Canadian Pacific Kansas City Ltd (CP) 2009 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Canadian Pacific second quarter 2009 results conference call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question and answer session. (Operator Instructions) would like to remind everyone that this conference call is being recorded on Thursday, July 30, at 11:00 a.m. Eastern time.

And I would now like to turn the call over to Ms. Janet Weiss, Assistant Vice President, Investor Relations, of Canadian Pacific. Please go ahead.

Thank you, Luke. Good morning and thank you for joining us for our 2009 second quarter conference call. The presenters today will be Fred Green, our President and Chief Executive Officer; Kathryn McQuade, Executive Vice President and Chief Financial Officer; Ray Foot, our Group Vice President of Sales, and Brock Winter, our Senior VP of Operations. Also joining us on the call today is Brian Grassby, our VP and Controller.

The slides accompanying today's teleconference are available on our website. Before we get started, let me remind you 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 MD&A filled 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. 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 Green.

Thanks, Janet. Good morning, everyone. I'd like to start by introducing Ray Foot, our new Group VP Sales. As many of you know already, Marcella Szel has retired, and I've used the opportunity to establish a pure sales organization. Ray is imminently qualified, having led our activities in Intermodal, grain, and most recently, merchandise.

Turning to the quarter. Today CP reported adjusted Q2 EPS of CAD0.59, reflecting some very good cost controls. These efforts help counter the continued volume weakness. In an economic environment like these where we're not seeing signs of substantive recovery, we continue to focus our efforts and actively manage what's within our control. We're doing a lot of things right. Our train productivity strategy is working, with train weights up 7% year over year and train lengths up 3%. Process enhancements aimed at lowering our structural costs are progressing, and approximately 300 supervisory positions have been eliminated with 100 given working notice of permanent position reductions. And setting aside the results of the one-off Teck Coal outcome, our core pricing success continued.

Ray will take you through our markets, and Brock will speak to the strong operational performance trends we're seeing. I'll now turn it over to Kathryn, who will give you a breakdown of our financial performance and highlight that from a cost management perspective, we delivered a very strong quarter. Over to you, Kathryn.

Thank you, Fred. And good morning, everyone. We experienced another quarter of significant volume reductions with carloads down 24% and RTMs down 26%. Our focus on matching resources to volume and the continued success of efficiency initiatives produced solid expense savings without sacrificing the consistency and reliability of our service offerings.

Let's begin on slide six, where I will take you through our pro forma income statement. Starting at the top, total revenues were down 21%. Without FX, revenues were down 29%. Lower volumes in every business sector except grain coupled with lower coal rates and fuel surcharge revenues drove the decline. However, an increase in other non-freight revenues did help to offset some of the impact. The increase in non-freight revenues, which is included in the total revenue line on this slide, was driven primarily land sales. Year to date, these revenues are CAD70 million, putting us well ahead of last year. However, I expect to end 2009 in line with last year's reported amount of CAD117 million. Moving to operating expenses, which were down 23%. Without foreign exchange, expenses were down 30%, which more than matches the revenue decline. Lower fuel prices and strong cost control were the primary drivers. Operating income was down 17% or 23% after removing the FX impact. This is a great result, considering the large quarter over quarter volume decline.

Below the line, other charges were up significantly, due to approximately CAD17 million in nonrecurring charges associated with the tender and debt offering we completed in June. Interest expense was up 18%, primarily due to the unfavorable impact of FX. Finally, income taxes were down 40% due to lower earnings. For the second half of the year, I'd expect or effective tax rate to be roughly 26%. Adjusted earnings per share came in at CAD0.59, or down 39%. This reduction in EPS is greater than the operating income decline principally due to the debt and tender offer this quarter and the dilution of the equity issue in Q1. Before I take you through each expense item, let me first touch on GAAP earnings. During the quarter we received regulatory approval for a sale of a portion of our ownership in Detroit River Tunnel Partnership, which added CAD69 million after tax to our GAAP earnings, and CAD110 million to our cash position. We also had a gain of CAD3 million after tax from the maturity of a portion of our asset back commercial paper portfolio, which was redeemed near par and at a higher value than was recorded on the books. Both of these are included in our GAAP earnings, but have been excluded from the adjusted earnings, a reconciliation is included in the appendix to these slides.

I will now take you through each of our expense line items, starting with comp and benefits on slide seven. As Brock will cover in detail, we continue to drive productivity by adjusting our operations to match volume declines. These efficiency gains reduced comp and benefit expenses by CAD37 million. For the quarter, we averaged 13,270 expense employees, which is lower than the estimate we provided earlier. Moving into the third quarter, we should average approximately 13,500 expense employees, as we will call back train crews to cover summer vacations and new hour service regulations in the US. Pension expense was lower, due to a higher discount rate at the end of 2008, and we reduced a post employment benefit accrual, which saved CAD6 million. Wage and benefit inflation and other items added an incremental CAD7 million, and despite a foreign exchange impact of CAD14 million, we delivered a CAD32 million improvement on the comp and benefit line.

Moving now to slide eight and fuel expense, which was down CAD158 million. Price declines saved us CAD125 million as our all end costs fell by 50% to $1.78 per gallon. And a 28% decline in consumption due to lower volumes and an improvement in fuel efficiency saved CAD90 million. Our mechanistic hedging program continues to move towards covering 10% of our fuel purchases by 2010. We have provided some more detail in the appendix. On a year-over-year basis, hedging benefits were smaller by CAD4 million, due to lower fuel prices. Foreign exchange and other items partially offset the gains from pricing and volume by CAD41 million and CAD12 million respectively.

Moving to slide nine, purchase services and other was down CAD26 million. Lower intermodal loads drove reduced intermodal expenses, while aggressively storing locomotive and freight cars meant fewer assets needing repair. These items reduced usage and volume related purchase services by CAD10 million. Casualty expenses were down CAD12 million. We do not use actuarial methods to value our casualty reserve. This reduction is a function of improved safety levels and less costly incidents. During the quarter we also had favorable tax adjusts totaling CAD8 million. Foreign exchange was a head wind of CAD10 million.

