Earnings Call Transcript
NORFOLK SOUTHERN CORP (NSC)
Earnings Call Transcript - NSC Q1 2020
Operator, Operator
Greetings. And welcome to the Norfolk Southern Corporation’s First Quarter 2020 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. As a reminder, this conference is being recorded. It is now my pleasure to introduce Pete Sharbel, Director of Investor Relations. Thank you. Mr. Sharbel, you may begin.
Pete Sharbel, Director of Investor Relations
Thank you, and good morning, everyone. Please note that during today’s call, we may make certain forward-looking statements, which are subject to risks and uncertainties, and may differ materially from actual results. 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. Our presentation slides are available at norfolksouthern.com in the Investors section, along with our non-GAAP reconciliation. Additionally, a transcript and downloads will be posted after the call. It is now my pleasure to introduce Norfolk Southern’s Chairman, President, and CEO, Jim Squires.
Jim Squires, Chairman, President, and CEO
Good morning, everyone. And welcome to Norfolk Southern’s first quarter 2020 earnings call. Joining me today are Alan Shaw, Chief Marketing Officer; Mike Wheeler, Chief Operating Officer; and Mark George, Chief Financial Officer. Before we discuss our financial results, I would first like to thank our employees for their dedication during these unprecedented times. Norfolk Southern employees are proud to be delivering an essential service. In a video message to employees, dispatcher Misty Brayton expressed the sentiment well when she said, 'We supply America with the goods that they are short of right now.' And I hope everybody that works for Norfolk Southern feels essential after this. It is truly inspirational to watch our employees rise to the challenge. In response to the COVID-19 pandemic, we established three simple goals early on: protect our employees, serve our customers, and exercise strong financial discipline. I will talk briefly about the steps we are taking in each area. Our first responsibility is to protect our people. We acted quickly based on CDC guidelines and took extensive measures to keep employees safe. We transitioned most of our office employees to remote work in a matter of days. For employees whose jobs require them to work on site, we implemented social distancing and established rigorous cleaning protocols for their work environments. Our preventive measures, combined with the diligence of our employees, have kept the number of confirmed COVID-19 cases at Norfolk Southern low. I am also pleased to report that our employees are working safely through the many potential distractions. Our thoughts are with all those whose lives have been impacted by the virus. Our second goal is to continue providing an excellent service product for our customers, and that’s exactly what we are doing. Our customers are making rapid adjustments to their operations due to the impacts of the Coronavirus, and we are right there with them every day as a valued partner. They count on us for reliable service, close collaboration, and nimble operational adjustments, and we are delivering. We will address our third goal, which is to exercise strong financial discipline throughout the balance of this call. The work we have done to implement our strategic plan has made us an even more resilient business, putting us in a good position to navigate the current market disruption. I will now turn to our financial results for the quarter. Allow me to first remind everyone of our announcement on April 16th of a non-cash charge of $385 million related to the ongoing disposition of 703 locomotives. Thanks to the excellent execution of our strategic plan, our fleet today is more efficient, and we are able to operate with significantly fewer locomotives. Mark will provide additional color. But as you can see on slide five, we have provided an adjusted view of our financials to exclude this charge. This is what I will reference in the rest of my comments this morning. Adjusted EPS for the quarter was $2.58, and the adjusted operating ratio was 63.7%. These numbers improved upon last year’s record results by 3% and 230 basis points, respectively. Within the context of an 11% volume decline, they are remarkable achievements that demonstrate this team’s urgency to transform our company. We also set records in metrics such as train performance, terminal dwell, and shipment consistency among others, and accelerated crew start reductions in excess of declining volumes for a third straight quarter. When coupled with the ongoing realignment of resources around our new operating model, we reduced operating expenses by $202 million in the first quarter when excluding the non-cash locomotive charge. Our team is committed to driving improvements across the network and significantly and consistently lowering our operating ratio. We are focused on the factors within our control and confident that by continuing to adjust and successfully execute our strategic plan, we are building a stronger, more resilient, and a more profitable Norfolk Southern. I will now turn the call over to Alan and the team to begin detailing our first quarter results and our progress executing the strategic plan. Alan?
Alan Shaw, Chief Marketing Officer
Thank you, Jim, and good morning, everyone. The first quarter started with the impact of low natural gas prices and mild weather on our coal franchise. In February, we saw the initial impacts of the COVID-19 crisis, impacting international intermodal volume. As COVID-19 evolved into a global pandemic, a majority of our markets experienced volume declines, with business levels further impacted by plummeting energy prices. In the face of this challenging environment, we are flexible and responsive to market changes and customer needs, adjusting our operating plan and resources where necessary. We remain focused on our long-term strategy with an emphasis on superior service to our customers and margin improvement, demonstrated by consistent growth in revenue per unit and revenue per revenue ton-mile over the last three years. Our service is the best in Norfolk Southern history, a testament to the commitment of our employees to respond to rapidly evolving customer requirements and deliver an exceptional service product, while producing structural and volumetric improvements to our cost. Moving to slide seven. The impacts of COVID-19, energy, and excess truck capacity lowered our revenue by 8%, with the volume decline partially offset by RPU less fuel growth in all three business groups, marking our 13th consecutive quarter of delivering year-over-year RPU growth. Merchandised revenue was down 1%, as record RPU partially offset a 5% volume decrease. Automotive car loads declined due to plant shutdowns late in the quarter in response to COVID-19. Steel volumes continued to be impacted by weak demand, and frac sand faced pressure from low energy prices, while favorable spreads allowed increases in crude oil volumes. Intermodal revenue declined 9%, driven by a loose truck market, lower demand, and the early negative impacts of COVID-19 in our International Group. RPU gains propelled by our strong service product offset some of the impacts of the volume decline. Coal volumes and revenue were both down 31% year-over-year, driven by extremely low natural gas prices throughout the mild winter. Our export franchise also experienced slight volume losses due to low seaborne pricing. Moving to our outlook on slide eight. We continue to monitor the combination of the COVID-19 pandemic and energy decline and the unprecedented impact on our markets. We project year-over-year volume declines across all business groups, with large impacts in the second quarter and future volumes dependent upon the depth of the downturn and the timing of the reopening of the economy, as well as energy prices. We are partnering with our customers to effect necessary short-term adjustments that allow for quick and decisive reactions to market changes, remaining in close collaboration with our customers and economic allies that place their confidence in Norfolk Southern. The chart on slide eight classifies our markets by revenue and the sensitivity to both COVID-19 and energy. The agriculture, forest, and consumer group includes among other markets, food products, which remain in high demand, and ethanol, which will decline due to demand and energy prices. Lower consumer spending and disruptions in the supply chain will likely continue to impact automotive intermodal and other consumer-driven products. Intermodal will be further influenced by low oil prices and the associated competitive dynamics with truck. Shutdowns in automotive and other manufacturing will drive declines in the already soft steel market. Our crude market will be adversely impacted by low energy prices and decreased demand from COVID-19 disruptions. Natural gas prices and mild weather coupled with declining industrial and commercial load will negatively impact our utility market. Lastly, export coal will continue to be pressured by lower seaborne coal prices and COVID-19. We maintain strong customer relationships, built on collaboration and constant communication, which facilitated our flawless implementation of PSR last year. We continue this approach as we adjust our network to conserve resources while continuing to meet our customers' needs. The economic headwinds will significantly impact 2020 revenue. The strength of our franchise, our commitment, the collaboration, deep customer relationships, and superior service product provide the foundation for success through this downturn and as economic conditions improve. I will now turn it over to Mike for an update on operations.
