Norfolk Southern - Q3 2014

Transcript

Operator (participant)

...Greetings, and welcome to the Norfolk Southern Corporation third quarter 2014 earnings conference 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 from your telephone keypad. As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Katie Cook, Director of Investor Relations. Thank you, Ms. Cook. You may now begin.

Katie Cook (Director of Investor Relations)

Thank you, Rob, and good morning. Before we begin today's call, I would like to mention a few items. First, the slides of the presenters are available on our website at norfolksouthern.com in the Investors section. Additionally, transcripts and downloads of today's call will be posted on our website. Please be advised that during this call, we may make certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties, and our actual results may differ materially from those projected. Please refer to our annual and quarterly reports filed with the SEC for a full discussion 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 (Chairman and CEO)

Thank you, Katie, and good morning, everyone. It is my pleasure to welcome you to our third 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'm pleased to report that Norfolk Southern achieved another very good quarter as third quarter financial results set records across the board. Earnings for the quarter were $1.79 per share, up 17% compared with the $1.53 we earned during third quarter last year. These strong results reflect continued high demand in most of our business groups, as overall volumes increased 8%, driven by double-digit increases in merchandise and intermodal, offset by a slight decline in coal.

For the second consecutive quarter, revenue topped $3 billion, up $199 million, or 7% versus last year. Don will fill you in on the revenue and volume details in a few minutes. Similar to our second quarter results, our expenses were up only 3%, and our resulting 67.0 operating ratio set a third quarter record. Now, while our financial results were very strong, much like in the second quarter, the railroad's velocity and operating metrics were considerably reduced year-over-year as we continued to be challenged by demand in excess of our forecast for the year. This was particularly significant in terms of our crew base, which was sized for lower volumes.

As all of you know, it takes from 7-9 months to hire and qualify new transportation employees, and we are just now starting to see newly qualified conductors marking up in our critical areas. We continue to actively hire and have taken steps to accelerate our training cycle. In addition, we've temporarily transferred over 100 train and engine service personnel to our busy Dearborn Division from other parts of the network. We have other special initiatives in place as well to help increase crew availability, and we have a number of important infrastructure projects and new locomotives coming online in the fourth quarter as well. Mark will go over our service metrics and our initiatives for improvement in more detail with you.

While we have demonstrated our ability to successfully manage overall expenses, the network slowdown and recovery efforts have translated to some additional operating costs, and Marta will go over all of them, as well as the rest of the financials. In spite of these operating challenges, we are excited about delivering another quarter of record results, and we remain optimistic about our prospects going forward. And on that note, I'll turn the program over to Don, then Mark, and then finally Marta, and then I'll return with some closing comments before we take your questions. Don?

Don Seale (CMO)

Thanks, Wick, and good morning, everyone. As Wick stated, we're pleased to report that the third quarter of 2014 was our second consecutive $3 billion quarter, with record revenues in both our merchandise and intermodal sectors, which were partially offset by a weaker coal market. Revenue growth of $199 million, up 7% versus third quarter of last year, was generated by our merchandise business, which generated $152 million, up 10%, followed by intermodal, which was up $62 million, or 10% over last year. In coal, weak global market conditions in the export sector and milder summer weather, which impacted coal demand, resulted in a decline of $15 million, or 2% compared to third quarter of last year. Volume increases in intermodal and merchandise accounted for $219 million of revenue variance in the quarter.

Also, positive year-over-year fuel surcharge revenue partially offset the negative mix effects associated with higher intermodal volumes and lower coal shipments. Accordingly, total RPU was down 1% in the quarter as a result of this negative mix effect between and within our business groups, which I'll discuss in more detail as I review each of the major business groups.... Now turning to the components of growth. Total volume increased 8% due to 10% gains in merchandise and intermodal shipments, which offset a 2% decline in coal. Across our merchandise business, very strong performance was led by increased chemicals, automotive, and metals and construction volumes. In intermodal, for the first time, shipments exceeded 1 million units in the quarter, a gain of almost 92,000 units, up 10% compared with third quarter 2013, with strength in both domestic and international markets.

In coal, volume declined by 2% as export shipments weakened due to continued global oversupply and sluggish demand. Now moving to our individual market segments, starting with coal. Coal revenue was down $15 million or 2% compared to third quarter last year. Coal revenue per unit was flat in the quarter as declines in higher-yielding export traffic offset the positive effects of increased longer-haul traffic to our southern utilities. With respect to utility coal, overall volumes declined by 3% as a result of milder summer temperatures, with July in particular, posting the lowest average temperature since 2009. Lower natural gas prices also impacted coal burn during the quarter. This factor, along with a competitive contract loss, resulted in a 14% decline in shipments to our northern utility plants, while volume to southern plants was up 9%.

In the export market, third quarter volumes were down 16%, as excess global supply and lower commodity pricing continued to impact the seaborne coal market, causing declines in both metallurgical and thermal coal volumes at our Lamberts Point terminal. Within our domestic metallurgical markets, volumes were up 8%, led by gains in coke shipments to the steel industry, which more than offset weaker domestic met coal volumes. And finally, industrial coal volumes increased by 32% due to new business and organic growth with industrial customers as the economy continues to improve. Turning to intermodal. Intermodal revenue in the quarter increased by $62 million or 10% to $667 million, which is a new quarterly record.

With respect to revenue per unit, positive pricing activity within the domestic intermodal segment was offset by higher volumes of lower revenue per unit international freight, leading to overall flat yield per shipment. Domestic intermodal volume was up 8%, driven by targeted highway conversions across all business segments, as well as organic growth with large key accounts across our domestic book of business. On the international side, strong volume growth of 15% was generated through organic growth with our existing shipping partners, new contract business, and from new terminal growth. Moving to our merchandise markets, these five carload business groups also set a new quarterly record with $1.7 billion in revenue, an increase of $152 million or 10% versus third quarter of 2013.

Our merchandise markets also faced negative mix effects as strong volume growth within our metals, construction, and bi-level automotive segments offset gains in higher revenue per unit, agricultural and chemical commodities. As a result, overall merchandise RPU declined by $7 and was flat for the quarter. With respect to volumes, growth was led by strong increases in crude by rail and natural gas liquids, which increased our chemicals volume by 17%. Automotive volumes were up 12% versus last year, propelled by significant increases as we took advantage of the auto manufacturer summer shutdown period in July to reduce finished vehicle inventory backlogs that were a result of national rail car supply issues incurred earlier in the year.

Growth in frac sand, aggregates, and steel increased our metals and construction carloads by a strong 12%, and the excellent 2013 corn crop continued to provide growth opportunities in our agricultural market, helping to generate a volume gain of 6% in the quarter. Finally, paper and forest products volumes were flat in the quarter, with double-digit gains in lumber, offsetting declines in pulp and clay and waste shipments. Now, I'll conclude with our business outlook. We see continued opportunity ahead to generate solid growth across most of our business units. The exception is coal. So far this year, our utility coal shipments have been higher than expected due to elevated natural gas prices and the need to replenish stockpiles. But the impact of milder weather and lower natural gas prices are now reversing some of that positive trend.

On the plus side, we estimate that stockpiles at our utilities remain 19% below December 2013 levels going into the winter heating season. So the wild card is what kind of winter demand lies ahead. In our met and thermal export markets, we continue to see global oversupply and low commodity pricing, and the weaker Australian dollar, which has declined another 6% since September 1st, is making Australian coal even more competitive in the global marketplace. Turning to intermodal, tightening capacity and rising costs in the trucking industry will drive continued volume growth in our domestic markets as we take advantage of opportunities for highway conversion and yield improvement.

We expect continued growth in our international intermodal business through organic growth and new services. In our merchandise markets, we anticipate continued opportunities in crude oil and natural gas-related products, as well as drilling materials such as frac sand and pipe. We also anticipate higher steel volumes to support the energy and automotive sectors, while housing expansion will help boost volumes in aggregates, lumber, and construction materials. In the automotive sector, volumes are expected to move higher, with increased vehicle production and with new models coming online at several Norfolk Southern-served assembly plants. Last, in our agricultural markets, expectations for another record corn and soybean harvest in 2014 will lead to domestic growth as well as potential export opportunities in the months ahead.

