Canadian Pacific Kansas City Ltd (CP) 2008 Q3 法說會逐字稿

Good morning ladies and gentlemen and thank you for standing by. Welcome to Canadian Pacific's third quarter results conference call. All participants are in a listen only mode. Following the presentation, we will conduct a question and answer session. (OPERATOR INSTRUCTIONS).

I would like to remind everyone that this conference call is being recorded. And I will now turn the conference over to Ms. Janet Weiss. Please go ahead, ma'am.

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

Before we get started, let me remind you this presentation contained 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 MDNA filed with Canadian and US securities regulators. Please read carefully as these assumptions 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 feel free to follow along. Following the presentation we'll conduct a question and answer session. Please feel free to queue up for questions now or at anytime. Here again is our President and CEO, Mr. Fred Green.

Thank you for joining us. For clarity, Kathryn's title is Executive Vice President and Chief Financial Officer.

This quarter the combination of continued pricing gains and good cost containment helped to offset weaker than expected bulk volumes. Excluding fuel, our operating ratio increased less than a point. This is a solid result given the 6% decline in revenue ton miles. The team did a fine job delivering on price targets and managing our expenses down in response to softer than anticipated volumes. You'll recall that in July, CP took a fairly conservative and some would say negative view of the economy for the balance of 2008, forecasting softer volumes. In hindsight I'm satisfied that we recognized the potential risk and began taking actions.

The October operating metrics are outstanding. And as Brock will share, our efforts on efficiency are starting to pay off and our early expense management efforts will serve us well in Q4 and 2009. All in, a good quarter under tough market conditions.

Now I'll turn it over to Brock, Marcella, and Kathryn to detail our results and tell you how Q4 is shaping up. Over to you, Brock.

Thanks, Fred. In Q3 we focused on improving our fluidity and productivity, while keeping a tight reign on mobile assets. We're continuing to adjust for volume changes and I'm confident you'll see further improvement in our fluidity and cost containment.

Now looking more specifically at results, let's start with safety on slide six. Our safety results were excellent. Our FRA personal injury frequency improved by 16% and we continue to be the leader in train operation safety with an improvement of 38% in FRA train incident frequency.

Please turn to slide seven. We started off the quarter with the recovery from flooding in the US Midwest. You will recall that this took our main line out of operation between Minneapolis and Chicago for 20 days in June. And this seriously disrupted our network fluidity. You can see on the charts, this line outage negatively impacted our key metrics for a portion of the quarter.

But we've made progressive improvement. We have sense returned to planned performance in all metrics and for the first weeks of Q4, we are running at a rate that is significantly improved over Q4 2007. Train speed is up 6%. Our car miles per day are up 5%. Our terminal dwell time is down 13%. And active cars online are down 5%. I am pleased with our fluidity and I expect these trends to continue.

Turning to slide eight, we are aggressively attacking the operational cost control opportunities given the slowing economy. In the quarter, operating expenses excluding fuel and foreign exchange were up 1.5%. We've been actively scaling back our resources in response to volume challenges and have eliminated all discretionary spending, adjusted our integrated operating plan to run longer and heavier trains and where we are seeing regional softness we're quickly tying up surplus assets and laying off crews.

And we're seeing the results. For example, train weights have improved by 1% and fuel consumption improved by 2.6% in the quarter and there's more to come. We continue to adjust our IOP to drive increased train productivity while still delivering a consistent, reliable product to our customers. In addition, we're implementing further efficiency measures current economic environment. The railroad is fluid and we are well positioned to efficiently handle Q4 volumes.

I look forward to reviewing our new cost containment and productivity initiatives at our investor day. I'll now turn you over to Marcella.

Thank you, Brock and good morning. In Q3, we delivered a solid 8.5% revenue growth before FX. Price, including fuel, was a key driver. Despite a softer economy our balanced portfolio performed well.

I'll now review both the current quarter and our outlook for the year by market area. All numbers exclude foreign exchange which had minimal impact. Turning to slide 10, overall our bulk portfolio showed good performance in the face of a number of unique events. The merchandise and intermodal businesses have strong price performance on the quarter.

Now looking in detail, grain revenue was off 4%. The harvest was later than normal and carrying stocks were low, resulting in volumes 13% lower than 2007. Volume declines were partially offset by solid price results. There is excellent production in both Canada and our US territories. Canadian production is estimated at about 50 million metric tons, an above average crop. In North Dakota, the main part of our US grain franchise, we're seeing record production of the major grains. I anticipate the volumes in Q4 will be tempered by farmers holding some inventory. However, the grain has been grown and what doesn't move in Q4 will move in 2009. Overall for 2008 revenues will be about flat.

In our pull franchise, revenues were up 5%. The improvement reflects our export rates increase April 1st and other price gains within the portfolio. Carloads were off just under 1% versus Q3 '07 and were less than we expected. The decline was due to down time associated with the capacity expansion at a port terminal, as well as mechanical issues at one of [El Fally's] mines, which has just been resolved. The production issues result in half a million ton reduction to our export plan with about 60% of the impact in Q3. As a result, I am now expecting our 2008 coal export volumes to be approximately 1 million metric tons over 2007 versus the 1.5 million metric tons I mentioned last quarter.