Mike Wheeler, Chief Operating Officer
Thank you, Alan. Today, I will update you on the state of our operations. The first quarter continued our story of superior service and improved cost structure, leading to increased operational leverage even in the face of declining volumes. We are continually improving our operating plan and using PSR principles to deliver superior execution. Going to slide 10. Continued improvements in train speed and terminal dwell despite tougher year-over-year comps drove record quarterly terminal dwell, train performance, customer service at the car load level, and unprecedented executional success in the service-sensitive intermodal segment. We achieved these milestones with fewer assets and lower employment levels, further reducing our cost structure and driving efficiency. These trends have continued into the second quarter. Moving onto our service and productivity metrics on slide 11, which I have shared with you in prior calls. These metrics measure important productivity and customer service levels and are indicators of our success meeting our productivity goals. The service delivery index measures our on-time performance at the shipment level and is indexed to 2018. Our first quarter 2020 performance is at our 2021 goal, and we are confident we will maintain these service levels throughout the year. Our lowest T&E headcount on record drives substantial year-over-year productivity while still providing stellar service. As I will show you on the next slide, we continue to aggressively size our train plan to the changing business levels. We continued our momentum of train weight improvements, showing further progress in the first quarter. Remember that we re-targeted this goal to 6,700 tons in light of continued changes in the coal market. Productivity driven by our top 21 operating plan will boost us towards this goal, despite the challenges of the current volume environment. We made considerable progress in locomotive productivity in 2019 by rationalizing our fleet, a trend that continued in the first quarter of 2020. Our active locomotive fleet is almost 15% lower in 2020 than in the first quarter of 2019, and our recent locomotive disposition announcement reinforces our commitment to getting the most out of our fleet. We also thought it would be useful to show you our year-over-year progress in fuel efficiency. This is an area of focus for us and the improvements in gallons per ton-mile reflect the results of efforts on many fronts, including increased train weight, continued rationalization of the DC to AC upgrade of our locomotive fleet, increased use of energy management technology, and completion of our full PTC footprint. Finally, even after we raised the bar on the Cars On-Line goal, we continue to beat our targets. First-quarter results were measurably better than goal, and we set a new record earlier this month. To be clear, this count includes cars in storage that can be brought out as business rebounds. Slide 12 shows our fifth consecutive quarter of accelerated reductions in crew starts. We are continuously improving our TOP21 plan and are now completing Phase 3 of the program. This will deliver the three phases of the program in 18 months instead of the anticipated three years. The first quarter saw a 19% decrease in crew starts, showing increased leverage between crew starts and volume. After we complete Phase 3 of TOP21, we will continue to optimize the operating plan, in part by combining traffic of all types on single trains and reviewing our yard network for further rationalization. Before I shift to discussing Norfolk Southern’s operational response to the COVID-19 pandemic, I want to emphasize our positive operational momentum. We are making progress on long-term structural changes in our asset base, service levels, and productivity drivers. We will continue to build on our progress from 2019, following PSR principles while proactively adapting our operating plan to the economic environment. Turning to slide 13. I am very proud of how Norfolk Southern’s railroaders have dealt with both the threat and the business impact of the pandemic. We took early proactive measures to protect our workforce and make sure that being at work continues to be the safest part of an NS employee's day. Because the railroad was very fluid and service levels were very high, we were able to quickly store surplus equipment while also mobilizing employees to provide extra manpower in hot zones like Northern New Jersey. We made special efforts to assist customers by expediting shipments of goods in short supply or that were urgently needed. All the while, we maintain service levels, and the railroad has run even faster in April. As you can see on slide 14, the pandemic also mandated a proactive response to the drop in volume. Tactically, we quickly and just a few days removed blocks and trains carrying auto parts and finished vehicles from our TOP21 plan. Crew starts dropped almost as quickly as volume, enabling us to preserve leverage even as shipment count declined. We will again redesign the operating plan as auto volume rebounds, using our operating leverage to handle returning volumes in the most efficient way possible. While we do not yet know the shape of the recovery curve, we are taking this time of lower traffic as an opportunity to challenge ourselves and our capabilities to improve our TOP21 operating plan in the long term. For example, we are successfully handling carload traffic on premium intermodal trains, blending previously separate service networks in a way that allows us to maintain service frequency and train size while reducing costs. In addition, we are taking hard looks at our yard and terminal network, testing what we can live without. I will now turn it over to Mark, who will cover the financials.