Now, let me summarize: We expect revenue and volume growth in our intermodal and merchandise markets, while we continue to face challenging and uncertain conditions in the coal sector. As we move forward, we remain keenly focused on improving service to meet the expectations of our customers and to support our ability to price the market at levels that equal or exceed rail inflation. In turn, we will continue to invest in equipment, locomotives, and our network to provide better service today and in the future for our customers. Thanks for your attention, and I'll now turn it over to Mark for our operating report. Mark?

Mark Manion (COO)

Thank you, Don. Third quarter operations were heavily impacted by very positive traffic growth. While we continue to target overall operating efficiency, network velocity and service performance have slipped. Initiatives to balance and effectively apply resources to those segments of the network that are seeing the most growth are stabilizing the operation, and customers should start to notice improvements in service and service consistency during the fourth quarter. More importantly, these efforts will position us for further growth going into 2015. On Slide 2, our 9-month injury ratio stands at 1.18, down slightly when compared to last year. But we've been seeing improving trends continuing into the third quarter, which had an injury ratio of 1.09.

Train incidents for the first nine months are flat compared to the full year in 2013, at 2.4 per million train miles. Crossing accidents increased to 4.0 per million train miles for the first nine months, compared to 3.6 for the full year 2013. As I noted on my opening slide, service levels have been impacted by volume increases and particularly traffic increases across the corridor from Chicago to Philadelphia. Consequently, as you see on Slide 3, our composite service performance dropped to 68.6% in the third quarter, well below customer expectations and the record service level of 2013. Moving to Slide 4, as you would expect, train speed and terminal dwell data show the same trend as the service composite, reflecting slower network velocity.

Train speed averaged 20.9 miles per hour in the third quarter, and terminal dwell was 24.7 hours. Both were impacted by volume, as we've discussed, but there were also a number of track work and PTC projects across parts of the Northern Region. These will be completed ahead of seasonal peaks in grain and intermodal. We have, and we will continue to take additional steps that will bring measurable improvements to network velocity and service delivery. Some of these initiatives are outlined on Slide 5. Aligning and positioning T&E forces with volume growth is our immediate focus. To address crew availability in the short term, we've offered various temporary incentives to our current T&E employees. 114 conductors and engineers agreed to transfer temporarily from various parts of the network to locations on the Northern Region, where volume growth has outpaced crew availability.

In addition, over 680 employees participated in a vacation buyback program, and we've also offered incentives to T&E employees who were eligible to retire but defer retirement until 2015. As discussed in my remarks regarding second quarter operating results, we stepped up hiring and training in order to bring T&E forces in line with expected volumes. Currently, we have 1,453 new T&E employees in various stages of the hiring, training, and qualification process. In the third quarter, 206 new conductors were qualified, and most of those were placed in the high traffic growth areas along the Chicago to Philadelphia corridor. In the fourth quarter, we expect that 596 will be qualified. At the beginning of this year, we had 11,290 T&E employees in active or training status.

By the end of this year, that number is expected to increase to 12,006, which is a net increase of 716 T&E employees this year. Several new infrastructure projects in the Chicago area and Upper Midwest have or shortly will be completed, adding more capacity and more flexibility in our operations in and around the Chicago area. Perhaps the most important of these is the expansion of the terminal in Bellevue, Ohio. This project, which nearly doubles the capacity of the terminal, will wrap up in December. We will then begin a phased-in operating plan with full operations at Bellevue online during the first quarter of 2015. In addition to more capacity, the Bellevue expansion will give us much more flexibility in routing of trains to and from Chicago and more bypass options during periods of bad weather.

Now, while Bellevue is the largest infrastructure project, other infrastructure projects are certainly worthy of noting. The Englewood Flyover at Chicago, completed just this month, separates NS operations from Metra trains through Chicago and has significantly improved fluidity of our operation there. The new Fifty-First Street connection near our intermodal facility in Chicago will be completed early next year. When completed, the new connection will improve train operations and reduce time and handling for trains moving in and out of that facility. Our new connection at Goshen, Indiana, will also be completed after the first of the year. It provides a direct link from our terminal at Elkhart to the Marion, Ohio, branch for more fluid operations and greater flexibility of operations around one of the largest terminals. And six new receiving tracks at our Conway terminal in Pittsburgh will be in service by the end of the year.

This new capacity will improve service in this rapidly growing corridor that includes new crude-by-rail volume. Finally, in terms of locomotives, we'll be taking delivery of 50 new EMDs SD70AC units beginning this month. In addition, we recently reached an agreement to purchase 100 SD90MAC units and started taking delivery of those units in September. We expect to take delivery of 40 of these units by the end of the year. With these, the number of units available for service has reached historic highs in line with historically high volumes. Together with aligning our T&E forces for expected demand, these projects for additional capacity and growth in our locomotive fleet gave us a very strong position moving into the fourth quarter in 2015. Moving to the next slide.

With volume increase of 8% in the third quarter, crew starts, including recrews, increased by 2%. This margin of difference is due in part to improving operating efficiencies, but also reflects efforts to conserve available crews through train combinations and train annulments. We would still see very positive margin, even with a more robust crew base. Our current crew base continues to be stretched, which is reflected in higher overtime hours, up 32% for the third quarter, compared with the same period last year. With hiring and other steps I've outlined, network velocity is expected to improve as we move into the fourth quarter, and we expect to see that reflected in further improvements in operating efficiencies, particularly reductions in overtime. That trend should continue into 2015, when we expect that our crew base will be fully aligned with expected volumes.

A 1% improvement in car loads per locomotive reflects our ability to absorb higher volume with existing train operation. 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. Now, Marta, I'll turn it over to you.

Marta Stewart (CFO)

All right. Thank you, Mark, and good morning, everyone. Let's get started with a summary of our operating results on slide 2. Revenues exceeded $3 billion, up $199 million or 7%, driven, as Don mentioned, by double-digit volume gains in intermodal and merchandise. Operating expenses increased only $50 million, or 3%, resulting in a third quarter record operating ratio of 67. Slide 3 shows the major components of the $50 million net increase in railway operating expenses, which you'll note, were almost entirely concentrated in the materials and other category. Now, let's take a closer look at each expense category, beginning with materials and other on slide 4. This line item increased by $45 million or 23%. As in the second quarter, the largest reason was significantly higher usage of locomotive materials, which was up almost $20 million.

As Mark discussed, we have all our surge fleet locomotives deployed, and total units in service are near historical highs. Also contributing to the rise in this category were higher casualty claims accruals and higher loss and damage costs. The relative increase in claims accruals was a result of favorable adjustments last year. The increased lading damage costs were due to two derailments during this quarter, which damaged finished vehicles and totaled $10 million. For the fourth quarter, we continue to expect a high rate of locomotive material usage, and we also face an unfavorable comparison in casualty claims accruals relative to last year. Turning to slide 5, purchased services and rents were up $9 million, or 2%, largely due to higher volume-related activities, particularly in the areas of intermodal ops, equipment rents, and joint facilities.

Next, depreciation expense for the quarter rose by $6 million, or 3%, reflective of our larger capital base. We expect a similar increase in the fourth quarter. As shown on Slide 7, fuel expense decreased by a net of $3 million, or 1%. The 2014 third quarter average diesel fuel price of $2.96 per gallon was the first sub-$3 quarterly average in more than three years. This lower price accounted for a $21 million reduction, while higher consumption increased fuel expense by $16 million. As Mark noted, this is only a 4% consumption increase on an 8% rise in traffic. Slide 8 details the $7 million, or 1% decline in compensation and benefit costs.

As discussed in prior quarters, continued favorability in post-retirement medical and pension accruals, coupled with slightly lower health and welfare costs, resulted in a $44 million reduction in expenses. Partly offsetting this decline were increased pay rates of $16 million, higher incentive compensation of $12 million, and $10 million more in overtime. With the exception of incentive comp, we expect these variances to continue at similar levels in the fourth quarter. Turning to our non-operating items, other income net was up $2 million on higher property sales, and interest expense on debt was up $7 million related to last year's debt issuance. Slide 10 depicts our income tax accruals and the effective rates. Total taxes were $333 million, up $67 million, largely due to higher pre-tax earnings.

The effective tax rate was 37.3%, compared to 35.6% last year, which had the benefits from a state tax decrease and tax credits. Slide 11 displays our net income and EPS comparisons, which were both third quarter records. Net income of $559 million was up $77 million or 16%, and diluted earnings per share was $1.79, up 26 cents or 17%. Wrapping up our financial overview on Slide 12, cash from operations for the first nine months totaled $2.3 billion, covering capital spending and producing nearly $1 billion in free cash flow. We distributed $511 million in dividends and $166 million in share repurchases. Thank you, and I'll now turn the program back to Wick.

