Schneider National, Inc. Q3 FY2022 Earnings Call

Greetings, and welcome to the Schneider Third Quarter 2022 Earnings Call. As a reminder, this conference is being recorded. It is now a pleasure to introduce your host, Steve Bindas. Please go ahead.

Thank you, operator. And good morning, everyone. Joining me on the call today are Mark Rourke, President and Chief Executive Officer, and Steve Bruffett, Executive Vice President and Chief Financial Officer. Earlier today, the company issued an earnings press release, which is available on the Investor Relations section of our website at schneider.com. Our call will include remarks about future expectations, forecasts, plans, and prospects for Schneider. These constitute forward-looking statements for the purposes of the safe harbor provisions under applicable federal securities laws. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. The company urges investors to review the risks and uncertainties discussed in our SEC filings, including, but not limited to our most recent 10-K and those risks identified in today's earnings release. All forward-looking statements are made as of the date of this call, and Schneider disclaims any duty to update such statements, except as required by law. In addition, pursuant to Regulation G, a reconciliation of any non-GAAP financial measures referenced during today's call can be found in our earnings release, which includes reconciliations to the most directly comparable GAAP measures. Now I'd like to turn the call over to our CEO, Mark Rourke. Mark?

Thank you, Steve. Hello, everyone, and thank you for joining Schneider's third quarter earnings call. In our opening comments, we will cover our third quarter results, what we are currently experiencing in the marketplace, and an update on our strategic imperatives as we head into 2023. As we indicated on our last earnings call, shipper freight allocation events were largely complete by the end of the second quarter in our truckload and intermodal network offerings. Therefore, the third quarter freight tender activity served as a gauge on actual fulfillment levels of those awards across our diversified customer base. In general, we experienced steady contractual demand throughout the quarter. However, freight order fulfillment levels post the implementation of those annual allocation events are lagging historical fulfillment averages. We would attribute the lagging fulfillment to inflated awards coming off of pandemic-driven freight levels and elevated inventories due to earlier than normal product sourcing to hedge against supply chain disruptions over the last couple of years. So far in October, we are experiencing sequential volume improvement, but muted seasonal peak demand and below historical average of special project programs. While the supply and demand market dynamics have become more balanced in the quarter, we continue to deliver customer value and gain market share across our multimodal platform with specific focus across our strategic growth drivers of dedicated truck, intermodal, and logistics. Our dedicated service offering grew revenues excluding fuel surcharges 50% over a year ago, a combination of organic and acquisitive growth. On average in the quarter, we had 6,020 tractors operating in dedicated contract configurations or 57% of the truckload fleet. We favor dedicated's resilient nature due to multiyear contracts, the high level of customer integration points, resulting in high renewal rates, and the preference of our professional drivers due to the more predictable nature of the work and the close alignment with the customers' business. Dedicated new business wins and sales pipeline remains robust, particularly in the specialty equipment segments. Additionally, our MLS acquisition at the end of last year is surpassing planned synergy and performance expectations, including recent new business awards due to its unique relay-based execution model. Intermodal grew order volume year-over-year by 4% as network fluidity issues remain despite moderate rail service improvement throughout the quarter. We did experience volume erosion in September as customers hedged against the labor uncertainty on the rails by converting volume back to truck. We continue to be encouraged by the positive customer response to our Western rail partner change, bringing our own container, chassis, and company-controlled freight to the Union Pacific Western network in combination with the high-performing Eastern network of the CSX, offering our customers a distinct asset-based alternative to our largest competitor. 20% of our Western volume is now moving on non-overlapping lanes on the Union Pacific franchise. Finally and importantly, our detailed conversion plan with Union Pacific remains on schedule and we are targeting a flawless transition at the first of the year. Our financial results in the third quarter reflect additional cost impacts resulting from executing on two Western railroads. The temporary redundant costs to protect the customer experience are reflected in suboptimal dray efficiencies as the business optimizes dray, chassis, and container resources between the two networks. We expect to quickly shed those additional expenses in the first quarter of 2023, consistent with our implementation plan. In a moderating spot market environment, our brokerage business grew order volumes year-over-year by 5% and expanded net revenue per order by 10%. Our logistics earnings contribution also increased by 26% by leveraging our digital freight power platform and its robust decision science capability to efficiently match transportation orders with third-party capacity in both carrier trailer and power-only configurations. We believe we are in the early stages of capacity level correction, especially with the small carrier community that increasingly relies on the spot market. It is our assessment that a meaningful portion of the spot market has dropped below the breakeven point for carriers. There are a series of meaningful and persistent inflationary impacts facing the small carrier community, such as wages, equipment acquisition costs, replacement parts, and fuel, to name a few. So let me stop there. I'll turn it over to Steve for more financial commentary on the quarter and our full year 2022 guidance.