Mark George, Chief Financial Officer
Thank you, and good morning, everyone. Before I get into the review of adjusted financials, just a moment to talk about the locomotive write-down that we disclosed two weeks ago. Simply said, it’s a capacity dividend of our TOP21 PSR implementation, which has resulted in the decongestion of our yards and road network, allowing cars to turn quicker in the terminals and trains to move faster on the network. The blending of our discrete networks resulted in fewer but longer trains; fewer trains, along with better balancing of our routes, require fewer locomotives. We enter 2020 with roughly 1,000 locomotives on the sidelines, out of the approximate fleet of 3,900. We spent time this quarter aligning on exactly how many locomotives we would need even at 2018 volume levels. Our operations team essentially modeled the capacity requirements in a post-PSR world and determined that of our stored locomotives, 703 are deemed excess and available for sale, while the balance are held for surge and in cycle for AC upgrades. In fact, 298 of the 703 were effectively sold in Q1, while the remaining will be marketed for sale or scrapped in the next 12 months. The $385 million is essentially the remaining book value on those locomotives that otherwise would have been depreciated in the P&L in the years to come. In the process, the team targeted removal of the oldest, least reliable, and least efficient of the locomotives and eliminated entire model lines, moving us to a more homogenous fleet of 10 models from '19. With that, we were able to eliminate inventory and rationalize mechanical resources. So moving now to slide 17, and the remaining slides will reflect adjusted results excluding the impact from the locomotive write-down. Recall this slide format we introduced last quarter to show large and anomalous events that impact our results. There is just one item in the quarter worth calling out and that is a one-time benefit on an income tax refund related to the 2012 tax year. That provided $0.09 of EPS tailwind in the quarter and contributed to the 12.6% effective tax rate. No other meaningful adjustments in Q1 of 2019 or 2020, so the improvement in the operating ratio of 230 basis points was core. Now moving to the adjusted results on slide 18, a very strong operational quarter, as both Jim and Mike described earlier. Revenue was down 8%, driven by an 11% volume contraction that was partially offset by the strong RPU improvement that Alan spoke to. Thanks to our effective yield-up strategy enabled by our enhanced customer service delivery. Operating expenses were 11% lower, almost mitigating the revenue decline in dollar terms, and that resulted in the strong 230 basis point OR improvement, which follows the 240 basis point core OR improvement we showed in Q4, despite a softer environment during that time. And you see on the right, very strong free cash flow performance, a record $589 million, which is 42% greater than Q1 of last year. So now drilling into the operating expense categories on slide 19, we drove down compensation and benefits in the quarter, 14% year-over-year on a 19% reduction in employees versus Q1 of 2019. Employee count was down 6% sequentially from Q4. Our employment levels declined throughout the quarter, and this along with lower costs associated with benefits, overtime, re-crews, and incentive compensation saved us $105 million. Fuel was down $61 million from a combination of lower prices, as well as lower consumption from both volume and also efficiency gains. Consumption declined 15% on a 10% decrease in GTMs, despite significant adverse commodity mix. Materials and other spending was down $24 million or 13% led by a $15 million reduction in materials. Gains on operating properties amounted to $11 million, which was lower than the $17 million recorded in Q1 of 2019. Purchased services and rents was down $21 million or 5%, with purchase services alone down 7%. Rents were actually up 5% in the quarter due to lower equity income from the TTX joint venture that more than offset savings from lower rent spend. So when looking at the big picture, the underlying change to our cost structure continues to shine through in the first quarter, as we reduce and realign resources around our new operating model. Moving to slide 20. Let’s take a look at our summarized first quarter financial results below the income from operations line. Other income was down $22 million from lower investment returns on corporate-owned life insurance, and a lower effective tax rate of 12.6% was driven by the refund I discussed earlier, as well as benefits from stock-based compensation. This first quarter low ETR will provide benefits to the full-year effective tax rate as we expect the remaining quarters to return to the guidance range of 23% to 24%. Moving now to slide 21, as mentioned, we generated a record Q1 free cash flow of $589 million. Thanks to expanding margins, but also from constraining our capital spend, which was $100 million less than last year. And we returned $708 million to shareholders in the quarter, with a solid dividend bolstered by our continued share repurchase activity. Now let’s talk outlook on slide 22. Obviously, the economic environment has progressively worsened here in Q2 and while we can’t be certain of the severity and duration of the downturn in 2020, we do know that revenue will be much lower than we thought at the beginning of the year. So we pulled our guidance for flat revenue for 2020, as well as the guidance for OR improvement. We are modeling a number of revenue scenarios, so that we are positioned to respond as a scenario starts to play out. We are focused on what we can control, service and costs. We feel that with modest revenue contractions, we can manage to match it with cost takeout. With steep revenue declines, you just can’t keep up with certainly not in the short term. To help you in your modeling and for illustrative purposes, you see the P&L cost categories that provide a general sense of how they correlated to volume changes. Most categories have an element of cost that is directly tied to volume and on a mostly immediate basis, fuel being the most obvious, but there are also structural components that take longer to move, as well as areas that are also subject to volume but pretty dependent on management decisions that are influenced by the expected duration of the downturn and the anticipated pace of recovery. We never want to cut in a way where we can handle volume when a recovery occurs, which would then adversely impact customer service. And we absolutely won’t compromise on network safety. In aggregate, roughly 50% to 60% of our costs could be categorized as volume variable and semi-variable. The balance is structural cost, and there is a reason I refer to this category as structural instead of fixed. We have been and continue to work on structural cost, trying to eliminate not just variabilize them, and we are looking at all structural buckets including even the biggest one, depreciation, a category that many would consider truly fixed. We have to look at how we can keep this bar from getting fatter, and certainly adding fewer assets over time helps, but there are even unique opportunities to make it skinnier. Our recent locomotive action, for example, will generate roughly $25 million of annual depreciation savings going forward, so all structural cost is under constant review by this committed leadership team dedicated to evaluating all opportunities. So while our deep revenue decline may put short-term pressure on the OR, I have every confidence that when we are on the other side of this market dislocation, we will be coiled up with great operating leverage to deliver significant OR improvement. Let me wrap up on slide 23. Given the steep drop in the markets and the lack of clarity on the slope of recovery, it’s important to share with you a bit about our financial standing. On top of significant expansion of free cash flow generation, we also maintain a solid balance sheet with good debt capacity and robust access to credit markets. We have relatively light levels of debt maturities in the next two years. More importantly, we have already significantly dialed back on our capital spend budget for 2020, recognizing the challenging environment that we are entering. Property additions will be limited to roughly $1.5 billion this year, regardless of revenue, which is a reduction from our 2019 spending levels by $500 million or 25%. If the right thing to do, it would be the lowest level of spend in absolute dollars since 2010, while not jeopardizing the safety, service, or near-term revenue opportunities. So we feel real good about our liquidity and our ability to weather this storm. Thank you, and I will turn the call back over to Jim.
