Norfolk Southern - Q2 2014

Transcript

Operator (participant)

Greetings. Welcome to the Norfolk Southern Corporation second quarter 2014 earnings call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Katie Cook, Director of Investor Relations for Norfolk Southern. Thank you, Ms. Cook. You may now begin.

Katie B. Cook (Head of Investor Relations)

Thank you, Rob, and good morning. Before we begin today, I'd like to mention a few items. First, the slides of the presenters are available on our website at nscorp.com in the Investors section. Additionally, transcripts and downloads of today's call will be posted on our website. Please be advised that any forward-looking statements made during the course of the call represent our best good faith judgment as to what may occur in the future. Statements that are forward-looking can be identified by the use of words such as believe, expect, anticipate, and project.

Our actual results may differ materially from those projected and will be subject to a number of risks and uncertainties, some of which may be outside of our control. Please refer to our annual and quarterly reports filed with the SEC for discussions of those risks and uncertainties we view as most important. Additionally, keep in mind that all references to reported results, excluding certain adjustments, that is non-GAAP numbers, have been reconciled on our website in the Investors section. Now, it is my pleasure to introduce Norfolk Southern Chairman and CEO, Wick Moorman.

Wick Moorman (CEO)

Thank you, Katie, and good morning, everyone. It's my pleasure to welcome you to our second quarter 2014 earnings conference call. With me today are several members of our senior team, including our President, Jim Squires, our Chief Marketing Officer, Don Seale, our Chief Operating Officer, Mark Manion, and our Chief Financial Officer, Marta Stewart. I am very pleased to report that Norfolk Southern's second quarter financial results set all-time records across the board. Earnings for the quarter were $1.79 per share, up 20, compared with the $1.46 we earned in the second quarter of last year. These very strong results reflect a substantial increase in demand, coupled with our continuing effective cost control. Overall, traffic was up 8%, reflecting a double-digit rise in intermodal, along with increases in both merchandise and coal.

These strong volumes resulted in record revenues, which topped $3 billion, a $240 million, or 9% increase versus last year. Don will fill you in on all of the details of these gains in a few minutes. At the same time, our expenses were up only 3%, despite the volume surge and some continuing slowdown in our network velocity. Our resulting 66.5% operating ratio set an all-time quarterly record. To put the volume growth in perspective, our weekly volumes averaged about 153,000 loads in the second quarter this year, compared with only 141,000 loads on average in last year's second quarter. In fact, we only saw volumes exceed 150,000 loads in two weeks of all of 2013.

And in contrast, we have seen only 3 weeks of less than 150,000 loads since the last week in March of this year. Now, going immediately from the severe winter weather that we experienced to this kind of volume growth has obviously created some challenges for us, but our operating team has clearly risen to the occasion. Our network continues to be fluid and stable, although our service metrics are not yet back to last year's levels. Mark will give you the numbers as well as describe our initiatives to improve network velocity. While the network slowdown and our recovery efforts did give rise to some added costs, our overall expense control was strong, and Marta will go over all of the financials with you in more detail.

To sum it up, it was a great quarter for our company, and while we don't necessarily see the same kind of volume growth being sustained for the balance of 2014, our results show the strength of our franchise and our potential for ongoing improvement. In recognition of this potential, I'm also very pleased that our board increased our dividends yesterday by $0.03 per share, or 6%. And on that note, I'll turn the program over to Don, Mark, and Marta, and then I'll return with some closing remarks before we take your questions. Don?

Don W. Seale (CMO)

Thank you, Wick, and good morning, everyone. The second quarter of 2014, as Wick stated, was Norfolk Southern's first $3 billion quarter, with revenue growth of $240 million, or 9%, compared to second quarter of last year. Revenue in all three primary business units increased, with intermodal up 11%, followed by merchandise at 8% and coal up 7%. With respect to the quarterly revenue variance, our volume increase of almost 145,000 units generated $221 million in additional revenue, while improved pricing and positive fuel surcharge revenue largely offset the negative effect, mix effect of having higher volumes of intermodal traffic. Turning to the next slide.

Despite higher intermodal volumes, our overall revenue per unit increased by 1% in the quarter, with steady price increases among most business units. Coal revenue per unit was up 5%, due primarily to longer lengths of haul for utility coal, which offset the negative mix effect of lower volumes of export coal. In our merchandise segment, RPU was up 2% in spite of negative mix effects from higher short-haul movements in the metals and construction and agricultural products segments. Lastly, our intermodal sector experienced positive pricing, which was offset by the negative mix effects of increased international volumes, which have lower revenue per unit characteristics compared to domestic shipments. Now turning to the details of our volume for the quarter, total shipments increased 8% due primarily to increases in metals and construction, intermodal, coal, crude oil, natural gas, liquids, and housing-related commodities.

Intermodal volume was up 11%, driven by organic growth and new business in international, coupled with continued strength in our domestic market and highway conversion programs. Our merchandise market also experienced strong growth led by our metals and construction franchise, which was up 13%, followed by chemicals, up 7%, and agriculture at 5%. Volume growth of 9,000 units in coal was primarily from increases in the utility sector, which were offset by decreases in our export traffic. Turning to the next slide, focusing on our individual market segments, starting with coal. Coal revenue was up $46 million, or 7%, which was our first quarterly revenue increase in coal since 2011. This gain was led by our southern utility business, which grew by 23%, partially offset by a 3% decline in northern utility volume.

Utility coal demand has improved as a result of higher natural gas prices and stockpile replenishment coming out of a harsh winter. Eastern utility stockpiles remained down by 18% compared to December 2013 levels. In the export market segment, volumes were down 13% as thermal supply competition remains very strong in Europe. The API 2 index to Western Europe is currently in the $70 range, pushing U.S. thermal coals out of the market. Export metallurgical coal is also being impacted by weak seaborne pricing and strong Australian competition. In our domestic metallurgical coal market, we saw a 7% decline in volume compared to the second quarter of last year, as the steel market remains oversupplied, and we experienced the impact of two plant closures in Canada. Finally, industrial coal volumes increased by a strong 24%, due primarily to new business gains.

Now let's turn to intermodal. Intermodal revenue in the quarter increased by $62 million, or 11%, to $650 million, which is an all-time high record for this high-growth business segment. International shipments grew by 16% due to strong general market expansion, new projects, and advanced shipments ahead of the ILWU labor contract negotiations at West Coast ports. The increase in our domestic volumes continues to be driven by highway conversions across all of our business segments. We are seeing organic growth in our large key accounts, as well as increased use of intermodal by recently acquired premium and truckload customers.

Our targeted corridor initiatives, which we've discussed with you in the past, coupled with associated infrastructure improvements made over the past 10 years, are providing the necessary tools to grow our business efficiently and profitably, and we're continuing to work on increased velocity and performance across this best-in-class intermodal network. On slide 7, we focus on our merchandise markets, which in the quarter increased by $132 million, or 8%, to $1.7 billion. Metals and construction led this growth, with 13% more volume generated by higher volumes of frac sand shipments to the Marcellus and Utica Shale regions, growth in imported slabs through our East Coast ports, and also increased coil steel due to continued strength in the automotive sector.

The 5% gain we saw in agriculture was driven by year-over-year improvement in shipments of corn due to increased demand in processing, primarily for ethanol production. Additionally, expanded export activity led to higher volumes of soybeans and wheat. In our chemical franchise, we continue to see increases in crude by rail, natural gas liquids, and other chemical commodities used in the growing automotive and housing markets. Automotive car supply constraints across the North American network moderated automotive volumes in the quarter. But as shown on the chart, our automotive volumes increased by 3% in the quarter despite these challenges. Lastly, volume within our paper, clay, and forest products group was down 1% for the quarter, due primarily to the impact of the recent closure of an international paper mill in northern Alabama.

On a positive note, these declines were largely offset by continued strength in the wood products markets for both lumber and wood chips. Now, let's conclude with our outlook for the balance of 2014. We remain optimistic that we will continue to generate growth across most of our business units. Utility coal shipments are expected to be up throughout the rest of the year as gas prices remain elevated and stockpiles are replenished. But overall, coal volumes will be tempered by weaker export met and thermal coal market conditions, along with lower domestic met coal shipments. Turning to intermodal, as truck capacity tightens, we anticipate continued volume growth and pricing opportunity in our domestic network.

