CSX Corporation (NASDAQ:CSX) Baird 52nd Annual Global Industrial Conference 2022 November 9, 2022 10:40 AM ET
Company Participants
Garrett Holland – Baird
Conference Call Participants
Sean Pelkey – EVP and CFO
Sean Pelkey
We’ll get started with our next session here. Hello. My name is Garrett Holland senior analyst covering transportation and logistics here at Baird. We’re very pleased to have CSX Corporation participate at the Industrials Conference this year. From the company, we have Sean Pelkey, Executive Vice President and Chief Financial Officer. And we’re going to head right into Q&A. But if you have any questions, feel free to submit them through the portal or raise your hand and we’ll be happy to field them.
Question-and-Answer Session
Q – Garrett Holland
So Sean, thanks for being with us. Maybe for the folks that aren’t quite as familiar with the CSX story. Talk to us about some of the differentiating factors about the network about the execution that position the company for better relative growth and performance in the years ahead.
Sean Pelkey
Yes. Thanks, Garrett, and glad to be here in Chicago with everybody. It’s a great conference. So CSX. Well, I’d like to say, if you like to play Monopoly growing up, you know the B&O railroad, and that is CSX. We were founded in 1826. So we are the longest standing U.S. Class I railroad as far as I know. We also happen to serve two thirds of the country’s population. We’re in the eastern half of the United States. We’ve got over 20,000 miles of track, 21,000 employees. We just recently acquired the Pan Am railroads and extended our reach up into New England. So we’ve got a phenomenal network.
We’ve spent a lot of capital into that network to make sure that it’s ready for growth that we’ve got significant capacity. And I think we’ve got the best run railroad in North America. We’ve got an operating team that is out there every day executing against a scheduled railroading plan. The majority of our trains are scheduled. And as long as we have enough crews to run those trains, we can run to that schedule. And I think you’ve been seeing that in the numbers that we report every week, certainly over the last month or 2, heading in the right direction again.
Garrett Holland
Yes, that’s very good. But also an exciting leadership change top of the house at CSX new CEO, Joe Hinrichs. What changes did investors expect under Joe’s leadership. Help us understand how the strategy changes, if at all. He brings a lot of operational expertise. How is that new leadership going?
Sean Pelkey
Yes. Great question. I think Joe has really brought a renewed level of energy to the employee base. He’s coming in from the outside, but he’s not new to rail because he was a customer of rail at Ford for a very long period of time. And I think being on the other side of the table gives you a very unique perspective on the advantages of rail as well as some of the things that drive you crazy in terms of rail service performance.
I think that gives him a really unique perspective to come in and say, “Hey, look, we’ve got an operating model that works, how can we do a better job of engaging with our employees to get them to come to work excited and motivated every day and communicating with our customers, so they have clear expectations of what the service product is going to look like and if we’re not meeting those expectations, we know what to do. “
There are 5 principles of scheduled railroading in the Hunter Harrison book. The 3 of them that we execute very, very well on is working safely, controlling costs and optimizing asset utilization. Those are things that have sort of become the hallmark of CSX. The last couple of years have been a bit of a blip in that story because we’ve struggled to get enough crews to run the railroad, but we are back.
The two things — I wouldn’t say that we’ve deemphasized, but the 2 areas that we — that Joe sees very clear opportunity is customer service and valuing and developing employees. And so those have been the areas where he’s been spending a lot of his time. He’s been out in the field, meeting with employees. He’s actually got this video series that he does with employees every week. It’s called On Track with Joe. He’s out in the field interacting with folks. And it’s really just, again, brought this new energy and life to the company that I think people are really excited about.
Garrett Holland
That’s great. When we think about demand and the volume trends you’re seeing, help us understand how volumes are tracking in Q4 relative to plan. What’s tracking a little bit better or behind?
Sean Pelkey
Yes. It’s funny how you asked the question relative to plan. it’s difficult to plan in this environment. But when we look at the business sort of broadly, there are some areas we’re up strength. Automotive, clearly, production is up on the automotive side. We’ve got a lot of finished vehicles that are sitting on the ground ready to move, and production is expected to be up going into next year. So that makes us feel very confident about our ability to serve it.
