Brian Ossenbeck (Analyst)

Okay, thanks a lot for your time.

Operator (participant)

Chris Wetherbee of Citigroup, your line is open.

Chris Wetherbee (Analyst)

Great, thanks. Good morning. You know, Hunter, I wanted to touch a little bit on sort of expectations and maybe cadence of improvement. You know, your points earlier were well received in terms of people's expectations about what we might see this quarter, but maybe you could help us sort of understand a little bit how some of the changes that you've been implementing early on in the process here ultimately play out sort of in the physical world, in terms of, you know, closing hump yards, obviously working with the employee group and generating that productivity. Just wanted to get a sense of maybe how we can start thinking about that as we move into the H2 of the year.

E. Hunter Harrison (CEO)

Okay, I appreciate the question, Chris. That's a good question I was gonna raise if you hadn't raised the question. You know, one, you should think about the sensitivity of timing. When we make an operating decision to reduce expense or change the operation, say in maybe early April, we might not see the benefit net net in the P&L till, you know, August or September, depending on collective bargaining agreements depending on, you know, the tax treatments and all those various things come into play.

So we can take certain actions and, but to know exactly when those benefits will start kicking in is a little difficult. And it's kind of, for me, here, it's a, it's a learning experience because it's kind of different everywhere you go. But, you know, the thrust of, of what we had talked about that we're trying to do, hasn't changed at all. You know, we're down, and look, I'm, I'm not restricting my numbers to Q2. This is just kind of where we stand today or where we see ourselves short term. We're down about 900 locomotives now. It's certainly not over, it'll probably clearly go through 1,000. I'm not sure where it's going to stop.

Then we're down, depending on the way you look at it, whether you count stored cars or not, but the way I look at it, if you look at the active inventory, we're down about 60,000 freight cars from where we were early on in the year of 200,000, down to 135,000 or 140,000. I think that we have, and I emphasize the we, this is more the team than me, but, I think from a hump standpoint, I think we started off, somewhere, I think 12, the number was kind of bouncing around. Humps, and I think, we think we're going to end up, probably within the next year, we'll end up with, 3. Could be 2 or could be 4, but in that range, a significant, drop in the number of, of humps.

I would add to that is that, look, those humps that we're taking out of service as humps, doesn't mean we're going to sell all the land and, you know, scorch the earth. And I would hope one day, post-Harrison, that this company is going to see some growth. We're going to see growth in the merchandise side, where we do need humps, and maybe there'll be a time in the future. So, you know, we're going to keep the whole party. We're not, we're not having a garage sale here. I think that, as a result of some of those things, the capital spend over the next several years, unless there's opportunities that come up that I'm, at this point, not aware of, will come down pretty significantly from what has been in the plan before.

I think this year, we're going to be down $500 million or so capital.

Frank Lonegro (CFO)

Well, it'll be down $100 million this year, when you look at it on a year-over-year basis, versus where we ended up last year, it'd be closer to $600 million.

E. Hunter Harrison (CEO)

Okay. Somewhere in that neighborhood, and I would expect, you know, that's going to, you know, the reason is we're going to be able to take a holiday, obviously, on locomotives, rolling stock, and a lot of the things that go to support that. That's going to help, obviously, free cash flow pretty significantly. Which I think my personal view is, it certainly had some influence on the board when they made the decision to authorize the additional buyback. That it's some will be done, financed internally with operating expense reductions. Just with basically one exception, all the operating metrics are trending and heading in the right direction. Very, very encouraging.

If you're a headcount person, I think the headcount as we stand today, I'm not doing this quarter-over-quarter, but we stand today about, I think 2,300. You know, that's not something we're trying to set some record with, but I wouldn't be surprised if before the year's out, if a lot of these things come together, that could be, you know, that could be 3,000. So, man, I look at that, I look at my past experience in this business, and I'm saying, "That's an order." You know, I hate to disappoint some people, but, I almost said that's all I got. And, but, you know, there's other opportunities that will come before us. And, you know, the team is coming together.

And clearly, you're going to ask this question, so I'll go ahead and try to address it. You know, what's the biggest challenges we have? Well, the biggest challenge we have is what I've talked to you about before, and it's the change. It's the change, it's the cultural change, and that's difficult for organizations to go through. And we're having a little bit of that ourself. And at all levels, you saw that, you know, this was right prior to my arrival, so I should, I think I shouldn't be criticized or credited either way. I'm a neutral with the 1,000 people. But I did take note that they were, I think, effectively all non-scope people. There were no Indians, if you will, in there.

So we didn't take away from what was being done to the physical plant. And I think our view going forward will put us in a position we don't have to replace those. Now, on the operating side, do we have a few gaps? Yes. Is that being addressed? Yes. I think our human resource group, along with Cindy and others here in the team, are sensitive to that. I think we've recruited, they know better than I, but 15 or so people, that we think are top-notch, high potential railroaders from various backgrounds and various locales. And so I, you know, I think that's, it's something we can solve and deal with. And there's a lot of other things in the budget.

So, you know, if I look at that and sit back, and review and take a look at Q2, I got, I gotta be pretty excited, and I gotta be excited about third and fourth and 3 or 4 years out. Y'all, you know, the other plan, the last plan we did before this, you all said I couldn't get it done in 4 years, and now you're on me because I can't get it done in 4 months. So the bar is being raised here, but I'm ready for the challenge.

Chris Wetherbee (Analyst)

Fair enough. That, that's a very comprehensive and helpful answer. I appreciate that. You know, the follow-up would just be in terms of initial customer reactions and sort of how you might think about, you know, the business from a volume standpoint as you also progress through that sort of cost and operational efficiency efforts as we go through the rest of the year. Have you been surprised? Has it been more negative or sort of more expected in terms of the reaction from customers and sort of what you've been sort of pushing off the network potentially as maybe some stuff has potentially moved competitively or otherwise? Just want to get a sense of how customers are sort of viewing the initial changes to the company.

E. Hunter Harrison (CEO)

Well, let me comment, and then I'll ask Fredrik to comment. This is not a lot different than what I expected. You know, customers are like other people. A lot of them don't like change. I've spent some time with them myself. It's hard to find me with them on the telephone and face to face. And I've tried to explain to them where we're going, why we're going there, what's important about it. And to get there, we have to go through this change. And so there's gonna be a little pain and suffering. I don't know, frankly, how to get there without some bumps and grumps. This is not just something you could turn a switch on. So I, I think most of them, by far, the majority are, are pretty sympathetic.

I've heard had some nice dialogue with them that, "Look, we look forward to the changes coming in. We're willing to, you know, suffer a couple of bruises along the way. Just don't bruise us up too much." And I think with, you know, with a couple of exceptions, it's been typical of what you might think and expect. Look, I, nobody loves everybody, okay? So we're gonna have people out there that are gonna go dark and second-guess us. But I don't, when the bottom line comes in, I don't think anybody's gonna change businesses plus or minus, based on that. They're gonna do it if we provide this service we've talked about, if we make the improvements that we've made, we'll be rewarded. If we don't, we won't. And that's the way it ought to be.

I'm not asking, we're not asking anybody to bring us business just because, you know, we need it. We're gonna work hard to earn it, and I think we can. I don't think any of those issues are insurmountable. Fredrik, you might have something.

Fredrik J. Eliasson (CMO)

No, I mean, I would say that it's about transit time, and it's about reliability. And if we look at transit time as an example, if I look at the scheduled organized network and coal network and an oil network, if I, if I compare transit time here in the Q2 versus the Q1, they all improved. And clearly, we're going through a lot of change. But Cindy and my team are working through that with customers, where we are impacting them specifically and trying to fine-tune the operating model and making sure that ultimately we reach what, what Hunter has been very clear about, that we're gonna get a better service product for our customers, because not only is that better for the customers, but it's also better for CSX.

Chris Wetherbee (Analyst)

Great. Thanks for the time. Appreciate it.

E. Hunter Harrison (CEO)

Sure.

Operator (participant)

Next, we will take a question from Tom Wadewitz of UBS. Your line is open, sir.

E. Hunter Harrison (CEO)

Hi, Tom.

Tom Wadewitz (Senior Analyst)

Yes, great. Good morning. So Hunter, I wanted to get a sense. You referred that I think all the metrics are moving the right way except one. I don't know if the one you're referring to is dwell time. But when I look at the dwell times at some of the yards, I see numbers that are kind of 40, 50 hours, which to me is unusual. You know, I normally think, you know, 20-30 hours is kinda typical dwell time. I know you've made pretty dramatic changes in converting hump yards to flat switching. So how would you characterize kind of the progression? You know, April and May were really good. June seemed to be a little bit of a pause. Are the dwell time numbers a concern, and how should we look at things in Q3?

Does that, those numbers come down? Help us with the forward look and also what's happening in the dwell times. I would appreciate it. Thank you.

E. Hunter Harrison (CEO)

Sure. And Tom, a lot of people don't understand dwell time. In my view, in this model of ours, scheduled Precision Railroad, the challenge is not to get the dwell time as low as you can go. There's a planned dwell time, and you hit the plan. So you don't hurry up and wait. You don't spend money you don't need to spend just to create some, to dwell 18 hours instead of 20, if there's no real true savings opportunities there. So it's. This is not how low can you go. This is, look, let's just say we're at 24 today or 5, and it was higher.

But let's just say that as we run all this plan out and say, how should the cars dwell at these various terminals that, that continue to exist, for example, you say, Well, what should the dwell time be? Should it be 21 hours? Should it be 19 hours? What is the dwell time? Now, what, what some people on the outside looking in don't understand, is they look and they say, "The dwell time is up an hour. God, that's a horrible trend." Well, wait a minute, we're going through one terminal instead of three. So would you rather go through three terminals at 26 hours or one at 27? Well, they said, "Well, I didn't get it." And I said, "Well, I understand. That, that's why we're trying to ask you the question." So, now, having said that, a lot of things affect dwell.

