Canadian Pacific Kansas City Ltd (CP) 2004 Q3 法說會逐字稿

Good morning ladies and gentlemen and welcome to the Canadian Pacific Railways third quarter results Conference Call. (Operator Instructions). This conference call is being recorded on Tuesday, October 26th at 11 am Eastern time. I will now turn the call over to Mr. Paul Bell, Vice President, Investor Relations, Canadian Pacific Railway.

Thank you Jennifer and thank you ladies and gentlemen for joining us in our third quarter teleconference this morning. Before I turn the presentation over to Mr. Rob Ritchie, our President and Chief Executive Officer I'd like to make you aware of the following. This presentation contains forwarding looking information. Actual results may differ materially. The risks, uncertainties and other factors that could influence actual results are described in our annual report, annual information form, in this presentation on Slide 2, and in the press release issued this morning. This presentation also contains non-GAAP measures as outlined on Slide 3 and as further explained in the press release. All dollars quoted in the presentation are Canadian unless otherwise stated. Our slides are available on our website, so please follow along. I will now turn it over to Mr. Rob Ritchie.

Thank you for joining us this morning. With me besides Paul Bell are Mike Waites, our CFO and Fred Green our COO. So let us begin by turning to Slide 5 please.

The railway is running very, very well. Safety programs are on track, service levels are much better than they were in the first part of the year and can be characterized as good to excellent. Bulk products are all current, and the railway is totally fluid. Our top line growth is impressive with double-digit growth in five of the seven commodity groups. Fred and his team are pushing very hard on yield with great success as you're going to see in his presentation. Overall our business as expressed in revenue ton miles is up over 8 percent while our train miles are up only 4 percent, continuing that productivity trend that you saw in the second quarter. This success is showing up in the EPS numbers that you can see in Slide 6. Earnings per share are up 8.3 percent in Q3, 13.2 percent YTD. Our team accomplished this in the face of fuel prices north of US$50 per barrel WTI and a late grain harvest which delayed the movements in September. The year is unfolding as planned. I will now turn it over to Mike who can take you through the financials in much more detail.

Thank you Rob. Turning to Slide 8 in the income statement you can see healthy top line growth of 9 percent, operating income increased $15 million to $219 million, net income on an adjusted basis was $104 million, also up 9 percent. As Rob pointed out EPS was $0.65 versus $0.60, up 8 percent. Tying out adjusted income to recorded, the Canadian dollar strengthened last quarter, which drove a $73 million exchange gain on long-term debt compared to a $4 million loss last year. So reported net income was $177 million versus $91 million last year. As in the past, these are largely unrealized gains and losses and we exclude them in discussing operational results for the quarter. However they do reflect our strategy of using US dollar debt as a natural hedge to offset foreign exchange impacts on revenues.

Turning to Slide 9 operating expenses rose $70 million or 10 percent to $771 million. The major expense drivers for the third quarter were volume related with RTMs up over 8 percent and the price of fuel. Comp and benefits were up 6 percent and I'll say more about this in a moment. Fuel expenses were up $25 million or 29 percent as world oil prices hit unprecedented highs in September, edging north of US$50 per barrel. Our average fuel cost for the third quarter was over $41 per barrel. Obviously price is masking some positive improvements in consumption efficiency and a good hedge position. In Q3 we had 25 percent of our fuel hedged to a price of just over US$21.75 per barrel, so very good prices and equivalent to a much larger percentage hedge at sector averages.

Fred will also take you through how we are using pass through mechanisms to mitigate these fuel costs later in the presentation. (technical difficulty).

Okay, there was a problem that we were having ladies and gentlemen, we apologize for that. Mike, why don't you start where you were, and just maybe go back 10 seconds and then re-start. And if there's any questions we'll handle that in the Q and A.

Thank you Rob, I have covered the income statement and so what I'll do is I'll lead into the operating expense discussion. So picking it up from Slide 9. Operating expenses rose $70 million or 10 percent to $771 million. The major expense drivers for the third quarter were volume related with RTMs up over 8 percent as well as the price of fuel. Comp and benefits were up 6 percent and I'll say more about this in a few minutes. Fuel expenses were up $25 million or 29 percent as world oil prices hit unprecedented highs in September, edging north of US$50 per barrel for West Texas intermediate. Our average fuel cost for the third quarter was over $41 per barrel. Obviously price is masking some positive improvements in consumption efficiency and a good hedge position. In Q3 we had 25 percent of our fuel hedged at a price of just over US$21.75 per barrel, so very good price and equivalent to a much larger percentage hedge at sector averages. Fred will also take you through how we are using pass through mechanisms to mitigate these fuel costs later in the presentation.

Materials expenses were up modestly and equipment rents declined almost 3 percent, quite impressive given the growth in the business that we've handled. No new news on depreciation and amortization, they're in line with earlier run rates. Purchased services and other expenses was up 15 percent, this include payments to IBM for our outsourcing agreement. This pertains to the operation of mainframes and servers and some of this is conversion of capital to expense. Also higher joint facility costs and increases in operating and intermodal expenses associated with the record volumes drove part of the increase.

Turning to comp and benefits on Slide 10, I'll talk about the change quarter on quarter. Reading from left to right on the waterfall, volume related running trade expense was up $8 million, wage inflation added $7 million, pensions and health and welfare costs accounted for a $5 million increase. Note however that our guidance for overall unit rate inflation continues to be in the 5 percent range. Variable incentive comp was up $10 million in line with guidance provided last quarter. We accrue the performance bonus each quarter, and last year you will recall we did not have any accrual for the third quarter. We've told you about our additional running trade training expenses which added another $4 million. Our FTE reductions are largely on plan and year-to-date we've reduced 165 positions. This brings us to a total reduction of 530 of the 820 positions since the beginning of 2003. We also outsourced information systems to IBM, as I mentioned, reducing another 90 positions for a combined total year over year benefit of $7 million. Finally we had a reduction of $11 million from a combination of our operating efficiency strategies, foreign exchange and a variety of timing differences offset by the cost of expensing stock options. All in all an increase of less than 6 percent and below the run rate predicted.