When we look across the rest of the merchandise markets, Ag & Food has been an area of strength here in the fourth quarter. That’s partially driven by demand for the product and partially driven by the fact that our service levels are better. So we’re cycling trains faster. When you cycle trains faster, you can move more volume.
Some areas of softness within in the merchandise segments, metals, forest products, things that are related to housing, phosphates has been down, especially with the storm down in the Bone Valley area of Southwest Florida. When we look at the coal business, that’s actually been up for us here in the fourth quarter, and we feel good about the underlying demand for both domestic and export coal going into next year. Part of the reason it’s up is because we now have the crews that we need in order to serve the demand that’s out there that’s been a struggle for us most of the year.
We’ve been, I would argue, underserving what the customers have wanted us to move. So that’s been a good news story. Intermodal has been kind of flat. And I would say, down a little bit sequentially from the third quarter. I think what you’re starting to see there is a little bit of customer demand that’s waning, you’re starting to see a little bit of buildup of inventories, and you’ve heard it from some of the large international steamship lines that they see some storm clouds on the horizon. So I think that could be a little bit bumpy going forward.
Garrett Holland
Yes, there’s been a lot of focus on the storm clouds potentially rolling in as we think about next year. Help us understand the demand visibility. There’s been disruptions this year across supply chains, I think industrial markets, auto markets, there’s got to be pent-up demand there, but you’re seeing weaker consumer demand, perhaps help us understand how CSX views that demand occur into ’23.
Sean Pelkey
Yes. So just to sort of take you behind the curtain in terms of how we do financial planning at the railroad. The first thing that we do is we look at what are the key economic indicators within each of our markets. And that sort of forms the baseline for, okay, are we going to grow above or below that level? I think as we go forward, what we can’t control is what the economy and what the consumer is going to do and what the Fed is going to do.
Those projections for IDP have been coming down in the last couple of months. And so we’re going to probably ride along with that. But what gives us a lot of confidence about our ability to actually do better than that is the fact that, a, we struggle to meet the demand that was out there for most of this year. We were running at order fill rates in the 60% range in many markets, in some cases, 70% on a good day.
So if you see the order rate come down just a little bit, our order — the absolute number of orders come down a little bit, our order fill rate goes up, we’re able to serve the customer better, some of that traffic this year that diverted over to truck, comes back to rail. And I think there really is an opportunity for us to offset any kind of economic headwinds that might be out there on the merchandise side of the business going into next year.
Garrett Holland
That’s great. And I know you’ve been working hard to restore the service product, maybe not being able to meet all the customer demand that was out there today. Is the sales team being empowered just to go out and ask for more volume now that you’re in a better position to deliver it? Are we at that turning point yet?
Sean Pelkey
Well — I think it’s hard to sit across the customer and say, “Hey, for the last 6 weeks, we’ve been operating really well, give us more volume. ” But the good news is, Joe, and all the conversations he’s had early on with customers and certainly what we hear from Kevin and his team is our customers want to give us more freight. We need to be able to deliver a consistent and reliable service product for them to be able to trust us. There are markets where having better service and having more crews translates immediately to more volume, that’s going to be your unit train business.
The grain business we talked about, the coal business we talked about. But it’s kind of a show-me story on the merchandise side. And so I think there’s 2 things there. One is, as we’re able to do this more consistently, you start to see some of those loads shift back. It’s probably gradual, not immediate. And then the second really is building that pipeline of industrial development opportunities as you see new manufacturing that’s coming online in the Eastern half of the United States. They’re looking for rail-served options, and we happen to have a very strong industrial development program where we partner with state and local governments. We get select sites that are build ready.
They’ve got utilities, environmental, everything is taken care of. They’ve got roads, and they also have rail access. So this is what customers are looking for. and they look across that landscape. They see the location that’s located with — on CSX. And they also look at the metrics, and they look at how well run the railroads are. And I think the good news is, we’ve been winning a lot of those opportunities.