Jim Squires, Chairman, President, and CEO
Thank you, Mark. There is much for us to be proud of in our report today, from our strong first-quarter financial performance to the incredible job the men and women of Norfolk Southern are doing to keep the trains running. Our industry faces a difficult volume environment with an uncertain trajectory. By executing our strategic plan, exercising capital discipline, and serving our customers well, Norfolk Southern is poised to emerge stronger and ready for growth as the economy recovers. Thank you for your attention, and we will now open the line for Q&A. Operator?
Operator, Operator
Thank you. Our first question is from Jason Seidl of Cowen. Please go ahead.
Jason Seidl, Analyst
Thank you, Operator. Gentlemen, good morning. I hope everyone is doing well. I wanted to jump on the outlook question. I think one of you mentioned sort of not cutting too much into the system, not only for safety but to handle the rebound whenever it does come. How much in expenses do you think you are holding in anticipation of that? Let’s say, if you look at the automotive sector, for example, plants being shut down, how much more expenses is Norfolk sort of maintaining right now and how do you think about forecasting some of these areas for headcount or equipment demand?
Jim Squires, Chairman, President, and CEO
Good morning, Jason. It’s Jim. We are committed to managing our volume variable and structural cost through this downturn. So you saw evidence of that in the first quarter with adjusted expense reductions totaling $202 million. We are pulling every lever at our disposal when it comes to cost reductions in this environment, and that’s the right thing to do given the trend in the revenue this year. Nevertheless, we do believe we are capable of responding to the upturn, which will come as volume growth resumes. We expect to generate significant operating leverage, and that will result in rapid margin improvement and bottom-line growth.
Jason Seidl, Analyst
And right now, how are you guys looking at the anticipated rebound because clearly, we are going to see 2Q that’s going to take a big step down, right, even from the weakness in 1Q? But what is Norfolk looking for in terms of a gradual recovery and how should we think about headcount throughout the system as we move throughout the quarters?
Jim Squires, Chairman, President, and CEO
Well, growth will resume and when it does, as I said. We will have the resources in place, and we expect to generate significant operating leverage. Let me talk a little bit further about kind of next steps in terms of cost reductions, and I will ask Alan to comment on the topline outlook. So we are pressing the TOP21 accelerator right now. And that, as Mike said, that means crew start reductions going forward, a hard look at our yard and facilities network, blending more trains, the kind of step straight out of the PSR playbook to continue to drive down costs. So, Alan, what about the revenue outlook?
Alan Shaw, Chief Marketing Officer
Hey. Good morning, Jason. We are staying very tight with our customers and modulating our expenses appropriately because we are going to make sure that we are there as they start to recover. The first step would be say reopening within auto manufacturing and that’s generally targeted to start slowly in the middle of May; that should pull some additional raw materials through the pipeline as well, say steel for example and some plastics. And then, as I noted on Slide 8, it really is about just the reopening of the economy and improvement in energy prices. Resolution of that is open-ended, and so it remains critical for us to stay close and tight with our customers as we plan going forward.
Operator, Operator
The next question is from Allison Landry of Credit Suisse. Please go ahead.
Allison Landry, Analyst
Good morning. Thank you. So, good progress on the OR improvement in the first quarter. So, I know you withdrew the 2020 guidance expect some near-term margin pressure, but I don’t think I heard you comment on the 2021 OR guidance, so is this intact and do you think a 60 is still achievable?
Jim Squires, Chairman, President, and CEO
We did not pull our guidance for 60 in 2021, and we are still focused on getting to a 60 OR as fast as we can. The timing and shape of the recovery will likely have an impact for sure. But one thing is for certain, as I said, we get to the other side of this and growth resumes, our operating leverage would be very powerful and should drive rapid OR improvement and bottom-line growth.
Allison Landry, Analyst
Okay. Given the decline in volumes, are you noticing any increased hesitation from customers regarding the yield-up strategy? We've heard from several shippers that they're being asked for monthly volume commitments and liquidated damages in return for one-year contracts. I'm interested in your perspective on whether this could result in some loss of market share to trucks and if you're contemplating any adjustments to the pricing strategy to retain more volume on the network. Thank you.
Alan Shaw, Chief Marketing Officer
Allison, there are a lot of unknowns in the market space right now. Our critical role in the nation’s economy and our customer supply chains is clearly evident right now, that is not an unknown. We are pricing the value of our product, we are pricing the value of our franchise, and we are very confident in our understanding of the market. We are maintaining a long-term view of this, and we are making long-term business decisions to benefit our shareholders. We understand that eventually we are going to cycle through this market, and we have got a great franchise and a great approach to support our customers’ growth when that occurs.
Operator, Operator
The next question is from Scott Group of Wolfe Research. Please go ahead.
Scott Group, Analyst
Good morning, everyone. I'd like to ask about costs, starting with the fact that labor compensation per employee increased by 6% year-over-year. What are your thoughts on how we should approach compensation per employee moving forward? Also, could you share what you're doing with headcount right now, considering the current volume environment?
Jim Squires, Chairman, President, and CEO
Mark?
Mark George, Chief Financial Officer
Yes. Scott, you are right, the comp per employee did move 6% sequentially. But remember, these are quarter-to-quarter in particular is very lumpy. And you are always going to have some noise on the timing of when you have incentive accrual top-ups or write-back. So I think you are got to look at it more over time and when you look at it over time, you are always going to be fighting inflation, wage inflation. So, that’s certainly something that we are dealing with every year. And but generally, we are really shifting our focus to the absolute comp and win numbers, which as you know, have gone down and continued to decline in part from the volume, but in particular from the PSR actions that we have taken.
Scott Group, Analyst
I guess I am not sure I followed. So, like, so as we think about going forward, I guess, was there anything unusual in this first quarter on the comp per employee or should we assume like that this level continues going forward, meaning, certainly…
Mark George, Chief Financial Officer
Well, look…
Scott Group, Analyst
In the first quarter, headcount decreased by 6% sequentially, but I believe total labor costs only declined by 1% or 2% during that same period.
