What changed in this filing

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Item 2. Management’s Discussion and Analysis

2022-10-26 compared with 2022-07-27 · 98 added, 92 removed, 142 unchanged (57% of the section changed)

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We are also a principal carrier of coal, automobiles, and automotive parts.

Strong revenue growth drove operating income improvement in the second quarter.

Although lower network velocity contributed to volume declines compared to prior year, higher fuel surcharge revenues and pricing gains led to revenue per unit growth that more than offset the impact of lower volume.

During the third quarter, strong revenue growth drove improved profitability despite higher inflation-related operating expenses.

Higher fuel surcharge revenues, resulting from higher fuel commodity prices, and pricing gains led to revenue per unit growth that more than offset the impact of lower volume.

The increase in fuel commodity prices also led to higher fuel expense.

The net impact of fuel prices on revenues and expenses, coupled with lower current-year gains on operating property sales, contributed to the degradation of the railway operating ratio (a measure of the amount of operating revenues consumed by operating expenses).

While network fluidity remained challenged, we are taking the steps necessary for service restoration.

These efforts include recruiting, training, and retaining our transportation crews as well as evolving our operating plan, with the goal of improving service for our customers.

The COVID-19 pandemic continues to impact the U.S.

and global economies and has resulted in ongoing supply chain challenges.

We are monitoring and reacting to the evolving nature of the pandemic, governmental responses, and their impacts on our business, including employee availability.

We remain committed to protecting our employees, operating safely, and providing excellent transportation service products for our customers.

Additionally, tentative agreements, resulting as part of ongoing labor union negotiations, included retroactive pay increases and other benefits for our craft employees that resulted in increased compensation and benefits expenses.

Finally, although we incurred incremental service-related costs, we continued to make progress on efforts to increase network fluidity and improve service for our customers.

SUMMARIZED RESULTS OF OPERATIONS

Second Quarter First Six Months

Third Quarter First Nine Months

2022 2021 % change 2022 2021 % change

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Railway operating ratio (percent) 62.0 60.2 3% 61.8 60.0 3%

Income from railway operations increased in both periods due to higher railway operating revenues.

Revenue growth was driven by higher fuel surcharge revenues and pricing gains, which exceeded the impact of a 3% and 4% volume decline in the second quarter and first six months, respectively.

The rise in revenues was offset in part by increased railway operating expenses, driven by higher fuel prices, other inflationary pressures, service-related costs, lower gains on the sale of operating properties, and higher claims-related expenses.

Offsetting the growth in income from railway operations were lower net returns on corporate-owned life insurance (COLI) and higher income taxes.

Income from railway operations increased in both periods, driven by higher railway operating revenues.

Revenue growth was the result of higher fuel surcharge revenues and pricing gains, which more than offset the impact of volume declines in both the third quarter and first nine months.

The rise in revenues was partly offset by increased railway operating expenses, driven by higher fuel prices, increased labor-related costs resulting from ongoing labor union negotiations, other inflationary pressures, and service-related costs.

The first nine months also include higher claims-related expenses and lower gains on the sale of operating properties.

The increase in estimates for retroactive wage increases anticipated under our tentative labor agreements and that pertain to prior periods lowered diluted earnings per share by $0.28 and $0.18 in the third quarter and first nine months, respectively.

Additionally, net income in both periods includes a $136 million deferred tax benefit resulting from a corporate income tax rate change in the Commonwealth of Pennsylvania, which increased diluted earnings per share by $0.58 and $0.57 in the third quarter and first nine months, respectively.

Our share repurchase activity resulted in the percentage increase in diluted earnings per share that exceeded that of net income.

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The following tables present a comparison of revenues ($ in millions), units (in thousands), and average revenue per unit ($ per unit) by commodity group.

Second Quarter First Six Months

Third Quarter First Nine Months

Revenues 2022 2021 % change 2022 2021 % change

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Total 1,938 1,619 20% 1,850 1,560 19%

Railway operating revenues increased $451 million in the second quarter and $727 million for the first six months compared with the same periods last year.

Railway operating revenues increased $491 million in the third quarter and $1.2 billion for the first nine months compared with the same periods last year.

