Canadian National Railway Co (CNI) 2006 Q3 法說會逐字稿

Welcome to the CN third quarter 2006 financial results conference call. I would now like to turn the meeting over to Mr. Robert Noorigian, Vice President of Investor Relations. Ladies and gentlemen, Mr. Noorigian.

Good afternoon and thank you for joining us today for CN's third quarter financial results. With me today are E. Hunter Harrison, our President and Chief Executive Officer; Claude Mongeau, Executive Vice President and Chief Financial Officer; and Jim Foote, Executive Vice President of Sales and Marketing. Today's remarks may contain forward-looking statements within the meaning of applicable securities laws.

Such statements are based on assumptions that may not materialize and are subject to risks described in CNs MD&A and other disclosure documents on our website. As such, actual results could differ materially from any non-GAAP -- differ materially. Any non-GAAP reconciliations are also on our website. After the presentation we're going to begin a question format and we will take questions from those who are listening on the call. Would you please identify yourself when you are asking questions and in order to be fair could you limit the number of questions that you ask to two. With that it is my pleasure to introduce CN's President and Chief Executive Officer, E. Hunter Harrison.

Thank you, Bob. Thank all of you for joining us this afternoon. I trust that you have received the press release and have had a chance to look at the results. I am almost at a loss for words to describe how pleased I am with the results that this group of railroaders produced. It's certainly beyond my expectations. I don't know if it gets any better than this.

I'm going to ask Claude and Jim in a moment to kind of break down the results and go through them for you, but let me just highlight a few things. Record third quarter results again, EPS growth of 27%. It's up over 30% if you look at it in U.S. dollars. Solid top line growth, revenues up 9% as reported. Exchange adjusted of 13%, revenue ton miles up, up 6%. When you produce that kind of solid top line growth and have the kind of efficiencies that we have had in some of the metric improvement that continue to move the improvement of productivity then you can produce this operating ratio of, and it's hard for me to say it, 57.4, almost a six-point improvement over the -- over last year. And it's productivity across the board.

If you look at our car velocity it's up like 9%, yard productivity which is we made big break-throughs from backyard is breaking new records, the yard productivity throughput is up over 20%, fuel efficiency 5%, train link up 2% to 3%, just to name a few. So I am delighted and thrilled with these results and let me ask Claude to run through some of the financial numbers with you.

Yes, thank you, Hunter, I think it's fair to say indeed that this is an outstanding third quarter performance. We have hit on all cylinders. Starting with top line growth on a reported basis 9% but as Hunter was saying it's 13% adjusted for exchange and the good news and Jim will give you the details is we had a very good blend between volume, price and the recovery we are getting from the fuel surcharge. Coupled with the top line growth we have excellent, excellent and solid cost control. The expenses on a reported basis are down 1%.

And I'll explain that to you in a minute. But even adjusting for exchange, very, very solid expense performance. And when you combine good top line growth, solid cost control in a high fixed cost business you do get the scope for bringing it to the bottom line through margin improvement, our operating ratio is at a record 57.4% which is 5.9 percentage points down from last year's third quarter. And our EPS at $0.94 is up 27%. So basically across the board very, very strong results and let's take a moment to take apart the expense performance.

As I said, expense performance on a reported basis is up -- is down, I'm sorry, by 1%, but we are getting the benefit of the exchange and really on an exchange adjusted basis our expenses have deteriorated by 3%. But the story is fuel. Fuel is up with WTI during the quarter at almost $71 per barrel. Fuel is up significantly and we didn't have a very high hedge position during the quarter. So really the expense on an exchange adjusted basis for fuel is up 36%. All the other expenses -- expense category are very well behaved starting with labor infringe. We're continuing to make progress with our head count down, working attrition in our favor, our headcount is down 2.5 points. So that helps us, those initiatives and the continued productivity gain helps us gain labor productivity of 8% on a year-over-year basis and contain our expense line for this large expense category of labor.

Now we did have some significant reduction on a year-over-year basis due to stock-based compensation to the tune of $30 million. Last year we had to accelerate our RSU grant payment and so we had the basically the full three-year RSU payment in 2005 started to get accelerated in the third quarter. So it's a good -- it's an an easy comparable that is helping us lower labor infringe. But even without that labor infringe is extremely well behaved.

Purchase services and material, up 13%. Some of this is a joint facility expenses which are one time in nature and a we are also spending a lot of attention to repair and material costs for our car fleet to get prepared for the volume that we see coming this fall and next winter. Fuel I discussed. The story here is fuel price but we also had excellent performance from an efficiency standpoint. Our consumption has improved by basically 5% on a year-over-year basis. Equipment rent up, up 13% on a year-over-year basis.

That's despite the significant improvement in car velocity. And the story here here is not a bad one. We are seeing our car higher income come down as a result of the cycle times on our peer railroads improving but also we are seeing fewer sensor beams off-line and sensor beams typically go deep in those -- in the other railroads territory and so our car hire income has been reduced on a year-over-year basis and that explains the behavior of equipment rents.

Casualty and other is down quite significantly but you'll recall that in 2005 we had the Wabamun uninsured cost of 25 million and we also have some unfortunate fatalities in the U.S. So really if you exclude that $35 million or so expense last year you would have had a run rate of $85 million or so and so the $74 million this year is slightly below that run rate, continued the focus on every expense category and bodes well in terms of performance going forward. So run it all up, solid productivity metrics as Hunter described them and continued focus on every expense category, that's how we've been able to bring the top line growth to the bottom line with solid margin and EPS momentum.

Free cash flow is a similar story. Very strong performance, year-to-date we are at just over $1.1 billion of free cash flow driven by increased profitability but also continues focus on working capital management. We're using this free cash flow to reward shareholders in the form of the share buy-back that we've announced in July. During the quarter we were opportunistic. We bought ahead of the pace a little bit, about 8.5 million shares for a total of around $395 million of share buy-back. In the fourth quarter here we'll likely get back to a more normal pace of around 7 million shares but we will be opportunistic if we see that there's an opportunity to get into market at slightly more aggressively. So all of this positions us well obviously in terms of year-to-date free cash flow to increase our guidance in terms of the full year and if you turn the page I'll do this for both earnings and free cash flow.