That sets us up really well longer term. It sort of builds the foundation of that pipeline of growth. A lot of that is not going to come in 2023. We’ll see a little bit in the back half of next year. But we’ve got opportunities for new plants that are going to open up in ’24, ’25, ’26. And so regardless of what the economic environment is, you’re going to see growth coming out of those development opportunities?
Garrett Holland
Yes. I think those are maybe underappreciated they’re a bit out of model since longer term, but really nice benefits. I wonder if you could size those for us a little bit. But also the debate for rails is — can they grow? PSR has been about efficiency, taking costs out. But how does that model really enable growth longer term?
Sean Pelkey
Yes. So I think when you look at what’s our goal, our goal is to outgrow the economy, right? And if you look at how have we done over the last 5 years. We did it once, and that was in 2021. And our service product actually wasn’t that great in 2021, but we were — we took advantage of a growing economy. As we look forward, our goal is to do that each and every year.
And how do we do that? It’s by rebuilding trust with the customer. It’s by investments in technology that give the customer a greater visibility to where their freight is. Even things like investing in a brand-new dispatch system, which will allow us to make better decisions, the computer will help to tell us which train goes first, not because that train needs to get there next, but because it’s going to have a downstream network impact by that train getting dispatched first. So ultimately, you get better, faster, reliable transit times and you do that over a long period of time. And you’re able to manage that through a cycle, you regain the trust of the customer.
You also have, frankly, the benefit of emerging trends around a focus on ESG. You’ve got customers of ours and of truck. We’re looking at the alternatives, and they’re hearing more and more about the efficiency of rail. The fact that we’re three to four times more fuel efficient than truck. And they’re thinking about how can I get rail to be a broader part of my supply chain.
We have 1 customer who is still a very small customer of ours. Today, they move about 80% of their business via truck, and they told us over the next 5 years, they would like that to be 80% rail. I think you’re hearing a lot of stories like that, maybe not quite to that extreme, but there’s — the demand is there. It’s just a function of can we serve it, do we have the right resources? And do we have the right operating model. I think the answer is yes, but we’ve got to prove it over an extended period of time.
Garrett Holland
In those conversations with shippers, are you hearing more focus on near-shoring activity Obviously, the East Coast ports have attracted a lot of volume, still working through some of that congestion. If you could speak on those topics, when do you expect that congestion to clear, but also our shippers bringing more production back to your footprint?
Sean Pelkey
Yes. it’s a good question. I think a lot of companies were scarred by what happened with all the supply chain disruptions in 2021 and then the Russia-Ukraine situation. So there’s a lot of talk and a lot of thought about do we move some of these manufacturing facilities back to the United States. You also have automation that’s come a long way at manufacturing facilities. The vast majority of those facilities are still very labor heavy. But as you see additional advancements in automation, the labor cost issue starts to become less and less of a problem.
So we’re optimistic about the ability to see more plants locate. And when they want to locate in the United States, there’s a lot of them that want to locate on our network in the eastern half of the United States because that’s where the population is, particularly in the Southeast. Those are areas that are very friendly for business development and growth.
And that’s where we’re seeing a lot of the announcements. We’ve got the new Ford F-150 electric vehicle plant, that’s on CSX. A couple of other EV manufacturing plants. We’ve got Nucor and Novelis that are — have announced new plants on CSX in the next couple of years. So, you’re starting to see that some of that momentum, how much does it pick up and how many new facilities do we see in the future? Our goal is to try to be positioned for it if and when it happens.
Garrett Holland
In the dialogue with shippers, obviously, pricing is an important topic. Inflationary pressures continued. You’ve got to earn a return on the investments you’re making here. Help us understand the pricing conversation. You didn’t participate like some other transportation modes on the upside. How do you recover pricing now?
Sean Pelkey
Yes, Garrett. In terms of participating on the upside, you’re right, we don’t most of our business doesn’t move spot. It moves contract. And the way the contract cycles work, we’ve got about 2/3, about 60% to 70% of that business that renews in the fourth quarter and the first quarter. So we’re in that renewal cycle right now, and the inflationary pressures are real. There’s no doubt about that.