Finally, on slide 10, materials were down CAD11 million, due to the lower freight car and locomotive maintenance I just spoke to and some non-locomotive fuel savings. Depreciation was flat with some small savings from asset retirements being offset by FX. Equipment rents were down CAD7 million, with fewer active assets online and fewer leased assets, we saved CAD20 million. However, these savings were partially offset by a CAD12 million reduction in car receipts from other railways. Absent of foreign exchange headwind of CAD7 million, our equipment rents would have been down CAD14 million or 28% more than matching the volume decrease.

As I did last quarter, let me summarize our cost management success on slide 11. If you remove the impact of inflation, lower fuel prices, FX, and the favorable one time items I spoke to, we reduced expenses by CAD182 million. When compared to the volume impact on revenue of CAD310 million, we removed CAD0.59 of expenses for every dollar of revenue lost. This was a very good quarter for cost control. And I'm pleased with the continued focus I'm seeing across the organization. Moving into the second half, I expect our run rates will be closer to CAD0.45 to CAD0.50 as we start to lap year-over-year management actions.

Now turning to slide 12 and an update on the balance sheet and our capital plan,. We now expect our capital program to be in the range of CAD800 million to CAD820 million. This increase is due to the refinancing of certain operating leased assets and will not impact this year's cash flow. As a reminder, during the second quarter, we issued debt of $350 million and executed a tender offer by buying outstanding debt of $475 million. These transactions smoothed our maturity profile and reduced both our near term refinancing needs and our overall indebtness by CAD125 million. Quickly looking now at the DM&E, our transition plans remain ahead of expectations. We successfully integrated our financial systems and this quarter we introduced our dispatching and crew management systems, which will help to manage the new hour of service regulations. Our plan to complete the integration of all of our IT systems by year end remains on track. To date we are ahead of target on capturing many of the identified synergies on both the operating and revenue sides to the business, and we continue to look for opportunities to extend our length of haul.

To summarize, in the face of continued lower volumes, our financial results demonstrate the team's success with strong cost management. We continue to strengthen our balance sheet, focusing on cash and liquidity. We are making the right decisions to navigate the current economic conditions, and while the second half will continue to present some tough challenges, we are focusing on those things we can control and that's cost management. With that I'll turn it over to Ray for the marketing review.

Thank you Kathryn, and good morning. Starting on slide 16. On the quarter, we continued to see the effect of the economic downturn and soft commodity markets on volume across most of our sectors. Reported freight revenue was down 24%. Excluding currency impact, revenues were off 31%. Volume was the big driver, with carloads off by 24%. Revenue ton miles were down further 2% at 26%, resulting in a negative mix impact and continuing the first quarter trend. Other factors included 8% lower fuel due to price, and a 1% reduction from the Teck coal decision. On price, excluding the Teck impact, same store price came in at just over 4% in the quarter.

Now turning to slide 17, let's run through the various segments looking at both the quarter and the balance of the year, starting with grain. And note in all cases I will speak the currency adjusted revenues. Canadian grain continued to be very strong in Q2 with volumes up almost 30% year-over-year. US grain was softer, as farmers continued to hold product, waiting for prices to firm up. All in, revenues were up 9%. New crop prospects remain somewhat of a tough call. Recent moisture in western Canada has mitigated some production concerns. At this point in time, we are modeling based on a normal crop. On the US side, growing conditions have been good. Not the record production of last year, but still very strong. While harvest timing and quality remain wildcards, forward volumes will be aided by a large carryover from this year.

Moving on to coal on slide 18, revenues were down over 49% on the quarter. This decline was driven by a 37% lower Canadian volume, including reduced east-bound long-haul shipments. The export price adjustment on Teck coal, retroactive to April 8, reduced revenues by CAD14 million. Over the past month export volumes have started to recover and indications are that spot sales to Asia will support more normal export volumes in the last half of the year. The associated revenue will be dampened by Teck's use of the new shorter hall routings over Kamloops. Over to slide 19. The sulfur and fertilizer story, as in the first quarter, is tied directly to extremely weak export potash volumes. Revenues were down 62%. Potash revenue ton miles and carloads continue to run around 80% below last year's levels. There has been some recent settlements announced by Canpotex, but the major breakthrough with China is still outstanding. Until this deal is completed, volumes will remain below 2008. We have the ability to ramp up quickly when demand recovers.

Let's turn to merchandise on slide 20, covering forest products, industrial products, and automotive. This sector was down 42%, with our most significant volume declines in the mines, minerals, and aggregates sector led by steel and in automotive. Steel related volumes were down over 60% and auto volumes were off 45%, very much in line with reduced North American late vehicle production. Our recent carloading trend has started to stabilize in some merchandise sectors. We have also witnessed positive trends in our new business pipeline. On the quarter, we generated some 4,000 new carloads of condensate and ethanol and look to keep growing these markets through the balance of the year. However, at this point in time, I don't see much, if any, improvement in the core merchandise sectors in the second half of the year.

Turning to intermodal revenues on slide 21. We were down approximately 25% on the quarter. Again, very soft consumer demand and weak global markets were the key drivers. Domestic volumes were down about 10%, consistent with the first quarter, but international traffic was again significantly down, reflecting close to a 30% decline in volume. Our primary retailers remain very cautious in their outlook for the balance of the year. Some very modest restocking and a slight late summer early fall demand bump might occur, but it is not likely to be reflective of the sharp peaking of previous back to school and fall seasons. Basically, we expect the back half of the year to look very similar to the first half.

And on slide 22, in summary, we're sticking to the basics in sales and marketing, keeping close to the customers to ensure we're on top of volume issues and sizing resources and products correctly. Targeting and aggressively working the new business pipeline. And pricing in a disciplined manner with an eye on both near and longer term value. Now over to Brock.

Thanks, Ray. Q2 was a strong quarter for operations. We've continued our actions to contain costs by adjusting quickly to changes in volume trends and advancing our efficiency initiatives to create a sustainable, lower cost operation. We've had good success, and I believe our operation is now running in lock step with current volume levels. Looking more specifically at our results, let's start with safety on slide 24.