Slide 11 ties the quarter out from an EPS basis. You can see the negative impact the changes in fuel price, wage, pension and benefits inflation as well as the other factors I've spoken about have had on our EPS, cutting last years EPS almost by half or down to $0.31. Fortunately we were able to offset these headwinds with our continued FTE reduction program and a successful fuel hedge adding $0.04 back. Furthermore, strong revenue growth (year) of yield of fuel surcharge growth, a $0.12 increase. Revenue growth from volume added another $0.31. Finally as you would expect, there were volume related costs amounting to $0.13, highlighting the good margins on the incremental traffic. All in all, a solid job of overcoming some tough negative forces to deliver a $0.65 quarter, up 8 percent.

Turning to Slide 12, I'll conclude with a few words on the full year outlook, a key takeaway that we remain on plan to deliver to the guidance we gave earlier of a 5 to 10 percent improvement in EPS. This is despite fuel prices continuing north of US$50 per barrel and a strengthening Canadian dollar. Fred will take you through the details of our strong revenue growth, but Q4 will remain in the 5 to 7 percent range, right in line with year-to-date accomplishments.

Our operations are improving in both velocity and productivity, so no change is expected there. You've heard my detailed explanation of comp and benefits. The unit rate will remain in the 5 percent range. You can expect the fourth quarter to come in at around a $315 million run rate. We continue to make improvements in managing our tax rate, and we expect it to approach the low end of the guidance we gave previously under 33 percent effective rate. We are now looking at a Q4 outlook of a stronger Canadian dollar, about $0.78, up from the $0.75 predicted earlier. Our 2004 average will come in at $0.76.

The significant change will be in fuel price. Our outlook for Q4 is now set at $50 per barrel, up from the $40 per barrel we had in our previous plan. This combined with the apparent lag in the fuel surcharge program will likely cost us $0.10 plus on an EPS basis in the fourth quarter. 2004 CAPEX will come in at the range previously specified. The free cash flow will be moderately positive. That concludes my comments. Fred, over to you.

Thanks Mike. On the revenue side we delivered another excellent quarter. Compared to Q3 of last year carloads were up 6 percent while freight revenues were up 10 percent. Revenues grew in 6 of 7 commodity groups with 5 of these groups reporting double-digit growth. Overall bulk revenues were up 8 percent in the quarter led by continued strong performance in our coal and potash businesses. Grain revenues were down 7 percent as a late harvest pushed back the start of the fall grain shipping season. Sulfur and fertilizers were up 13 percent driven by strong demand and excellent supply chain cooperation with our key customers. Coal generated a 30 percent quarter-over-quarter increase, and this was driven by bullish offshore and US demand for metallurgical coal combined with excellent unitrain (ph) performance. Merchandise revenues were up 10 percent quarter-over-quarter. We had a very strong performance in industrial products, up 14 percent for revenues. In our forest products sector revenues surpassed 2003 by close to 4 percent, driven primarily by price in some targeted truck conversions. Automotive revenues were up 14 percent versus 2003 reflecting some strong Chrysler shipments and a softer compare due to the blackout in the East last year. Intermodal also demonstrated strength up 11 percent over last year. Volume was strong across all segments. Most importantly the price action helped to drive a 6 percent revenue per unit increase on the quarter.

Turning to Slide 15 let me walk you through our third quarter yield performance. Looking at the graph I am pleased to say that the year-to-date average rate increase achieved on all contract and tariff renewals, the blue and red pieces of the pie is nearly 6 percent. In addition business covered by multi-year contracts, the orange slice, is taking average increases of just under 2 percent based on contracted escalation factors. Our pricing actions are clearly visible and third quarter cents per RTM improved 1 percent on the quarter and revenue per carload improved 3 percent. Without the $17 million of negative foreign exchange impact we experienced these key metrics are up 3 and 5 percent respectively. Our same store price metric is tracking above the 2 percent stretch target I gave you last November. This metric calculates the price improvements based on changes in revenues earned for like shipments on a year over year basis, and to clarify excludes the impact of foreign exchange and fuel surcharges.

Before I turn to our outlook, I know our situation with the Elk Valley Coal Corporation which I'll refer to as EVCC is a hot topic, and I'd like to provide an update. If you turn to Slide 16, I'll walk you through the situation. On July 24, CPR filed a Statement of Claim against EVCC for failure to pay applicable freight charges from its five coal mines to the Port of Vancouver. This matter is now working its way through the courts. On October 5, EVCC filed an Application for Final Offer Arbitration, or FOA, with the Canadian Transportation Agency for export coal from one of the five southeast BC coal mines. CPR maintains that the matter of applicable rates is governed by a confidential contract and so the FOA option under the Canadian Transportation Act is not available for Elk Valley. This matter is being argued before the CTA. Notwithstanding the FOA application, CPR will continue to progress our lawsuit. I continue to be very comfortable with the reasonableness of the level of revenue recognition in our statements. As both matters are currently before the courts and the regulators, it would be inappropriate to comment further at this time.

Now for the fourth quarter market projections on Slide 17. The grain outlook is solid, right in line with forecasts we gave you earlier. The late harvest is more of a timing challenge than a volume issue. For coal we are modeling continued growth both volume and price improvements surpassing the strong Q4 '03 performance. In the sulfur and fertilizer we are modeling a solid fourth quarter. Export potash shipments are expected to remain very strong. Industrial products growth rates will moderate somewhat, but revenues are still expected to significantly exceed GDP for the balance of the year. The forest products outlook is also solid. Recent improvements in interline car cycles will support volume growth in lumber while truck conversions are boosting newsprint shipments and our earlier price increases are holding. On the auto side consistent with past forecasts we expect revenues will be soft primarily due to sluggish sales and high inventory counts across most manufacturers. Intermodal growth is expected to continue although at a more moderate pace than the first nine months of the year. Through our western corridor allocation program we are able to handle this increased volume within the existing Max Stacks (ph) model. Importantly this disciplined approach is also allowing us to manage traffic flows and overall fluidity. We are moving all of the volume that we committed to in a planned and consistent fashion and we have recently offered capacity into the marketplace at premium prices. To conclude on revenues, fundamentals are strong across the majority of our markets. At this point I am expecting the full year 2004 revenues to outpace 2003 by 5 to 7 percent and likely at the high end. Excluding the year-to-date foreign exchange impact of $96 million growth would be outlooking more like 8 to 10 percent.

