Canadian Pacific Kansas City Ltd (CP) 2008 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Canadian Pacific's second quarter results conference call. (OPERATOR INSTRUCTIONS) I would like to remind everyone that this conference call is being recorded on Tuesday, July 22nd at 11 am Eastern time. I would now like to turn the call over to Ms. Janet Weiss, Assistant Vice President of Investor Relations, Canadian Pacific.

Good morning, ladies and gentlemen. Thanks for joining us for the 2008 second quarter teleconference. The presenters today will be Fred Green, our President and Chief Executive Officer; Kathryn McQuade, Chief Operating Officer; Marcella Szel, our Senior VP of Marketing and Sales; and Mike Lambert, our Chief Financial Officer. Also joining us on the call today are Brock Winter, Senior VP of Operations and Brian Grassby , VP and Controller.

Before we get started, let me remind you that this presentation contains forward-looking information. Actual results may differ materially. We make reference to assumptions used in our guidance and we provide sensitivities to these assumptions in the appendices, which can be found in the last section of the presentation material. The risks, uncertainties, and other factors that could influence actual results are described on slide one in the press release and in the MV&A filed with Canadian and US securities regulators. Please read carefully as these could change throughout the year.

All dollars quoted in the presentation are Canadian unless otherwise stated. This presentation also contains non-GAAP measures; please read slide two. The slides are available on our website, so please follow along. Following the presentation, we will conduct a question and answer session. Please feel free to queue up for questions now or at any time by pressing the star followed by the one on your touch-tone phone. Here then is our President and CEO, Mr. Fred

Good morning, and thank you for joining us. We have experienced a challenging second quarter with rising fuel prices, a significant lag in fuel recovery, economic softness, and Midwest flooding. These challenges overshadowed positive pricing gains and steady progress in operational solidity. This morning, we updated our guidance to reflect a higher fuel price outlook for the balance of the year and a softening economy. We characterized the fuel issues as temporary with enormous effort underway to speed the transition to a fully responsive program that achieves 100% coverage of fuel expense. Excellent progress is being made across all business groups.

The revenue impact of the economic slowdown will not be recovered in the short term. So I've accelerated the initiatives that we introduced at last fall's Investor Day and temporarily assigned our Senior Vice President of Operations Brock Winter to a full-time role to drive expedited delivery of improvement in efficiency, productivity, and yield across the breadth of the company. The outcomes will be reflected in the fall Investor Day. But the combination of far better fuel recovery, and expedited and broader efficiency deliverables will certainly position us for a more successful 2009. With that I'm going to turn it over to the team and come back to wrap up with some closing thoughts. Kathryn, over to you to discuss the ops performance.

Thank you, Fred. In Q2, we achieved improvements in operational fluidity. We focused on improving train speed and yard dwell, while keeping a tight rein on our mobil assets. It was a difficult quarter to manage with falling volumes impacting train links and weights on our merchandise trains. We're continuing to adjust for volume changes and I am confident you'll see further improvement in our fluidity and efficiency.

Now, looking more specifically on our results, let's start with safety on slide six. We did have an increase in casualty expense for this quarter, which Mike will explain later. However, in terms of safety results, they were exceptional. Our FRA personal injury frequency and our FRA train accident frequency both improved by 47%. Really outstanding results. We continue to be the industry leader in train operations safety. Please turn to slide seven. This quarter saw our train speed improve by 2% and active cars online improved by 6%. However, terminal dwelling car miles per day both came in flat.

We started off the quarter with a strong recovery from winter and improvements across all our metrics. But flooding in the US Midwest took our main line out of operation between Minneapolis and Chicago for 20 days and seriously disrupted our network. Typically we operate 20 trains per day on this corridor. In response we retooled our integrated operating plan, used detours over other railroads and rerouted traffic north of the Great Lakes to keep shipments moving. This line outage and detours increased our active cars online by over 2000 and negatively impacted our terminal dwell and car miles per day.

This added an addition to $3million to $4 million in costs. With the outage behind us we're back on our plan and I'm confident you will see continued improvement in our fluidity. Turning to slide eight, we clearly have some near term challenges and we're attacking the operational issues associated with the slowing economy and rising fuel costs. In the quarter, our operating expense excluding fuel and foreign exchange impacts was up by 2%. This was largely driven by higher purchase services and resource sizing and preparation for the expected volume growth in the 4th quarter. Head count was up versus 2007 largely due to the distortion created by last year's strike of unionized track maintenance employees in Canada.

We are focused on improving productivity and supplementing our IOP initiative with an intense focus on fuel conservation. Some of the things we're doing to reduce our fuel consumption rates include a focus on train handling, train design to ensure that we are operating at optimal horsepower per ton ratios and shutting down everything when it's not in use, not only locomotives but all of our vehicles as well. In addition to our fuel conservation activities, we're implementing more productive bulk train models, such as a pilot we will initiate to run a 142-car potash train to reduce train starts, a 15% improvement in productivity. We're also adjusting our IOP weekly to remove train starts in line with volume changes. We had a challenging quarter and we're actively adjusting our IOP to address the softening merchandise business while at the same time planning for an expected strong fourth quarter in bulk. We will drive hard to accelerate our cost initiatives and implement productivity improvement. Finally, I'd like to give you an update on our DM&E activity.