For example, in our rail-owned domestic container segment, we successfully increased transcon rates 4% on June 1, and we'll be taking a 3% increase on our local EMP freight, effective September 1st. These two business segments together represent 17% of our total domestic intermodal book. We also expect continued volume increases in our international intermodal business, but we expect the pace of growth in this sector to moderate somewhat in the second half. In our merchandise businesses, we expect growth across most market segments. In chemicals, crude by rail continues to be strong. Last year, as you'll recall, we handled approximately 75,000 carloads of crude oil, and we expect our full-year 2014 volume to be well in excess of 100,000 carloads, with substantial opportunities for continued growth in 2015.

And natural gas-related commodities, such as frac sand and liquid petroleum gases, are expected to continue to increase as well. In metals, U.S. steel production is projected to increase 3% for this year, and we continue to see growth across most of these markets. In automotive, our automotive volume should continue to improve as car supply becomes more fluid and production increases by over 4% this year. In our agricultural markets, favorable growing conditions for another robust soybean and corn crop should lead to strong year-over-year gains ahead. Lastly, with housing starts expected to grow by 15% this year, we expect continuing volume increases in housing-related commodities such as plastics for carpet, soda ash going into the manufacturing of glass, steel for appliances, synthetic gypsum for wallboard, and in asphalt and aggregates for paving.

In summary, to wrap it up, we expect continued volume and revenue growth ahead across most of our intermodal and merchandise market segments and in utility coal in the second half. With respect to our yield management plan, as we've shared with you in the past, we remain committed to providing improved service to our customers that supports our ability to price to market at levels that equal or exceed rail inflation, and which supports further investments in our network. Thanks for your attention, and I'll now turn the mic over to Mark for his comments on our operations. Mark?

Mark Manion (COO)

Okay. Thank you, Don. Well, the second quarter operations were definitely affected by the very positive traffic growth. On the heels of a difficult operating environment in the first quarter, the higher volumes presented a new set of challenges for our operations and slowed our progress in returning the network to targeted service levels and network velocity. However, it did demonstrate that we have a physical capacity in the network for further growth. It also pointed out that going forward, we need to find ways to respond more quickly to changing market forces, particularly with respect to train and engine employees. Turning to Slide 2 for a review of safety performance, we saw solid improvement in the second quarter. Reportable personal injuries dropped to 0.88. For the first six months, the injury ratio stands at 1.19. Furthermore, our serious injury rate has not increased.

We also saw improvement in the rate of train incidents in the second quarter, down to two incidents per million train miles. For the first six months, the train incident rate is 2.3 per million train miles. Crossing accident rates were up slightly to 3.8 per million train miles for both the second quarter and the first half of the year. As illustrated on slide three, our composite service metric improved modestly from 73.4% in the first quarter to 74.5% in the second quarter, below the high service levels of 2012 and 2013. For the first six months, the service composite was 74%. Our network has remained very fluid, with no significant bottlenecks due to physical constraints.

However, service performance and network velocity remained below targeted levels due to a crew base that was planned for. Based on recent business growth trends and an updated business outlook, we've stepped up hiring and training in order to align T&E forces with expected volumes. Looking at employment for the total company during the second quarter, we had about 900 fewer employees versus the full year 2013 average. With the additional T&E hiring, we expect that we will ramp back up to the 2013 employment level by the end of 2014. Train speed shows similar trends, and for the very same reasons. In the second quarter, train speed fell to 21.8 miles an hour. For the first six months of 2014, train speed was 22.1 miles per hour.

In addition to the efforts in crew hiring, we also pressed on locomotive availability. Not only did we have all of our surge fleet deployed, but we also stepped up repair activity to increase the total number of available locomotives. As Marta will discuss with you, this resulted in higher costs, but it was well worth it to assist in the recovery. This point is illustrated by our next slide of our dwell times. As you know, terminal dwell is the second major component of network velocity, and it improved by 6% from 25 hours in the first quarter to 23.4 hours in the second quarter. Terminal dwell remains above the high-performance levels of the last couple of years and will also improve over coming months with improved crew availability.

Moving to the next slide, with a volume increase of 8% in the second quarter, crew starts actually declined by 1%. This margin of difference is, in part, due to conserving crews through train combinations and train annulments. However, we would still see a very positive margin even with a more robust crew base. Our current crew base is clearly stretched, which is reflected in higher overtime hours and increased recruits, up 20% and 23%, respectively, for the second quarter compared to the same period last year. With the hiring plans I outlined, network velocity will improve over the coming months, and we'll see that improvement reflected in further improvements in operating efficiencies, particularly reductions in overtime and recruits. Higher volumes were largely absorbed with the existing train operation, resulting in a 4% improvement in carloads per locomotive.

Our fuel utilization was also favorable, as gallons per 1,000 gross ton miles declined by 4% compared to the same period last year. Thank you, and I'd like to take just a minute to recognize all of our operating department employees. The first and second quarters presented very different but very difficult operating challenges. As always, our people rise to meet every challenge. That's the Norfolk Southern spirit. Marta, now I'll turn it over to you.

Marta Stewart (CFO)

Thank you, Mark, and good morning, everyone. Let's take a look at how all of that strong volume translated into second quarter financial results. As shown on slide 2, and as Wick and Don already mentioned, our operating results were strong. Railway operating revenues of over $3 billion rose $240 million, or 9%, versus 2013, while operating expenses increased only $57 million, or 3%. This improved leverage resulted in a best-ever quarterly operating ratio of 66.5. The next slide shows the major components of the $57 million net increase in railway operating expenses, which, as you can see, was largely concentrated in Materials and Other and in fuel. Now, let's take a closer look at each of these variances. The Materials and Other category increased by $35 million, or 16%.

About $20 million of this was due to higher casualties and other claims, as the prior year had a large favorable personal injury adjustment. In addition, about $10 million of the increase is related to higher material usage, primarily for locomotive repairs. As Mark discussed, our surge fleet is fully deployed. As you would imagine, those locomotives typically require more maintenance. In addition, we had some spillover of locomotive work related to weather issues from the first quarter. With the anticipated demand that Don described, we plan to continue to use those older locomotives in the second half of the year. Therefore, you can expect a similarly elevated level of material spending. As displayed on the following slide, the $17 million, or 4%, increase in fuel expense was almost entirely due to higher consumption.

Gallons used were up 4% on the 8% increase in traffic volume. Next, depreciation expense rose by $12 million, or 5%, reflective of our larger capital base. As shown on the left-hand side of the slide, our fixed assets before depreciation are $1.3 billion higher than this time last year. Slide seven addresses the $4 million, or 1%, rise in Purchased Services and Rents. Most of this increase was due to higher volume-related costs, in particular, equipment rents, joint facilities, and intermodal terminal costs. Somewhat offsetting these volumetric increases were lower professional service fees as well as lower expenses associated with the Shared Assets area. Slide eight details the $11 million, or 2%, decrease in compensation and benefit costs.

As we previously discussed, the first quarter amendment to our retiree medical plan, along with strong equity returns in 2013 and a lower discount rate, resulted in a decline of about $40 million in post-retirement medical and pension accruals. In addition, health and welfare benefit costs were slightly lower for the quarter. Partly offsetting these declines were higher incentive compensation, increased pay rates, and increased overtime. The higher incentive comp was due to bonus accruals related to the strong operating results, as well as to higher stock-based compensation. Overtime increased by $9 million and was mostly incurred in two areas of our workforce: employees who operate our trains and employees who repair equipment, principally locomotives. We expect a somewhat elevated level of overtime for the remainder of the year.

As Mark described, we have already hired and will be continuing to hire train and engine employees, so the overtime in that area should gradually moderate as the employees become qualified. Slide nine depicts our second quarter income from operations. With revenues up 9% and expenses up just 3%, the operating margin expanded by 22% and exceeded $1 billion for the first time in the company's history. Turning to our non-operating items, both categories were $11 million unfavorable for the quarter. Other income net declined by 38%, due primarily to reduced coal royalties associated with lower coal production, and interest expense on debt was up 9% due to last year's debt issuance.