If we have too many cars in inventory, and if it's a slow period business-wise, or if it's a holiday period, what happens to the cars? They dwell because there's not a need, a demand for them. Now, that's a little bit our fault, by having maybe too many cars in the supply chain, the pipeline, whatever you might want to call it, but all those things affect dwell. So look, there's going to be Fourth of July. Although we would like people to work 365, they don't do it. We do. Can you imagine if the railroads did, we're going to take every Saturday and Sunday off like normal people, and we're gonna have our time off, we're not gonna work every day. The impact that it would have economically is cosmic.

I'm telling you, I've seen the numbers, and it's, it's another version of the Depression, I can tell you that. So, we're gonna have periods with holidays. So the dwell time as a gross number of we've gone from 26 to 25, that concerns me. Now, if I see, Tom, what you have, you know, mentioned 40-50 hours, it's certainly worth a second look to be sure that we know why that is existing. Is it because of service failures? Is it because of operations that we're not doing what we need to do? And then we will get in with those terminals and correct them. But when we get these pumps, the pumps stopped, that doesn't mean the whole yard is going to close down.

But I mean, significantly, maybe a place we're working 12 or 15 assignments, we'll go to 2 or 3, plus the fact that we don't have to replace the, the equipment and a lot of things about the, the pumping operation. You'll see the dwell time come down, and that'll be it comes down because we can take the product down consistently. So if we're giving 3-day service and we do those things, we can get to 2, and then the dwell time will change to the standard of 2, not, not what it was before. So that's a little commentary on dwell.

Tom Wadewitz (Senior Analyst)

Okay, thank you. Second question would be on the, I guess, the full year guidance when you consider the, you know, the upside in Q2, this, if you, you know, including the $0.64, it seems that it, it's a conservative expectation for H2. I mean, assuming, you're just kind of putting some revenue numbers in, I get a kind of, you know, call it a 67 OR in H2, maybe 66.5, 67, which seems, you know, seems that it implies you wouldn't have much sequential improvement.

I know there's seasonality, but I'm just wondering if that is appropriate to say, well, maybe there's some element that's conservative in the full year guide, or is it appropriate to say, well, it just takes some time to see the OR improve and, you know, don't expect a lot of sequential improvement in H2?

E. Hunter Harrison (CEO)

Well, you know, I think you have to be real sensitive to the timing. Now, I've just kind of made a case that a lot of the actions we took in the Q2, we haven't seen come to the bottom line yet. But they're going to come to the bottom line in third and Q4, and they're not in that headline. So, you know, one of the things I think we're all doing, and I've done at every one of the turnarounds, is that, for lack of a better term, we're dealing with a leap of faith. Because I'm saying to the team, we can do one thing, and they're saying, "We've never done it before, show me." So we're going through that phase. I am comfortable, and I know Frank's shifting hips over here on me as I start to say this.

I'm very comfortable. Have I ever been wrong before? I've been wrong before. Not many times, but I've been wrong. And we'll, I think if I know exactly where our guidance is, that we're gonna be somewhere around, if you're talking about a clean quarter, and we could talk about all that, you know, we're gonna be in the range of mid-60s, which could be 66, could be 64. You know, I think we're gonna be $1 billion+ free cash flow. And I think the earnings are gonna be pretty damn good year-over-year. So I don't, I, you know, I, I think it's pretty realistic.

Now, what I do think is this: I think we're all, and me included, short selling ourselves a little bit because we're really not seeing that these recruits and some of this cultural change, we're not really getting a lot of credit there. And those—I mean, we brought a couple of people in. We, the team, into this organization, and you don't think about this, but I'm telling you, they have made huge difference. One individual, huge. Millions of dollars in business. Now, you don't run upon those every day, okay? There's not a Michael George on every street corner in Chicago or North Carolina. But if you can get one or two out there, it really helps things as opposed to just having a group of players.

Tom Wadewitz (Senior Analyst)

Okay, great. Thank you for the time, Hunter. I appreciate it.

E. Hunter Harrison (CEO)

You have to double-click me and call me. We'll talk more about it, just you will then.

Operator (participant)

Excuse me, sir. Your next question is from Allison Landry of Credit Suisse.

Allison Landry (Analyst)

Thanks. Good morning. I just wanted to follow up on the headcount. Hunter, you mentioned earlier you're taking, you know, today you're-- you stand at a reduction of about 2,300 employees. Does that include the 1,000 management positions that were-

E. Hunter Harrison (CEO)

Yes.

Allison Landry (Analyst)

Okay.

E. Hunter Harrison (CEO)

Yes.

Allison Landry (Analyst)

Okay. And then, Frank, on the, on the contractors, could you, you know, how many do you guys currently have employed?

Frank Lonegro (CFO)

Well, we're we haven't published that number yet, but let me give you a sense of what we're gonna do, and then let me give you a sense of where we are. You know, what we're looking to do, and Hunter's given us some really good guidance on this one, is to look at what can be insourced economically, and being able to absorb that over the existing employee population, or do some sort of conversion factor, 2-to-1, 3-to-1, something like that, where we can, you know, take 2 or 3 contractors out for every employee that we might add.

So, you'll obviously see that flow through on the MS&O line, and then you may also see, you know, I'll call it a lesser degree of comp per employee takeout or comp per workforce takeout on the MS&O line than you might see on the labor line. What Hunter said on the Q1 call was, we would be down an incremental 1,000, in addition to the 1,000 that we did through the management restructuring. And that second 1,000 that he mentioned was going to be a combination of management, union, and contractors. I would tell you that we are through that. We've made great progress.

To Hunter's point around thinking about a 3,000 number, you know, by the end of the year against the 2,300 where we are now, I mean, we'll continue to work on all three of those elements through, you know, converting contractors. We'll look at the resources that we need in the field to run the operating plan, and we'll certainly look at continuing to manage attrition as tightly as we can. So I think all of those things, you'll continue to see sequential improvement in headcount. And as we get to a point where we have good year-over-year comparables for you on the contractors and consultants, we'll begin to publish that one. It could be as early as the investor conference, but it'll certainly be as of the first of the year.

E. Hunter Harrison (CEO)

Let me, if I could, just add a little kind of context to that. And what I'm trying to encourage, the organization is trying to absorb is this: You know, if I go back, one of my proudest moments was at Illinois Central, and we, after some financial engineering, and I became CEO, we settled in, and we had a little railroad that had 3,000 employees and an 80 operating ratio. And 2 years later, we had 3,000 employees, and we had an operating ratio of 62. Now, the issue is this, it's not bad heads. And people say, "Well, what-- how'd you do that? What was the difference?" We allowed those 3,000 people to create value. We gave them opportunities, and that's what-- that's a much better story.

It's a much better bottom line if you can say, "Look, this is not about stripping heads out. This is taking valuable people and allowing them to add value to the organization in the most effective, efficient way it can be done." by doing it with internal people, and you don't have to get into buyouts and all this other stuff. So that's kind of the road we're heading down.

Allison Landry (Analyst)

Okay, that makes a lot of sense. Hunter, you also made some comments earlier, which I think were alluding to long-term share gains in merchandise. So I guess, should we be thinking about that similar to where CP is now? In other words, does CSX eventually shift from a cost improvement story to a top-line growth story? And if—do you expect those share gains to come primarily from truck, or are there any opportunities that you see for CSX to take share in merchandise from your competitor?

E. Hunter Harrison (CEO)

It's a hell of a question. Number 1, we want to see CSX grow, obviously. Number two, one of the levers that'll help us grow is low cost and efficiency. So there, there's gonna be a continual drive and a, and a, hopefully, a compatibility between those two numbers. Because if we lose a sense of our cost, we lose the ability then to be able to grow the business as effectively as we like. Where can we gain the most share? Clearly, in my view, it's off the highway. There's something to competition, you know, and, and these folks in the room are better than I know more about that. But look, the focus is not, at least in my view, at this point, it's not the rail competition, it's the highway, okay?

You know, we've kind of although we let the jealousies get in here from time to time, you know, you go to Canada and you say the C word, depending on which part of the country you're in, and people just go nuts, you know, you know, most of that. But the big opportunity is on the highway. You know, we'll have, I think, what both of us have described as jump off business with our competitors. They know how to railroad. They're good railroaders. They're tough competition. And, and we'll have fun competing. That's the way it ought to be. That's, that's what capital systems are about. But the key is that we really hadn't really gotten it. It's just, it's just service factor. We have to understand that. We have to appreciate that.

We have to understand that it's difficult for people to change, and to some degree, it's gonna take a while. But that's where rail over the last 40 years has lost the biggest market share. That's the most probably all in, some of the most profitable business we have. And I'm not trying to say to you that, you know, we're gonna see some rapid growth over the next, you know, 15 or 16 months. And a lot of this will probably happen in the post-Harrison era. I think it will. If we do our job today in laying the foundation, there'll be a lot of opportunity for growth.

Allison Landry (Analyst)

Great, thank you.

Operator (participant)

We have our next question from Amit Mehrotra, Deutsche Bank. Your line is open, ma'am.

Amit Mehrotra (Analyst)

Thanks so much. Thanks for taking my question. Wanted to get a sense of the performance, I guess, in the quarter relative to your own expectations. You've kept full your guidance unchanged. There's maybe over $100 million of benefits in the quarter that may be considered, you know, extraordinary in nature. If you could just talk a little bit about that, in terms of maybe how your near-term assumptions have changed, if at all. And then, as it relates to the H2, it looks like the guidance implies something like $300 million of year-on-year incremental profit improvement in the H2 year-over-year, despite revenue that looks to be flat or down.

Can you just offer some color there in terms of, one, your confidence in delivering that and then maybe what the drivers are? Thanks a lot.

