Canadian National Railway Co (CNI) 2005 Q2 法說會逐字稿

Welcome to the CN second quarter 2005 results conference call. Please be advised, this call is being recorded. I would now like to turn the meeting over to Mr. Bob Noorigian, Vice President, Investor Relations. Ladies and gentlemen, Mr. Noorigian.

Well, thank you for joining us this afternoon for CN's second quarter financial results. With me today are Hunter Harrison, the President and Chief Executive Officer of CN; Claude Mongeau, Executive Vice President and Chief Financial Officer; and Jim Foote, Executive Vice President, Sales and Marketing.

Today's remarks may contain forward-looking statements within the meaning of the U.S. Private Securities Reform Act of 1995 and other applicable legislation. There could be a number of risks and uncertainties that could cause actual results to differ materially from what we present today. Also, today's presentations may refer to non-GAAP financial measures for purposes of comparability. Please refer to our website for reconciliation to GAAP. The Q2 2005 financial statements, the notes are attached to our press release and are available on CN's website, www.cn.ca.

The question format today, we'll take questions from all those who are listening. Could you please identify yourself and the firm that you're with when you're asking your questions. In order to be fair, could you please limit your questions to two.

With that, it is my pleasure today to introduce CN's President and Chief Executive Officer, Hunter Harrison.

Thank you. Thanks, Robert. Appreciate it. Thanks for all you for joining us this afternoon. Appreciate the opportunity to visit with you about some, obviously, dynamite results this quarter. I trust that you have by now seen our press releases of the results. When a group of railroads produce these kind of results, it makes the CEO's job pretty easy.

What I would like to do today, if I could is, before I call on Jim and Claude to give you some more details of the results, let me just highlight a few things that took place during the quarter that I think represents pretty outstanding performance. First of all, our earnings came in at $1.47. That was a 30% increase over last year. I would remind you it's up 35% if you exclude exchange. Very strong revenue performance, up 9% pro forma exchange-adjusted, or I think 15% as reported.

I continually say we're not obsessed with operating ratio, but it's something we would watch very closely, and our operating ratio for the second quarter was a record 61.2%. That's a 4.3% improvement over last year. And where I continue to be amazed is the free cash flow for the first half of the year came in at 787 million, and really was the impetus to consider and now we approved today the repurchase of 16 million of our shares, which represents about 6% of the outstanding shares.

A few other issues I should mention. In the second quarter we clearly went through and completed the integration of both BC Rail and GLT and both those operations are very accretive and have been very -- work very well in our -- the overall strategic issues that they were going to bring to the organization. We've made some real strides on the labor front in the second quarter.

We signed a three-year deal with the UTU that was ratified. We signed an unprecedented five-year deal with the engineers, the first time to my knowledge since I've been in this business that we've had a five-year deal. We had a four-year deal with the IBEW, which was ratified, but then after the engineers' agreement, they asked to extend and extended also to five years. And then rail traffic controllers came along and had already done a three-year deal, and they asked to extend theirs two more years to five, which creates a lot of stability from a labor standpoint. We don't have those issues diverting us from our real task of serving customers here. And we're looking forward to a re-vote on the engineers, the BLE teamsters and the U.S. with the IC, and get that issue resolved hopefully in the next month or so.

Our service was never better. The second quarter we ran at 93%. I hate to mention those percentages, because 93% is 93% of what? Our 93% I think is better. That's our service is the best in the business from a velocity standpoint, from a raw miles per hour, there's no tolerance. These are hourly trip plans that we describe them, dock to dock, door to door and right now we're running at about 94.5%. So from a service standpoint, from an operating metric standpoint, the Company has never run better.

A couple of examples of that, our car miles per car day and car velocity was up 8%, and there's some new processes that we put in place, which we think can really move us to the next level in that area of rolling stock, non-locomotive, an area that has lagged a little behind, but with some of the recent issues we've initiated, we've made some real breakthroughs there. And I would note that our locomotive utilization based off record -- lapping record numbers was up 6%.

So I am obviously thoroughly pleased, delighted about the quarter. And let me turn it over to Claude and Jim to go through some of the more details. Claude?

Thank you, Hunter. All these are great results and so I can be brief because the results really speak for themselves. We came in with $1.47 of earnings per share, which is an increase of 30% over 2004. If you step back, there are really three factors that explain this strong performance. First and foremost we have solid top-line growth. Revenues are up 10% as reported, but that's a 15% increase if you adjust for the foreign exchange. As Jim will explain to you later in more detail, we see strength pretty much across the board except grain and autos, which are the only two sectors that were down.

The second factor is solid cost control. The railroad is very fluid, the service is good, and we're continuing to make headway on the productivity front. And this all led to a record operating ratio of 61.2, which is a 4.3 percentage point lower than 2004.

Finally, the third factor is good accretions from our two acquisitions, with the system cut-over complete, we're now honing in on the last leg of the integration benefits. For the full year 2005, we received two deals generating $0.35 of accretion, or thereabouts, and we see this moving over the next couple of years to around $0.45, so clearly, those two deals are working for us and for the customers and our shareholders.

We also had some help below the line during the quarter with the share buyback and also better other income, offsetting the impact of higher interest expense and also a slightly higher tax rate. This is a quality problem to have, but as we generate more income, obviously we are having to increase our tax rate because some of our permanent differences are fixed in nature, and so that 34% book tax rate is not a bad number to use going forward at this level of profitability.

Turning to expenses, as I said, very solid cost control. On a pro forma basis and adjusting for the benefit of the exchange, our expenses were only increased by 2% during the quarter. We did very well on the labor front. Again, our average headcount that is apples to apples for the two acquisitions, our average headcount is down roughly 5%, but we also had some benefits during the quarter of a timing nature, lower incentive and also lower stock-based compensation.

Purchase services and material were very well behaved. There's one area of increase, which is our mechanical repairs, but this is a design program. We had a major push during the quarter on reducing bad orders to create fleet capacity, and I'm happy to report we hit an all-time record at some point during the quarter. We reached 1% bad order ratio, which is, quite frankly, something I didn't think possible, only a little while ago.