So for 2006 we had a very, very strong quarter. So year-to-date it positions us very well for the last stretch. We're comfortable with the fourth quarter earnings consensus that's out there. So if you do the math that would put us at around 3.37 for the full year, adjusted EPS excluding the one time tax item. So that's why we're guiding at this point in time to -- for full year EPS of $3.40 which would be just stellar performance, roughly 21%, 22% growth of EPS on a full year basis. As for free cash flow, we see a Q4 in terms of pace of cash generation slow down a little bit. We have a lot of CapEx at the end of the year, some pension contribution, et cetera, but we see the full year finishing at $1.3 billion of free cash flow. So on both counts this is a great platform to start looking into 2007.

So let me say few words as I wrap up on what we see for outlook in 2007. Now, it's fair to say there's a bit of uncertainty out there in terms of the general economy but we are seeing the economy slow down for sure to the range of 2.5% GDP growth, next year, 2.6% based on the latest consensus. But with that slow down we see continuing momentum on a number of fronts, certainly solid continued momentum in terms of top line growth and cost control. We'll need that to overcome some of the headwinds that we're facing into next year.

I will give you one or two that are important. We will no longer have hedging gain into 2007. So in 2006 we had $65 million of hedging gain which will no longer be there into next year. So when I look at fuel expense, leaving aside price for a moment, the loss of hedging gain, the crack margin which have been tighter recently and the fact that we're seeing some -- a little bit of expense creep from low sulphur diesel cost for the new products, we see fuel going up on a same price basis by roughly 80 million as a headwind.

Stock-based compensation, same way it's been a good tailwind in 2006 as I discussed earlier for Q3 and for the full year in general. Next year we will see the coming back to a slight headwind as you would expect with stock-based compensation from year-over-year standpoint. So if you compare that's a $70 to $80 million head wind. So despite that we see the momentum and we see ourselves basically with a strong 2006 to follow suit coming back to our long-range guidance of 10 percentage -- 10% plus or low double-digit EPS growth and also to continue to do that consistently going forward.

In terms of cash flow, I need to unpack this a little bit. We see our free cash flow next year at 800 million. But as discussed previously we have cash tax payments into 2007 that explain the reduction from year to year. Effectively in 2006 we are cash tax payable as we speak. But because we have not paid in the past Canadian income tax we are going to pay all of the cash taxes, roughly $325 million, in one installment early in 2007. From there we'll pay our normal installment throughout the year. So next year we should see cash taxes on the order of $650 million more than 2006. So that explains why you see free cash flow coming down.

But if you were to adjust and put the cash taxes in the proper year, really our 1.3 billion of 2006 is more a steady state of one 1 billion and next year 800 million is more a steady state of $1.1 billion of free cash flow. So, enough said, I think you understand this. We've discussed it. This is all a positive story. And with that I'll turn it over to Jim to talk about the revenues.

Great. Thank you, Claude. Hunter and Claude have certainly outlined how well the Company is running. We were able to continue to rely on our quality service and cost advantage to secure market share and develop new projects. On an exchange adjusted basis revenue growth up 13%. What's most impressive about that is the very balanced performance across the business segments.

Double-digit growth rates in all segments except forest products. Breaking that down in terms of price, fuel, and then a bucket of volume and mix, about a third each, a third from price, a third from fuel and a third from volume and mix, with car loads up 2% but RTMs up 6 and an increasing average length of haul in most of our business segments especially coal as we transition to the western coal, western Canadian coal, and as well as some of the petroleum products moving into the tar sands as far as from Texas and I'll talk about those right now.

Merchandise as a business segment, up 11%. Petroleum and chemicals up 16. As I said petroleum, relatively good quarter for petroleum products is new and growing shipments of diluents. Now these are products that we did not handle before which are moving into the Alberta oil sands from Texas and from the West Coast of Canada helped results as did increases in shipments of low sulphur diesel fuel. On the plastic side of the business there was a good demand for shipments of plastics from both Canadian and U.S. Gulf Coast producers. And the chemical business has been and continues to be rather stable, nothing unusual developing up or down in that business category.

Metals and minerals continues to be very strong, all subsegments continue to experience volume and price growth. Metals, we have very strong shipments of pipe and pipe fittings for the oil sands project, flat rolled steel products very good, good shipments of zink, zink ore concentrates and copper out of eastern Canada, iron ore has been very strong force and continued to be so in this third quarter as there is a big demand for steel and iron ore volumes. In construction growth and industrial development projects we had a much higher than usual number of specialty movements such as generators, pumping stations, blades that are going up for the winds mill projects. Quite a bit of that developing as we look forward.

Forest products, 5%, an area that I'll spend a little time on here, lower than usual performance in there. Definitely a slower quarter, 4% revenue growth, definitely slower for lumber. As speculation over the housing market, the implementation of the new Canadian, U.S. softwood lumber agreement, and the higher exchange rate between the U.S. be Canadian dollar caused lumber prices to decline in shipments to slow. However, at the same time, panel shipments were up -- panel shipments and revenues up 16% as new mills in western Canada commence production as well as a start up of previously shut down lines in eastern Canada. So kind of a different view of the market if you look at lumber and panels.

On the paper side we continue to gain share from truck with our white paper initiative which is moving higher quality finished papers into the UP -- into the U.S. midwest. UPMs coated paper mill in Miramichi is back in production for the full quarter after a lengthy shut down. Stora Enso's specialty grade mill in Port Hawkesbury which has been down for most of the year and therefore impacted the third quarter, lowering results, but that's started production a few weeks ago. Wood pulp also flat, paper was flat. But wood pulp also flat as eastern mills there continue to take downtime.