Slide 11 shows our bottom line results, with record quarterly net income of $562 million, up 21% compared with 2013, and diluted earnings per share of $1.79, up 23% versus last year. Wrapping up our financial overview on Slide 12, cash from operations for the first six months was $1.4 billion, covering capital spending and producing $628 million in free cash flow. Although capital spending year-to-date is somewhat behind last year's pace, we still continue to project full year CapEx of $2.2 billion. Within this total amount, we have reallocated resources to acquire some used locomotives and to enhance capacity. With respect to stockholder returns, we repurchased $100 million of our shares and paid $335 million in dividends.

These dividends reflect the $0.54 per share amount paid in the first and second quarters. As Wick mentioned, our board yesterday raised the dividend rate to $0.57 per share, a 6% increase, which will begin with our September dividend payment. Thank you, and I'll now turn the program back to Wick.

Wick Moorman (CEO)

Thanks very much, Marta. Well, as you've heard, we were obviously very pleased with our second quarter results. Clearly, there is still work to be done in terms of improving our network, network velocity and service levels, and we have a solid plan in place, along with a great operating team, to do just that. But even with that slower velocity, I am very proud of the way that our team kept our costs in check, even in the face of a volume surge, the magnitude of which, quite frankly, none of us saw coming. Looking ahead, as you heard from Don, while we still have some questions around coal and particularly export coal, we continue to see strong fundamentals in most of our businesses.

Looking even more broadly, we believe that the U.S. economy will continue to recover at a reasonable, although not robust, level for the balance of this year and next, which should also help us to continue our upward momentum. There are some question marks on the regulatory front, most immediately concerning the transportation of crude oil, but I remain convinced that the U.S. rail system can transport crude oil safely and that the regulators understand and believe that as well, and that they will not issue rules which will seriously diminish our ability to do so.

I'll close by repeating again our core strategy at Norfolk Southern, which is to focus on delivering superior transportation service to our customers in the most efficient and effective way possible, at prices which reflect the value of that service in the marketplace, and thereby deliver superior returns to our shareholders. We have the franchise and the team to execute this strategy, and our second quarter results offer proof that we're on the right track. Thanks, and I'll turn it over to the operator for your questions.

Operator (participant)

Thank you. We'll now be conducting a question-and-answer session. If you'd like to ask a question, please press star one on your telephone keypad, and a confirmation tone will indicate that your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Thank you. Our first question is from the line of Allison Landry of Credit Suisse. Please proceed with your question.

Allison Landry (Senior Equity Research Analyst)

Good morning. Thanks for taking my question. Wick, I wanted to follow up on the last comment that you made, with respect to crude by rail regulation. We've recently been hearing some chatter, actually, that the DOT and PHMSA might put out, you know, potentially even as soon as today or tomorrow, rules not only concerning the tank cars, but also the speed limits. And some of the numbers that we've heard are a limit of 25 miles per hour. I know that the industry has talked about 40 being, you know, the lowest that you could do, but, you know, and let's just say that the scenario is 25. What happens, and, you know, how would the industry respond? I mean, would you stop moving crude altogether or substantially decrease what you're moving?

Wick Moorman (CEO)

Allison, it's a good question. And we obviously do expect to see very shortly, the regulators put out a notice of a proposed rule. There's a lot of speculation about what might be in that proposal, but there will then be the opportunity for all of us to discuss it before they come up with a final regulation. And obviously, speeds in the range that you mentioned, 25 or 30 miles an hour, would be extraordinarily disruptive to our rail network.

Not only to trying to ship crude, in which the exposure, quite frankly, would go up significantly because it would take a lot more trains and cars to move the same amount of oil, but it would be incredibly detrimental to the service and all of the rest of our business, including Amtrak, and including our auto business, our intermodal business, you name it. And the resulting capacity loss, I think, is something that the rail network, quite frankly, could not manage. So, we have done a lot of modeling.

We have had a lot of discussion with the regulators, and I believe that we'll be able to make our case that a minimum speed in the 40-45 mile an hour range is not only safe, which it is, but also is the range in which it will not be extraordinarily disruptive to the North American rail network.

Allison Landry (Senior Equity Research Analyst)

Okay, so potentially, we could see the proposed rule come out with something on more onerous than you guys would like, but there is an opportunity to go back and revisit that?

Wick Moorman (CEO)

They're clearly in the process. It will be a proposal, and there will be, as I said, a comment period and a period for the rail industry to present evidence, and we will have compelling evidence that any significant speed restriction would be, in fact, disruptive to the point of almost shutting down the North American rail network.

Allison Landry (Senior Equity Research Analyst)

Mm-hmm. Okay, that's great color. And just a follow-up question, I guess, turning to coal. Is it safe to say that the rate concessions on the export side are largely behind us, or should we expect further rate cuts just as prices continue to be weak globally? And at what point does it become uneconomical to continue making these downward adjustments and maybe instead you start reallocating some resources elsewhere, since you're seeing growth in across the business?

Don W. Seale (CMO)

Good morning, Allison. This is Don. We believe as long as metallurgical coal prices in the world market remain in the $120 level, and they've been stable at the $120 level now for a couple of quarters, our export pricing is at the bottom, and it's going to remain flat in the third quarter based on that. I will tell you, thermal API 2 pricing into Western Europe has deteriorated further. We do not plan to try to follow that coal or incent that coal with transportation pricing because frankly, the delta is too wide for us to make much of a difference in that market.

Allison Landry (Senior Equity Research Analyst)

Okay, great. Thank you so much for the time.

Don W. Seale (CMO)

Thank you, Allison.

Operator (participant)

Our next question comes from the line of Thomas Kim with Goldman Sachs. Please proceed with your question.

Tom Kim (Senior Industrials Equity Research Analyst)

Good morning. Thank you. Can you elaborate on what your core pricing growth was in the second quarter?

Don W. Seale (CMO)

We don't comment on what our core pricing results were. I will tell you that we're pleased to advise that it was in excess of our rail inflation rate. As we pointed out in the revenue per unit review in my remarks, we were pleased to see the results in our coal business, with revenue per unit being up 5%, our merchandise business up 2%, and our intermodal business even with last year, even though our international business volume was up 16%, double the domestic rate of growth. As you know, our domestic intermodal has about a third higher revenue per unit than our international business, based on international containers moving. We were very pleased with our pricing results in the quarter.

Tom Kim (Senior Industrials Equity Research Analyst)

Okay, that's great. Thank you. And then, to what extent could you comment a little bit more about the coal pricing, you know, on the domestic coal, domestic utility coal versus the export side? Would you be able to elaborate in terms of the trends we've seen in the second quarter, in particular for the export coal?

Don W. Seale (CMO)

Our trend in export coal in the second quarter was essentially flat with the first quarter. As I mentioned in the previous question, we don't see that moving now. We're pretty much at the bottom of the market, and we don't have plans for any appreciable movement downward in our export market rates at this point. In the utility market, I will tell you that most of our gain in RPU, revenue per unit, was attributed to longer haul coal that's originating in the Illinois Basin and the Northern Appalachia Pittsburgh Eight seam, moving to our southern utilities. That business was up 23% in the quarter. And our business in the north was down 3%. So we had a very favorable extended haul result that drove RPU in coal.

Tom Kim (Senior Industrials Equity Research Analyst)

That's great. Thank you very much.

Don W. Seale (CMO)

You're welcome.

Operator (participant)

Our next question is from the line of Scott Group of Wolfe Research. Please proceed with your question.

Scott Group (Managing Director and Senior Analyst)

Hey, thanks. Morning, guys. So, Don, just to follow up on that last point about the coal yields, do you expect that mix of much better growth to southern utilities rail up to north. Do you, do you think that mix continues? Is that a long-term trend, or is this something that's choppy and, and maybe not so sustainable?