Wick Moorman (Chairman and CEO)

Thank you, Marta. Well, as you've heard, it was another very good quarter for Norfolk Southern. However, as good as these results are, it's clear that they could have been even better if we had been able to achieve the network velocities in line with our performance for the prior two years. Not only did these operating issues have an impact on our financial performance, more importantly, they kept us from delivering transportation services to our customers at the level that they have come to expect from our company. For that reason, we're very focused on getting back to the service metrics that we posted in the prior two years as quickly as we can, and then improving further from there.

Mark outlined some of the steps that we're taking, and while it will take a little time to reach our 2012, 2013 velocities, we're very confident that we're on the right path and that the infrastructure and resources that we are adding will set the stage for us to grow volumes and provide even better service in the future. We have a great team at Norfolk Southern, and I have every confidence in our ability to continue to provide outstanding service to our customers and outstanding results for our shareholders. Thanks for your attention, and I'll turn it back 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'd like to remove your question from the queue. For participants that are 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 comes from the line of Bill Greene with Morgan Stanley. Please go ahead with your question.

Speaker 15

Yeah. Hi there. Good morning. You know, Wick or Mark, I wanted to talk a little bit further on the service issues. Is it just as simple as adding locomotives and employees? Is it really a resource constraint? I'm sure you're aware of the other argument that M&A is a solution there. So can you sort of talk about what levers you can pull on, how you sort of see this?

Mark Manion (COO)

Yeah, well, I'm sure Wick will talk about the M&A side of it. In priority order for us, it's a crew issue. I mean, the reality is, you need a sufficient number of crews in order to handle your volume, and, our volume just outpaced the crews. So as I said, we're ramping those up, and we start to turn those crews on, Bill, in a bigger way in November and December, and that will be very helpful. But we're already seeing improvement from those temporary folks that I spoke of that went to our northern region. Now, in addition to crews, and, as far as locomotives go, I mean, the reality is we've got enough locomotives right now.

But when you get into a lower velocity situation, that eats up your locomotives, so you get to the point where you can't hardly have enough. So it will be helpful to have these additional locomotives coming on, and they already are coming on. So that will be good. Now, another important factor here is these infrastructure projects. As business is ramped, these projects, and I won't go through them again, I mentioned them, they will be no one project by itself fixes it, but you combine those projects, particularly with our Bellevue infrastructure project, that just plain gives you more capacity. And that's the sort of thing that from a standpoint of being sustainable and allowing for more growth going forward, that's what those infrastructure projects get you. So we're really looking forward to that.

And then the last thing I would mention is that we've been doing a lot to find some routes around Chicago. And for one, for example, we've got a line that's immediately south of Chicago. We refer to it as our Streator Line, and we're taking a hard look at, or we're actually starting to use that in a greater way for more interchange of traffic, but we're even looking at increasing our infrastructure on that route in the short term. So those are the kind of things that bulk you up to be able to handle more traffic and operate more effectively than we currently are. Wick?

Wick Moorman (Chairman and CEO)

Well, I will say, too, that, you know, the problems that we're experiencing are not unique to Norfolk Southern. There are a lot of issues across the industry, which are well documented, and everyone's talking frankly about them. That does have some impact on us. Certainly, the Chicago gateway has been congested and erratic over the past number of months, but all the carriers are trying to address that, and I think that collectively, we are all taking the right steps to address that. You know, the simple fact about Chicago is that there's an enormous amount of rail infrastructure from both the East and the West that just points that way. That's where a lot of railroad capacity meets, and we're always gonna do a lot of business through Chicago.

We and there are lots of different opinions about it, but we are looking bilaterally, as Mark mentioned, with other carriers in terms of thinking about alternative locations when that's possible. But it's not always possible for a number of reasons. And the other thing I will say is that we have seen a very positive impact over the past 2 years in Chicago from CREATE. It has opened up a lot of real congestion points for us, former congestion points. And not just CREATE, but projects like the Englewood Flyover, which effectively gave us 6-8 hours more access to our mainline every day, are really important.

So, every franchise is different, Bill, as you know, but when we look at the issues that we're facing, have been facing, and we do the analysis, and we've done a lot of analysis, it comes right back to what Mark was saying.

Speaker 15

Let me ask one follow-up to this, and if I missed this in your prepared remarks, I apologize. But have you quantified what the service challenges have cost this year, or maybe even include weather, just so we have a sense for, "Look, there's this much embedded in the cost structure this year that if it goes according to plan, won't be there next year?

Marta Stewart (CFO)

Well, in the third quarter, it is difficult, Bill. This is Marta. It is difficult, Bill, to kind of tease it apart from the volumetric increase, but generally speaking, rough numbers, you can assume that most of the increase in overtime, which this quarter was $10 million, and last quarter was a similar amount, most of the increase in overtime is related to that. And I'd say the other biggest item would be the increased locomotive materials, because Mark's folks have had to fix the heavy, bad order, you know, locomotives. And so I would estimate for this quarter, you take all of the overtime of $10 million, somewhere between half to three-quarters of the $20 million increase in locomotive materials, and that would be about the impact that the service had on our expenses.

Speaker 15

Okay. Fair enough. Thank you for the time.

Wick Moorman (Chairman and CEO)

Thanks, Bill.

Operator (participant)

Our next question comes from the line of Allison Landry of Credit Suisse. Please proceed with your question.

Speaker 16

Good morning. Thanks for taking my question. So in spite of the service issues in the third quarter, you guys were able to post pretty strong incremental margins. But looking at and granted it's only three weeks, but if we look at the recent volume data, it suggests that there's been a pretty material slowdown in growth. You know, is this sort of a direct result of not having enough crews? And you know, obviously, the outlook for coal isn't positive, but do you expect a return to growth in automotive and ag once you get some of these qualified employees in the network?

Mark Manion (COO)

Good morning, Allison. This is Don. We are-- we're not seeing a slowdown in our business. What we are seeing is the lapping of very strong comps in the fourth quarter from last year. As you'll recall, our merchandise volumes in 2013, in the fourth quarter, were up 8%, and our intermodal volumes were up 6%. So we are, we are beginning to face tougher comps year-over-year. The second thing I would add there, too, is that we are seeing a deceleration in coal volume on the export side, and we're seeing weaker utility volumes, as I pointed out, due to natural gas prices dropping and milder weather.

Wick Moorman (Chairman and CEO)

... We also saw our intermodal business peak fairly early toward the end of September. And that is predominantly on the international side, with consumer goods coming in for the holiday season. So I wouldn't read too much into the over year-over-year volumes other than the comp and the fact that coal is decelerating somewhat and that we probably have seen our fall peak, even though it was a small fall peak in intermodal.

Speaker 16

Okay. As a follow-up question, on the postretirement and pension expense for this year, could you parse out the difference between the two? I know that you made some changes to the postretirement plan, so how do we think about what will persist in terms of you know, a tailwind for next year? What are your initial expectations for pension expense in 2015?

Marta Stewart (CFO)

Okay, well, I'll take that in two pieces. First of all, with respect to this quarter in the postretirement and pension, the bulk of that is postretirement, it's $31 million, and the pension was $8 million. So both of those were decreases compared to last year. So, and we've had similar amounts in each quarter this year relative to the prior year. Going forward into next year, of course, we'll be able to give you more visibility into that in January. That's gonna be dependent on the interest rate as of the end of the year and where our pension assets stand. Thinking about it, if we had to look at it as the, those items right now, we would probably have about even 2015 expenses in those areas compared to, compared to 2014.

So in other words, we're not gonna have the big leg down that we had in 2014, but we think we're gonna stay about even.

Speaker 16

Okay. Is that basically because the changes that you made in the retiree medical plan, you know, could potentially offset any increase in pension expense?

Marta Stewart (CFO)

Well, the change that we made is going forward, so that's with regard to postretirement medical, the change that we made is a go-forward change, so that would impact 2014 and 2015 the same way. That's why that's the same. Then the pension on its own, the asset plan, the assets have done very well, and unless interest rates change markedly between now and the end of the year, that should stay flat the same.

Speaker 16

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

Marta Stewart (CFO)

Thank you.

Operator (participant)

Our next question is from the line of Jason Seidel of Cowen and Company. Please go ahead with your question.