In the automotive section our revenues were up 10%. Increased finished car volumes from some domestic producers were offset, there were some model changeovers that took place during the quarter. But our import vehicles, both import vehicles through the east and west coast ports as well as our new Nissan facility, the Nissan facility in Canton, showed good, strong performance. Those gains on a -- from a volume perspective offset somewhat as parts traffic was down during the quarter as there is a lot of changes going on in terms of feeding the assembly lines and we'll have to wait to see how that works out. Bulk a very good str -- a very good quarter, up 18%. Coal up 24%.

But Canadian coal continues to show the trends that we had expected. Canadian coal being up 50% in Q3 with mine expansion at two mine and the impact of start up, start up of two new mines earlier in the year drove those results. U.S. coal was only up 4% as we have had quite a bit of spot movement through our Gulf Coast facility moving into the -- up into the U.S., but that's been offset by this high volume PRB coal move that is diminishing on us as we go through the year which we've talked about, now this is the third quarter that we've been talking about that.

Grain and fertilizers, up 16%. A lot of export moves through Prince Rupert, west coast ports, higher canola volumes, I'll talk a little bit in a second about the very good quality product that we have there that's causing the Canadian grains to move very well. As well as very good, strong shipments of corn and beans in the U.S., favorable conditions of our rates versus forage rates are driving a lot of volume down to the Gulf as well as ethanol markets coming on line that are creating demand there, keeping the price strong and we're also moving a lot of product. U.S. demand for potash and other fertilizers is not as strong, it's about where we had expected but down about 15% to 20% during the quarter.

Intermodal continues to be -- do very well for us, overseas up 18%. Bigger boats, more boats coming into Vancouver, we are able to accommodate the growth coming through the port of Vancouver having added new train service and are seeing the benefits from that. As well as domestic intermodal doing very well, 10%, as we have some very good performance ongoing as a result of some very project focused initiatives in the U.S. to grow our domestic intermodal business down there in our north-south corridor as well as our trans-border business being up so in total intermodal up about 15%.

On the next slide Bob has helped you here with another visual to help us explain our third quarter performance. If we take and put in summary form from a volume perspective of what the car loads have shown throughout the third quarter it really just summarizes the initiative that I talked about with strong iron ore, intermodal and grain and Canadian coal added to the tar sands project, ramping us up in terms of carload growth into the 5% to 6% range but these one time specific initiatives, you know the decline in lumber and paper that we saw due to the strike and then the softening of the market, combined with this very high volume but low revenue Canadian -- I mean U.S. coal move brings us down into the reported 2% range.

Portfolio update on the next slide, kind of putting things in perspective of where we see the various markets, obviously forest products as I said has some challenges. There is certainly a lot of speculation about the over capacity in the market, the over building that has occurred and how long it will take for that to work off in the marketplace. We are certainly pleased to see the housing start numbers come out relatively higher than I think most people had expected. Our customers are going to continue to produce as a result of the beetle kill issue in western Canada. We do see opportunity for to us gain market share here from truck and are always looking for new opportunities whether it's in western Canada, eastern Canada or imports through many of our ports such as New Orleans where we're working very actively to tap into the South American market.

On the intermodal side of the business, we are well-positioned now that we have done the hard work of improving the profitability and the performance of our service in intermodal with our IMX program. We're positioned to take advantage of the growth opportunities that are there that are doing so. We're working hard on the development of Prince Rupert as we had said before. We certainly thought that facility would be sold out when it opened in October of next year. I think the last time we talked I said that I was hopeful that we would have customers committed to that facility by the end of this year. And after just returning from a two-week trip to the Far East I'm hopeful that we will have commitments for the capacity there before the end of the year.

On the grain and fertilizer side, Canadian grain crop is now estimated at 46 million metric tons there. But the good news is 59% of that crop is number one Canadian red wheat versus last year of only 14. You may remember some of the volatility we experienced, some of the loss of export business that we saw because of the quality of the grain. We have a very, very good size and an excellent quality crop in Canada combined with the highest carry we've seen since the '93, '94 crop year so we're very optimistic about the performance of grain shipments through the rest of this year and into next year. U.S. grain, similar story, very good crop in our territory. Corn in our territory is up 3% from last year, 5% ahead of the five-year average and beans in a similar format, up 4% ahead of last year and 11% of the five-year average. So a good grain outlook.

Going here we see a positive temperature reading on the chart in petroleum and chemical to be driven by what we see with the oil sands project. Similarly with metals and minerals we're going to continue to work on opportunities to make appropriate investments where necessary in order to bring pipe in there, bring fittings in there, bring pumping stations, so a lot of upside there. In automotive as well we're certainly well-positioned to accommodate import-export traffic that's feeding the U.S. market as well as working with the producers throughout our territory with the U.S. and Canadian manufacturing facilities that have not been detrimentally impacted by our -- by some of theory engineering going on there. And coal, as I said, a good run rates going forward in terms of the development of the metallurgical coal mines in western Canada.

Next chart in summary the revenue outlook, strong demand, an extremely well diversified portfolio of business that allows us to continue to have the growth rates that we have when we see softness which I believe temporarily in one or the other markets. A steady, sustainable growth rate that allows us to grow in the 2% to 3% volume range with reasonable, sustainable, disciplined pricing in the 3 to 4% range, that combined with fuel surcharge would now allow to us raise our expectation for 2006 revenue growth of in the 10% to 11% range versus the 7 to 8. And carrying forward into next year, the top line growth there on an exchange adjusted basis as well of around 6%, again half of that coming from volume and half of that coming from price. So with that I'll turn it back to Hunter.

Jim, thank you, thank you, Claude. What can I say in closing? Pretty simple story of how you produce these results. It's about 21,000 railroaders working very hard, focused on running a safe, efficient railway, providing quality service to our valued customers.

This organization has gone through and will continuing to through significant cultural change, real change that will serve us well years into the future. We'll continue to build on the momentum that we have put in place and that's why I think that Claude was able to provide those, what I would describe as pretty bullish outlook for the future, next year and on into the last three years of our five-year vision. And so with that, Christopher, we'd be glad to accept the questions from the audience.

