Canadian National Railway Co (CNI) 2007 Q2 法說會逐字稿

Welcome to the CN second quarter 2007 financial results conference call. I would now like to turn the meeting over to Mr. Robert Noorigian, V.P. Investor Relations. Ladies and gentlemen, Mr. Noorigian.

Thank you, Eileen. Thank you for joining us for CN second quarter 2007 financial results. With me today is Hunter Harrison, President and Chief Executive Officer; Claude Mongeau, Executive Vice President and Chief Financial Officer; and Jim Foote, Executive Vice President Sales and Marketing. Today's remarks may include forward-looking statements within the meaning of applicable securities laws, such as statements are based on assumptions that may not materialize and are subject to risks described in CN's ND&A and other disclosure documents on our website. As such, actual results could differ materially. Reconciliation of any non-GAAP measures are posted on CN's website, www.cn.ca. After the presentation, we'll take questions from those of you who are listening to the call. Please identify yourself and in order to be fair to everybody, could you limit the number of questions that you have to two. It is now my pleasure to introduce CN's President and Chief Executive Officer, Mr. Hunter Harrison.

Thank you, Robert. Thanks to everyone joining us this afternoon. Let me make a few remarks about the quarter before I turn it over to Claude and Jim to get more level of detail. If I had to, I would characterize this quarter as really a bounceback quarter. A bounceback from the labor strike and strife and lockout that we had in the first quarter and there was some lingering affects into the second and extremely difficult weather conditions that we talked about. The weather conditions did continue into second quarter where we had extensive flooding, particularly in northern British Columbia. We were out, for example, between -- we couldn't get to Prince Rupert for about seven days. We also went through two illegal blockades between Toronto and Montreal, probably one of our heaviest quarters, and we clearly saw some weakness as far as product sector and some pressure with the strengthening Canadian dollar, which Jim is going to talk further about.

But in spite of that, I was extremely pleased that we were able to come in with an operating ratio of 60%, which is for all practical purposes flat with last year. Claude's going to talk about our additional continuation of our share repurchase program in his remarks. I would -- before I go further, I would call to your attention a recent development where we have just received, Friday, the decision from Mr. Sam the arbitrator in our dispute with the United Transportation Union and we was ruled in our favor, selected our submission. Ours was effectively all in with the 3% increases and the $1,000 signing bonus and a few enhancements to the fringe. Our package came in at about 12.5% as we priced it and the UTU's package came in at 17.6%, if I remember it correctly. So now we've gotten that behind us and we can -- hopefully we can move forward.

I would call your attention to some of the metrics on the second panel that we provided with you that shows a little bit of the impact on the weather and the blockade hit to some of our metrics. Clearly, on the accident side and injury side, we saw good improvement. Our train size continues to pick up, our productivity in yards continues. But we did see as a result of the flooding and the blockades, some reduction in the locomotive productivity and the car miles per car day as far as the affect on the car fleet and I'll have some further remarks on those areas at the end, so with that let me call on Claude to talk about some of the financial numbers.

Thank you, Hunter. Indeed, I think overall if you look at the quarter, it's a reasonably good quarter given the challenges that we faced, the softer volume, and the operational challenges that Hunter described. We delivered C$0.95 of earnings per share, that is up 7% on a comparable adjustable basis, which excludes a C$30 million deferred income tax recovery for 2007. In last year, actually in the second quarter, we also had a very significant deferred income tax recovery of C$250 million. These two income tax recoveries are as a result of announced federal income tax reductions and this bodes well for the future, more in the 2010/2011 time frame, but as these new rates kick in, we should see our effective tax rate go down by as much as a full point from the 33% or so that it is now in the 2010/2011 time frame. So good news on this front and it creates a one-time EPS, which we exclude from our results to give you a better sense of comparability on a year-over-year basis.

As Jim will explain to you in more detail, adjusting for the foreign exchange, our top line grew roughly 2.5% in the quarter. Basically good yield performance offset by a small decline in volume, particularly a decline in volume in the forest products sector. I'll take a minute to review expenses on the second page. Basically, our total expenses increased by only C$21 million or 2%. If you adjust for exchange, in this case it's a benefit, the increase is closer to 3% on a year-over-year basis. Our labor expense is well behaved. Despite a slight increase in our head count, you see a decline in our labor expenses. We have seen fairly significant increase in stock-based compensation offset by some reduction in our bonus accruals, which means that overall the labor expense is well behaved and is a good indication of run rate. We saw an increase in our purchased services driven by higher repair and maintenance cost, but also the impact of the services we purchased at the CN worldwide. As you know, we are changing the way we report our results here with the gross revenues and the expense showing up in their respective categories.

We've seen increases in fuel despite the WTI coming down slightly, and that's because in the second quarter of 2006 we added $23 million gain for edging and we no longer have this benefit, so that creates an increase in expenses despite the lower fuel prices. I think we're about to lapse this phenomenon in the third quarter. We will have a residual C$9 million edging gain of last year to lap, but after that our expenses in fuel will be basically moving up or down in relation to the world prices and our consumption. The two big movers on the expense front were equipment rents and casualty and others. Equipment rents were C$23 million, about half of the increase is due to lower car higher income. We had less volume. The performance or the velocity of our peers in the U.S. is improving, which is good news, but that also means the cars are returning to us faster and we're collecting less car income. During the quarter, we also had a small adjustment to our standing accrual and we've seen our own velocity slow down a little bit, as Hunter described given the flood and some of the issues we had to deal with.