Thank you, Mark. Good morning to everyone on the call, and we appreciate you joining us today. Beginning with our Truckload segment, revenues excluding fuel were up $87 million over the third quarter of last year, driven by MLS and by organic growth in Dedicated. Speaking of MLS, they continue to meet or beat our expectations as we approach the 1-year anniversary of the acquisition. We also see solid growth prospects for them in the future, and they're a great addition to our dedicated operations. Truckload segment earnings of $83 million were close to last year's number despite having lower equipment gains this year. Also, there was a modest sequential improvement in earnings from second quarter levels - so while the segment was not immune to the changing market conditions, the constructive customer mix and largely contractual nature of the revenue base performed solidly. In our Intermodal segment, revenues grew nearly $40 million as both order count and revenue per order increased over the third quarter of 2021. Delivering volume growth despite the operational complexities of the quarter speaks well for what we can accomplish as we look ahead. Intermodal earnings of $31 million were well below last year's level, and there was also a sequential decline. Mark just provided the context for these results as we are making investments in the customer experience and managing temporary operating complexities during the transition to Union Pacific. Moving to the Logistics segment, third quarter revenues were down slightly from the prior year after nine consecutive quarters of year-over-year growth. Volume growth in both our brokerage and power-only offerings continued over the prior year, but it was more than offset by a decline in revenue per order. At the same time, our year-to-date logistics revenues were up over 20% to $1.5 billion, and this segment is a key component of our growth story. Logistics segment earnings increased about $6 million over the prior year to $28 million, while down from the elevated levels of 2Q '22, and margins of 6% remain historically strong and increased over the prior year. At the enterprise level, revenues, excluding fuel, increased $112 million, driven by dedicated growth complemented by MLS and higher intermodal revenues. Year-to-date revenues, excluding fuel, were up $675 million or 18% with each of our three primary segments contributing a similar percentage growth. Adjusted income from operations of $146 million was below the prior year comparison for the first time in a couple of years. For further context, last year's third quarter included $32 million of equipment gains, while this third quarter contained only $11 million. Adjusted diluted earnings per share were $0.70 in the third quarter as compared to $0.62 in last year's third quarter. On a year-over-year basis, there was a $0.12 benefit from our equity investments and a $0.09 drag from lower equipment gains. Year-to-date, adjusted income increased $113 million to $469 million with logistics driving over half of the increase. In addition, I want to note that over the past 12 months, we've generated $980 million of adjusted EBITDA. We have discussed EBITDA on a regular basis, but it is worth highlighting as we are near the $1 billion milestone. Looking ahead, our outlook for the remainder of 2022 continues to call for stable market conditions and freight volumes, along with a muted peak season. Freight volumes, especially in the contractual space, are expected to remain steady through mid-December and then experience a typical seasonal decline in the last couple of weeks of the year. We also expect intermodal margins to remain under pressure for the next 2 to 3 months as we invest in the transition to Union Pacific. In addition, we have again reduced our expectations for fourth quarter equipment gains by a couple of million to approximately $10 million. As such, we've tightened our full year adjusted EPS guidance to a range from $2.60 to $2.65. Regarding net capital expenditures, we are slightly lowering our full year guidance to $475 million from $500 million, as some units are now expected to roll over into early 2023. We look forward to deploying our strong balance sheet and furthering our strategic initiatives in the upcoming year. And I'll now turn it back over to Mark.