Thank you, gentlemen. [OPERATOR INSTRUCTIONS] The first question is from Ed Wolfe with Bear Stearns and Cowen. Please go ahead.

Hi, guys, a couple of different things. Claude if I look at your last three years, fourth quarter over third quarter sequentially you've improved your margin every year, yet the implication from your guidance is that you're going to have margins 300 basis point yea-over-year under pressure. Is there something I'm missing here or are you just being a bit conservative given the climate out there?

Actually, if you look at it sequentially you have to take into account when we get the benefits from capital overheads and capital programs, et cetera. I'm not sure sequentially would be the best way to look at it going forward. On a year-over-year basis we see flattish year-over-year operating ratio in the fourth quarter. We may do a little bit better than that but that's, when you work all the numbers including the fact that we don't have any hedging into Q4 that's our best guess for Q4.

There's no big change in incentive comp or anything like that that makes it a tougher quarter year-over-year on fourth quarter versus third quarter, how do I think about the big gain in year-over-year third quarter versus the flat fourth quarter?

Well, this year in the third quarter you had very significant reduction in our expenses just because of the expenses of the Wabamun incident and the legal claims associated with some of the fatalities that we had last year. So Q3 of last year was just an easy comp and Q4 will be a little bit of a tougher comp because we're losing hedging gain and we're starting to lapse some pretty strong quarter, Ed. We're focused, we're determined. I think our guidance is reasonably aggressive in the current environment and as always there might be a little bit of upside but I don't think it's as much as what your number would suggest sequentially.

Okay. And you mentioned in your remarks that the incentive based comp becomes a headwind next year. Is that because you pay out this year's comp next year?

No, it's just because as I said in 2005 we accelerated our RSU grant and so we had two years of grants -- I'm sorry, two years in one year was paid out in 2005. Now going forward in 2006 and 2007 we come back to our normal pace. So you would expect year-over-year to increase just as a result of stock price increase and the impact on all those units that management owns and are deferred into the long-term.

Okay.

So it goes from a tailwind, 2005 to 2006 to a small headwind, 2006 to 2007.

I see. You don't get the same advantage you got in '06 next yea in other words?

Exactly. That's the point.

And then you also made a comment that I didn't understand if you can just repeat it -- for sensor beams, I didn't understand what was going on with that comment.

Well, car hire income is down in the third quarter because as I said it's a positive story, the cycle times of our cars on the U.S. railroads is improving so we receive less income. And one car category that attracts at a lot of car hire income is sensor beams so the extent that sensor beam volumes were flattish to down during the third quarter we get less car hire income. And equipment ramps is a net of expense and income.

Okay. And how do you think about that as you start going out, realizing what's going on in the housing market, do you -- are you planning that that worsens or not worsen?

Well, we're continuing to focus on car velocity. There's a huge push across our system to improve our -- the speed at which our cars are moving. So we're going to be continuing to make -- trying to make progress in terms of the expense side of that particular equipment rents category. As for income, as we said before we are hoping for the -- our U.S. railroad partners to continue to improve their stock cycle times. That's -- we may see a little bit less income but that's good news story because the cars are coming back to us faster and we can translate that into volume growth on the revenue line.

When did you begin to sense -- or see the U.S. railroads improving that cycle time?

It's been about six months, Ed, six, seven months.

And just one, and if Jim said this I apologize, but on the expectations for the housing market and lumber in the U.S., what are your thought process of where it goes from here? What inning are we in this slow down?

Jim maybe can comment better but I can say this, I think some housing numbers came out yesterday, they were a little better than we anticipated them to be. Our lumber business on a relative basis, now you got to understand that these -- we've been going knock out numbers four, five years now, we know the cycle was not going to continue, it has softened up, we're seeing market share gains, as Jim mentioned, from the highway and from our producers in the west. So I think that's going to soften some of the impact of lumber but I think our numbers that you're going to see in the fourth quarter will probably be something around what we're going to see for the next year to 18 months.

Okay. Thanks a lot for the time, guys, and an incredible 57.4. Wow.

Thanks, Ed.

Thank you. The next question is from Tom Wadewitz from JP Morgan. Please go ahead.

Yes, good afternoon. So I guess those 59.9 coffee mugs from the Illinois Central days aren't going to be so inspirational any more.

I just crashed them.

Time to throw those away. Obviously a very impressive quarter and congratulations on the strong execution. If I look from an annual basis the last couple of years it seems like it's been about 300 basis points of year-over-year margin improvement, kind of '04, '05, perhaps what '06 will be, or maybe beyond that, and I'm wondering if you can give us some thoughts about what type of environment would enable you to continue at that pace?

Because I think if you asked us in '05, would you continue it again or in '06, it seems like it would have gotten tougher to continue that. But can you give us some thoughts about what would help you to do that or what might prevent you from continuing at that pace? And I know Claude noted some specific items but from maybe a a higher level, Hunter, if you could comment on that?

Well, I -- look, I know that the pace cannot continue like this at 300 basis points and I mean we're working, we're at the three-minute mile, I'm kind of trying to get my head on right to be able to reflect on these. So, I don't think we are going to -- I'm not sitting here predicting we are going to go to 55 or 56 or even sustain -- and I don't want us to, I want us to grow this business. And so I want to us take this service and this cost control and convert it to growth. So I'd like to see a 62 OR or 65 OR, but a $12 or $14 billion Company and I think that's the platform and foundation we're building it for. Now having said that, I want everybody to understand there are a lot of initiatives in this pipeline still to create a more efficient rail operation.

But I hope once again it's converted we can take that for Jim and he can convert it even more to growth. But, look, we've got the long sidings initiative, we're making real break-throughs in the terminals and the network. Backyard is just set records that they kind of -- they run in plateaus. Backyard is producing results that I don't think there's a yard in the world that's coming close to their throughput, the dwell time, their productivity. And so there's more to do now. But I'm not going to try to tell you we're going to 55 or 54, that's not my focus, my focus is to run a safe railroad, provide a quality service and grow the business and be efficient by growing it.

