Canadian Pacific Kansas City Ltd (CP) 2010 Q2 法說會逐字稿

Good morning. My name is Andrea and I will be your conference operator today. At this time, I would like to welcome everyone to Canadian Pacific's second-quarter 2010 conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Ms. Weiss, you may begin your conference.

Thank you, Andrea. Good morning and thanks for joining us. The presenters today will be Fred Green, our President and Chief Executive Officer; Kathryn McQuade, our Executive Vice President and Chief Financial Officer; and Jane O'Hagan, our Senior VP, Marketing and Sales and Chief Marketing Officer. Also joining us on the call today are Ray Foot, our Group VP of Sales; Brock Winter, our Senior VP of Engineering and Mechanical; and Brian Grassby, our VP and Controller.

The slides accompanying today's conference call are available on our website.

Before we get started, let me remind you that this presentation contains forward-looking information. Actual results may differ materially. The risks, uncertainties and other factors that could influence actual results are described on slide 1 and 2, in the press release and in the MD&A 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 3.

Finally, when we do go to Q&A, in the interest of time and in fairness to your peers, we will be asking you to limit your questions to two. If you have any additional questions, you may requeue and time permitting, we will circle back. Here then is our President and CEO, Fred Green.

Good morning and thank you for joining us. This morning, we reported adjusted EPS of CAD0.92, a 96% increase over Q2 of 2009. Volume growth coupled with our cost management efforts resulted in strong operating leverage. Our operating ratio improved 430 basis points and on a flood-adjusted basis, it improved roughly 600 basis points.

As you can see on the chart, we continued to see significant volatility in weekly demand. This makes for a challenging operating environment. We are adjusting our resources in line with volume and sustaining our productivity improvements.

Looking more specifically at the quarter, and at the end of June, Southern Alberta and Saskatchewan experienced some extreme weather with the heaviest rainfall in more than 100 years. The rains and subsequent flooding resulted in nine communities declaring a state of emergency, the closure of the Trans-Canada Highway and nine washouts over 60 miles that took our main line out of service for 11 days. This was the single worst line outage of my career and likely the past 50 years.

The team did a tremendous job working with customers, rerouting some traffic over our North main line and safely and efficiently restoring the operation. During the outage, our associates at BN, UP and CN assisted us greatly by providing numerous detours.

Additionally, we had fantastic cooperation from union leaders and our employees to adjust their locations and keep our customers' freight moving. Our thanks to everyone who helped us during these difficult days.

As we highlighted at our Investor Day, there are some core metrics that we are watching -- safety, train productivity, asset utilization and reliability. And even with the flooding disruption, we are seeing some good early progress.

Due to a commitment that Ed had prior to his joining CP, he is unable to be here this morning, so in his absence, let me take you through our operating results starting with safety. Personal safety in Q2 improved 15% over last year and train incident safety improved 24%, continuing our Q1 trend. I am very pleased with our progress, but of course this is an area where we are never finished.

Turning to slide 8, our long train strategy and fuel conservation actions are delivering improved train productivity. As you can see on the chart, train waits and lengths are both up 4%. This is allowing us to handle traffic growth with fewer incremental train and crew starts, saving fuel, labor and creating low-cost capacity.

Our GTM's [proactive] horsepower decreased slightly due to the flooding and the impact on the network velocity. Detours and reroutes created higher online queuing and we added locomotives to assist with the recovery.

Fuel efficiency showed modest improvement, even with a larger road fleet, which now includes some of our older, less productive units out of storage. Good disciplined execution of the operating plan drove these results.

Turning to efficiency, through on-time trains and continuously tighter schedules, we are targeting improvements in asset velocity and service reliability. While our network speed decreased with increasing volumes, other critical metrics are showing improvement. Our terminal dwell time improved 3% versus Q2 2009, a good result given the significant increase in work levels and the flood impact. Our locomotive velocity improved 2%, meaning we are working these expensive assets harder. Our labor productivity as measured by GTMs per employee is up 18% and our car miles per day improved 11%. In fact, we were tracking at 15% year-over-year improvement prior to the flooding disruption.

Car miles per day is a critical metric because it reflects the productivity of key assets, yards, network and rolling stock and I am pleased with our early results.

On the service front, our Winnipeg Yard pilot project is progressing well and we have received favorable feedback from our customers. It is a joint effort with our clients to improve the first mile/last mile service. Given our early success, we are rolling it out systemwide starting with Montreal and Toronto this fall.