Please turn to slide nine. This past quarter we crossed two key milestones. The STB determined that public hearings were not required and the deadline for submissions of final briefs has passed. We have encountered no surprises and the STB should render a final decision by September 30th. If approved, the effective date for control would be October 30, 2008. We continue to work with members of the DM&E team to plan for a smooth transition. I look forward to reviewing the decision with you next quarter. Now I'll turn it over to Marcella.

Thanks, Kathryn. In Q2, we delivered 5% revenue growth before FX. Price, including fuel was the major driver offsetting weaker volumes due to the soft North American economy. Looking to the second half of the year, commodity fundamentals remained solid based on global food and nutrient markets and continued strength in coal.

Alberta's energy-oriented economy is also delivering consistent growth. However, with WTI at historic highs and a vulnerable North American economy, the depth and duration of the current slowdown remains a significant uncertainty. I'll now review both the current quarter and our outlook by market area. All numbers exclude the impact of foreign exchange.

Turning to slide 11, grain revenue was off close to 6% due to two factors. First, a 4% decline in carloads over a task compare with 2007. Second, a reduced regulated grain revenue entitlement based on the Canadian Transportation Agency's February 19th decision. We are progressing our legal challenge to this decision. However, our Q2 reported grain revenues reflect the reduction of $2.59 a ton. As a judgment is not expected until the new year, we are modeling this impact through the balance of 2008. And for the second half, we're modeling the 2008 - 2009 crop year at 44.5 million metric tons, slightly below the average.

We are encouraged by reports, particularly good conditions in the southern part of our Canadian draw territory. Turning to coal, we had another solid quarter, up 7%. We moved 4% more tonnage for Elk Valley in Q2. And export pricing now reflects a year-over-year gain following the rate increase on April 1st. We continue to model about 1.5 million export tons over the 2007 actual volume. And we're progressing work on our upcoming Elk Valley contract renewal at the end of Q1 2009. Fertilizer revenue was down 1%, with units 13% lower. The lower units year-over-year are the result of a tough compare to record potash volumes in Q2 2007, due to carry-in from a difficult first quarter. An early maintenance turnaround this year at a major potash mine and a reduction in sulfur volumes due to declining Southern Alberta sour gas production.

While strong export potash volume over the balance of the year will be largely offset by other mixed changes, most notably the decline in sulfur, revenues will be up close to 10%. The Canpotex announcement to invest in ports will almost double their capacity, adding 11 million tons of port capacity by 2012, is a welcome affirmation of the continuing great prospects for this market. As is Potash Corporation of Saskatchewan's announcement last week of their plans to further increase their planned mine capacities, now targeted at 18 million tons up from 10.2 to date. In forest products, overall revenues were off 15% in the quarter due to lumber and panel products. Our outlook reflects a 10% decline for the full year with easier comps in the second half.

As a recurring and sharp contrast, industrial products was up 23% reflecting the continued strength in the Alberta energy economy for products such as condensates and aggregates. I expect industrial products to continue to produce strong year-over-year volume gains and my team will deliver leading price results as well. On the automotive side, revenues were up 3% despite lower volumes due to weak US sales and the impact of the American axle strike on General Motors. Price, fuel, and new long-haul revenues within the mix resulted in the net gain in Q2. Full year revenue expectations remained below 2007.

Intermodal was up 11%. Both domestic and international saw modest volume gains but the key driver was price, primarily fuel. I expect intermodal to deliver some year-over-year volume growth but in a very challenging marketplace. Besides bunker fuel costs, we've seen shipping lines rationalizing routes and low margin business. And domestic is also seeing North American economic impact in areas such as building products.

Now. turning over to slide 12, our revenue breaks out as follows. Price, including fuel, was the key component, up 9.6% with our fuel surcharge delivering about half. The CPA grain provision takes us down 1.1%. Volume and mix was minus 3.4%. And FX reduced revenues by 3.5%. This leads to the all-in reported revenue growth of 1.6%. Now over to slide 13. Contract renewals continue to deliver solid results with 7.4% in the quarter, now 6.5% year-to-date. Respecting fuel, the fundamentals of our program are improving. While the few legacy contracts limit responsiveness, we have accelerated our work with some success to redress these situations as Fred highlighted.

We will be better positioned in 2009. Strong base price results and fuel revenues are showing through an average revenue per car and cents per RTM is up seven and 8% respectively on the quarter before FX impacts. So in summary, a challenging quarter. Looking forward, the economic slowdown is impacting intermodal merchandise, demand for bulk remains strong. I expect stronger second half volumes versus 2007 and primarily in Q4. And with the impact of higher fuel revenues, I've raised my expectations for 2008 revenue growth to 6% to 8%. Now I'll turn it over to Mike for the financials.

Thanks Marcella and good morning, everyone. As always, I'll walk you through the second quarter and give you an update on our outlook for the remainder of the year. This quarter, we again faced record highs in fuel with WTI up over 80% and crack margins up over 60% versus last year. After including fuel surcharges and the lag, the net EPS impact on us was $0.12 in the quarter. Other notable items in the quarter included the flooding in the Midwest and the reduction in our grain revenue entitlement by the CTA. Removing these three impacts from our operating ratio would leave us flat with Q2 2007. An incredible accomplishment considering the challenges we faced.