Our equipment rents were down again in the quarter reflecting asset utilization gains, but also as we discussed previously, the benefits coming from BC Rail, which is in a car hire income position. The only expense category which is up significantly is fuel, and it's up in excess of 40% due to a worldwide prices that basically $53 during the quarter, but also refinery crack margins which have increased quite significantly and were on average at $10 during the quarter. Offsetting this impact is the benefit of our hedging position, but also the benefit of our fuel surcharge program as Jim will talk to you about in a minute.

Let me say a few words on our free cash flow before I wrap up with the outlook for the year. On the cash flow front, really outstanding performance. For the first six months, 787 million. That's a full $200 million ahead of last year. Obviously the improved profitability of the business is the key factor, but we also had a big push on a number of areas which are more nonrecurring in nature.

We had a tremendous effort in our revenue collection and I'm happy to report our days sales outstanding for the month of June was at below 30. In fact, it was 28 days on average. That generated a lot of cash through working capital.

We'll also have a big push on scrapping old equipment. Started this effort on bad orders, for instance, our scrap sales at today's high scrap prices are much higher than before and we also have the benefit of the second leg of the EWS recapitalization, which gave us 60 million. If I add it all up, roughly 200 million of free cash flow during the first six months were of a nonrecurring nature and are not going to come back going forward. But when I factor all of this, and taking into account the fact that we see our overall CapEx this year reaching about $1.4 billion, we are very confident at this point to increase our outlook for free cash flow, and we're putting that in the range of $1.2 to $1.3 billion for the full year.

This strong excess cash flow is going to be used to reward our shareholders, and this is why, as Hunter said earlier, we are pleased to announce that our Board of Directors has approved a new share buyback program of 16 million shares, which will be executed over the next 12 months.

Wrapping it all up. Overall, things are clicking with a strong first half of the year. Our business model is clearly working, and we are confident about the second half. H2 [ph] will clearly see the lapping of our two acquisitions, but if the economy holds, we see continued momentum in our results, our revised full-year guidance calls now for EPS growth of 20 to 25% and free cash flow of 1.2 to 1.3 billion for the year. Obviously this outlook is not without risk, but the management team is really focused on execution and we are committed to deliver a banner year in 2005. Jim?

Thank you, Claude. I'd like to take the opportunity to go through the numbers here in a couple of different ways as I do each quarter, and always talking about the revenues on an exchange-adjusted pro forma basis so we can compare apples to apples on a quarter-to-quarter basis.

First of all, a great quarter. The railroad is truly running, it's in great shape and running very well and we're delivering very high quality service to our customers. That allowed us to produce revenue gains in the quarter of 9%. First way we'll take a look at that is that fuel surcharge accounted for about 4% of that, four percentage points. Price consistently in the range that we've talked about, producing 3%, and 2% improvement from mix as we have improved our length of haul, and we have replaced some of the business that we talked about in the past where we were demarketing. As an example, the Road Railer with much better quality revenue business as we've gone forward.

In the various segments, merchandise was up 10%, bulk up 6, and intermodal up 10%. Take merchandise apart in greater detail, petroleum and chemicals up 6% driven by strong demand for petroleum products. Metals and minerals up 11% as we saw some decline in our iron ore business, which was offset with good quality business in our steel, bar, slab, pipe, et cetera, as well as strong demand for construction materials.

Forest products, the heart of the franchise, up 14%. Again, lumber up over 20%. Panels up 15%. Positives there from the strong housing market and the inclusion of BC Rail adding to our franchise and being able to move significant qualities -- quantities of this material. And pulp up 10% and paper up 8%. So forest products continues to perform extremely well for us.

Automotive up 3% as we saw continued improvement in strength in the import business offsetting some decline in the domestic production side of our business. As I said, bulk was up 6%, coal up 32%. Coal Canada up over 90%, as additional volumes have come on-line from new mines, and that's a trend that I'll talk about in a few second that we see continuing. Coal U.S. also up 14%.

On the grain and fertilizer side, we have talked about this in the past, it's the quality, not the quantity, but the quality of the grain crop in Canada was less than one would like to see. So the farmers have been holding back on that grain waiting for the new crop come to in so there could be some blending and they would get higher prices for that. That drove our Canadian grain revenues down 13% in the quarter, but the good quality crop that we have in the U.S. both corn and soybeans proved that that business was up 21%.

Intermodal up 10% in the quarter, driven both by strength in overseas and domestic. So very, very good quarter. Strength across the board and the outlook continues to be the same in all the various segments.

Merchandise, the outlook remains very solid. We see some pockets of softness, mostly in the chemicals area, but the other segments are doing very well. Housing starts continue to be strong in the U.S. driving our lumber panel business. Most of the customers are telling us they expect to see strengthening in the second half of the year as inventories come more in line. So the various segments of the merchandise business, we continue to have a very positive outlook.

On the bulk side, again, a very good story as I talked about, the results in the second half, especially in coal, that should continue. First of all, in grain, the Canadian grain crop, it looks like there's going to be a very good crop coming in this year. And that combined with the fact that the grain is being held back from the prior year's crop, and therefore, a big carry-forward could produce the most grain that we've had to move since 2000. The wheat board has already announced an increase in the export program, so the outlook for Canadian grain in the second half of the year and going into next year looks very promising at this point in time.

Grain U.S. on the other hand, although it's a smaller part of our business, the Illinois crop is under some distress because of drought conditions, although Iowa, another big draw territory of ours, looks very good.

On the coal side of the business, again, I talked about how well the Canadian coal produced in the second quarter. It's three new mines we had producing in Q2 that weren't producing last year. We are expecting increases in production in the second half from four mines, so the output at the mines will step up in the second half of the year, as well as another new mine is also coming on in the second half as well, and there are further expansions in the works for '06 and '07. So the outlook for Canadian coal, which had dropped down to basically nothing, has turned around dramatically and looks very promising going forward.