Finally, we continue to progress our structural cost reduction plans. In addition to our long train and fuel conservation efforts this quarter, we completed construction of additional capacity at our Calgary locomotive shop, allowing us to permanently close our Vancouver repair facility. We announced a number of personnel and facility consolidations affecting our DM&E and Soo properties and we took the necessary steps to implement work rule changes giving us added flexibility in how we execute track renewal programs. These changes are consistent with our new agreement with the Canadian Maintenance of Way Employees.

In closing, I am pleased with our progress, but there is much more to be done. I'll turn it over to Kathryn and Jane to report on our financial performance and the current market. Over to you, Kathryn.

Thank you, Fred and good morning, everyone. Q2 was a good quarter with volumes recovering and the continued discipline around cost management. We leveraged our capacity to drive productivity and improved our operating ratio 430 basis points despite the late June flooding.

Before I get into the details, let me speak to a housekeeping item. This quarter, we changed our accounting policy for rail grinding. Previously, we capitalized and depreciated this item. We now believe that it is preferable to expense these costs and have adopted this more common industry practice. This is a minor change and essentially increases purchased services and is offset by lower depreciation. You will find details of this change in the appendix at the end of this presentation.

Slide 12 provides a reconciliation of our GAAP/non-GAAP earnings we refer to as adjusted earnings. Reported net income was CAD166 million or CAD0.98 per share. When we take out FX on long-term debt and other specified items, our adjusted earnings are CAD156 million, or CAD0.92 per share. In 2009, there were similar adjustments, as well as a one-time gain from the partial sale of our Detroit River Tunnel Partnership interest. For the remainder of the presentation, I will be referring to adjusted earnings.

Turning to slide 13 and the FX adjusted column on the right side, total revenues were up 27% due to higher volumes, fuel surcharge revenues and price. Jane will provide more details on our freight revenues. Operating expenses increased only 20% and our operating ratio of 77.8% improved 430 basis points from 2009. I have noticed that some people have been quoting 410 basis points, but the difference is the retroactive application of our rail grinding changes.

With improving volume, operating income increased 61%. The team is doing a good job to quickly and efficiently adjust resources to changing economic demand. This ability will serve us well as I believe that the US and world economies are fragile. A sustained recovery will be prolonged and market demands will remain volatile.

So moving below operating income to adjusted earnings on slide 14, other income was positive versus 2009, which reflected charges from our debt restructuring and interest expense is lower as well. Income tax expense before FX on long-term debt and other specified items increased due to higher earnings and the effective tax rate of 26% is in the range we previously provided.

We had a Canadian dollar headwind, which reduced EPS by CAD0.03 this quarter and we expect the Canadian dollar to remain strong for the remainder of the year. Adjusted earnings almost doubled and adjusted diluted earnings per share was CAD0.92, up 96% from 2009. Overall, solid improvements year-over-year.

So let's turn now to the financial impact on the quarter of the main line flooding Fred mentioned. The late June flooding and heavy rains delayed loadings and reduced second-quarter revenues by an estimated CAD23 million and we believe that roughly half of those loads will be recovered in Q3.

During the outage, we utilized our secondary main line and detoured over other railroads to keep traffic moving. We estimate additional expenses of approximately CAD9 million as a result of these reroutes. All in, we estimate the impact of the flood was approximately CAD0.12 on EPS. The damage to track was significant and the repairs to rebuild the line was capitalized at a cost of approximately CAD15 million, but this should not change our capital guidance of CAD750 million to CAD800 million.

Now let's look at each of the expense lines in more detail starting with compensation and benefits on slide 16. We continue to see sequential productivity improvements as our GTMs per expense employee improved to CAD4.4 million and FX adjusted comp and benefits was up only 11% as our GTMs or workload increased 22%.

Volume contributed CAD12 million to the increase and wage rate and benefit inflation contributed CAD10 million. The increase in our pension expense run rate remains at CAD4 million and we had a CAD7 million headwind from a benefit recorded in 2009 associated with labor negotiations.

On the quarter, our expense employees remained essentially flat at 13,800. However, we do expect to see this increase closer to 14,000 in Q3. In total, including an FX gain of CAD11 million, compensation and benefits was up CAD25 million, or 8%.