Now turning to the details. I'll start with our income statement on slide 15. For this chart I'll focus my comments on the FX adjusted variances, which are highlighted in the far right column. Total revenues were up 4% while operating expenses climbed 10%. As a result, operating income fell 16% with fuel and the economy as primary drivers. Looking below the operating income line we gained $13 million after tax from the DM&E. Interest expense increased 35% consistent with our expectations. And income taxes fell by 36% due to lower earnings and lower tax rates in Canada.

Now on slide 16, I'll reconcile our Q2 EPS. Starting on the left with the price of fuel, which was our biggest head wind and cost us $0.43 before any revenue offset. Next, the flooding in the Midwest, which left our main line out of service for 20 days cost us approximately $0.03. The slowing North American economy continued to impact our volume and mix story as automotive and forest products both saw carloads fall by more than 10%. Overall, our carloads were down by almost 2%, which is substantially below our expectations going into the quarter. Versus 2007 volumes and mix net of expenses cost us $0.11.

Next, other revenue was down $0.06 as a result of fewer land sales. And finally, casuality costs were up, costing us $0.04. Now looking at the positives, the strike we faced in Q2 last year gave us a $0.04 tail wind. Price including fuel, offset by the CTA grain adjustment added $0.45. The DM&E contributed $0.04, which is in line with our guidance of $0.15 to $0.17 for the year. Finally, all other including changes in the province of Manitoba's tax rate and the impact of FX cost us $0.01. Overall, we ended the quarter at $0.97.

Turning to slide 17 and a more detailed look at our operating expenses, I'll focus my comments on the FX adjusted numbers shown on the chart. On the right side, you'll see the reported variances which include the impact of FX. Compensation and benefits were down 2% driven mostly by lower employee incentive program costs and lower pension expense. Clearly, the single largest impact this quarter was fuel, which was up 42%. Material costs were up 6% due to higher input costs, most notably the cost of fuel for our highway vehicles. Equipment rent improved 12%, due in part to higher recoveries on locomotive. Including productivity improvements, I expect equipment rents to remain in the $45 million to $50 million range for the remainder of the year. Depreciation and amortization was up 6%, which is in line with our expectations. Purchased services and other was up 12%, due in most part to higher casualty costs.

Though our safety performance was excellent, we did face a few costly incidents and had some trueups from incidents in previous quarters. So, all-in, operating expenses were up 10%. Now before I move to our outlook, let me sum up the quarter. On the top line, volumes came in lower than we had planned. On expenses, fuel was a bigger head wind that we had anticipated. Not only did both these items affect our quarterly results, they also affected our outlook for the balance of year.

Let's now turn to slide 18 and I'll tie everything together. Total revenues are expected to be up between 6% and 8%. This includes a large lift from fuel revenues, offset by lower carload estimates, particularly in forest products and automotive. Total operating expenses are expected to be up 11% to 13%, due again to the rising price of fuel. This includes updating full year assumptions around crude oil to $121 US per barrel - that's $140 US for the second half - and crack margins to $23 US per barrel. That's $27 US for the second half and our all-in costs to between $3.80 and $3.90 US per gallon. With these head winds, we'll continue to focus on driving pricing gains and strengthening our fuel recovery and cost management programs. That won't be enough to offset the challenges we're facing and with that we're updating our guidance to reflect our higher fuel cost assumptions and the deteriorating North American economic conditions.

We now expect our full year adjusted diluted earnings per share to be in the range of $4 to $4.20. Looking at capital, our guidance range is unchanged though we're continually evaluating and re-prioritizing these plans. With the lower earnings, I now expect free cash flow to be approximately $150 million for the year. All of these numbers are based on a full year tax rate of between 26% and 27%, excluding the impact of the DM&E equity pickup. And with that, I'll now turn it back to Fred.

Thanks, Mike. The longterm fundamentals of the rail industry and CP remain very sound and the DM&E continues to perform in line with our expectations. I won't repeat my opening comments, but let me reinforce my committment to overcoming the current obstacles and getting back on track to our sustained pattern of creating value for our shareholders. Now, I'll turn it over to Luke and we'll take some questions.

Thank you. (OPERATOR INSTRUCTIONS). Your first question comes from Cherilyn Radbourne of Scotia Capital. Please go ahead.

Thanks very much and good morning.

Good morning.

I wonder if we could get some commentary from you. We've heard about how the Midwest flooding impacted CP's own operations. Could you just speak to how the DM&E and the IC&E were impacted by the flooding and whether they've fully recovered operations as of yet?

Yes, thank you. DM&E did have some line outages, particularly on their ICE property. However, they are back in service as of several weeks ago. And they're still on plan for the financial targets that they set at the beginning of the year.

Okay. And then just a question with respect to the confidence that you expressed in terms of the bulk volumes in the second half of the year. Can your just speak to what gives you confidence and visibility to those bulk volumes in Q4 particularly?

Cherilyn, it's Marcella speaking. There are several factors that play into it. First, of course are the grain volumes which come up with the new crop year. We expect the crop to come off a couple weeks later than last year. But we will be seeing those volumes through the second half, particularly in Q4. Some of the issues that we saw with the potash, for instance on the potash side there was a significant mine shutdown as I mentioned this quarter which was unplanned. And that will of course, not occur. And so we will see more seasonallized movements of the potash volumes. And we will continue to see the steady increase in the coal side through the second quarter, as we planned.

Okay. That's my two. Thanks.

