Norfolk Southern Corporation — Q2 2018 Form 10-Q
Business context and reporting period
Norfolk Southern operates a roughly 19,500-mile freight rail network across 22 states and the District of Columbia. This unaudited report covers the quarter and six months ended June 30, 2018, compared with the same 2017 periods; balance-sheet figures are compared with December 31, 2017. Amounts below are in millions of dollars unless stated otherwise.
Financial performance
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Railway operating revenue | $2,898 | $2,637 | $5,615 | $5,212 |
| Income from railway operations | $1,026 | $872 | $1,861 | $1,629 |
| Net income | $710 | $497 | $1,262 | $930 |
| Diluted EPS | $2.50 | $1.71 | $4.43 | $3.18 |
| Railway operating ratio | 64.6% | 66.9% | 66.9% | 68.7% |
- Revenue rose 10% in Q2 and 8% in the first half; income from railway operations increased 18% and 14%, respectively. Management described Q2 as a record for operating income, net income and diluted EPS, and reported a record-low Q2 operating ratio.
- Traffic volume increased 6% in Q2 and 4% year to date. Intermodal revenue grew 20% in both periods; merchandise revenue rose 8% in Q2 and 4% year to date. Coal revenue increased 4% in both periods.
- Operating expenses rose 6% in Q2 and 5% year to date. Higher fuel costs were a major factor: fuel expense increased 43% in Q2 and 33% in the first half, reflecting higher prices and consumption. Purchased services and rents also increased, while compensation and benefits declined.
- Effective tax rates were 23.2% for Q2 and 22.6% for the first half, versus 36.3% and 35.2% a year earlier. Management attributed the reduction primarily to 2017 tax reform, with the year-to-date rate also benefiting from retroactively enacted tax credits.
Cash flow, debt and liquidity
- First-half operating cash flow was $1,826, up from $1,576. Investing cash outflow was $786, including $836 of property additions. Financing cash outflow was $1,300, including $700 of share repurchases, $408 of dividends and $750 of debt repayments. Cash declined $260 to $430.
- At June 30, total debt was $9,646, including $500 of current maturities; the debt-to-total-capitalization ratio was 36.8%, compared with 37.5% at year-end. The company issued $500 of 4.15% senior notes due 2048 in Q1.
- Working capital was negative $448, compared with negative $396 at year-end. Management said cash on hand and operating cash generation should be sufficient for ongoing obligations. The company had no borrowings under its $750 credit agreement or its renewed $400 receivables securitization facility.
- Repurchases totaled 4.8 million shares for $700 in the first half, versus 3.4 million shares for $402 in the prior-year period. The board authorization had 51.7 million shares remaining at June 30.
Outlook, commentary and risks
- Management expected merchandise, intermodal and coal revenues to continue increasing year over year in the remainder of 2018. It cited pricing gains, higher fuel-surcharge revenue and expected volume growth; coal expectations particularly reflected export-market volumes. The filing provides no consolidated full-year earnings or revenue guidance.
- Management cited higher fuel prices, lower network velocity and related service costs as expense pressures. It expected average headcount to trend slightly higher sequentially in the second half.
- About 80% of railroad employees are covered by collective bargaining agreements. Agreements had been reached covering 95% of unionized employees; negotiations with one union remained in mediation. New agreements generally reopen for negotiation beginning January 1, 2020.
- Key disclosed risks include rail-safety and Positive Train Control implementation requirements, potential additional regulation of rates and service, environmental exposure, and the effects of climate-related rules or market changes on rail traffic, including coal. The company recorded $58 of environmental liabilities at June 30 and cautioned that actual cleanup costs may differ from estimates.
- Fuel-surcharge antitrust litigation remained subject to possible appeal after class certification was denied; the company said it intended to defend the case and did not expect a material effect. A separate chemical-shipper rate complaint had been resolved in the company’s favor, with the appeal denied in January 2018.
- Unusual or period-specific items included a $31 employment-tax refund benefit in compensation expense in both Q2 and the first half, and a shift in presentation of pension costs under a newly adopted accounting standard. The pension presentation change had no effect on net income.
Important facts for investors to verify
- Whether volume, pricing and fuel-surcharge growth persist, and how higher fuel and service costs affect margins and the operating ratio.
- Whether management’s commodity-level revenue expectations for the second half are realized, particularly for coal and intermodal.
- Cash generation, capital spending, working-capital needs, debt maturities and the pace of share repurchases and dividends.
- Progress on Positive Train Control deadlines and labor negotiations, along with any changes in environmental liabilities or litigation exposure.
- The extent to which the lower tax rate and employment-tax refund affected reported earnings and how those effects compare with future periods.