Moving now to slide 17 and fuel expense, which was up CAD60 million or 51%. Price increased fuel expense CAD45 million as our all-in costs were USD2.55 per gallon, up from USD1.78 in the same period last year. Higher traffic volume drove increased consumption and expense by CAD22 million. Last year, our fuel efficiency was a record Q2 performance of 1.14 US gallons per 1000 GTMs and this quarter, we delivered 1.13, or 1% improvement, even with the flooding conditions and the return to service of some of our less efficient older locomotives. We are on target to deliver our annual 1% improvement in fuel consumption Mike spoke to at Investor Day. Other items increased fuel expense CAD4 million and finally, foreign exchange was a tailwind of CAD11 million.

Turning to slide 18, purchased services and other was up CAD10 million, or 6% before land gains. Volume-related expenses increased only CAD7 million with productivity improvements being seen in areas such as Intermodal. CAD4 million of the additional flood costs were purchased services and we also had a CAD4 million year-over-year headwind from one-time favorable tax adjustments in 2009 and FX was CAD11 million. The balance of the increase was primarily due to lower land sales. As mentioned in Q1, we still expect routine land sales to pick up in the last half of the year for a normal annual run rate of CAD30 million to CAD40 million.

Turning to slide 19, the remaining operating expenses were all favorably impacted by FX. Materials decreased CAD3 million due principally to currency. Equipment rents were flat despite higher car hire payments on volume increases, particularly in automotive and Intermodal. This increase was partially offset by lease returns begun in the second half of 2009. We will see this year-over-year benefit narrow as we lap our 2009 savings. Depreciation was flat.

We saw good operating leverage on higher volumes. Slide 20 summarizes our Q2 leverage. RTMs were up 23% and we saw core operating expenses, which exclude foreign exchange, fuel price and land sales, only increase 11%. We continue to sustain and leverage our productivity improvements; however, we will face tougher compares in the second half of the year as we lap last year's improvements.

I would like to highlight our cash on slide 21. We began the year with a strong cash balance of CAD679 million. With returning volumes and disciplined cost management, cash from operations, excluding pensions, added CAD550 million. We filed our year-end 2009 actuarial valuation and elected to accelerate most of our 2010 pension contribution requirements in the second quarter. Our 2010 required contributions will be approximately CAD190 million and to date, we have already contributed CAD178 million.

As planned, we paid our debt maturity of CAD350 million this quarter and in May, the Board of Directors approved a 9% dividend increase confirming our confidence in generating cash flow. Our capital program remains on target and we will continue to evaluate the best ways to put the remaining cash to use.

In conclusion, we continue to strengthen our financial position and deliver continuous improvement. We are driving productivity with returning volumes by leveraging our long train strategy and network capacity. We are building momentum to deliver improved bottom-line results. With that, I will turn it over to Jane for the marketing section.

Thank you, Kathryn and good morning. Starting on slide 24, this was our fourth quarter of sequential growth with carloads increasing 8% versus Q1 2010. On a year-over-year basis, total carloads were up 20% and revenue ton miles, or RTMs, were up 23%. The differential between carloads and RTM is largely driven by the recovery of export potash.

On a currency-adjusted basis, the increase was 28%. On top of volumes of 20%, fuel surcharge revenues generated approximately 5% of the gain and price and mix were 3%.

Now I will walk you through the markets, giving you comments on the quarter and then I will provide insight on the remainder of the year, finishing with price. For clarity, I will speak to currency-adjusted revenues.

Grain revenues were up 3%. In Canada, deliveries into the elevator system were impacted by the wet conditions on the prairies. On our US franchise, revenue was up versus Q2 2009, particularly due to movements to ethanol plants and processes.

Moving to coal, revenues were up 47%. Demand for exports of metallurgical coal to Asia was strong and thermal coal in the US was lapping a quarter that last year saw several receivers have significant outages.

Turning to sulfur and fertilizers on slide 27, revenues were up 88% on the quarter. International demand for potash was strong versus easy compares for Q2 of 2009, which was the bottom for the export market.

In our merchandise portfolio, revenues were up 43%. Automotive continued to be strong and was lapping easy compares versus Q2 2009 where there was major restructuring taking place. We also saw a significant improvement in ethanol and steel shipments. In other merchandise sectors, such as forest products, we continued to see modest volume improvement.

Now turning to Intermodal on slide 29, revenues were up 18%. Imports to the West Coast grew significantly as Canadian retailers replenished inventory and benefited from the improving Canadian economy. Eastern volumes were flat and we continued to see the impact of the loss of some short-haul business. Domestic Intermodal volume was up in line with GDP.