Turning to Slide 18, I would like to speak to our goal of increased fluidity. Achieving a marked improvement in network fluidity is the key operating priority of 2004. Improved fluidity creates more revenue generating capacity from existing assets and enhances the quality of our service resulting in a clear win/win for both our customers and our shareholders. We are extremely focused on this goal. Through the last two quarters of 2004 we have posted steady improvements in fluidity while at the same time handling ever-increasing workloads. We are focused on fluidity through a number of thrusts noted on the bottom right. I'll speak to just one of these, co-production. Last week we announced the implementation of six agreements with CN that will do much to improve fluidity of operations in the Vancouver area. We continue to pursue further co-production opportunities with all Class 1s and I am optimistic that we'll successfully execute more co-production initiatives in the near future.

On Slide 19, with our focus on fluidity we have not taken our eye off productivity. This quarter is a continuation of a now well-established trend of posting solid year over year improvements in productivity and asset utilization. Density on our network continues to build, and employee productivity continues to set new records. Train crew wages are and will remain a significant portion of our total operating expenses, so it's satisfying to see the refinements to our integrated operating plan continue to increase train rates and minimize the rate of increase in train miles. With fuel prices at today's levels it's also satisfying to see that we are maximizing the value of every drop of fuel consumed. I should not leave this slide without commenting on the very strong safety performance recorded in this quarter. Double-digit reductions in the rate of personal injuries and train accidents are in my opinion a solid testament to the efforts of our employees in this very, very important space.

Turning to Slide 20 let me say a few words about managing our exposure to record high fuel prices. Q3 2004 saw a fuel price increase of $22 million as compared with Q3 2003. In June of this year we announced a new fuel surcharge program which triggers monthly rate changes in response to smaller increments of change in WTI and highway diesel fuel price. This model will replace all fuel surcharge tariffs as new contracts renew. Fuel surcharge recoveries in the quarter increased by $11 million compared to last year. We also have contracts with annual indices, these are up modestly this year, contributing another $1 million. You can expect a sizeable improvement starting in January 2005 when 2004 record high fuel prices are factored into the indices. Mike spoke to you about our hedge program. This delivered another $5 million. Bottom line, we feel we are in reasonable shape covering approximately three-quarters of our increases with our pass through and hedge program. We continue to pursue every possible vehicle to mitigate high fuel expense.

Turning to Slide 21 on outlook, the fundamentals are strong across the majority of our markets, and from an operating perspective we are well prepared to capitalize on any Q4 upside. Our locomotive fleet is of high quality and properly sized with the addition of 34 AC locomotives in Q4. Another 130 running trades employees will be employed in active service before the year is out. Our rifle shot capacity projects will all successfully be implemented by October 31, and many are already making a difference in improved fluidity. Finally our new yard management system will be implemented across virtually all of our Canadian network before the end of the year. We started in the west and our Phase 1 of Toronto implementation went in flawlessly on Saturday morning. In short, I believe we are well-prepared for a strong finish to an already busy year. Back to you Rob.

Thanks Fred. Wrapping up, as you heard from the team, CP is on plan. Major points. The grain outlook is good, right in line with the forecast that we gave you earlier. The demand for metallurgical coal is very strong worldwide. Coal volumes are up, world prices are high. In other areas, we've got strong revenue growth, particularly in intermodal and merchandise, which we see that continuing through the fourth quarter. We're very focused on yield and we're going to do what it takes to improve our return. We've got excellent people, excellent processes and they're in place in this area and are achieving good results.

Operations aside, you've heard about our co-production initiatives, overall train speeds are improving, productivity improvements and cost reduction efforts are on track. On the labor front we have a tentative settlement with the running trades in Canada. This contract is now out for ratification. We have our capacity planning in hand and we are working on those three preconditions for proceeding. Just to remind you that these are first a continuing strong economy, we need to have faith in that, in the forecast giving us the required confidence that the Asian boom has legs. Secondly in the area of freight rates, they need to be at a level to support the additional investment. Finally we need a government policy that supports private railway investment. We are making good progress in these areas and a decision will be made before the construction season.

To close I want to emphasize that this railway is fluid and it's running well. CP is on plan to deliver the year end EPS within the guidance range that Mike provided. So Jennifer I'll now turn it over to you for the Q&As which will take us to the hour.

(Operator Instructions). Fadi Shemu (ph), UBS Warburg.

First question I have is on the outlook for operating leverage, so far this year we haven't seen real operating leverage despite really strong volumes. And there's some factors to the crew training and some other costs, one-time in nature, and fuel. Now going forward, aside from fuel, what other factors, if you can name two or three examples do you think will drive the operating leverage in the business for CP Rail.

Let me try and answer that. We think we are doing a very good job of getting operating leverage through at, let me say, the operating level, and clearly that has to get to the bottom line. When you look at our numbers, with train miles up 3.9 percent, the GTMs are up 6.4 percent, and the RTMs are up 8.3 percent. And so that's what we try to summarize on our EPS chart. You did pick up the fuel issue, and if we simply subtract the fuel price impact on the cost, costs are up about 7 percent, revenues up about 9.5 percent, and then we've shown you there was some other one-time issues in there, the IBM switchover, some currency issues and so on. So we know we're getting the leverage from an operating standpoint, what we have to do is overcome the headwinds. We need the volume and the leverage to do that. The training expenses for the running trains that you referenced will be coming down towards more normal levels next year, so they'll be, in round numbers, $4-7 (ph) million dollar improvement on the quarter. We've got to continue to take the work forward and taking out the 820 positions, and we'll benefit from that next year, including the full year's impact of this year's actions. And then obviously, we'll continue to push on the operations and productivity side. Fred spoke to you about co-production, IOP compliance, and Fred I'm not sure if you want to add anything on productivity with Max Stacks (ph) or things like that, but Fadi, we'll keep pushing, we can get better operating leverage to the bottom line.

Rob Ritchie Fadi, I'll jump in and suggest that Mike has characterized it correctly and I'm very satisfied that the train mile ratio versus the amount of revenue we're generating is emerging, and I can tell you that October continues to improve. So while it's not perfect yet for the reason Mike described, we're directionally moving along a path that I'm very satisfied with.