Don W. Seale (CMO)

Morning, Scott. It's a good question, and we're seeing a continued conversion of utility coal from Central Appalachia, with higher cost of production, to the Illinois Basin and to Northern Appalachia. And I will share with you in the second quarter, our origination percentages, we were 34% Central App, 31% Northern App. We're within 3 percentage points of Northern App now equaling Central App, which has been our traditional source of thermal coal. But the notable change was that the Illinois Basin, in the second quarter, was now 19% of our thermal originations, which is 3 percentage points higher than the PRB originations coming to our network now, at 16%. So we're seeing Illinois Basin growth take place, and we're certainly seeing Northern Appalachia growth take place, both into the Southeast. We expect that trend to continue.

Scott Group (Managing Director and Senior Analyst)

Is there something about why it's more going to the Southeast than the Northeast, and that should continue?

Don W. Seale (CMO)

Well, the Southeastern stockpiles are at a level that they're being replenished coming off of winter. We expect that replenishment to continue in the second half of 2014. And also, higher natural gas prices have created a situation where thermal coal is dispatching at a higher rate in the South than it did this time last year.

Scott Group (Managing Director and Senior Analyst)

Okay, great. And then just second question, you know, when we're hearing about adding more people, but hopefully over time and things like that, and come down and service gets better. Net-net, should that mix change, should that be good for operating margins and incremental margins in the back half of the year? You typically see earnings, you know, improve in the back half, and I just wanna understand, should that continue this year?

Marta Stewart (CFO)

This is Marta. Scott, the overtime was about half and half occurred in the T&E and the non-T&E area. So the effect of the hirings that Mark described will, will, will reduce and moderate as the year goes on, as these folks get qualified, will reduce the T&E overtime. We expect the non-T&E overtime to continue right about this level through the end of the year.

Wick Moorman (CEO)

Yes, Scott, this is Wick. I would say, too, that overall, we know and we've done a lot of analysis that tells us that as network velocity improves, our costs come out. And, our expectation is that over some period of time, through the second half and into next year, as that network velocity increases, even with the additional employees in T&E, our overall cost structure should benefit from it.

Scott Group (Managing Director and Senior Analyst)

Okay, so ultimately a good thing. Okay. All right. Thanks a lot for the time, guys.

Operator (participant)

Our next question is from the line of Bill Greene of Morgan Stanley. Please proceed with your question.

Bill J. Greene (Managing Director)

Hi there, good morning. Don, can I ask you to comment a little bit on some of the things you said in your prepared remarks. Capacity we know is getting tighter. You mentioned that it's getting tighter in the truck markets. We've seen that very clearly in a lot of the data points. How, how soon is it before we have to start to see some higher pricing for the rails, simply to handle this demand, right? To try to create, if you will, some elasticity, of which I know there's very little. And, and along those lines, how much is service a limiter on what you can do on price?

Don W. Seale (CMO)

Good morning, Bill. I'll take the first part first, first part of the question first. We are seeing truckload capacity tighten. We've seen that trend take place now over the past 15-18 months, and it certainly is continuing to open up opportunities for us to improve our pricing for intermodal, where you know, we still have a differential of 12%-15% generally, between intermodal prices and truckload prices. That's a good example of that is what I mentioned in my remarks, looking ahead of us taking a 4% increase on our originated business going west on transcontinental, and a 3% increase, effective September first, on our local EMP business as well. And that's 17% of our domestic book of intermodal, which I think is indicative.

It illustrates the movement that's beginning to take place on pricing and intermodal. We don't see any change or reversal in truckload capacity as long as the economic trends continue to move upward. And so we expect a more favorable pricing environment ahead, and you will see us take more selective increases ahead with that. Now, with respect to the second part on service, as Wick mentioned, and as Mark mentioned, none of us are satisfied with our service levels at this point. We are working very closely with all of our customers to work through any concerns and issues until we can service back to where we expect it and where our customers expect it.

But I will tell you that, with double-digit growth in most of our corridors, including Crescent Corridor and Heartland, in the quarter, service has not been an impediment to us handling our international business, continuing to have a successful track record of converting highway freight to rail.

Bill J. Greene (Managing Director)

Okay, very good. Wick, can I ask you one other question? And that is, you probably saw the BN agreement with SMART on possibly moving to one-man crews, if ratified, on areas where they have PTC in place. Do you think that this is a possible game changer for the industry? I know PTC is far from operable, but as we get there, is this something we need to keep in the back of our minds?

Wick Moorman (CEO)

You know, we certainly have seen that agreement. We're trying right now internally to work through all of the economics of that agreement to see, what kind of impact something like that would have at Norfolk Southern. It's clearly, a sea change agreement, but, I think it's we're a long way from understanding, how the economics play out. And as you say, you know, it's PTC contingent, and our best guess right now on when, you know, PTC is is actually operational across the entire North American rail network, is, approaching 2020. So is it, is it interesting? Yes. Could it be significant? Yes. Does it have any immediate impact? I don't see that.

Bill J. Greene (Managing Director)

Okay, that's great. Thank you for the time.

Don W. Seale (CMO)

Thanks.

Operator (participant)

Thank you. Our next question is from the line of Chris Wetherbee with Citigroup. Please proceed with your question.

Chris Wetherbee (Senior Analyst)

Thanks. Good morning, guys. Maybe a question for you, Mark, on the velocity side. Just looking sort of as you move through the second quarter, and clearly, there was well, volume growth, I should say, coming out of the winter. But as you saw the quarter progress, it seemed like some of those metrics maybe deteriorated a little bit towards the end of the quarter. We've seen a recent bounce back here, but just want to get a rough sense of when we think we can start to see some more material improvement there. And should we be focused on that? Is that something we need to be, you know, considering as we look for those metrics to improve and ultimately continue to drive, you know, what were very, very strong incremental margins in the quarter?

Mark Manion (COO)

Yeah, Chris, realistically, as we go through the third quarter, there's gonna continue to be a lot of pressure on the operation. The, you know, we just, we see a lot of volume. Third quarter is always a, is always a robust quarter anyway, and it looks like this one certainly is going to be. So, we're gonna to, we are gonna stay up against it, and we're not gonna have we're not gonna see additional crews that are, that are coming into the operation in the third quarter. We will start to see some, we will, we will put some additional locomotive power against it as we go into the third quarter.

We are continuing, as we have been, we continue to march forward with improvements from additional infrastructure projects, and they are very helpful. They just make a, they have made a world of difference, and we're certainly seeing that play out now. We're gonna hold our own, but we're not gonna see a tremendous amount of improvement during the course of the third quarter.

Chris Wetherbee (Senior Analyst)

Okay. That, that's helpful. I appreciate the color. And then, Don, just to follow up on the question before, as you talked about sort of the, the changing mix in southern utilities taking coal from, from different originations and ultimately how that's playing out through the business. Can you just give us an update on where sort of southern and northern utility stockpiles rest relative to sort of historical or multi-year averages? I just want to get a rough sense of kind of, have we played this catch up, or how much is left to go into the second half of the year?

Don W. Seale (CMO)

Chris, you may recall that, back in the first quarter, after we came through the so-called polar vortex winter, we, at the end of our first quarter, we shared a number that, the stockpiles in our network had come down by about one-third. We estimate now that we've worked off a portion of that reduction, but they are still down about 18% compared to December when we went into the, the weather.

And gas prices are still trending in an area of, you know, they're about $3.80-$3.90. Illinois Basin coal, PRB coal, and Northern Appalachia coal will dispatch at, at those prices. So stockpiles are, have not been replenished. There's still some work to be done, and as long as gas prices are in the range that they're at today or higher, we'll see utility coal demand in the South and hopefully in the North, pick up as well.

Chris Wetherbee (Senior Analyst)

Okay. And those stockpiles are relatively balanced between northern and southern utilities?

Don W. Seale (CMO)

We see a little more opportunity right now in the South than we do the North, but I will tell you that it's not much difference. As you know, our utility volume is about 50/50 split between the North and the South.

Chris Wetherbee (Senior Analyst)

Okay. That's helpful. Thanks for the time. I appreciate it.

Don W. Seale (CMO)

Thanks, Chris.