The table below reflects the components of the revenue change by major commodity group ($ in millions).

Second Quarter First Six Months

Third Quarter First Nine Months

Merchandise Intermodal Coal Merchandise Intermodal Coal

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Approximately 95% of our revenue base is covered by contracts that include negotiated fuel surcharges.

Revenues associated with these surcharges totaled $421 million and $148 million in the second quarters of 2022 and 2021, respectively, and $665 million and $245 million for the first six months of 2022 and 2021, respectively.

Revenues associated with these surcharges totaled $501 million and $174 million in the third quarters of 2022 and 2021, respectively, and $1.2 billion and $419 million for the first nine months of 2022 and 2021, respectively.

The increase in fuel surcharge revenues is driven by higher fuel commodity prices.

Should the current fuel price environment persist for the remainder of 2022, we expect fuel surcharge revenue to continue to be higher than 2021.

Merchandise revenues increased in both periods due to higher average revenue per unit, driven by higher fuel surcharge revenue and increased pricing, partially offset by decreased volume.

Volumes fell in both periods as declines in metals and construction and agriculture, forest, and consumer products shipments more than offset higher chemical shipments.

Agriculture, forest and consumer products volume decreased in both periods, as declines in corn, fertilizers, and pulp more than offset increases in soybeans and feed.

Decreased corn and pulp shipments were due to service disruptions.

Lower fertilizer shipments were due to high fertilizer prices causing customers to draw down on existing inventories or delay purchases.

Soybean volumes were higher due to increased opportunity for exports and feed shipments were up because of increased customer demand.

Chemicals volume rose in both periods due to growth in shipments of sand and solid waste, driven by growth with existing customers.

Metals and construction volume fell in both periods, largely the result of decreased shipments of coil steel, iron and steel, aggregates, scrap metal, and cement driven by commodity pricing, service disruptions and slower equipment cycle times.

Automotive volume increased in the second quarter but decreased for the first six months.

Higher shipments in the second quarter were primarily due to production shutdowns in the prior year caused by parts supply issues.

Volumes for the first six months were impacted by plant shutdowns, as a result of the global microchip shortage, and slower equipment cycle times.

Merchandise revenues for the remainder of the year are expected to be higher due to increased average revenue per unit, driven by higher fuel surcharge revenue and pricing gains, and volume growth.

Intermodal revenues increased in both periods, driven by higher average revenue per unit, a result of higher fuel surcharge revenues, pricing gains and storage service charges, partially offset by lower volume.

Merchandise revenues increased in both periods due to higher average revenue per unit, driven by higher fuel surcharge revenue and increased pricing, partially offset by lower volume.

Volumes fell in both periods as declines in metals and construction and agriculture, forest, and consumer products shipments more than offset higher automotive shipments in the third quarter and chemicals shipments in the first nine months.

Agriculture, forest and consumer products volume decreased in both periods.

During the third quarter, declines in ethanol, pulpboard, fertilizer, and pulp, more than offset gains in corn, food oils, feed, and soybeans.

During the first nine months, declines in fertilizer, corn, pulpboard, and pulp more than offset increases in feed, soybeans, and food oils.

Decreased ethanol shipments in the third quarter were due to a decline in gasoline consumption.

Pulpboard shipments declined in both periods due to decreased demand.

Lower fertilizer shipments in both periods were driven by high fertilizer prices causing customers to draw down on existing inventories or delay purchases.

Pulp shipments decreased in both periods due to equipment availability, service disruptions and over-the-road competition.

Increased corn shipments in the third quarter were due to improved cycle times on grain trains.

In both periods, feed and food oils shipments increased due to increased customer demand and soybean volumes were higher due to increased opportunity for exports.

Chemicals volume was flat in the third quarter but increased for the first nine months driven by growth in shipments of sand in both periods due to increased demand.

Both periods were impacted by reduced shipments of inorganic chemicals, plastics, and organic chemicals, due to decreased demand.

The first nine months also saw an increase in solid waste shipments due to growth with existing customers.

Metals and construction volume fell in both periods, largely the result of decreased shipments of coil steel, iron and steel, and scrap metal driven by service disruptions and slower equipment cycle times.