Speaker 17

Yeah, good morning, guys. Staying on the service a little bit, you know, with all these new locomotives coming on, should we start seeing that locomotive increase expense for materials start abating in four Q? Or should that be a little bit lower than it was in three Q?

Wick Moorman (Chairman and CEO)

Jason, I wouldn't want to predict that it's gonna come down much in the fourth quarter because we start to see most of this power in the November, December timeframe. But certainly, as we bring these new locomotives in and as velocity improves, as Mark says, we're gonna have the ability then to take hopefully a good number of these older, higher maintenance, less efficient locomotives out and put them back into our surge fleet and also put them back into the queue, where we've got a lot of them for our rebuild program.

Marta Stewart (CFO)

Right. And right now, Mark's folks are estimating they're gonna do whatever it takes to fix the locomotives. But as you know, the locomotive material was up $10 million in the second quarter, $20 million in the third quarter, and they think they'll be somewhere between those two for the fourth quarter.

Speaker 17

Fourth quarter, okay. Thank you. And as it pertains towards, you know, all the merger talk we have and also all the talk about Chicago, you know, Wick, I think you mentioned that there's only so much you can do with the rails working together. But what, what can the railroads do, short of a merger, to sort of help improve some of the service levels through either joint projects or joint ventures?

Wick Moorman (Chairman and CEO)

Well, I think everyone is doing a lot of work on that, Jason, along the lines of what we're doing. We work together in Chicago to try and manage the flows through there. We do that collectively, as you know. Every railroad that I'm aware of is looking at additional infrastructure, if it's required, on their routes coming into Chicago. Certainly, that's true in the West, as you know. And I think that as we do that, as we make sure that we're resourced properly, that we're going to be able to handle business and handle more business through Chicago successfully in the future.

I think what we, this is my opinion: I think what we have seen this year is something of an anomaly in that we had, as you know, an extraordinarily tough winter. And then we had a really very unusual kind of volume growth through a single gateway, driven by the energy business. And at some point, you know, that returns to more normal growth levels, and we can manage through that. So I'm optimistic that as the CREATE projects continue to come online, and as we all work together, that, you know, we'll Chicago will always be a very, very busy place to operate. We'll, it'll occasionally be a tough place to operate, but collectively, we can make Chicago work in the current industry configuration.

Speaker 18

Thanks for the commentary, Wick, and thanks for the time, guys.

Operator (participant)

Our next question comes from the line of Tom Wadewitz of UBS. Please proceed with your question.

Speaker 18

Yeah, good morning. Wick, I guess I apologize for asking you about this again. I don't know if you love talking about it, but just to be completely clear on this, and you've probably said this in various ways, do you think that it would be, you know, are you essentially, do you have a position on rail combinations in terms of, you know, you think it's a bad idea, and you think regulators wouldn't approve it? Or are you open to the idea, and you think there are, you know, pluses and minuses? Or just what's your, you know, what's your kind of clear position on the idea of rail combinations? I know obviously, you've talked around it a bit today.

Wick Moorman (Chairman and CEO)

Well, Tom, this is something that I have said in a lot of forums, and I'll go ahead and say it briefly. And I'll preface it by saying that, you know, different people in the industry have different opinions about this. And I will go ahead and say I have a very high regard and respect for the head of the CP, but this is just a place where I have a different opinion. I think that a major railroad merger is not a good idea. It's highly problematic for three reasons. The first is that our history is that putting these big companies together is very difficult and, at least historically, has led to significant service problems for some period of time.

The second reason is that while, you know, historically, a lot of mergers were justified because of significant synergies, if you put two big carriers together, there aren't that many overlapping routes, there aren't that many redundant facilities. You can save some money, yes, but it's not necessarily order of magnitude that it used to be. And then third, and most important, I think it would go into the face of a regulatory environment which is not receptive in any way to major combinations. And there are the new rules out there that it has to be pro-competitive. That is not defined, and it could be defined in ways that are very onerous and in which you could give up all of the potential benefits and more in a transaction. So I, I just think that, I just think they don't make sense at this time.

As I say, reasonable people can differ on that, but that's certainly my opinion.

Speaker 18

Okay. Yeah, that's very helpful. I appreciate you, you know, giving a very clear response to that. That's very helpful. I've got a question for Don. The yields in third quarter were weaker than we would have expected. I know you gave us a lot of detail on why mix is a headwind in various respects. What is your visibility to pricing and to yields as we go into 2015? You know, discussions with customers, contracts you've already signed for 2015. Do you, you know, can you give us some flavor and a sense of how much confidence you might have in stronger pricing and stronger yields when you look to 2015?

Don Seale (CMO)

Good morning, Tom. As you well know, the capacity factor in transportation in North America has tightened significantly. As we've said many times in the past, we price to the marketplace, and we see increasing opportunities for price improvement ahead. We have about 15%, right at 15% of our remaining pricing to do on the book for 2014, and we have about 50%, right at 50% of our book of business to be repriced in 2015. And we will be taking that tighter transportation capacity into our strategy, and you will see that in the results of our price activity. So we price to the market. The market is tight for capacity. That enables us to have a more optimistic outlook on pricing ahead.

Speaker 18

Should we expect the mix is gonna continue to be a headwind in 2015, or some of the mix pressures you saw in third quarter, maybe they ease up a bit, so, you know, the pricing flows through a bit more to the revenue per unit?

Don Seale (CMO)

Tom, we have so many moving parts with respect to the different business segments. I even mentioned this morning that in our automotive sector, which was very strong in the third quarter, up 12%, we had a much higher percentage growth in bi-level traffic, which is the rail cars that transport SUVs and pickup trucks. The load factor is not as high for SUVs and pickup trucks in a rail car versus passenger cars, and there's a differential of about 15% in the revenue per unit, revenue per car for those bi-levels versus tri-levels. That's just an example of how the mix continues to play out. In coal, when our export market is down, that's our highest revenue per unit business. And when our northern utility business goes up, for example, that's lower.

So I don't know what all the combinations are going to be in 2015. We will just have to see how it works out, but we will continue to see negative mix, if nothing else, as we grow intermodal at a much faster pace, and coal continues to either be flat or modestly down, which is the ultimate mix effect.

Speaker 18

Right. Okay. Thank you for the time. Appreciate it.

Don Seale (CMO)

Thanks, Tom.

Mark Manion (COO)

Thanks, Tom.

Operator (participant)

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

Speaker 19

Thanks. Good morning. Wanted to talk a little bit about the service metrics and a little bit more about the timing, I guess, of potential improvements, and maybe understanding a little bit better the sequential deterioration, at least in the velocity metrics and the terminal dwell that we see publicly. You know, it seems like we're sort of ending the third quarter, beginning the fourth quarter at a low water mark. Just want to get a rough sense if, you know, you think, Mark, from your perspective, that this is sort of November, December, as you get those new crews on board, you start to be able to turn those metrics a little bit more constructively. During the quarter, if there was something specifically, other than just the confluence of volumes, that was causing that sequential deterioration.

Mark Manion (COO)

Yeah, I think we've seen the trough on these, and this, and in fact, you know, the public metrics do lag a little bit, and we are seeing improvement that's going on more recently. Something that we track is specifically where our velocity is at in various parts of our system. The reality is our eastern region, our western region, that is two-thirds of our system, has been operating rather well from a velocity standpoint, and the problems have been pretty localized to that east-west gateway between Chicago and Jersey, or really, Philly. We see much better fluidity in that area at this point. Still very heavy.

I mean, we've still got, we've still got all the business up there because as far as the volumes go, that area has continued to have a lot of traffic, and we see that. I think we see that sustained. But we will see improvement as we go forward in the quarter, and I think we said that last quarter, that we'll start to see our improvements in the fourth quarter. But as we said before, the people, the resources really come along more in the November, December timeframe, but we're already starting to see that tick up.

Speaker 19

Okay, that's helpful. Thank you. And then switching gears, Don, if I could ask you about, a little about the coal side. Just want to understand sort of the yield dynamic as we think about fourth quarter and, and going forward. Obviously, you have had some mix issues and, and export declining a little bit. You had a pop in the second quarter, which I think was driven by some of the longer-haul utility moves. But as you think out to the fourth quarter with where the seaborne market is and where the utility demand is coming from, is this roughly the right way to be thinking about yield, kind of what we saw in the third quarter? Just want to get a rough sense on the mix potential in the shorter term, if I could.