Turning to slide 30, I will run through our views on the balance of 2010. There is still uncertainty and a lack of consensus around the pace and sustainability of the recovery of both the US and global economies. In grain, there has been a very wet start to the season on the Canadian prairies that has resulted in seeded acres being roughly 15% below traditional levels. We expect Canadian grain, which represents approximately 60% of our grain volume, to be weaker than 2009 from harvest forward. At this time, it is too early to determine the size of the impact or when in the crop year it will be felt.

We continue to model normal volumes in our US grain franchise, though very early weak harvest reports in the southern part of our territory make us optimistic the crop could be above normal due to strong yields.

Looking to coal, we expect the second half to be similar to the first half, which is in line with Teck's forecast. On the potash side, there is limited visibility to second-half volumes due to the shorter-term sales contracts in international markets. I will note the first three weeks of July have been below our Q2 run rate. In domestic fertilizers, the good progress in the crop should create a decent window for application in the fall, but the amount of application remains to be seen and will depend on commodity pricing. As we have demonstrated in the first half, we will be ready to move the volumes as they are presented.

In both merchandise and Intermodal, these segments are linked to the overall North American economy. In the Canadian economy, the second-half growth rates are forecasted to be lower than the first half and the US forecast is for modest growth. Most segments of both merchandise and Intermodal are likely to experience slower growth compared to the first half and year over year as compares are starting to get tougher.

Moving to price, renewals during the quarter were in line with expectations coming in just under 4%. As we said in Q1, price results would turn positive as the year progressed and we did indeed see positive price in Q2 of close to 2% on a same-store basis.

Looking forward, we continue to target 3% to 4% on renewals and we expect positive price results to continue through the second half. We'll remind you that the regulated grain index will increase 7% on August 1 and effect about 40% of our grain revenues.

To summarize, Q2 was another quarter of growth both year over year and sequentially. In the second half of 2010, we faced some tougher compares and there is uncertainty around the US and global economies and the sustainability of the recovery. We are well-positioned to participate in any volume recovery and continue to pursue the growth opportunities we outlined on Investor Day. Our focus on service reliability allows us to continue to target 3% to 4% on renewals.

Finally, I will note that we expect that RTMs increasing more than carloads will not continue as we lap the bulk recovery in the second half. Now over to Fred to wrap up.

Thanks, Jane. As you have heard, market visibility remains limited. We have proven we can adjust quickly up or down to fluctuating markets and we are monitoring traffic trends closely. We are rolling out our first mile/last mile yard initiative and expect this will deliver enhanced service reliability and yard fluidity.

Our improvements are leading to the elimination of redundant assets and as Kathryn highlighted, we are seeing the benefits in our financial results. And we are confident that by focusing on asset utilization and service reliability, we can create new market opportunities, sustained price in the market and improve our cost efficiency. Our priorities are clearly established and our progress is on track. Now, I will turn it over to Andrea to answer any questions that you may have.

(Operator Instructions). Walter Spracklin, RBC Capital Markets.

Good morning, everyone. Just on pricing, curious to -- you are guiding us, Jane, at 3% to 4%. Is that reflecting now what you consider to be the maximum pricing you are going to get now going forward or is that still reflecting a little bit of the economic recession and some of the uncertainty, Fred, that you pointed to? In other words, when we look further out, is that a good number to use longer term or is there some opportunity to get a little bit more than that further out?

Walter, it's Fred. I think Jane and Ray and the team have a pretty clear balance in mind. We are reluctant to chase numbers that are extremely high. All it does is kind of trigger reactions from the regulators from the marketplace. We believe that if we can attain price increases greater than inflation, that is good because that is helping margin. We think the quality of the product that we have been assembling and are continuing to improve is going to enable us to do that. And that will allow us to have competitive pricing, but fair pricing for the shipper community as well.

Okay. Did you mention what percentage of your book you'll price for 2011? I don't know if you --

Jane will catch that.

Yes, Walter, just so that you know, 50% of our business is locked in, so this would be where price would be adjusted by either indices or by fixed amounts. So approximately half of those price adjustments for us are known.

That's great. Second question here is on the one-time -- thank you for the color on the flood. I noticed it's CAD4 million in the purchased services. I don't know where the other -- I don't know if you -- the other CAD5 million I guess is spread throughout costs, I assume?

Yes, it is, Walter. It is just -- it's what we estimate an additional fuel cost can improve over time. It is just spread all over the place.