Thank you.

Your next question comes from Tom Wadewitz JPMorgan. Please go ahead.

Good morning. Let's see. Marcella, you referred to legacy contracts in 2009 and maybe I missed some comments Fred had at the beginning of the call, but can you elaborate on that? You implied that maybe you'd get a chance to take up rates on some of the legacy contracts earlier than expected or there might be some benefit in '09.

What we've done, as Fred mentioned, we're accelerating our efforts around the fuel side, Tom. And so what we have done is we are addressing some of those legacy contracts that have less effective fuel recovery than we would like to see. Those that are not otherwise turning over, let's say in the next three quarters, we are in dialogue with customers. And indeed, we've seen some success with them.

So can you give us a few more thoughts on the magnitude of that? of your bookIs that 5% of your book of business? Or 10%? Is this legacy with inadequate fuel recovery.

Those legacy contracts are about 10% of the book, Tom, in total.

Okay. All right. And then the second one, and then I'll pass it on to someone else. Wondered if you could Fred, maybe comment a little more, the outlook in second half seems pretty muted. I mean you're talking about bulk volumes being better. And I think we would say of the North American railroads, yours should be the least economically sensitive. And yet the outlook for second half seems pretty muted. So, is there-- You're just trying to get guidance a bit more conservative or is the expense performance just worse than you expected or-- I guess it's a little surprising to me that you wouldn't have somewhat more constructive outlook even in fourth quarter given that the bulk outlook seems to be pretty good.

We had to make an evaluation based on what we see happening outside the door. And when we look at the lumber and panel sector, where volumes are down 39% as of this morning. And when we look at the auto sector, where there's-- I don't know how that's going to unfold but it's clearly uncertain as to what plants will remain open and if so, what the distribution patterns will be. Those are the two major sectors that we feel. Now, if I can add just maybe a broader perspective, it would simply be that the US economy has been through a very tough time.

The Canadian economy has been less affected. There is clearly a correlation between the demand in the United States and the activity in Canada to supply that demand. So our belief is that there is no reason to believe at this point in time that we're going to see a resurgence of the economy in the second half. And as a consequence, I don't think I would call it conservative. I would simply say that we think it is realistic and if there is great news, if the economy grows by 2% in the US instead of maybe 1% or whatever the number may be, then that's going to be great news for us. Because we've got the capability and the capacity and the resources that would enable us to leverage that and it would be just more cars on the train. But I don't want to get into a routine hoping that the economy will pick up and building a business case around that. So we are not doing that. What we are doing is saying, we accept it for what it looks like outside the door.

If it gets better, great news. But we need to plan for the possibility that it will sustain or slightly deteriorate. In that case, we need to be focused on efficiency, efficiency, and when we're done with that, we'll focus on more efficiency.

It's Mike. Let me add color around the magnitude of the reduction in guidance. We reduced our guidance by about $0.40 EPS. $0.30 of that is the fuel head wind. And the remaining dime is our outlook on the economy that Fred talked about, somewhat offset by a reduced tax rate. But, three-quarters of our reduction is the actual fuel head wind.

Okay. That's helpful. It is a lot more the fuel than the economy sensitivity. Okay. Thank you for the time.

Thanks, Tom.

(OPERATOR INSTRUCTIONS) Your next question comes from Randy Cousins of BMO Capital Markets. Please go ahead. Mr. Cousins, your line is open.

Good morning.

Good morning, Randy.

A couple of questions with reference to the DM&E. You guys have basically indicated-- I think that things are supposed to be accretive after financing costs. If I look at the results year-to-date, you've got $24 million worth of contribution on a net basis. And if I just annualize that, that's like $48 million for the full year. On a $1.5 billion investment, that doesn't look particularly accretive. Are you guys just looking for an absolutely bangup second half or how are we supposed to think about the contribution from the DM&E in the second half?

Randy, it's Mike. Yes, a couple of things on that. It is still -- we're still projecting for it to be accretive. That's number one. Number two, the results are seasonal. They're right in the middle of the breadbasket of the US. They'll have higher earnings in the second half than in the first half. The third item around that is that we've structured it in a very tax efficient way. The total net impact after tax, our projections are that it'll be accretive $0.15 to $0.17 this year and growing from that.

So, it's still $0.15 to $0.17 for the year? Can you give us some sense of what you estimate the accretion to have been through the first six months then?

The first six months, I think we sized up on each of the quarterly calls. Last quarter, if memory serves, about $0.03 and this quarter about $0.04.

So we are looking for a good bang in the second half?

That's right.

And then with reference to the fuel issue, so let's look to 2009 because 2008 is a writeoff. You said that $0.30 is the hit. Of that $0.30, how much can you get back in 2009 if fuel prices just stabilize where they are today?

If they stabilize at where they are today, actually, we'll have some joy in the second half. I don't know if you've been watching today. So, our assumption is $140 and last I looked it was below $130. So let me at least mention that to you. But If it stabilizes at $140, let's call it, the lag impact next year will be nothing. So if it stays where we've assumed this year, we'll get no joy from the lag next year nor will we have an expense. But as both Marcela and Fred mentioned to you, we're working to get better recovery and better coverage on our fuel. And so the impact next year could be significant.