Okay. But I guess just in terms of thinking about the ingredients that help to you really deliver that type of OR improvement, the pricing environment still quite robust, demand perhaps noisy in different segments that are more economically sensitive but overall sounds like volumes outlook is pretty good. And productivity pipeline still, it sounds like it's pretty full.

Yes, it is.

Okay. Let's see, maybe just one follow up for Jim. The yield, a more granular question, the the yield growth was a fair bit different in third quarter than it was in second, it accelerated and I think a lot of it's driven by specifics on line items and mix and so forth but is that type of mix effect likely to continue when we look at fourth quarter and then perhaps next year? Because the yield seemed to accelerate quite a bit in third quarter versus where they were in second.

Some of the -- some of the third bucket, the volume and mix number that I talked about, the longer haul traffic should continue as we drive those types of initiatives, moving diluent from Texas to Alberta is a much longer haul than what we've traditionally had. Again, but that all gets offset as some of the lumber which has been historically some of our longer haul from western Canada down into the U.S., softens for a short period of time.

So we're always looking for these opportunities to use our franchise to the best that we can. I would tell you that we're working on those initiatives but I can't tell you that that's necessarily something that I would lock in going forward as a 1% additive to the guidance we've given you.

But in terms of what have showed up in third it's not -- might not be unreasonable to think that some of those mix effects would continue for a few quarters?

I think that's going to carry over, yeah, it's not -- it wasn't a one time shot. This diluent move is going to continue to grow, this oil sands project is going to continue to provide us great opportunity going forward. It's not a one quarter wonder. And so we'll continue to see the benefits from that. And hopefully I don't have anything that materializes that offsets it.

Okay. Great. Thank you for the time. Congratulations again.

Thank you. The next question is from David Newman with National Bank Financial. Please go ahead.

Good afternoon, gentlemen. Perfect quarter. Assuming you can achieve the hourly agreements in Canada and if you are able to increase train speed which I think is one of your goals, what do you think that might imply for the operating ratio?

David, I don't know if I'm smart enough to answer that. I hope it's growth.

But it would be a fairly quantum leap, wouldn't it? Obviously 10 miles an hour, what's the average, Hunter, around 30, 35, going to 40, let's say 40 to 45? It's a fairly significant increase I guess in terms of productivity, utilization? Would it be a material number?

Well, I mean -- that's -- let me see if I can address it this way. I have talked about my longer range vision and I'm talking eight, 10 years or so to increase speed and velocity of trains. We've already talked about cars and terminals but raw speed on the main lines. That will take capital investment. It will take a different -- little bit different equipment animal, there's some challenges there between standards, between roads and so forth. Our average train speed today as we speak is around 26 miles an hour which I think is probably the industry high. And that's all trains, coal, grain, intermodal, everything, the mix, and that's based on a 60 mile an hour railroad.

So, if you said one day the rails should go maybe to an 80 or 90 miles an hour railroad in miles per hour, then that that would imply to your number of moving from 26 to 40, 45. That has hugh implications, but they're implications that excite me most are the growth opportunities to take stuff off the highway, all the issues you hear now about the highway and about the problem that our friends in the trucking industry have and about rail capacity, speed creates capacity, a lot of people don't recognize that, speed creates capacity. You don't have to make new triple tracking in my view. You do it through speed. So if I dream about where the rails are going to be when I'm on the rocking chair in Florida, on the porch, it excites me.

Exactly. And just isn't terms of the UTU and this CAW, I know it's fairly early days. How confident do you feel at this juncture that the Canadian unions might be more amenable to, let's say an hourly agreement this go around.

Well, let me talk about the CAW first for a moment. We have worked very hard internally with the CAW. And the CA W has worked very hard with us to improve our relationships since the unfortunate strike that we had three years ago. We have already started the talks, I guess they started last week formally, I am -- I'm cautiously optimistic that we will -- we can make an agreement that's fair for our workers and it's good for us. So I'm hopeful there with CAW.

Excellent. And then last question if I may, on the intermodal side it looks like you guys are gaining some market share not only OCF trucks, et cetera, but just off some of the other railroads. Is there something beyond just expansion that you can point at? Any color you can add as to why the intermodal is -- was so robust in the quarter?

We added additional capacity in order to handle the volume and we provide good service and there is more than enough business to go around between all of the railroads in North America. And when you have capacity, you can handle the volume.

Excellent. Thanks, gentlemen, great quarter.

Thank you. The next question is from Cameron Jeffreys from Credit Suisse. Please go ahead.

Great. Thanks very much. Good afternoon everyone. Most of mine have been asked, just wanted to maybe get your thoughts, either Jim or Hunter, on the fuel recovery discussions in the U.S., talking about perhaps going to a mileage based system? I mean, just -- is that something that you guys might be amenable to or I just wanted to get some of your thoughts on that? I know you're going to get your fuel one way or another just wanted to get your thoughts on it.

We want to do what's fair and simplistic and easy for the customer and us to understand. Jim and his group have done a wonderful job I think in managing this process. I think our fuel surcharge, I think is the lowest if I'm correct is down to about. as we speak, now about 10%. We've made two changes to it recently. Jim testified before the STB. I know the STB is asking for certain information and we, I'm speaking for the CN Railroad, are perfectly happy to provide the information to them that they're requesting and so we're not looking to create any quote profit center out of fuel that some shippers have raised issues about.