Automotive volume increased in the third quarter but decreased for the first nine months.

Higher shipments in the third quarter were primarily due to increased production due to fewer parts supply issues when compared to the prior year, partially offset by slower equipment cycle times.

Volume declines for the first nine months were driven by slower equipment cycle times partially offset by fewer parts supply issues when compared to the prior year.

Merchandise revenues for the remainder of the year are expected to be higher due to increased average revenue per unit, driven by higher fuel surcharge revenue and pricing gains.

Intermodal revenues increased in both periods, driven by higher average revenue per unit, a result of higher fuel surcharge revenues and pricing gains, partially offset by lower volume.

The first nine months also included higher storage services revenue.

Intermodal units (in thousands) by market were as follows:

Second Quarter First Six Months

Third Quarter First Nine Months

2022 2021 % change 2022 2021 % change

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Total 972.7 1,021.0 (5%) 2,945.7 3,100.0 (5%)

Domestic volume rose slightly due to strong demand, partially offset by service disruptions and limited chassis availability.

International volume decreased as supply chain constraints with terminals, ports, labor, and chassis availability, as well as excess inventory in the warehousing retail sector more than offset strong consumer demand.

Intermodal revenues for the remainder of the year are expected to rise, driven by increased fuel surcharge revenue, volume growth, and pricing gains, partially offset by lower storage service revenues.

Coal revenues increased in both periods due to higher average revenue per unit, driven by pricing gains and higher fuel surcharge revenue, partially offset by lower volume.

Domestic volume declined in both periods due to service disruptions and terminal congestion.

International volume decreased in both periods as supply chain constraints, equipment shortages, as well as excess retail inventory which more than offset strong consumer demand.

Intermodal revenues for the remainder of the year are expected to be higher due to increased average revenue per unit, driven by higher fuel surcharge revenue and pricing gains.

Coal revenues increased in both periods due to higher average revenue per unit, driven by pricing gains and higher fuel surcharge revenue, and higher volume.

Coal tonnage (in thousands) by market was as follows:

Second Quarter First Six Months

Third Quarter First Nine Months

2022 2021 % change 2022 2021 % change

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Total 20,494 17,898 15% 57,748 55,862 3%

Coal tonnage declined in both periods primarily due to decreased domestic metallurgical tonnage.

While utility tonnage increased slightly for the first six months, it experienced a decrease in the second quarter due to service disruptions and tight coal supply.

Export tonnage decreased due to service disruptions and tight coal supply.

Domestic metallurgical coal tonnage fell due to reduced coke shipments related to customer sourcing changes.

Coal tonnage increased in both periods primarily due to increased utility and export tonnage.

Utility tonnage increased in both periods due to stronger demand.

Export tonnage increased due to increased coal supply.

Domestic metallurgical coal tonnage increased for the third quarter due to increased coal supply, partially offset by reduced coke shipments related to customer sourcing changes.

For the first nine months domestic metallurgical coal

tonnage decreased due to reduced coke shipments related to customer sourcing changes.

Industrial coal tonnage increased in both periods due to increased demand.

Coal revenues for the remainder of the year are expected to rise due to increased volumes.

Coal revenues for the remainder of the year are expected to rise due to increased average revenue per unit, driven primarily by higher fuel surcharge revenue, and volume growth.

Railway Operating Expenses

Railway operating expenses summarized by major classifications follow ($ in millions):

Second Quarter First Six Months

Third Quarter First Nine Months

2022 2021 % change 2022 2021 % change

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Total $ 2,071 $ 1,716 21% $ 5,880 $ 4,972 18%

Compensation and benefits expense decreased in both periods as follows:

• incentive and stock-based compensation (down $32 million for the quarter and $24 million for the first six months),

• employee activity levels (up $2 million for the quarter but down $15 million for the first six months),

• overtime (up $4 million for the quarter and $13 million for the first six months),

• increased pay rates (up $11 million for the quarter and $21 million for the first six months), and

• other (up $5 million for the quarter and $3 million for the first six months).

Average rail headcount for the quarter was up by over 100 compared with the second quarter of 2021, and up over 600 compared with the fourth quarter of 2021.