Okay, on the New York management (indiscernible), are the benefit from this mostly going to be in the second half of '05, or could we expect some pickup in the first half as well?

I think we'll start to see some pickup in the first half Fadi, because we will have all of Canada rolled out by the end of the year, and we're already starting to see the benefits now. It kind of lags by about a quarter until people familiarize themselves with it, and we start to get the adjacent terminals able to leverage each other. So, I would suggest you'll start to see some pickup in the early part of the year, but you won't hit the full year run rate until later in the year when the US properties have been brought on in the first quarter and they've had a quarter to learn how to use and leverage this new system.

One last question for me on fuel. As we move into '05, is there an opportunity for you to increase the surcharges to offset the decline in the hedge position, or even go beyond that?

The formula is fairly well established now Fadi, what's happening now is that the applicability-many of the things that we introduced in Q2, Q3, of course have not had the benefit of the full year run rate, so we'll get the benefit of those, plus more and more contracts come due, and as they come due they are all migrating towards this new fuel surcharge that we have put in place. So it's a bit of a complex answer to a simple question, the answer is yes, but those are the reasons why.

Scott Flower, Smith, Barney Citigroup.

Good morning. Just a couple of questions. I was wondering, I know you talked about the volume of the wheat crop is as expected, I'm just wondering, there have been some discussion that the quality of the crop is somewhat less, and therefore from a mix perspective you might have, obviously still up exports but perhaps not up as much as perhaps they might have been, and more, Mike, (on the) feedlot. I just wonder if you might comment to what your visibility is on the quality of the crop, and what that might be doing to the mix of your ag business.

Sure, I'll let Fred answer that, Scott, but with the caveat that all the official reports are not in yet. But Fred, the preliminary assessment that you have from the field?

The assessment at this point in time is that the, I'll deal with both Canada and the US, the US properties which is for us, is North Dakota, Minnesota, are indicating that the wheat crop is reasonably good, very good with a reasonably good quality, or an average quality. The corn crop is not yet harvested and early indications are it's a reasonable crop, but that the quality is still a little on the edge, and the reason that that becomes important is, where will the product go. It has to meet certain specs and standards. So we don't know the pattern yet, whether it will go export of whether it will be consumed more domestically. On the Canadian side, I don't think there's any doubt that there has been some product quality impact from the various things that we've all experienced over the last several months. At this point the indications are, and to Rob's point this is absolute preliminary off the ground type information, that while the quality is certainly not high percentage, number 1, of you will, the ability to mix product is a big part of how the grain companies do their business. So, we don't know how much can be mixed locally versus how much will end up being of such poor quality to go to feed. It's not a perfect answer, but the answer is, from our perspective, no news is good news, there's certainly no apparent crisis that we've had communicated to us, and our expectation is that between mixing and blending, we will probably be able to move the vast majority of the product for export. But really, let's let the proper authorities make those statements.

Okay. And then a couple of other quick ones. Obviously the Canadian dollar has continued being robust and obviously Mike describes the impact on your financials, but I'm just wondering, are you seeing any impact on your product loads, ie. particularly some of the pulp and paper products which might be more sensitive obviously as the Canadian dollar continues to rally. Are you starting to see volume impacts, or worrying about different segments for volume impacts in your North-South traffic flows.

You know Scott, we always try to take that into consideration, but I have to be very candid to say we have not seen any impact whatsoever. The demand is very strong, it continues strong into October. Logically, and it's very wise, we do need to pay attention to what could occur, and I think I've always historically said the one I'm most concerned about is pulp and paper, and to be candid with you, pulp and paper seems to be very robust in October. I can't figure it out at this point in time, we certainly don't have any indicators that we should be worried about it. We will continue to monitor it and pay attention, of course.

And last quick question is, could you, and it's twofold, one is could you give us what is the timing of the process of ratification with the running trades, a process question, when does it go, to what bodies within the running trades versus to the membership for votes, and Rob, I know things move around, and it's subject to how the trades may operate, but how, roughly that plays out. And secondly, has there been any sort of public discussion of what the rough terms are in terms of wage increase, etc.

It was just settled a week ago, Scott. So it is out, the union leadership, and it's the Teamster Union, which represents both the locomotive engineers and the conductors, are out on the property now with the members discussing the terms and conditions. It will go to a mail vote between now and the end of the year, and probably early into the new year. So we will get the results, our feeling is, early in the new year. And no, there has been no public discussion yet on what the terms are, and there shouldn't be, but sometimes they do leak out. But I haven't seen that yet.

Ken Hoexter, Merrill Lynch.

Good morning, it's Ken Hoexter. I guess Fred, if you could talk a bit about the coal rates for a second, I know you like to keep it brief on the subject, but is the upside here on the ability to get the cash flow from EVCC or is the chance, the ability to raise rates in other portions of the business, just wondering what the takeaway is once this process gets resolved.

Well, Ken, the only significant client in the export metallurgical coal business these days is what we describe as Elk Valley Coal Corporation. As a result of that, 100 percent of the benefit of what will come out of either the regulatory proceedings or the legal proceedings will be attributed to that account, or for the rates on that account.

Are there any upfront costs with the co-productions going on with Canadian National and Norfolk Southern? And have you already started to implement the co-production?

the co-production on the West Coast, the ones we announced with our associates at CN, very modest amounts of minor expense involved, and I can't even think of a penny of capital, to be candid with you, although there may be just a tiny bit somewhere. So it's a very low cost startup and they are in fact up and running to a large degree. I think we've got 4 or 5 up, or 4 of the 6 up and running and a couple of more we can move when it suits our collective purposes. And the NS situation, there is in fact a handful of investments that are necessary to make certain connections, and when I say this I'm talking about the Detroit to Chicago piece. Most of the other activity between Buffalo and Binghamton and up to Saratoga works with existing physical plant, and the activity is progressing well between ourselves and NS on the ability to bring the Detroit to Chicago piece to life. That realistically probably won't be active until mid-summer next year.

