Canadian National Railway Co (CNI) 2003 Q2 法說會逐字稿

Good morning, Ladies and Gentlemen, and welcome to the CN second-quarter Conference Call. I would now like to turn the conference over to Mr. Bob Noorigian, VP, Investor Relations, of Canadian National.

Ladies and Gentlemen, Mr. Bob Noorigian

Thank you. Good morning. And welcome to the Canadian National second-quarter conference call. Today, the presentations or discussions may refer to non-GAAP financial measures for purposes of comparability, and a reconciliation of those non-GAAP measures are located on our Web site, as are our financial statements, the press release, and also the presentation today. In addition, today we also may make forward-looking statements within the meaning of the U.S. private securities reform act of 1995, and other applicable legislation. There are a number of risks and uncertainties that could cause actual results to differ materially from what we present today. Some of those risks and uncertainties are detailed in the first slide of this presentation, as well as documents in reports that are filed from time to time with the SEC.

With me today is Mr. E. Hunter Harrison, President and CEO of Canadian National, Claude Mongeau, EVP and CFO, and James Foote, EVP of Sales and Marketing.

It is now my pleasure to introduce the President and CEO of Canadian National, E. Hunter Harrison.

Thank you -- Thanks, Bob, and thanks to all of you for joining us this morning to discuss with you our second-quarter results. I trust that you've had a chance to review our press release this morning. Let me just give a little -- few highlights of the quarter from my perspective. Our earnings performance at $1.26, which is versus $1.39 in 2002, I would highlight that as the slide indicates, 6 cents of that shortfall was due to the impact of exchange. Our revenues as reported were down $88 million, or 6%, but if you exclude the exchange, those results were slightly positive on the revenue side, despite the fact that there was a $37 million decline in Canadian grain. And I would also mention that there was also a $10 million shortfall in Canadian -- Canadian Cole.

On the expense side, we saw an improvement of 3% benefitting from some of our cost control initiatives, but at the same time we also -- a lot of that impact was as a result of exchange on the other side of the ledger. But overall, I was very pleased with the expense performance, particularly when you take into account the negative impact of fuel cost and the pension expense, which Claude will talk to you about in more detail.

Free cash flow, I would -- I thought was outstanding performance of $350 million. You're going to hear throughout the presentation some of the challenges that we faced in the second quarter. I was very pleased that we bounced back from -- from first quarter, where we had, as we talked to you about, some real adverse impacts from the weather standpoint. Some of that weather even carried over into this quarter, in April, where we had flooding conditions and several tornadoes in the southern part of our railroad. But in spite of all of that, we bounced back to our trip plan compliance over 90%, in spite of the fact that we continued to change those plans, continued to raise the bar.

One other issue that I would highlight in the quarter is we're starting to get some gain some real leverage from the benefits of the siding extensions where we have spent a good bit of capital over the last two years in siding extensions, mostly in -- mostly in western Canada, to some degree in the U.S. between the border and Chicago. But our train load factor improved 2% in the second quarter, and I'm pleased to see there's some new initiatives in place that Ed Harris and Company have taken, and so far this quarter, that train load factor, the run rate improvement, is about -- is about 6%.

So overall, I thought it was a nice performance with having to overcome some pretty -- some pretty tough obstacles and with that, I'll let -- ask Claude to review some of the financial with you.

Thank you, Hunter. Let me go straight to the bottom line. We delivered in the quarter $1.26 of earnings per share. That's down 9% on a year-over-year basis. This is pretty strong result when you consider the headwind we had to face.

Let me put things in perspective and mention only three factors. Our bulk business, grain and Cole, is down a full $65 million, with a 21% drop in grain and fertilizer alone. The WTI fuel prices are up 10% on a year-over-year basis, and perhaps the most important factor for us is the exchange rate for the Canadian dollar increased a full 11%. That alone on the conversion of our results into Canadian dollars, that alone cost us $25 million of operating income and 6 cents of EPS. So if you take into account those factors, the results of $1.26 is pretty strong. Revenues came down on a reported basis by $88 million, but $90 million is due to exchange. Excluding exchange, revenues are actually up with stellar performance in intermodal offset by grain. We also had, you know, very good progress on the yield front, as Jim will describe further in a minute.

Our expenses came down $35 million, with help from exchange, but also solid cost control, and I'll describe this in a minute. Below the line, we came in with a small loss in other income, offset by better than expected tax rate of 30.3% due to favorable settlements. Our other income on a year-over-year basis is down $27 million. That is close to 9 cents per share. A big reason for this decline is a swing in the exchange -- realized exchange gain and losses. Last year we had a gain. This year we had a loss of $8 million. The swing is close to $15 million on a year-over-year basis. So again, given everything, solid results, and let me spend a minute looking at the expense performance.

Overall, our reported expenses came down $35 million. If you exclude exchange, our expenses would have gone up by roughly $30 million, with the key driver being the significant increase in fuel prices. We again showed strong cost control, pretty much across the board. Labor expenses benefited from a full 5% drop in headcount. We have close to 1300 fewer employees at the end of the period. We also made continued progress on asset utilization despite flattish volume. Car velocity and locomotive utilization are up 2 and 5% respectively, and this is showing up in equipment rent, which is down on a year-over-year basis. Trainload, as Hunter described, is also a strong story, up 2% on a year-over-year basis as a result of our siding extensions. We also had major payoff on discretionary spending, with our purchased services showing significant reduction. This cost control bodes well for the future. We are lowering our fixed costs aggressively, and we are preparing for the rebound of business at very low incremental cost. Let me turn to cash flow.

On the cash flows side, very good performance. $350 million cumulative on a year-to-date basis. We made significant progress on working capital. This was offset by lower proceeds from disposals. The main reason here being last year in 2002, we had close to $70 million proceeds from the sale of our stake in trance rail, the New Zealand property. We used this cash during the quarter to buy back shares. In Q2, we bought back $3 million shares. On a cumulative basis, we're up to $11.8 million shares on the program of $13 million shares, which we announced in October. We will complete the program over the next two months, and assess where we stand in September. The good news is our balance sheet remains very strong. On a book basis, our debt ratio is below -- or just below 39%. 43.3% if you include all leases. This clearly gives us a lot of flexibility to use cash wisely, and reward shareholders going forward.