On the overseas side of the business, in the intermodal, we've certainly been to focusing on improving the profitability of that business segment through our IMX plant, and that has been quite a success story for us, but that does not mean, and I've said this in the past that we are not interested in growing the volume. In the second half of the year, on the overseas side of the business, we will see volume increase there.

We are adding new train service out of Vancouver into eastern Canada. Have built up enough volume so that next month we can start a new train service from the West Coast into the East Coast. As well as we will be seeing additional volumes from Halifax on the East Coast, as China Shipping has announced they will be making Halifax a new port of call with Asian business coming to North America through the Suez.

So we are able to participate in this growth of Asian imports into North America and are leveraging our franchise on both coasts. And we'll see that happening in the second half, and we will continue to focus on having rational, steady price increases in the 3 to 4% range in the second half of the year and beyond. So overall, we can see the trends that we saw in the second quarter continuing in the second half of the year.

Back to you, Hunter.

Thanks, Jim. And thanks to you, Claude. Let me just sum up this way. This plan is working on all fronts. This is the same plan that we talked to you about the first time in the Fall of '98. This organization just gets better at every day in executing. It's produced -- is producing record service levels, record productivity levels, and when you have those two things, they equal record financial performance, and that's what we saw the second quarter, and we're very pleased about.

So with that brief kind of recap of the quarter, we would be happy and delighted to take any questions you might have.

Thank you. We will now take questions from the telephone lines. [OPERATOR INSTRUCTIONS] The first question is from Scott Flower, Smith Barney Citigroup. Please go ahead.

Good afternoon, all. A couple questions. Maybe these would be for yourself, Hunter, and Jim. I just wonder if you can give us some update on some of the operational initiatives you all shared with us at your analyst meeting, and I know that some of these may be works in progress, but I'm just interested about carload excellence, as well as -- and I know that Jim sort of broached the topic, but I'm just curious, what other further things are left with IMX yet to do.

Yes, go ahead, Jim, and I'll close up.

Sure, Scott. We talked about some of the things that carload excellence was going to do, taking the principles that we -- the disciplines we learned with IMX and applying it to the carload side of the business, we are working very actively there to eliminate car pools and tighten up our asset utilization. That has been very, very successful. We're working on weekend loadings in the merchandise business, that -- our weekend loadings continue to grow and improve. So we're smoothing out the areas there, providing better service and reducing costs at the same time and I think you see that across is the board in our results.

Intermodal excellence, we have a lot of opportunity left there as we've said in the past, especially on the terminal side of the business. That has been the focus of our activities this year and we have continued to see improvements there in the profitability of that business. One of the things that I mentioned earlier was adding this new train start out of Vancouver, traditionally, the discipline that we have used here has not been applied and the worst thing in the world that you can have is the ability to move 100 cars on a train and have 101.

So we have waited diligently and built the book of business so that when we put this train service on, it will in essence be a full train and we will get it started that way. So, again, not selling our service cheaply and focusing on providing a good product and it's working.

I guess, just two other things of note, Scott, to add to what Jim said. The carload excellence, a lot of the initiatives they have going on really led to this opportunity to kind of move to the next level for our distribution utilization people with freight cars, and I'm real pleased about that. With the two acquisitions, our working active inventory got up, I think -- I'm talking from memory -- above 112,000 cars. Since that time, we've taken about 10,000 or 11,000 cars out of the pipeline. We're down now to 101,000 or 102,000, and I would expect that before the year is out we'll be below 100,000. Which is pretty significant. It has a significant impact on our costs.

The one other one, I think we didn't mention, but we talked about before, was this smart yard project, which is right now still in kind of the initial stages and Mac Yard is going very well. We still think it has all the opportunities that we had initially talked about.

Just to follow up, just curious, maybe this is too simplified, but if I think about IMX and CX, what inning, and obviously you keep uncovering new things, but what inning do you think you are in those? Are we in the third inning? Are we in the seventh? Are we in the fifth? I'm just trying to get a sense of how much impact has flowed through from some of those projects. I would imagine more from IMX than from CX.

We hadn't sang "take me out to the ball game" yet, so it's before the seventh inning. I would think that IMX is maybe somewhere around what we have known and recognize as opportunities, we're somewhere around the fifth or sixth inning. I'd say with the carload excellence people, that's a little newer project. They're still uncovering new opportunities every day so maybe they're third or fourth inning. So the point is, there's a lot more to uncover in those two initiatives.

And then the last question for me, and maybe this is for Claude. Could you help us understand a little bit more about the labor cost numbers? Because those are obviously very good. You've mentioned there were some timing issues as well as obviously headcount reduction. If you could help us peel the onion there, was the headcount reduction primarily related to BC Rail and GLT or are there other productivity improvements? I would imagine, obviously, those are more permanent in nature. Then help us break apart what were more the timing differences and what those were in the labor cost improvement?

Scott, our approach has always been to focus on every opportunity so the headcount reduction is really across the board, gaining productivity, one initiative at a time. And so on a pro forma basis, our headcount is down 5%. Now, one area where we have a lot of opportunities obviously is in the two acquisitions where you have the early integration benefits, but it's not enough to carry the day. We're continuing to make streamlining initiatives across our entire network, and that's what's paying off big time in terms of the labor cost at this moment.

The areas of timing which are a little bit less recurring are stock-based compensation and incentive compensation. Last year in the second quarter is when we stepped up to a higher level of bonus payout, and so you have kind of a one-time increase which occurred in the last quarter which is not happening this year. We're more on a run rate basis in 2005. And our stock price was a little bit under pressure on June 30, and that caused our stock based incentive expense to be mark-to-market down during the quarter.

Okay. Terrific. Thank you.

Thanks, Scott.

Thank you. The next question is from Randy Cousins, BMO Nesbitt Burns. Please go ahead.

Just to finish off on the labor side, could you give us for modeling purposes, how we should be sort of tracking or modeling headcount over the balance of the year?

As we said, we're trying to basically streamline and get our workforce and the attrition to work to our benefit. We won't see such an important reduction in the balance of the year because we will get less benefit from the two acquisitions, but we should expect headcount to come down slightly, and for us to be continuing to make productivity gains.