Our FRA train incidence frequency has improved by 8% on CP and 65% on the DM&E. For the core CP operations, we continue to be the industry leader in train operation safety, with the year to date improvement of 22%. I'm encouraged to see that our safety approaches are driving benefits and reduced casualty costs. Our FRA personal injury frequency for the DM&E improved 61%. For the CP operation, we were up by 24% though we still have work to do to improve our performance.

Please turn to slide 25. I'm pleased with the year-over-year Q2 performance improvements we posted. At our investor day conference we held in late 2008, I laid out our game plan for the key areas we were focused on to drive efficiency. Let me update you on our progress. First up is our attack on train costs. We've improved train speed year-over-year by 10% while disciplined execution of our long train strategy helped increase train weights by 7%. With GTMs down by 25%, our focus on productivity enabled us to reduce train and crew starts by 26% and 28% respectively, an excellent result. Moving forward, we're utilizing our industry leading Train Area Marshaling tool, or TRAM, which allows up to safely position multiple remote locomotives to join even longer trains, reduce starts, extending rail asset life, and saving fuel.

Please turn to slide 26, and I'll update you on progress in yard and terminal efficiency. We've improved yard by 6%. A good result, despite the actions we have taken to reduce road and local train starts. We also continue to push more volume into our most efficient processing yards, allowing us to close several satellite yard operations in Q2. This is helping us trim our car fleets in line with volume reductions. As our active cars online improve by 24%. We've done an excellent job matching car fleet size to the demand, and we plan to continue this action.

Please turn to slide 27. Next our attack on maintenance costs. To date we have consolidated the Coquitlam locomotive shop into our facility in Calgary and have revamped our car repair operations in southern Ontario, which allowed us to close two facilities. These early actions are exceeding my expectations, and as we complete our final analysis on additional maintenance facility opportunities, I expect further benefits. This facility consolidation work, coupled with improvements in cycle times, has helped us to tie up over 400 road and yard locomotives, representing over 25% of our fleet and to store roughly 15,000 railroad cars, or roughly 26% of our fleet. Another part of our program is to improve reliability and drive even greater efficiency. We continue to lean management techniques to targeted high value areas of our operation from repair activities in shops to customer pipelines. An example of the benefits can be seen in our core utilization which has improved by 16%.

Through aggressive management action we have reduced overtime costs by over 65% as we introduced better processes and scheduling. These actions have facilitated our ability to reduce crew and maintenance staff by 2,200 employees which represents about 20% reduction of our unionized work force. Clearly, strong cost management actions are leading to improved efficiency. In summary, we're sizing ourselves weekly to meet demand and I'm satisfied with the results. We are tracking well against our efficiency targets for cost savings and this has not impacted our ability to deliver a reliable and consistent service to our customers. Service reliability is key to both reducing costs and growing the top line. We are being methodical in implementing game-changing sustainable improvement that will better position us to serve our customers while ensuring lower variable and structural costs.

I look forward to reviewing our performance with you next quarter, and I'll now turn you over to Fred for the wrap up.

Thank, Brock. In summary, the market remains uncertain, so you can expect that we will continue to be focused on managing the things that are within our control. Operationally, we are executing the plan and adjusting to volume fluctuations, driving very good productivity improvements. In the markets, we're creating value for our clients and pursuing price consistent with the high quality product that we're delivering. Organizationally, we're implementing process improvements that will deliver a permanent, lower cost operation, and finally, financially, we're taking actions to preserve cash and strengthen our balance sheet to ensure that we retain our strategic flexibility. I believe these actions will ensure that CP is well positioned to deliver value over the longer term.

So on that note, Luke, please open the lines and we'll have some questions.

Thank you. (Operator Instructions). Your first question today comes from Randy Cousins BMO Capital Markets. Please go ahead. Mr. Cousins, your line is open.

Good morning. I guess I'll start off with -- I guess the first question just on the marketing side of the equation. I wonder if you guys could go into explaining some of the relative differences between sort of what we saw in carloads versus RTMs, and I'm thinking of the two product categories, forest products and grain where there seems to be some relative material differences. Is that just simply shipping longer haul of Canadian grain? What's going on exactly in those two product categories?

Randy, it's Ray. Let me touch on the -- first on the grain side with the high percentage of increase on the Canadian export. That's had an impact on RTMs given the longer haul nature of that business. So that's really what's happening within the grain side. On the forest products side, particularly on lumber with the closure of the various mills that are out there. They are having to ship basically longer distances to the markets that they're servicing. And that's the impact that you're seeing on the forest products side.

And Ray, one other question in terms of the marketing side. Could you a little bit talk about your transborder business on Intermodal as opposed to the Canadian business. You talked about the domestic and the international. International being down a lot more. How is your Canadian business doing versus the stuff that you have going across the border?

You have to look at it by segment. Relatively, on the cross border basis, we're pretty much flat. On the food business, that's holding pretty well relative to last year as well. Just given the basics of that business. Retail, as a I mentioned, is down and we're not seeing any significant signs of life there. So if you look at the food and cross border business, that's what's allowing us to only be at the 10% number on domestics.

Okay. Obviously, Fred, the Teck decision went against you. One of the issues that I guess you guys have had in the past is fuel recovery. I wonder if you can comment. Did you get -- with the decision did you get 100% fuel recovery on that contract with reference to diesel? Could you update on what the status is in terms of your fuel recovery programs and to some extent for Kathryn, was there a fuel hedge gain or loss in terms of the surcharge lag benefit in the second quarter?

Randy, we'll probably end up going through all three of us. So I'll start off. As with every other contract this year, we have 100% appropriate and current fuel recovery, including that in the Teck agreement. So on that issue, we're in very good shape. And pleased with the success of the commercial team's ability to deliver that. Ray, maybe you could address the recovery and Kathryn will pick up on the lag issue.