Don Seale (CMO)

Yeah, I think what we saw in the third quarter will be what we are seeing in the fourth quarter, predominantly, sequentially coming from the second to third quarter. You'll recall that we had a $43 million increase in coal overall, which was driven predominantly by a 23%, excuse me, increase into our southeastern utilities. That tended to weaken as the summer wore on, and we saw milder weather, lower gas prices. So, our northern utility business was down, but southern utility was only up about 9% in the third quarter. That did impact RPU. As far as export goes, we pretty much see the same type of market condition. Don't see a lot of significant change.

It's weak on thermal and met coal, and we don't expect that to improve in the fourth quarter, nor do we see any driver for improvement in the first quarter for that.

Speaker 19

Okay, so this is sort of the run rate in the next couple of quarters, at least on the export market, in your view?

Don Seale (CMO)

We hope so.

Speaker 19

Okay. Thanks very much for the time. I appreciate it.

Don Seale (CMO)

Thanks.

Operator (participant)

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

Speaker 20

Hey, thanks. Morning, guys.

Don Seale (CMO)

Morning.

Speaker 20

So, Don, that was helpful in terms of the coal mix and how you think that about that going forward. I want to ask about intermodal mix. With the peak, you're saying kind of happening, happened already, maybe international growth going to slow. Does intermodal mix become more positive as domestic starts to grow faster?

Don Seale (CMO)

We expect that mix to moderate, that mix differential between domestic and international. International has been very strong this year because of the West Coast ILWU negotiations that shifted business to East Coast ports. We've also had some organic growth with our international partners and some new businesses through new terminals and new contract arrangements. We will start to lap those events as we get into 2015, and we will see domestic growth outpace international growth, in my opinion, going forward. So we'll see that mix effect start to moderate.

Speaker 20

It should probably re-reverse and turn positive. Is that fair?

Don Seale (CMO)

It'll start, it'll start to turn positive. Correct.

Speaker 20

Okay. And then one for Mark: So you gave a lot of numbers around what you're planning with headcount. I'm not sure what it means for net overall headcount the way we see it. What kind of headcount growth do you think we should be modeling in fourth quarter and 2015. And given the catch up in headcount, do you think we'll have headcount up more or less than volume growth in 2015?

Marta Stewart (CFO)

I'll take the 2014 question and let Mark address the 2015 question. For 2014, we continue to think that we're going to end the year about even to where we were last year. So that would be, last quarter, we talked about being 900 up from the second quarter. As Mark said, we're up about 400 this quarter, so we think we're going to be up another 500 in the fourth quarter.

Mark Manion (COO)

Going into next year, partly in terms of continuing to build our crew base to keep up with today's business levels, and then partly for more business opportunities that are coming up in 15, we'll add another net 500-600 people to what we have at the end of the year.

Speaker 20

Okay, so we should probably think about volume growth still outpacing headcount by a good amount next year.

Mark Manion (COO)

Oh, yeah. For the first, it's going to take us. Well, really, we'll be working on it through the first half. But, keeping in mind that once we end the year and turn the corner into 2015, the additional people we have are going to be very helpful in terms of improving our service product. So we won't be completely done until we get into the latter part of the second quarter.

Speaker 20

Mark, can I just ask, what, what's the difference in, like, the 1,900 people you talked about that you're, you're training versus that 500 number? Is that just attrition? Is that the difference?

Mark Manion (COO)

Well, I want to make sure I understand the question. I, I'm not sure about the number.

Speaker 20

I thought in your prepared comments, you, maybe it's not 1,900, but you gave some-

Mark Manion (COO)

Yeah.

Speaker 20

a large number of people currently being trained-

Mark Manion (COO)

Right.

Speaker 20

Now you're talking about adding another 500 people from here. So, is the difference just attrition?

Mark Manion (COO)

No, I, I spoke of, since the beginning of the year, we, we have, we have started in training or have produced a total of 1,700 plus people. And then I further defined what that, how that looks in the third quarter and what will, what our net will be by the end of the year.

Wick Moorman (Chairman and CEO)

Yeah. Scott, I think there are three things that go on there. One is some of this, we continue to have attrition in the T&E workforce. So, that's a number we have to take into account. We have some very modest attrition, even in the training program. Not much, but there is some there. And then the other thing is, at any given time, you're trying to take a snapshot of qualified employees and trainees. So when Mark talks about the total number of people in the pipeline, there are 500 people who come out, finish their training in the fourth quarter, plus or minus. And then there are additional people who are in that bigger number he mentioned, who are finishing their training later in the first quarter of next year.

So it's always hard to kind of, you know, pin down at any given moment what's going on. But I think the net, the important message here is that we have a lot of people in the pipeline. We are starting to see significant increases. But going back to your original question, you know, our T&E staffing, once we get it to the point where we need for it to be, will still be growing at a rate that's less than our volume growth. We still expect continued efficiencies in terms of train length and train operations, in the same way that you've seen us produce them over the past couple of years.

Speaker 20

That's helpful, Wick. Thank you.

Operator (participant)

Next question comes from the line of Brandon Oglenski with Barclays. Please proceed with your question.

Speaker 21

Yeah. Good morning, everyone. I know it's been a long call, but I just, you know, Wick, I want to follow up on that commentary there, because it sounds like there's a lot of puts and takes as we look at 2015. But if you are adding all these assets and people, you should get better productivity, as you just mentioned. Does that suggest that, you know, the sustainability and incremental margins like we've seen this year should, you know, extend into 2015?

Wick Moorman (Chairman and CEO)

You know, I'll let Marta comment on that, too. I do think that as we increase network velocity, even as we add these resources, that it's a more efficient railroad. It's a more productive railroad. And in addition, it augments our opportunities for volume growth because of the service component. So there's a lot of goodness there. In terms of incremental margins, Marta, I think our expectation is they'll remain very strong. Whether they'll continue quite at the pace that we've seen them this year, we're not sure, but we expect to continue to produce strong incremental margins in the business.

Marta Stewart (CFO)

I agree with you, Wick. The only thing I would add to that is just a reminder, and you probably already have this, Brandon, but just a reminder that this year's incremental margin is affected by that post-retirement medical and pension, which Allison asked about. So if you back that out, we get a bit more to a-

Wick Moorman (Chairman and CEO)

Yeah.

Marta Stewart (CFO)

more closer to a run rate incremental margin.

Speaker 21

... Well, completely understood. I, you know, I think that shines a light on a pretty bright outlook here for the company. So if I, if I can just ask one follow-up here, I mean, you guys have, you know, well over $1 billion in cash right now, and I know you have some debt maturities, but, you know, it seems like your share repurchase program has really slowed down. You have a big authorization out there. With that outlook and arguably, you know, one of the cheapest valuations within your, your sector right now, you know, in the marketplace, why not be more aggressive on the share repurchase?

Speaker 22

Well, as you know, Brandon, I mean, we, we believe in share repurchases. We've been a longtime buyer of our shares. Other than the recessionary year of 2009, we've bought back a significant number of shares since 2006. But over that time period and continuing to now, we moderate those share repurchases just based on overall market volatility. And so all I can say is that we remain share repurchases. We expect to continue to remain that, and we're just going to modulate it based on market conditions.

Don Seale (CMO)

Brandon, let me add to that. As, as we always discuss, you know, our first priority is, is capital expenditures to grow the company. We're, we're in the middle of that process right now. Our second is dividends. We have a very strong dividend track record, and we will continue to have a, a, a strong dividend policy. And then share repurchases, as Marta said, we are, we, we stay in the market. But I will also say it's something that we constantly reevaluate, and we'll continue to reevaluate it. And certainly, the factors that you mentioned are very legitimate factors. So going forward, we'll continue to look at that.

If we see a certain point where we think we need to become more aggressive or change our policy, we're certainly willing to do that and will.

Speaker 21

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from the line of Bascom Majors with Susquehanna International. Please go ahead with your question.

Speaker 23

Yeah, thanks for the time. So the fuel surcharge program you introduced in 2008, I believe it kicks in at $90 WTI, and oil has trended below that for most of this month, which would imply that at least, you know, fuel prices could fall further, while at least some of your surcharge revenues are staying flat. And I know that's not your only program, and some are based at lower levels, but can you give us an update on the fuel surcharge mix and how it trends among your business groups, and how you expect lower fuel prices to impact your revenues on that front going forward, if energy prices were to trend around where they are today?