Let me wrap up with a few words on the outlook for the balance of the year. It's fair to say that we had very first solid performance in the -- in the first half, given the challenges, which I think clearly indemnify straits CN's resiliency. We think the tough quarters are behind us and we are preparing for an earnings rebound in the second half of the year. We'll need a bit of help from the economy, also a better crop which will have a big impact in Q4, but we see the makings here of our earnings to return to growth on a year-over-year basis starting in Q3.

Let me make no mistake, we also face a number of challenges. Exchange and fuel prices are, you know, the most important. But if exchange stays around 71 cents going forward, and the fuel prices had you ever around $30 a barrel on a WTI basis, we think we can come in at the low end of the guidance in terms of EPS and actually have strong free cash flow and year-over-year growth on that front.

Jim, over to you.

Thank you, Claude. I want to break apart the second-quarter revenues to try and give everybody a clearer understanding how well the businesses are performing. We had a very good quarter, considering -- if you exclude the impact of exchange. As we said, we reported $88 million, or down 6%. However, exchange had an impact of $90 million in the quarter, so revenues would have been up slightly for the quarter. We started the quarter, as we have in the past few, down significantly, or down 2.5% on a year-over-year basis due to a decline of 34% from lower Canadian grain volumes. Another 1% decline on a year-over-year basis came from a 10% decline in Canadian Coal. So we started the quarter a full 3-and-a-half points behind where we were the prior year. To grow back to where we came in, we first started with a full 3% increase in prices.

About a half of that comes from the fuel surcharge, so the price increases that we are realizing continue to be in a 1.5 to 2% range, which we've talked about on a quarter-by-quarter basis. And then we grew the business another full 1% during the quarter, principally in the intermodal area and forest products. If we take a look at this on a commodity-by-commodity basis and I try to adjust the numbers to take into effect the impacts of exchange, our petroleum and chemicals business was up in the quarter on an exchange-adjusted basis 1%, due to the strong growth in the sulfur area, being offset to a degree by a softness in the petro chemical businesses that are being impacted by the high gas prices. Melts and minerals on an exchange adjusted basis up 2%, and a strong steel market there driving and improving our business. Forest products, a very good quarter on an exchange adjusted up 6%. All commodities in that area grew. Lumber, panels, but now we're starting to see some strengthening in the pulp and paper area as well.

Cole, as I said, exchange adjusted would be down 6%, driven by the 30% decline in Canadian coal, grain and fertilizers down 16%. The Canadian grain being down 34%, offset by a very solid quarter in both U.S. grain and our fertilizer segment.

The intermodal business, as Claude said, a very good quarter. Exchange-adjusted, up 14%, very, very strong import business in the overseas segment, on both the east and west coast driving that business. And automotive, while down 3%, actually doing a little bit better than we had originally expected for the quarter, which would bring total revenues in roughly flat on a year-over-year basis.

A little bit about the IMX or the intermodal excellence project that we've talked about since the beginning of the year. We rolled out this intermodal excellence project in early February in the Eastern part of Canada. It has had quite an improvement in the service that we've been able to deliver to the marketplace, a more balanced and more consistent level of service, principally -- or so far in the Halifax, Montreal, Toronto, and to a degree in the Chicago corridors. Big improvement in terminal efficiency. A disproportionate amount of the cost associated with operating our intermodal service is associated with the terminals. This project is helping us improve the efficiencies, the dwell times, the turn times, and the amount of container handling costs that we have there, which is driving this potential for contribution improvement in this business to 25% to 30%, and the segment that we have been able to do in the east so far, we are meeting those objectives. Effective August 11th, we will be rolling this IMX out in western Canada, and we would expect to realize a similar type of improvement in profitability in that segment of the business.

Second half outlook, I continue to be optimistic about the merchandise growth. Certainly there are some segments of the business, principally the petro chemical industry, which is being impacted by these high natural gas prices, but the Canadian producers and those -- our customers located in Alberta continue to have a cost advantage as well as a production capacity and efficiency advantage in their production, and will continue to see their growth moving forward.

Grain outlook for the first time in two years I can say looks promising. We've had reasonably good, if not great, moisture level in western Canada compared to what we've had in the last two years. As you know, we have been cautious in terms of our outlook for the grain, taking into our budgeting process about 85% of a 5-year average. That 85% now looks to be too pessimistic and we're expecting that the grain crop will probably be much closer to average this year. And we continue to focus on selling service, focusing on our scheduled service in the high-quality product that we deliver to our customers, and continuing to get the price increases that we've talked about in the 1-2% range. Hunter?

Thanks, Jim. Let me take a few minutes to highlight a few other issues that took place in the second quarter of some significance. Number one, we realigned the field organization and went from five divisions to basically three regions, where we now have an eastern Canadian region, a western Canadian region, and U.S. This has helped us take some of the bureaucracy out of the field operation, reduced some of the administrative costs, and kind of streamlines the organization and hopefully makes us much more responsive to the market. That re-alignment went off without any problems, and I'm very pleased with that. The second and probably the most significant is on the labor front. We finally, with the UTU on the Illinois central, got our new hourly agreement ratified. Those of you that have followed this for some time, this is now about a 8 or 9-year battle that I've been going through and it's a big step, so now we have all the Illinois central, both the engineers and conductors, all the Wisconsin central, both engineers and conductors, under this new concept. That covers about 1600 employees. Also, at the same time, we have initialed an agreement, the same type of an agreement, with the DWP, which is effectively the railroad from superior to -- Duluth-superior to the Canadian border, and we are looking forward hopefully to rat if I ratification sometime in September. That will be a tough hurdle to get over. It represents significant change, but I'm cautiously optimistic that we will -- we will -- we'll see that happen.