As we've said in the past, Randy, our policy, first of all, all the programs that we have out there have margin recovery in them. Secondly, every contract that we renew, we make sure that the policy is held fast as Fred stated. And going forward, when we look at coverage, we talked about the fact that that will improve to the 70% to 75% range by the end of the year on the margin basis. So just one other comment. I think in 2008, we saw that CAD17 million lag in Q2 2008. We talked about the fact that moving to the bi-monthly program on June 1st would basically eliminate that going forward. So we did not see the impact that we had in Q2 of 2008.

So Randy, Ray just answered the question. We had no lag or lift this quarter. And when you compare it to last year, CAD17 million negative, it does look favorable quarter over quarter.

What's the coverage ratio right now? If fuel prices start to back up, are we going to get a little margin compression?

If you look at the margin coverage right now, we're in the 60% range, moving to the 70% to 75% by the year end. I think that if you look at the fourth quarter, there's definitely a downturn. But in terms of lag and lift, that will basically be removed.

Thank you. I'll get in queue.

And your next question comes from Edward Wolfe of Wolfe Research. Please go ahead.

Thanks, good morning.

Good morning, Ed.

Can you talk a little bit to -- I think I heard you mention ,maybe it was Kathryn who mentioned, that there was a CAD14 million reduction in revenue from the quarter related to Teck. Did I hear that right? And was that just on the pricing side? Or how do we think about that going forward with also some volume that will be lost to CN?

Ed, the statement was made and is correct that if one takes the -- I'll call it the retroactivity of the FOA loss, on price alone, in the quarter it was a CAD14 million negative hit. So your statement is correct. We'll have to leave it to others to judge the impact of that on a go forward basis because obviously, the volumes were low in the particular quarter, second quarter. It will be a number bigger than that as the volumes recover. With regard to the interchange at Kamloops, that is something that I believe another party has spoken to their expectations with regard to what they might get. I think Teck has publicly stated there's a cap or a elimination of 3.5 million tons. If it happens, it happens.

But was any of that in the quarter? Any of that movement? Or is that a next quarter and forward event?

It would all be Q3 and beyond. There's no volumes that move that way in Q2.

And Fred, just based on your comments, I guess the assumption is there's no volume targets within the new Teck contract that would alter the pricing. You're just saying that assuming the world gets better there's more volume because there's a lower revenue per ton that the total revenue number goes down. Am I thinking about that right?

I think you're interpreting it correctly. We can't predict what will happen in volume, although Teck has been quite robust in their expectations in the last couple of weeks. And you'll have to net out what could happen with the other guy. And our volumes will be what they will be and then obviously they will move at the numbers you have derived based on the second quarter.

Okay. In terms of seasonality, I know you're not looking to give guidance, but when you think of third quarter over second quarter, historically it's a seasonally stronger quarter. Is there a sense that assuming potash doesn't change that seasonality is out the window? Or should we think about the ongoing numbers that you drove and the productivity is ongoing and there's a little bit of seasonality improvement in third quarter as we model for things?

I think the way I look at it Ed is from an operational perspective, Brock and his team are in rhythm, and they will continue to pursue continued opportunities for productivity improvement, but sustaining those levels would be a good accomplishment and anything more than that would be gravy. I'm certainly seeking from Brock and his team continued improvement. With regard to volumes, I think it's unrealistic based on the evidence we're seeing and feeling so far in July. You follow the carloadings. RTMs down in the same zone, about 18% or 20% on RTMs, month to date. The big differential between the first half and the second half of the year is that we're seeing Intermodal as similar to Q2 which is weaker than it was at the beginning of the year. Ray gave you the numbers. That pattern continues in Q3. And the merchandise side continues to be very soft. Autos are down, I don't know, what did we say, 35% to 40%. Steel is down 40% to 45%. Forest, Brock's business, continues to be brutal.

The merchandise sector continues to be very strong, weak rather and the difference is that we are starting to situationally see some of our bulk commodities that were so difficult for us, particularly in Q2, make some level of rebound. We just don't want to get ahead of our customers. If Teck feels they are going to have a good strong year, you can do the math on that. If Canpotex or the underlying companies make statements about their belief on settling China and getting the volumes back up, you can anticipate that we will move 100% of that Canpotex volume. We're ready to go. We are seeing some spot levels better than the second quarter. But not substantially better, and in the fertilizer side we're probable down about 65% Q3 over Q3 in the July numbers. We're still waiting to see that one kick back up.

That's very helpful explanation. Can you talk a little bit about the thought process in moving the CapEx back on balance sheet versus leasing, how you're looking at the asset change?

Ed, this is Kathryn. We're really looking at it opportunistically as we work with each one of the lease companies, depending on what kind of deal they are bringing to us in terms of the operating leases, these were assets that we needed longer term. We got favorable capital leasing opportunities there.

Thank you very much. I appreciate the time, everybody.

Thank you.

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

Thanks very much. Good afternoon. Just on-- going back to the coal decision. Fred, when you're looking at what happened and we're looking at it now less than a year you're going into a new coal year, negotiations conceivably starting up again soon. How are you going to change your tactic going into negotiations with Teck over the next couple of months? Are you going to try to get that 3.5 million tons back? Are you looking at a different way of linking the coal to the coal prices to your freight rate? Can you give us a little sense of how you're reframing your negotiations going into the next couple of months?

It's a little premature and probably can't offer up the negotiating strategy in a public forum. What our team has to do is stand back and ask ourself the outcome for a perspective as brutal as the FOA outcome was, it was still substantially better than the last commercial offer we had from Teck. So in a weird way it's far better than a commercial term. With that as a basis, we'll have to evaluate what it is that the client would like to do going forward, the value they place on our service, and we'll have to calibrate our ability to meet their needs. We don't know the answer to that. It's premature to judge where the outcome will be. Nobody likes to fight with their biggest customer. We seem to have a pattern of that over the last five to eight years. If there is a way to bring that to a resolve that is good for both parties, that's great. But needless to say, we need to protect our shareholders' interests. These are very long term assets and when you have a crack in the ground you need to earn a return satisfactory to the shareholders. We're going to have to recalibrate, work together, do our best to find a solution for both sets of shareholders. Clearly it's premature for us to determine what it is that will be of interest to the client.