In the sulfur and fertilizer portfolio, revenues were up 8% on price. Revenues were impacted by lower than expected potash carloads due to a strike affecting three mines. The timing of the resolution of the strike remains an uncertainty so we've modeled it to continue through Q4. Export sulfur volumes also declined, largely due to a plant outage. Overall in this portfolio, 2008 revenues will be modestly up.

Forest products volume declined 15%, offset by price improvements, resulting in revenue down only 2%. Given large declines in the first half of the year, we expect the full year to be down double digits in both revenue and volume. Industrial and consumer products continues its strong performance with 25% revenue growth, reflecting both price and volume gains across the whole group. Q4 and the year should see continued double digit revenue growth based on our strong price performance.

Automotive revenues improved 17% on the quarter despite an 11% decline in carloads due to weak auto demand. The average revenue per car was up 30%. This reflects key contract renewals with improved base pricing and fuel recovery. As well, a reduction in short haul volumes contributed to the average revenue per car. For the year, I expect continued volume weakness in this sector.

Finally, intermodal revenues were up 12% in Q3 with flat volumes, price was the primary driver of the improvement. And with the fall shipments complete, there will be a small volume decline year-over-year were Q4 and declining WTI will moderate price, so for the year, I expect single digit revenue growth.

On slide 11, you can see the breakdown of the revenue performance. The quarter presented some challenges, but revenue was still up 8%. The breakdown is as follows. Price, including fuel, was up 14%, with fuel representing approximately 60% of the improvement. The impact of the Canadian Transportation Agency's reduction to the grain revenue entitlement takes us down nearly 1%. Volume and mix was minus 4.5%. And FX had a negative half point impact. This leads to revenue growth of 8%.

Finally, over to slide 12. The value of the service we provide to our customers enabled the team to bring in solid price results with contract renewals of 6% for the quarter. Our fuel program delivered improving quality and coverage. With respect to timing or the lag impact on fuel recovery, a moderating fuel price late in the quarter provided a small lift but it was an insignificant tail wind overall in Q3.

Looking to the fourth quarter, bulk demand is solid, but volumes will be limited by the customer production issues I mentioned. In the balance of the portfolio, I'm modeling the Q3 volume trends to continue into Q4. With continuing solid price and fuel results, I expect 2008 freight revenue growth to come in the mid-single digit range. Now over to Kathryn for financials.

Thank you, Marcella and good morning, everyone. To begin, you'll note in our press release we further reduced the valuation of our investment in asset backed commercial paper by C$28 million, a further 19% writedown. To date, the cumulative is C$71 million or 49% of the original investment. While these securities have not traded to date, we believe the lower value better reflects current market conditions. For balance of the presentation, I'll be discussing earnings excluding the impact of this writedown. The reconciliation to our GAAP earnings is in the appendix of our slides.

Now turning to slide 14 and a look at the Q3 income statement. I'll focus my comments on the far right column which shows foreign exchange adjusted results. Total revenues were up 7%. Freight grew 8% over last year with price increases, including fuel more than offsetting softer volumes. However, our other revenues ended down 37% due to the timing of land sales, but are expected to be in line for the fourth quarter. Operating expenses were up 12% and I'll go through each of these expense line items in the following slide.

Overall, operating income was down 7% and our operating ratio came in at 76%. Taking away the impact of fuel price, our operating ratio would have been 275 basis points better. The DM&E equity income was C$17 million in line with our expectation. DM&E equity income net of the associated after tax interest expense added C$0.05 to our EPS in the third quarter. The impact is C$0.13 and we expect the end of year to be above our estimates of C$0.15 to C$0.17. As you know, the STB issues its decision on September 30th, giving CP approval to move forward with the acquisition. We will be taking control of the property on October 30th and 4th quarter results will reflect the DM&E earnings on a consolidated base for November and December.

Next, interest expense increased by C$20 million or 46% due to higher debt levels. Income taxes were down by 15% as a result of lower earnings and lower tax rates. Finally, the adjusted diluted earnings per share came in at C$1.20, down C$0.03 from last year.

Now turning slide 15 and a look at our FX adjusted operating expenses. The largest increase was fuel, which was up over 50% followed by purchase services up 7%. All other expenses were relatively flat, so I'll give you further detail on the puts and takes.

Now let's turn to slide 16 and fuel expenses. Our all end cost of fuel was $3.94 US per gallon, a 64% increase over third quarter 2007. Turning to the right side of the slide, you will note that fuel prices increased expenses by approximately C$104 million. Lower volume and improved fuel efficiency programs discussed by Brock partially offset the price increases by C$14 million. Fuel used in transportation services was up C$90 million.

Turning to slide 17, purchase services and other, casualty costs were up quarter over quarter by C$9 million, and this was the primary reason for the rise in this expense line. Looking at the graph on the left, year to date total casualty expense is over C$23 million higher than the average for the last three years despite our improved safety performance. This is due to higher lading and wreck damage costs and the second quarter floods that Brock mentioned again. We do not expect casualty expenses to continue at this level and believe it will better correlate to our safety performance in the future.