At the same time, we are actively in negotiations now on the grand trunk with the engineers, with the BLE, and so this whole issue is gaining some momentum and we're far ahead of the schedule that I had initially set. We continue to fight this war on bureaucracy, particularly here in headquarters in Montreal, and we are -- we're clearly seeing the benefits of those efforts. Jim talked about growing this business, this service-sensitive business, which he has talked so much about, and I don't know when I have ever been as pleased with an initiative that we've taken on as I have been with this IMX initiative with intermodal. Intermodal has grown to a significant part of our business, over a billion dollars now.

As I had shared with most of you, I have -- at the same time I was pleased at growth, I was concerned about the profitability, and this project that we first rolled out and talked about now over a year ago is starting to really come together. It's really gaining some traction. Of as Jim, as Jim mentioned and I'm extremely pleased and this issue of profitability in intermodal, I think is behind us.

So overall, an excellent quarter, particularly considering some of the -- some of the hurdles we had to get over. We've learned to manage through some of these tough, difficult times. As Claude mentioned, I'm confident that we did everything in with a reasonable grain crop and with the Canadian did not -- if the Canadian dollar does not skyrocket above the 71 or 72-cent level, that fuel prices maintain their position about where they are, I'm confident that we can deliver the type of earnings that we had indicated to you in the past, and probably more importantly, really ready for a big solid rebound in 2004.

So with that overview, we'll be glad to address questions you might have.

Thank you, Mr. Harrison. If you have a question, please press "*1" on your telephone keypad and you will be placed in our priority sequence queue. If at any time you wish to cancel your question, please press the pound key. There will be a brief pause while the participants register for their questions. Thank you for your patience.

Our first question from Morgan Stanley, Mr. Jim Valentine, you may now proceed.

Great. Can you guys hear me?

Sure, Jim.

OK. Good. Great. I just want to ask about maybe Claude, you could kind of go over a little more detail in terms of -- you're saying you still -- you feel comfortable at the lower end of guidance, and kind of refresh us on that, and kind of remind us again, because we've got Canadian numbers out there, and then those of us in the states have U.S. numbers out there. I'm just trying to get my hands around whether or not you're feeling comfortable with the numbers that are out there or you think numbers need to come down or go up or what your expectations are.

Yes, Jim. I mean, there's a lot of uncertainty out there, but, you know, with the first half in, the way we delivered performance and, you know, as we said, with a good grain crop, you know, going forward, and the exchange settling in at 71 cents, we think we're going to have growth in the Q3 and then -- and then double-digit growth in Q4, which would allow us to come in for the full year, you know, at the low end of our guidance, which is, you know, basically flat on a year-over-year basis with what we delivered in 2002. All of the guidance and the -- you know, the -- that we give is always in Canadian dollar terms, so that's -

Right. So that -- so we're looking at a 522 from last year. You're basically saying that's your target?

Yeah. And, you know, we're working hard to get there and, you know, we'll need a bit of help on a number of fronts, but, you know, we have a lot of initiatives and -- going on and we're gaining traction on a number of fronts. You know, it's a challenge but, you know, we've -- that's where we sit at the moment and we hope to deliver in line with this target. That's for earnings.

On cash flow, you know, we have a pretty good story there. You know, we think we can most likely grow free cash flow on a year-over-year basis, and that's despite the significant step-up in our dividend rate which we announced, you know, last year. As you know, we measure free cash flow after dividend, so I think, you know, all in all, this bodes well for performance in a very tough year, and I think most importantly, as Hunter said in his closing remarks, that, you know, it sets us up well for a rebound in 2004 when -- when we have a full year with better grain and a full year benefit of all the initiatives we're grinding out as we speak.

Great, great. Can I ask a second question here regarding BC rail? Hunter, I know you've said and you've shown and demonstrated in this in the past. You've been very disciplined about any kind of acquisition activity. It looks like if BC rail, is my understanding, they interline quite a bit of their traffic with CN, so if for some reason you were to be very disciplined and not get BC rail, I guess to what extent could that acquirer your overall revenues or am I making it a much bigger deal than it probably could be?

No, Jim, I think that we have, you know, clearly in the past, we have looked at the impacts of BC rail if it was sold, and if we were not the successful acquirer. Clearly, from a revenue standpoint, it would be -- it would be negative, but it's not -- you know, it's certainly not the end of the world. You know, we're part of the process. We're on the short list. We are limited, to some degree, about what we can say about the transaction, but we clearly are not going to fall in love with it. Clearly we'll maintain our discipline.

And I would add, Jim, the following comment, that, you know, this -- this property here under Canadian rules will, as it gets sold, will -- will have to remain an open and neutral railroad, such that interchange carriers have the ability to continue to move the traffic going forward. That's certainly the way CN is thinking about the transaction, and I think that's how the others will have to down the road when they get their mind around the regulatory hurdle of the Canadian competition bureau. That's number one. Number two, we have anywhere from 600 to 800-mile route advantage out of Prince George, where 75% of the traffic of BC rail originates, so we feel pretty good about the situation one way or the other.

Great. Thanks so much, guys. Appreciate it.

OK, Jim.

Thank you. Our following question from Scotia Capital, Mr. James David, you may now proceed.

Thank you. Good morning.

Good morning.

Just a couple questions. Jim, perhaps you can address this. You may have touched on it in your discussion on -- on rates, but the RTM rate down 5%, is there any breakout I could have on the impact of currency and mix, in terms of that 5% decline?

Yeah. I suppose we could -- when we went through that on an adjusted basis, we would show that the RTM was up about 2.3%.

Uh-huh.

On a total.

Uh-huh.

I don't think -- unless Bob feels comfortable going through all of the various segments line by line -

No, no. Really I mean if I looked at a yield decline of 5%, part of that would be a result of currency. You said you had a -- a -- or you went through the currency impact but was there a mix impact at all or is mix kind of neutral?

Yeah, there was a positive -- positive mix impact as well.

Uh-huh.

Our -- as the length of haul went up. On a revenue per ton basis, we're positive 3.5% on a currency adjusted basis.

Uh-huh.

On a revenue per carload basis on a currency-adjusted basis, we're positive 1.4%. So in all segments, all segments, you would look at, we would be positive if you take out the effects of currency.