Okay. Moving to the grain side, there's a few moving parts. You've done a good job getting some market share gains against your competitor there. There is the longer haul mix effect that is impacting going forward. The rate cap adjustment kicks in the third quarter, and you are modeling for a normal crop. There's a lot of moving parts there. Is there anything you can help with in terms of framing our forecast for the the second half, maybe on a -- if you look at it compared to the second half of last year. Given the moving parts.

Walter, it's Ray. If we look at it. It's tough on to add to the comments we've already made to you. But if you take them in part, our service to the ports has been excellent. Our turn times have been very good. Much better than we've seen in the past. Our customers like that. And we think we've benefited from it. We think that's going to continue going forward. On the crop side, tough to call. You've heard from Viterra and others, they're modeling average crops. So that's what we're looking at. There is a strong carryover in both Canada and the US that will help. But in terms of trying to put a number on it and knowing dependent on quality what will get shipped in the third quarter or the fourth quarter, difficult to come down on any specifics.

Okay. I don't know if you covered this -- last question here is a technical question Your other line item has a pretty big growth or other revenue line item. What's in that? Is that a new DM&E in there? It went from 27 to almost 50.

Walter, I think you are talking about the other non-freight revenue line.

That's correct.

That was -- and I did mention that in my comments. That was land sales.

The land sales are in there.

As you know, land sales can be chunky, and we do expect to end up comparable to where we were last year. Ahead of right now -- ahead of where we were for the six months last year. But we expect the year to end up close to same.

Perfect, that's exactly what we're looking for. Thanks, that's all my questions.

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

Good morning.

Good morning, Tom.

Wanted to see -- I guess the weekly coal volumes for you have started to pick up quite a bit. As you said, Teck's outlooks improvements quite a bit. Did you have any broad sense of what your coal volumes in second half might look like year-over-year.

I don't think there's any way for us to predict that. Unfortunately, it's really as we've learned over the last six months, in the hands of the shipper and what it is that they expect to accomplish in their markets. The indications that we get, obviously, from the pretty strong statements coming out of Teck these days about their production intent is that it should be a pretty robust second half. And then of course you would have to discount off of that anything on that could end up moving on a different routing.

Okay. But the different routing is not going to reduce volume, it would just reduce revenue per car, right?.

The short hall, that's correct. It would just short hall us a little bit.

Right. Okay. In terms of the costs that you have with the Teck business, it's a unit train business, it's presumably highly efficient already. Given that they're taking 15% price away from you, is there a way to take cost out of the system and say we won't hold as many crews waiting for the business or we'll somehow we'll lower the service and take out some costs in response to getting paid a lot less for doing the business?

A little bit of a delicate question, Tom. A fair one, but delicate. Our basic approach has to be that as an organization, we have an obligation to fulfill the commitments of the arbitration finding. We will live up to everything we are obliged to do. The bigger issue for us is preparing ourself for the future. We clearly cannot sit with an abundance of resources just in case somebody wants to ship with us. We'll have to recalibrate the amount of resources that we have available and hopefully, we'll end up with the commercial terms that are satisfactory to justify those. And if we can't end up with commercial terms that satisfy that, obviously we'll have to keep trimming resources to match that. But there's no reason at this point. It's still premature for us to determine exactly where that discussion will end up. But you can be assured that to the extent that we can fulfill our commitments, we will. And to the extent that we can find ways and means to remove resources that don't impede our ability to do that, we will also do that.

Okay. And then one more question on the resources side of things. In terms of comp and benefits in second quarter, you did a nice job getting more aggressive with head count reduction and that cost side came in pretty well. When you look at third quarter and fourth quarter, do you think you can keep those levels for comp and benefits similar? Or with the pickup in coal volumes does that naturally have to come up a bit?

Tom, Kathryn is going to address that. For calibration, it's important to understand that in Q1 we started off, actually, quite aggressive on removing the resources. But we misread the market based on the demand for clients. We had about a week of demand and we called a lot of people back. Our Q1 results reflect the fact that although we started an aggressive layoff program and ended up calling back nearly 600 or 800 people in January. And of course when they come back they stay on for four weeks or five weeks. As a consequence, the team was trying to be nimble and trying to be responsive to the market. We got burned in Q1. The run rates you saw by the end of Q1 in March and certainly what Brock and his team have done in April and beyond are much more calibrated. We have migrated away from a forward looking expectation to calibrating our resources based really on the last four weeks demand. And that's a function of the fact that nobody, including our clients, have a clue what's going to happen. And as a consequence, we just can't be speculating and having resources on stand by. Yet, we've delivered a great product and we haven't missed a beat. That model will continue until we see some stability. Kathryn, do you just want to calibrate?

Tom, we do think it will be 13,500 and again, Brock is trying to AB the hours of service in the US as well. There are a couple other things in the comp line I think you need to take in to consideration also. Of course, our unions got increases this year. So we are fighting some inflation in terms of salary increases for our union forces. As well as we did have the one time in the comp benefit line from our post employment benefits adjustment. And the other thing that we will be a little different from where we've been in the past in terms of our TRS. We have attempted in the first quarter and towards the end of last year to make it more effective. But we did choose to not take out return swaths on any new PSU issues. We'll have depending on what the stock price does that could have a slight impact as well. There's a lot of moving pieces in comp and benefit. When you're looking at the overall cost, but I think in terms of our ability to variablize the head count, Brock and the team have done a good job. That will very much be a function of what level of business we have.

Right. Okay. Thanks for the time.

Thank you.

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

Good morning.

Morning, David.

Just on the theme that seems to be playing on the pricing overall. All the rails have reported and are still reporting consistent pricing across the board. Net-net, how do we think about this? First of all, did you manage to continue to secure pricing at the same level into Q2 for 2009 and 2010? How much of your book has been priced for 2010? And overall, as you are looking at it from a customer perspective, obviously, fuel surcharges come off fairly significantly here. How do they look at it year-over-year? And are they actually getting a bit of a break in terms of what they're actually paying for rail services?