Mark George, Chief Financial Officer
You had some differences in incentive accruals between quarters. In Q4, due to the way the year concluded, you benefited from adjusting some of the incentive accruals, which led to a lower Q4 figure and makes the sequential comparison a bit more challenging. Moving forward, you can expect a more consistent pattern throughout the year.
Operator, Operator
The next question is from Brian Ossenbeck of JP Morgan. Please proceed with your question.
Brian Ossenbeck, Analyst
Hey. Good morning. Thanks for taking the question. Mark, can you go back to the locomotive side and maybe just walk us through the potential benefits, some that you may be recognized or whether you called out like the depreciation? And then, secondly, out the different components on the labor side, maybe even further on the D&A side, on the efficiency side for fuel and just how do you think about what this has done for Norfolk so far and what it could represent in the future, your call this year and next year as it rolls out completely.
Mark George, Chief Financial Officer
Sure. I mean, we talk a little bit about the locomotives first. And again, we took out 250 locomotives last year as we launched the TOP21 strategic plan and mainly those were on the sideline, but they were with a lot of other locomotives that we had on the sideline. We knew that every quarter throughout this year, we were probably going to see, we were going to convince ourselves that we were going to have more and more surplus locomotives. So rather than leak it out over time, we really held hands as an organization and said, look, we have got very good progress here on liberating assets in the field. Where can we be in a post-PSR world with regard to locomotive needs? And there were several iterations; I think the PSR experts that we have in-house really pushed the envelope and said, look, we know where we can get to. So, we had 1,000 when we started the year on the sideline; the numbers initially started with 400, maybe 450; the team iterated several times and ultimately got back to a number of 703 where we said that is absolutely doable, even if we go back to 2018 volume levels, we can still manage with the remaining fleet. So we decided, rather than just leak this out over time to take a look at it, it was clearly a significant portion of that particular asset base. So we decided the right thing to do, the appropriate thing to do is actually pull it out of group accounting and write it off. The benefit of doing that, first off is, we get the organization focused on removing assets, and I think that’s a very important thing for any company when you have surplus assets is to eradicate them, because assets attract cost. You got yard congestion in our case. You have got network congestion by parking all these excess locomotives, let’s commit to get rid of them quickly, and then they will attract less cost, less maintenance and less attention and less property tax whatever you can assign to it will end up being savings. So it’s healthier just to get to recognize what surplus upfront and move as quick as possible to remove them from the company’s properties. And then by removing them from group accounting, you also now have taken that $385 million asset and you avoid depreciating it over many years and absorbing it into your remaining assets, it seems like it’s a very unusual form of accounting that’s relatively unique to our industry, where you have group accounting attaching excess book value from discarded assets to remaining assets and depreciating further over time. So we avoid doing that; we get rid of it; we get depreciation benefit in the future. So that’s really how this came about.
Scott Group, Analyst
Can you provide any insights on the implications for maintenance or mechanical resources and fuel efficiency as we transition to a more uniform fleet, especially beyond the depreciation and amortization benefits you anticipate in the upcoming quarters or into 2021?
Mark George, Chief Financial Officer
Yes. Clearly, they attract less maintenance, and part of that $385 million is a little bit of inventory that went for the model lines that are no longer here, the seven model lines we eliminated. So that’s another trailing benefit that we have. And but, yes, clearly, we are going to have some mechanical benefit from this, savings that arise from having fewer locomotives and a more streamlined fleet model. Maybe, Mike, you want to make some comments.
Mike Wheeler, Chief Operating Officer
Yeah. I mean, it helps your whole material network because you are managing less, less materials with less models. A lot of these models were smaller type models and so that helps to be efficient. And it’s also going to help our sharp footprint going forward as we continue to rationalize that; you have heard some of the things we are doing there, and those are coming to fruition now and those will help that as well. So, yeah, there’s a lot of ancillary benefits to this going forward.
Mark George, Chief Financial Officer
And remember, Brian, we got rid of 300 of those already in Q1. So the physical assets have been removed and there is just the remaining 400 now that over the next 12 months, hopefully in the next 9 months or so we will follow.
Operator, Operator
The next question is from David Ross of Stifel. Please proceed with your question.
David Ross, Analyst
Yeah. Good morning, gentlemen. I wanted to talk a little bit about Phase 3 of TOP21. We mentioned combining the cars of all different types onto a single train. Where are you in that process, has that been done yet, what’s left and how might mix in the second quarters, you are doing this, I would say not look normal depending on the restart of the economy in which commodity types come back online and is that going to create any issues at completing Phase 3?
Jim Squires, Chairman, President, and CEO
Well, Mike went through the steps that we have taken under TOP21, and essentially we have completed all of the network redesign to this point that we had mapped out through 2021. So all phases of TOP21 that we had initially signaled we would implement, we have implemented at this point. Going forward, our focus, as we have said, is on additional crew start reductions, blending more trains, and a hard look at the facilities we use, the yards we use to support network operations. Mike, anything to add?
Mike Wheeler, Chief Operating Officer
Yeah. We have been talking with you on all the quarters about our blending of our network. We first started talking about blending bulk into the general merchandise and we did that. And then we started blending the automotive into the general merchandise as well, and that was a big part of TOP21 last year, very successful. And as we have continued on, we have blended general merchandise and bulk into the intermodal network that’s been very successful. And then, now we are in the process of blending traffic even into our premium network. So we have really blended all of the different traffic types into our network. So we are to the point now where a train is a train. So our Phase 3 implementation is really in place. And the beauty of this, as you go forward and traffic comes back, we are blended now that a train is a train, and it can ride on a train that gives us the right service requirement that it needs, but also as efficient as it can be. So we are really in a good place with our network with the TOP21 implementation, and going forward, we are just going to continue to optimize the network as traffic comes back on.
Mark George, Chief Financial Officer
And David, if I could add one thing, it also benefits us and our customers in that it provides us with a broader product offering, and no longer do we need to find enough density for a point-to-point intermodal train. We could find smaller blocks of intermodal and put it on a merchandise train and open up some lanes, which we are doing.