Thank you, Steve. I'll finish up our opening comments where I started. We have deep and strategic relationships with customers that are winning in their marketplaces, and we are intensely focused on delivering value to them that only a diversified transportation and logistics offering like ours can. The mix of services has been purposely constructed with the intent to be more resilient through economic and freight cycles. And I would offer you a few important proof points. First, dedicated's prominence within truckload is now approaching 60% of our deployed tractor units. We continue to invest in innovations such as freight power for shipper and carrier that enable us to improve the business results year-over-year in a moderating freight market and leverage the highly variable cost nature of our brokerage business. We continue to develop and mature new capabilities to grow revenues and earnings beyond our driver and tractor assets with the power-only offering that links small carriers to large trailer pool shippers. We have grown our intermodal container count and are in the process of growing chassis to align ourselves with the customer value drivers for economic and sustainability benefits that Intermodal uniquely offers. Our innovation efforts also extend outside the four walls of Schneider. In the quarter, we experienced a positive valuation change involving our equity investment in Mastery Logistics. However, our primary interest at Mastery is the value we will achieve operationally as we implement the Mastermind TMS across our various service offerings. In the third quarter, we fully implemented power only with the rest of brokerage and dedicated scheduled next. Finally, our strong balance sheet offers us optionality to pursue our capital allocation priorities of ensuring maximum resiliency through business cycles and to maximize total shareholder return. Those priorities include targeted organic and acquisitive growth and reliable and consistent quarterly dividends. We are well positioned as we close out the year and look forward to advancing our strategic objectives in the year ahead. With that, we'll open it up to your questions.

Thank you, operator. Morning, all. I wanted to focus a little bit on the intermodal side. As we look into 2023, how should we think about both the top line and the margins? I mean, obviously, you're going to have some of these start-up expenses go away. I'm assuming that the congestion issues in the network, whether they're on the rail or they're on the drayage side, will have abated by then, so you should have a better comp there. And also how maybe should we think about pricing given where truckload rates are in a slower economy?

Cleanup phase. And I believe, certainly, the...

Could you please start over again? Your line was muted. I apologize.

I guess I left you guys speechless.

Can you hear us now? Can you hear us, Jason? We can, I can, yes. Okay. We'll start over again. Was all of that not captured?

None of it was.

I'm sorry, Jason. To address your question, we believe that most of the costs, expenses, and redundancies related to our transition will be incurred in the third and fourth quarters as we prepare. We anticipate a few weeks in the first year will focus on the cleanup phase. However, we expect that the majority of transition expenses will be accounted for this year, allowing us to start smoothly, which is our main objective. Part of our strategy includes moving 20% of the volume this year to help us identify and resolve any potential issues. We feel confident about our position. There are concerns regarding our volume, but I can assure you that UP's planning has been exceptional, with significant investments in lift capacity that exceed our initial needs, as well as enhancements in driver experience. Their investments have led to improved experiences at ramp locations with our fleet. This gives us confidence for a strong start to the year. It's a bit early to provide full-year guidance for 2023. There remains a wider than usual gap between Intermodal and truck pricing, which is expected to narrow as we progress into next year. By the first quarter, we will offer more insights into our business outlook.

Fair enough. Appreciate the time, guys.

Hey, good morning.

Good morning.

Maybe just a follow-up to that question a little bit of a broader question. Do you still feel comfortable with the margin targets that you have out there by segment? Or do you anticipate any of those will change not just in '23, but just as we progress over the next couple of years?

Yes, this is Steve. I'll take that one. I think that we feel quite comfortable with our margin profiles that we've laid out there. As you know, we go through an annual process. And if we're going to make changes, we'd do that in our fourth quarter call. So three months from now, we would make any adjustments. And like we signaled on the last earnings call, if there's anything under review, it's our logistics segment margins, and there would be an upward bias in how we view those targets, but I think we remain quite comfortable with where we stand in the Truckload segment and Intermodal segment margin profile.

Okay. That's great. Thanks so much, Steve. And just as a follow-up, maybe sticking on to that logistics topic. What do you see as the next phase of growth there? It seems like currently lower spot rates seem to be weighing on the top line, but volumes and power only remain pretty strong. Is there a way to drive top line expansion in an environment like this? Or does your focus become more squarely on margin expansion?

Bert, we think the primary growth of our earnings contribution from our logistics offering is in top line growth. And our model is one that, as we've talked before, certainly collaborates at the customer level between our assets and our non-asset capability and even further now with the power-only offering. But we also have a freight generation capability in our own brokerage area. So it's not reliant on what's happening on our assets. They generally target a smaller shipper base. which we've invested heavily in the digital connections via our freight power for shipper to make that more efficient to get after that type of customer versus how we typically serve medium- to large-size customers with sales resources. So again, that's why we continue to invest not only in the technology there, but the resources that can decouple their success simply what's going on in the asset side. So it should continue to be a volume driver for us. As you saw this quarter, we still grew volumes in a moderating spot market because of that capability.