E. Hunter Harrison (CEO)

Sure. So a lot of the questions last night really asked us, at least implicitly, did we know about these things? And when you, when you're dealing with a 10-year-plus condemnation litigation that's coming to a conclusion, you know about it. When you have a liquidated damages dispute that's coming to a conclusion, you know about it. The exact timing, did we know which quarter it was gonna fall in? No. Did we know whether it was gonna be 2017? We thought so, but we weren't 100% sure. So I mean, all of these were in contemplation. We're probably experiencing a bit more inflation this year than we were originally expecting. The tax rate is probably a little higher than we were expecting. Fuel price, at least in the H1 of the year, was probably higher than we were expecting.

So there's a bunch that's happening, just like every quarter and every year, there's lots of moving parts. So, you know, all of this was in contemplation as we thought about the guidance, and one of the reasons why we gave you a range of guidance was because you never know which way the pluses and the minuses are ultimately gonna go. Turning to the H2, I think what you're going to see is an improvement in sequential productivity. You know, when you think about a $90 million number in Q2, and you look at the record productivity guidance that we've given you, again, that's against the $427 million that we delivered in 2016.

When you do the math real quick, you realize that we've got to be at least as good in the H2, if not better, in order to hit that target. And, obviously, we have a lot of confidence in our ability to do that. So you should see sequential ramp and productivity between Q2 and Q3. And again, Fredrik and his team are doing everything on the customer side to bring in more business and to price it appropriately. Cindy and her team are gonna run the railroad better and better on a quarter-over-quarter basis. So, you know, we're excited about the H2.

Amit Mehrotra (Analyst)

Right, but just a quick follow-up on that. I mean, it's, I guess, the productivity, the way I think about it is it shows up on the bottom line when, you know, revenue and volumes are a little bit more cooperative, and they certainly were in the H1, partly due to easier comps and then some tailwinds on the coal side, too. In the H2, you don't really have those tailwinds. Hopefully, you will, but that doesn't seem like you will in the H2. So can those productivity savings actually drop to the bottom line when revenue growth is zero or negative in the H2?

E. Hunter Harrison (CEO)

Yes.

Amit Mehrotra (Analyst)

Okay. Okay, I'll leave it there. One quick question on the capital structure. You've caveated your comment by saying that you want to keep the balance sheet Investment Grade. Can you just give us a sense on what actually constitutes Investment Grade? I mean, is it two times gross or net debt to EBITDA? So just so we can get a sense of maybe the firepower the company has, I guess, to optimize the balance sheet, which is, I assume, what you're trying to do for the benefit of shareholders. Thanks.

E. Hunter Harrison (CEO)

Sure. So, obviously, we go with the same Moody's and S&P ratings that you all follow very closely. You know where those ranges are. Really, what we did was, you know, took a fresh look at the, at the balance sheet. We took a fresh look at, leverage and, and the implicit ratios based on the free cash flow for the year and for, a going forward basis. You know, we've got, obviously, a new CEO in Hunter. We've got a reconstituted board. We've got the shareholder vote behind us. So a lot of things really said, "Hey, it's time to take a look at the capital structure," and we wanted to provide the maximum flexibility, for the management team and the board to weigh in on those issues.

And so we felt like it was appropriate, during this period of reevaluation to make sure that we weren't tied to anything specific.

Amit Mehrotra (Analyst)

But given the momentum you have on the profit growth and the cash flow growth, I mean, is there any? Have the rating agencies told you or given some guidance around what parameters, maximum parameters they'd be willing to accept and still keep an Investment Grade?

E. Hunter Harrison (CEO)

They have.

Amit Mehrotra (Analyst)

Can you share those with us, please?

E. Hunter Harrison (CEO)

No. I mean, you know where the ratios are. You know where the boundary lines are. Obviously, you know, we're currently rated triple B plus, Baa1. You know what a step, one step down looks like, you know what two steps down looks like. All of those are in contemplation, so we'll report back to you on that one as we make those decisions. And it, you know, could be as early as the investor conference or certainly as we turn the page into calendar 2018.

Amit Mehrotra (Analyst)

Got it. Okay. Thanks for answering my questions. Appreciate it.

E. Hunter Harrison (CEO)

Okay, thanks.

Operator (participant)

Ravi Shanker of Morgan Stanley, your line is open.

Ravi Shanker (Analyst)

Thanks. Morning, everyone. If I can just maybe follow up to that last response, and, and, Hunter, not to steal your thunder, but can you just help us frame the kind of topics of discussion or kind of the broad agenda for the investor day? What can we expect to hear? What do you expect to learn or, or kind of progress through between now and then that you can share with us at the event?

E. Hunter Harrison (CEO)

Well, what do you want to hear? We'll give you, give to you. No, seriously, look, you know, we're gonna, we'll spend a lot of time on this. I tell you it's not gonna be a restatement of all the numbers you heard today. We're gonna peel back the onion a little bit. We're gonna talk to you about why a hump yard doesn't work today like it used to 50 years. We're gonna talk to you about the economy of scale. With that, we're gonna talk to you about why we're able to use locomotives more effectively than some others, and some of the techniques. And I guess it's kind of a, hopefully, a restatement of saying, you know, we happen to know a little bit about what we're doing here.

We got a pretty good track record, and we're gonna try to reinforce that with you. At the same time, you know, have a little fun, enjoy ourselves, and that's, that's the objective. I'm sure that each time we've done this, I think they've been rather successful. A couple of presentations I would change a little bit, but too late for that. But I think they've been very helpful in letting you, representatives of our shareholders, know, for example, when they ask you, "I don't understand this, why, if they close hump yards, then I'll deny that's a good deal or what," that you have some knowledge and understanding and appreciation for that.

So that's our intent, but I would certainly say to you that you know, if you have a request that you'd like us to consider of addressing, you know, we'd love to hear them. David, I'm sure, would love to hear it, and we'll try to address those things.

Ravi Shanker (Analyst)

But it sounds like a great event, but would you have made enough progress by then to give us, like, longer term OR targets and balance sheet targets?

E. Hunter Harrison (CEO)

I certainly think the trends will be there. You can see what, you know, what we're doing. You know, I don't know if you want to have a wait and say, "We're gonna have a validation meeting," but you pick it, and when y'all are gonna be satisfied that everything's validated, your heart is pleased.

Scott Group (Analyst)

Understood. Just as a follow-up, just an end market question on autos. You guys clearly identified that as a market with a negative near-term outlook for obvious reasons. Can you just help us understand kind of the puts and takes behind kind of decremental margins and what you can do on the auto side if the SAAR were to decline sharply from here?

Fredrik J. Eliasson (CMO)

I mean, I think historically, we've been moving very much in line with what automotive production has done. And obviously, it's been a great 7 or 8 years here, where we're riding it up, and here we've seen a little bit of a softening as expected, and we will monitor that very closely as we move forward. We do have the opportunity as part of our scheduled merchandise network to monitor that and make appropriate changes to the plan if we see certain areas where train lengths get impacted.

So, like any other part of our business, Cindy and team, and Hunter has an operating plan that is flexible enough to be able to address that, to make sure we don't lose any of the productivity gains that we have gotten so far, and that we're contemplating in the future.

Ravi Shanker (Analyst)

Great, thank you.

Operator (participant)

Next, we have a question from Ken Hoexter of Merrill Lynch. Thank you, sir.

Ken Hoexter (Analyst)

Great, good morning. Hunter, I just want to clarify, or maybe it's Frank, just by including the two gains, should we read this as you're reducing the H2 targets? Or, Frank, were you suggesting before that this was in your kind of original thoughts and the employee savings in the H2 should continue to scale?

E. Hunter Harrison (CEO)

Yes and yes.

Ken Hoexter (Analyst)

I got that. So when you say yes to that first one, you are reducing H2, or you're not reducing H2?

E. Hunter Harrison (CEO)

I mean, so was it in what we were thinking at the beginning of the year? Yes.

Ken Hoexter (Analyst)

Okay.

E. Hunter Harrison (CEO)

Does it, does it change our internal views of the H2? No. You know, will we continue to see productivity accelerate and, and headcount gains, et cetera, continue in the H2? Yes.

Scott Group (Analyst)

Okay.

E. Hunter Harrison (CEO)

In my, you know, look, you, you got to appreciate where we are here. You know, I got here, I didn't know about them. So if you don't know about them, you can't, you can't figure them in. But this is what I call, this is what gets into that leap of faith area, okay? And look, I appreciate that, Frank and others in this organization, you know, there needs to be some checks and balances. I just don't want anybody checking me. But there are some, you know, issues internally of saying: Can we get there? Can we make it? And there's a tendency, and y'all accused us this before, and I didn't think we were guilty of being conservative or sandbagging or whatever.

You know, I'm telling you, my numbers that you hear me talk about, not official guidance, quote: "Let's put it in those terms." You know, we don't determine whether the quarter is clean or not. Generally speaking, there's principles, there's GAAP, there's rules and regs that says, you get the check, you got to report the check. Now, it's not like we got a drawer down. I used to know CFOs that had the left-hand bottom drawer, and they'd get down there anytime they needed it, and they could come up with miracles. Well, you learn that life's not like that. But I think that what I said to you is, and to one of the questions earlier, it's more to operating metrics. I'm not a big, you know, well, it's an easy comp. Well, the hell with the comp. The comp is gone, and it's done.

We get a number that says we ought to be at this growth ton mile available horsepower, no matter what it was last year. If it was horrible last year, we look 50% better, but our standard says it ought to be 100% better. I'm not being influenced. I'm not going to allow myself to be influenced by easy comps. Now, whether you all let your customers be influenced that way, that's, that's something else. But I think it's that there's a little bit of that, land of unknown here. And, you know, look, if we get too precise and hit this thing right on the head every day, something's wrong. That's my-

Ken Hoexter (Analyst)

No, I, I appreciate that. Now, if I could talk, follow up on the, maybe the competitive environment a little bit. Do you—you talked about, your, your thoughts on, on where things stand, but the—any competitive response, from, from your peers in response to your cost cutting or, or maybe on a strength in the truck market, are, are you, you seeing any strengthening in the pricing on, on intermodal? Maybe you could talk about the competitive market response.