So if we model in like a couple hundred people out, go forward, that's kind of the number you're talking about?

That wouldn't be a bad assumption, yes.

Second question, I wondered if you guys could give me some additional clarification on revenue ton mile changes. I guess is what your page number 22. Particularly, there seems to be some negative variances. I'm trying to understand a little better what's happening at the RTM levels.

Okay. The question is?

And the question is I guess, Jim, metals and minerals shows down 9%. What's exactly -- so I guess what the question is is really what's happening on a revenue per ton mile basis? Because your revenue growth looks good, but I'm trying to get a better understanding of what your expectations are from a volume perspective and how we should be modeling volume as opposed to just revenues.

Well, yes, there's a lot of changes going on. As I said, the iron -- we had some changes iron ore business last year in metals and minerals as an example, where we had some long-haul moves going form the Massabi iron range in Minnesota over to the West Coast for export to China, that changed and some of that business now is moving 60 miles down to Duluth, having been replaced by some much higher quality per car or per ton revenue in the construction markets and the steel market. So that's a mix -- most -- that's a mix issue that you see in metals and minerals.

Forest products on the other hand, good quality revenue, going up there, as we've seen the change from the eastern producers to the western producers, the value from the BC Rail franchise coming in. 6% improvement in tons actually moved in the forest products business. So all of those aberrations going up and down are really being driven by mix change that I talked about that was overall for the overall Company on a quarter a positive 2% for us.

So when you talk to your customer -- when we talk to the customers, for the second half of the year, how should we be modeling sort of revenue ton mile growth on a cost basis?

I think if you took a look at kind of like the first half as a whole as opposed to the second quarter, you take a look at the first quarter and the second quarter together, that would kind of give you this run range for the second half of the year. 1 to 2% improvement in volume going forward.

Thank you.

Thank you. The next question is from Ken Hoexter, Merrill Lynch. Please go ahead.

Just want to talk to you about -- I think you just mentioned at the end of Scott's conversation there on the increase on comp last year. Are there any new programs that are coming on board that could cause that comp expense to jump up or anything that you see in the second half that should increase that salary and expense per employee line?

No, Ken, we've always said, if you look at it through a rolling quarters as opposed to one quarter at a time, we've always said that you should expect our compensation per employee to increase in the range of 3.5 to 4% depending on how these factors play out. And so that's the best guidance I can give you at this point in time, and there's nothing new to our compensation except for the fact that with these results we expect to have high incentive payments at the end of the year.

So your operating ratio, to bring it back a step, when I look at your now 20 to 25% target, are you viewing this as the low point in the year or do you view this as something that is the new trend line or even lower than this going forward?

There's always seasonality, depending on the mix of business and depending on whether we have capital expenditures. As you know, in the CN when we have summer programs, we have more CapEx, more capital surcharge credits that come through results. In the winter you have the snow and you have all of the other issues that come with the hard climate. So looking back to our seasonality in terms of operating ratio is something you could probably do and get to a sense of things. Going forward, what we see is an ability to continue to drive improvements on a year-over-year basis from an operating ratio standpoint.

Great. Hunter, when I first met you you said you weren't satisfied until you saw a 5 in front of the OR, should we now look for a 4?

No, let's get a 5 first. But, Ken, this performance is not an aberration here to Claude's point. If we -- there are continued efficiencies that we're still learning to ring out of this network here. We believe very sincerely that good service and low cost go together. And if we continue to see this type of quality revenue that we've been experiencing, this is not some one-time world record of 61 that you'll never see again, we sometimes don't set the bar high enough. I think to some degree, and for this team we're still amazing ourselves. We're outdoing some of what we thought.

The last time we had our analyst meeting a year or so ago when we talked about going below 65, well, we didn't set the bar high enough. And we're probably going to do that again I think this fall, maybe until then we'll kind of update you there, but I think we might have some targets there that says 65 is not the best and 61 might not be the best ever.

Thanks, Hunter.

Thank you. The next question is from Joseph Leinwand with RBC Capital Markets. Please go ahead.

Can you please update me on the problems at Delta Park, the truckers strike, is that starting to cause some congestion?

That's isolated to that the haul-away truckers strike there in Vancouver is isolated to the boxes that are destined for the local Vancouver market. I think everybody, the railroads and the ports, have been working very hard to make sure that this disruption of this local issue, the local market, doesn't congest the ports, doesn't congest the railroad, et cetera, and so far we have been successful in doing that. We hope it comes to a conclusion, but as of yet, as of today, it has not had any impact on our business, nor do we think that it will.

Next to last question, just -- equipment rentals is one of the cost variances that were positive and you indicated that that had something to do with BC Rail being low in cost. Can you give me a little depth, a little explanation as to what's happening there?

The BC Rail network has a lot of business going off-line long distances, so traditionally the BC Rail has been in a car hire net income position. So they collect more off-line than the expenses, so when you look at our results on a year-over-year basis, about half of the decline of the $15 million or so is due to that car hire income from the BC Rail.

So on a go forward basis for modeling purposes, the sort of percentage declines you had in the first half of the year on a car equipment, I can model that into the second half also?

Not quite. The second half will be lapping.

That's great. Thank you very much.

The next question is from Jordan Alliger, Deutsche Bank. Please go ahead.

Quick question. You obviously talked a lot about the factors driving the operation ratio to the 61 level. On the IMX side, can you give a little bit more detail, I know in the past you talked about sort of where the returns were, the margins were, and I'm curious a year plus or certainly longer now into the plan, where do you stand in terms of the returns that you want it to be at this point versus where you are? I think you're running pretty good given the operating ratio.

Let me throw some numbers at you, then Jim can give you the explanation. I think we said that when we first started this mission that we wanted to improve the margins 35 to 40%. They have broken through that barrier, so I think as they broke through that barrier they saw other opportunities. So clearly, it's improved since the initial application about 43 or 44%. And I think they have some, you know, expectations of the future that it will bring some more opportunities. And I think at a point there, as we go through our other business, we're going to get to the point where we kind of cleanse that market to some degree, and we will refocus efforts on growth and keep that harmony between the quality of revenue and the growth. And we talked about the sustainable profitable growth, and I think they're maybe 10 points from there to get this thing where we think it ought to be, and then we'll grow from there. Jim, I don't know if there's anything you want to add.