Casualty and other, on the other hand, came down by roughly $40 million, which is largely as a result of good performance overall, but also a Fila legal claim credit from our actuarial study. We do an actuarial study on Fila legal claims twice a year and basically the performance that we are showing on this front is starting to -- or continuing to pay dividends. Our frequency and our severity of Fila claims is coming down significantly and that is what is reflected in the actuarial study. So some of this is lumpy, but some of this a good indication of going forward lower legal claims. If I turn to free cash flow, year-to-date, that's for the first six months, we generated C$51 million of free cash flow. That's good performance given that we paid out more than C$600 million of cash taxes. Roughly half, actually a little bit more than half of this amount is really on account of 2006 results, as I explained on previous calls. Basically we have C$325 million to C$340 million of cash taxes during the first quarter, which were on account of 2006 results. So going forward we're paying cash taxes on a more normal level, and you should see the back end of the year improve. In fact, we're maintaining our free cash flow guidance of C$800 million for the full year and we're continuing to focus on strong cash flow generation.

This is what gave confidence to our Board of Directors earlier today to approve management's recommendation for a new, larger share buyback program. We are announcing today a program of 33 million shares. This is basically 5 million more shares than the previous program which we announced and completed, basically from last year in July to just recently. At this level, our pace of share buyback is increasing to around 6.5% of our flow and a cash outflow, if the price stays around where it is today of roughly C$2 billion per year, which is up from the guidance that we had given earlier that we were buying about C$1.5 billion of share buyback per year. The focus is on maintaining a strong coverage ratio. We think that we should maintain a coverage ratio in the range of 2 times debt to EBITDA, but as we move to a coverage ratio, we have an ability to continue to increase our leverage gradually, and over the next three years, you could see our debits see an increase on the order of C$3 billion.

And so by maintaining the coverage ratio in the range of 2 times or thereabouts, you should see our adjusted debt ratio increase over the next couple of years beyond our previously-announced target of 45% adjusted debt ratio. In fact, if you do the math, you should see our adjusted debt ratio increase in the low 50% range on an adjusted basis to include leases. All of this is a reflection of the strong cash flow that we deliver, our ability to basically optimize our capital structure and create shareholder value for the long-term.

Let me say a few words to wrap up on the outlook for the year. It's fair to say that we've had a tough first half with the strike and the softer volume year-to-date for the first six months, our earnings per share are up only 1%. We do face some headwind in the second half of the year with the dollar at $0.95 and world crude prices hovering just below $75. But we have the momentum in the pipeline to turn the corner and we expect to deliver stronger EPS growth in the second half, particularly in the fourth quarter and our revised guidance, as a result, is for the full-year EPS growth to come in around 5%, and that is for the full year. Our free cash flow, as I said earlier, we are maintaining our C$800 million free cash flow guidance, and if you couple that with the results that I just gave you in terms of outlook, we believe it's a solid year despite the challenges. With that I'll turn it over to Jim.

Great. Thank you, Claude. I'd like to go through the revenue page now on kind of a line-by-line basis. And as always, talking here on an exchange-adjusted basis. Revenues in the second quarter, up 3%. Let's first take a look at volume. And I'll review the carload data in more detail in a few minutes, but generally carloads declined 3% and revenue ton-miles declined 1%. Continued softer business volumes in a few business segments as well as some lingering impact on operations from the labor issues earlier in the quarter, as well as the June floods in British Columbia were mainly responsible for the decline. Our fuel surcharge recoveries, as -- were down 1% as a result of lower crude prices this year.

On a price -- from a price perspective, prices again increased in revenues in the quarter. On a per-unit basis, our same store prices increased 4% from last year. This is consistent with prior quarters. Our average revenue per car was up 6% and on a cents per RTM basis, we were up 4%. And also we had a favorable mix of traffic, which added probably approximately 2% to the revenue line, primarily driven to a 2% longer average length of haul. Going through the various line segments, on a petroleum and chemicals basis, up 8%, very good results in the petroleum group, which was up 10%. This is a result of initiatives to capture opportunities that we talked about before. As an example, the shipments to the Oil Sands region of western Canada from both the west coast and Texas grew. Our low sulfur diesel shipments increased as did fuel oil, gasoline, and jet fuel. Very good LPG shipments during the quarter. This was somewhat offset by some reduced plastics demand coming out of the Alberta region.

On a chemical side, we were up about 5% as we had some new movements of methanol shipments in through the west coast, which helped boost traffic there. Metals and minerals, plus 5% exchange adjusted, metals up 6%. Our strategy here to grow market share in the flat-rolled market as yielding results, as our shipments of sheet, slab, and plate steel were all up. The Oil Sands opportunities continues to provide opportunities for us as we increased our shipments of large diameter pipes from the west coast and other North American producers into western Canada. On the minerals side, very little growth here. The vast majority of the minerals business here is construction-related materials, roofing materials, cement brick, all of which have been weak due to lower construction activity. And in the iron ore segment, again weaker volume there in the second quarter as some producers -- iron ore producers took downtime for maintenance because of the softer demand.

Forest products, it declined 6%. Again, the U.S. housing market here driving declines in our lumber shipments. Again, also the Canadian dollar having some impact on our customers and restructurings going on there. Lumber shipments down, or lumber revenues down about 3% this quarter. In the panel business, panel side of the business, we're actually seeing a bigger decline there. There is more activity being -- declines in the east than we see in the lumber and shifting more production into western Canada occurring there. And again, softness in the paper business offset to a degree as Stora Enso, the mill in Port Hawkesbury, returned back to activity in this year versus the quarter last year.

On the automotive -- wrapping up on the merchandise business segment, on the automotive side, we had a great quarter in our automotive business, up 19%. Two new initiatives that are driving most of that growth. One is the new Suzuki traffic that we're handling this year versus last year as well as traffic out of a new General Motor facility in Michigan. We have seen additional increases with the launch of a new vehicle by another one of our producers in Canada, which has been driving results as well as a great import traffic through both the east coast and west port coasts in Canada, as well as new traffic that we're bringing into North America or to Canada actually that originates in Mexico.

On the bulk side of the business, bulk up 7% with Coal Canada being up 16%, again being driven by new mines that have come online, as well as great demand for metallurgical coal movements out of Canada, offset by almost a similar number of declines in the U.S. due to the loss of the Powder River Basin coal move into the Tennessee Valley Authority's facilities that we've talked about in the past and which we'll continue to see the results of for the rest of this year. Granite fertilizer is up 8%, grain revenues in both Canada and the U.S. up about the same amount. A very strong demand and a good crop and good product in Canada for wheat for export and in the U.S., we continue to see growth in ethanol. The derivative byproducts of ethanol, as well as a strong demand for corn moves into Canada and fertilizers and potash has just been very good and shown very strong results in the second quarter as well. On the intermodal side of the business, the domestic side of the intermodal in total up -- or down 3%.

Our domestic business down slightly. The lingering impacts from the strike as some of the traffic moved to truck when it could and our overseas business, most of that coming as some decline -- we've experienced some declines on the east coast as traffic into the port of Halifax has shifted more to different ports, as well as one of our customer's decisions to rationalize its business throughout North America. So our overseas business down 3%. Quickly, Bob's got another page, as always, just to keep me on my toes. I've talked about the carload traffic here where we can see we've got some very good demand in petroleum and chemicals, Canadian Coal and auto. And then you see the stepdown here on the page showing the declines in the business.

I guess in a nutshell, the best way to look at this from a carload perspective, a third of this decline is associated with this high-volume, low-revenue PRB coal move that I discussed. A third of this comes from various declines throughout the forest products business and the rest of it there, again mostly contraction-related materials in the metals and materials business as well as declines in intermodal. The outlook from a topline perspective, clearly pricing opportunities remain firm. We have consistently gotten 4% price increases and have achieved that here again this quarter. My guidance that I've discussed earlier in terms of the ability to move up in price, I believe, remains intact. Our Prince Rupert initiative is on schedule to open in October, service to begin there in October. Everything is on schedule and we have announced, previously discussed that we're very pleased to have Costco as our first customer and with one or two more customers calling that facility. I believe that facility will be sold out.

The second half of the year, great opportunities for us on the bulk side, the second half of the year and looking out. It looks like we're going to have a great crop in both the U.S. and Canada. The Canadian crop should be about 6% above a five-year average and right now looks to be in very good to excellent condition. The U.S. corn crop is clearly on track to be a record. The corn harvest expected in our draw territories should be 16% higher than last year. Good, positive news on the coal outlook as well. In Canada with the ramp-up of the new mines and the continued strong demand, our volumes in the second half of the year should be about 40% higher than the previous second half of last year, as well as we have a number of new initiatives. In fact, the opening of a new mine in the U.S. in the Illinois Basin, where these new business opportunities that are coming online will offset in the second half this decline associated with this Powder River Basin move that's gone away.

So despite the fact we will still have the impacts of that PRB move, we will show positive carload volume in the second half. And ethanol is just going to continue to drive the demand for fertilizers and potash throughout North America and we expect to see very strong shipments there, as well in the second half of the year. So we're targeting revenue growth still for the year, despite the very difficult first half in the3 to 4% range on an adjusted basis. And with that I'll turn it back to Hunter.

Thank you. Thanks, Jim, and thanks, Claude. So all in we're looking for a solid second half. We have made some pretty significant operating changes in the West, where we have experienced most of our growth the last year or so. And we expect in the future, particularly with Prince Rupert coming on board in the fourth quarter, additional growth there in the west. Some of the productivity initiatives we have put in place have really gained some traction and with the guidance of our Keith Creel, our new Executive Vice President of Operations that we announced in the second quarter and Jim Vena assisting him as Senior Vice President in western Canada, we're looking for a solid bounceback in the second half. With that, Eileen, we'll be glad to answer questions the group might have.

Thank you. We will now take questions from the telephone lines. (OPERATOR INSTRUCTIONS) The first question is come from William Greene of Morgan Stanley. Please go ahead.

Hi. Good afternoon. I'm wondering if you can talk at all about what kinds of initiatives you can put in place to counter some of the exchange rate impact on some of the freight flows on your network? Is there much you can do, or do you just have to kind of wait for this to turn the other way?

Well, I guess there are two things. One that we can certainly work with. The exchange impact on our customers is something that we are certainly always cognizant of and have worked with our customers to help them through these difficult periods for their business. And in most circumstances, what we can do for the customer is reduce their transportation costs by getting them to shift more product from truck to rail. So we are working aggressively there with the customers that have been impacted by the exchange impacts and we will, in most circumstances, have to just kind of go along with the flow here and see whether the Canadian dollar is going to settle in at some place in the high to mid-90s or is going to find some place in the 80s or wherever it decides to settle.

We're also, obviously, looking at everything we can do improve our own cost structure to protect profitability. As you know, Bill, we are reasonably well hedged from a structural standpoint. When the dollar increases by $0.01, we lose about $0.02 of EPS on a reported basis, so that's well hedged. But the fact is that the dollar has ran up basically $0.08, $0.09, $0.10 in the last several months. So that's why the size and the volatility is why we are having a bit of headwind at the moment, but both on the revenue side and the cost side, we're geared up to address the issues and over time improve our profitability.

Great. Okay. And Jim, one other question. The percent of your business that reprices each year. Can you remind me what that is?

I guess the best way to look at it is most of our contracts are in the 2 to 3, probably average three-year time frame, so about a third rolls over every year.

Okay. And then Claude, the Fila impact was how much?

The Fila reduction this year about $40 million.

That was a full 40?

Yes.

Okay. Thanks.

Thank you. The next question is from Tom Wadewitz with JPMorgan. Please go ahead.

Good evening. Let's see. Wanted to ask Claude another question on the expense side. On the comp and benefits, I'm just wondering if trend on a per-worker basis, I think it was -- my number showed down about 2.3%, if there's some puts and takes in the quarter that wouldn't continue or if that's a representative run rate the next couple quarters.

Tom, I think as you know, given the exchange impact on our labor expense, it is tough because you do have volatility, but the core components remain the same. We're settling with our employees in the range of 3, 3.5%. There's a little bit of additional inflation from benefits and medical costs, and that's the wage increase. After that, we're trying to maintain and use our workforce as productively as we can and grow at low incremental costs. The cost per employee is up something like 3.5, 4% before the exchange comes in and some of the other factors like stock-based compensation and bonus accruals come in.

So we should pay attention to exchange rate, but if the exchange rate doesn't change a lot, this per worker in second quarter is probably representative?

Within the guidelines I just gave you, yes.

Okay. Let's see. When I listen to Jim, it sounds like things are pretty good on the volume outlook side, but I look at the guidance and it's more muted. And I'm just wondering if you can give me a sense. Is your outlook pretty cautious in terms of volumes and in terms of the economy, or is it actually, you've just -- the change in the guidance is you've had a tough first half and you're just really reflecting that as opposed to cautious on second half?

I think it's mostly due to the difficult first half that leads me to where I am today in terms of my numbers. I mean I'm still expecting a very strong fourth quarter, as we always have, but that's not going to be enough to overcome the first half.

So, Jim, do you see signs the economy is improving or it still looks pretty weak and it's other factors like the Oil Sands that are driving some improvements?

I think what's driving our results are clearly the specific bottom-up initiatives that we've talked about in the past that are allying on to have growth in petroleum and chemicals, phenomenal growth in the automotive segment. We see strengthening in the metals side of the business. At the same time, I don't see much of a turn around here on the forest products side in the second half of the year. I think what we've got in the first half is what we're going to have in the second half there. So it's still this mixed bag that I add to with the initiatives in order to get back to the numbers that we're talking about.

Okay, fair enough. And then last one and I'll pass it along to someone else. In terms of a second or third customer at Prince Rupert, do you think that's pretty close or are we better advised to have a little bit of patience on that?

I still think, as I've said all along here, it's my goal to have it sold out by October. And that's still my goal. That's all I can tell you, Tom. We need another one or two customers in place and we'll be singing.

Okay. Very good. Thanks for the time.

Thank you. The next question is from Ed Wolfe of Bear Stearns. Please go ahead.

Hey, good afternoon, guys. Hey, Claude, just a point of clarification on the guidance. The 5% EPS growth, what are you including in second quarter as earnings? Are you including C$0.95 or C$1.01.

It's C$0.95. When I give you the guidance, it's on an adjusted basis, Ed.

I assumed, I just wanted to be clear. Hunter, kind of a big picture questions. If CP as a competitor were to split out the rail and the real estate, would that matter to you as a competitor?

No.

Is it something that you would consider doing at Canadian National and have you considered and what are the positives and the negatives as you see it?

You know what, Ed, this is always something we are looking at. In the days where the incomes for us in Canada were there, we looked at this concept. More recently, we looked at the idea of splitting the operating and the infrastructure. The long and the short is the following. When you review it in detail, you realize that there is a lot of leakage from an economic standpoint, tax recapture, transfer taxes for the actual splitting of the assets, and quite frankly our analysis, unless we're missing something, would show that even at very rich valuation for the real estate, there is just no compelling case from an economic standpoint. So leaving aside the obvious complexities, we don't see how it could add value. But if others were to do it, that wouldn't have an impact on us.

You don't see that that might lead to a lack of infrastructure that you might be able to take some shares from, gains or something like that?

It depends on how it's structured. As I had read and understood, the basic scheme is just like a sale leaseback. It's the same infrastructure that you're talking about. Now, if that's the case, it wouldn't be. I don't know if they want to sell off -- if somebody is going to sell off part of their railroad at less capacity it might impact, but I don't think it would ever impact us negatively.

Okay. Let's leave the hypothetical then. Speed and dwell has't been improving like we normally see it at Canadian National. When should we start to see these statistics improving?

I think you're seeing them now, if you're watching very closely.

On a year-over-year basis?

Well, on a year-over-year, we are as we speak about back where we were last year on train speed, if you're talking about that standpoint of velocity. On a car miles per car day basis year over year, we're maybe 6 or 8% off and quickly catching up. Dwell time, I think -- I don't know what numbers you see, but the next numbers you see, the dwell time overall will actually be down, the working inventory is down. So all the -- as we speak today, all the operating initiatives are really kicking and going well.

You would think for third quarter, year over year, we should see improvement in those metrics?

Yes.

And then last one, the UTU settlement, is there some impact that we're going to see at some point, either one-time or ongoing in the numbers, and when would we see that?

No. We were all properly accrued for the settlement.

So you don't expect a gain or a negative impact next quarter when you report.

Nope.

Claude is very accurate in his accruals.

That's what I understand. Thank you very much.

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

Good afternoon, all. I was wondering if you could give us a little more color about -- obviously, you had the strike and you had weather and you alluded to operational changes in the west. I'm just trying to understand, when you look at all these things together, what things in the west were really more things that you just wanted to change versus you had adverse circumstances? Maybe, if you could give a little bit more color as to what has changed and how you're running out west and what things you've done differently or expect to do differently?

Scott, several things. Let me just touch on a lot of them quickly. One, we had stopped humping at Edmonton -- I mean at Winnipeg, excuse me, and we stopped humping there are for effectively two months. Now, we are humping there again, but we're humping there again with about 60 or 65% of the staff we had before, so we learned a lot. Our inventory at Edmonton is down, working inventory on a daily basis is down 30%. The dwell time is accordingly down, so there's been big improvements there. Crew size continues to increase, so crew starts on a per-basis are down, train miles are down, much more so than any related business stuff. So I think the best indicator I can give you is this. If you have problems, that we've alluded to we've had some problems second quarter, come in at 60 OR, that's pretty damn good. I just read a headline or something that said our weakened at 60. That's the first time in my career I've heard that statement.

I was just trying to get at what you physically have changed, as opposed to commenting one way or another.

We're going to add back the hump at Winnipeg, which is we really wanted to do. We are probably going to close the hump at Edmonton, which is what we really wanted to do. We're adding further infrastructure between Edmonton and Prince Rupert in anticipation of the business in the fourth quarter to further improve train speed. We've already finished that in the Vancouver quarter, so the western metrics are stepping up pretty significantly.

Okay. And then Claude, obviously, I understand what you don't do guidance and obviously you're maintaining your free cash flow numbers, what things have you been able to do as an offset then on the free cash flow. Obviously, net income is not inconsequential in terms of the starting point for getting your free cash flow, so obviously you've got some other offsets on the cash flow side that you've been able to manage to maintain that C$800 million target. I'm just trying to get a sense of what those are.

Well, we're focused on a number of initiatives. We're getting much better -- continuing to make much better collection cycles so that generates revenues from working capital. And we're focused on generating every dollar of cash in every area, including monetization of real estate assets and the usual. The one element that will help us this year, if we're successful in getting the regulatory approval, is the sale of our EWF equity interest, which should give us on the order of C$90 million or thereabouts if the regulators approve in the fourth quarter.

Okay. Then just one quick clarification. I know that you talked about the moving parts and pieces and the accrual for the casualty, but is there a reasonable range in what we should think about as run rate for casualty, understanding that twice a year you go through this process on actuarially reviewing claims versus the frequence, etc., etc.

It is a more lumpy category, but as we've guided before, a run rate on the range of 80 to C$85 million is not a bad number to use on a going forward basis and basically that's about consistent with what we had last year.

Okay. Thank you very much, all.

Thanks, Scott.

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

Good afternoon.

Hi, David.

Besides fiscal prudence on the buyback, which makes sense, any other reasons why the buyback program may not have been stepped up more? Are you keeping your powder dry for acquisitions? And in a perfect world, what would you like to add in terms of let's say network, geographies, or services like CM Worldwide?

Our buyback --

It's still great.

I like your word, prudent. The C$2 billion of share buyback per year plus about C$0.5 billion of dividend leads to C$2.5 billion return to shareholders and the guidance we're giving you is that we see our leverage and our debt increase over the next two to three years by roughly C$3 billion. So these are not inconsequential numbers, but my view is the following. We have a very transparent financial policy, we are changing our targets away from adjusted debt ratio to coverage ratio, which means that over time we have the ability to leverage. The key word is gradual. We're paid to invest back in our business, to find niche acquisitions, to grow the business and we return excess cash and then some to reward shareholders. I think on balance it's a good recipe.