If you have read the headlines you’ve seen about the rail union labor issues and the recommendations that came out of the Presidential Emergency Board which call for a 14% increase in wages upon ratification of those agreements and 24% over a 5-year period in addition to $1,000 bonuses. We’ve also got headwinds on the nonlabor cost side. We’ve talked about this before, but a lot of those nonlabor costs that we have, whether it’s third-party contractors or outside labor tends to be based on lagging indicators.
So even if we see a decline in inflation next year across the U.S. economy, we may not be the beneficiary of that on our nonlabor costs until we get into 2024. So we’ve got visibility into some higher inflation next year. Those are all things that come into play in those pricing conversations with customers. Service is also important.
So it’s critically important that we continue on this trajectory of improved service and improving service and remain dedicated to having the right number of crews out there in the right locations. So we can look across the table with the customer and with a straight face say, yes, you’re getting the service that we told you, you were going to get. We’re facing inflationary pressures and here are the rates that we think we need to charge.
Garrett Holland
Yes, that’s great. Encouraging to stay on the right side of the price/cost spread. Also interested if you could talk a little bit more about the mix shift dynamics you’re seeing in the book of business, both in Q4 and ’23 and some of the yield and profitability implications.
Sean Pelkey
Sure. In terms of mix as we get into next year, on the merchandise side, you’re going to see the impact of the consumer economy show up, housing. We talked about that earlier. So there will be some specific headwinds. You’re also going to see the benefit of growing automotive business more than likely with production expected to be up 5% to 10% next year.
We feel good about aggregates as well. You’ve got the infrastructure bill, you’ve got rebuilds going on in Florida and hopefully, this next hurricane isn’t too bad. But at the same time, when these things happen, there’s rebuilding efforts that need to occur and that’s traffic that we can move.
As we think about coal going into next year. I talked about us missing some of the demand that was out there this year. We have reason to believe that there’s still going to be strong demand for domestic coal going into next year. Inventories are quite low.
Natural gas prices are still high. So even if we’re in the middle of a recession next year as long as those commodity prices stay high, we feel good about the demand for domestic coal next year and export coal, it’s been a very strong year for us, particularly on the pricing side. As we go into next year, we might see a little bit of moderation on the pricing side, probably higher than it was historically. But not as high as the record levels that we saw for the majority of this year. But we should be able to still move a fair amount of export coal next year.
Garrett Holland
I had a couple of questions on the OR trajectory as we think about Q4 and next year. Clearly, this quarter, you’ve got some dynamics with seasonality, fuel costs. We talked about volume trends, inflationary pressures, some pricing power as well. Help us understand those moving parts as you put together the ’23 plan.
Sean Pelkey
Yes. Well, you hit on all the Q4 factors there. Yes, as we think about ’23, our goal is to grow above the economy. If we can do that on a sustainable basis, margins will take care of themselves, right? So our #1 goal is not necessarily to drive down the operating ratio. That’s a small part of our incentive compensation. The biggest part is to actually drive growth in the business, drive profitable growth in the business.
As we go into next year, we’re going to have inflationary headwinds. We already have a pretty good inkling of what those labor headwinds are going to be, and we talked about those on the third quarter call. I just talked about the headwinds in non-labor inflation. So those are going to be working against us. We’re going to have higher depreciation and some other structural costs.
We have some locomotive rebuilds. On the flip side of that, as the business runs more fluidly, we’ll be able to take some cost out. We’ve been running with more locomotives than we need. We are going to continue to hire crews for the foreseeable future to make sure that we’re adequately resourced everywhere across the network.
So there’ll be some puts and takes on the cost side to factor in for next year. I would say 2 big variables that will sort of drive the OR trajectory going into next year are going to be export coal pricing. And then the other piece of that is intermodal supplemental revenue or other revenue. That’s been a big driver of revenue gains this year for us as we’ve had a lot of containers that have been sitting on terminal or at container yards off terminal.
And we charge a daily usage fee for that as the supply chain clears up as inventory starts to come down, we expect that to work its way down. There are some costs associated with that, but that would be a net headwind to operating ratio as well.