Turning to the next slide, compensation and benefits, this quarter compensation expenses were flat to last year. However, there are a number of moving parts. Incentive compensation was lower by C$19 million, which reflects our lower year to date financial performance. Stock based compensation was higher this quarter despite our lower stock price due to the total return swap. The swap is in place to reduce earning volatility when our stock price takes large swings up. However, it has created head winds this quarter as the stock price fell. If the stock price closes the fourth quarter below this quarter's close, we will have further expense.

Another headwind for the quarter for this quarter was the C$11 million benefit recorded in 2007 from a one time trueup for post retirement benefits in the US. Inflation, FX, and a number of very small items added C$3 million for a quarter over quarter decline of C$1 million.

Touching quickly now on other expenses on slide 19, depreciation came in as expected, ending up C$2.8 million including a very small benefit from FX, while materials ended the quarter essentially flat with good cost discipline offsetting inflationary pressures. Finally, equipment rents fell by C$5.2 million with C$1 million of that coming from foreign exchange. The remaining came from a combination of higher recoveries, lower volumes, and improved productivity.

Before I conclude, I'd like to touch briefly on our balance sheet on slide 20. With the volatility in the markets and the tight credit environment, I think its important that I briefly discuss our liquidity. First, we are still projecting free cash flow of C$150 million for 2008. Second, I will remind you we did go to the markets and raise over a billion dollars in long term notes in May and June of this year with very favorable terms. The proceeds from those debt issues were used to pay down the majority of our bridge financing in place for the DM&E. We have $200 million US outstanding that we plan to repay from cash between now and its maturity date in April 2009. Beyond that, we have no remaining long term debt to refinance in the near term.

Turning now to my final slide and a look at our 2008 guidance. For the fourth quarter we are now assuming foreign exchange to be $1.14 per US dollar and WTI to average $85 US for barrel. Looking to the full year, lower volumes and falling fuel prices will likely move our revenues into the 4% to 6% range and separating expenses into the 8% to 10% range. These ranges for revenue and expense are for CP only and do not reflect the impact of consolidating DM&E for the last two months. We are keeping our guidance for the adjusted diluted earnings per share in the range of C$4.00 and C$4.20. We believe the volume uncertainty stemming from the global economic slowdown and some customer production issues are offsetting tail winds created from lower crude prices and the weakening Canadian dollar against the US dollar. I'll turn it back to Fred for closing thoughts.

Thanks, Kathryn. As you heard expense management and discipline pricing were the key drivers of our Q3 results. Going into Q4, we have some volume uncertainty with strike related production issues in potash and coal production issues that have caused us to moderate our full year export forecast. Fuel is volatile but has come off the summer peak and is providing some welcome relief to CP and our customers and the quality of our fuel recovery program continuing to improve. As we move into this period of economic uncertainty, you can expect both our disciplined approach to pricing and our heightened level of expense management activity to accelerate. We look forward to having a dialogue with you regarding our 2009 expectations at our investor day in November. And with that, I'll turn it over to Janet.

Before we move to Q&A, I'd like to remind everyone the focus of our today's discussion is on our Q3 results and expectations for the balance of the year. We will address 2009 in our investor conference on November 13th. The event will be webcast and will cover our market outlook strategies and prospects. Details can be found on our website at www.cpr.ca and with that I will turn it back to Yvonne for questions.

Thank you. (OPERATOR INSTRUCTIONS). Our first question comes from Walter Spracklin of RBC Capital Markets.

Good morning, everyone.

Good morning, Walter.

First on the pricing, I was wondering, given the current environment if you always do get pushed back on price increases. If you could give us a sense of what your price increase is excluding fuel surcharges in the quarter and if you're getting any significant price pushback from your customers given the current economic conditions.

Thank you, Walter. This is Marcella. On the price increases on the quarter, we've achieved on our renewals a 6% range over all on our book. And that is a very solid price increase and we expect to see that going forward into Q4 with a disciplined price program.

And what percentage of your business is rolling over the next 12 months?

I can speak about 2008. The percentage of the business rolling over in 2008 is about 50% of book. Of that we have already rolled over 3/4 of the book with the price improvement about 6% renewal on average. We have a quarter left to go. If you just take a note that into the last quarter with the fuel alleviating, that will alleviate some of the total pressure on price. So, I've got confidence that going into the last quarter, we'll be able to maintain our pricing discipline.

That's great. Thanks, Marcella. Second question on your industrial and consumer product line item, strong growth so far this year. I was wondering what you see as the risk here. Is this the one that you would consider to be the most sensitive to the economy? And therefore should we start looking at that very strong trend starting to come down? Or are there things that should lead to continued strength in that segment?

Walter, the two segments that are most subject to the economy are the forest products and the automotive which are not included in our industrial products category. In industrial products we have largely the energy related commodities. So we have seen strong growth over the year and certainly in Q3. And going into Q4 I expect that growth to continue at double digit growth. It will moderate somewhat because it includes steel. And we have accounted for some of the deterioration in the steel markets.

And then last question on the DM&E. I believe there were two appeals that were files against the STB ruling. Is there any update on those?

This is Kathryn. The appeals will not interfere with our ability to take control on October 30th.

Okay. That's all I was looking for. Thanks very much for the color.