David, it's Ray. Let me come at the three components. First as I said, in second quarter we were just above 4%. That's not different in any material way from the first quarter. So we continue to sell the value of the product in the marketplace and get good prices as a result of it. To your second question as it relates to 2010 book, we're about 50% in that respect at this point in time looking forward to 2010.

That's also at 4% as well, Ray?

Well, I'm not going to talk about where the pricing might be in 2010. We've achieved 4% year to date. I'm talking about the fact that when you look at 2010, about 50% of our business is locked in.

At positive pricing year over year?

Positive pricing. and on the third piece in every negotiation, we're looking at all the factors in terms of how price is moving around and the relative competitive position in the marketplace and then the customers are doing the same thick.

How much did the fuel surcharge affect the top line in Q2? I'm trying to do the waterfall or attribution analysis. We have most of the elements, I think it's just mix and fuel surcharge -- maybe Kathryn, any thoughts there?

In terms of the total impact, we said 8%.

Okay. On fuel.

Yes.

And mix was how much?

Mix was two.

Mix was two. Very good. And in terms of the number, the taxes. I think Kathryn, did you say there was an CAD8 million positive benefit? I assume that's the provinces that have an impact on that?

No. What we had was some -- it was a capital tax adjustment in this quarter. The province would have been under the income tax and the income tax rate and there was only the first quarter income tax.

Okay. And you've assumed 26% for the year. Am I seeing that Ontario also goes?

For the second half of the year, I would say you can model 26. And what that combines with what you have for the first six months. We expect the second half of the second six months to be at 26%.

So if Ontario does adjust their income tax rates should that take that down once again?

Yes, it would.

Very good. Thank you.

Your make question comes from Jacob Bout with CIBC World Markets. Please go ahead.

Good morning. Can you talk a little about how you are handling the decline in automotive volumes in Vancouver. Both from a pricing perspective, but also any thought about switching from rail to truck similar to what your competitor has done in Vancouver as well?

Well, Jacob, it's Brock. Let me start with the operational side. At this point, we obviously looked at that. And it didn't make any economic sense for us. So no, we intend to continue to serve the port by rail. Obviously we are taking action on our train designs. in fact, last week we piloted our first 10,000-foot train off the port of Vancouver in our equipment yard heading east. We have lots of capacity on the existing train starts to and from the port of Vancouver. And we're able to handle the volumes that are projected for the balance of the year with that train model.

Jacob, it's Ray. There's no truck competitive situation on the international business coming out of the port of Vancouver.

And then turning to more of a macro for CP as a whole. Talk a little bit about the targets for your operating metrics from a dollar perspective and then maybe do you have targets as far as fluidity metrics and head count as well.

Jacob, when you don't give guidance it's hard to back into all those things. I can assure you that Brock and his team have some very clear expectations of improvement over the past, and I think the evidence in Q2 is that they are stepping up big time to realize those. The difficulty that we and probably everybody else has is that you don't know what you don't know in times like this. The volumes have been so volatile. Look at April and May where you dropped literally, 32%, 33%. And that kind of volatility requires almost instantaneous reconfiguration, redesign, and for that reason I don't think it is realistic for me to turn to Brock and say, look I haven't got a clue what's going to happen on the demand side, but you have to do this. What we have said is that productivity needs to more that off set wherever it is if at all possible and obviously, Brock and his team have delivered that and we will continue to pursue even more.

The variable cost side of things we're having great success on all the operating data that is available. It's a great new story. What I'm more interested in over the longer term is the structural cost reduction. It is my belief that we can go back to the comments that we made last fall at the November investor day. We said we'd start to focus on variable costs, and as we saw the traction delivering on that and we estimated that to be CAD85 million to CAD100 million over one to two years. Every reason to believe we'll deliver to those expectations. What I introduced was that we would then turn our attention to the fixed costs or the structural costs, and I can assure you there's an enormous amount of effort and energy going into that. What I said at the time was we didn't know the quantum of that, but that I hoped and believed that it could be at least as large as the savings attributable to the variable cost side. A little premature to declare yet. We won't go there. But I can assure you that the amount of energy in the Company is now probably proportionally much greater at looking at the structural fixed costs because we are in rhythm on the variable cost side.

All right. My last question then, we've heard from a number of your competitors on the volume side starting to feel like a bottom. What are your thoughts there?

I don't know that I can draw that conclusion. When you look at the underlying business, it's just so uncertain and so flat in both the merchandising, Intermodal side. We haven't seen the end of layoffs. We know we are going to see some spot inventory fills in various commodities and they may be blips more than the beginning of a sustained recovery. I'm probably on the more conservative side of anything I've heard from anybody so far. I'd like to believe it. We've got the up side, of course, against some very brutal down volumes in second quarter on the bulk commodities. That is an up side for us. And we're starting to see some of that materialize. In the general merchandise, retail side, we're still bumping along. Don't have a clue to be honest with you. And certainly we aren't seeing any evidence from customers that they're seeing sustained recovery. Probably pretty conservative.

It's Ray. There has been some stability certainly when you look at those volumes over the last 8 to 10 weeks. In my discussions with the customers, they've got no signs of strength going forward or any signs of upticks in terms of the merchandise and Intermodal world. So they're just not able to tell us that they see a recovery.

So Jacob, my summary for all of this is that guidance I'm providing inside the Company is we're about 85% focused on cost management, driving down long term structural costs, and obviously, we've got a sales and marketing organization that's seeking every opportunity. Ray gave us some examples and other products, the ethanol. We need to stay focused on establishing ourself and being opportunistic, but calibration is very much focused on a sustained long term recovery and as a consequence, we're heavily weighted to the expense management side over the foreseeable future, while trying to be opportunistic on the revenue side.

Thank you for that.

You're welcome.

Your next question comes from Matt Troy of Citigroup. Please go ahead.

I wanted to ask about the land sale and other revenues. Could you quantify that? I'm just trying to level the expectations going forward. If I normalize your other revenue for what you did last year, I come out with that land sale contributing about 200 basis point of margin improvement, without which, DOR would have actually slipped a bit. Is that the right way to think about it? Or are there moving parts and pieces that I'm missing?

The land took up about CAD20 million.