Okay. And I guess where I was really focusing on was the impact of the port strike. Do you have any quantification for the third quarter on what that might've meant or is the deferred -- were there any shipment deferrals that you'll just make up in the balance of the quarter?

Walter, I mean it was I think five or six days all in. We would characterize it as a pain in the butt, but not one that has a material impact on us. And some of those shipments, which were diverted, ended up coming there any way or will come there any way with people changing their plans. So I would call it a non-issue unfortunately. Just disrupted some service, but I don't think it will have a material impact of any kind.

Okay, that's it for me. Thanks very much.

Chris Ceraso, Credit Suisse.

Thank you. Good morning. A couple of items. Did you see any slowdown in your exports to Asia either in the grain business or coal or potash or anything as you got deeper into the quarter?

No, we did not, Chris.

And what about here into July?

No, we have not seen that. I mean I would say that, if you looked at Fred slides that he put up at the beginning, we have seen a little bit of fluctuation in terms of volume. But as we have said since 2008, the biggest impact that we have seen in the last three weeks is really around the potash side. And as we have said, certainly the recovery we will see is volatile and we will see some movement in volume in terms of that week to week.

Chris, one other little bit of color would be we call it the Teck did have an explosion fire at their dryer at one of the mines, so we did go through a couple of weeks of uncertainty as they got their contingency plans in place. But I think on a call as recently as yesterday, they have basically confirmed their expectations with regard to 23 million, 24 million tons and they expressed how they are going to do that while they repair the facility.

So the first couple of weeks have been kind of funny both in potash and coal, not the perfect pattern, plus we were going through the recovery from the flood. But all the customers seem to still feel fairly strong about -- whether it is export potash or coal or the green business, subject to whatever the crop is. So we are getting good feedback from the client base that they still expect a strong balance of the year.

Okay. I understand in your comments with some caution about the second half in terms of the growth rate relative to the first half, but comps are getting harder. How do you think about things in absolute terms? Should we expect absolute carload volumes to go sideways from where they are now? Can they get better or are you nervous that carload volumes could be lower in absolute terms in the second half?

At this point, as we have said, we can't really predict the market. What we can say is that we will be ready to move what we can. We have proven that we have been nimble; we have been agile. The only other comment that I would say is that the trend that we saw, RTMs and carloads growing at a different pace, as I said, we would expect that to level off in the second half.

Okay. And then just one sort of big-picture question, Fred, maybe. How would you rank the growth drivers for CP on a three to five-year view, growth either in volume or revenues, whether it is potash or coal or energy? What is your ranked list of what is going to drive growth at the Company?

Well, Chris, it's kind of an Investor Day level question, so I will just repeat what we said then is that the feedback we have from the producers of metallurgical coal, they are making major investments. They feel there is a strong long-term growth opportunity to supply coal, particularly to China, but also to other parts of Asia.

The potash guys, you have heard that story directly from them, not through us, not just through us and obviously, they have got -- I think they are spending almost CAD2 billion a year in capacity expansion in Saskatchewan.

So when you add up the combination of just those two big drivers, granted driven by the Asian economy, those are the fundamental big-ticket drivers and then there is whatever happens in the North American economy happens. So I think those are the two big ones and we will continue to keep improving the quality of our product, which will allow us to pull more and more product off a truck or anybody else who is a competitive alternative to us.

Okay, thank you.

Scott Malat, Goldman Sachs.

Good morning. Thanks. Just wanted to talk about the improvement in car miles per day; that is up 11%. Help us think through the drivers here, how much of that is volume improvement, how much of it were initiatives and kind of what's your outlook for this metric?

Well, I think in broad terms, I'm going to make a directional statement. Up is good and a lot of our focus over the last quarter has been looking at the yards and how we operate the yards, what we could do differently. There is a whole other set of activities with regard to train design and making sure that we don't unnecessarily go through yards. So avoid going through them first.

Second, when you do go through them, go through them as efficiently as you possibly can. The train speed over the course of time is a little bit of a deceptive number. I am not particularly concerned about that because we will get that up over time. And so I think the key drivers are avoid the urge when you can and when you do get there, make sure you handle it exceptionally efficiently. And we have made some pretty strong aspirational statements about moving trains such as grain. We have come from 18-day cycles down to 12-day cycles, been a bit blippy lately because of the floods, but those are massive improvements when you start to move at 24,000 car fleet that much faster.