Thanks a lot, Steve.

Thank you.

Good morning, and thank you for taking my questions. My first question is for Steve. I know we'll get a more detailed 2023 outlook in the next conference call, but I'm interested in discussing the larger picture regarding inflationary pressures for next year and potential offsets. Could you share your insights on where you are experiencing the highest levels of inflationary pressure and some areas you might be able to mitigate that, such as improved equipment utilization or possibly stable driver wages? I would appreciate your thoughts on this.

Yes. I do think, to your point, that there will continue to be some inflationary pressure on the cost base but at a much lower rate than what's been experienced over the last 18 months or so. So I would anticipate a plateauing in most of those areas, but not going away, still something to be very conscious of and to deal with. You mentioned efficiency and I think assets and productivity is one of the biggest opportunities we clearly have in front of us as things become more fluid at customer locations and our partner locations as well and things that we can do with our own four walls to become more efficient. So I think that would be our primary offset vehicle. And at the same time, I think that there's a reasonably good construct as we head into 2023 as we start out the year. I think there was a pull forward in freight volumes that happened earlier this year that are leading to a softer peak season as we're currently in. But then just the pull-through of that and roll that forward into next year, I think there's a reasonably solid start to the year. So feeling that well positioned, I think, across the portfolio and excited about the intermodal opportunity that we have in front of us to start to capitalize upon that as the year progresses, and 2023 is part of our self-help story there, too.

Okay. Okay. That's very helpful, Steve. And I guess, Mark, maybe if you could just expand a bit on Steve's comments, bigger picture macro thoughts on ‘23. I mean I guess, the setup just from a market perspective in the first half of the year is pretty challenging. But you noted that you're starting to see some capacity begin to come out of the truckload market. I guess, how do you see the next three to four quarters playing out, maybe two quarters playing out just in terms of the broader freight markets? I know it's tough to have a crystal ball, but I think you guys have a great insight into that.

Yes, Jack, thank you for your question. To expand on Steve's comments, one of the challenges we face with the OEM issues is that we expect these to continue to some extent throughout 2023. We have several hundred units beyond what we consider our ideal lifecycle, which from an expense perspective results in significant maintenance costs that impact our operating income. These same factors likely affect the small carrier community even more severely. Consequently, as we evaluate our brokerage business and the spot market, we believe there is considerable stress that should lead to a reduction in capacity in the marketplace, and we are currently at the brink of that situation. This isn't something we need to wait until the first half of next year to see. Regarding our truck business, in terms of inflation, we expect some gains in the results, whether they rise or fall, as part of normal operations. With approximately $20 million less in gains mainly in our truckload sector, and relatively stable earnings, it shows that the business has managed to remain resilient despite the ongoing inflationary pressures. I concur with Steve that we are beginning to see moderation, particularly in capacity acquisition. As we look ahead to the first half of the year, there are some intriguing developments regarding customer interactions. One of our significant customers shared insights on demand, discussing how this peak season compares to prior years. They mentioned they have extended their product lead time three to four times beyond their typical average. Their seasonal goods arrived in July rather than the usual later timing. As we approach the holiday season, they anticipate returning to their standard lead times and expect the first quarter to reflect normal timings. While this is just one data point, it suggests that we may not be facing as significant a downturn as generally believed, but we will see how that unfolds.

Okay. Thank you so much for the color. Really appreciate it.

Good morning, Mark. I found your insights on timing very helpful. Steve mentioned some points about the balance sheet, and I wanted to hear more about your thoughts on strategic acquisitions. Currently, your debt coverage is at 0.2 times, while it has been above one previously. What is your preferred level for leverage ratios? Are you observing more market opportunities? Have valuations changed? Additionally, do you believe we can achieve economic benefits by consolidating further within the TL assets?

Yes, Ken, this is Steve. I’ll address the first part regarding our comfort level. We will definitely maintain a strong balance sheet regardless of the strategic paths we pursue, as we view it as a crucial asset in this industry. Our comfort with debt varies based on the opportunities and the type of cash flow we are looking at. In terms of ratios, a 1 times EBITDA ratio feels comfortable, and 1.5 times is acceptable as well. For the right opportunity, even a 2 times ratio could work for our profile. This outlines how we consider our capacity, or firepower, based on our balance sheet strength. Mark may add more insights on this, but regarding M&A, there appear to be several assets either currently available or expected to enter the market soon. We are assessing these opportunities carefully. The cost of debt has increased, but it is still within reasonable limits compared to what we've accessed in recent years. This will likely influence how much buyers are willing to pay in the M&A space. We may see a normalization of earnings streams from assets available in the market, leading to a potential balancing of valuations.