OK. Second question, perhaps Claude, you mentioned you've got a -- just over another -- I think it was about a million shares to go and you expect to get that done in a couple of months in terms of your share buyback. Is there any implications, you know, considering the amount of free cash flow you're generating? Will you sort of being keeping your powder dry until October or will you -- you have talked in the past your payout ratio possibly addressing that again? Could we expect something like that to happen before October?

No. I mean I think it's a quality problem to have. We still have $1.2 million shares to buy. In Canada, under a normal course issue or bid, you have a program for one year, so we'll be assessing the situation with our board in September. It's the right timing because that's when you start to look at the following year in terms of, you know, budget and business plan forecasts and make a determination at that point on the best use of cash.

OK. Many thanks.

Thank you. Our following question from Smith and Barney, Mr. Scott Flower, you may now state your question.

Yeah. Good morning, gentlemen. Just a couple of quick questions on the -- on the revenue side. One would just be, I know we've talked about the -- the formulaic impact of currency right now on your revenues and your expenses. I'm just wondering, with a -- let's say that the Canadian dollar stabilizes at 71 cents or so. Are there any lag negatives in terms of the volume stream on a go-forward basis, do you think, Jim, whether it's in forest products or metals or in automotive, but just the fact that the Canadian currency has strengthened so much over the last, I don't know, three to six months, that some of the trade effects lag and therefore the volume streams might be a little bit softer as you look toward 3Q and 4Q because of that?

No, not in the -- not in the 71-cent range. You might remember back, Scott, to the IPO when we were looking at a 75-cent dollar, so we're still -- we still have a -- are in a better position, the Canadian dollar vis-a-vis the U.S. dollar, than we were at that point in time, so you're looking at a 25 to 30% discount from a U.S. purchaser. And the one positive impact that these -- that the -- I guess you would say the weakening of the U.S. dollar has had, we have seen some product moving into the U.S. market from Europe in the paper side and the steel side, et cetera, as the -- as the Euro had become cheaper as well. Well, as that has turned around, we've seen that flow of commerce shut off, so it's actually had somewhat of a stabilizing effect for the Canadian producer.

OK. And then just one other question, and it would relate to trying to get a little more color on the IMX program. As you push this forward in the Eastern part of the system, I'm just wondering a couple of things.

One, were there any changes or things that as you got into this, that you that you adjusted, mid-course corrections, if you will? I'm just trying to get a sense of what things maybe you have fine-tuned from what your original program was or did it perform basically as expected. And secondly you gave us some broad framework of where you thought the contributions could get to. I'm just trying to get a sense of how much of a move there was. I'm assuming that in the east, you're already in the 15% to 30% range, or thereabouts. I'm just trying to get a sense, order of magnitude. Is that a doubling of where contributions were? Is that up, you know, 40%, 50%? I'm just trying to get a sense of, (a), what changed or didn't change, in the IMX program, as you fine-tune that approach, and then now going to western Canada, and then secondly, just some order of magnitude of how much the contributions have improved in the east.

Well, I could tell you this, Scott, that, you know, we came up with a game plan that we thought, you know, we could throw the ball but we got ourselves in a situation where the weather was so terrible that when we rolled it out that we had to run the ball.

OK.

So yeah, we changed the game plan. But the end result is that we still scored -- we still scored and we got the ball in the end zone, so there were a lot of fine-tuning and a lot of variations and a lot of things that we did as we went along and learned as we went along. Some areas, we were -- that we went a little bit slower than we thought we would in terms of the number of trains initially that we thought we would take out, so we were practical and logical about what we did. But methodical and have been able to make the adjustments. I think some of the changes that we're making in the way we operate our terminals is probably -- we've accelerated some of the things that we've done there because we realized that the efficiency and the service improvements that we can generate by being more disciplined in the way we operate our terminals gives us not only a significant cost advantage, but truly a different product that we can sell to our customers. So that area, we're doing different and faster.

And again, other than to say that overall, we think that we can get, you know, 25% to 30% improvement in contribution on the overall business unit, I don't think we want to be any more specific than that right now.

Great. Thank you.

Scott, I would -- this is Hunter. I would hasten to add, certainly from my perspective, we knew there were too many assets in the pipeline, but as we've gotten into this further, there's far more than we ever dreamed, opportunity-wise. And I think the encouraging thing is that the customers recognize and understand this also, so there's big opportunities, far too many bosses out there, that only be consistent terminals and there's opportunity from their standpoint and our standpoint far beyond what we first imagined.

Great. Thank you.

Thank you. Following question from Bear Stearns, Mr. Thomas Wadewitz. You may now proceed.

Good morning, everybody. Two questions here, one for Claude. A follow-up on the -- an earlier question regarding free cash. As you said, it is certainly a high-class problem or high-class issue. Not a problem to think about. Do you favor dividends increases over share repurchases? Is there any kind of favoring of that? And especially in light of the changes in some of the U.S. tax rules?

Tom, I would tell you we like both, and we've delivered both over the last few years. You know, we have a general dividend policy to-- you know-- increase our pay-out ratio, which means that, you know, on the year-over-year basis you should expect our dividend to grow faster than earnings, which is certainly the case over the last few years and we've increased that dividend, you know, every year since the IPO. And to the extent that we have free cash flow and no, you know, call on the cash with, you know, strategic opportunities, the -- you know, the share buyback allows us to -- a lot of flexibility and it's a very efficient way to bring back cash to shareholders, you know, when that cash is available. So it's really a mix of both, and -- and, you know, that's the way we've been thinking about this -- this high-class problem over the last few years.

OK. So I guess you can make everybody happy and do some of both?

Exactly, exactly.

Yeah. OK, so a question for Hunter. First, congratulations on the agreement with the UTU at Illinois central. Sounds like that's been a long time coming. Certainly a lot of hard work on that. I'm wondering if you've got basically a year under your belt at the Wisconsin central with these new flexible agreements. I'm wondering with that experience in mind, can you give us a sense of how to view the potential productivity gains you may realize from the flexibility that you get with this new agreement at the Illinois central, and, you know, whether we should be looking at headcount reduction or merely just more focused on improvement of service or how we can really view the impact from this agreement?