No.

Not a bad answer, huh?

That's a very good answer. He thinks it's a great answer.

Is the plan for the carload excellence side comparable?

Yes, it obviously did not have the opportunities that intermodal did, because it was pretty strong when we started those efforts. But, I mean, that's kind of -- there was some that was doing real well and there was some that was kind of lagging, and so it's kind of all across the board. There's certainly not 40% on the merchandise side. But there are learning curves that, if you go back, and Jim said, we started schedule railroading and learned from that and applied that and that created IMX. IMX taught us some new things. We said let's go back and apply those things we learned there to the carload excellence. So the yield, quality of revenue on the merchandise side is driven to some degree by the carload excellence will move up, and I think overall, I haven't looked at the numbers like that, but I think it can go up what it has in future another 10, 12, 15%.

Just a technical question, you guys have a new buyback in place. Is the period end shares that we should work off of, I think I saw 275 million. And then do you roughly balance out the share buyback evenly over the next year?

Your period end share count is the right one. We will be buying shares opportunistically over the next couple of months as markets unfold, and so to start with using an average for the next 12 months is not a bad one, but as we just did here, if the cash flow is strong and we have the opportunity, we might accelerate. If we come up with a strategic opportunity we might stop and regroup. So that's our approach.

Thank you.

Thank you. The next question is from James Valentine, Morgan Stanley. Please go ahead.

Great, thanks. Very impressive results. If I'm doing the math right, you guys had about a 6% drop in cost per employee. I know you've already brought up this topic a few times, but I'm wondering if any of it -- some of it obviously was currency, but we estimated to be less than -- wouldn't bring you back to even 0 in terms of your cost per employee, and most railroads tend to see the number up 4 or 5% in the quarter. I'm kind of wondering -- what I'm wondering is, is there anything in there that might have been due to what is typical for in terms of management conservatively over accruing for unionized labor when you're still in negotiation period that that would have been reversed in the quarter and could have resulted in something that we shouldn't necessarily be modeling going forward?

No, Jim, other than trueing up to the final exact numbers, nothing of any significance on that front. As I said, if you look at it for the first six months, our cost per employee is more in line with what you would expect the second quarter is a reduction because of some of the elements that I've discussed. Stronger incentive compensation in 2004, and lower stock-based comp in 2005, when you combine those two items they explain the majority of the difference.

Okay, great. And then second, if -- is it possible yet to quantify the benefits in the quarter from some of the routing protocols? I know you're not going to probably get it down to the exact dollar, but just kind of ballpark talking about in terms of how maybe your revenues are down in a particular area, because you're short hauling yourself, on the other hand, you've got even lower expenses in that area, and therefore, it's a net positive.

Jim, nobody likes me to talk about this, and it's very, very hard as we've gotten into it to start quantifying and saying what is directly attributable to the routing protocol and the pluses and minuses and so forth. I know it's simplified the operating world. I know it has simplified things from a customer base, and hopefully the other railroads. I think we measure this every day, we look at every car every day that does not go the right gateway. That's how close we are to getting it right.

On the CN origination, we're running, Jim, 96, 97 level. The other carriers are doing well, they're a little behind us. But they're on their origins, and some of them have been at it longer than the other ones, but they're in the 91 to 94% range on the origins on the foreign lines coming to CN. Jim, I probably said, I think I said, much to some people's chagrin here, I thought it was worth 70, 75 million to us on an annual basis. We're clearly starting to see some of that.

I don't want to tell you something I can't see yet, but it does in certain areas cause some little weakness to revenue because you say, look, I'm worried about the net more than the top line, so there's some that might be perceived a little weakness, that we were flat here or there, but it's clearly the right thing to do. The next stage we're going into is moving and saying, not only moving it the right way, but what way should we try to sell it? If there's options in the East and options in the West what is the overall best place for the customer for us to sell? So there's another step to it. So it's powerful.

I commend you for taking that leadership position, because to your point, it ultimately results in the customer getting the best service, and hopefully it should help grow revenues. If I can just ask one last question of, I think probably Jim, in terms of overall merchandise, in terms of where we were in the quarter and then going forward, specifically one of items was forest products, and you mentioned a few reasons why it was up so strong, but I think if I look at the pro forma page that it looks like forest products in the quarter -- car loadings were down about 1%. I'm just trying to reconcile the two.

But I think even more importantly, going forward, when I look at the AAR loadings and I look for the last four-week trend on a year-over-year basis, we see things like pulp and paper, chemicals, intermodal all down about 2 to 5%, and I'm wondering on those three areas, pulp and paper, chemicals, and intermodal, what do you think is causing this slowdown? I know this -- of all the railroads and all the commodities, this is one of the top on our list of kind of mysteries here because we're not seeing it across all the railroads, but we are seeing some softness and we're not sure how much it's inventory just being worked down, or weakness in the economy, and then specifically intermodal, it seems to be a Canadian problem.

In the -- in the four strikes, take a look at the amount of tons we moved. Our tonnage -- we moved 6% more tons in the quarter than we did last year. We're selling cars on a per car basis versus a per ton basis. They're putting more tons in the car, the center beam traffic is growing in the West versus the East so it's longer hauls. So overall, the strength of the forest product franchise is very good. There is some -- continues to be some softness in the pulp and paper. One of our bigger customers, UPM-Kymmene in the maritimes has been on strike now and it's been having some impact on our car loadings.

The chemical business, as I said is in my comments about merchandise, we're seeing some spot areas of softness. Chemicals being down, being one of those areas -- petroleum and chemicals being one of those areas that's been impacted, but the indications are that that should get stronger in the remaining part of the year.

And intermodal, intermodal, as I said, we have not been focused on volume growth there. If we can't do it profitably and we are making sure that we do that and we will be bringing on some additional business here in the second half, that should pick up the volumes there. Overall, I am very optimistic about the second half and don't see anything major on a negative sense in the market.