So those are the kind of things you can expect from us and we will just take it one chunk at a time rather than set a long-term aspirational statement. But we want to be -- over time, why wouldn't we want to be best in class? So we will keep driving towards that.

Thanks. That's helpful. The other thing that was a little surprising as I was trying to model it was just the revenue ton mile per gross ton mile in the quarter. That ratio is much higher than we would have thought. It is usually down in 2Q. What is that a function of and how do we think about that? Is there improved scheduling or any other initiatives that are helping that ratio?

I think it is probably just generally a mix issue. We might have to take it off-line for more details, but whenever you get major mix shifts such as a massive increase in the bulk commodities that you have seen, those are different RTM, GTM ratios because you don't have triangulation occurring. It is basically 100% empty movements on one half of the move. So instincts would just be a mix, but we will take it off-line for more detail.

I would just add that it is likely the return of the export potash and of our coal volumes coming back in the quarter.

All right, that's helpful. Thanks so much.

Bill Greene, Morgan Stanley.

Yes, hey there, good morning. I just wanted one clarification on the comments you had made about the percent of business. I think you said that it is locked in for 2011. Do we know the rate at which that is locked in? Is it in line with sort of the guidance you have here for the second half as well?

No.

Well, I asked Jane to be short with her answers, but not that short. Bill, I would be just (inaudible) there. It is really important that we say this clearly that 50% of the business, as Jane said, is -- we know that it is either under a fixed rate. In other words, we know that number and that portion would be consistent with the guidance that Jane and Ray have provided. But then half of that, or 25% of the total base, is under an index. Well, we don't know what those indexes will be until the indexes -- the year completes and then the indexes are adjusted. So 25% is a fixed number and that is consistent with the targeted pricing ranges and 25% has an index. They will be what they will be and 50% remains to be negotiated.

Got it. Okay, good. Thank you for that. Second question is, as we look at the forward sort of margins, if you think about OR, right, so the second-quarter OR obviously had an impact from weather. If we adjust for that, I think normal seasonality would say that your third quarter is typically better than your second. Is there anything about the third quarter this year that would cause that not to be the case? Is the logic sort of sound or is there something in this third quarter that we need to keep in mind as we start modeling these unseasonable patterns.

Well, Bill, we don't give guidance on operating ratio by quarter, so I think you guys know the patterns. I would leave it to you to judge from what you can see. It is really -- Q3 is generally a pretty good volume quarter and if everything materializes the way the shippers seem to think it can, then that should be a good news story for all of us.

Okay. And then just last question is I know you expressed a little bit of concern on the economy, but what are the customers telling you about sort of the merchandise customers on their inventories? Have they fully restocked and they want to start to destock or are we still in a rebuilding mode in terms of inventories? Thank you.

I think as we look at the merchandise side, what we have seen is we have seen some restocking that has taken place. But it's hard at this point to really be definitive in terms of whether or not this restocking is in fact over. I think that, again, given the outlook for GDP and that type of growth rate, it will all depend on how strong sales are to drive that that much further.

And Bill, if I can add any color to that, it would simply be that both Jane's recent trip in Asia and my visits with certain steamship lines within North America in the last couple of months, last couple of weeks, even though GDP doesn't seem to be growing very quickly, there still appears to be a very strong lineup of containers arriving at the West Coast right through Q3 because they have probably got three to five weeks worth of visibility into what is being presented back in Asia.

So there seems to be an inconsistency and I guess you could conclude that may still be the tail end of or maybe not the tail end of inventory replenishment because the volume of containers arriving on the coast is certainly greater than GDP consumption of retail products. So I guess there is still some of that going on.

Yes, and I mean I think that makes sense just from the perspective of what we heard out of other rails that they are reasonably upbeat about the peak season. Your comments seemed a bit more subdued, so that is why I wanted the clarification. Thank you.

Ed Wolfe, Wolfe Trahan.

Good morning. Is there any ongoing flood impact? You talked about maybe some makeup of volumes. Is there any additional impact to the network or the cost side or how should we think about that for third quarter?

I would say none with regard to the Saskatchewan floods. I think like everybody else in the US Midwest, we are having I would call them minor situations right now in Chicago and Iowa. There has been another little series of minor floods occurring down there, which is leading to a little bit of rerouting by virtually every railroad on other people. And also is leading to a little bit of congestion, but it appears from what we have seen so far, Ed, that that area of flooding will be a reasonably minor incident and will probably pass within weeks and we are off to a normal pattern.

So a summary answer is we don't see any impact going forward of what we have experienced other than that first couple of weeks of having to clean up what was left over on July 1.

Okay, but am I right that Saskatchewan is a net positive then because you have got some makeup?

Well, we hope so, but, again, the volatility that we experience day to day, week to week on demand is making it very hard to decipher how much of that is catch-up and how much isn't. There is a nice opportunity in the green side and obviously, we're working very hard to catch up on some of those loads.

Okay. What does a 15% decline in Canadian grain acreage typically mean for your volumes? Is there any way to think about what a normal impact that might have?

At this point, I think, as we talked about it, what we are seeing is a 15% reduction in seeded acres, but we have got to see how this crop matures over the next months to see how that impacts actual yields. So I think if you look at it last year, there has been some discussion about the crop being 44 million metric tons and it ended up coming in at 48. So there is some play there.

And you had mentioned that the 7% grain index increases or impacts 40% of your grain business. What happens to the other 20% of the Canadian business? Why does it only impact 40%?

Because it is the regulated portion of regulated grain. The rest of it is commercial grain.

So (multiple speakers) commercial grain, what are you expecting I guess is what I am asking?

Well, as we said, we have -- our price plan, as we look out on a go-forward basis, we are talking about 3% to 4%. That is what we are targeting.

Okay. And then the last question, you had mentioned that in July for export coal that the run rate had slowed a bit. Is that just the year-over-year comp?

No, Ed, that was my comment and it was really to do with the fact that they had an explosion and a fire and as a consequence, the first couple of weeks at one of their mines led to some disruption and the good news is that they are back into a pattern. We have been hauling really the last I would say week and a half to two weeks, it is back into a very normal rhythm and they have come up with a contingency plan on the ability to ship basically wet coal as opposed to going through the dryer, which will be good, from what they say, good to get through the season and they will have the dryer repaired in time for the colder weather.

And just to add, as I said earlier in my remarks, is that we expect the second half to look much like the first half and that we are modeling in fact to the Teck forecast.

Did I hear right? Was it coal or did you say potash in July was below the 2Q run rate?

I did say that it was potash and again, as we said, the move to shorter-term contracts creates some lack of visibility for us. And we certainly see and believe in the long-term fundamentals of potash. And we always expect some volatility, but our message is clearly that we have the resources, we have the ability to be nimble. We have demonstrated that in the past that this has become our reality and we will continue to do that.

Okay. Thanks, everyone, for the time.

Ken Hoexter, Merrill Lynch.

Good morning. Kathryn, just I guess looking at the employees, they jumped up a bit on a sequential basis. Is that related to the floods or are you starting to significantly add some headcount again.

Well, they did come up, but I think it is consistent with the guidance that I gave, which I said we would probably hover around 14,000. Part of it is the fact that we have some business in the US and we are hiring in the US in the running trades area, as well as trying to get ahead of the curve on our demographics as well a little bit through training. So it is responding to the higher volumes. It is right in line with the estimates that we have consistently given over the last couple of quarters. And we do see it somewhere between 13,800 and 14,000 through Q3.

Ken, I might add that, remember that the recovery has been in big bulk commodities -- potash and coal -- so those aren't incremental cars on a train; those are train starts, which requires running trades.

Have you used everything that you had -- what do you still have left in storage I guess in terms of locomotives, employees --?

We still have a couple hundred employees in laid-off status. We have approximately about 10,000 cars of different kinds and about 120 locomotives still in storage.

As you get to the end of the locomotives and cars in storage, presumably those are the ones that may need some more maintenance. Are you seeing that as you pull them out or are we going to see a capital budget impact? It sounded like Kathryn I think said the CapEx still staying the same even with everything with the floods and everything. Is that something you are going to start to refocus on?

We don't see any immediate capital changes at this point. Of course, as you bring equipment, older equipment out, there could be some higher maintenance costs. But overall, we are not seeing anything that would be a major item for you guys to consider.

Ken, I would add that I would like the source of those incremental cars to be cars moving more quickly. So I don't particularly want to bring more cars out unless there is a massive spike in demand. I would much rather see the assets we have utilized more efficiently and that creates capacity in itself and we would avoid all the things you talked about.

Wonderful. I just have two quick numerical ones. Kathryn, there was a collection of a receivable from a financial institution on the cash flow.

Yes.

What was that from?

Well, I'll tell you what. It is a little complicated. Why don't you take that off-line with Janet and we can walk you through. It is a net net not much.