Great, and two quick ones just to wrap up. Is there any impact on the business from the BC Rail acquisition by CN? And then secondly, the state of the crop, I know it depends on the quality, but when do you anticipate seeing a pickup on the volumes there?

First on BCR, I would say at this point in time the impact has been negligible, we continue to interchange well with our associates at CN who now manage that property. And obviously we are well prepared to remain a player in that marketplace should that not be the case in the future. On the crop, we've had sporadic weeks, they've had a little bit of issue at the port with some different specialty grades and things like that messing up the cycles, but I would suggest that we would anticipate that they're going to want to move substantial amounts of grain between now and the end of the year. I do think that the split will be different because of the last harvest than most years where we usually move about 50-50 (percent), sometimes it's a couple of points one way or the other. We will probably only more 45 percent of the crop this fall, versus a normal 50ish percent. But that's more due to late start. So I think you can expect to see it picking up in the coming weeks.

James Valentine, Morgan Stanley.

What portion of your, this is for Fred I guess, what portion of your 2005 fuel inflation do you think you can pass through to your customers in fuel surcharges. You mentioned the 75 percent in the third quarter, but that included the hedges which, as you know, you don't have a lot next year. So, when you think about modeling fuel inflation, how much of that do you think can ultimately be passed through in fuel surcharges for full year 2005. Could it be three quarters?

I think it will approach that. I think that might be a little on the high side. I'm comfortable, Jim, saying that we're going to get 60 percent of it. And I aspire to get at least 75 percent on the fuel surcharge side, but I think there's a reality check, as I said, only certain contract come due and some of those big ones aren't going to come due, so I can't change history.

Okay, and you've got another 10 percent hedge, so presumably that would leave then 15-20 percent of your-exposed in terms of fuel inflation.

Jim it's Mike Waites. That's correct. The other thing I'll jump in on, is here again, candidly, we'd like a tad more hedge. Having said that, we're going into next year with about a 12 percent hedge position in the first quarter. And obviously there's a big difference between having a 12 percent hedge at $35 or $40 versus the $20-$21 range, so a smaller percentage, but still, nevertheless a good hedge for us to have, so we'll continue to work that (for you).

The other question, and I fully understand the sensitivities of Elk Valley, so I don't want to talk about what's going on now, but I guess what I'm trying to understand is, when we get into April of next year, which presumably, the new contract year for coal pricing, if the global coal prices are up, let's just say, another 10 percent, which right now they're up a lot more than that, let's just say they're up 10 percent. Is it fair to say that CP then would get a 10 percent increase in terms of the amount it should generate from the transportation fees?

Jim, I'll answer that in two ways. The first is that if the contract as we understand it, and believe it to be applied was to be enforced, then that's a reasonably accurate statement. But, of course, all of these processes must be completed with the Canadian Transportation agency and then also in the courts. And so, until such time as they have proceeded too, I can't answer your question with any degree of certainty, it's going to be a function of both possibly arbitration and certainly the legal case as to applicability of the contract as we believe it should be applied.

Okay, great. And my last question is for Mike. Mike, clearly in 2004 you've seen a lot of headwinds in costs, some of which are non-recurring, or hopefully will be non-recurring, I was wondering if you could take us through a few of them. You already touched on training, and it sounds like that's going to go down, I think you had $12 million of higher training costs this year that should go down next year. The 4 other areas I was wondering about, if you could just touch on, is pension, incentive comp, these customer related service costs which I presume are mostly due to the UP (ph) problems, and the harsh winter weather costs that you incurred earlier this year. Can you give us some kind of feel? I have them, all 4 of those being about $100 million of headwind this year, which is 202 (ph) basis in your operating ratio. And I'm just trying to figure out if those could potentially go away, or at least on a year-over-year basis not go up again in '05/

I think certainly with the way the railroad is running, the customer costs will go out of the system, the training costs will return to normal, so the increments there will go out of the system. All in, Jim, the incentive comp, which is the combined total of bonus, DFUs (ph), the stock options expense is around $50 million in round numbers. That will be there obviously, what we're trying to there to mitigate that is working hard on the 820 staff reduction. Pensions year-on-year, it's still early to tell, as you well know, you derive your pension expense number basically out of what happens at the end of December in terms of the assumptions that you use, and how you measure your asset returns. I would imagine pension expense would go up moderately next year. This is very early, but perhaps $10 million or so, but Jim, you're going to have to stay tuned on that. So certainly on year-on-year we're not going to see the same types of increases that we've seen here on the headwinds, and I think what you're going to see going into next year is, as we roll through with some of the investments we've made, the co-production issues that Fred has spoken about, IOP and so on, we'll have more and more momentum, if you will, to move forward, and the headwinds that we'll be facing '05 versus '04 are lower. There may be a moderate increase again, in costs, but far less in magnitude. Fred do you want to add something?

Jim I would pile on with Mike's comment that there will be far less, if any, consequences in the marketplace of the customer related things for two reasons. First of all, we're running very well and anticipate being (able to do so) but also because having taken some scars and learned some lessons, we have worked very diligently on the contractual terms in 2005 which do not leave us susceptible to those kinds of penalties.

James David, Scotia Capital.

Just one quick question on page 11, you talked about, Fred you talked about revenue growth being a combination of fuel surcharges and yield and it was worth about $0.12. I suppose I could kind of back it out based on the rest of the information in the presentation, but just to make it easy, can you provide a split on that $0.12, what was surcharge and what was yield?

It's Mike Waites, James. In terms of the of the overall amount, it's about one-third fuel surcharge, two-thirds yield. That's very round numbers but that gives you a rough breakout.

Okay, that's good. And a related-sorry not a related question, just sort of looking at the labor picture, I think the workforce reduction program started in the second quarter of last year, if memory serves me correctly. You said 530 reductions. Now we don't' have an apples to apples comparison in this presentation, in the notes, but your number of employees at the period end was down 103. So obviously there's been some hiring underneath that, and I presume that's what's driving the training. Is this something that will persist, what it looks like you're effectively taking, you know, you've got early retirement or whatever, buy-outs, and then you've got entry-level wage people coming in. Is that more the strategy rather than just absolute workforce reduction?