Okay. And there'd be no incremental costs or margin hit from that?

Right.

Okay. Second question would be then on the pension expense side, I think you reported CAD2 million or CAD3 million this quarter versus about CAD20 million last year's quarter. If you could just give us an update on pension. What your funding requirements through the balance of the year, and where you are in the funded or unfunded basis.

I do refer you to our MD&A. As you know, we have extensive disclosures around our pension, Matt. As you know, it's very fluid out there in terms of funding requirements. There's temporary regulations. There's potential permanent regulations coming out before the end of the year. Therefore, we've only given a range of what our possible pension contributions could be for the year. And that's CAD100 million to CAD150 million. We will wait and see as the regulatory environment solidifies a little bit for us in terms of our deficit, as of the end of last year, I believe its -- close to CAD1 billion. And just to be honest, we've seen improvement this year through the six months and where we are to date of course. By interest rate changes and asset equity improvements. Again, funding is based on a point in time. And that's an end of the year. We'll take a lot of factors in consultation and decide what we will do in terms of following evaluation or not. I refer you back to the MD&A and there's no difference in what we have projected in the past which is the CAD100 million to 150 million for our pension contributions this year.

Got it. Thanks for the time.

Thank you.

Your next question comes from Cherilyn Radbourne of Scotia Capital. Please go ahead.

Thanks. Good afternoon. Most of the questions have been asked. I'll just ask a couple. You did indicate in your commentary that you had exceeded the expectations that you set out last quarter in terms of your ability to control head count. And I just wondered if you could give us a sense as to where you found additional efficiencies in head count in Q2.

Cherilyn, it's's Brock. Couple of things. Firstly, we're very nimble in changing our train design. We were able to reduce our train starts greater than our actual volume reductions. And the other big contributor, this is on the running trade side, we were more efficient than we had planned in terms of our crew utilization. That was a large contributor. And the second one as we took more locomotives out and we applied some lean principles in terms of locomotive repair, we were able to cut our labor ratio to locomotive further than planned. Those are the two big areas where we were able to succeed on the unionized expense side, on the running trade side and on some of our mechanical forces were able to go a little deeper than we had planned.

Okay. Great. And last question for me. Could we just have a bit of color on how the DM&E performed in the quarter and how their volume declines compared to your own.

Sure Cherilyn. We are not going to continue to report on DM&E separately in any way. But suffice it to say as Ray mentioned, we've seen an uptick in ethanol volumes. We're beginning to see some strength in the US grain. So generally, they've experienced reductions just as everyone in the rail industry has. In this recessionary time. But overall, we're still very pleased with the book of business and we are seeing -- beginning to see some strength coming back in some of their key areas, which is ethanol and grain.

Okay. Thank you very much. That's all for me.

Thank you.

Your next question comes from Benoit Poirier of Desjardins Securities. Please go ahead.

My question is more on the free cash flow standpoint. If you look at the quarter, you generate almost CAD4 million of free cash flow. I'm just wondering what should be your expectation going forward?

We have not given guidance on our free cash flow. And you are correct on the Detroit river tunnel. It was a great monetization in this quarter. We have indicated earlier that we will have another major land sale this year that should complete in the third quarter. And that's our Windsor station.

Okay. Perfect. And another question. Could you please give us more color about the progress for the new Intermodel complex in Les Cdres I am just wondering where you are. Is it still moving forward at the same rate?

This is Fred. The progress is being made through all of the appropriate regulatory and permitting steps. Obviously, with the economy having gone soft, the volumes having dropped off, we will pace the construction or the decision for construction to reflect the demand or the capacity situation that exists. Clearly in today's economy, we don't have to proceed with that. It may be in our interest to proceed with that in the immediate term. The more likely scenario is that we'll defer that out a little bit. But not very far based on demands rebounding over time. We're just going to keep our powder dry and continue to protect the ability to respond when the market is right. But we won't make any decisions until we see the sustained demand recover.

Okay. Very good. And maybe a quick one. What was the return on capital this quarter, Kathryn?

We don't -- I don't know that we have that.

We'll have to take that off line. It's a pretty easy calculation. We just don't have it at our fingertips.

Thank you very much, again.

Thank you.

Your next question comes from Jason Seidl of Dahlam Rose. Please go ahead. Mr. Seidle, your line is open.

Hey, everyone. Quick question here. Kathryn, could you remind us of the pending wage increase, what percentage is that?

3% this year.

It's 3%?

Yes.

And when is that kicking in?

It kicked in at January 1st.

January 1st. So there's not one in the back half of the year?

No.

Okay. That's all I have. Thank you, guys.

Your next question comes from Chris Ceraso of Credit Suisse. Please go ahead.

Thank you very much. When I look at the fuel expense, it looks like, relative to the other railroads; you didn't perform as well in Q1. So in other words, fuel expense was down about 30% year to year. Whereas the other class one has fuel down 50%, but here in Q2, your fuel expense declined by the same amount as the other guys. What explains that sequential improvement? Was there something unfavorable such as hedging in Q1 or that helped Q2? Or is this the winter fuel effect that hurt you in Q1 and it goes away in Q2?

I'll start off and then Brock may want to add to it. The fuel, the winter fuel did have an impact in the first quarter, and I think we spoke to that as well as in winter months, we didn't have the productivity and efficiency that we had in the second quarter. Those were two item that is hit us. It all depends on where we're doing most of our buying, if we're buying more in western Canada versus other locations like Chicago as well. So it can have to do with the mix of where we're doing our purchasing as well. And there's different times of the year that you do buy from different locations and just to remind it's significantly impacted by the higher taxes in Canada versus the tax in the US on a cent per gallon basis. A lot of factors that can move that where we stand in relationship to the other guys. Brock, you might want to mention the efficiency gains this year.