Operator, Operator
The next question is from Jordan Alliger of Goldman Sachs. Please go ahead.
Jordan Alliger, Analyst
Hi. I wanted to ask about the yield in relation to price. We've seen that volumes have been significantly affected, as you mentioned, they're down about 30%, which lags behind the industry to some extent. I'm curious, especially since your yields appear to be improving, whether the volume discrepancy might be linked to that and how you manage price for yield amid these steep declines going forward? Thanks.
Jim Squires, Chairman, President, and CEO
Jordan, at Norfolk Southern, we are fierce competitors, and we are determined to make decisions in the long-term best interest of our shareholders. We have got a deep knowledge of our markets and we are confident in our ability to price to the value of our service product, which is outstanding and our franchise with a focus on margin improvement and also providing our customers with a platform for growth, and you can see this in our RPU, in revenue-to-revenue ton-mile trends over the last three years, it’s a consistent and strategic approach for us. There are some specific market forces that are impacting our volumes. Last year, 60% of our coal volume was in the utility coal network. That volume was down 44% in the first quarter of this year. We participate in the energy markets, whether that’s frac sand or ethanol and those have been pressured. They have been pressured for much as a year, as I called out. And separately, we also are highly integrated with customers who are the integrated steel mills, so that has taken a hit throughout the year. One thing to point out is we are running against our toughest year-over-year comps of the year. I believe week 20 of last year, so mid-May was our highest volume week of the year. So that’s causing part of the volume decline year-over-year. But we also understand, and it’s important to note, that our opportunities are within that $800 billion plus truck and logistics market. We have got the most powerful intermodal franchise in the east, and as you know, we are aligned with the best channel partners in the industry. We have got a diverse merchandise network with a great service product. We are staying very close to our customers and we are collaborating with them right now, near-term opportunities as they adjust the supply chain dislocations and on longer-term opportunity. So we are confident about where we are headed.
Jordan Alliger, Analyst
Thank you.
Operator, Operator
The next question is from Brandon Oglenski of Barclays. Please proceed with your question.
Brandon Oglenski, Analyst
Hey. Good morning, and thanks for taking my question. Alan, I guess, if we could just follow up there though, I mean, in an environment coming out of post-COVID. Are you talking with your customers right now about what’s going to take for a recovery and get them back up to prior volume levels and does that include changes in service patterns or pricing or I guess what’s the path forward once we get beyond the shutdowns here?
Mike Wheeler, Chief Operating Officer
Yeah. Brandon, I think, you are going to see some differences in supply chain requirements moving forward. There are going to be potentially more forward positioning. There is going to be more an emphasis on reliability and consistency. And frankly, that benefits Norfolk Southern because we have got the best intermodal franchise in the East. When the recovery happens, people are going to be focused on capacity, cost, service, and ESG, and Norfolk Southern offers all of that relative to our primary form of competition, which is truck. So we touch over 50% of the consumption and the manufacturing in the economy. We are staying close to our customers. Even now we are launching innovative service products. So we are pretty confident about where things are headed once the economy re-opens.
Operator, Operator
Okay. I appreciate that. And then, maybe follow up for Mark or Jim, you guys did say that some of your cost variability is dependent service product expectations. And Jim that was pretty bullish that you are not backing off of the 2021 OR target. So, I guess, are you putting a cost structure in place where you see line of sight to achieving that type of operating ratio at some sort of volume level in the future?
Jim Squires, Chairman, President, and CEO
Well, the question is not if, but when we get to a 60 operating ratio. That remains our goal. We are going to get there as quickly as we can. And yes, that will be through a leaner cost structure, with the kinds of cost structural initiatives that we have been through this morning. And so, yes, that’s very much part of the outlook, and we believe we will have strong operating leverage when growth resumes, which it will.
Brandon Oglenski, Analyst
All right. Thank you, Jim.
Operator, Operator
The next question comes from Bascome Majors of Susquehanna. Please proceed with your question.
Bascome Majors, Analyst
Yeah. Thanks for taking my questions. Mark, most of the class ones have pulled their guidance like you did today, but several have continued to provide investors with some sort of framework to think about kind of a worst-case free cash flow scenario in their own stress tests of the business. How should we think about free cash flow for Norfolk this year?
Mark George, Chief Financial Officer
Thanks, Bascome. So we have modeled a number of different scenarios and we haven’t picked one because we know whatever one we pick will be wrong. But we have modeled high single-digit declines to mid-upper teen declines on revenue and volumes to ‘20s and ‘30s. And in all those circumstances and cases, you are going to see that we have modeled free positive cash flow contribution, we are going to grow cash flow this year regardless. But one thing we are doing is to preserve cash, you would have noticed, we have really taken a significant chunk out of capital expenditures this year to make sure that we maintain the proper balance and we augment our liquidity and certainly what is going to be an uncertain time because we don’t know how deep this will go and how long it will last before recovery begins again. So in pretty much all the scenarios we have modeled, we are still generating positive cash flow and positive free cash flow, and we feel actually very good about our whole liquidity equation as well as you can see from the slide I shared. We have got plenty of vehicles to go for credit, if we needed, and again, the capital reduction is also very, very meaningful to us as well as frankly, a very strong cash balance opportunity.
Bascome Majors, Analyst
Thank you. Thank you for walking us through that. I am sorry, so on the January call, maybe take that a step further to the structural discussion, you said one of the biggest surprises coming into this industry from the outside was the capital intensity of the business and that was going to be a priority for you to take a hard look at that as the CFO. I mean, so you have been going through this process of broader structural cost reductions, any update you could have on some opportunities you think where you could kind of change that equation longer-term within that?