Compensation and benefits expense increased in both periods as follows:

• increased pay rates (up $130 million for the quarter and $151 million for the first nine months),

• employee activity levels (up $28 million for the quarter and $13 million for the first nine months),

• overtime (up $4 million for the quarter and $17 million for the first nine months),

• incentive and stock-based compensation (down $38 million for the quarter and $62 million for the first nine months), and

• other (up $2 million for the quarter and $5 million for the first nine months).

The increase in pay rates in 2022 includes higher estimates associated with previously recorded amounts for retroactive wage increases and other benefits anticipated under our labor agreements.

For the third quarter of 2022, compensation and benefits includes $85 million and purchased services includes $3 million of additional expenses pertaining to estimated wage increases recorded in periods prior to July 1, 2022.

For the first nine months of 2022, compensation and benefits includes $54 million and purchased services includes $2 million of additional expenses pertaining to estimated wage increases recorded in periods prior to January 1, 2022.

Average rail headcount for the quarter was up by over 800 compared with the third quarter of 2021 due to the hiring of additional conductor trainees.

Purchased services and rents increased in both periods as follows ($ in millions):

Second Quarter First Six Months

Third Quarter First Nine Months

2022 2021 % change 2022 2021 % change

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Purchased services increased in both periods due to inflationary pressures which resulted in higher intermodal-related expenses, increased operational and transportation expenses, as well as higher technology-related costs.

Equipment rents increased in both periods as lower network fluidity led to greater time-and-mileage expenses and increased automotive equipment expenses.

Additionally, both periods had lower equity in TTX earnings.

Fuel expense, which includes the cost of locomotive fuel as well as other fuel used in railway operations, increased in both periods due to higher locomotive fuel prices (up 124% in the second quarter and 102% in the first six months), partially offset by decreased consumption (down 3% in both the second quarter and first six months).

Equipment rents increased in both periods as lower network fluidity led to greater time-and-mileage expenses, increased automotive equipment expenses, and higher short-term locomotive resource costs.

Fuel expense, which includes the cost of locomotive fuel as well as other fuel used in railway operations, increased in both periods due to higher locomotive fuel prices (up 88% in the third quarter and 97% in the first nine months), partially offset by decreased consumption (down 2% in the third quarter and 3% in the first nine months).

Should the current fuel price environment persist for the remainder of 2022, we expect fuel expenses to continue to be higher compared to 2021.

Materials and other expenses increased in both periods as follows ($ in millions):

Second Quarter First Six Months

Materials and other expenses decreased in the third quarter but increased in the first nine months as follows ($ in millions):

Third Quarter First Nine Months

2022 2021 % change 2022 2021 % change

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Total $ 163 $ 170 (4%) $ 506 $ 418 21%

Materials expense increased in both periods due to increased track and freight car materials costs.

Locomotive maintenance costs were also higher in the second quarter.

Claims expense increased in both periods as a result of higher costs associated with personal injuries, environmental remediation matters, and derailments.

Other expense increased in both periods due to lower gains from operating property sales and litigation-related expenses.

Gains from operating property sales totaled $28 million and $67 million for the second quarters of 2022 and 2021, respectively, and $34 million and $71 million in the first six months of 2022 and 2021, respectively.

Materials expense increased in both periods due to increased freight car and track materials costs.

Claims expense increased in both periods as a result of higher costs associated with environmental remediation matters and personal injuries partially offset by lower derailment costs.

Other expense decreased in the third quarter due to a favorable legal settlement and increased gains on operating property sales, partially offset by higher travel-related expenses.

Other expense increased the first nine months due to lower gains on operating property sales and higher travel-related expenses.

Gains from operating property sales totaled $17 million and $5 million for the third quarters of 2022 and 2021, respectively, and $51 million and $76 million in the first nine months of 2022 and 2021, respectively.

Other income (expense) – net

Other income (expense) – net decreased $49 million in the second quarter and $61 million for the first six months.

Both periods experienced lower net returns on COLI partially offset by a higher net pension benefit.