Operator (participant)

The next question is from the line of Jason Seidl of Cowen and Company. Please proceed with your question.

Jason Seidl (Managing Director)

Good morning, gentlemen. The first question is gonna focus on the intermodal side of things. Obviously, we've seen you take some of the prices up on some of your book of business, but I think you mentioned it was 17% of your domestic book. Can you talk to us about, you know, what percentage is more of your domestic book that you might be taking up in the near future? Like, can you just do an across-the-board tariff increase on some other segments of your business? Are there any larger contracts that are rolling over this year?

Don W. Seale (CMO)

No, we have contracts in place with intermodal, and we cannot do an across-the-board increase. What we will have to do is time those increases when the contracts make available the opportunity to do that. Quite a bit of our business is priced year to year. So as we get through this calendar year, that will open up additional opportunities for our partners in the intermodal market to take up pricing as well. So, you know, this is a good start with our rail-controlled containers, our EMP containers, taking the 4% westbound on Transcon, the 3% coming September first within local. You will see us take more, but it will be incrementally as contracts open up and give us the opportunity to do that.

Jason Seidl (Managing Director)

So this seems like more of a 2015 event then?

Don W. Seale (CMO)

Yeah, in those contracts, I would point out that we do have escalators that apply in until we get to the point where we can take a market-based increase.

Jason Seidl (Managing Director)

Okay. And a follow-up is related to crude by rail. When you're looking at sort of the safety statistics, and I know that part of the focus on this release is gonna be on some of the train speeds, but of the accidents that we've seen sort of across the rail networks have been highly publicized, how many were actually due to excessive train speeds?

Don W. Seale (CMO)

None, to my knowledge.

Jason Seidl (Managing Director)

Okay, that's what I thought. Okay, guys, those are my two. I appreciate the time, as always.

Don W. Seale (CMO)

Thanks.

Operator (participant)

Our next question is from the line of Ken Hoexter of Merrill Lynch. Please proceed with your question.

Ken Hoexter (Managing Director)

Great. Good morning. Congrats on, on pretty solid, results and, and, record operating ratio. Great to see that it continues. On the, just a thought on, on Mark, on, on the capacity here. You're almost running at 2006 peak levels, on a carload basis. You mentioned how much you're up or we did, I guess, year-over-year. So you mentioned your thoughts on your ability to recover velocity with employees and, and adding the crews on. What about CapEx? Do we need to- do you need to increase that?

Is this a, a physical capacity that you're, you're starting to bump up against, or I guess, can you talk about what your thoughts are? And maybe, Don, your thoughts on throwing in there on the Crescent and Heartland, if you're starting to see the ramp up on the capacity there as well.

Don W. Seale (CMO)

You know, it has been very interesting to see how well we have digested the freight from the additional freight volume from an infrastructure standpoint. And we just have not had bottleneck situations. And like I've commented some in the past on these calls, it is the, you know, the more than 10 years' worth now of continual infrastructure improvement that it takes place on an ongoing basis, and there are a variety of projects that are loaded up in the pipeline, and they keep coming out. We've got more that will be completed and more that will be started this half. So we're trying to stay ahead of it, and so far, we are staying ahead of it.

You know, we've got our, we've got our modeling and our capability to, based on traffic forecast, to see where the next tight spots will be, and that's when we put the infrastructure projects up against them, and that process has been working well. And, so we're gonna keep doing what we're doing, and we got a major project I think you're aware of, coming out later this year. It'll be in the fourth quarter when we have our Bellevue expansion that opens up, and, that is going to be very helpful to, as far as, as far as lightening any capacity constraints up in our northern areas. So that's, that's the way we're looking at it. Ken, I would add, this is Don.

I would add, too, that when you look at the composition of our growth in the quarter, for example, out of our 145,000 loads, 95,000 units were intermodal. And we've done a lot of work to densify our double-stack operations, get the right box on the right car, and that helps us manage capacity much more effectively. We're not adding trains and intermodal to handle the 95,000 additional units that we handled in the quarter. So that, de facto, is additional capacity. And with respect to the corridors, the Crescent Corridor, I mentioned double-digit growth earlier.

Crescent was up 11% in the quarter. Heartland was up 10%, Meridian was up 15%. And because of what I just mentioned, we're not running into capacity issues at all in those corridors. As I had also mentioned in my remarks, we, we've made the investments over a multiyear period in those corridors with speed enhancements and terminal operations, new terminals, and frankly, we're positioned for growth, and we're planning for growth.

Ken Hoexter (Managing Director)

Great. Appreciate the insight. And then, secondly, on your strong free cash flow, I guess two parts to that. One, we, I guess we saw the dividend increase. Why not more engaging on the share buyback, given your large authorization? And maybe, Marta, your thoughts on that. And then also, I think, Marta, you mentioned you're buying used locomotives. Are there any available out there, given everybody's using surge capacity? And does that mean maintenance could go up even higher, I guess, given these are the bottom of the barrel ones that are left in the market, if they're not already being on the network?

Marta Stewart (CFO)

Well, with respect to the locomotives, yes, what I mentioned was that we've reallocated within the capital budget some of the funds towards used locomotives this year, and our mechanical folks have inspected those, and luckily, we have the Juniata Shops, and they can refurbish those. And so we feel that we're in a very good position to be able to acquire those. And those are small pockets of locomotives here and there that our purchasing folks can find and our mechanical folks inspect and know that we can repair adequately at Juniata.

We already had, before this reallocation, we already had 75 new locomotives that we're buying this year. 25 have come in, and 50 will come in the back half of the year, and that's why our one of the reasons why our capital spending is back end loaded this year, because those 50 will be coming in in the last six months. So with respect to your free cash flow question, you are correct.

We're having very strong free cash flow. Wick talked about the increased dividend. We have the strong capital spending this year. We have been forecasting for the next 2 or 3 years, we're gonna have heavy capital spending as we have some freight car purchases that are gonna be timed in the next couple of years. And so we feel that the share repurchase level that we have is appropriate given the free cash flow, given the capital that we feel is needed to reinvest in the system and which has good returns. And really overlaying it all, too, is that as the entire stock market is high, and so we have, in the past, moderated our share repurchases when the stock market is high.

Ken Hoexter (Managing Director)

Thanks for the insight. Appreciate the time.

Don W. Seale (CMO)

Thanks, Ken. Appreciate the kind words, too.

Operator (participant)

Thank you. The next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.

Brandon Oglenski (Director and Senior Equity Analyst)

Well, good morning, everyone, and congrats as well. Wick, can I just ask you? I mean, we've seen several quarters now of pretty robust margin expansion, I think driven by some pretty good cost outcomes. You're getting the growth outside of coal, and I realize, you know, we still have some questions going forward in your coal markets. But I think, you know, the big issue for investors in your stock is, you know, can this company sustainably grow earnings even with a segment like coal down, let's say, in 2015, if that were the case?

Do you feel like you have the confidence that you're at a point where it doesn't necessarily matter what one commodity segment is doing on your network, you have a robust enough franchise now that you can maintain earnings momentum and margin expansion as long as, you know, the macro economy is cooperating?

Wick Moorman (CEO)

You know, I think the overall answer to that is certainly yes. We have some work to do, as we discussed extensively, in terms of continuing to improve productivity and efficiency from the levels we're currently at. We're going to do that. I think that that's going to give us the ability to continue to drive more volume through the network, in a very cost-effective manner and, give us strong operating margins, operating leverage on that growth. I think the caveat, only caveat, and you mentioned it as well, is that, we're gonna have growth. We see strength in a lot of our businesses as we've all discussed, and as Don has really kind of worked through the details with you.

I think the only question mark about coal is it's still a significant amount of our business, and I know, Brandon, you're aware, and everyone on the phone is, of how much coal revenue we have lost over the past 2-3 years. I guess in excess or at least close to $1 billion over a 2-year period. If we see stability in that market, and there are certainly lots of signs, particularly in the utility world, that we are seeing stability now, I think we're poised to do very well.