Mark George, Chief Financial Officer
I believe we've demonstrated some progress with the capital reduction we initiated early in the year. Reducing $500 million, or 25% of our annual capital spending, is not an easy task. Our team collaborated extensively to determine how we could lower capital expenditures and establish a new baseline. This reduced level is something we haven't experienced in absolute dollars since 2010. We felt it was essential to undertake this because we anticipated volume pressures, which have indeed materialized. I'm pleased with the steps we've taken. Moving forward, as our revenue increases, I hope we can manage our capital expenditures at a more moderate rate, ideally below our revenue growth, and potentially aim for a lower percentage of revenue over time. This is a key focus for our organization. Additionally, we are reassessing our asset pool, particularly concerning locomotive rationalization. We've thoroughly evaluated the assets in that category and will now consider other asset pools as well. It's crucial to examine these assets since they incur costs. We're asking critical questions about our infrastructure along the network, assessing whether we have buildings and structures that are no longer needed, all of which lead to maintenance, electricity, and property assessment costs. We've also noticed a significant shrinkage in our coal franchise, prompting us to reevaluate potential surplus assets in that sector. Our team is open to these discussions, and I think we've already seen some evidence of this in the first quarter.
Operator, Operator
The next question is from Ravi Shanker of Morgan Stanley. Please proceed with your question.
Ravi Shanker, Analyst
Thanks. I just wanted to follow up on the discussion about the incremental margins when volumes do come back. You have a pretty illustrative cost structure slide on slide 22 of your deck. It’s really helpful, which shows that you have a pretty variable or semi-variable cost structure, which should help you on the way down. But I mean, how does that not become an impediment to incremental margins on the way back up again, given that we just by very nature if it’s more variable, a lot of those costs need to come back?
Jim Squires, Chairman, President, and CEO
Well, we do expect to be able to hold the line on many of the costs within our cost structure as volumes return and there lies the operating leverage in the model. Now, certainly, we will have some volumetric expense increases with volume on the way up as is the case on the way down. But the key will be to hold the line in terms of additions to the asset and resource base as much as we possibly can. We know we can do that and ride that wave of volume upsurge, which should generate rapid and significant operating ratio improvement and bottom-line growth.
Ravi Shanker, Analyst
Okay. And as a follow-up, how would you characterize the competitive environment in the east, I mean, obviously, we know what’s happened in the truck side, but just more with your rail competitor?
Mike Wheeler, Chief Operating Officer
Trucks are currently very competitive, presenting opportunities supported by the strength of our franchise. We are developing service products to assist our customers in managing changes in their supply chains and are focusing on both near-term and long-term solutions. Our merchandise franchise has excellent exposure to the U.S. economy, and we have the best intermodal franchise in the east alongside outstanding service products. Looking back three to five years, it's evident that Norfolk Southern and our customers have led industry growth during that time, dating back to the recovery from the Great Recession in 2010. As I've mentioned previously, we are making decisions that are in the long-term best interest of our shareholders, which includes our market strategy and our commitment to partnering with our customers to support their long-term growth.
Operator, Operator
The next question comes from Ken Hoexter of Bank of America. Please proceed with your question.
Ken Hoexter, Analyst
Good morning. Great job on managing costs and moving the locomotives. Mike or Jim, it's interesting to see the decision to shut down the yards and other measures you're implementing during this downturn in volume. Could you discuss which moves might become more permanent and provide some examples? I know you've mentioned blending the trains, but I'm curious about the steps you're taking that could be lasting as the business starts to recover.
Mike Wheeler, Chief Operating Officer
Yeah. Sure. Thank you. As you have noted, we have been looking at our terminal yards for long-term since the great recession; we have either idled or converted five of our top terminals, we did two of them last year, and we are continuing to look at that, and those are long-term structural cost reductions, and you will see more of that as we go forward. I would also note that we have talked about we have shut down a lot of our smaller outline yards, brought that traffic in, and consolidated it. And as Mark noted, those are assets over time that will go away and take less cost. But we continue to look at it and find out what we can live without, and we have got a lot of opportunities out there that we are looking at, more to come, and you will hear more about it as we go forward. But yeah, those are things we are looking at and are going to do.
Alan Shaw, Chief Marketing Officer
Ken, we recognize that our utility coal business is experiencing a long-term decline. Therefore, we are actively engaging with our customers to find ways to encourage coal usage compared to natural gas, and we are also making adjustments to our operations. Recently, we idled the Ashtabula facility and sold our Pocahontas Land Corporation assets. Currently, stockpiles in the utility coal sector are extremely high, sitting at approximately 125 days worth of supply. Coal consumption in March hit a record low of 29 million tons nationwide. Consequently, our utility coal business will continue to face significant pressure for an extended period. We need the economy to recover to bring back industrial and commercial demand, and we also require an overall rise in energy prices; currently, prices in the PJM area are in the low teens for electricity, which does not support increased coal consumption.
Operator, Operator
The next question is from Chris Wetherbee of Citi. Please proceed with your question.
Chris Wetherbee, Analyst
Hey. Great. Thanks. Good morning. Maybe, Mark, if you could drill in a little bit more specific around some of the CapEx comments, I think when you outlined or when the company outlined the plan, the PSR plan locomotives were kind of decent size chunk of the 16% to 18% CapEx spend over time. I think it seems like some of the actions you guys have taken recently have the potential to really rationalize that, even just obviously this year but potentially in 2021 and 2022. Is that the right way to think about it or could there be other puts and takes that might drive that number back up into that sort of longer term rate? Just want to make sure I understand that this is sort of a spin that likely is going to come down relative to maybe what you thought it was a year and a half ago or so?
Mark George, Chief Financial Officer
Yeah. Thanks for the question, Chris. I am going to tag team this with Mike. But the reduction in the CapEx is really a little bit across the board, not so much on the locomotives, but in other areas, whether it’s IT, a little bit of our maintenance; we have really taken a look at all the various categories and tried to bring it down a notch, even some of the terminal spends, especially given the volume pressures that we have. So it really went across the board, and we know though like I mentioned earlier, we are going to have pressure to raise from here. But I want Mike maybe you can talk a little bit about locomotives and cat 1 versus cat 1 on the ops stuff.