The second-quarter and six month effective tax rates for 2022 were 24.7% and 23.9%, compared with 21.3% and 21.8%, respectively, for the same periods last year.

The increases in the effective rates for 2022 reflect lower returns on COLI and lower tax benefits on stock-based compensation.

Additionally, in 2021, we recognized a $23 million reduction in deferred taxes associated with a state tax law change.

On July 8, 2022, House Bill 1342 was signed into law in the Commonwealth of Pennsylvania, making significant changes to its corporate income tax rate.

The bill reduces its corporate income tax rate from 9.99% to 4.99%, with reductions occurring in phases beginning each tax year from January 1, 2023 through January 1, 2031.

Other income decreased $16 million in the third quarter and $77 million for the first nine months.

Both periods experienced lower net returns on corporate-owned life insurance (COLI) partially offset by a higher net pension benefit.

The effective tax rates for the third quarter and first nine months of 2022 were 12.4% and 19.8%, lower than the 23.6% and 22.4%, respectively, for the same periods last year primarily due to a change in a state corporate income tax rate.

On July 8, 2022, House Bill 1342 was signed into law in the Commonwealth of Pennsylvania, which reduced its corporate income tax rate from 9.99% to 4.99%, through a series of phased reductions beginning each tax year from January 1, 2023 through January 1, 2031.

GAAP requires companies to recognize the effect of tax law changes in the period of enactment.

As a result, it is expected that there will be a decrease in “Deferred income taxes” on the Consolidated Balance Sheet and a corresponding decrease in “Income taxes” on the Income Statement in the third quarter of 2022.

We currently estimate that the impact will be approximately $135 million.

As a result, we recognized a benefit of $136 million in the third quarter of 2022.

FINANCIAL CONDITION AND LIQUIDITY

Cash provided by operating activities, our principal source of liquidity, was $2.0 billion for the first six months of 2022, compared with $2.1 billion for the same period of 2021.

We had working capital of $248 million and negative working capital of $354 million at June 30, 2022 and December 31, 2021, respectively.

Cash and cash equivalents totaled $1.3 billion at June 30, 2022.

Cash used in investing activities was $714 million for the first six months of 2022, compared with $529 million for the same period last year.

Cash provided by operating activities, our principal source of liquidity, was $3.4 billion for the first nine months of 2022, compared with $3.3 billion for the same period of 2021.

We had negative working capital of $83 million and $354 million at September 30, 2022 and December 31, 2021, respectively.

Cash and cash equivalents totaled $1.2 billion at September 30, 2022.

Cash used in investing activities was $1.1 billion for the first nine months of 2022, compared with $847 million for the same period last year.

The increase was primarily driven by higher property additions.

Cash used in financing activities was $877 million for the first six months of 2022, while $1.0 billion was used in financing activities for the same period last year, reflecting increased proceeds from borrowing partially offset by higher debt repayments and dividends.

We repurchased $1.5 billion of Common Stock in the first six months of both 2022 and 2021.

On March 29, 2022, our Board of Directors authorized a new program for the repurchase of

up to an additional $10.0 billion of Common Stock beginning April 1, 2022.

Cash used in financing activities was $2.0 billion for the first nine months of 2022, compared with $2.1 billion for the same period last year, reflecting lower repurchases of Common Stock, and increased proceeds from borrowing, partially offset by higher dividends.

We repurchased $2.3 billion of Common Stock in the first nine months of 2022 compared to $2.5 billion in the same period last year.

On March 29, 2022, our Board of Directors authorized a new program for the repurchase of up to an additional $10.0 billion of Common Stock beginning April 1, 2022.

Our previous share repurchase program terminated on March 31, 2022.

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Any near-term purchases under the program are expected to be made with internally-generated cash, cash on hand, or proceeds from borrowings.

Our debt-to-total capitalization ratio was 53.4% at June 30, 2022, and 50.4% at December 31, 2021.

Our debt-to-total capitalization ratio was 53.6% at September 30, 2022, and 50.4% at December 31, 2021.

In June 2022, we issued $750 million of 4.55% senior notes due 2053.

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The term expires in May 2023.

We had no amounts outstanding under this program and our available borrowing capacity was $400 million at both June 30, 2022, and December 31, 2021.