That's right James, and Mike can give you the specific numbers, but really there are 3 buckets. The 820 was mainly white collar, but there was some blue collar workers, if I could call it, in that as well. And we are on track as Mike said, to take that original plan out, even with the uptick in the volume. But we have had to add mainly running crews. So that we have added, but we've also had retirements in that group. So you've got grain trades being added, running trades being retired that aren't in the 820 and then you have to 820, and so they all net out to that one number that you see reported.

Okay, if I look to the balance, the 820 minus 530, so 290, can I assume that that plus attrition comes out, or should I assume that those 290, to some extent, that some proportion will be replaced at entry level? With new entry-level hirings.

James, the 290 will come out as part of the original program, and we're obviously very focused on doing that. Any additions, as Rob spoke about, the additions to running trades, will be driven by volume. Basically this quarter we added close to 200 running trades employees because of the volume. But the 290 should come out and additions back, which would take the number obviously, the other way, will be function of how busy we are, which is not all of a bad problem, but we're going to stay focused.

James, just with color, any additional add to the workforce has to go through the Executive Committee with CP.

Okay, it's not-you're not hiring people back, you're hiring entry-level or whatever.

Rob Ritchie. No, we're hiring front line people to handle the increased train volume, (indiscernible).

Okay, last question, and I suspect you'll probably go into more detail at your November conference, but it hasn't been addressed yet, and that's, you've got a track CAPEX program. Fred, you've been on record in the press, this is about track not rolling stock or locomotives, and as well you mentioned a figure in the Globe and Mail recently, about $.5 billion dollars, so I don't want to go into that because I suspect if you wanted to talk about it you would have done it already. What I'm really curious about is, just how difficult is this in terms of your fluidity. You're talking about pinch points, Revelstoke, you're in the mountains and you want to put track down. Does this disrupt a railroad that's running full out already? How do you manage? I'm really curious about the physical consequences of doing this next year, if you do it.

James, I'll answer that because Fred probably can't, he's too modest. We have a design capacity in the track. Fred and his team have, are getting the optimal out of that design capacity based on various demands of the different lines of business, whether it's bulk, intermodal or industrial products. They do not oversell into that design capacity, that will give them capacity issues that will cause queues, which cause the pileup of traffic at various nodes on each side of the pinch points. So, the pinch, you're right, we will discuss it in much more detail at the mid-November analyst meeting and it will be on the website so that people can see what opportunities we have, because it really is a good news story. We've got customers who want to significantly take advantage of the Asian boom, and I think that's driving the Canadian dollar, my God, it's at $0.82 yesterday. And so I think, the way I tell it to these people here, it just reminds me of the early 1970s when Western Canada took off again. I look forward to it.

Have you been sort of through this before Rob, in your-

Yes, a couple of times. And I like it.

Jackie Boland (ph), CIBC World Markets.

Hi, thanks. Just further on that, can you talk about the co-production projects that you have, what kind of capacity they've given you with some of your pinch points?

Jackie, it's Fred. The group that we announced last week was really meant to focus on the US-or-the Greater Vancouver area, to ensure that between ourselves and our associates at CN, we are able to move both bulk commodities and containers to the multiple terminals in and around the Greater Vancouver area as efficiently as possible. There were some, and I'll call them unnatural inefficiencies that built in over history and time, and agreements that suited each of our purposes. After a very robust discussion and debate for a good long couple of months, we found compromises that we think, not think, we know that are acceptable to both parties. The benefit of that is really fluidity. It means that when trains arrive in the Greater Vancouver area, coming, a CP train, we've made arrangements with our associates at CN that will not see that yet reduced in size, or not see that held in a terminal for a period of time, but rather run right through. It allows us to run between each other's terminals to move our interchange traffic as opposed to moving to like, a third location, and you drop it off and the other guy picks it up. Those are examples of the kinds of things that are, they're just really good common sense decisions that, thanks to the cooperation of our associates at CN we were able to come to, so you'll see the benefits in the fluidity, and therefore fluidity creates capacity at a time that the Port of Vancouver generally would like to see that happen.

Okay. You had kind of talked about a ceiling for growth and being able to accept growth. Do any of the co-production agreements change that at all?

I think the combination of this and other things that we're working on position us well. We went in-things were a mess in the first quarter, kind of uncontrolled demand, it took us a while to sort it out, we got it sorted out and we introduced the allocation system, which is what you're referring to Jackie and we have been running that like clockwork. And having reached a very high comfort level in September that we were capable of doing that and assessed the balance of the demands, and looked at our own fluidity. As I said, we were able to put out some more capacity into the international arena, which has been gobbled up quickly. And what we will do now is assess that, run that well, and as we create more capacity through these types of co-production initiatives I'm optimistic we'll be able to put a bit more capacity out, and do it in a very organized and planned way.

Great, and you mentioned rate hurdles as well as one of your criteria for doing some of the work. Can you talk about what rate increases you're hoping to get, what you're looking for now?

Well, I think because of the competitive nature of it, I would prefer not to be too specific, obviously, by account, or even by industry specific. But what I'd like to suggest to you is, Rob made reference to the rate hurdles because it's critical that we generate cash with this company. And to get the cash that we want to make these further investments should we go down that path, it's going to require us to command as much value as we can from the clients. Demand exceeds supply, it's our responsibility to command as much value for our shareholders as we can, and that's the behavior that we're taking.

Tom Wadewitz, Bear Stearns.

Good morning. I've got two different questions for you. The first one I think is for Mike, and perhaps Rob. You've talked a fair bit about operating leverage and also some of the expense headwinds you had this year. As you look to next year, are you pretty optimistic that you would start to see some leverage and see that margin really improve a lot year-over-year, or do you think it's more appropriate to be kind of cautious on that and say, well, margins may be modestly up or flat.

Tom, as I mentioned earlier, we're gaining momentum in terms of our ability to offset the headwinds, and year-on-year the headwinds are an order of magnitude less. So I would describe it as, we see a good solid robust year next year, and I probably shouldn't go beyond that at this point. We'll come back and talk to you in November and give you some more color on that, but a lot of good stuff happening.

We're focusing on the end of the year, Tom, planning for '05, but focusing on '04.

Okay, that's fair. And when you go to the analyst meeting are you going to give us any sense of kind of timeframe for when you might get back to the 2000 type levels of OR where you were in the 76-77 area?