Would you see any kind of impact if you were to go to a mileage based system on --

The only issue with the mileage based system that is one its complexity and it's -- your ability to administer it and properly charge the customers on an individual basis for the miles moved. And the costs associated to the railroads for setting up new computer systems and the costs associated with our customers for them having to go out and reprogram all of their systems in order to accommodate payment of it which I don't think a lot of the shippers thought about when they went in and asked for it. So we are going to work with our customers and we are going to work with the

STB to try and meet their suggestions on this topic. We are formulating some ideas that we could put into effect if necessary. And do so in a manner that's the most simplistic, easily to administer and cost-effective for both us and our customers. And if we do it correctly, there will be no material effect or no effect on anybody other than more transparency which I think is what everybody is looking for here, transparency as to what they're actually paying in terms of fuel.

Great. That color is helpful. Thanks very much and congratulations on a spectacular quarter.

Thank you.

Thank you. The next question is from Jordan Alliger with Deutsche Bank. Please go ahead.

Hi. Just a question on the intermodal side. Is there any more, I guess competitiveness, competitiveness on the price side? Just curious because yields across the board were very solid intermodal, not as much growth as we've soon in the last few quarters, so I'm just wondering what might have gone into there if anything.

As I'd said earlier there's more than enough business to go around. I don't think there's any reason for anybody out there to be doing anything on the price side to attract more business when some of the railroads are already having difficulties handling the business volumes that are there today. So going forward -- going forward the traffic patterns are going to continue to shift. That might have some impact based upon length of hauls, et cetera. But certainly -- certainly there is a demand for the transportation product in North America, not on us, that exceeds supply.

Okay. And would you say just -- I would imagine the intermodal piece is probably on the more sensitive end to economic activity. Sort of what are your thoughts on that if we do go into a bit slower environment? Does the secular trend keep the growth sort of above what the underlying transport view might look like.

Well, when you talk to the manufacturers overseas, when you talk to the shipping companies that are building 8, 10, 12,000 TEU vessels to try and stay ahead of what is viewed as this continuing ongoing growth in demand, one would certainly be led to believe -- and when you talk to the major retailers of the products that are being manufactured over there, everybody is the on the page that this growth is going to continue and not be subject to any kind of economic sensitivity that we're, again that we're used to not modeling.

Okay. Thanks.

Thank you. The next question is from James David with Scotia Capital. Please go ahead.

Thank you. Good afternoon. Hi. Jim, sorry, just very quickly, I missed some of your comments on the Canadian grain metrics in terms of production and quality. If you could just repeat them very quickly.

Well, it's a short answer. We've got great grain crop in Canada, it's a 46 million metric tons with 59% of it being number one red wheat versus 14% last year with the largest carry in -- carry forward in, since I think '93, '94 is what I said crop year. So we've got the perfect storm in the right way in Canadian grain.

Okay. Perfect. I know you that you've had a lot of intermodal questions, I just wanted to go back just to it. If I look sort of back historically that was a double-digit growth business for you and I do recall Hunter saying several years ago that returns weren't adequate, you reworked the economics of the business, the volume growth kind of bottomed out sometime in '05, it's been re-accelerating. Is this a business that if the ports can handle the capacity that will return to the double-digit volume growth type look again or is this something that's going to be high in single digits, not that there's anything wrong with that, but is this a double-digit business on a volume growth basis?

My view is that with Prince Rupert, yes, it will be and then we've got to see about phase II and I don't think it's going to be 15% but I think it might be low double digits and could be in the probably settle in the 8 to 11, 12% range. I don't think we will see 18% or 20% pipe increases but I think that's a whole lot better quality business than it was and we're looking for quality shippers that want good service, reliable, consistent service. We don't discount. We don't rebate. We don't give green stamps. So we're looking for the quality players that are willing to pay for good service and -- but I think we can look at 10, 12% growth as reasonable.

I mean given the investment requirements in that business, do you -- can you benefit from operating leverage, if you get good volume growth? Do you get good impact from volume or do you have to keep reinvesting to handle more volume?

No, I think that intermodal is to the point now that some of the prices we paid in the past, I mean we paid for it. It's there. And can take some additional growth and that business has as much return now operating leverage as anything we've got.

In terms of the operating changes that we have made over the last few years that we've talked about in past calls, in the velocity and throughput that we now have in terms our trains in the interface and the terminals and the interface with the truckers, et cetera, there is not -- there is no longer the inefficiency that one used to see associated with volume. So now based upon this new model, running volume is a great thing and we want all we can get.

If -- thank you for that, if just for some reason unexpectedly your panel and lumber business was to be hurt by some surprisingly low housing results, how nimble are you in terms of being able to reallocate, take advantage of some of our excess demand in intermodal? Is this something you can do relatively quickly? I know the track -- the routing wouldn't be exactly the same but in terms of reallocating locomotives in some track capacity would you be able to take advantage of that?

Absolutely.

Similar to -- take a look back and did what we -- when we had a kind of a one-year off there with -- actually it was two but it impacted a big one year when the grain went bad and we were able to very, very quickly reallocate assets and take advantage of this.

Okay. Well, it goes without saying but really great numbers.

Thank you.

Thank you. The next question is from Rol -- Walter Spracklin with RBC Capital Markets. Please go ahead, sir.

Thanks very much. Just on -- you gave us some good guidance on your '06, '07 outlook and Claude, perhaps you could touch a little bit on CapEx spend, I think on a -- turning toward your guidance for '06, you're coming in a little on the lower end on the Q3, are you expecting to make that up in Q4 and what can you talk about in terms of 2007?

We're still on plan. Our CapEx is fairly backed up into the fourth quarter of this year. So we'll finish the year at around 1.55 billion of gross CapEx for 2006. And we see that growing just with inflation and our continued focus on leveraging the opportunities we see in front of ourselves, next year $1.6 billion CapEx envelope would not be a bad number to be using.

Just on the topic of tax, I know this is one that's becoming increasingly important as you become cash taxable, had a lot of questions recently with the conversion of BCE or the intended conversion of BCE and Tellus into an income trust, can you go over with us if you've looked at that, what would be the impediments and just give us some color on that?

Well, I think Tellus and BCE and a few other companies who have gone the income trust route are fairly different than CN. First they tend to be mostly Canadian shareholders. We have a good -- roughly half of our shareholders are U.S. shareholders. Second, they have almost all of their income in Canada and we have a fair bit of our income in the U.S. which was -- wouldn't get any benefit from that.