E. Hunter Harrison (CEO)

Let me comment, and then I'll fall off record to be the expert here. My experience has been a little, you know, I've been all over this continent, and I go here, and I get here, and I say: What's the competition doing? Oh, they're nuts. Kamikaze pricing. They're killing the market. They're putting us under. Then I leave, and I go over there, and they say: "What are those guys doing you left?" Oh, kamikaze pricing. They're giving business away. I don't know, so I don't kind of know where we are there. I do know this, you know, back to my point about competition. Look, they're not going to lay down to us. We're not going to lay down to them.

You know, we're going to be as aggressive as we can be, and I say this, as we can be, because we're going to be disciplined, because we're going to, you know. Look, a lot of companies can get it to the top line. That's not the hard part. The hard part is getting it to the top line, and there'll still be something there when you get to the bottom. So we're trying to, you know, fulfill both of those, and Fredrik is much more qualified than I to specifically about those markets and competition. So-

Fredrik J. Eliasson (CMO)

Sure.

E. Hunter Harrison (CEO)

David, why don't you?

David Baggs (Head of Investor Relations)

So I mean, all our customers have options, so ultimately, it goes back to the fundamental thing that we're trying to do at Precision Scheduled Railroading, which is to make sure we improve our transit time and improve our reliability. And we're in the early stages of that. Specifically right now, to competition, I think the key thing, it's been a tough transportation environment for several quarters now in terms of pricing for that market, and generally, it is about truck competition. There's a lot of excess truck competition. Fortunately, though, as we look at the market over the last few months, and we've seen some signs of tightening capacity.

And I think the combination of a tightening capacity environment as we move into the second part of this year and early 2018, coupled with what we are expecting to do here from a service perspective, should lead to a 2018 that is, that's good from a top-line perspective. And, and as I said, ultimately, this is all about providing a service product to our customers that they want to use day in and day out. And if we do that, I think it's less relevant what our competition, either on the rail side or on the truck side, is doing.

Ken Hoexter (Analyst)

Great. Thanks, everybody, for the insight. Appreciate it.

Operator (participant)

Brandon Oglenski of Barclays.

Brandon Oglenski (Analyst)

Hey, good morning, everyone, and thanks for getting my question on.

Fredrik J. Eliasson (CMO)

Sure.

Brandon Oglenski (Analyst)

Hunter, you know, earlier in the call, you talked about challenges inside the organization to change and how, you know, you've seen that at your prior, leadership positions. Can you talk about how that progresses and how you've brought your team together and, you know, how that plays out from a financial perspective as we go through over the next year or two?

E. Hunter Harrison (CEO)

Wow. Well, one of the things it did is the group has convinced me, and they did, not me, that we got to do some learning, that people have really got to understand what we're trying to do. We're going awful fast, and that's a very important component here. To be very, very frank with you, we have just had to say to people, "You have to change. We've got to get the things done that maybe you didn't expect or do in the past. But you got to get with it. And if you can't get with it, then we're going to do something different. And we'll try to treat you in the most kind and humane manner possible.

But look, we got a responsibility to the shareholders and our customers and our other employees that, you know, we can't carry dead weight. Everybody's got to do their job. Everybody's got to do their part. And that's a tough assignment for a leader to do. In the camp, when we talk, and I teach a little bit about leadership, one of the things I talk about, the hardest part for a great leader to do and where they fail and what makes the real differences, is the ability to make the tough decisions. Nobody likes to call an employee in and say, "Hey, we can't use you anymore." I don't know of anybody that gets pleasure out of it, that enjoys it. It's hard, it's difficult. Somebody's got to do it.

So we have been very honest and straightforward with people about what the expectations are. We've tried to display and have the appropriate amount of patience with people, knowing that, you know, that, look, you know, I'm not saying which strategy this company has had over the years was right or wrong. You know, it's had a lot of different mergers. People have been exposed to a lot of different operating philosophies and all, and it gets confusing to them. So, you know, one of the things you have to do today, you got to be flexible. You know, I learned that early on in my career.

You get a new chief and a new leader, and he comes in and says, "We're going to play this game different." You kind of blow up a little bit, and then it's put to you, and if you can make that change, you get to stay and be a player. Well, I heard that until you make a change. So I think we try to be honest with people. I think they know what's expected of them. But they also know and understand it's difficult. And that's what I think is the difference in organizations. Look, you know, if you look at the rail business, you know, we all got the same locomotives and same gauge and the same signal apparatus, all the same, and similar markets. Nobody's got some huge handle on the market.

What's different about organizations is people and leadership and how they respond and how they lead people. And, you know, that's why, in spite of the fact that we have been criticized, maybe I shouldn't say we have, I have been criticized for creating cultures of fear or whatever. And, you know, that's not what we're trying to do. That's not part of the mission. And in spite of that, though, people are saying: "Why are you poaching all my people?" And I'm saying: "Well, why do they want to come over here? If we got this culture of fear, and we're so demanding and unreasonable, why would they ever want to leave that lovely railroad of yours and come to mine? Maybe you ought to look at your home first." Now, I'm not being specific about anybody.

I'm just saying that I have, we have no one to my knowledge working at CSX that can't get released. If there's some, they got some handcuffs on I don't know about, I got the keys to the handcuffs. Because if they don't want to work here, I don't need them. If they want to go someplace else, that's where they ought to go. It's kind of a free market. That's what capitalism is about, except when you get into non-competes, and I'm an expert here, if you need any advice. So that's kind of where we are there.

Brandon Oglenski (Analyst)

I appreciate that insight, Hunter. And if I can respectfully ask the question on top line, because like it or not, there is a perception among investors and maybe some of your prior colleagues that you worked with, that, you know, your focus is not really on the customer. And you've mentioned it a couple of times today, the post-Hunter era, you hope CSX grows a little bit more. But, you know, I'm trying to line that up with Fredrik's comments about next year, and you guys, I think, did win some contracts this quarter. You know, how do we think about the focus on top line? Is that part of the plan over the next couple of years, Hunter? Or should we just be thinking we got to get service and cost in the right place, then we can grow beyond?

E. Hunter Harrison (CEO)

Well, I think Fredrik commented on it, and I'd like maybe Fredrik and Cindy, if she feels to join in, you know, the difference here. Look, to be successful, we've got to have top line growth. You can't do all this with cost. You know, when people would come benchmark with us in the late nineties and said, you know, why was our operating ratio just happened to be at here in Eastern Canada, so low, and they saw that we were taking price increases. And they said, "Hell, you're cheap." I said, "What do you mean, cheap?" Well, operating ratio is just supposed to be about cost. Well, I learned early on that this is a balancing act between cost and service. You know, I've got scales in my office back in one of the places I still own my bank.

That goes back to the days when I was first being taught about controlling costs, and it was a balance scale that shows one side service, one side cost, and you got to keep that in balance. You know, if you spend too much time providing this premium service that the market doesn't want to pay for, you don't make any money, you know, and vice versa. So look, I get a little, I have to be honest with you, I get a little sensitive about those remarks. Go back and look at the track record. You know, I went to CN. They didn't have a great reputation about service, okay? Now, they didn't have to pay their bills, but they didn't have a great reputation about service. Look at how the top line grew.

I guess, in spite of all my bad actions with customers, we grew the top line pretty good. I don't think there's anywhere we've been that we hadn't seen top line growth. And I look at some of the places that I've come to, and I ain't seen anybody that's had any crazy outperformance of top line growth. You know, I just think that's something that, you know, if they don't, if they don't like you, they don't want to say anything nice. They say, "Well, what can I say?" Well, say, he's not sensitive to the customer. And I was talking to somebody about that yesterday, and I said, "You know, and I think this is right." I've never had anybody say who it was, what it was, where it was. It's just this perception, you just don't like customers, and I don't, I don't buy into that.

So I don't think any of that went in spite of the fact they might not like me, even in spite of the fact this company puts the best service out there at the right cost structure, we'll take the business, okay? This is not like the old days, and you can argue about this relationship spending and all that. I tell you, that's where the relationship is, it's that almighty dollar, that's where it is. So, Fredrik?

Fredrik J. Eliasson (CMO)

Sorry, I'll just add, I mean, I think ultimately, there's absolutely nothing inconsistent with Precision Scheduled Railroading and being customer-focused. What is challenging is short term, it's just a change, and that's what our team is out there selling right now, because there's a lot of change, and it's not linear in terms of the improvements that we've seen. Albeit, we still have seen improvements in terms of transit time from Q1 to Q2. And ultimately, as we go through this change, we feel confident, and we've seen some early signs of it, that we'll have a superior service product to sell than we had before. That's why I don't see and I've talked to a lot of customers over the last 6 months or so, that have had a Precision Scheduled Railroading experience.

Ultimately, the feedback is almost consistent from all of them, which is that once you get through the period of change, we get to a better service product. I think both Cindy and I are very much focused and aligned around that, and that's where our team is out there selling to our customers as well.

Cindy Sanborn (COO)

I would echo that. One of the core tenets of our model here is do what you say you're going to do and that is 100% focused on the customer. I think, Fredrik, you know, we are, you mentioned we are going through some transition here that is, you know, problematic, but I—looking at the model, how it works, I am extremely confident that we have, this model will work well. It will work well on this co—it did for this company, and it will drive not just cost reduction, it will drive superior customer service.

Brandon Oglenski (Analyst)

Thanks, guys.

Fredrik J. Eliasson (CMO)

Thank you.

Operator (participant)

Our next question will come from Cherilyn Radbourne of TD Securities.

Cherilyn Radbourne (Analyst)

Thanks very much, and good morning. Wanted to dig into one of the changes to the train plan that's been mentioned, which is incorporating some of the unit train business into the carload network. Can you give us some examples of what commodities that's been appropriate for, and talk about how that's influenced train length, service and balance and so forth?