Mike Wheeler, Chief Operating Officer
Sure. Yeah. On the locomotive DC to AC conversions, we are committed to that revitalization because we have got some DC locomotives out there that upgrading to the AC is really cost efficient from a capital standpoint, and have been really pleased with the reliability from this. So that project will continue on going forward over the next couple of years; it’s the right thing to do. And what we did push out, we had taken some opportunistic additional DC to AC conversions that we were looking at this year, we are pushing those out, we are not going to do those. Some rebuild of our yard and local fleet we have pushed out. So the DC to AC conversions will continue at the pace that we have talked about in the past. Relative to the capital expenditures, we are very fortunate that we have got some great technology in our company, particularly on the engineering side. We are making sure that we are putting our rails, ties, and ballast in the right locations. We have got technology these days that are they are using machine vision to determine whether ties are good or not. They are even doing X-rays internally. So we are making sure that when we put ties in, we will put them in the right place at the right time; same thing with rail where we are using predictive analytics to determine where the rail needs to be replaced at, and that’s allowing us to really pinpoint our asset replacements. And we are really comfortable with the fact that we are doing the right thing for maintaining this railroad in the long-term, both on the locomotive reliability front as well as the track infrastructure.
Chris Wetherbee, Analyst
Got it. Okay. That’s very helpful. I appreciate the color. And then maybe a quick follow-up, Alan, would you think about the truckload market? I think there is a building sense that coming through this downturn when volume comes back, we could be coming into a somewhat tighter truckload market than what we sort of exited. So can you talk about sort of how that kind of plays into the strategy on the intermodal side and what the opportunities might be there for you?
Alan Shaw, Chief Marketing Officer
Yeah. Chris, it’s that’s very similar to what you saw in 2009 and 2010, isn’t it, where you saw some pretty considerable supply reactions on the truckload side to a steep downturn and spot prices. And so for us it means continuing to collaborate with our best-in-class supply chain partners, our channel partners on how we give them an exceptional service product, how we look for new opportunities, new lanes for them to grow into, and then it’s also selling the things that are going to be pretty darn valuable post-COVID-19, which is capacity, a lower cost structure than truck, its service, and its ESG. And we have got the best intermodal franchise in the east. So we are in great shape there.
Justin Long, Analyst
Thanks and good morning. Maybe to follow-up on that last question, regarding domestic intermodal, obviously, one thing that’s changed is the fall off in fuel prices. So I was wondering if you could comment on the gap in pricing between contractual intermodal pricing and contractual truckload pricing in your network today. And as you think about domestic intermodal going forward, do you feel that it is still a GDP plus growth business, whenever things recover even if fuel prices hang out around the current levels?
Mike Wheeler, Chief Operating Officer
Hey, Justin. The gap has certainly closed. The real pressure is coming from that spot truck market. And at some point, as the economy starts to improve and as there are supply ramifications throughout the truckload market, that’s going to particularly affect the spot market. So it’s important for us to maintain that vision as we are approaching the market and not chase the spot truck. You have heard me talk about that before. That’s not within the long-term best interests of our corporation. So we are focused on what we can deliver and that is a great service product, a great intermodal franchise that has allowed our customers to outpace the industry and growth over any number of years.
Justin Long, Analyst
Okay. And maybe looking bigger picture at the volume performance of the business, obviously, it’s weak across the board right now, but there is a pretty substantial difference in the year-to-date volumes at in as procedure eastern competitor. I am curious if you could just comment on that gap, if there have been any major market share losses this year that are driving that is, it’s a function of mix? And as you look at that gap, how should we be thinking about the actions you are taking to close that gap and the timing around that going forward? Thank you.
Mike Wheeler, Chief Operating Officer
Justin, I previously mentioned the utility coal franchise, which constituted 60% of our coal volume last year, is down 44% in the first quarter. This decline is affecting us. The ethanol markets, including both inbound feedstocks like corn and outbound ethanol, are also having an impact. We have discussed the energy effects of frac sand and the influence of integrated steel mills on our franchise. Additionally, the spot trucking market is affecting intermodal services, and we noticed this impact on our international intermodal business in Asia in February. All these factors contribute to more challenging year-over-year comparisons. We are still measuring against last year’s elevated volumes and expect to see improvements by week 20, when our volumes were at their peak last year. Overall, we have a strong understanding of the markets, confidence in our pricing strategy, and a commitment to making long-term decisions that benefit our shareholders. This is reflected in the trends of revenue per unit and revenue per ton-mile, not only for this quarter but over the past three years as well.
Operator, Operator
The next question is from Jon Chappell of Evercore ISI. Please proceed with your question.
Jon Chappell, Analyst
Thank you. Good morning, everyone. My first question for you, it’s been a lot of time on the CapEx changes. Any comment on capital returns, should we assume that given a bit more of a disciplined manner in CapEx that you keep pressing the pause button on the buyback program and give us a little bit more clarity on coming out of this?
Mark George, Chief Financial Officer
Thank you, John. We continued our share repurchase activity in Q1. However, as we see the markets contracting significantly, we will adopt a more conservative approach to share repurchases while keeping our options open depending on the depth of the decline and the pace of recovery. Therefore, we will take a more cautious approach moving forward.
Operator, Operator
The last question comes from Thomas Wadewitz of UBS. Please proceed with your question.
Thomas Wadewitz, Analyst
Yeah. Good morning. I wanted to follow up a little bit on train starts and leverage, maybe if I can refer Mike to your slide, I think it’s slide 11. So, you are improving on all the metric that gets the weight expansion or probably moving with train length has been more muted, obviously, a function of tough volume backdrop. So how do you think about coming out the other side what the ratio might be or how rapidly you might need to bring back train starts or is there a period of a couple of quarters where you just really see that metric expand a lot and you don’t have to add train starts back to use to run longer trains?
Alan Shaw, Chief Marketing Officer
It really will depend on and where the traffic comes back and what type of traffic it is, obviously, if it’s full both you are going to get more of an incremental train starts. But if it’s just across the Board, we have got capacity still in our train lengths to add train lengths before we have to do a lot of train starts. We have got capacity in the terminals as well with both the road crews, the local service crews and the yard crews to handle the capacity. So, we have got a while before we have to make train start deduct or increases. So we are still going to continue to get the upside leverage as this things pulls up, it’s in a great place.
Operator, Operator
This concludes the question-and-answer session. I will now turn the call back over to Mr. Jim Squires for closing comments.
Jim Squires, Chairman, President, and CEO
Thank you for your questions this morning. We look forward to talking to you again next quarter. Stay safe, everyone. Thank you.
Operator, Operator
Ladies and gentlemen, thank you for your participation. This does conclude today’s teleconference. You may now disconnect your lines and have a wonderful day.