Garrett Holland
Yes, on the timing for those — the burn off of the storage and premises and use charges, are they starting to fade? When do you expect those completely flushed out and the timing of the offset, the $40 million quarterly P&L drag you’re seeing from an inefficiency perspective, help net those out for us.
Sean Pelkey
Yes. So on the storage fees, I would say there’s glimmers of things starting to get a little bit better, but we still have a lot of containers that are dwelling on the terminal and at container yards. So our expectation as we work our way through the fourth quarter here and get towards the end of the year, you’ll see that step down a little bit. And then as we get into next year, it will step down even further. And more than likely, if we see a slight downturn in consumer demand, you’re probably going to be getting closer to more normalized levels as you go through the year on the intermodal storage side.
Garrett is talking about the congestion-related costs that we’ve talked about over the course of this year, roughly $40 million a quarter. What I talked about on the third quarter call is that some of those costs are going to be a little bit sticky. The network is already beginning to run faster. So things that naturally fall out are things like freight car rents, as your cycle times improve, you’ve got fewer cars that are on your network, you’re able to push more of that off-line.
And so that has a positive benefit. Some of the costs will be a little bit stickier though, included in that $40 million in — are hiring and training costs for T&E employees. We’re going to continue to hire and train. And once we get the right number of conductors in the right location, we’re going to switch over to engineer training. You’ve got the conductor and the engineer on board, the engineer drives the train. And there is a real need to train engineers in a lot of different areas of the network. So that will continue into next year.
There are costs associated with moving those intermodal boxes around and storing them at our facilities. So that will go generally speaking, hand-in-hand as the intermodal supplemental revenues work their way down.
Garrett Holland
I think CSX was out in front as much as possible of this labor challenge you got after the problem earlier. I think you’re in a better position now the training pipeline, the additions of the training pipeline puts you well on your way to meeting your target. How has your staffing model changed? I know you’re trying to deliver a resilient service product.
You talked about continuing to hire not that you keep a buffer, but has the approach to staffing change potentially in a downturn? I know you have attrition that could help manage the network if things get really bad. But talk about the change in the staffing model.
Sean Pelkey
So the historical wisdom in the railroad industry was if you have someone that’s furloughed and just the way it works, if you have a conductor engineer, you’re in the middle of a business downturn. You can furlough that employee at any time. They’ll have their health benefits for a period of time, but there’s no wages that get paid. So you’re in the middle of a downturn, you would typically furlough your employees. And then if you brought them back within 6 months, the conventional wisdom was 90% of them would come back.
That is not what we saw in 2020. Within 6 months, we called them back because demand cratered and then came back very quickly. And I would say we probably had about 50% of them if that, that showed back up. And so that — and I don’t think that, that dynamic has changed, especially with the struggles that we as an industry have had in attracting talent to 6-figure jobs in a sector where there is the education requirement is quite flexible.
But as we think about how do we manage that going forward, I think the first lever is not going to be furlough, the first lever is slowing down the hiring in areas where we’re doing okay, where we probably have a little bit of buffer. And then letting attrition take care of itself. If we have too many active employees, one of the things that we can do is move them into engineer training to set us up for growth coming out of a potential downturn.
Garrett Holland
a couple of questions. You’ve done a good job on the intermodal trip plan compliance. How quickly do you expect to restore the carload side of the business. And then the labor agreement, the ratification process, help us understand the time line as you see it today.
Sean Pelkey
Okay. So in terms of trip plan compliance performance, and this is probably the closest that we have today to a real customer-facing metric. I think Joe is really pushing the team to think about even new and better ways to give us a sense of how well we’re serving the customer. But trip plan compliance tells us, did we meet the trip plan. It’s just exactly what it says. We’ve been running 90% to 95% in the intermodal service product. In fact, we had 2 days in the last couple of weeks that were at 98%. So we’re there.