Okay. Great. Thanks much, guys.

Jim, let me add one other thing there. On the lumber side, for example, let me add that we have virtually been sold out of cars. And one of the reasons why our car hire is as strong as it has, is our cars continue to go to the U.S. and stay in the U.S. a long time. That's good for car hire, but it's not good for getting them back and getting another load. So just until almost this week, as we speak, due to seasonal slowdown in Canada with the civic holiday and with the construction holidays in Quebec, we have been probably missing 200 to 300 lumber loads a week.

So some of that -- a little bit of what is perceived weakness is the inability to get the cars turned back, we're still acquiring more cars, and I'm told that this lumber business, as soon as we go through this three-week lull, which we've got caught up with inventory we would pick up. The only other thing I would add too is, some of these pro forma numbers get tricky when you're trying to apply them to the economy and year-over-year, and last year it was two loads and this year it's one, and where are the ton miles in different routes. I wouldn't use those too much as a guide.

Okay. Thanks so much, guys. Appreciate it.

The next question is from Ted Larkin, Orion Securities.

Jim, you're talking about Costco coming into haul term [ph] this fall, I wonder if you could give us some sense of the increase in traffic that you'd expect to see out of Halifax this fall. And also in line with that, given your other port in Prince Rupert, how's the timing of development on that coming along? I know it's longer term, but any updates on Prince Rupert?

Prince Rupert, we're still optimistic that everything's going to go forward there. We're anticipating the Federal Government signing off on their investment sometime in August, which would then open the way for the terminal operator to order the cranes and we would get this thing back on our 16, 8-month time frame to be up and running. There's still a huge interest by the steamship companies to come there when we get that up and going.

We're reluctant at this point in time to give any kind of specific guidance as to what the volume increase may be on the East Coast with China Shipping coming there, because it seems to be -- so far the numbers that I have been given by the steamship company are all over the place in terms of what it could be. It's a big vessel, it's going to be doing around-the-world service and there's a lot of interest in people using the Suez and we'll have to really wait and see.

Okay, Jim. And one brief question for Claude, with respect to CapEx, you mentioned that this year a run rate of 1.4 billion for 2005. I'm wondering if you believe 1.3 would be a reasonable guess at this point for 2006.

Actually, no, I think 1.4 billion is a good number to use. We are continuing to find new opportunities to invest in our business profitably, whether it's extending our sidings to allow us to lengthen trains, whether it's investing in initiatives to drive productivity or to support growth with what we've discussed earlier in terms of, for instance, premium cars to help us get the -- satisfy our customers with the higher payload boxcars, for instance, so we see a number of opportunities to reinvest in our business profitably. And at this juncture, although it's very early in our thinking for the planning, I would stick with the 1.4.

Okay, Claude, thank you. Hunter, just a comment for you, I guess that 59.9 that you had painted up on some coffee cups some years ago doesn't look that silly now.

No, it's not silly.

Thank you.

Thank you. Your next question is from Ed Wolfe, Bear Stearns. Please go ahead.

A couple of quick cleanups before some questions. Claude, I want to make sure I understood that the way to model the share repurchase for lack of any other better way right now is roughly 4 million a quarter for four quarters?

Yes, I hesitate to give you more precise guidance than what I said earlier. We will buy into the market opportunistically. There's no commitment to buy any amount any month. And so in the absence of that, what I would suggest is prorating. But we will be -- we just completed our share buyback program, the most recent one in seven months as opposed to 12 months. And the reverse could also be true, if we have an opportunity to invest in a strategic opportunity.

But there is a commitment to buy all 16 within at least 12 months, is that right?

I wouldn't frame it as a commitment, but that's clearly our intention with the cash we're generating at this point.

Okay. And just at the risk of beating to a dead horse, but the change in employee compensation, is it possible some of that is related to a different characteristic or a different employee comp for GLT and BC Rail or is there an average employee --?

No, no, no. As I said, we're working on overtime, we're working on controlling our healthcare costs, we're looking at reducing our overall headcount, and streamlining and gaining productivity. And then you have accruals for things like bonus and stock-based incentive and other normal accruals, which from a quarter to a quarter may play with the numbers. If you're looking at it for a couple of quarters at a time, you'll see that our patterns are quite consistent and in line with the guidance we've provided. Our average headcount should come down slightly with attrition and other initiatives, and our cost per employee should go up in the 3 to 4% range.

Okay. Just shifting gears for a second. There's a lot of moving parts with your coal franchise given the new mine coming on and new production in the three mines. Can you give us a sense going forward, and I think pro forma yields were up about 12%, what should we look for in terms of volume and yields of coal as we go forward a little bit? Can you give us some guidance there?

Well, yes, you're right, there are a lot of moving parts, some of it relates between the Canadian growth and somewhat lower volumes in the U.S. The guidance I think that I've given before was that we had 30 million say so to speak of Canadian coal revenues. We were basically down to nothing. That business had -- that business I said would double this year and double again next year. It is moving faster than that. It is growing faster than that, so we'll almost get that kind of two-year growth rate this year and then kind of level out for a little while. So we're going to roughly put $100 million worth of new coal revenues in the Company at very reasonable profit levels.

Over what time frame?

Over the second half of this year and next year.

On the refinery side, is there any help on the way in terms of the fire in the West? We can we expect to see that gap narrow a little bit on the fuel side?

We're expecting toward the end of this year for Suncore to be back in operation if I'm not mistaken. And I don't know about crack margins, whether there is is any relief in site, quite frankly, because they're running at full capacity and refining capacity is in short supply at the moment.

When you look at your hedge for the rest of the year, that's remaining, how much of that is at the refinery level?

We have a blend of heating oil and WTI in our hedge position. And we have 50% of this year's consumption hedged overall and 17% of 2006 consumption. We have not entered into any hedge position for the last couple of months because we are going forward, going to be relying mostly on the fuel surcharge mechanism which comes through the revenue as opposed to hedging the expense.