If something unforeseen comes along in the coal world or in the overall macroeconomy, then clearly, we'll have challenges, too. But given the conditions that we're seeing today, we continue to see, have a very positive outlook for, our company in the next, certainly in the second half, and I think in 2015 as well.

Brandon Oglenski (Director and Senior Equity Analyst)

Well, I appreciate that, Wick. And Don, maybe as a follow-up, I mean, beyond intermodal, because I know you talked about rate increases this summer, but are we, because of the constraints that we're seeing across the system, you know, not just at Norfolk, but it seems like some other carriers are at capacity as well on the rail side, are we moving into a higher rate of price inflation for this industry?

Don W. Seale (CMO)

Brandon, we always price, try to price to market, and we think, we think the truckload market will continue to tighten, and that will support pricing with anything that's related to truckload activity. The rest of the business, we'll just have to stay tuned and see how the market moves. We're going to stay close to that market, and we will, we will price to that and ensure that our yields meet our target of equaling or exceeding rail inflation going forward.

Wick Moorman (CEO)

Brandon, let me, and to everyone, let me say one other thing. I think that we talk about capacity in the transportation marketplace, but Don always points out that there's truckload capacity, and that's one marketplace. But, you know, we have a very different set of dynamics in utility coal, where the competition is not with the highway, it's more and more with the gas and different coal sourcing. You look at the energy markets, the competition there has a very different set of factors, which aren't necessarily all driven just by what we see in the transportation marketplace. So every marketplace that we're in is different, has different dynamics, and as Don always said, we take that into account and try to price effectively in that particular marketplace.

Brandon Oglenski (Director and Senior Equity Analyst)

Thank you.

Wick Moorman (CEO)

Thanks.

Operator (participant)

Our next question is from the line of Walter Spracklin of RBC Capital Markets. Please proceed with your question.

Walter Spracklin (Managing Director and Senior Research Analyst)

Yeah, thanks very much. Just, following up on that last question, we've heard some of your competitors up north talking about more about yield management programs, and in fact, coming up with tight capacity in the rail system, where in fact, looking at kind of pruning some of the lower returned customers. Is that something that you foresee that perhaps without really rate increases per se, but rather reallocating capacity to higher returning customers, is that something that is new to your organization? Is it, is it an opportunity that is emerging for Norfolk Southern, and is it something that you see playing out in the next, next year or two?

Don W. Seale (CMO)

Good morning, Walter. This is Don. We plan to continue to improve our service product to serve all of our customers. We do not have plans to segment business that would deviate from that overall objective. So I would say that our commitment to our customers are, is very strong, and that's to provide a good, reliable service at a fair price.

Walter Spracklin (Managing Director and Senior Research Analyst)

Okay, and second question here. I guess, Wick, you mentioned in your opening remarks that, the first or the second quarter, saw some volume that perhaps unsustainable for the rest of the year, and I think a lot of the questions today were zeroing in on the fact that, you know, you typically do better in the third quarter than you do in the second. You had a very good quarter this second quarter.

So I guess what I'm trying to understand is, was there any carryover volume from first quarter to second quarter that really helped you drive some good operating productivity that probably won't carry into third, as Mark indicated, with some of the higher headcount? Or is there the incremental margin here that you're getting on this volume steady through third quarter, mean that the seasonal pattern of you doing better in the third quarter than the second quarter can hold again here again this year?

Wick Moorman (CEO)

Well, first of all, in terms of first quarter carryover, we've looked really hard at that question, and quite frankly, we, as the second quarter went on, we became more and more convinced that there was very little of that. There has been some pent-up demand in the automotive network with vehicles stored at assembly plants because of the slowdown of the North American rail network and the car supply problems for the automotive industry. We've had a big push on in the past 3 or 4 weeks, and Mark and his team have done a great job on our network of bringing those numbers down significantly.

I think the tenor of my remarks to begin with is that, we certainly didn't forecast an 8% year-over-year volume growth, and we saw a lot of strength across a lot of businesses. We continued to see that strength. I was just, I guess, trying to temper my own enthusiasm and say, I'm not sure we're going to see the third quarter up 8% year-over-year or the fourth quarter. We had a good second half last year, but we do expect to see continuing strength in these businesses.

Walter Spracklin (Managing Director and Senior Research Analyst)

Okay. Well, it was very, very much a good quarter. Congratulations. Thank you.

Wick Moorman (CEO)

Thank you so much.

Operator (participant)

Our next question comes from the line of Justin Long of Stephens. Please proceed with your question.

Justin Long (Managing Director of Equity Research)

Thanks, and congrats on the quarter. I wanted to first follow up on an earlier question in Intermodal. So Intermodal growth has really started to accelerate. I was wondering if you could just talk a little bit more about how much runway you still have to add to train lengths. How long can the high single digit or low double digit Intermodal volume growth continue without adding an additional train starts?

Don W. Seale (CMO)

Mark, do you want to-

Mark Manion (COO)

Yeah, I'll let me just lead off with a comment about that, Don. Our Intermodal train length is in the neighborhood of 6,000 feet. And so when we look at our high-density corridors, as far as where we handle Intermodal, we can handle significantly more than 6,000 feet, 8,000 at a minimum, and in a lot of cases, we run over 10,000 feet. So there's still a lot of room to grow in that area.

Don W. Seale (CMO)

Yeah.

Justin Long (Managing Director of Equity Research)

Okay, great. That's, that's helpful. As a follow-up, I was wondering, in coal, do you have any major contracts in that business that are coming up for renewal over the next couple of quarters or so?

Don W. Seale (CMO)

Justin, I will tell you that we have some opportunities that will be coming over the next three-to-three quarters, and we're optimistic that those opportunities will bear fruit, but we're not there yet.

Justin Long (Managing Director of Equity Research)

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

Don W. Seale (CMO)

Thank you.

Operator (participant)

Thank you. Our next question comes from the line of John Larkin with Stifel. Please proceed with your question.

John G. Larkin (Managing Director od Research)

Hey, good morning, and thank you for taking the question. Mark, I think you mentioned that you were planning on adding roughly 900 new folks throughout the remainder of 2014 to bring the manpower level up to roughly where it was in 2013. Are all those people coming off furlough? Do they need complete training, partial training? How long does it take to bring them up to speed, and how expensive is that process?

Don W. Seale (CMO)

Earlier this year, we began bringing people out of furlough. We were pretty successful in getting more people than usual to actually make some transfers from the location they were furloughed to other locations where they were needed. That process is complete, and going forward, the additional people we bring on are new hires that go through our training program, and we will see, we'll essentially see the first of those people coming out qualified in the fourth quarter.

John G. Larkin (Managing Director od Research)

Okay, thank you. Perhaps another question on the reallocation that occurred in the capital budget, maybe for Marta. It sounded as if some money was reallocated towards the purchase of used locomotives that could be remanufactured at Juniata, and there were some bottleneck elimination projects perhaps in there as well. What projects did you draw that capital from, and what was the thought process behind perhaps paring back the spending in that area?

Marta Stewart (CFO)

Well, some of those areas were naturally delayed, frankly, because of the weather in the first quarter. Our engineering forces were busy with the weather, and so there was a little bit of when you schedule out their work for the rest of the year, a little bit of over, flopped over into 2015. So some of it occurred naturally, both in engineering and some of it also in the mechanical area.

There were some car work that is gonna flop over into 2015. So the total amount that we reallocated is about $40 million, about two-thirds of it to used locomotives and about a third of it to very targeted, very specific locations that came out of that model Mark described, about very small pinch points. The remainder of that is spread throughout the system in different places with sidings and that sort of thing.

John G. Larkin (Managing Director od Research)

Very good. Thank you again.

Marta Stewart (CFO)

You're welcome.

Don W. Seale (CMO)

Thanks, John.

Operator (participant)

Our next question is from the line of Rob Salmon of Deutsche Bank. Please proceed with your question.

Rob Salmon (VP and Associate Analyst)

Hey, good morning. Thanks for taking my question. Tom, when I'm thinking about the intermodal pricing opportunity, you had highlighted the 17%. If I'm thinking about that remaining 83%, I know you said basically over a full year, the majority of that kind of comes up, whether it's a rebid or it's just an escalator embedded in the contract. Can you give us a sense what percentage is going to be repricing in the back half of this year with a new contract as opposed to an escalator?