We had no amounts outstanding under this program and our available borrowing capacity was $400 million at both September 30, 2022, and December 31, 2021.

In February 2022, we issued $600 million of 3.00% senior notes due 2032 and $400 million of 3.70% senior notes due 2053.

We also have in place and available an $800 million credit agreement expiring in March 2025, which provides for borrowings at prevailing rates and includes covenants.

We had no amounts outstanding under this facility at June 30, 2022 or December 31, 2021.

In addition, we have investments in general purpose corporate-owned life insurance policies and had the ability to borrow against these policies up to $630 million and $715 million at June 30, 2022 and December 31, 2021, respectively.

We had no amounts outstanding under this facility at September 30, 2022 or December 31, 2021.

In addition, we have investments in general purpose COLI policies and had the ability to borrow against these policies up to $605 million and $715 million at September 30, 2022 and December 31, 2021, respectively.

We expect cash on hand combined with cash provided by operating activities will be sufficient to meet our ongoing obligations.

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On June 17, 2022, the National Mediation Board notified the parties that all practical methods of ending the dispute had been exhausted without effecting a settlement and that its mediation services had been terminated.

Although negotiations between the parties continue, this release allowed either party to engage in self-help (strike or lockout) after a 30-day cooling off period.

However, because the dispute threatens to interrupt commerce and deprive certain segments of the domestic economy of essential transportation service, President Biden created Presidential Emergency Board (PEB) No.

Shortly thereafter, President Biden created Presidential Emergency Board (PEB) No.

250, effective July 18, 2022, to investigate the facts of the dispute and make recommendations.

The creation of the PEB delays any potential self-help for 60 days while the PEB makes recommendations (expected 30 days from the date the PEB was created) and the parties engage in further negotiations (for a period of 30 days).

The outcome of the negotiations cannot be determined at this time;

however, if the dispute is not resolved during this final period of negotiations and either party rejects the recommendations of the PEB, self-help could occur in mid-September.

As has occurred during prior labor agreement negotiations, the parties could potentially reach an agreement during post-PEB negotiations, or Congress could take legislative action to preempt self-help and avert a service disruption.

The PEB issued its recommendations on August 16, 2022, and the parties engaged in further negotiations.

By late September, management had reached tentative agreements with all relevant unions.

Some of these agreements have since been finalized through ratification by union membership, but others are still subject to ratification.

In addition, two labor unions did not initially ratify their tentative agreements (with one union putting out a second tentative agreement for a vote and the other agreeing to maintain the status quo as negotiations continue).

The outcome of the ratification process for the outstanding tentative agreements cannot be predicted with certainty at this time;

however, if one or more of the tentative agreements fails ratification and is not subsequently ratified during a final “status quo” period where self-help (strike or lockout) is not permitted, self-help could occur in mid-November or early December (dates vary by tentative agreement).

In this scenario, the parties could voluntarily agree to further delay self-help and continue to pursue voluntary ratification, or Congress could take legislative action to preempt self-help and avert a service disruption.

A service disruption, depending on the duration, could have a material adverse effect on our financial position, results of operations, or liquidity.

In addition, changes in our labor agreements could significantly increase our costs for health care, wages, and other benefits.

In addition, the resulting changes in our finalized labor agreements (and our tentative agreements, if ratified) are expected to increase labor costs.

New Accounting Pronouncements

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In preparing financial statements, GAAP requires the use of historical cost that disregards the effects of inflation on the replacement cost of property.

As a capital-intensive company, we have most of our capital invested in long-lived assets.

As a capital-intensive company, we have most of our capital invested in long-

lived assets.

The replacement cost of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical cost.

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While we believe these expectations, assumptions, estimates, beliefs, and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which involve factors or circumstances that are beyond our control.

These and other important factors, including those discussed under “Risk Factors” in our latest Form 10-K, as well as our subsequent filings with the Securities and Exchange Commission, may cause actual results, performance, or achievements to differ materially from those

expressed or implied by these forward-looking statements.

The forward-looking statements herein are made only as of the date they were first issued, and unless otherwise required by applicable securities laws, we disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis