Canadian National Railway Co (CNI) 2012 Q2 法說會逐字稿

Good morning, ladies and gentlemen. CN's second-quarter 2012 financial results conference call will begin momentarily. I would like to remind you that today's remarks 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 CN's second-quarter 2012 financial results press release and analyst presentation documents that can be found on CN's website. As such actual results could differ materially. Reconciliations for any non-GAAP measures are also posted on CN's website at www.CN.ca. Please stand by; your call will begin shortly.

Welcome to the CN second-quarter 2012 financial results conference call. I would now like to turn the meeting over to Mr. Robert Noorigian, Vice President Investor Relations. Ladies and gentlemen, Mr. Noorigian.

Morning and thank you for joining us for CN's second-quarter 2012 financial results. I'd like to remind you again about the comments that have already been made about the forward-looking statements.

With us this morning is Claude Mongeau, our President and Chief Executive Officer; Luc Jobin, Executive Vice President and Chief Financial Officer; Mr. Keith Creel, Executive Vice Presidents and Chief Operating Officer; and Mr. J.J. Ruest, Executive Vice President, Chief Marketing Officer.

In order to be fair, as we have done with the other quarters, could you please limit your questions to one each? And with that it's now my pleasure to turn the call over to Mr. Claude Mongeau, our President and Chief Executive Officer. Claude?

Thank you, Bob, and thank you to all you for joining us bright and early on this call. It is sunny in Montreal and the leadership team here at CN is pleased to be with you to discuss our results. I think our second-quarter results show a lot of strength; we are very proud that our team of railroaders has been able to deliver strong operating service and financial results throughout the quarter.

If you look at the key highlights, our revenues are up 10% on a year over year basis. If we look at them on a constant currency basis, we were able to accommodate that growth at very low incremental cost and the proof of that is our operating ratio at 61.3%, which is the same as what we did last year.

You bring these two elements together and that allowed us to show for an adjusted diluted EPS of CAD1.50, which is up 19% over last year, and free cash flow was -- for the first six months was just over CAD700 million.

So clearly, again, you look at it from a service standpoint, you look at it from an operating standpoint, and Keith will discuss some of those trends in a minute, and you look at it from a financial standpoint, our agenda is working, we do have momentum and we are pleased with these second-quarter results at this point in time. So, Keith, over to you.

Okay, thanks, Claude. Listen, as we close out the first half of 2012 I'm not going to hesitate saying I'm extremely proud of our operating team's performance in the second quarter. Our team produced solid results in what proved to be a record quarter in CN's history. We've moved more traffic than we ever have before, handling on average over 1 billion GTM's per day.

Intermodal, automotive, coal, petroleum and chemicals in our metals and minerals business units all registered double-digit gains in revenue ton miles driven by economic growth, market share gains and a labor disruption at a key competitor. And I would be remiss not to point out that we handled this record volume while continuing to gain traction in our service and operational excellence agenda.

So let's spend a few moments reviewing the highlights of the key productivity metrics we speak to each quarter. As you can see, the team produced year over year improvements in virtually every productivity category, we're moving bigger trains, handling increased volumes through our terminal 7% faster, we are using less yard resources per car handled.

These improvements in yard productivity again, I'll remind you, are being done at the same time we are absolutely focused on improving the reliability of our first mile/last mile performance. Locomotive productivity improved and car velocity, I will note, is at record levels. And again, this is being accomplished against a backdrop of our improved customer service in terms of car supply performance which is helping drive a lot of our revenue growth.

In the second quarter we achieved 96% [carload] fulfillment performance and provided empty cars by the requested date and time to our customers with an 86% reliability level. The only metric we didn't see improvement on is our industry train speed, which, as we all know, is a standard AAR metric that measures train speed performance and, emphasis added, terminal to terminal.

As you can see, while absorbing over an 8% GTM growth second quarter this year versus last we were down slightly. This is driven more specifically by line segments where we've experienced concentrated significant growth in 2011 and again in 2012, which has created a strain on our long train line capacity which impacts this metric.

One meaningful example of this is our BC North territory running to Port of Prince Rupert where in large part coal, grain and Intermodal growth has driven 13% volume growth in 2011 and an additional 17% in 2012, so effectively 30% volume growth in a two-year time span. To manage this growth we are in year two of a four-year capacity improvement plan.

We've got seven additional long [sightings] that will come online late third quarter, early fourth quarter this year that will increase our long trade capacity which obviously will help us drive our industry train speed back up and at capacity for continued growth in this key corridor.

So with that said, we have and will continue to report industry train speed externally to allow an apples to apples comparison to other roads. But, in line with our supply-chain and then mindset at CN, we have also established a network train speed measure two years ago that is an all-inclusive train speed measure which is meaningful to speak to.

So whereas industry train speed excludes time spent in terminals or at crude change points, network train speed does not; it captures both road and yard time for our trains. What is meaningful about this at CN is that during the same time we were slightly down in our industry train speed, we made gains on network train speed in spite of this GTM growth that we've experienced across our network. Our network train speed actually improved just under 3% quarter to quarter despite this growth.

So the network train speed improvement, what it's done for us is help us fuel some of the additional customer flexibility J.J. and our marketing team are converting into carload growth. At the same time it's contributing to improvements in our core metrics that you see in car velocity and locomotive productivity.

Another example of investing in our network for the future are the upgrades that we continue to pursue in the Chicago terminal leveraging the benefits of our EJ&E transaction. Work will be completed this year on several more key connections which will enhance our already very reliable and efficient rail corridor around the city of Chicago that connects the Northeast, South and Western portions of our network to one another.

In line with these improvements we are working closely with our rail partners in Chicago developing new interchange agreements that make use of this new infrastructure, which improves the efficiencies of the traffic flow between CN and our connecting carriers in this key corridor.

Beyond the connection side of this transaction, in August 2011 we announced our plans to invest CAD165 million over four years to expand Kirk Yard. I'm happy to say that this work is well underway. This fall we'll complete reconstruction of our [hub] facility which will add more capacity to help additional cars. Currently the capacity is about 1,000-1,200 cars; we are creating a yard that will have a capacity to hub consistently 2,500 cars a day.

Effectively we are going to expand receiving and departure tracks in line with this expansion this year as well, then open our new administration building there in the facility. This sets the stage for Kirk to be a significant player for us as a key switching facility in this key Chicago corridor, allowing us to consolidate our switching activities to this efficient modern facility.

These types of strategic investments continue to position us well for the growth that J.J. and his team continue to deliver on. So with that I will turn it over to J.J. to expand.

Well, thank you, Keith, and thank you for moving 1 billion GTM on average per day during the second quarter. And good morning to everyone who is on the phone with us today. In the next few minutes I will review the revenue, give you an outlook and I will also touch on some initiatives that we have to give you more color on how we intend to keep growing the top-line.

As Claude mentioned, the second quarter was really solid, not only our strategic engines working, but we also had a phenomenal strike performance during the CP strike. With only 72 hours Keith and my commercial team jumped into the fray serving pre-selected trusted partners and producing an incremental CAD40 million.

In summary, the second-quarter revenues were up 13% versus last year and 22% versus 2010. About 5.5% came from volume, the RTM increased 8%, the length of haul was up 7%, and the carload was up 4%. Same-store price on same-store sales increase almost 4%, in line with our guidance of inflation plus pricing. 2% came from fuel surcharge; mix was slightly negative; and, finally, the 3% came from exchange. The Canadian dollar was CAD0.043 weaker this year. All in all a solid quarter.

Now let's review the revenue by segment and, as always, I will do that on an FX adjusted basis. Starting with petroleum and chemical revenues which were up a big 16%. The length of haul between P&C was up 9%, therefore producing solid RTM growth of 14%. We had some brand-new long-haul crude movement as our team initiated sales from two new crude loading stations, one of them in Sexsmith, Alberta, the other one in Unity, Saskatchewan, both shipping conventional heavy crude.

By using rail small- and mid-size crude producers get a better net back for their barrel. That is why they use rail, for better net back. (Inaudible) revenue increased 8%, but the (inaudible) carload decreased at the end of the quarter. Metals increased 4%, but was up 28% versus 2010. We experienced sustained demand from the automotive sector, energy and industrial construction in Alberta.

Minerals was up 34% from last year and 51% from 2010, a phenomenal progression, namely in frac sand and construction aggregates. Forest product revenue was up 6%, the US housing starts drove a 13% increase in our lumber and panel carload to United States. Automotive revenue gained 15%, our carloads were flat, but the length of haul was up 15% producing our nice RPM volume of 16% higher.

The story for coal remains exciting, supported by our infrastructure export supply-chain strategy. Core revenue was up 13% in the quarter driven by a 14% increase in revenue ton miles. The 30% drop in our carload of domestic terminal coal was made irrelevant by the success of our export strategy. In any event, the domestic coal is now only about 1.5% of the total CN book of business.

Pet coke from the Oil Sands also increased 25% in carload using our recent Fort McMurray infrastructure investment. Canadian grain revenue was down 3%, US grain revenue was down 6%, we had weak export for corn and pees, but we had good export for Canadian barley and Canadian canola. Fertilizer was almost flat, the North American market is still soft, but we moved the Canpotex exports during the nine-day CP strike.

Overseas intermodal remained very strong and sustained. Our revenue came in 15% up from last year and 35% up from 2010. The CN transpacific volume outpaced the North American West Coast run rate average again and Rupert is just a phenomenal product in the marketplace with very strong support from service sensitive (inaudible). On the East Coast our Trans-Atlantic business was flat.

Domestic revenue was also just as robust as the overseas revenue. We had a 14% increase over last year and 30% increase over 2010. The domestic story is quite simple; it is driven by new product, new geographic coverage and new services. On the operating side of intermodal our train length was up 2% and, even more relevant, our revenue (inaudible) per train was up 4.5%.

But all in all, what is truly driving our growth is our people. We have one of the best teams in the industry.

Now if we could move on to the outlook and I will start with the page on intermodal. For CN the second half outlook is positive, the overall fall peak will be higher than last year, but will only be somewhat higher. On the West Coast the CN transpacific supply-chain should outperform the market again. On the East Coast we have weaker European fundamental and the growth will be less.

On the bulk, I'm now looking at the page on bulk on the outlook; I would like to start with giving you an update on our coal export initiative. When we sold the Convent terminal in 2011 our strategy was to have it expanded into a major coal export play. We were targeting 8 million tons of export within a few years. We are well ahead. In 2012 we are on pace to do about 7 million tons which would be about CAD50 million of incremental revenue over 2011.

On potash we now have a solid long-term partnership with Canpotex which is in place as of the 1st of July. Asian demand for Canadian met coal and for Canadian Oil Sands pet coke remain in place. In the US electricity production from natural gas is now in the range of [30% to] 32% of the total production which is same -- almost same as with coal.

In my opinion the hot summer will not reverse the fundamental trend. Cheap natural gas is the new normal, therefore the thriving coal producers of the future will be those with further production cost per Btu and those with solid export solutions already in place. The US Midwest heat is burning the corn crop and, versus last year, our corn will be worse. However, the bean might be better.

I took down my second half internal forecast to be more in line with last year revenue on US grain. The Canadian crop looks good and we do have a higher carryover from last year which is what we are moving in July and August. Our fleet is pre-inspected, pre-deployed and ready for record. With the Canadian wheat borne monopoly coming to an end, the October to December fall peak, we believe, might be more pronounced.

Now looking at the outlook for the manufacturing sector. First an update on our frac sand initiative. As an example, we are close to investing CAD35 million in Wisconsin to reopen a 40 mile subdivision and serve some new frac sand plants to be open by year end. More of the detail is coming later in the weeks to come.

Regarding our crude by rail initiative, you will remember that you have seen our press release in conjunction with Southern Pacific putting a new supply chain in place for markets underserved by the pipeline industry. The bottom line is better net back per barrel is why producers use rail, and this year we are tracking to be about CAD140 million above last year in crude by rail by year end.

Paper is in its usual circular decline. Iron ore and sulfur will decline but eventually will cycle back up. The automotive revenue will be strong but strong from an RTM point of view while the carload will be near flat. Lumber and panel will be strong driven by US shipment and we also still have five to seven panel mills idol in CN, this is about 15,000 carloads -- old cars, if you wish -- waiting for the future development in the US housing starts.

I also want to make a general statement on our volume outlook. Iron ore and domestic coal carload will drop, but long-haul export coal, long-haul crude by rail and long-haul intermodal will overcompensate in RTM volume growth. To understand CN's true volume growth in the second half you will need to pay more attention to our weekly revenue ton mile.

In conclusion, another solid quarter, phenomenal strike performance, positive volume outlook ahead and more proof point that our strategic agenda is working. Now I would like to take it over to Luc.

Good, thanks very much, J.J., and good morning to everyone. Now turning to page 14 of the presentation, let me walk you through the key financial highlights of our quarterly performance. Revenues were up 13% to CAD2.5 billion, and that is 10% on a constant currency basis.

The moderate growth in the economy and volume gains during one of our competitor's strikes constituted a favorable set of conditions in the quarter compared to last year. J.J. and Keith and their teams combined efforts to help us achieve solid volume increases in practically all commodity sectors. And once again, several categories performed better than base market conditions.

Operating income was CAD985 million, that is up 13% versus last year, driven by strong revenue growth handled at low incremental cost. In fact, our operating ratio for the quarter was 61.3% and that is in line with what we had seen last year.

During the second quarter we had an unfavorable one-time tax adjustment of CAD28 million or CAD0.06 of EPS. This was needed to adjust our deferred income taxes as a result of the enactment of higher future provincial corporate income tax rates. But this was also partly offset by a small tax recovery resulting from the re-capitalization of a foreign investment.

So, our net income for the second quarter of 2012 was CAD631 million, up 17%. And the reported diluted EPS was CAD1.44, up 22%. Excluding the one-time tax adjustment the adjusted diluted EPS for the quarter stood at CAD1.50, that is a 19% increase over 2011 and that is up 17% on a constant currency basis. The impact of the foreign currency was actually CAD13 million favorable on net income or CAD0.03 of EPS in the quarter.

Even when excluding the favorable foreign exchange the Fuel Act benefit, which was actually about CAD0.04 per share in the quarter, and the CP strike, our adjusted diluted EPS would be up about 10% versus 2011, which actually is remarkable given the pension headwind that we have been facing this year and given a very modest economic backdrop.

Now let's turn to the operating expenses on the next page. As Keith pointed out, we came through with another solid quarter in terms of operational productivity and customer service. Yet this performance did not come at the expense of overall cost management. Our operating expenses were CAD1.558 billion, up 12% versus last year or 10% on a constant currency basis. At this point I will refer to the variances in constant currency.

Labor and fringe benefit costs were CAD504 million, that is up 15% higher than last year. The overall wage cost was actually up 6% and this was the result of wage cost inflation of about 3% and a 2.5% higher headcount in the quarter versus last year.

Our average headcount was just over 23,745 employees, so up 2.5% while at the same time we were growing our GTM's by up to 8%. So the headcount dynamics continue to be driven by advance hiring ahead of attrition to allow for training along with our assessment of future volume growth.

Meanwhile fringe benefit costs, including pension, accounted for 8 percentage points of the increase mostly due to the amortization of the accumulated actuarial pension losses as expected. This also included a higher stock-based compensation expense which was 1 percentage point unfavorable during the quarter.

Our purchased services and materials were CAD305 million, up 12%. This was mostly a factor of higher volumes leading to more repairs and maintenance and higher contracted services relating to non-freight volume increases. The fuel expense stood at CAD379 million, an increase of 3%.

Higher volume represented 8 percentage points of the increase in the quarter, but this was partly offset by lower price and improved fuel efficiency. Actually the fuel efficiency was favorable 1.5% which is very good given the much higher intermodal volume that we carried during the quarter.

Casualty and other costs were CAD81 million, up CAD19 million versus last year as we incurred higher expenses relating to environmental issues, and we also reported higher personal injury claims costs resulting from an actuarial study that we had done in the quarter.

Turning to free cash flow -- in the first six months of the year we generated over CAD700 million of free cash, this compares to CAD823 million last year. The difference comes principally from higher net income and lower tax payments, offset by higher working capital which mostly resulted from the voluntary pension contribution of CAD450 million which we made in the first half of the year this year versus last year it was actually done in the second half.

Our balance sheet remains strong and our debt ratios are well within our internal guidelines. We also bought back 4.5 million shares in the quarter and we now stand at about 75% of our stock [back] program for the year, which is supposed to end at the end of October for 17 million shares.

Finally, let me speak to our 2012 outlook. We continue to see modest improvements in the North American economy. While we do not assume at this point a significant change to prevailing conditions, there is a risk that things could slow down somewhat in the second half of the year in North America. Obviously we are also keeping an interested watch on China as it attempts to reenergize the pace of its economic growth.

All in all we are still looking at mid-single digit carload growth in 2012 and pricing above inflation. But we do have more difficult comparatives in the second half of this year as we grew revenues by 9% and 12% in the last two quarters of 2011. With this in mind we are now revising upward our guidance.

On the basis of our strong performance in the first half of the year, and assuming continued positive economic conditions in the second half of 2012, our annual 2012 guidance therefore now has us aiming to deliver double-digit diluted EPS growth of up to 15% over the 2011 adjusted diluted EPS of CAD4.84. And this despite the pension headwind of CAD100 million that we are facing in 2012.

This implies high-single digit EPS growth in the second half of the year, but keep in mind that we will be lapping strong EPS growth in 2011 of 16% in the third quarter and 20% in the fourth quarter. We are also calling for free cash flow to be in the order of CAD1 billion; this takes into consideration our capital investment program of approximately CAD1.8 billion.

It also considers a potential additional voluntary pension contribution in the order of CAD250 million which could occur in the latter part of 2012 and this on top of the CAD450 million that we have done earlier in this year.

Given that we are on the topic, allow me to say a few more words on the pension area. As you know, interest rates continue to decline and market returns have been both subdued and volatile.

In fact, on the basis of current conditions we foresee another pension headwind for 2013 of the same magnitude that we experienced in 2012, so in the range of CAD100 million. This would bring our pension expense roughly in line with our cash contributions for current service costs which is approximately CAD145 million.

In any event, in closing we are very pleased with our second-quarter results for 2012 is also lining up to be a good year and we maintain our focus on delivering superior returns no matter what economic conditions we have. On that note I will turn it back over to you, Claude.

Thank you, Luc, and the team. As you can see, the team is clearly ready to seize on opportunity and we have shown that in the second quarter. We did achieve record volume in terms of throughput during the second quarter, the best performance this railroad has ever seen.

In fact, if I look at the first six months of this year, each and every one of those months on an RTM basis have been above our previous peak in the history of CN. We have also had record operating and service metrics and this is what drove the excellent financial results that we have just explained to you.

The confidence we have based on this first-half result is what allows us to have a revised outlook which is upward from previous guidance. We are confident if the economy holds that we can get close to that 15% EPS growth on a year over year basis and deliver that CAD1 billion of free cash flow even though we will have to most likely contribute another CAD250 million for our pension contribution.

So all in all, clearly our strategic agenda is gaining momentum. We are delivering shareholder value. Our agenda to help our customers win in their end markets with industry-leading service and supply-chain performance is what drives this performance and we see solid shareholder value for many years to come. With that, Ann, I will turn it over to you for questions.

(Operator Instructions). Turan Quettawala, Scotia Bank.

I guess my question is just a little bit in terms of the risk. We have seen the economic environment unravel a little bit here. Just wondering, your (inaudible) have been pretty solid obviously. Looking to the next six months which areas of your book do you think carry the most risks? Thank you.

J.J. can comment further, but I would tell you if I look at our volume performance -- and I extend into the beginning of the third quarter when I make these comments -- we are seeing constructive growth very much across the entire book of business.

Now that doesn't mean our customers are not mindful of the prevailing wins and focus on what could happen with the uncertainty that is out there, but certainly we haven't seen our channel checks, we haven't seen evidence yet of any slowdown except for the noneconomic sectors that J.J. alluded to -- the grain crop; the difficulties in the US, for instance, for corn; et cetera. The rest of our book of business is actually quite constructive.

That's right. Thank you, Turan; it's J.J. On the intermodal side we will grow both domestic and overseas. It may not be the most fantastic peak, but as we do usually at CN, we are going to be helping ourselves and the right. Whatever peak comes at us then do better than the average of the industry.

On the grain it is kind of good news bad news. Canadian is good news and US is bad news so we will take the two together. And on the merchandise and bulk side, as I went through the review I think you have seen some areas where we have legs and some areas other areas where there is some weakness. All in all, whether it's intermodal, bulk or merchandise, all of them should be growing in RTM and revenue obviously.

Great, thank you.

Bill Greene, Morgan Stanley.

I am wondering if you can comment a little bit about will there be any change in your marketing strategy or your operating strategy now that you kind of have a very clear idea of what the competition is likely to do since you work so closely with him. Does it create opportunities to collaborate more with them or does it create opportunities to sell against a reputation?

You know, Bill, as I said before, we have one franchise to manage and we got our hands full doing that and it is going well for us. The team has good chemistry, we have good momentum, we have a game plan that is pretty clear, we have a network reach and spend that takes us across North America and we are focused on delivering value to our customers day in, day out.

So we are obviously mindful of the changes at CP, we think it is constructive for the industry. I am convinced Hunter will focus on service and I know he is mindful of the value of the services we provide with all of our hard work. And we will just wish him and the rest of the CP team good luck and focus on our own agenda.

Yes, I just didn't know if there was a place sort of collaboration where you could end up with maybe some operating gains that we hadn't thought through. But that was all.

Benoit Poirier, Desjardins Capital Markets.

Congratulations for the good quarter. Could you maybe give an update on the opportunities in Northern Quebec with the [plan now], more color about the milestone and also in terms of timing.

Yes, thank you, Benoit, that is a good question. We focused on our second-quarter results and we deliver value day in, day out. But we also have to have a pipeline of longer-term opportunities and this is clearly one of those with the Northern Quebec Labrador Iron Ore (inaudible).

We have been at it, working very hard with the miners that are looking to develop mines in that territory for almost a year now. I think we have a compelling offer that we have put forward with our partner Caisse de depot, and we do have a few mines that have signed up with us.

But we do need several of them to join us if we are going to be able to make it an economic undertaking, that is pay for the share in the -- pay for the feasibility study and ultimately share in the financing and the development of what would be a very significant undertaking.

I am talking here if it was the southern leg of that railroad we are talking in excess of CAD3 billion in investment. If it went all the way north of [Shekarville] we are talking in the range of CAD6 billion. So obviously large investments and we need the support of the majority of the mining customers in that territory.

At this point in time, despite the compelling offer that we put in place, it would seem that some think they still have alternatives that would be much cheaper than what we believe the cost of this infrastructure will be. Some may be a little bit -- and I hesitate to say it that way, but that is what it is -- free riding on the side, thinking that maybe CN will get moving even if they don't sign up so that they could share in the small cost of the feasibility study.

And so what we have done recently is effectively put a deadline out there, we will give it another week or two for people to sign up. If they do we would move forward, file an application, do the feasibility study and continue to update you. If they don't we wish them good luck and move on to other opportunities.

Okay, thanks for the time.

Walter Spracklin, RBC Capital Markets.

So my first question I guess is on sustainability. I mean you have posted what is clearly a very strong volume year here, part of it great railroad and great service, part of it some of the problems that CP is having. I think your guidance this year is in line with where everyone is expecting. The real question becomes the sustainability of some of those volumes, particularly on the intermodal side, given CP's efforts to recoup their lost market share.

My question is whether you can -- is there strategic assets that you have, and I want to point toward Prince Rupert in particular, that you can use to leverage or maintain market share gains because of that non-replicable service that you can offer going up to Prince Rupert? And is there -- and is that the right way to look at it and can you expand Prince Rupert further and do you have plans to do so if that is indeed the case?

I think, Walter, that Prince Rupert is certainly a key competitive advantage for CN, there is no question about that. And we are making good use of it. The terminal as of late has been running at an annualized run rate of more than 600 CEUs per year and there is the (inaudible) peak that J.J. is thinking about for the fall. We might get awfully close to that capacity at least on an annualized basis in Q4.

Rupert is investing, they are going to get another crane in the fourth quarter and we continue to see growth opportunity in that territory. But I would say that our agenda and our success in outpacing base market condition is much broader than just Rupert. We are growing our Vancouver Gateway very nicely. In fact, if you look at it at the moment, our Vancouver franchise -- our Vancouver relationship or corridor is just as large as Prince Rupert even to the US, in terms of US Gateway traffic.

We are growing beyond intermodal and gaining -- outpacing base market condition in merchandise. We are doing so in bulk, and it is not against CP, it's against -- it's our customers that are winning in the marketplace and it's against all railroads and it's against trucks. It's a broad-based strategy. It's anchored on a solid game plan, and I think it is highly sustainable.

Okay, that is great. Congratulations on a great quarter.

Tom Wadewitz JPMorgan.

I wanted to ask you, J.J., you've got a lot of positive things to talk about. I think you had a brief comment on capacity that could -- where you could see some volumes in the housing side and some idle panel mills.

Can you give us a further sense of I guess what you are seeing in terms of lumber or associated volume increase related to an initial move up in US housing market? And then if there is some further momentum how would you frame the opportunity, let's say, next year for what you could see on lumber and panel and so forth?

Thank you, Tom, and good morning. We do have still idle capacity in our line for even for lumber. We obviously have a lot of capacity in our line for panel, which I would broadly estimate depending on how many would come back, there was a demand of 15,000 carload annualized.

Another aspect also is that it could be some shift of lumber from Asia back to the United States. We did see in the second quarter a reduction in our carload to Vancouver going to China and some of that lumber going to United States because of better net back to the producer.

So when you add all these things, I mean definitely of Albany West is better because of the demand, definitely it's better because it is better net back to China at this point, so you have length of haul, you have idle capacity and that idle capacity is a little more prevalent in panel because panel had a bigger drop, if you wish, during the housing recession.

So the housing starts for us has been good the last two years. It has driven our volume in the US, especially lumber, on a consistent basis. We did some model for both panel and lumber as to what point we would be so-called sold-out with the capacity that we have in our railcar fleet as well as the sold-out in terms of when our customers' existing capacity would be sold out. And one does not need to get 1.5 million housing starts to reach these -- to get this capacity out in the marketplace. But we will see how the market evolves.

Thanks.

Scott Group, Wolfe Trahan.

So if we think about CN, you guys have been leading the industry by far on margins for years without much bulk business. It feels like bulk is really kicking in with long haul, export coal, now that potash starting to ramp up and crude oil. And the wheat board is going away too.

So once we get through these pension headwinds, should we think about kind of a step function in terms of potential margin improvement going out the next few years? Or are we not thinking about the potential implications of more long-haul bulk correctly? How do you think about that?

Well, Scott, let me make a few comments and then maybe J.J. will want to add to it. But essentially, again, we are showing some very good numbers in terms of operating ratio and we have been this year able to absorb the pension headwind. I did mention that unfortunately we are seeing a similar headwind showing up for next year, so we have our work cut out to continue to try to keep the operating ratio within the low to mid 60s, but again we will come up with the goods.

There is no question that the franchise has been very good and very strong and the shift to longer haul has helped us considerably. So I think it bodes well for us to stay within that sort of window of low to mid 60s and hopefully at some stage we can see interest rates coming up a little bit and we can have a little bit more air to breathe in terms of the pension pressure. But I still believe that is going to be around for the next couple of years and we have to deal with it.

If I may add, what we call bulk may not necessarily be unit trade. A lot of the grain that we move is actually moving in merchandise. And we also track our revenue in terms of train service and our train service on pure unit train, those RTM are up 10%. But the RTM also for the carload service, for example moving product cars, is also up 10%.

So when we say bulk, often we mean that from a commercial point of view. From Keith's point of view, to him unit train is -- there's a lot of bulk, so-called bulk that we don't move in unit trains. So we are not necessarily moving -- necessarily doing a big shift here.

That makes sense. How about the wheat board going away? Are there positive margin implications there?

The wheat board will be an important player in the marketplace. We understand they might be as much as 30% what they used to be and they will the one without assets. So we will change the marketplace I'm sure, time will tell more clearly.

One of the things that we think will happen is that when the market really heats up and people want to sell product, the peak will probably be more prevalent. Because the wheat board was really a pool type system where the farmer was selling to the wheat board and getting an average price over 10 months.

Now most other companies on the grain side don't do that, they do cash sales, they don't do pool sales. So people want to move into -- when the market wants to move it might move to a higher peak, and when the market is slow the market might move slower.

Although I would say that the capacity to peak -- and it's not a railroad issue, it is a supply chain issue when you look at the ports and all the pieces coming together there is a limit to what the supply chain can peek at. But I agree with J.J., we should see more, if anything, potential for efficiency over time. But the fundamental structure of the grand business is not changing because of the decision to move away from the [CWP] (inaudible).

It might be a good thing long-term, Scott.

Okay, great, thanks a lot for the time. Appreciate it.

Cherilyn Radbourne, TD Securities.

So you are at record workloads, which is pretty amazing, and the mix has shifted, which I think raises the question of capacity to some extent. And I realize that is a bit of a nebulous concept when you talk about a railroad. But if we set aside the BC North, is there anywhere else on the network where you foresee needing to put growth capital sometime in the next few years based on what you are seeing?

Yes, Cheryl, there are some locations that certainly we've got a plan to put some strategic investment into. Another key corridor of growth, that growth that is moving over the BC North territory, concentrated in large part because of the coal that originates BC North and terminates, so to speak, export at French Rupert.

But if you take the other business, the intermodal business, you take the potash business, a key corridor for us is the Winnipeg to Edmonton corridor. So we are taking -- we've got a plan to invest there. Actually I was out last week in the territory and rode a train from Saskatoon to Edmonton where we are bringing on a lot of that Canpotex business where we are making a plan to put some strategic investment.

As well in the south -- on the south end of the railway we have got significant growth with frac sand, with crude oil pipeline that is going to be going down to Geismar. So we are looking at that in conjunction with the Cline coal growth to put some strategic investment, Illinois South on the south end of the Roadway.

So we will see some sightings, we will see a little bit of improvement in our Harrison yard facility for servicing trains and then down on the Baton Rouge side in that industrial complex where it's effectively a long switching lead, we'll add some additional capacity to handle this growth with crude oil, frac sand as well as the coal.

Thanks for that detail, that is my one.

Thank you, Cherilyn. Just to add up to that, that's one of the key assets of CN. We have targeted investments to make to keep our network in sync with the growth, but we have a lot of available capacity on the line basis or our structural growth opportunity is significant across our entire network.

Christian Wetherbee, Citigroup.

Maybe just a quick follow-up to that. As you think about some of the opportunities to add incremental capacity, should we be thinking about CapEx any differently than we have? It sounds like they are going to be fairly targeted kind of investments. But I guess I just wanted to get a sense that you guys are kind of back at or at record volumes, how you think about CapEx. Does it change at all as we go forward over the next couple of years assuming continued growth in the economy?

Yes, I think -- I mean are view on CapEx I think was quite well described by Claude. We always try to anticipate where the business and where the puck is going to be heading and then to be prepared to handle the growth in a seamless and low cost fashion. So clearly we are looking at the capacity issues, we are looking at where business is going to be growing for us and I wouldn't at this point foresee any decline in terms of our capital expenditure program.

First and foremost we remain focused on the fluidity and the safety of our network so that is the base and that takes usually care of about over CAD1 billion. The balance is really to try to -- again, to prepare the network to handle the business and the growth and to look for these opportunities where we can continue to take this franchise to the next level.

So we have been -- we will be around the 18% to 19% of revenue in terms of CapEx, I mean that is kind of aware I think things should be heading for us. And I wouldn't expect anything significantly different otherwise.

Okay that is very helpful, thank you.

Fadi Chamoun, BMO Capital Markets.

So a lot has been discussed. But a question on the intermodal side. We are seeing a fairly big amount of investments going into the intermodal network in the US by your partner carriers there. I was wondering whether there were sort of meaningful collateral benefits for CN rail in terms of marketing some of the services you have on the international side from Canada into the US.

Thank you, Fadi, it's J.J. Yes, there might be. Definitely we like what we see, for example, some of the things that CSX did where they provide a good service connection from Chicago to go east and some of their yards that they have and the market they reach makes it attractive to come from the West Coast. We also look at what the KCS is doing and whether or not there's a better market to be connected between Mexico and Michigan and Eastern Canada that CN and KCS can capitalize.

So definitely some of these businesses might be network business beyond one railroad and I mentioned two here. And for us to be able to access a market that otherwise obviously we can't access on our own self. So there is some potential and these are being worked on.

Okay. The other thing maybe you can help us understand, the magnitude of the crude by rail pie looking out maybe two or three years out.

It could be quite a significant pie for CN, everything we do today by the way is all in merchandise service, we are very good at merchandise service and including that crude by rail is on merchandise train. It has been our fastest-growing revenue segment this year, we will see how next year is.

The crude producer like rail, especially for the thick viscous bitumen from Alberta because it does not require condensate which is expensive, and it gets them to market where they have access to the Brent pricing as supposed to WTI pricing, there is a huge gap between Brent and WTI. So it is not so much a question of transportation cost, it is a transportation cost when you back out the condensate and when you get to a market which is a Brent market as opposed to a WTI market.

So when you look at it from the point of view of the junior and mid-size crude producers, even more so those who are in Alberta from Alberta crude as opposed to Bakken crude, they are very focused on improving their net back. So there is real potential there.

I would add to this, Fadi, that we went from a concept a few years ago to aggressive trials by a number of customers over the last year or two to a real business now. As J.J. said, we see our crude business exceeding 30,000 carloads this year, that is more than 50,000 barrels per day. So it is already a small pipeline if you think about it this way.

And of course we see a lot of potential growth into next year, just the carryover of that run rate leaving 2012. What is happening is really a game of net back and we believe we are -- we can bring bottom-line value to these producers long-term. It's not just about matching a gap or an issue with pipeline to come, it is about supply-chain, it's about diversity and it's about real dollars to the bottom-lines of these producers.

That's right. We can execute very quickly, we have the rail lane, we have the capacity, we have all the permits, we can get product anywhere on our rail line and connecting to other railroads. The pipeline industry is challenged with execution -- finally. Thank you.

Okay, thank you.

Ken Hoexter, Bank of America.

Can you talk about on the strike volumes, did most of that kind of migrate back to its original source? Did you keep any of that? And I guess following up on that, with the Canpotex contract that kicks off, any update on the Prince Rupert access link?

Let me comment and J.J. can add the color. We were pleased to be able to help in the circumstance. Railroads are typical -- are an important supply-chain and we are a backbone to the economy. So when one railroad is facing a labor disruption the fact that the other railroad is able to step up and provide service in those circumstances is a good thing.

I am very pleased with the way J.J., Keith and their team came together to be able to do just that because it takes a lot of planning and a lot of execution focus and it does show the resiliency of our business model. We were able to deflect up for that two week period.

Now much of that business, except perhaps a few customers, much of that business is now back over to their natural carrier, but it was a great opportunity for us to showcase our service and we see it as a lead-in to a deeper relationship in the future.

A good example is Canpotex. We were able to show them during the strike again, and I believe that their owners, whether it is Agrium or (inaudible) or PCS, are all happy we were there to step in and protect their results in Q2. I believe Canpotex had a record export program in Q2 and for sure we were there to help them.

We are carrying that through with our normal contract at the moment and we are in discussion with them about Rupert and hope they will make a decision between now and year end. Everything is lined up, we are working on the road rail utility corridor, they are seeing at first hand the value of a diverse supply-chain with two carriers. And I think we will extend that to a two corridor strategy in dialogue with them. But it is their decision and they will make it on their own time line.

That is very helpful, Claude. If I could just follow up on grain yields. They are up about 3.5% at CN and over in double digits at CP. Would there be anything I guess, J.J., that we could read into that? Is it a mix difference or anything kind of contractually that you can kind of think of that causes a difference like that?

Ken, I'm not sure I understood the question. The difference in yields, what (multiple speakers)?

Grain yields for CN were up 3.7%, at CP it was up over 13%.

You're talking revenue per carload or --?

Yes, yes.

Okay, well our revenue per carload, I would -- all I would read into that is the mix length of haul. And I did a just my pricing, it went in the revenue cap in the second quarter, that would be in excess of the cap. So I took some pricing down to come in line with the regulation by August 1 and then August 1 we start a new year again.

So all there is in there is mix, timing issues and how we manage our revenue cap, it could be length of haul. In July our carload is actually quite up from last year because we do -- are still moving last year's crop, same thing in August. All that we are very satisfied with our Canadian grain and looking good for the coming season. Coming season should be good for most because the Canadian grain so far, and we are in touch crops, looks good.

Helpful, helpful. Appreciate the insight, thank you.

Jacob Bout, CIBC.

I was hoping you could provide a little more detail on the US drought and some of the hot weather that you are seeing there. So specifically thinking about the impact on ethanol, the movement of ethanol, grain and I guess there's going to be some -- we are reading a bit about corn coming up from Brazil. Are you seeing any examples of that? And then the barge traffic on the Mississippi with the lower water levels, is there a positive impact there as well?

Maybe if we start with the barge traffic. The barge traffic I mean is affected and it's not, it's all the same by region because there has been -- you remember there was a lot of rain in Minnesota. In fact I think [Keith] was challenged with some flooding that we had there on our (inaudible) network. So some areas had drought, some areas had a lot of rain and all of that eventually found its way to the Mississippi River.

So even though the Mississippi River at this point might be somewhat challenged on the level of water, it has not affected the -- I would say the rail rate but the rail volume, not so far anyway.

Corn looks -- it doesn't look too good. The USDA numbers will probably come down in terms of the acres per -- yield per acres when the revised numbers come out. So the official numbers are probably hire than what they really are. But I think the market understands that, it's dismissing that and that is why the price of corn is up. And has far as coming from Brazil, I don't know if that is going to be the case or not.

Regarding ethanol, definitely I think the carloads for ethanol for most railroads in the second quarter were down. It may be known as a fact of the gasoline consumption, right, the overall gasoline consumption in the US is not as strong as it used to be years back. So we have lower consumption of gasoline ethanol as a result. And the subsidized amount of ethanol that has to be in the pool is in the pool; over and above that you've got to buy corn, quite expensive, and make ethanol. And that is probably not a very profitable business right now.

So as long as you went into the regular amount of the pool it works out, but the total consumption is weak from that point of view. So the ethanol industry might be facing different time this year than they have had in years past. I don't know if that helps.

Yes, that is helpful. Would have been nice to wrap some numbers around that.

Thank you, Jacob.

Okay, thank you.

Brandon Oglenski, Barclays.

Luc, if we can discuss your expectations here on labor costs for the second half of the year. Productivity looked really good in the quarter, but I am assuming some of that came on the back of the CP traffic for a while. Was there any extra over time that you were running in the quarter? And as well, can you also talk about stock comp? I know year on year you said the variance was minimal, but it was it significant in the quarter itself? How do we think about these things looking forward?

Yes, let me start with the stock-based compensation. The impact in the quarter was actually very small, it was a negative CAD4 million, so it is not significant, it accounted for about 1% of the change, unfavorable change in the labor variance.

I think in terms of productivity, we did not have a significant amount of overtime in the quarter, we had a little bit but not very much. And again, as we look to the back end of the year I mean I would expect our numbers to continue to show some good productivity. It really depends on the business that comes our way and we have demonstrated the ability to absorb that business with minimal increase in staffing.

So we keep going at a little bit faster pace in terms of lining up our resources to make sure that we have time for training of the folks; it takes about six months to train a conductor. So -- and we continue to see attrition running at about 500 people or so per quarter. So those things are what is driving the changes in terms of headcounts. But productivity is going to continue to be part of the equation for the back half of the year, there's no question about it.

All right, thank you. Good quarter, guys.

Matt Troy, Susquehanna.

Quick question just on end market exposure in coal. I was interested in your commentary on how small the domestic component has become as part of the mix. Could you just refresh us in terms of your export coal business since that has been faring so well? What percentage of it is met versus thermal roughly?

And in terms of end market exposure, I know you've alluded to the fact that Asia is the primary driver, but maybe just the top one or two countries as we help try and formulate an outlook for export coal in the second half as prospects for China appear to be dimming somewhat.

Thank you, Matthew, it's J.J. You would take our coal revenue and then 1.5% -- roughly 1.5% of our total revenue at CN is met coal -- thermal coal in the US, you would take that out. And after that what you would take out is some petroleum coke revenue which by and large is all export.

So all of our export coming from the Gulf is the thermal coal and our exports from the Canadian West Coast is mostly met coal and some thermal coal and some pet coke. The destinations for the met coal are historically Japan, Korea and more and more China. And on the thermal coal it's -- when you go to the Asian side obviously it is by and large China and then some of the thermal coal from US Gulf also goes to Europe.

So that is kind of the breakdown. I don't have the exact breakdown between thermal and pet coke and met, but take out the 1.5% of our book of business which is US domestic, the remaining is product which is export, either met coal, thermal coal or petroleum coal.

That gets me what I was looking for. And just a follow-up would be then -- what is it that gives you comfort that that long-haul business, the export business that has been growing so nicely for you should continue just again with storm clouds maybe just perceptually gathering a little bit more noticeably in China?

Is it customer conversations? Is it stockpile levels? What is it that you look at on a concrete basis to get comfortable that that's a good business still in the second half, a nicely growing business? Thank you.

On the met coal, obviously it is on a relative basis all longer haul than our domestic thermal coal in US. Domestic thermal coal in the US on average is less than 200 miles, so it is not difficult to read that on the length of haul. So the mix is always improving.

So the met coal, the sign there would be looking at a price of met coal in a world market. (Inaudible) released their result this morning, I think they were saying that their pricing set for the third quarter is in the range of the premium up to CAD225 a ton on an average CAD198 a ton. At those prices the Canadian met coal producers should be making money to be competitive.

On the thermal side, we really ride on the back of the strong production costs on a Btu basis of the Illinois mine that we serve. It is tough to compete in the world market from the US to sell thermal coal so you've got to have a real low cost and that is what Cline Energy has which is a prime source of export coal for CN. And they do have laid down very nice export capacity and doing a great job running Convent.

So on thermal what gives me comfort is our producers are low cost. And on met coal what gives me comfort is the selling price of met coal in the world market seems -- even though it is weaker, it still seems to be relatively good enough for the Canadian met coal producers to make money and run a decent business.

Okay, thank you for the great detail.

David Newman, Cormark.

You have alluded to it, but your strategic investments that you seem to be paying off, the sightings, the [J] -- Keith is almost downright excited about the J and the opportunity there. Can you scale the opportunity? I think one of the things coming out of the J, they said US velocity could increase.

Obviously does this eliminate some tension points, et cetera, for the long-haul RTM. Like how do you scale that up? Where could it be? And how does that open up areas like Rupert and other areas that you might see potential pinch points on?

You are right about Keith being excited about the J, so I will let him take that question.

Okay, let me say this, train speed -- we talked about this, southern region growth is up in Chicago, train speed -- we talked about industry train speed is down.

But in this growth we have actually improved train speed in Chicago, which is a key connection, the busiest connection with all of our carriers in and around through that corridor, train speeds solid double digit improvements in spite of all of this growth, which is a very, very significant component to our ability to convert our markets and to provide that reliable service that connects to Prince Rupert.

So by extension Prince Rupert, Vancouver, Chicago -- if you look at that triangle, everything we are doing in Chicago provides a reliable service base to leverage for growth and expansion at those key ports in Western Canada. So as we move forward not only the connection piece, this other piece as far as switching cars, providing consistent service -- we do a lot of our switching in Chicago and Markham yard which is the old IC.

It used to be a dual hump, it's not a very efficient place to switch cars. As we get this yard online September/October this year we are going to switch that switching into Kirk Yard and effectively garner and convert, much to Luc's happiness, that some operational savings -- safety savings, safety improvements as well as operation efficiency.

So it is strategically -- I don't want to say it genius, I don't want to say it's luck, it took a lot of time and a lot of investment, energy and a lot of credibility to make that transaction happen. But I will tell you, it is a once-in-a-lifetime transaction for an operating guy that I think Claude and the people that made it happen day in and day out every day, we run that place more consistently, more reliable.

And just one add on just quickly. Beyond Kirk Yard is there anything else that remains to be done around the J that you need -- that we should anticipate and when might it be completed?

Yes, there is some tweaking and we've got it there on the chart. We tried to put a time line on it. There is a few more connections that will provide some additional efficiencies for us. You will see the fourth quarter 2013, that is probably the longest out is Munger.

Right now we've got trains that operate through the city -- that have to operate through the city efficiently because we don't have a connection there to efficiently take a right, for lack of a better term, and go south down to Matteson.

So as we get that Northwest leg of the wire -- Southwest leg of the Y installed in 2013 we will take some additional train starts out of the city and put them south of Munger, run them down to Matteson and up over to Gary where we are going to switch boxcars or south in our network. So that is going to help the additional stuff up at Leithton. We are going to have a double track up there that is going to have some additional capacity, pick up some train speed improvements there as well as velocity on our cars and locomotives.

And then finally, the connection down at Joliet. We've got Joliet subdivision which runs in the city of Chicago, it is heavily used by Amtrak, it is heavily used by Metra and now it is being used as well by UP coming out of their Global IV terminal.

We are going to take the Glen Yard access -- right now we have to go through the city again to get to Markham which in the future will be Kirk, we are going to put a connection in that allows us to come out of Kirk at Gary, stay out of the city, go down to Joliet, take a right and go up into Glen. So that is going to take additional savings synergies, car velocity, locomotive improvements and costs that we are paying to the harbor (inaudible) for [track] access fees as another step improvement in that corridor.

Excellent. Thanks, guys.

David Tyerman, Canaccord Genuity.

It's a broad question. I'm wondering how much outlook/visibility you really have going forward if we are looking at a downturn. How far out can you see? Is it months, is it quarters, is it weeks?

It really depends on the market, but generally speaking, and I speak from experience, things can turn fairly quickly on you if people are concerned and they stop to deplete inventory. But we do have visibility for a few months out, we do constant channel checks with our customers, and we are privileged to have a huge database of information in terms of what is actually going on in the economy.

So we are well positioned to see the turn coming and we would react accordingly. But the visibility is in a few months as opposed to weeks. But we certainly don't have much more than a few months.

Okay, that is very helpful. And just can you tell us where we are in the Canadian rail review and if there is any risk there?

You know what, we have an industry-leading service and we have been working at it hard here for the last several years. And I think it is fair to say if you go out on the property, whether it is in grain country or whether it is across the territory and the forest product sector, et cetera, the customers are recognizing the significant improvement and we are continuing to add to it.

We just launched recently (inaudible), a new service notification process for first mile/last mile, which is something our customer base has been asking us. And so we are doing what we have to do on the ground. The government has received the report from Mr. Denning. Mr. Denning I think was a very wise and smart men. I think he said it the way it is, that things are good, but some customers continue to want legislation.

And we will have to convince the government that this is not good for innovation, this is not good for the country. And if we can't do that we will have to convince them to make sure that whatever legislation they put forward is balanced and will be good for all stakeholders, not just the shipper associations.

Great, thank you very much.

Thank you. This concludes today's question and answer session. I would like to return the meeting back over to Mr. Mongeau.

Thank you, Ann, and thank you all for this call -- for attending on this call. Let me just repeat that I believe our agenda of operational and service excellence is delivering value. We are clearly having success in outpacing base market conditions on the top-line. We are accommodating that business at low incremental cost.

We are rolling with the punches including the big ones like pension that are difficult to control other than from an accounting standpoint basing it. And it is all coming together driving value for our customers and our shareholders. So we are pleased with how things are going and are looking forward to report again on a solid third quarter next time we are together.

Thank you. The conference has ended. Please disconnect your lines at this time and we thank you for your participation.