Seek and Ye Shall Find; or, Big Day for the Black Thoroughbred!

February 13, 2019

Greetings;

“Ask, and it shall be given you; seek, and ye shall find; knock, and it shall be opened unto you….Ask, and it shall be given you; seek, and ye shall find; knock, and it shall be opened unto you”/Matthew 7:7

  • Q: “When will Norfolk Southern be more like CSX?”/”Average” Analyst Question, 2018 (AKA “The World Turned Upside Down”)

  • Q: And when will we get a real dialogue with detail on their Operating Plan?”/my own longstanding inquiry 2016-2/10/19

  • A: “Sooner than you think!”/NSC Management 2:11:19 (regarding PSR implementation, commitment and margin improvement as well as the sharing of detailed information)

Reflections on Norfolk Southern’s Investor Day in Atlanta - Greetings after a snow-day delay, which served to allow (force) me to take the time to reflect on the events of Monday, when, after an almost 5-year absence, NSC hosted an investor conference in its soon-to-be HQ city….and, as the King James Bible quote notes, management faced up to a skeptical and questioning audience and gave us what the audience and I were seeking (see the Investor Day Preview):  a bold three year transformation plan (“TOP 21”), rich with detail; a bold, strong goal (60% OR in 2021), with lots of detail; key leadership/”change agent” introductions; and a demonstrated level of drive and commitment from the management team, and CEO Jim Squires in particular, that had been heretofore hidden from view by what I hope is now the old IR (“say little and stick to the script”) methodology. 

Presents under the tree - This was a big meeting and it could have gone very badly – instead it was a great success.  The market liked what they heard right away (the shares were up over 3% on the day); upon reflection I would like to see more (of course) – more numbers, more info, more education of the shareholder base (on OR/Capex/ROIC, etc); that’s always the case.  But make no mistake - this opening salvo of the “Reimagined Norfolk Southern” hit it’s mark and then some.  I was looking forward to this for months – no, years – and like a perfect Christmas when one is a child, it was worth the wait.  Let’s just not wait as long next time.

What went right for NS Investor Day?  Most of it, for me and the Investor/Analyst audience.

  • Demonstrated commitment – This was clear throughout the meeting, from the CEO and the known-C-suite to the new players, particularly their new prized change agent, SVP-Transportation Mike Farrell, whose reputation precedes him; while much was expected of him by the financial community, the vague language describing the initial PSR decision (“informed by PSR” etc) meant that the audience entered the David Goode building skeptical and left (almost) entirely convinced.

  • Bold Targets – to hit the 60% Operating Ratio in three years means a reduction of close to 700bps – NSC uses 65.4% OR for the past (2018) year, while the Street sees that as more like 67% due to a big “lump” of RE sales in Q4, as we discussed last month.  In point of fact, that makes the goal that much more bold.  Yes, we saw huge OR reductions in the first years of PSR implementation before (CSX and CP), but from higher start points.  A key point here is that the OR target – and even the 5% CAGR level for revenue growth in the Plan period – were above Street expectations.

  • New Plan Detail – I want to taste the sausage (improved financial results), sure – but I also in this case want to see how it is made – and NS provided a lot of detail on the transition from initial terminal focused “Clean Sheeting”, led by Farrell (and with a great deal of customer involvement, it seems) to “Top-21”, the latest, PSR-infused version of the “Thoroughbred Operating Plan”.  The focus want on “hump yard reduction” (the simple, even simplistic analyst proxy for PSR).  Although that may have contributed to questions regarding the possible differences between Top-21 and other railway PSR conversions, I heard a lot of similarities, starting with hearing the word “accountability” often on Monday:

o   Simplification

*  Of service offerings  - “single network optimization”

*  Of organization (the Networks Ops Center/dispatching centralization, for example, with all four regions dispatched under one roof)

*  Of Top-21 management – a new cross-disciplinary Network Planning & Optimization (NPO) group under John Friedmann will be in charge of the plan, rather than 4 independent networks on the system

o   The reduction/elimination of (what UP calls) “Boutique Services”, or trying to be all things to all shippers

o   Possible de-marketing, using its “Yield Up” focus; changing customer behavior (from 5 to 7 day service, etc) via carrot & stick (“this wont be ideal for every customer”) – note that while NS is using assessorial charges & demurrage to “change customer behavior”, it isn’t a major line item and they a re also offering credits for when the delay is on their side of the ledger.

o   Large reductions of excess assets – railcars, locos (-500 by ’21) and headcount (-3000, back-end loaded, by ’21).  Rail car fleet size reduction, for NS and their shipper/customers, is a direct target of TOP-21 (and PSR in general), through better asset utilization.  The loco  fleet will be renewed at the same time by a stepped up AC-conversion plan, mostly rebuilds supplemented by some new unit acquisitions.  See photo, below.