Tom, there's a couple of things I suggest, you know, Wisconsin central, it was the first we converted to the hourly, but at the same time I would hasten to add, it did not have some of the archaic, antiquated work rules that the other class ones had. So it's hard for them to give us an order of magnitude of the potential. But we've certainly had a learning experience from the engineers on the Illinois central.

You know, I can give you some kind of order of magnitude. I've said and I think I feel even more confident of this all the time, that the U.S., all in, you know, is worth -- just if you look at that individually better than a point on the operating ratio itself. If you'd like another metric to look at, I think you could -- one of the ones that people grab the quickest is it takes about a third less people (ph). Now, some of that we have to do over time with some attrition, but it's a big step. It's certainly to your point, gives us more flexible -- flexibility with serving the customer, and there's certainly beyond just a, quote, headcount, there's a lot of productivity issues that present itself. And I think one of the use of phrase of Claude's, first-class problem is that it's difficult right now for some of our operating managers and leaders out there to operate from kind of a Greenfield approach of out of the box without these work rules handcuffing them. It's hard for them to recognize what the potentials are. So there's a lot yet to be learned.

OK. All right. Great. Well, that's helpful in terms of framing it, sounds like it could be a really big impact. One last question, then, for Jim. It sounds like you're reasonably upbeat on revenue outlook, even in setting aside Canadian grain coming back. Are you getting a sense the economy feels at least a little bit better, or are you still pretty cautious on industrial economy?

I think the segment -- the non-gas-related segment of our business, the segment of our merchandise business, our customers seem to be more optimistic, or continue to be optimistic about the second half.

OK. Thanks for the time.

Thank you. Following question from Deutsche Bank. Mr. John Barnes, you may now proceed.

OK. Thank you. Hey, good afternoon. Hunter, you talked about the war on bureaucracy and when you took over the reins you had a couple of things very quick hit that helped improve the operating ratio and it looks like a little bit of that is -- has begun to plateau. Is there anything low-hanging left, or is what is left on the war on bureaucracy, you know, much more difficult to get at?

Well, I mean, it's a continual battle but I mean it does a lot of things for us. The biggest issue it does, it just changes the culture, how we do what we do. You know, I've talked about that I think over a year or two, that all these various initiatives that are taking place, both here and headquarters, and in the field, some of the most basic things I think have the opportunity once again to get a -- a point on the operating ratio. But I can tell you this: We have been into it long enough now that I couldn't characterize any more of it as low-hanging fruit. There's still fruit there. There's still some tough hurdles to get over. But we've gotten most of the stuff. Now, some of it has not kicked in yet, so we've not seen, certainly, the full -- full benefits yet, but it certainly is -- it's certainly something that's gained some momentum and it's become a way of doing business around here, which I think is -- is very positive.

OK. When you say not all of it has kicked in, can you give us some kind of rough time frame on when you expect us, you know, to see the full -- the full impact of what you targeted initially?

Yeah. I mean, of the things we initially looked at, you know, it was my view that as we looked at those things, all the way across the board -- and I've talked about the issues -- that probably over a two-year period, if you went back from a zero base and said what is all is here, it was in the neighborhood of a point on the operating ratio, and I still think that we can achieve that.

OK. In terms of the labour negotiations, now, you know, that you've gotten agreements signed with the IC, can you give us a -- an idea of what might be next on your agenda in terms of line negotiations? Is there some of that you've achieved in the U.S. that you can apply in Canada and, you know, when do you -- when do you start that process?

John, I should mention one thing that -- along those lines is that I have talked to a lot of you in the past about the -- this so-called fertile board in Western Canada where we have this phenomenon where between 4 and 600 people, as a result of a 1992 agreement, are allowed to sit at home and collect between 55 and $60,000 a year. We are in intense negotiations, as we speak. I am very hopeful of a resolution on that front. And in the next month or so I would say to you that our whole labour relations effort, our relationship with labour has improved significantly.

Throughout Canada and the U.S., I'm pleased by that. I think with the -- with the exception of this one issue of the furlough board, we do not have, quote, major disputes or issues that are before us. I do think that the potential exists to take this model that we used in the U.S., as far as the hourly concept with the operating crafts. This is something that people in Canada now have heard about, and are familiar with, and I think that what applies in the U.S. would apply for Canada. It's good for us and it's good for the employee, we think. And I'm hopeful that maybe in the next year or two, we will be able to take that model and overlay it in Canada, so our whole system in North America will have this -- this one simple effective agreement.

OK. And then last question and I'll turn it over. Jim, you came -- mentioned during part of your comments on the agriculture side that you had picked up some market share on U.S. grain. You know, we're hearing that there is going to be just a record year on U.S. corn. Looks like the U.S. wheat crop is very strong, and there's only about 65% of the trucks that were available this time a year ago now available to move wheat in the U.S. Do you see your opportunities on U.S. wheat market share improving? Do you have the assets to take advantage of that? And what do you think so it -- it means to your overall outlook?

Well, our U.S. operation would be principally corn and soybeans, very little exposure to the wheat market. And yes, the U.S. crop in general appears this year to be much higher than it has been in the past, especially last year, but our -- the corn and beans in our territory last year were not as depressed as the rest of the marketplace was, so our upside is probably less than what the -- is principally the western railroads would be looking at in terms of opportunity but still very, very good for us. And we continue to -- continue to be optimistic there. Obviously, the big, big story for us on the ag side is the Canadian crop.

OK. Guys, thanks for your time.

Thank you. Following question (inaudible) Mr. Andy Cousins, you may now proceed.

Jim, I wondered if you could go into a little bit more detail with the intermodal business at sort of two levels. First off, what's been happening to your market share in the Eastern part of the country versus the western? Has the -- has the change in the game plan in the east had any effect in terms of sort of your market share or your penetration in the Eastern part of the country?

And what's happening with the mix between your domestic customers versus the, you know, international container shipping lines? Who is it that likes the new IMX program the most?

And then as a corollary to that question, going forward, if you're getting lower costs as a consequence of redoing the intermodal model, you know, what do you see as a growth rate and sort of RTM volumes for intermodal? You did 11% in the second quarter. Should we be using double-digit type growth for intermodal with this new model in place?