E. Hunter Harrison (CEO)

Why don't you take it?

Cindy Sanborn (COO)

Sure. So, let me go back a little bit to drive some context. So if you recall, variable train scheduling in our merchandise business, that was really just our scheduled network, and we drove train length as a result of that. And as Hunter came along and we talked about precision scheduled railroading, and we looked at opportunities where we had overlap on the same subdivisions, where we had a rock train, maybe a metals train, occupying that same territory. And generally speaking, the quarry or the loading facility did not load a full train in a very few number of hours. They were loading a portion of the train in a different time.

And so as we looked at the opportunity to incorporate that in the merchandise network, then that allowed us to go to seven-day train operation, incorporate those commodities into that merchandise train and drive train length that way with very consistent service. And then, as you mentioned, on top of that, then look and as another layer onto the, onto the concept of how do we make sure we have the same number of trains going east and west or north and south, depending on where we are, to allow even more efficiencies in terms of locomotives, and full utilization, full utilization of our people.

That's an example of where and the types of commodities that it has worked for us, and we see pretty good progress with that, and I think it's driving some good efficiencies, and Fredrik can comment on the impact.

Fredrik J. Eliasson (CMO)

And I think there are certain places where we've been very successful at, and it has been actually improved the cycle time for the customers. There are certain places where we have yet to improve the cycle time, and we're still working through with the customer to make sure we get the operating model, I call it fine-tuning the operating model, to make sure that we provide the level of service that is needed. As I said, there are certain places where we're not there yet, but we are relentless of trying to get there.

Cherilyn Radbourne (Analyst)

Great, that's helpful color. I wanted to ask a quick one on coal RPU, which was relatively stable versus the Q1, notwithstanding some likely sequential moderation in the export coal rates. Can you just dig into some of the moving parts on coal RPU for us?

Fredrik J. Eliasson (CMO)

And I think in the Q1, we mentioned it, we had a plethora of things that was all moving in the right direction, especially on the mix side, within both the domestic side and the export side, that all created positive mix. As we think about the coal RPU components here in the Q2, clearly, the export price is the biggest driver there, albeit probably not to the same degree we saw in the Q1. And we don't have as much mix improvement as we saw, and that's just luck of the draw, so to speak. In each and every quarter is different, depending on which utility wants more coal and where do we go in terms of the different export terminals.

So it was really the key driver for coal RPU this quarter was clearly the export pricing.

Cherilyn Radbourne (Analyst)

Thank you. That's all for me.

Operator (participant)

Thank you. Scott Group of Wolfe Research, your line is open.

Scott Group (Analyst)

Hey, thanks, morning, guys. Just a few quick ones. Frank, can you just clarify, do you have any liquidated damages in the guidance for the back half of the year or anything else unusual?

Cindy Sanborn (COO)

Uh, no.

Scott Group (Analyst)

Okay.

Cindy Sanborn (COO)

If one comes up, we'll certainly let you know, but no.

Scott Group (Analyst)

Okay, I would say, always helpful to let us know in advance. That'd be great. Fredrik, just on that coal yields, do you have any view on how much of a sequential drop we should expect in the Q3? And then just on the merchandise intermodal pricing number, do you think that continues to decelerate the back half of the year before, I guess you say, re-accelerate in 2018?

Fredrik J. Eliasson (CMO)

I want to take a look at our general counsel is here, and I'm gonna make sure that I state that we never forecast price. But more importantly, though, if you go to the coal side, clearly it is a commodity market that is very volatile, and we have made a decision strategically to align ourselves with the producers to go up and down with that curve, partly because we want to level load the railroad as much as possible. You know, benchmarks have gone away in the export market, but instead there are a lot of indexes that are out there that our customers and we are using to determine what sort of price we should use.

And I think you can follow those. They're well publicized, so there's an opportunity to see what they will do, and they will be, based on what we're seeing right now, obviously some impact. On the merchandise and intermodal network, as I said before, it has been a tough market for, you know, numerous quarters, for a year and a half, two years now in terms of pricing. And as I said, as I see the truck market tightening up, which there are clear signs that it is, and we go through this change period and really start improving the service product the way we expect. I think as you get to 2018, you'll have an opportunity on both merchandise and intermodal to turn this kind of sequential decline around.

Scott Group (Analyst)

Okay, that's helpful. And just lastly, for Hunter, I know you've got the Analyst Day coming up, so I don't know if you want to get too specific, but it felt like last quarter, on last quarter's call, you sort of blessed a low 60s operating ratio next year and a 50s, maybe even mid-50s, longer term. Anything three months later change in your mind on that directionally, those kinds of numbers?

E. Hunter Harrison (CEO)

No. I just, you know, I felt very confident then, and it's been now, I'm a four-month guy here, so, but I feel even more confident than I did then, given that I've seen these additional four months of the potential we have.

Scott Group (Analyst)

Okay. Thank you, guys.

E. Hunter Harrison (CEO)

I think the numbers are still solid.

Operator (participant)

Thank you. Jeff Kauffman of Aegis Capital, your line is open, sir.

Jeff Kauffman (Analyst)

Thank you very much. Just one brief question. Hunter, as you've gotten deeper into the details, what have you found that you've been able to make greater traction on maybe than you'd had anticipated coming in? And what have you found is gonna be a bit of a longer haul or a more complex process in terms of getting done the things you're looking to do?

E. Hunter Harrison (CEO)

Well, clearly, Jeff, I think it's probably pretty obvious to you, but, you know, clearly, this cultural change, or call it what you want, of a kind of a shift in strategy. And at the same time, you know, I don't want to avoid it, you know, just turn my back on the obvious. You know, there's some people that, you know, they're more pleased with this change. They weren't pleased with what we went through, with the proxy fight. You know, I tried to plead with people during that time that, you know, it's hard to fight one day or one week and then, you know, be all for one and one for all the next week. So we didn't come in here with the best chemistry. It's pretty core. We're all in this together type thing.

So, you know, we've got some open wounds there. So that's a key because if we don't have the right leadership, you know, driven the right way, we're not gonna get these things done. And the first part of the question was more of the opportunities that are even more than I thought initially. Well, obviously, I didn't think there was more opportunity with the hump yards than I thought. You know, I just had this general feeling about railroads, but I've been associated with a lot of them in North America that had too many humps. So I think that opportunity, although it's not really easy to get to, was more than I thought.

We have an opportunity, and I hadn't had a chance to spend a lot of time on this personally, but, you know, we need to improve our engineering productivity, particularly on the capital side, which impacts the capital spend even more, which people don't recognize. But, you know, I'd rather put another tie in than I would have inefficiencies and not productivity and labor. And I guess the other one that was not on my list at all, because I just was not familiar with the collective bargaining issues and so forth, was it going from the nine dispatching offices towards such a location? And I think Cindy can comment on this a bit, but I think the plan is to have that done by Q1 of 2018.

Jeff Kauffman (Analyst)

That's correct.

E. Hunter Harrison (CEO)

Which is, you know, that's all gravy from my bowl of stew. And so, I guess that's some, just some observations there, Jeff.

Jeff Kauffman (Analyst)

All right, Cindy, Hunter, thank you, and we'll see you in October.

E. Hunter Harrison (CEO)

Thanks, Jeff.

Operator (participant)

Thank you. We have a question from David Vernon of Bernstein. Your line is open.

David Vernon (Analyst)

Hey, good morning, and thanks for taking the time. Fred, are there any metrics on sort of customer satisfaction around service availability that you can share to help us to mention this? And are there any segments in particular that stand out as either being more or less happy with some of the changes that are happening at the customer touchpoints that are enabling some of these changes in the schedule?

Fredrik J. Eliasson (CMO)

I mean, I think we're trying to work through all parts of our network here in a very rapid phase, in terms of making sure that we provide the service we want and with the cost structure that we want long term. So as we are encountering challenges from one customer group or from one specific customer, we're trying to be as responsive as we possibly can, as quickly as we can with Cindy. We use J.D. Power to look at customer service and customer responsiveness, and we continue to monitor that. We normally don't talk too much about that externally, but that is a gauge for us. Ultimately, this comes down to reliability and transit time, and that's what we're trying to go through right now. And, and there will be pain points. We know that, and we communicate that to our customer.

The key thing is the responsiveness from Cindy and the team to try to address whatever challenges that we see as quickly as we possibly can.

David Vernon (Analyst)

Can you help us dimension some of the change in these metrics? Obviously, I know you're not going to share your internal customer satisfaction scores, but I'm just kind of struggling with trying to dimension how unhappy or unhappiness could be and where the source of revenue risk could be within the top line.

Fredrik J. Eliasson (CMO)

No, those, you know, specific competitive information, we try to stay away from talking about that. But clearly, when you're changing somebody's service from a unit train to a scheduled merchandise, or when you go out and you change the network as significant as we changed in a very short period of time, whether it's intermodal or merchandise customers, there's going to be pain points. And the key thing is that we're asking our customers to hang with us and see what is ultimately on the right side. We look at the new schedules that should allow for better transit time, better reliability.

But in the short term, we are out there on a daily basis, out to our customer and kind of working through those changes and make sure they see where the light is at the end of the tunnel.

David Vernon (Analyst)

All right, I guess thanks for that. And, Hunter, you know, one of the broader questions we get asked a lot is what does the company need to do to make this Precision Railroading less of just a Hunter Harrison competency and more of a CSX competency? If you think about the next sort of couple of years on the contract that you have with the company, and what you're going to be doing, what are the two or three tangible things that you think you need to do to make sure this Precision Railroading model becomes a CSX competency and is not as tied to you as it seems to be at the early going?