Chris, I will just maybe talk about our consumption that we achieved in Q2 which was more in with my expectations and a couple of things contributed to that. Again, we saw the benefits of our top of rail lubrication program. We've implemented pretty much 300 sites between Calgary and Vancouver that are mostly kicked in now. We have a few more sites to put in and that's producing the results that we expected in terms of consumption. And we have also decided to move forward on applying 200 fuel optimizers on our most recently purchased locomotives, and we're excited about what benefits that might bring. It's like a cruise control, if you will. And our preliminary testing is suggesting that on a go forward basis we could see benefit there. I'm pleased with what we were able to achieve in the quarter and too early to declare a victory. In terms of fuel consumption rates, but I think you can expect to see it move along in line with Q2.

Okay, thanks, that's helpful. And one other question with regard to the business that you lost or the change in the contract with Teck. Do you think that this signals an increase in competition between railroads? I think Fred, once you told me that one of the keys in your view has helped pricing in the past few years is that the railroad stopped fighting with each other. Do you think that is at risk? Should we be worried about price stability going forward?

Chris, I think the commentary from the past was more along the lines of selling your strengths, instead of selling your weaknesses. I think over the last five or 10 years, everybody realized the need for capital employed, people have sold their service levels, their relationships, their equipment supply, the nature of their equipment, etc. And not reverted solely to price competition. Price competition is part of it. It's a competitive world. I have no reason to believe that we need to be worried about the future. We'll continue to be competitive. We have an incredibly robust franchise and product offering. I'm pretty sure we can be competitive in any environment. I'm not terribly concerned. I'm disappointed with the sequence of events, in the arbritrary finding, but I'm sure we can figure out how to believe competitive going forward.

Okay. Thank you very much.

Thank you.

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

Thanks. I just wanted to go back to the discussion on variable verse fixed cost reductions. It sounds like the vast majority of fuel efficiency savings we are seeing right now are on the variable side. Can you give a little bit of commentary as to when will we see those fixed costs reductions kicking in? Is that possibly a second half event? Have we started to see that? Is there much of that in Q2? Or is this more of a longer term process to get realized?

Bill, it's Fred. There's no black and white line in time. I would suggest if you put in context the structural costs, they can often involve other parties, so for instance, if we want to do something working with our mechanical sites, we'll need to consider the alternatives. We'll need to perhaps put capital in place. We'll need to perhaps have labor dialogue with the parties effected. If we do that, we have to have advance notice that can vary 90 to 120 days. There is clearly a time lag between the evaluation and the discovery of things. But I guess the way you probably want to look at it is that the approach, and we'll use some of Brock's efforts on lean, that these are continuous improvement opportunities. It's not like you're going to flip the page and the next day you are going to see a dramatic drop in expenses. What we are going to do is complete our evaluation on these many, many initiatives we have underway. We will make decisions and they will have a lead time to them with regard to the capital or the labor issues and you will see them phase in over time. I would like to think we'll start to see modest impact in the second half of the year, but I'm not counting too much on that. I think they are going to be a 2010, 2011, 2012 story.

This is Kathryn. I guess I am kind of a dog of the bone on this. There are very few costs that are totally variable and very few costs that are totally fixed, and there's a lot of intermingling of costs. And if you go to what Brock talked about, a lot of the work that we have been doing in the shop area is realizing benefits today. As we sit down the look, the working notices that Fred was talking about in terms of some of our salaried employees that are taking salary points, we are seeing benefits of those today. But there are a lot of interdependencies, and so it's very hard to be purely volume variable and to look at things in this pure way that a lot of people like to do. In my view, we have started so see a lot of the costs beginning to sustain itself in the structural area. And I think we try -- we say volume usage and everything in the slides. But there's a lot of things behind those initiatives that are creating the reductions through each one of the line items. So I just -- I caution people back to what Fred said. It's everything variable and now we're going to turn our attention to structural. This is about an evolution of changing our total cost structure and a continuous improvement through lean management and through centralization of processes, etc. that will be an evolution over a longer term period.

Thanks, that's helpful. And then on the coal side, Teck had about 1.5 million tons of carry over tonnage in Q2. And I'm wondering in terms of your contract that you had with them, does that impact you at all? Is there any benefit in Q2 from sort of carryover tonnages from previous coal year, or was your agreement, the old agreement with them not tied into carryover tonnages.

The rates that we collect apply in the period in which we move the coal.

Perfect. And then one last thing on coal. You've given some pretty helpful disclosure on the expectations there. Basically CAD360 million of revenue in the upcoming coal year. You disclosed that you did CAD560 million in 2008. And I'm just wondering if you can give one last kind of important piece of disclosure to that. How much of that reduction is fuel related?

I don't know if we can do that. I just don't know if we can do the math.

Let us take it off line.

We can explore off line if there is something there, Bill. But certainly don't have it at our fingertips.

That would be great. Thank you very much.

Your next question comes from Seth Lowry of Merrill Lynch. Please go ahead.

Hi. This is Seth in for Ken Hoexter. Most of my questions have been asked. If I could get clarification on the fuel expense line. I was looking at your year-over-year decline in gallons was at 24%. That was a little bit more than carloads at RFMs and I realize there are some efficiency gains. Would you expect that spread to stay constant or absolute gallons used we're going to stay near the second quarter run rate?

I guess it's a combination of volume and the consumption rate. I would expect our consumption rate certainly in Q3 to reflect what we achieved in Q2.

Seth, I would caution anyone to use absolute numbers. The volume is so unpredictable and so variable that I would just encourage you to look go back and look at run rates, as Brock said, on productivity. And he is pretty comfortable, has got in rhythym, and the Q3 consumption rates, unless there's a dramatic change in mix, ought to be in the range of what you saw

Okay. Great. And then quickly on depreciation side I guess you sold some assets. Is there any -- looking forward can that move around a bit or should it stay fairly constant in that 135 range looking forward?

That's one area I'm really challenging the team on to look to see if there's further retirements that we can do. Right now I'd say the run rate is about what it is for the rest of the year. But if we're able to figure out more assets to retire between now and the end of the year, that could be a help. That's something that we're going to aggressively pursue. But I have no numbers to offer up at this time.

Okay. Great. Thank you.

Thank you.

Mr. Green, there are no further questions at this time. Please continue.

Well, thank you everybody. Appreciate the time together and we look forward to seeing you or talking to you in the various conferences and at the third quarter. Over and out.

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