Of the 50% and that 17%, roughly how much of that is heating oil, how much of that does that break down on WTI?

You know what, you should call Bob off-line on this one. I don't remember off --

Just call me afterwards, I'll give you the --

Will do. Thanks.

Thank you. The next question is from Bill MacKenzie, TD Newcrest. Please go ahead.

Good afternoon. Just getting back to labor costs, and I apologize for harping on this, but, Claude, can you break out what the lower incentive and stock-based comp delta was year-over-year?

You know what, I think we've beaten this issue to the ground here. I'm not giving detail on every item. Overall, I think you've listened to my answers. The stock-based compensation is down. Last year we had the first quarter catch up of higher incentive booked into the second quarter, and this year we've been booking at the higher level since the beginning of the year, so the two items together explain most of the difference in terms of year-over-year labor that is of a nonrecurring nature. The rest is, our focus on overtime, our focus on productivity, and our focus on reducing all ancillary expenses including fringe benefit in the U.S.

Fine. And then just on the guidance, if I'm doing the math right, it seems like EPS growth in the second half that you're including the guidance is around 9 to 17%. The last few quarters you've been tracking it around 30 to 40% growth, so either the guidance is quite conservative or you are expecting some slowdown in the earnings growth. And I do appreciate that you are lapping the acquisitions so we won't have the same sort of accretion year-over-year. But just wondering if you could highlight maybe two or three of the biggest factors that you're incorporating into your guidance to explain this slower year-over-year growth. It's still good growth numbers for sure, but what are bigger factors driving the growth to a lower level?

I think you pointed out one of the biggest ones, which is the accretion of the two acquisitions which is lapping. The other one is, if you recall in the first quarter of 2004 we had a strike which cost us about 35 million or $0.08 cents per share. Those are the two factors. The other factor I would say is at some point you're lapping pretty strong performance and I think our guidance for the second half is for strong results and in the current environment is what we see coming our way.

That's great. Thank you.

Thank you. The next question is from Thomas Wadewitz of J.P. Morgan. Please go ahead.

Yes, good afternoon. I've got two different questions for you. Very impressive quarter, certainly. Hunter, I'm going to say congratulations on the labor contracts. I know that was pretty hard fought to get those agreement. Can you give us a thought on whether there were any things that got put into those contracts at the end of the day that give you some opportunity in terms of flexibility or productivity that are a notable change from the prior contracts?

No, there's not anything of any large significance. I would hasten to add a couple things. We can agree to anything with those organizations. So if the world changes on us and we want to reopen negotiations on two and a half or three years and both of us agree to, we can still do those things. But we know we can have peace for five years for that -- the only thing additional, and I'm just kind of painting these all with a broad-brush, a little bit of difference, was the comp for the fourth and fifth year, a little additional comp. But of any significant breakthroughs in work rules or productivity gain, not anything that would make your column.

Well, it's good to hear there's going to be peace for five -- looks like a large part for four or five years. A question, I think for Jim, on the fuel surcharge coverage issue, I was wondering if you could give us any thoughts on where you are now and perhaps where you think you would be at the end of the year. And then also, whether or not you have longer term pieces of business that will really limit how quickly you get up to 100% coverage on the surcharge, if you have got any kind of ten-year agreements or anything like that, as hard as you work you can't access those for a period of time.

Well, it's safe to say that today 100% of the customers are covered by some kind of escalation clause that's related to fuel. Whether that's an RCAF-driven number or something like that. Second, I don't have any long-term contracts out there like that, the longest contract I've got really is a couple of years. And thirdly, we're getting close to 80% of the customers being on the direct fuel surcharge tariff, and our goal is to get that up to 100% as quickly as possible, and I continue to see gains being made there all the time. All of our customers will be paying fuel surcharge and there are no exceptions. It's just a policy decision across the board. We treat every customer the same on this issue.

How long do you think it takes to get to that 100% coverage with fuel surcharge tariff?

We've got Canadian grain, which is regulated. You pull that out, and then there's no reason in the world I can't be there in the next six to 12 months.

Okay, great. Thank you for the time.

The next question is from John Barnes, BB&T Capital Management. Please go ahead.

Good afternoon, guys. Let me -- I'm not going to beat labor to death here, but I want to ask you on the labor contracts that you extended, was there anything that maybe boosted compensation in the quarter on those contract where if they wanted an extra two years on the contract, did you have any one-time payments to those employees or anything like that?

No, basically they were all straight across the board that if they wanted the fourth and fifth year, they got the fourth and fifth year for 4%.

So no real material changes to the terms of the contract.

No, no. To some of our benefit, there was these so-called signing bonuses that have got to be part of the agreements and all, that was a one-time deal for five years instead of a one-time for three years. So push and takes in there, and I think they like the stability, nobody likes to go through some of the processes we go through with it. It's not fun, it doesn't add a lot of value to anybody, and for all of us to be able to think on both sides of the table for five years, we can focus on other things, we were all tickled with that arrangement.

Hunter what do you ascribe your success to in negotiating what I think everybody views as industry-leading contracts? You've gotten a lot more flexibility than some of your counterparts. You've got unions coming to you asking you for stability and longer length contracts. What's the key component to your success there?

Look, I say this with due respect, I'm telling you about us, I don't know about others. We know the business. Number one. I know the business. Number two, I think we're viewed as fair people. Maybe hard, but fair, but fair in the final analysis. And I think people that's seen our performance over time, they've seen that we do what we say we're going to do. And we have gained some mutual respect. And so we've had relative success across the board, whether it's the U.S. and Canada, without exception, with all organizations of making progress.

Now we've had some bumps along the road. We had one unfortunate work stoppage. We got through that. I don't believe we should go to the table unless we got the ability to say no. We don't want confrontation. We want to move on and serve customers, we want it to be something in it for us, and something in it for them, and I think we've come close to hitting that combination with the leadership of our labor relations people.

Can you remind us, are there any trades left outstanding on new contracts?

Not in Canada. The only one is the U.S. with the engineers, that I think will get worked out, who were the leaders in the hourly agreement. And then we don't have anything up in Canada for 18 more months. I think with the UTU and the CAW coming back up.