But in terms of sort of the $0.30, you said that the $0.30 of the reduction in your guidance, $0.30 of it is in fuel. Can you give us some sense as to looking into 2009 how much of that $0.30 you can get back from the customers by adjusting the fuel surcharge systems and just simply allowing the lag to catch up to the reality of where pricing is?

Let me remind you the sensitivity we put out there last quarter and what we're reaffirming this quarter in terms of our recovery, we are recovering. When you exclude the impact of lag, we're recovering in the mid-80s in terms of percentages. By year end, essentially every contract that we have will have some sort of fuel recovery built into it. And so, for modelling purposes, next year, I think on average you could model about 90% coverage. If the coverage is still imperfect in the sense that by year end we're going to have 50% covered on crack and the balance on some sort of WTI metric. And, by next year, we're hoping to have 75% coverage on crack and of course, the balance on WTI. So, for this year, we've been modelling that for every $2, WTI impact costs us $0.01. Next year, that will go down. And the lag of course will affect everybody.

Okay. Great. Thank you.

Thanks, Randy.

Your next question comes from Jacob Bout of CIBC World Markets. Please go ahead.

Good morning. I have a question on the fertilizer and sulfur division. I think you said previously here that revenues would be up 10% by year end. Have you factored in anything for the potash strike at three of Potash Corp's mines? And then does higher potash pricing play in at all for the improvement that you're expecting for the second half? What I'm trying to gauge here is just your leverage here to potash pricing.

Thanks, Jacob. It's Marcela. Let me answer your second question first, as to what impact higher potash prices have. The obvious impact is the strength of the market and continued expansions of the mines and the ports that have already been announced. In terms of our price, it will have no impact on our price, to Canpotex. Your first question around the strike-- At this point in time, it's not clear whether or not in fact there will or will not be a strike. So I can't say what impact if any it will have on us through the second half.

Okay. And then my second question is more of a general question. As far as the switch in freight volumes from truck to rail, what has been the impact that you've seen to date on your book business?

We've been seeing some modest change moving from truck to rail in the shorter haul markets, Jacob. A lot of that is massed by the general economic environment. Because a lot of that short haul environment is also affected by the economy, the moves, the across-borders moves particularly between Canada and the United States. But we have been seeing some migration to rail.

Can you quantify what you think you're picking up as far as market share is?

Jacob, it's really tough for me to quantify because we've also got the impact of the economy in those same sectors. So it's very tough for me to do that.

Jacob, it's Fred. One of the things that's worth noting is that the more sustained the higher fuel prices are, the greater the likelihood that people will make those kinds of choices to do a modal shift. People are hesitant to abandon their supplier of choice, which historically may have been trucks for the medium haul. If it becomes apparent that the price of fuel is going to be sustained at $100 plus, I think after a couple of quarters of that experience, the decision makers in the shipping community are going to be much more prepared to make those leaps. Because there's a leap of faith to give up on a past supplier and move to a different mode. And I believe you'll start to see that manifest itself as we go through the next couple of quarters.

Thank you.

Your next question comes from Walter Spracklin of RBC Capital Markets. Please go ahead.

Thanks very much. Good morning.

Good morning.

Just on the first question I guess will be on your Canpotex announcement on the new supply. There was a great, great news item almost doubling that. And looking at Neptune and just wondering whether yours is a brown field rather than green field project. Have you had any talks with Canpotex as to when they would be looking to roll that out and when you might see some impact from that. And how long that time frame would be for that project and a bit of the cap ex, what you expect the cap ex will then be.

I'd be happy to address it. Let me refresh you on the Canpotex side. And that is this - under the contract that we have with Canpotex today, they've commited 100% of their volumes to Canadian Pacific through to June 2012. So, we've got a full four years of 100% of their volumes. And we currently moved those export volumes to the ports of Vancouver and Portland. Now, in terms of the volumes that we've moved, again to give you some perspective of the history of the Canpotex . In 2004, we moved about 8 million metric tons and in 2008 we expect to move about 10.5 million metric tons. Over a four-year period, We've seen a 30% growth in the volume.

And again, we've got four more years on the contract to go through the ports of Vancouver and Portland, where they do have capacity to grow. Their expected brownfield-- Their announcement around their Vancouver expansion is indeed, as you say, very exciting news. And we've been working with them and in discussion with them on how we can continue to position Vancouver and Portland for the majority of their volumes. Their announcement indicated that they expected to see the port in place by about

Okay. And any -- what kind of cap ex would it be to get set up for that brownfield expansion?

I don't think, Walter, at this point in time, that there's necessarily any capital requirements with regard to the brownfield expansion. I never reject that possibility, I guess, if there's a business case to be had. But our future interest in particular would be to ensure that we have sufficient capacity with regard to locomotives and with regard to track capacity between the ports and the source of the product. So we'll leave that very early. Four years to run on the contract. So we'll get into dialogue, we are in discussion today and what comes out of that remains to be seen. But I won't speculate other than making sure that, with regard to the main line, we will be there with capacity if that's what's needed of us.

That's great color, thanks, Fred. The second question, though, is on staffing levels. You added a nice jump or a pretty big jump in staffing - 1100 about. Is that temporal with everything going on in the quarter or are we seeing some right- sizing in anticipating of the increased volumes that Kathryn mentioned in the second half?