Thank you.

Your next question comes from Jason Seidl of Dahlman Rose, please go ahead.

I'd like to drill down a little bit more on the contract renewals. An average of 6% on the book. If you were to look at the more economically sensitive commodities that you're repricing, would that be significantly lower than 6%? Would that be flat?

Overall, we're achieving a 6% range on the renewals. That changes in different commodities and different groups. But overall our expectation is to continue at that range.

Okay. And for Q4 with the Canadian harvest, you mentioned that the expectation is for some of that not to move with the farmers. What percentage do you have baked in your forecast in terms of expectations for the harvest moving?

It's Marcella speaking. What we expect to see and I'm anticipating seeing is that some farmers will hold inventory in order to achieve a higher price. They're sitting here with prices for the grain commodities down over the highs this year, but not as low as it has been in the past. We still have a pretty good price out there. I expect they're going to hold it to see if the price improves over the balance of Q4. But probably into 2009.

Jason, for clarity. We're going full tilt moving grain right now. Marcella is trying to be as transparent as she can be about the motivations of the farm community, which we understand. When it comes to moving grain, Brock's team is hustling grain like you wouldn't believe.

I appreciate the color on that. If I can turn to expenses for a moment, expense is still up 8% to 10% for Q4. When should we expect that to get more in line with sort of your revenue line item? And what are the key things? Fuel is going to be helping out in the fourth quarter. What are some of the other key things?

Jason, it's Fred. If you exclude fuel from the increase, I think in Brock's statement, he said our expenses were up 1.5%. If you want to take a peek at our performance from a productivity perspective on expenses per GTM level, we're performing quite well. The fuel is masking a lot of performance. We understood that. That's visible to everybody. Obviously, fuel is coming off in the fourth quarter. I would expect that you're going to see the evidence of our productivity and our efficiencies manifest without the fuel confusion in the fourth quarter.

Okay. Fair enough, guys. Thank you for the time.

Thank you.

Your next question comes from Randy Cousins of BMO Capital Markets. Please go ahead.

Good morning.

Good morning, Randy.

I wonder if you could comment on the tail wind for fuel. For a number of other class ones, the tail wind actually worked in Q3. Clearly it did not work for you at least based on your commentary. Could you give us some sense of tail wind for Q4?

I guess for context the most important way to think about this is that the reason it wasn't much of a tail wind, an insignificant tail wind in Q3 is that the coverage that we have which we've been beaten up for appropriately over the course of the year didn't give us the kinds of revenue streams that we would have liked to have had and obviously, in the future we would expect to have as we convert our program. We're not going to ride that tail wind into Q3 in the order of magnitude of other parties. What we've said the insignificant in Q3. It will be bigger in Q4. But I'm not sure it's going to be a material item on a relative basis. Is there good news? Absolutely good news. Orders of magnitude, we didn't get the run up so we're not going to ride the tail wind the way some others might for the fourth quarter. By the time we get to the end of the year, beer back on a level playing field.

You seem to be make progress in productivity at least from an asset perspective. I wonder if you could comment on what's happening in terms of GTM's proactive employee. We have 5% deterioration in the first quarter. When do we get that back to zero? Or when do we start to see that on a positive note?

My expectation is that we'll start to see that take effect in the fourth quarter. And let me just give you some color on that. As Marcella said our expectations for volume were a little bit higher than we expected for Q4. We obviously sized our resources, our locomotives and employees primarily anticipating those volumes. And so we'd be ready for the end of the third quarter and into the fourth quarter. With that softening, we've taken aggressive actions quickly in terms of laying off locomotives and laying off running trades employees. I would expect our productivity on a GTM per employee basis to come into line by the end of the fourth quarter.

Just a little bit more color. I think Brock has told the story very appropriately. One of the things that can be a little deceptive is the expense employees versus capital employees. In the third quarter we had a full capital program underway. Last year we had our strike that affected us because we had to cut back our programs. Of the total employees, we are flat on expense employees, our capital employees were up in the third quarter. What you'll find is that we've hired and trained and unfortunately we're in a situation to lay off some of the employees we brought on in an effort to meet the potential big volumes. We see good volumes. We don't see the far end of the spectrum. I'm comfortable and Brock is that we'll start to see that productivity, which is already pretty good compared to some other folks, really come together in the fourth quarter.

And then final question, I wonder if you could with the Canadian dollar where it is, what your sensitivities are to earnings in changes in fuel and looping back as part of the tail end of it. Are you looking at hedging fuel is C$70 a barrel or less. You may still have exposure. Are you looking at putting in a hedge program so that if fuel went back to C$140, you wouldn't take the pain again.

There's a lot of components to the question. Let me address fuel. The important thing for us is to take a program that was nonresponsive to WTI in some cases largely overcome that. Particularly, nonresponsive on portions of our business to the crack. And we've tried to identify that and make that clear to people. As we've turned over contracts and renegotiated a number of contracts even though they weren't due, we have continued to shrink the amount of nonresponsive business. There is still some. You can expect us to do some form of forward purchasing to protect that risk about the possibility of a run up, particularly on crack that we are not covered for in the foreseeable future. As an underlying premise, we are not going to get into the game of speculating on where the price is going to go as our coverage improves on both WTI and crack, we would ideally like to be in a world that we don't have to forward buy or forward hedge. But, in the interim until we get there and it will e a diminishing amount over the course of 2009, we will take the volatility out of our next 2009 that we experienced in 2008.