And I think, more importantly, we have better valuation and we hope that our story will continue to convince shareholders that we deserve higher valuations. So when you do the analysis basically for CN it doesn't really give a pop. And so that's not our business model. Our business model is around growth and we hope the market will give us a valuation that continues to deserve that type of approach.

How much of the tax is U.S. versus the cash tax U.S. versus Canada?

You can what, in looking backward would not be a good indication going forward because we had a lot of tax attributes in Canada which we were shielding income taxes. We pay a fair bit of U.S. cash taxes which would not get any benefit under an income trust structure.

Okay. All right. thanks very much.

Thank you. the next question is from Scott Flower of Banc of America. Please go ahead.

Good afternoon, all. Hunter, I just want to -- obviously it doesn't sound like you're going to print coffee mugs at CN that say 49.9 but just wanted to get a sense of-- your margins are getting to a point where they're at or better than Microsoft, is there a point at which margins do come into your thinking at least broad politically, i.e. can there be a point where your margins are too big and they attract too much attention therefore maybe growing's the right thing to do but also is there any political context to that?

Yes, I think you know the answer to that and the answer is yes. And we're sensitive to that. But the issue is what we really want to do is convert this into growth. But keep in mind, I mean, at the same time I'm not sure, I'm not sure how it all comes out but we're giving I think the best quality service in the rail industry. Okay. Our prices are lower than, and I'm not bragging about that, but our prices on a per are lower and we're producing outstanding results.

Now, and if we have to apologize for that and they want to treat us individually maybe that happens. But I've said for five or six or some years, some maybe longer now, that there's opportunities in the rail industry and there's opportunities in productivity gain far beyond what anybody can see. And what we're seeing here is fundamental cultural change in the way the Company operates and does business and the way people behave and it's continually going and it's building strength right now to take this Company forward for years and years. We are different.

I would just add, Scott, that the hard facts is we have got to where we are through innovation. I mean the pricing strategy that Jim is carrying out is a fair pricing strategy. Our pricing when you compare them are very advantages versus the competition especially when you take into account the service that we provide. And so if we shine, we shine because of innovation. And some people think railroads shouldn't be making as much money but that's just the price of success.

Don't get me wrong. I'm an advocate. I'm just -- politicians may not always be on my same side. Also just sort of last question just sticking with that theme and again sort of just macro, I'm not trying to get you to pick apart what else is going on in the industry but do the fuel hearings have any risks for the industry? It just seems like you are trying to be solicitous, you're trying to be helpful. Others are taking a different posture broadly and I'm just wondering is there any risk to the industry how those hearings or is it just a minor event in your view?

It's hard for me to say. I'd just only make one comment that I've always said and believed in. If you abuse authority you're going to lose it.

Okay. Thank you.

The next question is from Randy Cousins from BMO Capital Markets. Please go ahead.

Afternoon. Claude, your profitability's never been higher. Your return on equity's never been higher. You're running with a debt to capitalization that's 36.5 and I guess slightly higher than that on a fully basis. But have you ever given thought -- any thought to sort of significantly taking up the debt position in the corporation given that your new levels of profitability and then using that capital to more aggressively buy back stock because it sounds like maybe the markets don't believe that you can sustain an 18% return on equity?

Randy, I think we are factoring that in a very consistent approach and that we've laid out and that we've just basically carry in and execute on. We have said we want to see our leverage increase from the 40% adjusted debt ratio level to the 45% level over the next couple of years. And so as we -- that means that's about a $1 billion of additional debt capacity over the next couple of years which we intend to through share buy back. We have been opportunistic. We continue to use our cash slightly ahead of our cash generation to buy back shares and leverage up in a manner that makes sense.

So when you put those targets in place I assume that you weren't expecting to have a 57% operating ratio.

Oh, you're talking about --

Is there an opportunity to get more aggressive on it and move faster?

No, we take -- when we look at it, we think that we are being reasonably aggressive and as I said we bought $400 million of shares during the quarter and we think that leveraging up and managing our balance sheet from a debt holders standpoint and we're creating shareholder value, our approach to use of cash is to continue to increase our dividend faster than earnings.

That's good news for shareholders to the extent we've just upped our guidance for the full year in terms of EPS year-over-year. That means our dividend is going to go oven even faster next year and using that cash between long-term commitment through higher dividend and share buy back, leveraging up over the next couple of years is we believe achieved the right balance.

Okay. Hunter, the third quarter is typically when the guys go out on the lines and make -- give the sighting extensions, et cetera, was there any kind of disruption to the operation as a consequence of work that was done on the system and in terms of sort of looking forward, did we get the sighting extension benefit, was that in the Q3 results or is that something to -- that we're going to see a lot more of come to us during the next few quarters?

It's, Randy, it's about 80% complete as we speak, between Winnipeg and the West End. We did have some disruption, aggressive as we tried to do the program, I got a few more gray hairs, and my patience at a couple of times didn't last. But you didn't see much of it in the third quarter and you'll stop -- probably start seeing the full benefits of it first quarter of next year as we adjust the train starts and the service levels that really justified the investment there.

So there's still a lot to come in this and you call productivity bucket over the next two to three quarters.

Yes.

And smart yard has obviously been a huge win. What's the intention in terms of rolling that across the system and how fast do you roll it out?

Well, part of smart yard is just getting smarter. And so the learning from backyard has been extended but there's two things that we've learned about smart yard, we should have known this. It's one thing to develop the model and the information systems and all. The seconds thing is you got to convert it and get people to execute it. And so there's a lag time between doing the analysis and you say, well, there's opportunities here, but there's lags of converting the opportunities.

So I think you're going to see -- we have seen significant improvement at Symington yard in Winnipeg which will improve further. We'll see further improvement, I think, at Walker yard, then we've got the Memphis project coming up that'll be on board in a year and a half which will effect the network. So the terminal throughput productivity, numbers, will continue to improve going forward.