E. Hunter Harrison (CEO)

Well, let me make this observation first. I mean, this is not the first place that scheduled Precision Railroading has been tried or exercised. It has a pretty good, not me, it, scheduled Precision Railroading. It's a pretty good track record, and it's left a pretty good path. If you look at Illinois Central, referred to bankruptcy, good or whatever, now, that was just a little small regional that ran downhill with coal, so we don't count that. Then we go to Canada. The product does, not me. I also went along, but and, it had a big positive influence on Canadian National. And I would say this, it's still hanging on because I think, I think to the best of my knowledge, they've still adopted that model, certainly from an operating side.

They're looked by a lot of people, rightly so, as maybe still the top railroad out there. Then they went to CP, and things went pretty well with CP, and I think they continue to go pretty well from what I read. So, you know, this is not the first place that it's being tried. Now, I think what I would say to you, the key is this, is how well we teach it, if you will, here. And, and so the better job we do of teaching, coaching, mentoring, developing, letting people understand it and understand really the, the whys and the ins and outs, which, you know, a lot of people just don't. And I don't, I don't mean this disrespectfully, just don't have an appreciation for it.

I mean, you know, some of you have probably heard your whole career about unit train efficiencies, and I can tell you that unit train efficiencies are the biggest fallacy that ever, ever hit the railroad, okay? They're. It's not. Unit trains are, on average, way more costly, okay? If you run balanced in a lane, which is what you want to do, because if you don't have balance, you don't know when that imbalance is coming, and there's a lot of cost associated with it. And you're balanced, and here comes grain, a grain train. So you have to deadhead because you don't have a source of supply there to get the loaded train. You get the loaded train after you deadhead it, and you run the train to the port.

Well, they dump it, but it takes 3 or 4 days, and so there's no empties to move back. So you deadhead the crew back because there's nothing for them to do. Well, 3 or 4 days later, now the train is empty, and it's time to run it back. So you run 4 trains instead of 2, and everybody says, "What a beautiful operation." And we don't do that like that. And, you know, to – I think it was to maybe to Cherilyn's question earlier about, you know, this, the changes with the rock trains and the merchandise and so forth. You know, we had grain trains, and we run into 56 cars, unit grain trains. Other railroads running 130. We're running some at 115. Can you imagine that the incremental cost, the difference is basically fuel?

If you're making money at 56 cars in a unit and you double it to 112, which is very, then you're really making a lot of money. So there's real questions raised there. So I think that, you know, I think that I'm amazed that I sit down with people and start to go through the things like that, and they kind of look at me like, "God, why haven't I heard that before?" You know, why? Well, why are we running unit trains? Because somebody one day in cost and statistics says, that's the way to do it. And so everybody, you know, that defaulted to their systems.

So the more time, and we're gonna get a good feel for this next week with the first camp, because the people that are going this time are a little different than what we've done before. These are gonna be operating people. These are gonna be basically transportation operating people, which is where we need the help the quickest. So it's gonna kinda be a specialized course with handpicked individuals from the existing team. Because people said to me here, we just don't have people ready or able, or I don't believe that. A railroad this size has got a lot of smart people that wanna be successful, that wanna do well. It's just our job to find them.

And, so I think that'll be the key as to how well we do in this development at every level, and that we're consistent, from classroom to the class yard. Okay? You know, we used to talk when I was coming up early in my career, we'd come in for a staff meeting, and they'd talk about three things: cost, service, and safety. And they'd just beat us over the head with all of them. And we'd leave to go home, and every morning they'd talk to us about cost. The only time they talked about service and safety was when we came back for another quarterly meeting. They talked about service, cost, and safety. What do you think we reacted to? Cost, because that's what we heard. So those people understanding what you want will give it to you if they understand.

But if they don't know, and if you just say, you know, knock down target one, and they don't know why or whatever, if that's not the right strategy, they don't know the alternatives of what to do. So the better I do, we do, collectively as a group, developing these people, the more successful this company's gonna be and get ahead of some of the competition. Now, whether that's on the highway or wherever, but competition. Any more questions?

Operator (participant)

Mr. Vernon, was that all?

David Vernon (Analyst)

That's it.

Operator (participant)

Thank you. Our next question is John Larkin of Stifel.

John Larkin (Analyst)

Hey, good morning, and thank you for taking my question. We haven't talked a lot about intermodal today, but I thought it was a good topic to bring up, especially, given that CSX historically has had a relatively unique intermodal strategy with what I'll call the regional sortation centers, like the one in Northwest Ohio, the one that may be planned in North Carolina. Perhaps there's a third one in the long-term plan for somewhere in the Alabama area. Allows you to serve a much larger number of origin destination pairs, but does take a little away from the truckload-like service potential.

Just wondering how that plan looks relative to the overall Precision Railroading emphasis, and whether that will survive as envisioned, or whether you plan to adjust that to make it more compatible with the overall Precision Railroading operating strategy?

E. Hunter Harrison (CEO)

Well, we're both afraid and I'm both on it. Look, John, I think it's a case of whatever works. You know, the challenge that we have with intermodal is price. There's no doubt about it. But at the same time, I would say to you that, you know, we're pretty this company that I'm new to has been pretty disciplined in their approach on cost control. So I don't think we're out there right now calling intermodal a practice. And if you believe any of our numbers of what we're to improve on, and so we're gonna see our margins improve in a number, 8%-10%, well, that really gives us the opportunity to be even more aggressive in going after growth.

That's where I think, John, some people miss it, that cost control or controlling expenses is so paramount in this effort to grow the business. You know, we had my last episode like this with CSX, the last time I did this, you know, the group invited me in, and a week before I got there, they took our largest customer and signed a 10-year deal and then said, "Now you know what? You can make money out of this business." Now, that's tough to face. So, and they were down about 267 on margins rank, which meant there was no free cash flow. But I'm proud to report to you that 18 months later, they were in the top 5.

They were in the top five because the team had been able to take the number of sets, which was 29, down to 17, and haul 10% more coal. And now, what was a dog, no price difference to the customer, just internal controls, made us be able to play in that market. So I think to some degree, you know, that will offer some opportunities for us to continue, and I'm not sure I understand totally the regional strategy, but that strategy and others that Fredrik and his team might want to pursue.

Fredrik J. Eliasson (CMO)

And I think the key thing here is that you've heard Hunter talk about the opportunity to continue to grow the business, because that's ultimately what we need to do. Traditionally, intermodal has been a key growth market for us. We've been able to grow, you know, the pace domestically at 5%-10%, and we don't see any reason why that should change. But it's not—it's always about converting traffic off the highway system. And what Hunter is focused on, in addition to intermodal, is also to convert things off the highway into our merchandise network by significantly improving that service product.

You know, the key thing for us on intermodal has been, and will continue to be, to make sure that we drive productivity, and we have always been focused on that at terminal train length, making sure we're pricing appropriately. Clearly, with the new balanced train plan, we've taken train length to an even greater level, and that's going to be helpful. In this short haul kind of area that we're in, being able to connect the dots in a way that we can do with Northwest Ohio, has really allowed us to grow that part of our network in a way that we haven't been able to do historically. I think being able to connect the dots efficiently, like we have, is critical.

Every piece of business has to carry its own weight, and when we look at Northwest Ohio and what we do there, it is carrying its own weight, and it's been a great success, and we've posted on it several times, and I think that's a business model that we think will continue and make sense.

John Larkin (Analyst)

Thank you. Maybe just a quick question on the international side of intermodal. Now that the third set of locks has been open for quite some time in Panama, have you noticed any increased volumes along the East Coast ports? And now with the Bayonne Bridge completed, do you see that as an opportunity for incremental business?

Fredrik J. Eliasson (CMO)

You know, if you go back to 2010, 70% of our international intermodal business came through the East Coast. Today, it's 80%, and even slightly higher than that. So, you know, we've seen this go on for the better part of a decade in terms of the more and more of our traffic coming into the East Coast ports. And if you just look at the raw growth numbers by the East Coast port versus the West Coast ports, you see that trend generally seems to be continuing. So the good news is that we have the infrastructure in place to be able to support that, and I know that the ports are working very hard on the sorts of things that you said, that the New York is doing. Savannah is expanding their capabilities.

Charleston is expanding their capabilities. Norfolk has always been in the forefront of that as well. So all of the ports, and as is Jacksonville, all of the ports are preparing for additional growth, and we are well positioned to capture that as we see additional cargo coming into the East Coast ports.

John Larkin (Analyst)

That's terrific. Thanks very much.

Operator (participant)

Thank you. Next, we have a question from Bascom Majors of Susquehanna.

Bascom Majors (Analyst)

Thanks for fitting me in here. So Frank, you gave us considerable detail on the restructuring charges that you broke out of the labor expense line in the quarter. But is there a way you can help us quantify some of the other costs you incurred during the quarter, as, you know, related to the closing of hump yards and other changes to the operating plan? You know, net net, just trying to get at what a reasonable run rate expectation could be for the non-labor variable expense lines, like MS&O and rents, look like as we head into the H2 of the year.

Frank Lonegro (CFO)

Okay. In terms of the restructuring charge, Bascom, the only thing that we're putting in there are things associated with the management restructuring that we did, as well as some of the dialogue that we were having between Mantle Ridge as an activist shareholder and the company. And so those are the things that we're putting in there. In terms of the restructuring charges going forward, you should see very minimal restructuring charges in Q3 and Q4. Now, to your point about run rate expenses, if you want to just take it down the labor and fringe side, obviously you saw significant efficiencies there, offset by inflation, incentive comp, and things of that nature.

If you were thinking about looking forward on labor and fringe, your year-over-year should be favorable on labor and fringe for both Q3 and Q4. If you want to talk about MS&O, obviously, we were down $29 million year-over-year and down $77 million sequentially, or $22 million, if you want to back out the condemnation gain. And so if you look at Q2 versus Q3 sequentially, ex condemnation, you should see MS&O lower. And then just as you know, Q4 had the real estate gain in Q4 of last year, so you got to pull that one out as you think about run rates for MS&O. You know, fuel, let me jump to fuel real quick.