Yes. We will.

Fair enough. And for Fred on pricing, I know you guys are real focused on price, are you optimistic that you see the same magnitude of price increases in 2005 as you're seeing this year? Do you actually think when you talk about fuel surcharge and price, the level of what you're getting next year is greater? What's your broad sense on that?

Tom, I think the same kind of answer Mike gave, which is, obviously we're going to talk about 2005 in greater detail at our analyst meeting in November, but directionally, I am very positive, we have a great team of people, very focused, they understand why we need to do these things, and we have a marketplace that is now seeing the value of the services we offer. So, directionally, as Mike said, we like where '05 is going, but I'd prefer to kind of use the quantification, or use November 19th to get a bit more specific on qualification.

Okay, then, I guess one specific one for fourth quarter, if I might. In terms of incentive comp, that was a bit of a headwind because you didn't book incentive comp in the third quarter last year, what about fourth quarter, did you book come incentive comp last year in the fourth?

Yes, we did, it was moderate though, Tom, so you should see a little bit of an increase this quarter over last quarter, single digits.

So, $2 million dollars you booked last year.

Yes.

Horst Hierniken (ph), Westmin Partners (ph).

Thank you. My first question relates to the Canadian dollar which has reached $0.82, some believe it might even go higher. Should we be looking for changes in the way CPR manages its balance sheet as a consequence? I'm referring to changes in the level of use of FX hedges, perhaps the reallocation of assets such as your long-term debt, or even changing the company's reporting currency.

Well, at this point in time Horst, it's Mike Waites, at this point in time we're not anticipating changing the reporting currency. I suppose that's a question, we have discussed it, but it's certainly not high on the radar screen, if I can put it that way. We have done a great deal of work to try and mitigate the impact of the strengthening Canadian dollar, and about three-quarters of our debt is US dollar denominated. And so what happens, obviously, as the Canadian dollar strengthens, we benefit from lower interest expense in Canadian dollar terms, but obviously those liabilities, which are long-term liabilities, we've gone 10 and 30 year maturities for a lot of our debentures, are lower in Canadian dollar terms. You might point out over time, that will swing back, but it's going to be a very long time. I think the balance of what I say, is we'll continue to look at different ways of mitigating that impact, but all of that to say, a great deal of work, and we've benefited very significantly. Of course on an operating income basis a $0.01 change Canadian, I think we've spoken about this before, reduces-if the Canadian dollar strengthens by a $0.01, reduces operating income by about $3 million. But on an EPS basis, when you take into account the interest expense benefit, a $0.01 Canadian swing is about $0.07 on the EPS calculation. So, lots of work that's occurred there. We'll continue to look to other alternatives, don't anticipate restating the reporting currency.

Okay, thanks. The other question, Mike, relates to your purchase services. I noticed that in the latest quarter it's up roughly $10 million and $160 million versus a running rate of about $149 million in first and second quarters, is that simply a volume issue, or is there something else going on? I would have thought that it would have at least stayed flat, given the efforts you've made to pare down costs.

Good question. The purchase services, again, we've been camped on that. If we take a look at the increases quarter-on-quarter, some of that was volume related to your point, some of it was the impact of the IBM deal. In general terms we had IS charges up in round numbers about $5 million, that was not all due to IBM. At the same time we had joint facility charges up about $5 million, we had intermodal operations charges up $2 million, so those last 2 reflect volume increases. I think, Horst, one of the things I might point out, is if you go back, we're benefiting, I should say, in terms of lower materials expense in some respects because of higher purchase services, but if you go back and say, look at materials expense over the last several quarters, you see a number trending in there around $45 million. And you've seen, in this quarter, we came in at around $40-$41 million. So we're down fairly good on materials expense, but part of that shifting into purchase services which, as around about a $145 million number. So if you kind of move $5 million over, we're running about a $155 million versus a $145 million purchase services, and I would say a good two-thirds, three-quarters of that is volume related. And as you know, this is a catchall, you have timing differences on A/R, billing, and all kinds of things. But we're very focused on it, we'll keep pushing. The fourth quarter, I would anticipate a number, probably similar to what we've seen this quarter, only because we tend to see a little bit more charge in there for winter preparedness, and those types of things, but we'll keep banging away at it.

That's great, thanks for the insight, and that's all for me.

David Newman (ph), National Bank Financial.

You've implemented a lot of fixes to keep the network fluid into Q4, what sort of growth would you anticipate you can handle next year without the significant CAPEX? Or looking at more traditional growth. If you have another strong year, let's say, in intermodal, which looks like to be the case, what do you think you can handle in terms of the bottom line growth?

David, it's Fred. I think that that will obviously vary by (lean), everything from Moosejaw, Saskatchewan east, we don't have any substantive issues we're concerned about in the immediate future. Anything in the mid-single digit growth is probably manageable for us throughout the west. And if you end up with extreme volume increase, or multiples of that number in the West, then obviously we'd be forced to cap our growth in some way shape or form. So we're in the marketplace now, talking with people about the ability to grow, and we can grow, and we will grow. Obviously our belief and our early evidence of the capacity we're creating through fluidity and co-production is such that not only can we use what we kind of traditionally though we had, but we're creating capacity for ourselves though operational practices. So, again, we'll talk about that in the analyst meeting in a bit more detail in November, but we're not feeling uncomfortable.

Okay, very good. And in 2005, it does look like we're going to have another good year on intermodal overall, certainly that's the projections right now, are you taking measures to protect yourself for any continued interchange delays with your US rail peers?

I'll speak to that not so much on intermodal, because we don't interchange that much business, intermodal, with our US counterparts.

This does cascade into other segments as well, right?

Right. It's more on the merchandise side, and some bulk commodities. And while they're-I like everyone else, read reports about people's issues, but I can tell you that the relationships that we have with the 2 western carriers where we do an awful lot of interchanges are wonderful. The performance that we are experiencing with our western carriers has been improving and continues to improve. So somebody must have issues, because somebody's talking about them, but they're not being experienced by us. Our fluidity interchanging with both the BN and the UP, other than the odd circumstantial thing about a port not being available, or whatever, has been good and is getting better. So we're not experiencing that issue and I'm not anticipating that we will in the foreseeable future.