Don W. Seale (CMO)

Rob, I will tell you that the EMP fleet, the rail-owned or rail-controlled containers that I referenced with respect to the increases we're taking locally and westbound, that will be most of the increases we're taking in intermodal for the second half, unless we're taking an increase in an existing contract with an escalator that triggers quarterly or triggers annually within the second quarter.

Rob Salmon (VP and Associate Analyst)

Okay, all right, that's helpful. And then with regard to the ag outlook, I think your words were either strong or robust in terms of the back half of the year. How should we be thinking about that in terms of the, you know, third quarter, fourth quarter? Because I realize there are puts and takes with your network.

Don W. Seale (CMO)

Yeah, with respect to the third quarter, we'll see the new crops start to come in late August, early September. So we'll be into that time frame before you see it. We still see a lot of volume activity associated with the 2013 crop, which was strong as well. So we see opportunities ahead in corn and soybeans, predominantly with this new crop. There's over 90 million acres of corn planted and over 80 million acres of soybeans planted, and growing conditions are very good because they're getting the proper rainfall. So we expect export activity to be there and some other domestic opportunities as well.

Rob Salmon (VP and Associate Analyst)

We should think about that rippling through your, your ethanol franchise as well, I would imagine.

Don W. Seale (CMO)

Well, the ethanol production, ethanol prices and ethanol demand continues to trend upwards. So we see opportunity ahead for greater activity in ethanol and inbound corn for processing to make the ethanol.

Rob Salmon (VP and Associate Analyst)

Thanks so much for the time.

Don W. Seale (CMO)

You're welcome.

Operator (participant)

The next question is from the line of Keith Schoonmaker of Morningstar. Please proceed with your question.

Keith Schoonmaker (Director of Industrial Equity Research)

Thanks. Good morning. If I'm reading the data correctly, it appears you improved RTM per fuel gallon pretty nicely over the prior year period, almost 5%. As we think about the sustainability of the quarter's low operating ratio and the importance of fuel in the cost structure, maybe you could comment, is this an idiosyncratic period as far as fuel economy, or is this just another data point on the overall improvement trend line?

Wick Moorman (CEO)

I think, the way we would look at it, and the way we do look at it, is that, it is, just a data point on a trend line. But it's trend line that we expect to continue to get better over time. We have a lot of technology out there that we're employing to reduce fuel usage. That's ramping up nicely. We still have a ways to go with that, the LEADER technology, but it's employed across more and more of the railroad. And our goal is to drive, on an average, the fuel usage per ton mile down.

We're always going to see seasonal variations. We certainly saw that in the first quarter, particularly with the very cold weather. You have to leave diesel locomotives idling, you run shorter trains, and you do a lot of things. But we think it's obviously this quarter is a good productivity improvement, and we expect overall to see our fuel usage go down in the future as our technology gets better and better.

Keith Schoonmaker (Director of Industrial Equity Research)

Thanks. And for a second question, I'd like to ask a little bit about the intermodal volume increase. I know it's a phenomenon that probably occurred later in the quarter, but could you comment on what portion of the volume increase you believe resulted from customers concerned with West Coast disruption risk? And sort of related to that, does the summer's intermodal volume trend give any insight into your expectations concerning volume that may result from the completion of the Panama Canal project? Thanks.

Don W. Seale (CMO)

We have difficulty identifying the portion of the 16% increase in international that was directly attributable to the ILWU contract negotiation. We know it was present. We've been told by customers that they were making some secondary arrangements or contingency plans. So part of our increase, of that 16%, we know came from that. But frankly, we've also been seeing an ongoing trend of conversion of international shipments in our network from the West Coast ports to East Coast ports of entry with all water services, so we know that's a part of it. Plus, I have to remind you, too, that the inland port that we opened in partnership with the Port of Charleston had a very good quarter. That's in that higher number. Plus, we had a couple of new accounts in that quarter as well. It's a combination of all of those things.

Keith Schoonmaker (Director of Industrial Equity Research)

Okay, any insight in Panama yet, or too early?

Wick Moorman (CEO)

You know, on the Panama Canal, our view, and of course, our view is going to be basically predicated by what our customers decide to do, and our customers are the steamship lines and the beneficial cargo owners that are working with the steamship lines. But they're telling us that they don't see, at this point in time, a pronounced impact when the canal opens, most likely now in 2016, because of so much activity that's already beginning to take place through the Suez Canal, with larger vessels coming to the East Coast ports, and as the freight originations in Asia continue to shift away from China and go southward toward Malaysia and Vietnam, et cetera.

So we're being told at this point not to expect a significant shift in business when the canal opens. We just have to wait and see. Of course, we're staying close to our customers who will make the ultimate decision of how they want to move their cargoes.

Keith Schoonmaker (Director of Industrial Equity Research)

Great. Thank you for the comments.

Operator (participant)

Our next question is from the line of Jeff Kaufman of Buckingham Research. Please proceed with your question.

Jeff Kauffman (Graduate Research Analyst)

Thank you very much, and thank you for taking my question. Congratulations. I mean, the quarter looked fantastic.

Wick Moorman (CEO)

Thank you.

Jeff Kauffman (Graduate Research Analyst)

Marta, I want to come back to the question Ken Hoexter asked on cash flow. I heard what you said. You have the debt coming up in September. I think it's about $430 million, give or take. I guess the question I have is, your cash balances are up almost $1 billion from where they were a year ago. Working capital, the whole increase has been cash. I hear you that the stock's up a lot with the market, but is there a better use, ultimately, to or a reason to have $1 billion, $5 billion, $6 billion of cash sitting on the books?

Marta Stewart (CFO)

Well, we don't believe we do have that now, you are correct, but we don't believe we're going to end the year at that. As you have pointed out, we have that $430 million debt maturity in September, and we now currently plan to pay that off. So that's going to be a use of the cash. And also, as I explained earlier, we have higher CapEx in the second half of the year, so we do not expect to end the year at this high of a cash level.

Jeff Kauffman (Graduate Research Analyst)

Okay, but even with all that, it still looks like you're going to finish close to $1 billion, $2 billion, $3 billion. I mean, that is above the normal amount of cash you hold. Is there like a 2015 project that you're thinking about?

Marta Stewart (CFO)

Well, you are correct that that's above what our historical norm, where we run cash. 2015 will have the heavy CapEx. We also hope that it's going to have the very strong free cash flow, which will support that. And so I think what we're trying to do is just maintain our discipline, keep an eye on the market, and be ready to, you know, take advantage of any volatility that that arises.

Jeff Kauffman (Graduate Research Analyst)

Okay, well said. Thank you very much.

Wick Moorman (CEO)

Thank you, Jeff.

Operator (participant)

Our next question is from the line of Don Broughton of Avondale Partners. Please proceed with your question.

Donald Broughton (Managing Director and Chief Market Strategist)

Well, thank you for taking my question. I just want to kind of strategically get your outlook on this. Both you and CSX have certainly seen strong demand, at least in your system. In the short term, you've proven to be much more resilient than they have. After reporting a multi-quarter performance that we had high volumes, lower headcount, I'm hearing a prediction of higher overtime in the second half, but you also had strong safety performance. So when you're looking at this, do you look at, is this an opportunity to leverage, further leverage your assets and infrastructure with existing headcount or just slightly higher? Or do you think there's a greater opportunity in just materially growing headcount and using the service disparity to gain real volume, real market share?

Wick Moorman (CEO)

Well, I, Don, that's an excellent question. The one correction or clarification I'd make is what I think we expect in terms of overtime is just to see overtime rates year-over-year, certainly in the third quarter dollars, continue to be higher. But that I will also point out is in contrast to in 2012 and 2013, we drove overtime way down compared to prior years. So, we think we have the capability, and we'll do that again.