Don Seale (CMO)

Good morning. This is Don. As you indicated, we, we have many different fuel surcharge formulas that have been negotiated with numerous customers in contracts and other instruments. So we do not have one fuel surcharge program. Our carload business generally is based off of West Texas Intermediate crude oil, while our intermodal business is based on, on highway diesel fuel. So we don't even have the same standards for all of the business because there are different characteristics of the business itself. So we have a 60-day lag generally on our carload business, a weekly lag on our intermodal business. That will continue to move up and down with crude oil prices, diesel prices, crack spreads, all of the things that impact fuel over time.

I can't give you a specific outlook for that because, frankly, I can't tell you where the forward curve will wind up for West Texas Intermediate crude or on highway diesel for next year.

Speaker 23

Well, if oil were to stay in the low 80 range, is there a significant portion of your business where surcharges would be locked in at the or not fall further?

Don Seale (CMO)

I just can't give you color on that, because we have so many different formulas that have been negotiated, with customers.

Speaker 23

All right. Well, thank you for the time.

Don Seale (CMO)

You're welcome.

Operator (participant)

Our next question is from the line of John Larkin with Stifel. Please proceed with your question.

Speaker 22

Thanks, gentlemen, for taking my questions.

Don Seale (CMO)

Thank you, John.

Speaker 22

Just wanted to talk a little bit more about the application of incremental crews and incremental locomotives to solve the service issues that you've been grappling with here the last couple of quarters. It seems to me that as things play out here into 2015, that you're going to have enough resources to bring your velocity up and your terminal dwell down, which effectively will create more capacity. Now, you said earlier that the new locomotives will be here, and that will give you the opportunity to push the more costly, less efficient, older units into the reserve fleet. How do you handle the crew situation at that point, if in fact, you do rebound to previous velocity and terminal dwell numbers?

Don Seale (CMO)

Well, that would be a good thing. As far as the crew base goes, we're planning, like I said, on that 500 or 600 net add people next year, but as velocity goes up, it lessens the need for crews, so we can always throttle that back some if we need to.

Speaker 22

Okay. And then, Marta, you answered a question earlier regarding the cost of the congestion, and I was just wondering if there was a revenue component to that also, if in fact, service had gotten to the point in some parts of the network where customers have, have gone a different direction with their transportation needs until you can get the, the service back up to, where, you know, it needs to be?

Don Seale (CMO)

...This is Don. On the top line side of our business, car utilization and available capacity to move more volume is probably the, the larger concern with respect to current velocity. Obviously, we're having, we're having some pressure points with, with certain customers. We're working through those. But my larger concern is, is utilization of equipment and capacity of the fleets in general.

Speaker 22

Is it reasonable to assume that revenue growth might have been a point or two higher if you had not had those equipment availability problems?

Don Seale (CMO)

We would have had some higher revenue in the automotive sector, some areas like that. But I'd like to, you know, maybe showcase that question and just point out that sequentially, from the second quarter to the third quarter, the second quarter was our all-time high top line revenue. We only missed that by $19 million in the third quarter, with coal being the swing of $58 million between the second quarter to third quarter. We were up $43 million in coal in the second quarter. We were down $15 million in the third quarter. So sequentially, we came close to meeting an all-time record with coal swings of $58 million quarter to quarter.

Speaker 22

Got it. Thanks for the color.

Don Seale (CMO)

Thanks, John.

Operator (participant)

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

Speaker 6

Thanks, and I wanted to ask my first question on pricing. As you've implemented some of the rate increases in Intermodal that you talked about last quarter, have shippers been pretty receptive given the tightness in capacity, or are you getting any pushback on pricing up in this type of service environment?

Don Seale (CMO)

We're always sensitive to the timing of pricing, but capacity and tight capacity are the two things that are driving price improvement in today's marketplace. So the price increases that we took in our domestic rail-controlled containers in June and September have stuck, and we continue to assess that market going forward for additional price opportunity.

Speaker 6

Okay, great. And as a follow-up on coal, I wanted to ask about domestic coal into 2015, and I know it's tough, but let's just assume normal weather patterns. And based on the stockpile levels that you referenced in recent conversations with customers, do you think domestic coal is flat or down again in 2015, or is there a chance you could see some improvement?

Don Seale (CMO)

But let's segment the market with, with respect to export, with the Australian currency differential expanding, and the benchmark met coal price of $119 a ton and a thermal index to Europe at about $72 a ton. If those two indices continue to be that low, U.S. producers will be very pressured, to have any growth in export in 2015. The wild card, as I mentioned on our utility call, will be what kind of weather we have during the winter. We are 19% below, stockpiles, as of December 2013, right now.

If we get anything like last year's winter, we will see some increase in demand for utility coal during the winter and coming out of the winter, because I suspect natural gas prices will rise as they did last year, and electricity demand will increase. So those are, those are export, we don't see any significant driver in the near term. Utility would be the upcoming winter and what, what kind of weather we get.

Speaker 6

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

Don Seale (CMO)

Welcome.

Operator (participant)

Our next question comes from the line of Walter Spracklin with RBC. Please proceed with your question.

Speaker 7

Yeah, thanks very much. Most of my questions were answered. I'm just gonna call, follow up on one, and that is on your buyback. I know, Wick, you were saying about reevaluating constantly that buyback, and certainly, it's trended well below what we thought you would do when you announced your last program. So I see, you know, $1.5 billion in cash on the balance sheet, but also about, you know, $550 million of debt repaid. What, in that reevaluation aspect, what has caused you a little bit of concern about buying back your shares at these levels? And if you do reevaluate, do we go to, you know, what is the flex up that we could see?

Is it incremental, or could you see a significant increase in your buyback next year?

Don Seale (CMO)

Well, I don't know that I'd comment on what we would see in terms of any magnitude of a change. I certainly think, though, that you know, as we went into the year, we were looking at all of the factors around share price, and as they have moved—as, and as factors have changed, valuations have changed, we'll take a look and see if our program needs to be evaluated again, as I mentioned. It's I think the important message is that you know, this is, this is something obviously that we actively discuss, and that we look at where markets are, and we'll come to an opinion on what we need to do going forward in 2015.

Speaker 7

... Okay. Just to slip in another one, I guess, on the crude by rail, we've heard the other, the other companies talk about the factors and spreads and, and, and drivers in their specific origination markets that might-- that the current volatility in the energy prices would, would cause. Don, what are you hearing from your customers in terms of their propensity to relax some of their shipments on, on crude that you, that you either, originate or, or, or carry by interchange? What's your thoughts going forward on, on that market?

Don Seale (CMO)

We're not receiving any input from our customers that the short-term Brent crude spreads that have become very close, they're within $3 a barrel right now, are impacting their plans to continue to take Bakken and Western Canadian crude. We're being told that most of them have arrangements that go beyond short-term fluctuations in the market, and their expectations are that the Brent and WTI spread will increase over the next several months.

Speaker 7

Barring that increase, then you might, we might see some action?

Don Seale (CMO)

We're not getting that indication at this point. Our crude oil, for example, in the third quarter, was up over 12,000 cars over the third quarter of 2013. We're now handling 30,000 cars a quarter, which is what the third quarter represented. So we're seeing our crude oil business, both from Western Canada and from the Bakken, the Williston Basin, continue to show some robust dynamics.

Speaker 7

Okay. That's all my questions. Thank you very much.

Operator (participant)

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

Speaker 8

Hey, good morning. You know, Mark, you did a really good job in terms of laying out the expectations with regard to overall, locomotives and crew that are coming on and how that should play out with regard to service performance. If I could barrel in a little bit more in terms of your intermodal service performance, it looks like that's taken a little bit of a harsher leg down in kind of the start of the fourth quarter relative to where we had been in the third. Could you talk a little bit about the dynamics and how you see that side of the segment kind of improving throughout the fourth quarter?

I realize a lot of this traffic is coming on that, that Chicago and to, to kind of, the New England area, which is more heavily, congested right now.

Don Seale (CMO)

Yes, I'd be glad to. And that fits right up with the comment I made about the fluidity on that East-West corridor, opening up so nicely here more recently. And along with that, while our intermodal terminals still have a lot of business, they're heavy, they are in a very, what I'll call, in a very orderly fashion. So they're able to process well in the intermodal terminals. And our main lines, which, as I've said before, is our heaviest capacity main lines we've got on the system, they are open for business. So I see that moving in a positive direction for our intermodal business as we go into the rest of the fourth quarter.