Okay, and final question if I may, on the intermodal side, with CP Ships, they removed a few large ships out of the Port of Montreal, and it looks like they're sort of grappling with what their strategy is going to be going forward, and it looks like they may start to consider redeploying other ships into other trade lanes, will that have any net effect on you, given that you're somewhat reliant on them for your intermodal side?

We don't believe so. At this point in time our dialogue with CP Ships, clearly they weren't running to capacity with those, and what they've done is try to right-size the ships to reflect the demand that they were bringing in. So, we are one very busy railway, over the Port of Montreal, and happy about it, and do not anticipate any dramatic change based on our dialogue with them.

On the back of that though, let's say they did decide to build their Asian presence, would you accommodate for that in your allocation system?

We have worked, and continue to work with important clients including, Lifeline (ph) is the arm of CP Ships on the west coast. So, we continue to have dialogue with them about their aspirations to grow and I won't speculate on something, what they might do or what I might do in that case. But be assured that we're tightly related with all of our major clients on the west coast and trying to stay tuned into their aspirations.

David, I'd just add to that, we look at managing, our vision is to work with our shipping partners, of which SP Ships is a long-term partner. And managing the value chain of their customers, from Asia for example, or Europe, right through into final destination in North America, so that's our vision, that's CP Ship's vision, so how we accommodate that as Fred says, as the volume in Asia, in your question, took that big delta, is something that we're working on with them directly.

Okay, and last question, I just wonder if I can squeeze one more in. On the grain volume side, are you-what sort of a surge do you expect you might receive in terms of an uptick, given the delays, and certainly, I think some of the tangential evidence coming out of the Prairies is that the dire outlook wasn't as dire as initially forecast. What sort of an uptick percentage wise might we see in Q4 and Q1.

Again, very difficult to predict that with certainty. We do anticipate the Q4 grain volumes in November and December in particular this year will be greater than volumes last year. And I don't know how to quantify that any other way than to say we expect to be higher than last year, in the last 2 months of this year, and probably in the single digits higher.

Well, great quarter gentlemen, and through some very difficult headwinds, so congratulations.

Joseph Leinwand, RBC Capital Markets.

Most of my questions were already answered, but let me go back to one issue. On the capital expenditure issue, expanding the capacity in the west, does this have to be a one-shot all or nothing, could you just gradually increase capacity at sort of a-in a step basis?

Joseph, yes, let me say, it's under active discussion right now with our customers. Mike is working the costs, the benefits, with Fred. I would-it doesn't lend itself to a simple explanation, so I think if you wait until the November analyst meeting you will be satisfied there. But directionally yes, it does lend itself to a, what we call a 'gated' expansion process.

Okay, and just very briefly, just a clarification for Fred. When he said he was offering capacity at premium prices, I assume, and it maybe-correct the assumption, but we're talking about intermodal?

That is correct.

Okay, thank you guys, very good quarter despite the headwinds.

Okay, we are now going to go to the media, I apologize for this going longer, but we did have that transmission issue. So, I will, operator, open it up to the first media question.

Rick Watkins (ph) from Bloomberg News.

Can you give us a specific measure in terms of capacity you expect to create from the co-production agreement in the Vancouver area, and how much more business you could handle if you had incremental capacity and fluidity. Just in that particular location.

Rick, I don't think I could quantify exactly the amount of new business. I would have to turn my mind to that, and perhaps be able to say to you, we can move an extra bulk train, or an extra container train across the terminal every six hours or something. So, by itself, it's important and I think it's the beginning of some good work together with other Class 1s to create capacity, but I just don't know how I could possibly quantify it, other than to say that it's very, very important that we improve the fluidity in the area, and then that positions us to do even more beyond that.

Just to follow up very quickly. Can you give us more details on other co-production agreements, specifically in terms of geographic areas, or other railways that might be involved?

It would be premature to do that, Rick, again, I'm optimistic because I think the interest in this subject matter is heightened in recent times and we have ongoing dialogue with multiple Class 1 railroads, so I would be hesitant to say anything more than I'm optimistic based on the intensity of the dialogue that we've got going with multiple Class 1s that we will be able to consummate some further deals in the foreseeable future.

So that means you're optimistic that you would be able to.

Absolutely.

Brent Gang (ph), the Globe and Mail.

I had a question for Rob Ritchie. I wanted you to maybe elaborate on timing-you said in November at the analyst meeting you would talk about major line expansions. How would your previous comments about getting assurances from Ottawa fit into that as far as open access versus not open access go?

Well, at the analyst meeting Brent, what we can share with other people is how we see the demand. How we see the yield issues developing. How we see the investment matching that demand, how much and when, so what kind of returns we can expect. Now the third one was the, a stable environment, and that relates to price as well. And we will share at that time the discussions that we have had ongoing really, for the last year, about which way we can see transportation law in Canada developing. I will never be able to give certainty in this, no matter what kind of government we have, but it is made obviously more difficult given a minority government, but we will share at that time how we see the lay of the land, the environment at the regulatory level. And it is going the right way, I would say, that's without preempting what we're going to say in November, I believe that the dialogue that Mike, that Fred have had, in provincial capitals and federal capitals are good.

Okay, would this suggest that you're optimistic about having, I guess, the confidence to forge ahead with what could be, I guess you call it 'gated,' but a gradual $500 million investment so that you're not faced with having this, I guess challenge, of having to open the rail lines?

Well, I think we're going to just see how it evolves, a lot can happen in politics in a week as they say, so we're making progress and we just have to finish it off. So we'll know more as the year unfolds.

And just sort of a final query, as for timing, would you like to begin this work by next spring? Or what are you hoping.

We would-if we're going to go ahead, obviously we would like to go-make an announcement before the construction season as I said, so there's nothing we can do between now and the spring, so we've got a window in which to work those 3 pre-conditions.

Mr. Ritchie there are no further questions at this time, please continue.

Thank you. Okay, operator, no further questions, and I thank everybody for joining us, and we will see those in the analyst meeting in November. And for those who don't join us there, we will talk for the year-end results. Thank you very much. Bye.

(Operator instructions).