Again, as I mentioned in my opening comments, we very much are leaning into accretive ways to grow the business. And the acquisition front is along with our organic growth objectives are kind of prime A and Prime B. So we'd be disappointed if we couldn't find opportunities to do that.

Is there a particular area that stands out, such as truckload or dedicated services, where you are noticing an increase that you find favorable?

Yes, as you look at our portfolio, we certainly believe our logistics business is a great and has been a great organic driver and even more now so with our ability with the power-only offering, as we discussed. So our intent and our focus is on the specialty truck side of the business presently and dedicated is obviously very interesting there, but it wouldn't necessarily have to be just dedicated, but something that adds something unique and sticky and that we believe is highly defensible. And so Dedicated is probably our most interest, but we are looking at a series of other specialty type operations as well.

Thank you. Good luck.

Thanks. Good morning, guys. I guess I wanted to ask a little bit about sort of the rate environment versus the cost environment as we start to get into next year. And maybe it's a little too early to start talking about sort of the financials, but maybe in sort of bigger picture trend dynamics. How do you expect sort of the dedicated and truckload pieces of your business to trend from a rate standpoint? And then when you look at the cost environment that we're in, which is quite inflationary, do you think that there are lags between when one is still rising and the other is potentially falling? Just want to get a sense of roughly speaking, how you're approaching 2023 from a price cost perspective.

As we consider the truck side of the business, the dedicated segment remains more stable, and we have mechanisms in place to manage inflation and rising area costs, particularly concerning drivers. As annual renewal dates approach, we continue to address these issues, and customers are responding to the needs related to drivers. Consequently, dedicated pricing is likely to continue an upward trend, whereas the network side has leveled off. Our focus, as Steve mentioned, is on restoring fluidity as customers utilize equipment for shorter periods. We aim to enhance asset utility and utilization across trucks, trailers, and containers, which is a daily focus for us. Inflation related to equipment remains a concern, and obtaining relief from OEMs to phase out older equipment would be beneficial. Overall, the industry will face challenges throughout 2023, as allocations and production levels are expected to remain difficult compared to 2022. However, I believe that the costs associated with capacity and recruiting, along with other inflationary factors, will not significantly hinder us as we move into 2023.

Okay, that's helpful information. I appreciate that. I have a couple of quick detailed questions. Do you have any estimates for the gains expected in the fourth quarter? Also, have you provided a breakdown of the intermodal costs this quarter that were associated with the administrative or technical aspects of switching carriers?

This is Steve. On the first part of that, I had indicated that we're at about $10 million or so expected of equipment gains in the fourth quarter. So...

And that was, I believe, $16 million or so a year ago. So again, another slight step down. We talked about the buckets of inefficiencies for making the transition, but we haven't shared the dollar amount.

Okay. Thank you very much. Appreciate it.

Thanks, Chris.

Morning, gents. So just to kind of summarize what happened this quarter. When we look at the sequential step down in the kind of earnings trajectory at IM and logistics. I mean, how much of that would you say was like almost one-time-ish or kind of driven by events that are specific to the quarter versus not carrying forward? Or is this kind of where the cycle is right now and kind of the new base going forward?

Good morning, Ravi, let me take the logistics one first. Clearly, we believed in the second quarter, we were at the maximum benefit of the economic condition there between the buy-sell and contract spot as we played out in logistics. And also, we had a very robust quarter on the port services part of our business that we don't talk a lot about, but we support the customer around warehousing and port management and portray that was also at its peak in the second quarter. So there was a step down in the port activity as well. And as spot prices moderated in brokerage, you saw our results follow that. Still expanded net revenue per order still expanded volume, certainly over a very good third quarter of a year ago, but it was a really special quarter for logistics in the second quarter of this year.