Speaker 8

Okay, that's helpful. And I guess, you know, given the lower kind of, overall fuel prices, obviously, that, that does cage a little bit of the value proposition for the, the intermodal, side of the business. Don, if the intermodal velocity improvements are constrained, would that cage at all your optimism for the growth outlook for intermodal as we look out into 2015 at kind of current WTI levels? Or are the trucking capacity constraints such that you think you'll be able to materially outgrow GDP, even if the, the velocity is constrained near term?

Don Seale (CMO)

The latter is the case. Truck, trucking and motor carrier capacity will be tight in 2015. We don't foresee fuel prices at current levels changing that dynamic or changing the economic model. So we expect our domestic intermodal business to continue to show significant growth.

Speaker 8

Perfect. Thanks so much for the time, guys.

Operator (participant)

Our next question is from the line of Thomas Kim of Goldman Sachs. Please receive your question.

Speaker 9

Good morning. I just had a couple questions on the coal side. In prior calls, you talked about export coal freight rates effectively bottoming out. And I was wondering, Don, if maybe you could just give us a little bit of color around the third quarter export coal freight rates versus the second and the prior quarter or, and, and maybe year and year?

Don Seale (CMO)

No, no change second to third quarter, and we anticipate no change third to fourth quarter, and for that matter, based on what we're seeing, first quarter as well.

Speaker 9

Okay, thanks. And then, just with regard to the utility coal mix, can you talk a little bit more about how the sourcing has shifted, maybe Q on Q? Like, can you give us a breakdown of how much coal is coming from the App versus Illinois Basin and so on?

Don Seale (CMO)

Yeah. We're still about 34% of our originated coal coming out of Central Appalachia, 28% coming out of Northern Appalachia, 19% from the Illinois Basin, and 16% from the PRB. The largest change, as you know, year-over-year, that we described in the second quarter, is the Illinois Basin now exceeding the originations that we handle from PRB.

Speaker 9

Thank you.

Don Seale (CMO)

Welcome.

Operator (participant)

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

Speaker 10

Great. Good afternoon, I guess, by now. Just wanted to follow up on the efficiencies, and I guess this might sound odd, just given your operating ratio being at 67. But looking at, you talked about having more locomotives on the fleet now. If we go back, you know, a decade, you still haven't hit peak volume, so kind of surprising you've got more locomotives. I just want to understand, over the past years, have we lost some of those efficiency gains? Does it take a whole new, you know, operating plan or anything that has to shift in order to get the velocity and everything back up? Or is this just, you know, little bit by little bit, just looking at what some of the other carriers we've seen making major changes to improve performance.

I just want to understand how we, you know, we've gotten to this point of decreasing efficiency, yet having more on the network. Should we take some of that off in terms of the locomotives and crew and get that efficiency back up?

Wick Moorman (Chairman and CEO)

Well, you know, obviously, a big add on these locomotives these days is working our way out of a difficult situation with the velocity issue. So we should see that improve as we go into next year, like we've already talked about. But in addition to that, we've got to keep in mind that there has been a significant mix change over time, and with our intermodal business growing the way it has, that adds locomotives to the fleet. And, you know, just looking at productivity in a little broader way, also keep in mind that we are three years in a real concerted way, working on various things from a productivity standpoint that has had the effect of lowering our overall cost structure.

That's why we see a more modest expense increase with all these other things going on.

Speaker 10

But just to understand that, wouldn't they be more, I guess, unit trains, if you're running more intermodal, and especially given the Crescent and Heartland Corridor buildouts, so you've got kind of more point to point? I guess I'm just trying to understand, have you put too much on to create too much congestion, and that's causing that velocity, given the volumes? I'm just trying to understand, you know, versus 10 years ago, where you had more volumes, and now you've got more locomotives and more infrastructure on the network today. I'm just trying to understand, is there something that needs to be overhauled in the operating plan, or is it just continuing to add more assets?

Wick Moorman (Chairman and CEO)

Well, I think, let me let me add to what Mark said. If you go back 10 years, the railroad and the operations looked very different than they do today in terms of our mix of business. And we have added substantially more intermodal business. It's a big, much bigger part of our franchise, and intermodal trains are dispatched with higher horsepower per trailing ton, and that's had a significant impact on our locomotive requirements. The second thing that has happened to us is that our unit trains have grown significantly, and particularly with the crude oil, but even before that, with real emphasis on unit trains in ag, automotive and grain.

And all of that traffic is great traffic, and it's, it's very profitable, and we want it, and that's the way the customers want to ship it. But it has, in some ways, also impacted our requirements for locomotives. Unit train movements in and of themselves require more locomotives for volume growth than just putting volume on the existing merchandise network. So, you know, we... Listen, we tune our operating plan every year. We have a significant number, as Mark mentioned, of operating efficiencies and plans for even more, and we'll continue to achieve even more. But as I think I said earlier, Ken, every franchise, every railroad franchise is different, and we do a lot of analysis on our franchise to ensure that we don't have too many locomotives, but that we don't have too few.

Speaker 10

Great. And Wick, if I can just revisit your answer to Tom's question on the M&A side. You know, you talked about, you know, history of putting them together was difficult and the mergers didn't justify or might not have as many synergy opportunities, and then the regulatory environment. What was your reaction, though, when you heard this news that you said, "No way," right away? Do you think, Hey, we've got to sit down with the board and sit and look at opportunities? Because if CSX is taken off the board, do we need to think about how we line up? Because yesterday, obviously, on Hunter's call, he kind of went over why the regulatory issue might not be as big, but it's kind of finding a partner and gaining efficiency.

So, just trying to understand what was your and perhaps the board's kind of view in terms of if it does move forward, how do you think the industry changes, or does it not, and that's just a one-off?

Wick Moorman (Chairman and CEO)

Well, I think, you know, without going into specifics, listen, we're always thinking and always have about the industry structure and ways that it might change, and we review that with the board every year. As we go forward, if there are changes in the structure, and as I said earlier, people have different views of what the potential is, what the likelihood of a transaction being approved is, we, and, you know, we'll evaluate it with our board and see if there are actions that we need to take. You know, and that's what we've always done. That's what we'll always do.

But I'll say something that Jim Squires reminded me of, and that is that, you know, we may not agree or I may not agree with Hunter on everything, but there is something that Hunter and I agree on wholeheartedly, as does everyone else in this business, is that we don't really have to have mergers to have a very bright future here at Norfolk Southern and as an industry.

Marta Stewart (CFO)

Wonderful. Appreciate the time and insight. Thanks, Wick.

Operator (participant)

Thank you. Our next question comes from the line of David Vernon of Bernstein. Please proceed with your question.

Speaker 11

Hey, good morning, and, thanks for taking the question. Hey, Don, could you comment a little bit about how historically you've seen, you know, tighter truck capacity or looser truck capacity actually impact rates in the merchandise segment, obviously excluding the coal and the intermodal business? Just trying to think, like, what, like, what percentage move in truck rates has turned into what type of base pricing kind of in your experience.

Don Seale (CMO)

Well, certainly, as the trucking market tightens, it has a positive halo effect on intermodal pricing opportunity, as well as the carload pricing opportunity. In our merchandise business, anything that moves in a box car, from paper products to consumer products, to manufactured components, a lot of that business is directly competitive or driven by trucking capacity, and that gives us an opportunity. So, and other components like automotive parts and vehicles, steel traffic. So there's a range of commodities that tighter truckload capacity—and when I say truckload capacity, I'm talking about everything from dry van to flatbeds to covered bulk trucking. That gives us an opportunity, and I would add, not just trucking.

When we look at the barge industry right now, it is essentially sold out in agricultural commodities, and with the crop being as large as it is, we expect barge to continue to face that type of capacity constraints. All of those are pointing to a market that's more favorable for improving yields in our book of business.

Speaker 11

But I guess as you think about how to dimension that and how you've seen it kind of play out in the past, is there anything you can share as far as orders of magnitude in terms of how impactful that, the changes in the trucking market are?

Don Seale (CMO)

I can't really put a number behind it or a past trend. I'll just say that we see it as a positive opportunity in the marketplace.

Speaker 11

Okay. And then maybe just as a quick follow-up, you mentioned that the export rates had held flat, sort of sequentially, but it does look like the rate per ton is still down a little bit sequentially. Is that just the mix in the underlying domestic? Because the overall length of haul doesn't look like it's changing all that much. So I'm just wondering, is there any pressure on you guys to start thinking about pricing in that domestic market, given the challenges and competition with lower priced gas?