It's a great story. Thanks a lot.

Thanks, Randy.

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

Great, good evening. On the employee side, I just want to talk to you about this because it looks like you continued to eliminate some employees, continue obviously part of your efficiency drive. Is that something we've kind of been going that -- just about a year on the elimination of employees is that something you look to continue going forward or how should we think about employee count going forward?

I take exception, Ken, with your word eliminate. We're working with attrition from where we are. We're trying to be extremely surgical in the way we approach things and take advantage of the demographics so that it's more painless way of getting productivity. So we have some benefit. We are at the tail end of some of the synergies on the two recent transactions.

Going forward, our goal is to make attrition work for us and to maintain our headcount flat to slightly down. We've been doing good here over the last couple of quarters. I wouldn't expect us to continue to necessarily be down 2% to 3% but keeping it flat to slightly down is something we can do smartly and wisely and continue to deliver service and grow it at the same time.

So on that labor line which you noted there was kind of some one time things a year ago that pushed cost artificially down year-on-year, what would labor costs per employee have done? I mean it was down 6% with the reported numbers. How would that have looked year-over-year without the gain?

Well, more in line with our -- what we said before, 3% to 4% per employee and then because we are taking down the employee headcount a little bit so it's flattish on a year-over-year basis. As you can see our FX adjusted labor is down 6% and really that's the stock-based compensation. So without that it would be flat to up 1% which is consistent with a 3% to 4% increase per employee.

Great. And then on the coal side, look like volumes were down, Jim. I think you said there was some softening on the U.S. side. Is that where the declines come from? I guess on the carload side?

Yes, it's all due to his short haul part of our basin move that we handled in the midwest that has been going away now, this is the third quarter that it's been going away.

So then overall yield's jumped about 39%. Should we look for that level now with the mix shift? Should we look for that level of average revenue per car increase on a year-over-year basis at least the next three quarters?

Through the fourth quarter and the first quarter of next year you will see this trend line of carload business going away in the U.S. which on a revenue per car basis is very low because it's very short haul. And being replaced with western Canadian coal which on a per car basis is much higher because it travels much further.

And that's started when, did that just start this quarter?

It started in the middle of the second quarter.

Okay.

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

Thank you. I just wanted to first go back to forest products. I know you touched on this a bit earlier but you guys have never built your assets to meet peak of cycle demand. And I'm just wondering if you could comment a bit on if you go back over the last couple of years and look at the housing market how if you can quantify at all or maybe talk qualitatively in terms of how much your market share has been constrained by not getting the cars back fast enough to ship all the demand. And it sounds like that's the situation that's easing up and I'm just wondering if there's any way, if there's a housing start number, any point of reference that we could look at in terms of how much market share gain is going to offset some of the weakness that we're going to see in housing over the next couple of years?

Let me just make this comment, I think Bill is, number one, at the peaks of the -- of lumber, we were fulfilling 92, 3, 4% of the demand, at its real peaks. That has dropped off a little bit and we have gained efficiencies with that center beam fleet. And the U.S. roads were doing better and we now have center beams, a significant number of center beams that are in storage. But the -- here's what that gives us the opportunity to do. We've got a lot of leases with -- there with cars that we can turn back, that they're higher turn. And guess what, there's some manufacturers out there that have got center beams and we were very opportunistic to take advantage of buying center beams at a real low price and so when you're in this kind of position it puts you in a good - to be able to react and take advantage of opportunities.

I think that the numbers that we have recently, if you look at our loadings lumber wise, and Jim can help me with this, but if you look at what we're doing as we speak I think that's where we continue to see the lumber market absent more market share gains that we can make from stuff off the highway with our superior service and some stuff even off the water. So I think that even if things get softer, I don't lay awake at night and worry about the lumber market, okay. And we wouldn't be giving this bullish outlook if we thought it was going to be some devastating impact on us. Jim, you want to add to that?

No, I mean we're -- we always have had expected the -- I guess if you want to put a number in someplace, just for sake of conversation here, around 1.9 or something like that in terms of housing starts is something that is probably more sustainable than what we've seen over the last few years in which no one in the industry was able to eat that -- meet that demand. So as some rationality comes into the marketplace and that over-burden on the market in terms of housing is worked off and prices return we certainly expect in some reasonable time period to get back to that run rate.

Great. Thanks. And then, Claude, on the -- just on the cash flows and the buy back, right now you're buying back stock at around sort of the $1.5 billion worth of stock, if you look at the current share price, and I just assume you keep the same volumes, I'm just wondering, 800 million in free cash flow next year and I know some of that is temporary issue and you do -- you talked about plans to increase your debt over time. Are you comfortable with increasing that, given those higher debt levels, quickly or is that a longer term goal and I guess the question is do you expect to continue to buy back the same level, 7 million a quarter for the next kind of four, five quarters?

That's certainly our intention and basically next year because of the 800 mil, next year is when you'll see our debt level go up. And so we've been very consistent. We're going to get to that 45% adjusted debt ratio and just because of the math into next year if we continue to buy back at around 7 million shares a quarter, next year is when you'll see our adjusted debt ratio move much closer to the 45% level.

Great. And then one last if I could, on just on the taxes, once we get past next year, what sort of -- what's kind of longer term cash tax rate that we should expect for the Company?

Yes, well, next year where there'll be this double whammy with $325 million on account of 2006 which is what I was explaining. And then after that, in the range of -- like if you look at our book tax rate and you assume that 70%, 72% of that is our cash tax rate going forward you're not going to be wrong in terms of the -- where we're -- where we see our cash tax rate in relation to the book tax rate.

Perfect. Great. Thank you very much.

Thank you. There are to further questions registered at this time. I would now like to turn the meeting back to Mr. Harrison.

Thanks, Christopher, and thanks to all of you for joining us. We appreciate it and we are obviously delighted with the quarter and look forward to the next time we do this. Thanks.

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