And you're expecting similar results that we've seen so far?

Yes, I would hope so. I would say this to you. We had very, very positive dialogue, very refreshing dialogue with the UTU at the end of these last negotiations, which I felt very good about, which left a real good taste in my mouth and a mutual respect that I think we can build on. We've had some bumps along the way with our friends at that time CAW, but I think we're even making headway there. And I think both of those processes will get better rather than worse.

In terms of the new earnings guidance that you issued, I just want to make sure I'm modeling this right. Are you including any adjustment to your share count for your repurchase in the higher guidance or --

Yes. It's all in.

We're giving you an all-in view of what we think is out there.

And that incorporates what Ed was asking about, 4 million a quarter for the next four quarters? That's what you assumed as you gave that guidance.

We didn't get that close. You've got to make that choice, John.

All right. That's fine.

Can't be too far off of that number.

Lastly, as you look at the share repurchase, number one, how did you arrive at kind of the 16 million? Is that just -- that's the number that kind of eats up this year's free cash flow or is there some other magic to it? And then more importantly, Claude, you indicated that if you'd pull back on the repurchase if you found something that was attractive strategically. Hunter, wouldn't you rather buy 6% of somebody else or 100% of somebody else right now? There's some other rails that could use your help in getting to a 61.2.

Let me give you my crude answer, and let Claude refine it. The 16 million in my view represented, one, aggressiveness, and two, an opportunity because we thought this stock was far undervalued. If you look at our performance for the year, our operating performance and if you look at the market they don't come close. We think that that's the best return we could get at the prices we had. I got to go check the market in a minute. But let Claude -- and then strong free cash flow gave us the opportunity. Claude will talk to you, maybe mention the upgrade yesterday, our debt ratings, and all those things put together, we felt like we could do this and I would hasten to add, all -- you're not required to do the full program, ever since I've been associated with this Company, whatever we said we were going to buy we bought, we bought early not late. Claude.

That's pretty much it. This is the best use of our cash we can see at that time moment. We are generating significant excess cash after we pay for the dividend. Our policy is to gradually increase our dividend payout ratio, and to use the excess cash in the most flexible manner to reward shareholders, because our balance sheet today is, quite frankly, a little bit underleveraged. So that's where we stand and that's is how we came up with the 16 million. It makes for a total of 30 million shares when you add it up with the 14 that we just did in the last several months.

[Inaudible], John.

Very good. That's the answer I was looking for. So hey listen, congratulations on a great quarter. Thank you for your time.

Thank you. Your next question is from Robert Fay, Canaccord Capital. Please go ahead.

A couple questions on the fuel side, the fuel surcharge. My calculation's right, Jim, that the fuel surcharge added about 70 million on revenue in the quarter?

Yes, that's about right.

So it's the first two quarters, is that sort of the run rate that you've been getting on the surcharge, about 70 million in each of the quarters, correct?

Correct.

On the realized gains on the fuel hedging, they're coming in at about $37, $38 million per quarter, is that right, Claude?

That's not a bad number, yes.

When we look through the rest of this year, is that going to sort of be a similar type of profile that we're going to get per quarter between those two items? Because I noticed the hedges are down about half.

I mean, Bob, as you know, and I think you got all the numbers you need at the moment to make your own assumptions, but quite frankly, fuel is very volatile. If the fuel price stays in the high 50s, our revenues will go up as a result, and our hedge position might go up from what it was in the first quarter. You know what our hedge position is for the full year. And you can make your own estimates as to exactly where the fuel price will be in the next six months. It's very, very difficult to pinpoint a forecast with such a volatile item.

So when you're looking, though, at the hedges, you haven't been doing much hedging in the first six months of this year.

We've actually discontinued our hedging as I said. We are not hedging any more beyond 2006 where we are at 17%. At the moment we see the fuel surcharge as being the mechanism to deal with volatility in the fuel price going forward.

When we're looking at fuel surcharge, Jim, what's sort of the base fuel price that's used in those surcharges on average?

25.

What's that?

$25.

$25 per WTI?

Right.

Okay. Last question is on the labor, I'm more interested sort of in the sequential change that occurred from quarter to quarter, and the average comp just from Q1 to Q2 went down about 7%, so we don't have that sort of year-over-year issue with Q2 last year. Is that again going to be something that we should be looking at as we go forward in the next couple of quarters? Should we be looking at sort of a quarterly run rate of about 460?

I think you should assume that our cost per employee will go up in the 3 to 4% range, and that we will be off the thing, some of that with a number of productivity initiatives, whether it's what we're doing to streamline the workforce or what we're doing to reduce overtime expense, or what we're doing to contain what I call ancillary labor expenses, things like fringe benefits and healthcare and other elements. At this point in time that's the best guidance I can give you for labor costs going forward.

All right. Thank you.

The next question is from Chris Sorenson, National Post.

Hey, there. I just had a quick question, and this is not necessarily related to this quarter, but the U.S. is proposing changes to its daylight savings time, extending it by two months. I'm sort of been hearing that this is going to raise a lot of issues for cross-border businesses, which I would imagine would include CN. Hunter, I was just wondering if you had any thoughts about what impact that would likely have if Canada doesn't follow suit.

I don't have a clue. I really hadn't given at lot of thought. I don't think it's going to be negative, or I can't think about anything. I just read it this morning. I know what it's all about, but I don't know.

Well, I guess there would be a few months of the year where we would be operating on different times depending when we're in Canada or in the U.S., so I don't know how that effects schedules --

[Inaudible]. You do one side of the U.S. today as one time zone, and go three time zones over it's another, we'd get through it okay.

Fair enough. Everything else has been answered. Thanks.

Thank you. This concludes the question period. I'd like to turn the meeting back over to Mr. Harrison.

Well, thanks so much, Operator. And thanks to all of you. Some very, very good questions there. Obviously a great quarter that we're delighted about and we hope we can talk to you again and have more of the same. Thanks.

Thank you. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation and have a great day.