Well, first, let me try to take these -- your three questions there in order, east versus west. And domestic versus overseas. This is a service that lends itself best to both, really. I mean it's not -- you know, we're not -- this is not favorable to the overseas guys or the domestic customers. It is a service that brings consistency and efficiency to both the domestic and overseas people.

In the -- the growth so far that we have seen this year, the overseas import business is -- is very strong. On both the east coast and the west coast. So the gain that we have realized this year, the growth we have realized this year, has been principally in the import/export business into and out of Halifax and Vancouver.

And I think that's more a factor of the strong, strong shipments into Canada and the U.S. than it has to do with our service.

In terms of growth rates going forward into the future, whether that be in the second half of this year or into 2004, the challenges that the railroad industry has faced in the past has not been in the level of volume growth that one can achieve. Being able to grow the business either high single digits or double digits was not the challenge that we were faced. The challenge that we were faced was growing the business profitably, and we were very comfortable with the growth rates that we had set up for ourselves earlier this year in the 5 to 10% range, knowing full well that we were -- could grow that business faster if we wanted to.

I would say -- and -- and we were -- and we were willing to hold back the overall growth rate to make sure that we grew the business profitably.

As we go forward with IMX, and as we begin to achieve the rates of returns that we should expect on this business, we would not have to put that self-imposition of restraint on, and therefore we'd be able to grow the business at rates faster than we have historically done, but do so profitably.

OK. Second question. Just with reference to the grain crop, you know, obviously your plan -- your cost portion of your plan was based on I don't know that was 85% of normal. If we come in with a normal grain crop, does that mean that we should be budgeting for a higher headcount? And I know you guys are in a lot of mixed rate consists. You know, is this a situation where you can basically add in this incremental grain revenue with just a little more fuel

Yeah, Randy, this is Hunter. You're right there. If you look at our capacity right now, not much of our grain moves in (inaudible) train consists, so incrementally, the only increase -- not the only increase, but the only increase of any significance that you'll notice would be fuel usage relative to. So the labor and asset utilization issues will -- you will not be able to hardly see.

OK. That's it for me. Thank you.

Thank you. Following question from Canaccord Capital, Mr. Robert Fay, you may now state your question.

Good morning. A couple of questions, Claude.

If we go forward, if there's movement in the Canadian dollar up or down, what's the type of sensitivity we should be modeling into our EPS calculation?

Well, we've given guidance in the past that, you know, a cent appreciation in the Canadian dollar is -- you know, impacts us on an annual basis by about 4 cents in terms of bottom-line impact. The-- you know, basically that's -- that's the bottom-line. You know, given the size of the increase in the Canadian dollar this quarter, we've given you in the press release and will file with the MDNA a little bit more information and you have that available to you and can model the impact. The dollar went up 7 cents on a year-over-year basis, and that impacted our revenues by $90 million. You know, our -- benefited our expense by 65, which means that operating income was impacted by a negative $25 million, and then you work the intrip, the benefit, et cetera and you get down to the bottom-line impact of, you know, roughly a four-cent annual basis for every cent in appreciation.

Question for Jim. With the move, the sharp move in the price -- or the exchange rate, sorry, have any of your customers been putting any rather pressure on you regarding yield or pricing that you're offering in any of the specific commodity groups?

No. The dollar -- I would say that the dollar at this point in time has no impact on our customer base. They're selling into the U.S.

Good. Headcount for the rest of the year, given the decline you had in the second quarter, is that the type of number we should be modeling on a year-over-year basis for the rest of the year?

I think you should expect a slowdown in the rate of year-over-year decline just because you know, what you're seeing at the moment for the first six months is the benefit of our program announced last year, but -- so in terms of -- at the margin area, in terms of year-over-year decline, it's going to be slightly less than the 5% reduction you've seen in Q2. Having said this, our headcount for the full year will continue to be down, and on a full-year basis will be down, you know, quite significantly.

OK. On your fuel hedging, what's the current position that you're running on your hedges for the rest of the year?

Yeah. We're -- you know, we're as at 46% of our anticipated volume consumption, and we're hedged up to $22.72 for the full year.

That's great. The last question. Tax rate for the rest of the year, what should we be using as sort of a sustainable rate?

We keep on covering, you know, a number of opportunities to reduce our tax rate, both on a book and a cash tax basis. You know, our people are making headway with revenue Canada on claiming, you know, research and development credits and that's helping us on the cash taxes front going forward. Having said this, our first six months were at 30.3% or 30.4% effective book tax rate. For the full year, we have given previously guidance for an effective tax rate of 321/2%, so, you know, basically we'll beat that by a long shot, just because of the first six months, you know, where it is. But if you want to model going forward, and be, you know, conservative, you could use, you know, around 321/2 for the remaining two quarters.

OK. The great. Thanks very much.

Thank you. We now have a question from Credit Suisse First Boston, Mr. Gary Yablon Yablon. You may now proceed.

Hi, guys. I wanted to ask a little bit about locomotives. Maybe this is for Jim and for Hunter. At what kind of volume levels going forward in terms of growing the business, do you need to re-up on locomotives? I'm getting a little bit uncomfortable with the capacity available.

Gary , I think that we're probably two years away from what we anticipate as growth. Of course there's a lot of ambiguity out there about that now. But particularly, we're going to see growth in the intermodal side, and we've got -- you know, we've acquired the 60 new locomotives that will be completed at the end of the year, and so I don't see any need for locomotives going forward for another two years.

OK. Hunter, can I back to this discussion about the furlough board.

Sure.

That you'd talked about. These folks are currently not working at all on the system?

Yeah. It's a pretty complex yes, but for all practical purposes, 90% of the time, they're not -- they're not working, period.

Is this a relatively new project for you, or has this been a work in process for some period of time?

Well, it's -- it's been a job for me for the last year on or so you. Now, this has been ongoing, as I said, for over 10 years now, but the issue is, when it's become a problem, the more you increase productivity, the more people, quote, go to the furlough board, so there has to be a resolution to that.

Right.