And in terms of the sensitivities, I think number used to be a buck and the price for oil was a half a cent and a buck in the crack spread was $0.02, are those good numbers?

We're just --

Randy, its Brian, those still hold for 2008. We will be updating you on that in 2009. This sensitivities around that. And your first question was around foreign exchange. Still within the range of and C$0.01 cent change in the Canadian versus US would be roughly C$0.01 cent EPS.

Thank you.

Thank you.

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

Thanks, good morning. Kathryn if there's any change in the CapEx guidance for the year?

There's no change in the CapEx at this point.

Can you talk a little bit, Marcella, about pricing in terms of as you end this year, how much visibility do you have roughly directionally? What part of your business is locked in for next year as you end this year at year end?

We've got 50% of our book turned over. 3/4 of that is repriced. So that is locked into next year.

Hello, Ed?

Your next question comes from Cherilyn Radbourne of Scotia Capital.

Thanks very much and good morning. Marcella, I wonder if you could speak to the strong pricing in industrial and consumer products automotive and intermodal where you had performance substantially above the other business segments. Were there some contract renewals in there that were particularly strong?

I mentioned that in the automotive side we had some old legacy contracts that turned over in the quarter and we were able to bring them up to a good range on the pricing and fuel side. The balance of the portfolio that you referred to is a continuation of our strong pricing program.

Okay. And can your just give us a little bit more color on the extent to which you improved your fuel recovery in Q3? Review the coverage ratios that you have in place at the end of Q3 versus the end of Q2 based on the work that you did in the quarter?

Sure. As I mentioned, we've been improving our coverage over the course of the year and certainly into the last quarter. We've attacked it on a number of bases. First of all, 100% of our customers are covered with some kind of fuel provision. And thus, all the contracts contribute to our fuel recovery. We said that we would be at 50% coverage to reflect crack margins within those fuel programs and we will be there by the end of the year.

And how close were you at the end of Q3?

At the end of Q3 we were, oh, let me say 48, 49%.

So pretty close already.

Pretty close.

and then last question, this has come up on a number of conference calls, we're hearing in the press about global trade slowing down because banks are reluctant to accept letters of credit from other banks. And you're hearing about things backing up at the ports as a result. Has that had any impact on your business in Q3 or early in Q4?

Its had no impact on our business so far as we know in Q3. Going into Q4 I'm aware of one commodity with one country where there has been product that has not been taken. Other than that I have not heard of any such indication on our business or our customers.

Thanks very much, that's all for me.

Thank you.

Your next question comes from Ed Wolfe of Wolfe Research.

Thanks. I got cut off. I was trying to ask to clarify the 75% pricing visibility. What you were saying is effective January 1st. You have full visibility to 75% of your pricing for the full year '09 at that point.

I have full visibility to 75% of the 50% that is turned over this year, Ed. In terms of what we have for the full year of 2009, we're going to update you at our investor date.

Okay. Can you, Fred, just talk bigger picture about DM&E today. What if you had to look at this from what you would have thought nine months ago, what's going better? What's a bit more of a challenge than you would have thought?

Overall we're quite pleased and delighted with the work that the management team and integration team has done. Kathryn made reference to the fact that we would expect to outperform our anticipated EPS contribution to our CP numbers and that's overall a pretty good story. The demand has remained quite strong. The conservativism that we took when we evaluated the property and when we built our own assessment of the revenue generating capabilities is paying off. Some of the ethanol expectations put in by other parties. And of course, we have seen some ethanol deferrals and a handful -- I'm not aware of anything that shut down as much as things that haven't started up yet. But all said and done, they are surpassing the top line, we said we'd do double digit topline and EBITDA growth. Both of those have delivered. Kathryn and her integration team have successfully worked in a fashion that we have now been given the authority to proceed. And we got every single thing we asked for. And the only conditions imposed on us are those which we offered up, which we think are very modest and sensible. And I think I come away saying that everything that could have occurred in a favorable way has. So I don't have any apprehensions going forward that it's going to deliver all the things we said it would deliver to our shareholders.

In terms of Elk Valley, can you talk to I assume you're in negotiations already and just directionally if you expect to structure the contract in a different manner than the last time around.

I think Ed, we're in dialogue as we've been for a period of time. Where that leads is yet to be seen. Probably best because it's a 2009 issue that we don't spend much time today if that's okay. I prefer that we'll try to provide whatever insight without compromising negotiations if we can at the 2009 day which is only two weeks away.

See you in two weeks.

Thanks, Ed.

Your next question comes from Ken Hoexter of Merrill Lynch.

Hi, if I could start out with a couple of financial questions. Kathryn, when you talk about the C$4.00 to C$4.20 EPS number. What base are you working off of for the first nine months? Are you excluding the foreign exchange gains?

Yes, I am.

So you are starting about C$2.75?

Yes.