And Claude, how much would you, if you want to do an acquisition, where could you step it up to and feel comfortable?

We're comfortable with having a strong investment grade balance sheet that allows us to do what we have to do in a capital-intensive business?

Is there anything out there in terms of geographies or networks or services? I know you probably can't talk about it, but is there anything out there in an ideal world that you would say, geez, we would love to that?

Any railroad that we could get our hands on at the right price, as long as it extends our network and we can deploy our business practice and pay the right price. It's a recipe that we have shown can work for CN shareholders and customers.

Okay. Last one, if I may. In light of the UTU settlement and with reduced guidance, I know it's something you're constantly working on, but is there any areas where you could step up cost reductions at all, where you've probably already tackled the low-hanging fruit, but is there anything else out there that you can do in the next 12 months?

David, I don't think there's not any huge big initiatives, there's not any low-hanging fruit left. There's a lot of smaller initiatives. As you get down in the range we're in, it's a little harder to step up and make those kind of significant improvements, but there are a lot of initiatives going on. We have, for an example, we have explored internally that we were, in my view, paying too much for contracting out and so we have been insourcing work, which we think -- I'm not in through the per employee, I'm trying to lower expense. If we can add people and get rid of contractors and be more effective, we're going to do that. The operating initiatives that I mentioned about in the west, there are several initiatives going on in the U.S. and throughout. And so is there still some improvements to be made in the operating performance, yes, but there's not anything that you're going to write an article about.

Excellent. Thanks, guys.

Thank you. The next question is from Walter Spracklin from RBC Capital Markets. Please go ahead.

Thanks very much. Good afternoon, everybody.

Good afternoon.

Just a question to Claude on the move to sort of a coverage ratio away from -- as a percentage of your total capital. How much of that -- can you explain the motivation behind that? I do think it makes sense, but how much is sort of the private equity aspect of things encouraging you to look at your debt ratios a different way and some of your motivation behind that change.

It's not the private equity, Walter, it's more the signal that we get from capital markets and the fundamental underlying improvement in the rail sector profitability. As you get to a point, where not just CN but the rail industry in general is cash positive and the strength and the beginnings of a clear story of a secular shift, you have the ability with that profitability to incur a little bit more leverage and to lower your taxes, improve your capital structure, and that's what we're doing very responsibly in a manner that's not -- we're doing this on our own basic view of where the world is going and how we can create value for our shareholder, not by reaction to private equity or anything like that.

Okay. Next question for Jim. You mentioned that Halifax is seeing some lower volumes in the customer shipping to another port. Are they going back to west coast port, or sticking on the east coast?

No, that's a result of some consolidation within the steam ship industry that resulted in some shift from Halifax to Montreal.

Okay. So you're not seeing any -- the question, I guess, is with some of the lower volumes, is the idea of the congestion mainly Long Beach, L.A./Long Beach coming off a little bit that makes Halifax perhaps a little less opportunistic and are you at all concerned at how that may play an important in Prince Rupert given the dynamic in congestion is the main draw for Prince Rupert?

No. I think this is clearly just a -- this is clearly just a blip here on the screen. Everyone is still talking about huge Asian demand. And the ports are not able to accommodate that, so our strategy of developing Prince Rupert Phase 1 and Phase 2 as well as looking at import traffic through the east coast of Canada as well as the Gulf Coast is going to play out.

Okay. One last question, if I may. The CN worldwide, if you have the opportunity there, is that something you can only grow -- Hunter, perhaps you can talk to this. Is that something you can only grow organically, or is there a potential to make some acquisitions here to get up to speed a little quicker on your initiatives on CN worldwide?

What the opportunities are and what we would do are two different things. Clearly, there will, I think, be opportunities in the future. We'll have to view those and see the prices and look at the value creation and this is something that we're taking little small steps with. We're being relatively cautious, but down the line, I'm not talking about fourth quarter, but two, three, four years out, I think there's some real exciting strategic opportunities for us potentially.

That's great color. Thanks, guys.

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

Thanks. Evening, all.

Hi, James.

First question on head count, head count was up in the quarter. GTMs were down, so you lost some productivity here. And I just want to understand is that more a function that you figured volume issues were transient, didn't want to scale back, or is this more a function of, Hunter, as you discussed bringing work in house, or is it a head count ramp ahead of Prince Rupert.

I think it's a couple things predominantly. It's, one, it's bringing work back in and hiring people and getting rid of contractors where we can have a better quality worker and something we can control. I would point out also that we're anticipating very heavy attrition rates the next two or three years and we have in excess of 530, 540 people now in training. So just that training issue and the contracting in, if you looked at, we'd be down as we have trended in the past.

Oh, thank you. Quick question, Jim, on grain. '06-'07 was strong due to high quality and a very strong carryover from the previous year, so 6% above a five-year trend is going to be a tough comp for Canadian grain. Do you expect that the strong U.S. corn will provide CN overall with the ability to drive a positive volume comp for '07-'08 crop season?