Okay. Walter, it's Mike. I'll take the first part of that. Just to level set everybody on the numbers. In terms of our FTE, the average is up 345 and in the period end basis it was up 687. If you think back a year, our conference call a year ago, I sized up the impact of the strike and I said last year the impact on our average was 400 FTEs and on a quarter end balance it's 784. So we still haven't come up to those levels. But essentially, you'd argue that our FTEs on an expense and capital base were essentially flat. Up until the end of the first quarter, we've always had productivity gains. This quarter it was very difficult to get productivity gains just because the volumes didn't come in as we had planned. And maybe I'll turn it over to Kathryn to give it some color.

Walter, this is Kathryn. Yes, I think I mentioned in my speech that we did have some re-sourcing that we are beginning to do in this quarter in anticipation of our fourth quarter heavy bulk. So you should see productivity improvements in the fourth quarter when the heavier volumes come in.

Okay, that's great. Thank you very much.

Thank you.

Your next question comes from Bill MacKenzie of TD Newcrest. Please go ahead.

Thank you. Mike, just a clarification on the guidance. I just want to make sure its right. You guys have had about $0.13 of tax benefits year-to-date for the reevaluation of your income tax balance sheet. That $0.13 is included in the range, is that correct?

Yes, it is, Bill. But in the first quarter, in terms of our guidance in the first quarter, we had some of that benefit already built in. You recall that the BC tax rate was lower in the first quarter. That helped us in the first quarter. In the second quarter, of course, we had the Manitoba tax benefit. That was a little bit less. And so that's why I'm saying that the economy -- the economy offset by a reduced tax rate, cost us $0.10.

Okay. And then the tax guidance of 26% to 27% for the year includes that. So, next year would you expect tax rates to get back to that original guidance range? What you were expecting prior to these benefits?

Yes is the short answer. The longer answer is a couple of things. The two tax rate reductions, BC and Manitoba, helped us by about 1.5% to 2%. That's a one-timer. And the DM&E has a higher tax rate, so that'll have some upward pressure in terms of our tax rate. But, the Canadian rates are coming down. It'll be an offset. So, our original guidance this years is actually good for your model next year.

Okay, great. And just going back to the fuel recovery program. You've mentioned that roughly mid-80% of your business is covered by fuel recovery program and you expect that to get up to 90% next year. Just to be clear on that, is that mid-80% of your business has some form of fuel recovery or 85% has kind of full recovery. So, for example, if you have a contract that might be tied to WTI but it has a cap in it, would you include the full revenue benefit or just the portion that you're covering on. Or for example if you have contracts that are tied to CPI you might not get the full fuel recovery. Maybe you can help me understand that 85% and 90% number. Whether that's based on customers or actual fuel exposure.

Bill, it's Marcela speaking. I just want to talk about the fuel program for a minute to help clarify a comment you made and then I'll turn it back to Mike. You spoke about an 80% and then a 90% recovery. We are actually going to be 100% covered by the end of the year. That is to say, 100% of our contracts with our customers, our revenues will have some form of fuel recovery mechanism in them by the end of the year. Now, let me just speak a bit about the fuel program recovery mechanism. We started in 2001 when we first began the programs. And obviously, at that time it started with WTI. And as the conditions changed, we modified our program and moved from WTI and from WTI plus margin coverage. In our latest view of the fuel program, which we believe is the correct view, is a mileage based on highway diesel, because that is what most effectively reduces our exposure to margins. On our conversion from contracts to the on-highway, diesel-based program, we will have converted about 50% of our book by the end of this year.

Bill, I'll add to that what I think you're getting at, which is for every incremental dollar of fuel, how much do we get back in terms of fuel revenue? When you take the lag impact out at current assumed WTI and assumed crack margins, we're in the mid-80s in terms of that kind of recovery. I think that's essentially what you're trying to get at.

Yes.

And if you make those similar assumptions for next year, we're saying that's moving to 90% as Marcella continues to improve the coverage.

Okay, great, that's helpful. And just one follow-up on that if I could. How much of that is based on kind of monthly recovery programs versus annual programs? For example, Canadian regulated grain price resets only once a year. How much of that mix of business would be monthly versus annual resets?

Obviously, you've hit one of the key areas, Bill, which is a regulated grain area. Most of the bulk of the rest of the coverage is around monthly program which lags a month. We do have the legacy contracts which I spoke about earlier which represent about 10% of the book. And then you've got you regulated grain on top of that.

Thanks very much.

Your next question comes from David Newman of National Bank Financial. Please go ahead.

Good morning, folks.

Good morning, David.

You mentioned at the outset you're looking at a rigorous process of improved product efficiency and yield. Any specific areas that you're looking to address? And any measures that you're looking to take?

David, it would be a little premature in regard to the quantification. My committment is, by the time we present in the fall, you'll get a very definitive quantification. But, you will recall, that in the investor presentation last fall, we introduced a series of initiatives that were what I would call preliminary. We had IOP and others that were well progressed and well quantified. And we gave you either EPS or operating income benefits that we thought would come of those. But we also introduced a few others. One of which was, for instance, finance ahead of the curve, which was a complete reevaluation of the finance department, its processes, its efficiencies, where technology could help us. We introduced engineering excellence. We believe as well we learned some things during the strike last year about how to get more, I'll call it face time, work time on the track to make our people more productive by changing processes inside. We introduced another evaluation of how to be more efficient in the yards. And we introduced lean approaches within the yards, which was over and above the work we had done earlier in some of the yards. We spoke about railway of the future and how we thought there were a whole series of items with regard to inspection technologies, ECP breaking, fuel efficiencies trough things like Trip Optimizer and other vehicles. And we also spoke about in-train repairs and how we can progress and push that harder and faster. Those are examples. But the point I'm trying to make, David, is that culturally, I think my assessment is that while we're doing good work, the speed between concept and generation of benefits to our shareholders has been too slow.