And then any reason why you're looking for oil of C$85 for the fourth quarter? We're at C$63 now. Are you anticipating a big run up?

You know, it's a sliding scale. When we were first doing our outlook, it was C$85 still looked good. You know, we feel that WTI has up and down. It's volatile. And so we tried to pick a middle ground. I don't know if you have keen insight, we'd love to see what you think. You always go into the winter months wondering what's going to happen in terms of supply and refining margins and everything else. So it's a lot of volatility.

Okay. And then the customer production issues you mentioned. Is that -- can you delve into that a little bit?

Ken, this is Marcella. There were customer issues on a number of fronts. As I mentioned with Elk Valley coal, there were a couple of issues. The first was at Westshore terminal they took it down to start capital expansions. The second was equipment at the one of the Elk Valley mines which was down for a significant period of time and it has just come up. Because of the lack of production, the volumes simply weren't there.

I meant going forward when you talked about the risk to the fourth quarter. You said one of the concerns were a customer production issue.

With respect to Elk Valley because the belt just came up just this week, it's going to affect October and our volumes have come down from expectations for quarter. Turning to potash, we have modeled that the strike will continue. I have no idea what will happen with the strike, when it's settles and how it settles.. The strike will develop for the quarter and that affects our production and takes our volumes down.

As we look to November and December and integrating DM&E into the results. A size of the number of carloads what the average yield per car for those DM&E cars.

We'd have to do that on the run. We're not able to do it off the top of our head. I'd prefer not to speculate. I don't see a reason we can't provide that information.

And what we plan to do in terms of giving your visibility is in our fourth quarter we will provide a 2008 pro forma completely consolidated with DM&E. You'll have a good year-over-year comp for 2009. And for 2009 in our analyst meeting, we'll give you a little better idea of the impact that DM&E will have.

Okay. Fred, just looking into -- I know you don't want to talk about '09 yet. I just want to look at revenue and expense targets that someone brought up earlier. The expenses were 2 times right now. They were basically on fuel as you look forward I know Brock said it was up only 1.5%. I take it you don't expect that two times relative to revenues to continue?

And Ken, again, it's almost entirely driven by the fuel. Our belief is that improving that ratio is clearly something that we aspire to and it's clearly consistent with what we've done for three years in a row until we got whacked with the fuel and some pretty dramatic slowdowns. The pattern that worked for three years is a pattern we'd rather have.

On the oil sands, have you seen a pullback in commitment as we see WTI drop down to low 60s?

There's been a lot of dialogue in the community. But I'm unaware of a lot of specific cutbacks that have been publicly documented at this point in time. So I think it's probable that of the portfolio of potential capital investments, that there will be some that either get deferred or actually even killed. But it's out of such a large portfolio that as Marcella said earlier, we continue to see, and I have to say our merchandise business is strong in October. We continue to see a lot of inbound products. We think it will be a function to have sustained price of fuel. If price goes down to C$50 and stays there, clearly it would have a bigger impact. I don't know if anybody believes that's a realistic scenario. The amount of capital in the oil sands is substantial. And those programs can't really shut them off overnight anyway.

That's helpful. Thanks for the time.

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

Yes, good morning.

Good morning.

I know you've had a couple questions on fuel. I don't have my arms around it. A couple details on that. What it was the impact that you characterized year-over-year from fuel if you look at the expense and surcharge combined impact?

In the - -

In the third quarter.

Fuel had a 275% basis point reduction to our - - increase in our operating ratio.

And that's the increase in sur -- or increase in expense net of increase in surcharge revenue?

Also the impact of adding both to the revenue and expense line. It causes a portion of that as well.

I'm sorry. You cut a little bit.

What we were saying that is if you exclude out of your revenues, your revenue fuel surcharge and exclude out of your expenses the price run up. It had a 275 basis point impact on our operating ratio.

And Tom, maybe for clarity on the last point. If you put a couple hundred million dollars in or half a billion dollars in, and take the same amount out, it's effectively 100% operating ratio. That in addition to the net impact is what adds up to the 275 basis points.

Right. Okay. So was there a big difference in the increase in surcharge revenue versus the increase year-over-year in fuel expense?

It's consistent with what we've told that we've been improving our effectiveness and we're in the high 80s in terms of price recovery. So 88 to 90.

I know you have the different moving parts with the crude oil and crack spread. But you're saying you're high 80s coverage on an all end basis is that the right way to look at it.

That is.

Okay. Why wouldn't you see -- if that's the case -- why wouldn't you see a benefit as fuel prices decline. If you're undercoverred you would then be seeing a meaningful benefit. But it sounds like you're saying don't expect too much of a benefit as they declined.

I'm trying to be balanced, Tom. We're not -- we don't have that big sale that we've been enjoying as some others have had. We're not going to have the same tail wind into the fourth quarter. There is in fact reducing volumes relative to our expectations that will mitigate some of the potential benefit if there is a tail wind. I think we're just trying to be balanced in our perspective and you guys can reach your own conclusions. My assessment at this point in time is that we should have a better tail wind if I can use that phrase in the fourth quarter than in the third. But it's not material and as a consequence I don't want people overreacting to it and getting excited that it's going to be our salvation. The good news is with the coverage improving and it will get better through Q4 and Q1 this whole fuel issue ought to be a nonissue by April of next year.