I think that the new crop, which is still should be higher than last year's crop in Canada coupled with, although not the very high carrier-in we saw the prior two years but a relatively high on an average basis carry-in, will give us a very good base to work off from in Canada. So I'm expecting that our volume, especially if we have more reasonable -- a more reasonable operating conditions due to the weather this year than last year should be a good year for us going forward with a Canadian crop. Then that will just add to that on an additive basis, the good corn crop in the U.S.

Okay. Does the new arrangement in terms of the rate on regulated grain in terms of, there's a bit of a clawback for maintenance on the grain hoppers, does that change the revenue picture for you at all, or were you kind of anticipating it?

We were anticipating -- we were anticipating a rate increase reflected in our numbers and this whole issue of the retroactivity is something that will have to be hashed out as we go forward.

Okay. Many thanks.

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

Hi, good afternoon. Claude, I just want to jump back to that C$40 million charge on the Fila legal claim study. Is all of that a one-time catch-up, or is some of that ongoing?

No, it's a continuation of the good efforts we are making. The actuary reflects the progress you're making on the severity and the frequency of your claim, both of which in our case are going down. When he does that, though, he reflects it in his book of all the claims, and that gives you a one-time trueup or a one-time truedown or credit, which has been helpful in the second quarter. But just to give you an order of magnitude, we anticipate our run rate of legal claims as a result of the recent trends to improve by C$20 million on an annual basis. That's recurring. But there is a one-time truedown, which is lumpy and is helpful in this quarter. You take the good and you take the bad.

If it's a run rate of C$20 million a year and there's a C$40 million catch-up, you said you -- I want to make sure, you marked to market this every two quarter, you said, right?

The Fila claim is every two quarters, the occupational disease every year.

Okay. Jim, on the forest product side, it looked like volumes were actually a little bit weaker than we had expected. I know you had talked last year even with the decrease in housing, you had said that with the beetle issue, you were going to see pretty decent volumes. What differed from your expectation at this point on the forest side?

I think that the difference that we're looking at now versus almost a year ago now when we started planning for this was the impact that the Canadian dollar would have on the paper producers. So our declines that we have seen have been mostly in eastern Canada where the infrastructure is not as efficient and monitored as it is in the west. So most of the strategy, other than the magnitude of the decline in paper is where we have seen -- not seen the increase we thought.

Okay. Can we get an update on, Hunter, I guess on where you stand with the employees on the negotiations obviously with the settlement with the UTU? You obviously have continual contracts rolling over. Can you tell us what is -- anything major on the docket to come?

I would not call it -- I don't want to slight anyone, but nothing major. We have the steelworkers coming up in the fall, I think, which is the maintenance people, and we have the communications people coming up not long after that. But I think that I would refer you to this. If you want to get some reading as to where those might come out, I would you refer you to read the arbitrator's award, because it's very -- I think his remarks are very appropriate and kind of send some signals to both of us.

That's helpful. Thanks for the time.

Thank you. The next question is from John Barnes of BB&T Capital Markets. Please go ahead.

Good afternoon, guys.

Hi, John.

Can you guys quantify at all your start-up costs year-to-date associated with the Prince Rupert? More importantly, as you look at the fourth quarter, Jim, your comment in terms of wanting to be sold out when you get up and running in October. Is that a requirement for Prince Rupert to be profitable in '08 or can you be modestly profitable given what customers you've already secured?

Well, to answer your first question, I don't think we have any kind of number that we could give you in terms of start-up costs. Certainly from our perspective, insignificant because it's developed by the port as the footprint out there, developed by the port authority and Mar's responsible for putting the material on top of it. So very little cost on our part. Two, I think where we stand today in terms of my hope and my desire and my plan to have this facility sold out in October would be an overachievement from the guidance that we have presented in the past in terms of what we think our revenue stream from Prince Rupert will be in 2007. We have certainly not -- we have certainly not planned for that in our financial model, because even though I think that we can achieve it, it would be -- and I hope that we achieve it -- that would be pretty significant to have your facilities sold out before you open the door.

Okay. As you look to get started, will there be any one-time costs, maybe in August, September as you begin to locate equipment and employees and that type of thing there, or -- and if so, is that already encompassed in the guidance that you provided?

John, let me make a couple comments here. Jim's right. The port did and the terminal operator did the footprint and the facilities. We made some obligations relative to BC rail sales of adding some modest infrastructure improvements of about C$15 million, if I remember correctly and we said also that we would make some clearance improvements on that route that would give us the ability to not be limited in our clearances and that was another C$15 million or so.

Now there's a lot of things going on with growth up there in that area besides just that intermodal facility. The backhaul stuff, the grain -- a bigger percentage of grain each year is moving to Ridley, the coal business. So we have purchased or are purchasing some additional locomotives, but they're not associated directly with the Prince Rupert facility. Clearly, we're going to have to have so many locomotives if we're going to gain that business, but that was mostly an infrastructure outside of Rupert.

Okay, all right. Very good. Just a follow-up on to the question that was asked earlier in terms of the PE money that's floating around out there. Just given the level of activism, and Claude, to your comment about the signals to your capital markets, was there any direct signal towards CN specifically that was the impetus for the share buyback or is it just the general comments being made by the investors or some specific activism that took place that was the impetus for this?