Okay.

And whether it's an operations-finance yield or administration within this company, we need to elevate the speed and expedite the process between concept and generating benefits for our shareholders. So the initiative that we are pursuing and that Brock is assigned to full-time, across the breadth of this company is to shrink that time frame and generate benefits. I hope and believe we'll see some early benefits in the last half of the year. But my primary focus, very candidly, is to make sure we get ourself in great shape so that we can really get a full year run rate of those types of efficiencies across the full year of 2009.

So, Brock is coming out of the line personnel and working in the capacity to really do operational, for lack of a better word, audits and put a new level of diligence on it. Is that the takeaway?

The way you phrased it, it almost sounds administrative. And what I want you to understand is that Brock and I together a number of years ago worked on several several major initiatives. And we will be taking the same rigorous process approach with intensity and with deliverables. There's not a lot of "audit and overview". It's more action oriented. We think we've dome a lot of the research. Now it's time to bring them to life.

Very good, And the second question more of an operational one. The Western corridor-- Yyou're putting some initiatives in place in the Western corridor. Obviously, you're looking for a very robust outlook in the second half and into Q4 on the bulk side. Is there any measures that you need to take to handle the increased level of volume to ensure that the network is fluid?

David, excuse me. We feel confident that we have adequate capacity in terms of our mobile assets and in terms of our crews and in terms of a track on the Western corridor. I told you in the past we have been powering up our coal trains. We have powered up our potash trains. We also mentioned the longer potash trains as well, which will add capacity. We have ETP braking that for two train sets that we are implementing. And in terms of crews and locomotives, we feel very comfortable to handle the bulk that Marcela is projecting for the fourth quarter.

Is there a number you can put on it in terms of the capacity utilization that you're at right now and what you might scale up to in Q4 by taking various initiatives.

David, as you know, over the course of time in addition to the major initiative we put in place about two years ago to expand the Western corridor, we've also been doing rightful shot, de-bottlenecking. And we have done some of that work again this summer or are in the process of finalizing that type of work. We would like to believe for lack of perfect science that we're probably positioning ourself to be running in the high 70s, low 80s percent of capacity utilization, which we think is an optimal zone. And we think we have a couple more points of activity that we can undertake this fall with new volumes and still leave us in a very efficient zone. Kathryn mentioned, Ill call it, the prehiring. There's a six month lead time between trying to find people, getting them trained, and having them in place. Some of the Q2 expenses we've incurred and some of which we'll incur in Q3 are about getting the right numbers of running trades employees and the right number of mechanical employees so we can keep these locomotives running efficiently and on the road all the time. We've resourced up and we will continue to resource up. We believe that, particularly in the west, the potash story is great; the coal story at $300 a ton, they're going to want to ship a lot of coal. And we're positioning ourselves to be an important and vital part of that supply chain.

So, you don't see phase II Western corridor expansion in the next several years or is that --

I think the secret is that if we can predict with comfort and certainty what the coal company wants to do, then we could consider that. I don't know what the coal company wants to do with regard to volumes. So that's a bit of an unfortunate situation. We can't go out and make a major expansion and hope somebody ships things. What we've been doing is being much more selective. In places where we've got good longterm relationships and contracts-- Potash is a good example. We are putting the capacity in place. In places where we can't get clarity or certainty from our shippers, such as the coal situation, we need to keep our capacity very tight. If at some point in time we can get commitments from those shippers with regards to their intentions and a price that makes sense to us, we'll create the capacity.

Excellent. Thanks, folks.

Thank you.

Your next question comes from Ken Hoexter of Merrill Lynch. Please go ahead.

I want to go over, Mike, some of the numbers. If we go back to last April, at the end of last quarter, when you lowered the target to $440 from $460 and $465 to $480, that was a $0.20 to $0.25 reduction. And you said it was because of the CTA adjustment on the car rental costs. I guess that meant about a $0.05 to $0.06 per quarter. If I take a look at this quarter with as much as yields were down, it seems to be about a $25 million hit to revenues or about $0.10 for the quarter. Am I looking at that the right way? Were yields hit in a bigger way than you would have anticipated on the grain side? Or is there something else within those numbers?

No, Ken. We did and I think we did quantify the CTA adjustment as $0.05 but it was $0.05 to our original outlook. It was only $0.05. It wasn't $0.05 a quarter. It was only $0.05. And so, no, we haven't been surprised by the amount. And that's not what is causing us to reduce our guidance right now. Of the $0.40 reduction, $0.30 relates to fuel, $0.20 of that is just in the price and $0.10 is on the lag.

No, no, I'm not arguing the reaction this quarter. I fully understand what you're saying about fuel. I'm going back to last quarter when you had lowered last quarter. I thought that you had said in the first quarter conference call that the reduction was due to the CTA. Was it also due to other things?

Yes, we only reduced the guidance by $0.05 related to the CTA.

So, of the reduction, only $0.05 was due to the CTA in the first quarter?