If you think about where we were in fuel prices, the big driver of the year-over-year change in expense in Q2, I think you should probably think about Q3 as a set of brackets, depending on where price ends up going, it's probably on the expense side, up year over year due to price, but likely down sequentially because of continued improvement on the efficiency side. So that'll give you a range there. You know, on the rents, that line doesn't move a heck of a lot. You know, you saw the reclass that we called out, in that particular line, and so I don't think you're gonna see a lot of movement in that particular line. Car hire should come down as part of that line as your days to load or cycle times improve in the H2 of the year.

Bascom Majors (Analyst)

I appreciate all that detail there. Just one follow-up for Cindy or Hunter here. Just, you mentioned some of the talent gaps, you're having some success filling on the operating team. Where are those left, and when do you expect to fill them? And, you know, just curious, where you're finding these people that you seem pretty excited about to add to the CSX team? Thanks.

Cindy Sanborn (COO)

Well, I think, you know, as we change our operating model and the culture that goes with that, that Hunter's pulled upon, I think it is a big part, maybe the biggest part of implementing what we're working on implementing. So, we've pretty much gone external in terms of attracting people through our normal channels to attract people, and they're coming from other railroads. Excited about the opportunity here. I think we have a huge opportunity here, and I think the folks that are coming in do as well.

Bascom Majors (Analyst)

Thank you.

Operator (participant)

We will move on to Jason Seidl of Cowen.

E. Hunter Harrison (CEO)

Go ahead, Jason.

Operator (participant)

Jason Seidl, did you have a question?

Jason Seidl (Managing Director)

Yes, guys. Sorry, I was on mute. Given, Fredrik, first question for you. Given that, we've seen some strength in the truckload marketplace and the looming ELD mandate, have customers on the intermodal and maybe some of the competitive merchandise lanes come to you guys and talked about capacity on the railroad for next year?

Fredrik J. Eliasson (CMO)

Well, I think those are the sort of conversations that we are in the early stages of having. It's been pretty recent that we've seen the spot market move up in a sustained fashion. We have some fits and starts in the past, but the spot market is moving up. So as people are trying to get into planning for their needs for 2018, I expect those dialogues to occur much more frequently. So, and that's where some of our encouragement is coming from.

Jason Seidl (Managing Director)

Okay. Well, fair enough. And I guess the last one's for Hunter. Hunter, you know, you talked a little bit about how there's changes, obviously, when you come to this organization, and some people are happy about it and some people might not be. Could you talk a little bit about the changes and how you're handling them, even for the people that are happy that they're there? And you know, does the dynamic change much between operations and sales and any communication gaps that there may be? And should we see, I guess, a ramp up of things just running smoothly as we run throughout the year?

E. Hunter Harrison (CEO)

Well, you know, I don't wanna necessarily present all of these in some bucket of problems, but clearly, you know, we're trying to take a team approach with this. We're into a kind of a freelancing here, where we don't really have set plays. We're kind of feeling our way along. I think that there's a lot to be determined yet on how the organization will eventually end up, and I'm not sure what that's gonna be. I, Frank and Cindy and Fredrik are all gonna, and others, will have a big part to play in where we end up there. I think, you know, some of that, some of that's creating some anxiety with people, that we have tried to say, that's not, you know, that's not an issue.

It's not something that you should necessarily worry about or try to do. I know, Fredrik, I've tried this before and been real successful making it work, but I think they're talking about maybe doing some commission sales in certain areas. You know, I would certainly encourage that we do some things differently, that we throw some mud on the wall differently. I think Cindy is, given her comments, you know, clearly, I think she's got a certain grasp on where we're strong and where we're a little weak and where we need help, and the various ways to deal with it.

We've recruited, we've recruited different places, although I'm not a big advocate of consultants, we have two to three people that I've worked with over the years that are in a retired capacity, that are out doing some basic work today, where, you know, where we have some very hardworking, competent managers, but, but we can, we can prop them up a little more by giving them some help. So I think all those things are, are very important to us, going forward. You know, team players. And it doesn't take you long when you walk in that room to get a sense of, are they for me, are they against me, are they with me? Are they mad, are they happy? No matter what, no matter what their mask is, okay?

I mean, we've got some people that have got the prettiest smiles, but if you pull them back, they've got the ugliest growl underneath the smile, and we got to be able to read some of that. So, I mean, it's trying to put that chemistry, that the esprit de corps, getting everybody to pull together. And it's tough enough, pulling together. When you're pulling apart, it really makes it difficult. And I just, you know, hopefully, I can be, as I told you my first time on the, before you, look, I'm a short-timer here. I'm an interim person that's going to try to get this company to the next step, to, to the foundation. You know, I'm, I'm a, I'm an active shareholder.

I want to see this organization do well, and, you know, I don't want to be viewed as getting in people's way and their careers, and that's not my role, that's not my purpose. You know, I had a very fascinating dialogue with some of the board members about what I felt like I could do or couldn't do for the organization. I think that's clearly spelled out. I think most of the team here knows pretty well what I'm coming from and understand the agenda. And, so far, you know, we've been successful and, you know, people haven't been running for the door to get out. We've had to lock it. And so I feel pretty good about what's taking place.

Jason Seidl (Managing Director)

Well, thank you for the color, and thank you for the time.

E. Hunter Harrison (CEO)

Sure.

Operator (participant)

Thank you. Next, we have a question from Keith Schoonmaker of Morningstar.

Keith Schoonmaker (Analyst)

Thanks. Hunter, some investors have questioned the ability to achieve results on par with the Canadian rails due to CSX operating in more populated regions and configured in a less linear design. What structural objects- obstacles have you found that could constrain some aspects of performance, maybe velocity, operating ratio, or customer service, or some other aspect of performance? Asking about structural obstacles, I guess.

E. Hunter Harrison (CEO)

Well, I don't know that there are any. I mean, look, there are some, but I mean, we have to deal with them. I can tell you the quick story that answers it this way. When I went to Canada, and CN had made some pretty bold changes, mostly around the financial engineering and taking a lot of people out. But one of their statements was, public, was: Don't ever expect a Canadian railroad to be able to compete with U.S. numbers. It's just not structurally in the cards, okay? Except when CN became the lowest operating ratio, the U.S. roads said, "Don't ever expect we're going to improve in the U.S., but don't ever expect us to get to CN, to Canadian standards.

It's just not in the cards." Well, I've been on both sides of the border, and, you know, I vote for CSX headquarters over Calgary with CP. That's one vote, okay? You know, look, healthcare is an issue that, that's obviously on the fringe, and the healthcare costs and all that makes it much better to be in Canada. But, you know, then we got some weather in Canada that doesn't make it so pleasant to be there. And some mountains, although we got some mountains down here, too, and people forget about the Smokies in Tennessee and so forth. And, so, I don't think there's any structural issues. I think we got a playing field that if we do our job, then we've got plenty of opportunity, and you won't hear any excuses out of me about the density or spaghetti roll.

You know, I think some people lay awake at night and say, "What can I come up with that makes, that makes some sense?" And I, I don't know what it is. I ain't, I ain't heard a good answer yet. First forty years, I didn't hear anything about structural, and all of a sudden it was the big impediment, structural. And, well, that went away, particularly when we found out that I won't say much more about this, except the two competing forces had the same consultant were going to get to each other developing the structural problem. That creates a structural issue. So let me, I think there's maybe no more questions. Let me wrap something up and sorry, there's going to be a couple more, but let me, let me close it.

You know, there's been, obviously, we've talked a lot today and around this issue of clean quarter and where we're going to be and so forth. Let me say this to you. It's going to be a challenge going forward because one of the things we hadn't talked about is we're in a position that this organization is going to develop, in my view, a whole lot of free cash from the real estate market, not unlike what we experienced at my last employer. For example, I'm not an expert on this, but I think I'm right about, we were in seven different locations in Jacksonville. Next year, we'll be in two. So five locations will need to be sold, we'll get out of the lease, or whatever the case might be.

You know, we're we moved out of our training center in Atlanta off a very pretty expensive piece of property there. You add all those up, there's a lot of money in there. Now, we've debated internally how much, and I'm always, I get criticized internally on the high side. I think $1 million plus. And my point is this: I can't tell you how the real estate market's gonna move over the next two or three years. I can't tell you exactly what interest rates are gonna do. I can't exactly tell you what the timing of some of these issues are, but when they're concluded, they're concluded, and you can call them nonrecurring, although they happen 24 straight months. All we can do is do our job of running the railroad and operating.

And then, by the accounting rules, when we do something with real estate, or other assets that are made available as a result of these operating changes. So that's something that we should think about. I think you should think about it and consider as we go forward. You know, I thought back last night, and not the first time I've done this, and I've been a CEO for, I don't know, 20 years or close, maybe longer. Time flies. A little interim break in there, but, you know, count that. And I said, "Have you ever seen a clean board? I mean, clean, clean board. Squeaky clean board." No? Well, you know, somebody's gonna have to describe a clean board.

But I looked at these results, and I looked back, to some degree, earnings, and I looked at operating trends, productivity improvements, those type things, to say what this organization has potentially in the future, and I'm excited. So sorry for only cutting two questions off.

Next question, please.

Operator (participant)

Certainly. Thank you. Walter Spracklen of RBC, your line is open, sir.

Walter Spracklen (Analyst)

Thanks for squeezing me in there. I guess, Hunter, when I talked to investors about the opportunity you're proposing, I think no one questions really that there will be significant change. I think really the question comes around how fast and how significant. So my two questions are around that. You've kind of addressed both, but we'll start with the how fast. When you did what you did at CN, it was a little bit over a longer period of time. I think you're building a team, you're applying a Precision Railroad model that you'd used once before, but over a larger network. When you went to CP, it was much faster, and I think part was you brought over a team that knew in depth how Precision Railroading worked.