Regarding our intermodal business, despite facing various complexities this quarter, we achieved a four percent growth in order count. However, we experienced a notable decline in our regional business due to concerns about rail labor, particularly for shorter hauls. This decline in volume was unexpected and has taken a few weeks to start recovering, as the transition back takes time for customers. We are beginning to see improved volumes, and as Steve mentioned, we anticipate some additional expenses this quarter as we finalize our transition efforts, which involve new facilities and drivers optimizing operations between the two railroads concerning chassis and containers. We expect to quickly eliminate redundancies as we move into the first quarter.

Yes. So great. And just as a follow-up to that, speaking of potential strike and the impact, I mean, we've seen two of the unions have had rejected the tent agreement. Do you feel like there's a risk of a potential strike action maybe a couple of weeks from now and the kind of two big unions announced their verdict? And if so, do you think shippers will similarly try to adjust for that beforehand and so you may see a similar headwind in November or December?

It's difficult for us to provide specific comments on that, Ravi. From our assessment of shipper behavior, it became evident early on that they were taking more diversionary actions due to concerns. Currently, the sentiment suggests that there's an expectation for some level of government intervention this time, rather than allowing a strike to happen. However, that's beyond our area of expertise, and so far customer behavior hasn't shown any indications that they are taking those actions.

Understood. Thank you.

Thank you. Good morning. Steve mentioned that if there were to be a review of the long-term margin targets, there might be an upward bias to logistics, primarily due to power only. When we look at the third quarter and possibly moving forward, the revenue per load decrease you mentioned, is there a way to differentiate how much of that was traditional brokerage versus how much was in power only? This would help us understand if power only needs to be more consistent throughout the cycle.

Yes. We haven't broken those two dimensions out within our logistics results that we report. We are growing both the rate of growth within the power only has been higher, but it's off a smaller base, obviously, and we would anticipate that dynamic continuing as we go forward. And the power-only contribution is the reason why there is an upward bias within our targeted margin range for the logistics segment. So I agree with all those, but I think we'd stop short of giving specifics between brokerage business and the power-only business at this point.

Yes, John, I would like to point out that our power-only business is primarily contractual, which means we are making commitments through those allocation events. Our brokerage business, on the other hand, is split roughly 50% between contracts and 50% spot market. This creates a more variable revenue per order in our traditional brokerage compared to our power-only business due to that difference.

Got it. So even without a magnitude specifically it's telling better. Mark, my second question for you forgive me, it's probably a bit of a long-winded one because there are some puts and takes here. We've had one month now of a real acceleration in Class 8 orders opening up the book for next year. Finally, pent-up demand. As we think about the benefits or potential risk to Schneider, on the one hand, I think it would help you with some of those hundreds of units that are aged beyond where you'd like them to be. So maybe replacement would be really good. On the other hand, maybe it takes away from some equipment sales opportunities as others are able to get access to new equipment. How do you think about, first of all, the duration? Is this just a one-month blip? Or do you think that there's a lot of kind of demand for the coming months, and two, when you kind of net it all out for Schneider positive, negative, neutral?

Yes, that's a good question. Let me break it down a bit. While the order board is active, I wouldn't overreact to that. What I focus on is the expected deliveries of new units in 2023. I don't anticipate any significant increase compared to what we saw in 2022, and there’s a possibility it could even be slightly lower. So the timing of orders is not as important. In my view, it’s all about delivery and what can actually be put into service and sold. I don't see a substantial change there. The dynamics of ownership, including maintenance and disposal sales, are likely to remain similar to this year. Of course, market conditions may affect value dynamics, but I don’t foresee a significant influx of new equipment altering the marketplace. I’m not concerned about that being a risk in 2023.

Okay, great. Thank you.

Hey, good morning, Mark and Steve. So you mentioned in your opening comments that a meaningful portion of the spot market or you think that it's now dropped below the breakeven point for a lot of carriers. I just wanted to ask, how do you think about what the floor might be on how much further downside there might be to rates? And one of your competitors, as I'm sure you are well aware, has kind of given an indication of what the implied earnings might be based on kind of what their view is on what that floor might be on rates. I was hoping we could get your thoughts on that, even if it's not a specific number, maybe directionally kind of how you're thinking about what that floor might look like.