Don Seale (CMO)

No, there are no, there are no pressure points that changed from the second quarter to the third quarter. It's all, relative to mix. We saw our southern utility long-haul traffic start to moderate in terms of its year-over-year increase because of milder summer weather and lower natural gas prices. And also within the export market, we saw a relative larger decline in tonnage over our Lamberts Point pier versus our Baltimore tonnage, which is shorter haul.

Speaker 11

All right. Thanks for the time.

Don Seale (CMO)

You're welcome.

Operator (participant)

Our next question is from the line of Jeff Kauffman with Buckingham Research. Please go ahead with your question.

Speaker 12

Thank you very much, and good evening, everyone. Thank you for taking my question. Well, first of all, congratulations on a challenging quarter. I'd like to ask about two items, which I think are more temporary in terms of, of weighing on earnings. Marta, you hit the first regarding the cost of congestion. You talked about the $10 million in overtime. You talked about the effect of locomotive maintenance. What you didn't discuss is maybe what the effect of this congestion and slower train speed might be having on insurance and claims. I know you did note the $15 million increase in personal injury reserve. What do you believe, you know, Wick or Don, the impact of this congestion is having on your claims expense?

Do you believe this is more of a transitory thing, and when fluidity gets better, we hopefully see that begin to come down? How would you ballpark the impact of that financially?

Marta Stewart (CFO)

We don't believe that the service is having any impact on our, on our claims expense. I think what I was talking about there was the year-over-year, last year in the third and fourth quarters, we had favorable claims experience-

Speaker 12

Mm-hmm.

Marta Stewart (CFO)

and so the comp this year. So we have a comparative increase, but the costs themselves have not increased because of the service.

Speaker 12

All right, but your personal injury rate's up above the last couple of years' level, and it's up above the nine-month level. What would you attribute that to?

Marta Stewart (CFO)

That isn't in the serious injuries area that would be impacting expenses in any significant way, but I'll have Mark elaborate.

Wick Moorman (Chairman and CEO)

Yeah, as far as our injury rates this year, we had some higher injuries. Actually, January, February, second quarter was improved, and now third quarter is improved as well, and we've got a strong start on fourth quarter. So that's actually going in the right direction.

Speaker 12

All right, and then let me switch to Don. Don, it seems like a lot of shorter-term items are depressing the yield. I know you mentioned coal may stick around for a while, but others are more mix related. But your revenue per car was up almost 1% last quarter, is down almost 1% this quarter. What do you think the underlying rate of core price increases are relative to kind of what the reported rev per car we're seeing is? And when do you think we start to see a number that's a little closer to what your core pricing is actually doing?

Don Seale (CMO)

We see our core pricing continuing to exceed rail inflation right now. We think it'll continue to get better. The all-inclusive less fuel index, which is in a lot of our contracts, in the third quarter, only generated about 0.8% in terms of year-over-year increase. That is slated to increase in the fourth quarter up to about 1.8%, and for 2015, it's projected to be running about 2.5%-2.6%. So we'll see, we'll see the escalators in our base contracts and our repricing activity, which I've discussed relative to a much tighter transportation capacity market. Those two, in combination, you will continue to see improvement in our overall revenue per unit and also our core price.

Speaker 12

Okay, guys, thanks a lot. I know it's been a long call.

Don Seale (CMO)

Thanks.

Operator (participant)

Our next question is from the line of Keith Schoonmaker of Morningstar. Please go ahead with your question.

Speaker 13

Yeah, thanks. You know at the operating ratio, but in the long run, there are strategic paths that would enable handling demand surges while maintaining high service, or is this just the inevitable nature of dealing with high demand? For example, changes to work rules or single-man crews that might enable handling a little more adeptly.

Wick Moorman (Chairman and CEO)

You know, I think that that's a great question. One of the things that we certainly are doing right now is going back and looking through a lot of our processes and a lot of our practices to see, you know, to take the lessons learned. And clearly, one thing that we're very being very thoughtful about is adding some more what I would describe as resiliency to our network. And that can come in the way shape of, you know, a slightly different, not radically different way in terms of how we thinking about—think about our crew base, particularly in critical areas. It can come in the form of making of having a somewhat bigger surge fleet of locomotives.

And it certainly comes in the form of doing something which, as many of you know, we've systematically done, which is think about, continuing to look at pinch points on the network. So I, I think that, we'll take these learnings, and, and we'll, we'll make some changes that will give us that additional resiliency. Certainly, you know, work rules are, are something we're always focused on. There's another round, of labor negotiations that, kicks off here soon, and we'll see if there are things that can be done there as well. But I think that, we, we can do a lot in the shorter term, to give ourselves, to give ourselves the ability to, to handle situations a little better. But I'll go back to what I said.

I think we had a somewhat extraordinary set of circumstances this year with the very unusual weather, followed immediately by significant surge in traffic beyond what we expected. But we'll learn from that.

Speaker 13

Great, thanks. Just as a quick follow-up on service issues, do you believe that highway conversions was constrained or slowed due to service issues, or does trucking capacity offset most of these decisions?

Don Seale (CMO)

I think the overall intermodal network, we saw growth that we would have seen. I think equipment availability would have been a little higher in the third quarter, which could have generated, on the margin, higher volumes and higher revenue in intermodal and automotive. I will add automotive to that. I don't think it was material. Going forward, we don't see in the fourth quarter, in and on into 2015, we do not see a lot of excess trucking capacity that can take any diverted traffic from rail, not that we expect that. So as our service continues to improve, that really shouldn't be a major concern going forward.

Speaker 13

Good. Thank you. High quality problem to have.

Don Seale (CMO)

Yes, thanks.

Operator (participant)

Our next question is from the line of Cleo Zagrean with Macquarie. Please go ahead with your question.

Speaker 12

Good morning, and thank you. Could you please comment a little more on same-store pricing trends in the quarter, perhaps put some detail into repricing for new business and how you see the balance of price and volume begin to shape for 2015? Thank you.

Don Seale (CMO)

As we've indicated, we are seeing our core pricing coming in excess of rail inflation.

Wick Moorman (Chairman and CEO)

... we expect that to pick up as we continue to reprice into 2015. As I mentioned, we still have about 15% of our 2014 book to reprice and about 50% of our business next year in 2015 to reprice. Our prices will reflect the tighter capacity in the transportation market as we complete that.

Speaker 14

Thank you. As my follow-up, we heard yesterday on the Canadian Pacific merger conference call their view that the national network is about to hit some limits to capacity and efficiency, absent mergers, which they see as the main solution. Would you agree that absent mergers, the national network is coming up to some significant challenges? Maybe as part of your response, if you could help us with some quantification of the impact of your infrastructure projects into next year's results and into the longer term, as much as you'd like to comment. Thank you.

Wick Moorman (Chairman and CEO)

Well, I'm not really of the opinion that we're in any imminent danger of hitting significant capacity problems across the industry that will impact our ability to grow for the longer term. I think if you just look at Norfolk Southern and the things that we're doing in terms of everything that Mark mentioned, the Bellevue expansion, a lot of work in our Chicago-Philadelphia corridor, and a lot of work in other places to streamline the network, to add capacity in critical areas, I think that we have a very solid program, as we have had for years and will continue to have, to strategically augment our capacity as we see volume growth.

When we get into a period, as I've said several times, of unusual volume growth that was difficult for us to predict, we may get a little bit behind the curve as we have. But we're responding to that. We have a lot of work underway, and once that work is in place, we expect our velocities to go right back up, as we've said. So I think that. And I think every rail carrier looks at it that way. So I think we have the ability to continue to invest, continue to add infrastructure, and continue to grow the business, without the need for a merger.

Speaker 14

Thank you. So, to clarify, you do not see any structural thresholds or limits to growth for the industry, given the current makeup of the players?

Wick Moorman (Chairman and CEO)

No. No, I don't. I think that we can all respond as individual carriers and working together to handle what we think is, as I said before, a very bright future in terms of increased volume on the railroads.

Speaker 14

Very much.

Operator (participant)

Thank you. At this time, I'll turn the floor back to management for closing comments.

Wick Moorman (Chairman and CEO)

Well, thank you very much, everyone, for your patience, and for the very good questions. We appreciate them, and we look forward to talking to you again, at the end of next quarter.

Operator (participant)

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