On the carload side, that’s the one that’s been lagging most of the year. Happy to say that we’re now consistently running over the last 3 weeks, above 70% in that 70% to 75% range, which is good, not great. Just to give you some context, back in 2019 when we were operating probably at our best in the company’s history. Our average for that year was 77%. We have seen some days that have hit 80%. That’s kind of our internal target for now. It’s not the destination, but it’s where we would like to be. And it’s good news to see that we’re actually hitting up against that. And I don’t see any reason to believe that we’re going to go backwards on those measures we’ve got the right number of crews now.
We probably still have a few locations where we’re short, but that’s where the intense focus is. You also asked about the union labor negotiations. We got some good news yesterday the BMWE had until November 19, and that got pushed back into early December. So it will line up. We’ve got 2 more big votes outstanding with the conductor and engineer unions. Those will come out next week. And depending on the outcome of those, that will sort of determine the course from there. We’re optimistic we’ll get to a good solution, be able to pay people much more than what they’re taking home today.
And that really — once that’s out of the way, that really gives us the line of sight to figure out how do we drive a better employee experience on the whole. Joe has been gathering a tremendous amount of good feedback from both the employees and the union leaders. And he’s talked about interest-based bargaining which is something that we are already doing at CSX, but we’ll continue. Trying to get cut through all of the noise of what are the current agreements and what are all the things that get in our way in terms of getting a better employee experience. And let’s actually look at what the employee needs and what the company can offer and figure out where those interests align and then work from there.
Garrett Holland
That’s very helpful. Just a question on some of the investments you’re making. You talked about technology on the M&A side, some interesting deals with Quality and Pan Am. How do those investments organically and selectively with M&A help you to achieve these growth ambitions consistently.
Sean Pelkey
Yes. I would say, as we were going through the scheduled railroading transformation, the first couple of years was really focused on let’s make sure that we’re shoring up the network and there was a decreased emphasis on growth investments as we tried to just get the service product to where it needed to be. As we now make our way out of that and especially as we see a reacceleration in the service product, we’re trying to think about how can we innovate? How can we do things differently? Because we — you look at 40 years of railroading history since deregulation. The industry has not been able to sustainably outperform IDP outside of the Intermodal business.
And that is our goal going forward. So how do we do that? There are places where you’re going to need to make investments. The good news is across the network when you think about the rail, we’re in very good shape. There are some places where we’re investing in siding capacity and terminal capacity. But on the whole, we’ve got room to add trains to add cars to existing trains.
And so it’s really a matter of how do we think differently about ways to grow. I think technology plays into that, as I talked about some of the customer-facing tools that we’re developing. And then some of the smaller acquisitions that we’ve made, the footprint up in the Northeast gives us access to new ports, new customers and the initial conversations that Kevin and the team have had with those customers indicate that when we get the railroad up to the right standard, there’s a lot of opportunity to grow.
And you talked about Quality Carriers, CSX buying a trucking company on the face of it doesn’t make a ton of sense. But Quality is an extremely well-run specialty trucking — specialty chemicals trucking company. And they are excited about all the opportunities that they’re hearing about with their customers to convert some of that freight from truck from over-the-road truck to rail and actually grow the freight pie as well. So a lot of different opportunities there that we’ll be able to build on in the coming years.
Garrett Holland
Running up on time, but just to pull up and think a little bit beyond some of the cyclical factors that are weighing on investors. What’s the right way to think about the growth algorithm for CSX — Growth fast with volume faster than economic activity, you’re trying to deliver attractive incremental margins, earning returns on these investments. How do you bottoms-up make that build for growth potential at CSX long term?
Sean Pelkey
Yes. I think all the elements are there. It’s delivering the service product, communicating better with the customer and having the right technology and tools in place to ultimately drive that growth, I talked about the baseline of industrial development activity that sort of forms the — we don’t have to worry about the economy if we have new plants that are coming online because we know we’ve got a piece of the business that’s going to grow no matter what.
And then on top of that, it’s having those conversations with the customer about, hey, today, we’re serving 20% of your demand in and out of the plant. How do we move that to 30% to 40% to 50%. And that’s really the key to unlocking the growth.
Garrett Holland
Fantastic with that, we’re running up on time, but I want to thank Sean for being here.Thanks CSX, and hope everyone has a great rest of the conference. Thank you.
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