No activism. We're very, very thorough in our approach. In fact, when we met with you in Toronto, we told you that we would go our board several months ago. So we're just carrying on on our plan and it's reflecting our belief that the company will continue to generate strong cash flow and our belief that we can reward shareholders by optimizing our capital structure.

Very good. Nice quarter, guys. Thanks for your time.

Thanks, John.

Thank you. The next question is from Jacob Bout of CIBC World Markets. Please go ahead.

Good afternoon. Had a question on the backhaul at Prince Rupert. Maybe you could just talk a little bit about how successful you've been in booking that and what you're targeting there for your -- for the percentage booking in the backhaul?

So far we've been successful in terms of the development of the facility that we've talked about in the past, building a grain stuffing facility that we operate ourselves in the prairies. That facility is almost sold out to its capacity. We've announced the development of an additional facility to do backhaul stuffing of paper and lumber products in Prince George. That is in the process. We are building a facility near Chicago to accommodate stuffing containers with the DDG, the by-product of the ethanol production, and we think that will do very well. So we're very aggressive in expanding, on our own and in partnership with others, these capabilities across our network. We have a lot of interest in that and our target would be to probably get about 50% would be a reasonable -- right now, that's our target to try and get about half of the containers moving back, filled with some product.

And do you have anything booked right now?

Like I said, we're -- we built a grain-stuffing facility about a year ago in the prairies and that facility is already filled up. There is a lot of product today that gets put into a container somewhere else before it goes back. Our strategy is to find that opportunity and put the facility in place so that it moves back on our railroad. And then hopefully, we can actually do through our CN worldwide North American and operations team, we can actually do the stuffing ourselves and not only get the rail revenue, but get -- make a buck in the process of stuffing the container at the same time.

Okay. Switching gears here, next question would be on the port of Halifax here. Maybe just remind us, what kind of capacity utilization rates you're at right now and what you're expecting for intermodal growth there say over the next two to three years?

I think the capacity of that terminal right now is probably at about half. Their numbers have moved around recently, but I think the port authority there has said they have about 1 million TEU capacity there and they're probably doing about 500,000 now. 500,000 TEU seems like a lot, but if one major steamship company were to change its port of call, they could suck up that capacity very quickly. I think the big strategy there and the one that we're all focusing on is as more and more imports come to North America from India, as an example, that clearly, when the utilization of the Suez picks up, Halifax will be a key drop-off destination point for movement further into the U.S. And there are currently initiatives underway to build additional terminal capacities on Canada's east coast, similar to the project that we have developed in Prince Rupert.

So rough ballpark here, would you be looking at mid-single digit growth rates?

I think we're going to look at, I think it's going to be a stairstep. I think you're going to see two times GDP, which is the intermodal average run rate with -- like I say, when a steamship company decides to call there and it suddenly goes from two times GDP to 22 times GDP. So we're very optimistic about the future there and believe that over the next few years the capacity in Halifax will probably be sold out as well.

Okay. And then the last question just on a the housekeeping side. This EPS growth rate guidance that you've given, does that include the share buyback being completed on an orderly basis?

That's always the assumption we've led you to use, that we will buy pro rata, but we are opportunistic and sometimes we front load. Today, you should be assuming we'll buy the -- we'll execute on our program on a pro rata basis.

Great. Thanks, guys.

Thank you. We have time for one last question. Randy Cousins from BMO Capital Markets, please go ahead.

Claude, for you, you indicated that -- or I guess Hunter as well, indicated that you guys are trying to bring in-house some of the costs. So when we're looking at purchased services, it includes obviously the materials that you would use, but is also -- presumably you're going to lose some of the money you're writing to outside service providers. What should we be looking at as a run rate for purchased services given the kind of things that you're doing?

Again, I always hesitate to give you a run rate other than categories that are very lumpy to help you come up with your own assessment of the expense categories going forward, but the reality is so much can impact the run rates from exchange to inflation to everything else, including the fact that our purchased services now include the services that are purchased by our subsidiary CN worldwide, for instance. We get the revenues on a growth basis. We also get the expense on a year-over-year basis increasing as they're growing their business. So purchased services will continue to increase in line with all of these thing, but we are focused on gaining productivity and making our unit costs go down and growing at lower incremental costs and so we think this expense category will be well behaved going forward.

So if we were to model this thing, would it be best to model it as purchased services per RTM and assume that it grows at less than the revenues per RTM?

The best way to handle this one, Randy, would be to take it offline. Because I don't know the answer to your question, to be honest.

Okay. Second question for Jim is, given the escalation in the U.S. dollar or the Canadian exchange rate versus the U.S. dollar and the desperate work on the part of the container line, global container lines to avoid in-line transportation costs, what's that doing to your about to raise international container rates or should we be modeling much more modest outlook for growth in yield on intermodal?

I think the transportation market for container shipment is very strong. The demand is very strong and we've seen price increases pretty consistent amongst all of our business units and would expect that to continue.

So you don't see the dollar impacting the intermodal business more than any other part of your business?

Not at all.

Okay, great. Thank you.

Thanks.

Thank you. The question-and-answer session is now closed. I would like to return the meeting to Mr. Hunter Harrison. Please go ahead.

Well, thanks so much for joining us, and we're looking forward to a real positive outlook for second half as we explained and we hope to report that to you the next time we meet. Thanks.

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