And the -- I think it's safe to say that the bargaining units understand that, and so we're in a very fruitful dialogue right now that this problem cannot be perpetuated further, and we've got to get this resolved, and -- now, is 30 million going to go away overnight? No. But I am confident, going forward, from a cash flow standpoint that we will have this resolved.

OK. And finally, you put in a filing, as I understand it -- I haven't had a chance to read through it yet -- with the STB as regards to the KCS NAFTA rail proposal. What -- what are you looking -- what bothers you about that? What -- what might you be looking to get out of that? Could you help us a little bit there?

Yeah. Let me just give you a little -- a couple comments here and then maybe Jim can add to it. There's just information we need, and need to understand, about the transaction that we have not been able to determine yet, and if and when we receive that and we've been in dialogue, we'll be comfortable with the transaction given what that information tells us. Jim, is there anything you want to add?

Other than the alliance agreement has been, you know -- it's been a very good deal for us and I'm very confident will continue to be a very good deal for us going forward.

I mean there's nothing about the NAFTA rail deal, Jim, that impacts the alliance, correct?

No. This was just a question -- some technical questions about, you know, their intentions going forward.

OK. Thanks a lot.

Yes, sir.

Thank you. From Merrill Lynch, Mr. Keith Augustyn, you may now proceed.

Hi. Good morning. Just want to talk about the -- two things. On the fuel, gallons were up fairly significantly. Was just wondering if you could talk about why, what caused that jump. And then secondly, you talked a lot about the IMX program. Are there any metrics that we can look to on an ongoing basis to -- to kind of gauge the progress of this, or is it just something by looking at your overall velocity, which is up 1% year-over-year? And then just to wrap up on Claude on the taxes, I just want to understand, what exactly caused this quarter's decrease? Thanks.

Yeah. On the fuel efficiency on a year-over-year basis, we -- our fuel efficiency is down slightly. There's a -- you know, a variety of reasons for that operating conditions, mix, et cetera. You know, our continued focus is to improve freight handling and, you know, lengthen the trains and get both the trainload and fuel efficiency going forward. You know, to your question about the impact on productivity that is tied to the IMX, clearly the -- you know, if you look at the overall system of CN, it's difficult to find in the productivity indicators the -- you know, you know, parcel out the impact of IMX because I -- because, you know, at the end of the day, intermodal is lessor around 20% of our business. It is, as Jim said, however, having tremendous impact on intermodal productivity measures, which we look at internally. Whether it's, you know, the slot utilization of containers on flat cars, whether it's the terminal efficiency, the cost per lift, whether it's the -- you know, the trainload of intermodal trains per se. All of these measures are going up, and that is the reason we are getting a significant profitability improvement in the territory where we've implemented this initiative so far.

To your last question about the tax rate, the -- you know, very simple reason. On an ongoing basis, we settle, you know, tax returns with various authorities in Canada and the U.S., and we had a few favorable settlements which we had provisioned against, which -- which, you know, came into our favor and we have to reverse those provisions and that's why you get a slightly lower tax rate in Q2 than we did -- than we did give you guidance for.

Great. Thanks. If I can just one quick follow-up. Hunter, is there any chance to restart up negotiations on Owen rail, or what is the status of that?

Oh, I would never say never. You know, it's still the -- you know, it's still -- I think opportunities are there. I guess there's a point, if the problems changes their mind, they know what our position is and what we'd like to do. You know, if they called tomorrow, it could happen but, you know, it's hard to speculate.

All right. Great. Thanks, guys.

I thank you. From J. P. Morgan, Mr. Gregory Burns, you may now proceed.

Thanks. Hi, guys. Just following up on the comments on price, if I heard correct, pure price was up in the 1 1/2% to 2% range ex-currency and mix. Is that correct?

No. It was -- pure -- okay. Pure price excluding the fuel surcharge as well. If you add in the fuel surcharge that we had in the quarter, we were up 3%.

Right. OK. Looking at that -- at that price, then, I'm just curious, was there -- and I assume that's a total book of business. Is there any anything in the contracts that were -- that came up to suggest that pricing is either getting better or worse? Any leading indicators one-way or the other or sort of is this the kind of outlook, ex-fuel, that we should see for the balance of the year?

I think this range of 1% to 2% price increase is something that we've talked about that is achievable, reasonable, and what we would expect to get as a return as we improve our service, and I see no reason to believe that that won't continue into the future.

OK. And then I guess just following up on -- on the question on BC rail and -- I'm curious maybe just refresh my memory as to -- as to how you guys would look at the strategic stuff from an earnings accretion standpoint or hurdle rate and just how -- how you think about those opportunities.

This is Claude. We can -- you know, we always approach every transaction with a sense of discipline. The railroad deals are complex transactions. You need to line up a lot of ingredients to make them work. You know, getting the proper support from stake holders, lining up the two organizations so that you can have a flawless execution, and actually integrate the two properties in a manner that creates value. And for all of that to happen, you really have to be disciplined on valuation. You cannot fall in love with a transaction. There's got to be enough in it for the -- the -- you know, the buying shareholders, if you wish, and that's certainly the way we've approached every transaction. You know, the latest we did, the WC, was acreative from day one, quite significantly. You know, we would like to have every ^ transaction accretive. It's not always possible, but clearly they have to be accretive in the very short-term and more importantly, they have to add something to our customers and they have to have significant value creation potential for our shareholders for us to consider going through the pains of entertaining any deal.

Great, great. Makes a lot of sense. One final question on -- on fuel protection. What percent of the revenue base is protected either by revenue adjustment or surcharge of some sort?

Well, just about all of our business at -- in some way, shape or form has a fuel adjustment associated with it, whether it be a specific fuel surcharge or whether it be something that's a cost-based generate increase. The portion of the business that has specific fuel surcharges associated with it, just specific fuel surcharges s probably about 30% of the business right now.

OK. But then assuming that since you hedge part of your fuel, I should assume that even though you've got a hundred percent somehow covered, it's not a hundred percent coverage and hence the need to hedge?