Yes, that's right.

Then it would seem like the actual impact-- It seemed like even a little larger, almost twice as big as that, then. If I go between first quarter and second quarter revenue impact or even what a normalized growth rate would have been on a year-over-year basis, if you had held yields flat.

We're not sure we understand the question. You're talking specifically about grain, are you?

I am, I am, yes.

So we had just to give you round numbers, grain was $0.05, fuel was about $0.125, volume around $0.125.

With regard to grain-- I think what Ken's question is, when he looks at the numbers on the Q2, he's seeing a big grain miss. And Ken, that is largely volume. There is the grain haircut. We call it a price haircut. What you're really seeing with regard to the reduction in grain activity is the fact that the prices were so high that the farmers shipped or I wouldn't say preshipped but they advance shipped an awful lot of product. And now we're basically faced with about 50%, 60% of our normal volumes during July and August.

That's helpful, Fred. That was actually the second part of my question, was why volumes were down. What I did on the math was I held volumes flat with year-over-year and using a flat sequential pricing or even flat year-over-year pricing, it still seemed that revenues were down about $25 million, which seems to be about $0.10 a quarter. It seemed like the pricing was also maybe bigger than the 6% decline year-over-year.

Let me quantify the haircut for you. The haircut in dollars is about $11 million a quarter. And we had planned for some of that. And that's why we revised our guidance by only $0.05 in total.

Okay.

Sorry, Ken, that's the missing part. The quantification of the hit is quite large, but we had planned for that in our original plan. So, when you saw the $0.05, the $0.05 only reflected the differential we were surprised by.

By the incremental change. Okay. So, Fred, then help me out. Help me understand how we should look forward then, again, enough of the past. It sounds like still appealing this, you're hoping is maybe something comes, but not until early next year. For the next two quarters, should we look for a similar 5%, 6% yield?

In very simple terms, Ken, Marcela said in her talk, and we want to be very transparent - it's $2.59 a ton. That's is what has come off of our rates relative to last year for the-- And it will be offset by some form of index as of August 1st. I don't know what the number is--

8% index increase.

So, last year, minus $2.59 a ton plus the 8% price increase. It's as simple as that. Accruing that in the expectation that we'll -- we have to take it, but if we win our case, then obviously, that will be a good news story.

And, of course, on the regulated ton.

Okay. And if I can wrap up on that subject, you were talking about the 44.5 million metric ton market as your outlook for the next crop year and that starts --

August 1st.

August 1st. Okay. So with the new contract. Thanks for clarifications.

Thanks, Ken.

Your next question comes from Ed Wolfe of Wolfe Research. Please go ahead.

Hey, guys. It's been a long call. I'll get to you off line. Thanks.

Your next question is a follow-up from Randy Cousins of BMO Capital Markets. Please go ahead.

One quick question. Your real estate or other income was down. Can you give us guidance for the second half?

Randy, you may recall in my commentary in the first quarter, I had alerted everyone that the second quarter would be lower than last year. Essentially, we will be down for total of the year. In modeling I'd say it's just the impact of this quarter. For balance of the year, we should be flat.

Okay. Thank you.

Thank you.

Your next question comes from [Cecilia Quamio] of Platts. Please go ahead.

Good morning. There have been reports that more US coals are moving to Asia because of the unprecedented rise in coal prices and are US coals set to be from as far Utah -- inaudible. It has been stated in this webcast that your company cannot predict what coal companies want. Could your just guide us about your company's plan of action if this development continues and how it can benefit from it in light of DM&E?

Cecilia, at this point in time, of course, we don't source any US coal. We occasionally will terminate some coal at facilities on the current CP or should there be some on the DM&E. The answer is that until such time as we consider whether we ever want to be a railway that sources the Powder River and we are not at that point in our decision making at this time, there's no impact whatsoever on either the DM&E or on the Canadian Pacific franchise.

My second question [your company 7% more] in Q2 2008. Is this largely a result of increased demand for the material in Asia? Do you expect to move more tonnage for Elk Valley and for other Canadian coal producers?

Cecilia, it's Marcela speaking. As Fred mentioned earlier in one of his comments, we don't know what else Elk Valley plans to move in 2009. And we'll wait for their guidance and we would hope to see they would move more coal. But they'll tell us what they want to move in 2009.

But for the second half, yes, we do expect good strong demand. It's within the range we had told the street. I can't remember the exact number, it was 21 or 21.5 million tons total for the year. So, we are pretty much right on target for what we thought would happen. And there's no reason to believe that'll be different unless Elk Valley shares that with the marketplace and they'll share it with us at the same time.

Is this for the second half or for the whole year?

I believe that was full year absolutely full year but I don't remember the exact numbers.

I can give you that. For the full year we planned on moving 1.5 million tons more in 2008 than 2007. And as Fred said, we are right on plan to do that. We've moved about half the total volumes and we're about halfway through the year.

And that is just for Elk Valley?

Yes.

What about for the other Canadian coal producers?

We're not involved in anybody else except Elk Valley.

Okay. Thank you.

Thank you.

This concludes the question and answer session. Mr.Green, please continue.

Thank you everybody, for spending time with us. We look forward to getting together at the quarter and Luke, thank you for all your help. Bye now.

Ladies and gentlemen, this concludes the conference call for today. Thank you for your participation. You may now disconnect your lines.