Yes, I believe there is a different baseline than usual if we are experiencing a long-term shift in the freight cycle. However, it remains to be seen due to factors like wage inflation and equipment costs. These primary drivers impacting the income statement are currently seeing significant increases, even though we may see some moderation in variable costs, such as driver recruitment. Wages are likely to remain stable, along with equipment costs and inflation-related expenses, including replacement parts and maintenance. Operating costs will likely stay elevated, which may limit potential rate changes. Regarding the potential downside for rates, I believe we've observed some stabilization, particularly in the spot market. As we approach the allocation season next year, I don't foresee a dramatic decline in contract rates given the fundamentals we've discussed. To answer your second question, I feel that our current portfolio is more resilient compared to several years ago, positioning us favorably to handle variability. While I won’t provide specific figures, I am confident that we have established a more durable earnings stream.

Got it. Okay. That's very helpful. And then just for my second question, I wanted to ask, operating supplies and expenses took a big step up over the past two quarters. Maybe you could speak to what's driving that increase? Should we interpret that as being related to some of these costs related to intermodal and kind of operating across two networks? Or is it something else that's going on there? And then obviously, forecasting that how should we think about kind of can that moderate in the coming quarters?

I think the main factor here is that equipment gains impact that line. Last year's comparative period had significantly more gains, while this third quarter had fewer. If we remove those factors, we would likely see a year-over-year increase in that line of about 9% to 10%. This is all within the context of the inflationary pressures we've experienced.

Got it. Okay. That's very helpful.

Next question comes from Brian Ossenbeck with JPMorgan. Please go ahead.

Can you discuss the recent service improvements on BNSF after two years? Given that you are transitioning off that network, do you think this will provide any assistance as you near the end of the transition, or are the additional costs and duplicate chassis too significant to overcome? Additionally, can you provide some context regarding rates? I understand there are factors like mix and length of haul, but the intermodal rates increased less than expected. Is there anything notable in that regard compared to the market or your peers? Also, could you comment on the spread you mentioned, where intermodal remains considerably cheaper than truck?

Costs in the quarter can you repeat just the first part of that - sorry, Brian - yes, sorry. Sorry for the two there. The first part was really just BNSF finally getting some service improvements realized you're transitioning off. But does that provide any benefit here? Or is it just too late essentially given the big lift to get the shift done? Yes, thank you, Brian. Sorry for missing that first part. Yes, absolutely. Fluidity and service is a big help. The more predictable we are, the more turns we can get. And yes, we're pleased that any part of our partner network can improve upon that. So I would not diminish the importance of that. We're going to be on the BN in a meaningful way, all the way through the tape. So every bit of help there that helps us get another box turn, get another customer served, the box freed up all contributes to improved results. So I appreciate their focus and am impressed by the improvement. The second part of that is regarding rates. We saw JBI go up close to 20%. China was up closer to 10% excluding fuel. I'm curious if there's any mix impact between those two and if there seems to be more room to price at least at this point in the cycle? Yes, our mix did change. International was certainly a nice bright spot in and out of Mexico. As I mentioned, we had a contraction in our regional lanes, particularly out east due to the more readily available option to convert to truck because of labor uncertainty. This quarter was a bit unusual for us compared to typical comparisons due to the mix. We also introduced more Western regional type lanes that do not overlap with the UP. So it's a little tricky to draw comparisons because of the different mix and various influences at play. Okay, Brian. I appreciate the details there.

Next question comes from Tom Wadewitz with UBS. Please go ahead.

Mark, I wanted to get your perspective on how optimistic we should be about intermodal volume in 2023. It seems like there are significant opposing factors at play. On one hand, there may be notable weakness in freight and container imports. On the other hand, there appears to be significant potential for conversion from truck to intermodal. How do you assess the situation? Are you hopeful about volume growth for intermodal in 2023, or do you think we should be cautious due to the overall softer freight environment?

Yes, there are opposing forces that could influence the situation. However, we have seen two consecutive years where more freight has shifted from rail to truck than the other way around. We believe there is significant pent-up opportunity and demand to return to more freight being moved via rail, whether regionally or between the East and West. We are optimistic about the prospects ahead. Additionally, international trade, particularly with Mexico, could serve as a strong growth catalyst in the upcoming year. Overall, we perceive more opportunities than we have experienced in the past few years. When we combine this with an increase in origin-destination pairs and improved efficiencies from our changes in the West, as well as better connections with CSX, we can enhance our operations. One persistent challenge has been the fluidity at the customer level due to inefficiencies in rail transport. By improving this fluidity and optimizing the placement of our containers, we can foster growth. I believe we may see a quicker recovery in demand than anticipated because of the distortions we've encountered and the early placement of goods earlier this year that need replenishing. I am hopeful for some positive surprises as we transition back to a more normal replenishment cycle.