Okay. I appreciate your patience on those topics. Any comments you can make about bulk outlook, let's say coal outlook? I think a lot if you look at the coal stocks and commodity stocks, there's a lot of concern about global demand for commodities. Is there anything you can say about what you're hearing from your customers? I know that's a little bit of an '09 question, but are there are any near term data points that you can provide?

Tom, it's Marcella. I can certainly speak to a near term outlook as we've mentioned we'll share everything that we can at our investor day. Turning back to Q4, if you recall, the coal year doesn't end until the end of March of 2009. The coal commodity price remains the same as it has and doesn't appear to be affecting any decision that our customers are making. Same with the potash prices. In place for the balance of this year. Those commodity prices are holding to Q4.

Tom, I would maybe just wrap around those comments. It's almost impossible for us to decipher who's got what in the demand supply game at that point in time. My point being that there's been a strike issue in one major commodity and a production capability on behalf of the coal company in the second one. As a result of that, our volumes are down. It's our belief based on kind of the short term demand or the interest in the coal company to start moving coal again that in Q4 we'll see normal demand as soon as they have their production capabilities. We're not picking up signals of a some of the softening market in the short term. And we'll deal with '09 if there's new information at that time.

Okay, great. I appreciate it. Thank you.

Thanks, Tom.

Your next question comes from [Arturo Vernon or Macury].

Good morning. Regarding intermodal, is there any breakdown that we could hear about between domestic and international? How each is holding up?

Arturo, what we're finding is that the domestic side was strong over the quarter. Our international side on the import export side was strong to the port of Montreal but weaker through the port of Vancouver.

I think it's important correlation between the two. Mostly, the intermodal business be it international or the domestic is the distribution or redistribution of retail type products. It's probably fair to assume over the course of time that would end up seeing similar patterns. The one thing that differentiates international from domestic in our experience is that there's still a sourcing opportunity that neutralizes some of the GDP growth diminishments that might occur. You could end up with a slower domestic market on the basis that GDP is down. And a modestly stronger international business because the sourcing is offsetting some of that from overseas. From the GDP growth.

Thank you. I'm just referring to what's happening south of the border and you have much stronger domestic business than international because of a more lopsided import export situation. I'm trying to gauge if we have a really softening economy in Canada whether you might see an imbalance of this nature developing or not.

Currently on the domestic side, Arturo, a lot of the demand is being driven by transloads, particularly at Vancouver as we're seeing our ocean carriers not to move intact. More offshoring where some of the retail products the domestic side holding somewhat stable over the course of certainly through to Q4. And in terms of what we're going to see next year, again, we'll be sharing that with you at our investor day.

The last point is that we we've seen in the last 30 days a rapid decline in the value to have Canadian dollar which has got to be good for -- on a relative basis. In some form of economic slowdown, but to the extent that the Canadian producers are better equipped today with a weaker Canadian dollar than they were 30 days ago at a dollar much stronger. It's a little hard to judge how all of this is going to unfold, but - -

I would agree to that. [Laughter] Let me quickly ask about your industrial segment. Most of it comes from mining, aggregates, minerals, how are those holding up?

In terms of the aggregate, those that are related to the construction industry, we've seen softening in those segments, but we continue to see strength going through to the fourth quarter, Arturo. As Fred mentioned earlier, we still see some of the inbound supplies going into the Alberta area for the oil sands development in the north of the Ed Mono-ton area. We're seeing that continuing.

Sorry. And the mineral metals, and aggregates would be impacted by the Alberta?

Some of them come -- a lot of the commodities come into Alberta.

An example would be frac sand is coming in for drilling. If drilling goes down, you end with not as much moving.

Aggregates coming in from road and parking lots. We see those coming in still.

Okay. Fair enough. Thanks. On taxes, how are you thinking about your taxes going forward in Q4?

It should be a more normalized tax rate.

All right. Closer to the statutory level.

It will still be below the statutory level, but consistent with our overall run rate.

All right. And finally, on pensions, are you defined contribution?

We are a defined benefit.

Defined benefit. How is your funding doing?

Well, I will say just like the rest of the world, we are experiencing in our equity portion of our plan some significant reductions. I think as of September, we were around the -- around the end of September we were around the 11% range. It changes every day. But we are continuing to monitor it.

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

Thank you. Marcella, could you quantify the change in the potash volumes for your - - I guess primarily as a result of the strike here. If you look at what you're expecting for Q4 now versus what you're expecting back at the end of Q2. How much things have changed?

The increase that we had expected just to put it into perspective was about a million ton increase '08 over '07. And the deterioration due to the strike we've seen beginning in Q3 to Q4. In Q4 I expect to see of the increased volumes, 60% decline. Off of that additional million ton.

Thanks. And then so has anything else changed over than whole and potash volumes versus what you were originally thinking back at the end of Q2 from a volume perspective? Have you brought your expectations down for any other parts of the business for volumes? Or is it just primarily coal and potash?