  • Yield Up – taking advantage of “one of the best pricing environments in years” as well as changing the volume mix, etc (above); putting rail assets to best (ROI) use….

  • Still healthy Capex (ongoing range of 16-18% of revenues) – of course, what I call a necessary – and rewarding investment in the network is still challenged by large sectors of the financial community as the Q&A demonstrated….

  • Improving sequential service levels – Velocity is up 13% and dwell down 20% YTD, for example.  Service improvement is a usual (although sometimes eventual) PSR outcome, leading to a hoped for return to the virtuous circle (AKA “the Grand Bargain”, unspoken but understood, between shippers and rails – price for service and capacity – and investment).  NS has redefined (though not to us, fully) its’ Service Delivery Index and targets a 40% increase by ’21.  The “capacity dividend” coming form TOP 21 will be used to serve, in part, as “surge capacity”, which should be reassuring (for shippers and regulators alike). 

  • Short lines remain important – 250 of which touch NS.  There have been rumors and discussion of how PSR changes would raise costs for their SL partners; that was left unexamined but their importance to the railroad was underscored several times and by the fact that top marketing/strategy leadership left ATL after the Conference for a major S/L meeting at their “Brosnan Forest”….However, Squires said that unlike CSX, they expect no major “package” of short line segments (just the usual small amount from time to time).

  • Technology understanding – we got to hear from VP-Customer Service Karol Lawrence on customer-facing technologies (new portal, no mobility access, improved terminal ops, etc).

What we might have heard still more about –  OK, so  the conference was a success – but I cant get no satisfaction (though I try).  One issue is that unlike “traditional PSR implementation (big operational & financial gains early in the process), the NS Top-21 Plan is, in the 3-year time frame, back-end loaded – with 100bps coming out of the OR this year (and about 1/6 of the headcount reduction, there is a bit of trust required to believe that years 2 & 3 will deliver.  Some of my suggestions are to simply build on what they shared – for example to make a pledge to come back very couple or few years (a la CN) to update us and provide detail – even if we have to wait on the 2021 completion of this Plan and the official opening of the Atlanta HQ…..Others, in the first bullet point, deal with marketing in what was clearly, and rightfully so, an operations-driven meeting. 

  • Details, details - Volume estimates weren’t provided  - I understand the macro-economic elements involved (auto production, consumer spending, etc) but I like to look at rails through units (and not – only, RTMs, eh?) as well as revenues. 

o   The 5% CAGR revenue growth outlook to 2021 looked high to some in the crowd; it seems low to me given the described pricing environment – the breakdown being Intermodal 10% (low!); Merchandise 5%, Coal – 2%

o   Does the 5%  revenue CAGR, assuming, say, 3% price – mean net of “de-marketing”?

o   Can they define their “lane rationalization” (a la – sorry – CSX)?

o   The macro data used wasn’t always directly relevant – for example, FTR’s intermodal expectations of 2019 (domestic unit – unit! – growth of 4.9%E and international of 2.4%E) are interesting, in a vacuum (although we tend to follow Larry Gross) – but the NS domestic intermodal machine should continue to grow much more than the industry!

o   The 3 segment VPs didn’t answer Q&A (nor mingle much), and head of Strategy Mike McClellan didn’t get a presentation slot - which is a shame and hopefully the last vestige of the “old IR regime”.  I had a lot of questions for Intermodal VP Jeff Heller, and hopefully wont have to wait till IANA in the fall for answers….One was – what does JBHunt think of slide 5 of the Network Planning presentation – coal cars running on a double-stack train?!

  • Still no ROIC! NSC didn’t reveal their ROIC – neither 2018A nor their 2021 Target

o   ROIC is the ultimate justification for “high”  or “elevated” levels of Capex, an evergreen issue for some in the analyst community, especially given the UNP “line in the sand”

o   ROIC is a great counter to the “Cult of the OR”, especially when:

*  Achieving their 60% OR target will only serve to shrink but not eliminate their so-called “OR Gap” to their peers, especially CSX

*  Given the premium intermodal franchise, and the contribution to said “OR Gap” of IM, ROIC serves to help publicly justify the IM franchise

  • More could have come on tech – this will be the big rail/investor issue post-PSR.  Given the NS leadership role on the rail-tech regulatory side (led by EVP John Schieb, whose RailTrends2017 speech on moving PTC from the “unfunded  mandate” to the “backbone of the future digital railroad” you might recall) as well as fascinating projects like the visibility into inbound empties, a huge market share issue, with short-lines and a big paper company, I highlighted after the Short Line Conference last spring – well, they had more to say than they did….

Anthony B. Hatch 
abh consulting
http://www.abhatchconsulting.com