Well, it's a question of timing. You know, it's like I say, I got 30% fuel surcharge -- 30% of the business which has a fuel surcharge on it, which would adjust on a quarterly basis specifically tied to the price of fuel, and then I have, on the remaining 70% of the business, annual escalators that are tied in some -- in almost every case to some sort of index of prices which would be labor, fuel, et cetera, and/or CPI, and/or I just have a 2% to 3% price increase tied to the business.

Got you. Thanks a lot.

Thank you. We now have a question from West Wind Partners, Mr. Horst Hueniken. You may now proceed.

Thank you. I have two questions. The first relates to the other income line. I'm just trying to get a reasonable expectation for the second half of this year. Is it reasonable to go back to the sort of $10 million per quarter basis?

The -- you know, the answer, you know, is yes, but let me give you a bit of a -- of a -- a few caveats, if I may. It is difficult to predict, you know, real estate monetization opportunities and pinpoint them to any given quarter. These deals, there's a number of them which are small in nature and just flow along throughout the year. Others are larger and more lumpy in nature and so you can have more in one quarter, less in the next, and so that creates volatility.

The other factor, which is difficult to predict is the realized gains and losses on foreign exchange. As I said, for Q2 specifically last year, this was a gain of some $7 million. This year, in 2003, it was a loss of $8 million, so you have a swing of $15 million just on that account alone, and that is difficult to -- to predict, given the volatility we've seen on the Canadian dollar. So run rate on the order of around 10 million. That's not a bad number to use. But the -- you know, give me some leeway from a quarter-to-quarter basis to, you know, reflect that volatility, which is part of doing business.

Fair enough. Question for Hunter. In the past -- and I'm referring to the intermodal, specifically the IMX project. In the past, Hunter, you had mentioned that you were not willing to commit more capital to the intermodal business until you saw signs that the intermodal business was sort of gaining traction. Now that you are -- are are there any plans to commit more capital to that side of the business?

No, because the thing we're finding out now is by IMX, you need less capital because there's not boxes sitting around in the terminals, they don't have to be sized, so we can absorb a lot of growth just through the efficiencies without having to add capital from an infrastructure standpoint. Now, I would hasten to add that we will have issues going forward from a rolling stock standpoint, depending on what happens with GTX, what acquisitions they might make and what we decide to do from a strategic standpoint for rolling stock. Now, we have -- I should qualify that by that we -- we announced, oh, a couple months ago now the -- a new super-terminal in Memphis where we're hoping to create a terminal that several of the class 1 carriers -- basically a replacement, so we're moving the facility and moving out of an old and moving into a new. Now, the bottom line of this is that I'm -- I'm very encouraged, and if we continue to see -- and I'm sure we will -- the kind of results that Jim has produced already, if we reach a point in a year or two that there's other market opportunities, we're certainly to the point where I'm comfortable spending capital.

That gives me a good sense. Thank you very much.

Thank you. We now have a question from Doiathe Asset Management [ph], Mr. Vick Kape. You may now proceed.

Thank you. Claude, a couple of questions. One, this leverage ratio, debt to capital ratio. What is the right level for your company in terms of going forward? And I got one more question.

Yeah. The -- you know, our -- we're comfortable with the leverage we have at the moment. We see no need to reduce it, and so -- so, you know, the first call on free cash flow at this point in time is clearly to the benefit of shareholders. That's-- that's, you know, where we stand and that's been our policy now for the last two or three years.

OK. And the second question was regarding a comment made earlier that you are loading fixed costs quite a bit, so that should improve the incremental margins. Could you quantify that a little bit more as to what incremental dollar brings to the operating line?

It's a range of initiative. I don't -- I cannot give you a -- you know, a data point, you know, estimate of the net benefit of all these initiatives, but you just looked at our -- at our results in Q2 as an indication, you know, purchased services are down quite significantly. You can see our -- our, you know, headcount reduction of, you know, close to 1300 people on a year-over-year basis, that's 5% of the workforce that, you know, we're getting through a range of initiatives, and continuous productivity improvements. So a lot of our cost is fixed to start with, so -- and, you know, we have -- you know, with the war on bureaucracy and the range of initiatives, we have, like the regional structure we've put in place, we have an intense focus on taking out fixed costs that does not add value to the business. And that just helps you going forward and, you know, at the moment it's helping us go through tough times with grain but going forward, those costs will not come back. That's for the fixed costs.

On the incremental cost side of things, you know, our business model is inherently leveraged to accommodate growth at low incremental cost. We have a schedule, we do not stop trains when business is down as is the case for the moment in grain, for instance. The -- but when the business is back, we have capacity at the end of the trains to, you know, handle that business and do so at relatively low incremental cost. So you should see, you know, a good boost to income as grain comes back in Q3 and more so in Q4, and you should also see -- be able to accommodate general growth across the range of business units we cover at fairly low incremental cost, which is good to margins and good to earnings momentum.

So that should continue to improve your return on capital employed quite a bit, so -

Yeah. You know, again, at the margin. Recognizing, Vick, as you know, that we have a $20 billion asset base, you know, every step helps but it takes a lot of work, you know, to -- to move the needle on that particular measure. We're pleased that we are comfortably above our cost of capital, and all the initiatives we have point in the direction of continuing to improve on that front.

Good. Thank you.

Thank you. We will now take our last question from CIBC World Markets, Rosa O'Reilly. You may now state your question.

Thanks very much. Just wondered if you could comment on what some of the short-term implications may be of the progress on the people agenda that you've talked about in terms of moving workers onto an hourly wage agreement. Will that increase costs before it decreases costs?

No. No. I -- I don't think so. You know, we had -- if you look, for an example, at the Illinois central, we had worked very, very hard to control the head count, given that we felt like that we were going to make a break-through. If you looked at the demographics, if you look at the people eligible for retirement. I do not think that you will see the meter go up before it starts to come down. Now, there -- you know, in certain pockets, could there be some issues there? But I -- I don't perceive that.

Well, thanks very much.

Well, thanks very much for joining us today, and we look forward to seeing you at the end of the third quarter.

Thanks.

Thank you, Mr. Harrison. At this time, we would like to thank all participants for joining us today. The conference has now come to an end. Thank you for using Bell Conferencing Solutions, and have a great day.