I think it goes back to what Don talked about, is that we have done a lot of analysis across our railroad, which has really proved to us that maintaining a high network velocity, albeit it may take more resources in some way, it's certainly going to require some more crews, as Mark pointed out, ultimately gives us a lower cost structure, total cost structure and a more efficient operation. And in addition, it gives customers the service that we want to give them. So when we see our network running at the levels that it is today, we know it's still efficient, and you've seen the numbers. And we think that, you know, we need to still bring on the resources, drive the velocity up, give the customers that service.

That's going to give Don and his folks more ability to go out and get more business. It's going to allow them to go out and charge fair prices in the marketplace for that, and it's going to give us a better cost structure. And Mark reminds me that, you know, we said at the beginning of the year that we had a number of productivity improvements underway, and that we estimated at the time that that would take about $100 million out of our cost structure, and we still think we're going to achieve that number this year. So we think we've got a good strategy, but it's a service and velocity-based strategy, and it's paid off for us in the past, and it'll continue to pay off for us.

Donald Broughton (Managing Director and Chief Market Strategist)

So your comments about overtime are really more of a reflex back towards what's more normal after making the kind of significant productivity and velocity gains you've posted recently, is what you're trying to say?

Wick Moorman (CEO)

Yeah, go ahead, Mark.

Donald Broughton (Managing Director and Chief Market Strategist)

If I hear you right.

Marta Stewart (CFO)

The overtime that we think we're going to have for the rest of the year is very targeted where we think it's going to occur. So let's split it into the two pieces.

Donald Broughton (Managing Director and Chief Market Strategist)

Right.

Marta Stewart (CFO)

On the T&E side, which is about half of it, we think because of the need to train these people, as one of the other people asked about, those are not going to be qualified until the fourth quarter, many of those new people. And so we don't expect the T&E overtime to decline until the fourth quarter, but we do expect it to decline. On the other side is our shop employees, generally speaking, and most of that has been incurred on the taking care of the older and now the used locomotives. So on that side, we are not projecting to significantly ramp up the number of employees because that is more of a shorter term in nature.

Donald Broughton (Managing Director and Chief Market Strategist)

Temporary.

Marta Stewart (CFO)

Exactly.

Donald Broughton (Managing Director and Chief Market Strategist)

Yeah, that makes much more sense. Thank you.

Marta Stewart (CFO)

So that portion of the workforce will stay most on overtime, but the T&E will work itself back to straight time as the people get qualified.

Donald Broughton (Managing Director and Chief Market Strategist)

Thank you, and, I look forward to seeing you next week.

Wick Moorman (CEO)

Thank you. Look forward to it.

Operator (participant)

Our next question is from the line of David Vernon of Bernstein Investment Research. Please just give your question.

David Vernon (Managing Director and Senior Analyst)

Hi, thanks for taking the question. Marta, just to kind of step back from the short term use of cash and think more about the longer term, you mentioned a step up in equipment car replacement. Is that something that you think could push the capital spending above that 18%-19% of sales that we've been seeing in the last couple of years?

Marta Stewart (CFO)

Yeah, for that, that 18%-19% of revenue is an elevated level for us. I think we've signaled in the last, in, within the last year, that we think we're going to stay at that elevated level for at least two more years, largely because of the car replacement needs and longer term. And of course, PTC is in that, too, is elevating that, too. So right now, trailing twelve months, we're at our 2.2 is at 19%. 2% of that is PTC. So when you back that out and get to 17%, and when you get past the next two years, we are targeting after that to get back more in the historical range of 16%-17% of revenue.

David Vernon (Managing Director and Senior Analyst)

Given Wick's comments around PTC, maybe extending into 2020, would that 2% kind of continue to linger, or is this going to be more front-end loaded?

Marta Stewart (CFO)

Yeah, that, that we'll have to see how that plays out.

David Vernon (Managing Director and Senior Analyst)

All right, thanks. And then maybe just as a quick follow-up on intermodal, Don, you mentioned the escalators that are in the contracts. Would you have expected them to maybe deliver it a little bit more on the wholesale contracts from a pricing perspective, given the spike in truck rates? Or can you talk a little bit about how that lag or mechanism should work so that we can try to gauge the opportunity going forward?

Don W. Seale (CMO)

The escalators in our intermodal contracts would be more, correlated to the Rail Cost Adjustment Factors, all inclusive, less fuel, which is an independent factor from motor carrier cost. So those escalators are not tied to truckload pricing in general.

David Vernon (Managing Director and Senior Analyst)

So you haven't tied the intermodal pricing to your wholesaler or to your retailers to the truck rate?

Don W. Seale (CMO)

No, we do not in general.

David Vernon (Managing Director and Senior Analyst)

All right. Thanks. That's my, that's my follow-up. Appreciate the time.

Don W. Seale (CMO)

Thank you.

Wick Moorman (CEO)

Thanks.

Operator (participant)

Thank you. Our final question is coming from the line of Cleo Zagrean of Macquarie. Please proceed with your question.

Cleo Zagrean (Senior Analyst)

Good morning, and thank you. In the opening remarks, you mentioned that you're looking to price equal or above rail inflation. Can you help us understand how you think about pricing a portfolio, how managed portfolio on pricing versus margins? Are these areas where you're only able to price in line with inflation, benefiting from more slack capacity, such that margins and returns across the portfolio are even? Would appreciate any insight into that.

Wick Moorman (CEO)

Cleo, good morning. You know, with, with respect to our pricing philosophy, again, we look at the market segments, and we try to maintain a direct correlation with our yield management plan and the various market segments that we're participating in. And that runs the range of, conditions from truckload capacity to barge capacity, conditions in barges, the availability of barges to a lesser degree than truckload, and then rail-to-rail competition. And, and then, of course, we always have an ongoing, change in the mix of our business.

So when you're looking at revenue per unit of our, of our book, it will be an ongoing change in that book based on things like, the longer haul of coal that's taking place today in utility coal. The fact that, for example, in this quarter, we had no liquidated damages on coal, so the revenue of coal has no LDs in that. So, does that get at the essence of your question?

Cleo Zagrean (Senior Analyst)

Yes, I was trying to make sure that we keep our eyes on the right metric in terms of the bottom line and do not get overly concerned if some mixed issues at the top line could point to a deterioration. Is there any reason of concern to you that in some pockets you're only pricing in line with inflation versus, say, maybe other roads are trying to price consistently above?

Wick Moorman (CEO)

No, you're making a very good point, and we look at the overall margin and incremental margin of the business, the book, taking into account the price and mix, and we're not - we don't become concerned with mix changes. They are what they are, and we manage through that, and that doesn't impact or alter the yield management or pricing plan.

Cleo Zagrean (Senior Analyst)

Thank you. My follow-up is also in regards to a comment you made, in the opening remarks, that, from the experience so far this year, you have learned, about new ways to adjust your resources to respond to changes in demand. Can you help us understand whether some of the changes that you are making, should help with the long-term progression in margins once we're out of this congestion? Any benefit, a sustainable benefit from, the changes in the network and investments that you are making, spurred by this experience, that maybe would list your long-term efficiency goals or bring them, sooner? Thank you.

Wick Moorman (CEO)

You know, we obviously, anytime we not only experience a high volume growth quarter like this one, but certainly the quarter, like the first quarter, with the network disruptions across the North American rail network that we've seen, we try to go back and see what learnings we can take from them. I think to Mark's point about, you know, we have to think again about our train and engine service resources and how we are able to respond to unanticipated growth. We're gonna go back and, I think, learn some lessons from that.

I think what you will see as a result is that over some period of time, we will become more efficient, because when we see something like the situation we've had in the second quarter, we'll be able to react more effectively to it, and hopefully not lose network velocity or see increased overtime because we'll have responded with the resources in a more flexible way. There's a lot of learning to be had out of all of these experiences, and we're always looking at what has happened and trying to improve ourselves as a result.

Cleo Zagrean (Senior Analyst)

Thank you very much.

Wick Moorman (CEO)

Thank you.

Operator (participant)

Thank you. At this time, I will turn the floor back to Wick Moorman for closing comments.

Wick Moorman (CEO)

Well, thank you, everyone, for your patience, and your questions, and we look forward to talking to you all again at the end of the third quarter.

Operator (participant)

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