Okay. Great. For the second question or follow-up, how do you view the relationship between volume and price? It seems you're optimistic about volume growth in intermodal, and it appears your competitor from Arkansas shares that optimism given their new capacity. I assume your competitor in Chicago will also be optimistic about volume. There may be more flexibility in rail arrangements than we’ve seen historically. Will you prioritize volume, and if necessary, be willing to push harder on pricing? Conversely, if there is significant pressure on prices, will you decide that volume growth is not essential?

We aim to optimize our contribution to the business and consistently evaluate the balance between volume and price. We are prepared to respond to market conditions and possess the necessary resources, capabilities, and technology to do so effectively. As for our brokerage business, we are currently operating with 60% of our trucks dedicated, which means those dynamics have less impact on that part of our business. While still significant, the influence is reduced due to our shift to a dedicated portfolio. We have more containers available, though we are slightly behind on our chassis. We expect to resolve this in the fourth quarter, putting us in a better position for volume growth next year. Our customers have been very responsive, and although we will face tough competition, we will adjust and respond to market conditions as needed.

The underlying guidance for Q4 is higher than Q3. If we exclude the equity gain, which differs from what some other truckers have reported, can you explain what’s driving the sequential earnings growth from Q3 to Q4? Which segments are contributing to this improvement?

Yes, Scott, Steve, there are several factors at play. I believe that some of the complexities in our intermodal operations will persist into the fourth quarter, but I see an opportunity to generate more revenue from our intermodal segment in the fourth quarter than we did in the third. This trend may also apply across all three of our primary segments. The increase is incremental, not substantial, but I do believe there will be some lift from volume dynamics. Looking back at the third quarter, July was a relatively weak month for volume, but I expect improved volumes as we move through October, November, and into mid-December. This improvement in volume will positively impact our service portfolio, which is beneficial.

I'd also add, Scott, that our dedicated fleet is largely implemented. We don't have a lot of start-up activity in the last six to eight weeks of the month. So there's generally a little less drag than we typically have as the start-ups push into next year.

Okay. That's helpful. Mark, you mentioned that our costs have increased, leading to higher rates than we may have seen historically. I'm curious about the current spot rates compared to previous lows. Are they aligning with your observations or not?

At the bottom, that's specific to the lane, and I believe it has stabilized. As we look at what we do on a more moderated basis and consider our brokerage offering, I think carrier costs have stabilized. Consequently, net revenue per order is likely to stabilize as well. I can't say for sure if we're at the bottom, but it feels that way to me. This has been evident over an extended period of several weeks, so I believe we are at what might be considered the trough.

I guess what I was trying to say is that if this is the trough, we need to evaluate how this trough compares to previous ones. Are we experiencing a higher trough than in prior cycles? From a carrier costing perspective, I believe that to be true. I don't have a specific percentage to share right now, but Scott, we'll take a closer look at that and potentially have a better answer in a follow-up call. Our expenses are indeed higher than the last trough in relation to carrier costs, and this trend seems to be consistent across the industry, which involves third-party costs. We've discussed this position for several quarters, and we believe that various factors, including constraints on OEM capacity, contribute to a higher trough.

Yes, Scott, the reason for my hesitation as we evaluate our business is that we consider net revenue per order, which reflects the difference between those two factors. We don't solely focus on the price point; we also examine the spreads. That's the perspective I have regarding this metric.

You guys have a relatively diverse customer base. I'm just curious, I know you've touched on demand and thoughts around that and replenishment big picture. But as you look at the various subsectors, some of the bigger pockets like retail or consumer home improvement, can you maybe talk a little bit about sort of some of the demand thoughts on some of the bigger segments and maybe even how they're suggesting inventories look as we move into peak?

Yes, Jordan, we operate in a diverse array of sectors across the economy. Currently, one of the strongest areas is the home improvement channel, which is performing surprisingly well, along with off-price and value retail. We are also busy with our distribution centers and preparations for the holiday season during this time of year. Additionally, I see strength in the food and beverage sector. These are the main areas we feel optimistic about. On the other hand, other retail segments seem to be more stable rather than declining or significantly increasing due to seasonal trends. The segments I mentioned are performing above their usual levels.

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