The two large ones are coal and potash. We have brought it down modestly in the US grain side into Q4 as I mentioned. Some of the holding of the inventory in Q4. We are going like gang busters on the Canadian side but not moving as quickly in the US because of the hold of the inventory. In the rest of our portfolio, which to the extent we've got economic sensitive factors, our outlook looks to see some of that going down. I mentioned steel for instance. And that's already built into our Q4 numbers.

And then in terms of the efficiencies you have been realizing over the last weeks, is that contemplated originally in your expectations earlier in the year for Q4? Or is this sort of an added benefit in terms of how well the railroad has been running the last few weeks?

I think the best context for everybody on that one is that as we saw the volumes starting to soften in Q2, we initiated a series of actions under Brock's leadership and Jane O'Haagen. While many of those were targeted at getting them up and running so that we could lower our cost base in 2009, obviously, we got some early results out of those in Q3. Hopefully, some more in Q4 so we can hit with a full year run rate mindset for 2009. We'll talk more about that next week. I think it's fair to say that the some of the efficiency initiative that is you will see the benefit of in Q4 were not originally contemplated by us in the plan we built last fall. And are a result of some pretty dramatic volume dropoffs if you will, across the board over the course of the year relative to our original expectations.

Okay. Great. And then I guess a bit of a housekeeping question on the carloads. Down 2.4% year-over-year. I'm trying to reconcile that to the weekly stated that you put out that show car loads down 3.4% in the quarter. Is there any sort of color you can provide on tying those two numbers together?

The impact is when you look at the carloads, they straddle -- they don't line up perfectly with the calendar dates. When you actually use the calendar dates, that explains the difference.

Great. Thanks. And then one last question. On your revenue per carload, on the coal side, represent per carload was up 5.5% in the quarter. The company is at 10.7%. And just wondering if you could talk about what's going on there. Is that one part of your business that has a lower level of capture on the fuel side? Or is it more just a function of the way the pricing works for the base contract?

Bill, it's Fred. I think probably the best way to describe it is because we really only have one significant coal customer, any comments we make about the specifics on the contract would be compromising the confidentiality of the contract. You put forward a reasonable hypothesis. I'll let your draw your own conclusions about it.

Thanks a lot.

Your next question comes from Chris [Julapo] of Credit Suisse.

Just a couple of quick ones left. Have you seen any difference in import traffic for your intermodal business in stuff that destined for the US versus what's destined for Canada.

There hasn't been much of a switch. It comes through the port of Montreal and the port of Vancouver. Our port of Montreal is very strong. We've got a strong route into the Chicago area. So that is continuing to grow on both the import and the export side. On the Vancouver side, the imports have softened although the exports continue to move out through that port. But the difference of what goes out between Canada and the US is still the same balance.

The flooding in the Midwest had a pretty big impact on your network for a while. Would owning the DM&E have made that different? Or the next time you come up against a similar change will that make it easier?

I think it will give us more routes to detour around that we didn't have this time around. The DM&E were severely impacted by those events as well. Yes, in the future, I think it will give us more options.

During the period of the flood, we actually did detour over the DM&E as well. So it will give us quite a bit more flexibility.

And the last question, what's your expectation for wage and benefit and other nonfuel expense inflation going forward?

For the fourth quarter?

Yes, I know you're trying not to talk about '09? Wage and contracts.

We're still at 2% to 3%. For the year.

Is that just wages and benefits or overall expense?

That's wages and benefits.

And does that count '09 or just Q4?

We're talking about 2008, Chris. [Laughter]

Okay. Thanks.

Thank you.

Your next question comes from Omar Aleem of National Bank Financial.

I just want to get a sense an idea in terms of what the [calvin] could be. We've talked about about fuel, but for FX with the exchange rate dropping off like it has.

Well, of course, it all depends on where it is. But the sensitivity hold that Brian gave yearly for every cent of FX change it will be about a cent of EPS.

In terms to have DM&E with the closing shortly, do you have any plans in terms of extensions or things like that? I believe those were on hold until it was closed.

I think at this point in time, the key thing for us is to stay very, very focused on an excellent integration. We have had I think a very, very good year with regard to planning, our transition planning. And I've made it clear to the team that success is about keeping your eye on the ball and illustrating to our ourselves and our shareholders and any other interested parties that we know how to integrate a business and do a great job at it. So, I can assure right now, without preempting my comments for 2009 that the vast majority of our focus is on a fantastic integration, capturing those synergies and integrating that company into our bigger company. If there are opportunities to do beyond that, we will consider those of course, we'll deal with that a little bit further at the 2009 meeting in a couple of weeks.

Okay. And my final question goes back to the pensions. I believe you had a C$450 million deficit as of the January 1st assessment actual valuation. Do you have an update for the January 1st, '08 valuation?

You're talking about January 1st '09?

I think your said the next valuation would be based on January 1st, but I believe that hasn't been out yet?

That will only be locked in producing it in our annual report. If you read our MDNA, it gives you the sensitivity to the deficit in terms of both interest rates and investment returns.

That's fine, thank you.

Thank you.

Mr. Green, we have no further questions at this time. Please continue.

I think we're done. Thank you everybody. Appreciate your time. See many of you in a couple of weeks.

Ladies and gentlemen, this concludes the conference call for today. Thank you for participating and please disconnect your lines.