Are you building, rebuilding a team at CSX? I know you've said you're pulling people in, you're using a few experienced, those experienced in Precision Railroading. But overall, is this a longer process because you're kind of rebuilding the team, or is this something you've done now three or four times, and you can hit the ground much quicker than before?

E. Hunter Harrison (CEO)

Well, I mean, I think we can hit the ground a little faster than in each case, it was kind of a stairstep. Because, you know, the team here, you know, they've read a lot about this, good, bad, indifferent. They get to see every day the results of the, you know, Friday night fights, and what they were and what it might be, and, and do a little research. And I think maybe someone was saying, "Hey, this might be a good opportunity." Maybe others were looking at it a different way. But I, you know, I quickly came to the conclusion here that, we have at the senior level, I don't think we have near any deficiencies like I maybe described at this middle manager level.

So, as I told you, I'm kind of an interim step there, and then the board, which I'm part of now, and with my and others' assistance, will make the selection for who's gonna lead this company in the future after I'm out. And that's important. I think that, and I give the internal team credit for this. I think once they heard a little bit from me, and the more they heard, they understood to some degree that it was a good match, and we had some great people at the wrong spot without the appropriate amount of expertise and knowledge, and some of that was their fault, and some of it wasn't.

And so that's when we, you know, kind of went after the—well, we brought a couple of people in that were, you know, had the kind of rock star attached to them. And then we brought these other, or bringing, I guess, Cindy and Kevin are bringing in about 15 more. And I think that's, you know, that maybe is all there is to do, given that what we do in the camps and given that things fall into place. But if it's not, you know, we know what to do next.

So I don't think that's gonna be, you know, we've got, and I really take this as a compliment, and we've got some restrictions from our last employer, who, you know, I just love the kind of party that they gave me, but at the same time, they told me I couldn't hire anybody from them. And I said, "Well, why would I want to hire your people?" Well, that's another story. And then, so there's all kind of restrictions out there about who can hire who and so forth. And I'm just proud to say that we don't have any handcuffs on anybody. One of the things that Cindy encouraged, and we've done, is that we really, from a market standpoint, we're behind the times with transportation supervisors.

I don't believe that any of them are born to chiefs, and that's what we had, and we had good and have good conductors and engineers that didn't want to take a supervisor job because they couldn't pay them. So that's wrong. That's wrong. That's people that don't know how to value a good car, good railroad. They just want the railroad, railroad. So I don't think that's, I don't think that's, going forward, will be a continuing issue. I just think the, the issue will be is, kind of, to your question, how quickly will they look, down? If we go through. Well, look, I've never been through, a time when this country is like it is politically, ever. I've never dreamed of a time like this.

So I don't know what's gonna happen in Washington, and the scary thing is, I don't think they got a clue either. So, you know, we thought one time that whatever you think about Trump, he might be good to railroads, selfishly, if for no other reason, than trade and making America good. And, you know, a lot of things, infrastructure. Well, I don't know where it's going now. But if there is such a thing as a normal, without any geopolitical interruptions, you know, I think it's very reasonable to say that we can get this done in the timeframe we talked about, which is, I guess, 2020, my contract goes out, that we'll have it done by then. I think it's very reasonable.

But, you know, if we miss three or four months or, you know, you're going to shoot us, or the shareholders are not going to love us, I think it's a pretty good run anyway, you know? So, so I, I think we're gonna get there. I don't. I ain't missed one yet. I sure don't want to miss the last one because I will hear about it, and y'all will write about it, and I won't have any way to get back at you. I'll say I'm frustrated, you know, saying it's just not being fair enough.

Walter Spracklen (Analyst)

So, on the second question then, the impact, I don't think again, I don't think many doubt your ability to drive the OR lower and down to the range that you mentioned. The question would be is, what revenue are we shoving through that OR? There's views out there, they were espoused on this call, that perhaps there will be some service disruptions. My question to you is, and when we look at the data, we do see a contraction in, or we see, your volume level tracking below peers. Now, there could be kind of individual reasons for that, and I'll let you touch on that, but we're also seeing your pricing come down on the rate of growth.

My question is, are you right now seeing volume share losses on account of those disruptions, or are you having to price lower to keep that volume because of the perceived volume disruptions or service disruptions? I guess, your view as to when that will smoothen out, if it is happening.

E. Hunter Harrison (CEO)

Well, I mean, look, this service disruption has been way overplayed. There's been, of all our customers, of which we have many. I forgot the numbers the other day, but, you know, it's like, so you got 400 or 500 customers do 90% of the business or what? There's a lot of customers. You know, we have had two that might make the case. They had a quote, major disruption, and in one case, the major disruption was back to where they were before we made the improvements, okay? And it was a result of some labor actions a little pushback by some of the troops, and we're going to take a few names and apply some other pressures. So that is really not, in my view, affected any top line.

I don't know that there's been anything, pricing-wise, that's affected the bottom, that we've made any different moves in. Now, we've got a couple of both. You know, you all know, this is no secret. I'm not a big gov. I'm not a big gov, contract advocate. I think it's, you know, it's not in anybody's interest, but others did differently. They go out and do 3, 5-year contracts and so forth. But we've got a couple of big ones over the next 18 months that are coming up. And, you know, look, part of the honeymoon you get here is when you walk in, they say, "Well, you know, you're a new guy on the block.

If you don't give me a cut, if you don't do this for me, I'm going to say you're not sensitive to your customer, and I'll get you, and you just have to " You know, when I get criticized about this, I don't. I don't. I'm not worried about it. Somebody said, "You're the one who learned to say no." Well, I did, and that's some discipline we got up a lot. I don't think that, and to Cindy's point earlier, what we said to the customer is, we're going to do what we say we're going to do. Okay, now, you know, you go to one railroad, and they say you don't have any schedules. Okay, so you got bad service. You go to another railroad, you put schedules in, and now you're not being sensitive to customer.

I mean, how would you like to go and call somebody to book a flight on United, and, and they say, "What time do you want to leave?" And everybody that doesn't get to leave at their time, files a service complaint. So I don't think that the people in United would think that's fair necessarily. All that being said, the service and the operating, metrics, and all those things, to Fredrik's point earlier, is only going to improve the service. When you improve the service, it happens to lower costs. And, and you got a double effect here. You got a domino effect. So I don't see anyhow. And you know what I'd love? I'd love for somebody to set up a public debate, okay?

Get Ralph Nader to represent the shippers, and I will debate in town square and about this issue of who, where, when, why, and how this came about. So I'm not. I think that's all a positive point.

Walter Spracklen (Analyst)

Fair enough. Just a housekeeping for Fred, and maybe for Frank as well. Frank, did you say 39% was the tax rate for the rest of the year, or is that the new tax rate going forward?

Frank Lonegro (CFO)

What I said was 39-40 in Q3. I think it'd probably be somewhere in the 38-38.5 in Q4. And then, obviously, we'll take a look next year, next year.

Walter Spracklen (Analyst)

Okay. And Freddy, did you update on the export coal? I don't know if I missed it, but did you give any update to your guidance on the export coal? I think you're around 30 million tons or high 20s.

Fredrik J. Eliasson (CMO)

Yes, Frank, did his prepared remarks. We said around 30 million tons in export coal market for the year, with a declining rate structure, most likely based on what we're seeing in terms of indexes.

Walter Spracklen (Analyst)

Great. Okay, thank you very much for your time.

E. Hunter Harrison (CEO)

All right, thanks so much. Oh, sorry. One more question?

Operator (participant)

Thank you. Yes, we have one more question. Justin Long of Stephens.

Justin Long (Analyst)

Good morning, and thanks for fitting me in.

E. Hunter Harrison (CEO)

Sure.

Justin Long (Analyst)

Hunter, maybe to follow up on the point you made a little bit earlier on real estate, are you factoring in those real estate gains when you talk about the potential for a low 60s OR next year and something in the 50s longer term, or would the real estate gains be incremental to those OR objectives?

E. Hunter Harrison (CEO)

Incremental, that's gravy.

Justin Long (Analyst)

Okay, great. And then-

E. Hunter Harrison (CEO)

If we don't do anything in real estate, we still achieve these numbers.

Justin Long (Analyst)

Okay, that's helpful to clarify. And then secondly, I wanted to ask about coal and how that's influencing some of the changes you're making in the network today. When you think about your coal business, you know, what's your assumption on how that looks 3-4 years from now, as you start to implement various structural and operational changes in the network as a whole?

E. Hunter Harrison (CEO)

Well, I'll comment before he has other comments. Look, I'm not going to buy any locomotives for coal, okay? I'm not buying a 40, assets that's got 40 years of life. And, my personal view, I'm not an expert on this. People have made a point, I almost got run out of Canada, that fossil fuels are dead. Now, that's, that's a long-term view. It's not going to happen overnight. It's not going to be 2 or 3 years, but it's going away, in my view. With all the issues, environmental and so forth, natural gas and all the other pressures, coal is not a long-term issue. And, you know, we'll see what Trump does with his commitment to coal and so forth.

And so look, having said that, the last carload of coal that's shipped out of this country, I want to be the carrier that ships it. Now, I don't know if that's, you know, 2020, 2030, or when, but we're not going to make long range unless something changes drastically in the market. We're not going to go out and put double track in or, or buy locomotives or anything for coal.

Fredrik J. Eliasson (CMO)

And just to build on what Hunter just said, I mean, I think we've been pretty clear that over the long term, we think it will decline. There will be periods like we're seeing right now, where coal will be going up, and we're going to try to capture that value economically and serve our customers as their needs are increasing or decreasing. But overall, it's a good business for us, and to Hunter's point, we want to be there to serve the last carload that is there.

Justin Long (Analyst)

Okay, makes sense. I know it's been a long call. We really appreciate the time.

E. Hunter Harrison (CEO)

Oh, thanks a lot. Thanks, everybody, for joining us. We appreciate it, and I'm keen, hardly wait till the Q3 comes. Have a good day.

Operator (participant)

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