Okay. And then the other one was the tax rate, which after adjusting for the foreign exchange gains and fair value adjustments still seemed a bit low. Is there anything sustainable to that?

Well, we do believe it is sustainable and it is within the range that I have given you. It is 26% and we have consistently said that, based upon our tax planning, etc., we believe it will be in that range. I think we have given 25% to 27%, so it is right in the middle of that range. And of course, any incremental effective tax rate is always a function of the level of your income.

Understood. I am sorry. So that 25% to 27%, that should continue through the end of the year?

Yes. We haven't changed that at all.

Wonderful. Thanks for the time. I appreciate it.

Tom Wadewitz, JPMorgan.

Yes, good morning. I wanted to ask you a bit about some of the productivity. It sounds like you are having pretty good traction on a number of productivity initiatives in the quarter. I know there is a little noise related to the line outage at the end of the quarter. But how would you view that progression? Is that something where you think you build further momentum in the second half and looking into 2011? And I guess I am thinking of train length types of things and other I guess weight per train, those type of productivity metrics. I know it is also a function of volume growth, but maybe if you could give us some thoughts on that, that would be helpful.

I think, Tom, again, we have to look at it by segment. So remember that we have got bulk trains recovering as we've spoken about. And you recall from the investor day that we've got some plans to take those already productive trains. Where we can we'd like to migrate towards some longer trains, but it is a function of terminal capacity and origin and destination and of course our ability for citings, etc.

So on the merchandise and intermodal side we have the capacity, as I think we said in June, of probably 15% to 20% on those trains. We have already run a series of 12,000 foot train, some 14,000 foot trains we are experimenting with. So I think directionally you should expect us to continue to strive particularly in merchandise and intermodal in the I'll call it the reasonably short term, to continue to drive those train lengths and weight up.

On the bulk side they will come, but they come with some technology and with some I'll call it cooperation from the parties at origin and destination to ensure that the full supply chain is capable of making those step function improvements. So directionally I would expect us to continue to drive up.

Now the thing to remember, of course, is a lot of our initiatives kicked in in the summer of last year. And so as we work into the second half of the year the percentage increase, the comps become more difficult.

Okay. Thank you. That's helpful. And then on the facility consolidations, I think, Kathryn, you mentioned about or maybe you did, Fred, on the locomotive maintenance facility and expanding Calgary and shutting Vancouver. And I think you may have some other facility items that you are working on. What kind of impact might that have had in the second quarter or going forward in terms of expense savings and which line items would that show up in? Is it materials or purchased services or what?

I think as we even talked about in Investor Day, when you close a facility, it hits every line item. And whether it is utilities, supplies and services, communication costs, property taxes, I mean it runs the gamut. It just hits your entire income statement. So for us to be able to quantify each and every piece of that it is just impossible. It is moving the right direction, it is moving to larger facilities, getting higher productivity out of the facilities that we have and bringing work together to improve the productivity through the shop.

So at this point, it is just not reasonable for us to try to quantify each and every piece of where those savings are. But it is spread throughout. So we will continue on our plans on facility consolidations because we believe it will ultimately drive to lower structural costs.

Not on a line item basis, but can you give a broad sense of the item you mentioned, the consolidation of the locomotive facility in Vancouver and expansion of Calgary? Is that a CAD5 million or CAD10 million type of benefit annually looking forward or what is the magnitude?

We just aren't going to quantify each and every consolidation because, again, even when we look at the overall consolidations of our shops, there will be puts and takes in every direction because it is looked at as a major overall plan. So as we move and drive toward higher efficiency and whether it is all of our different facilities, you are going to see some increases in some line items and decreases in others. So we are not going to quantify each individual facility closure separately. We have a good ROI, just as we have some capital additions and so as we look at what we have to do at each facility in order to drive these consolidations, they are based on good and solid ROI.

Okay. Thanks for the time.

Fadi Chamoun, BMO Capital Markets.

Good morning. Still have one more question. The contribution margin in the second quarter, if I back out the flooding impact, something around 55% or a little bit more, and as you said, the recovery has been led by potash and coal to a large degree. I'm just wondering if you can shed some light on the degree of influence, this sort of volume bias towards bulk on this contribution margin. And as we go into the second half, how would the makeup of volume impact sort of your operating leverage and your contribution margin, if you can help us out there?

So Fadi, I will start out and Fred will probably add. But the way I look at it is we have said consistently you are going to have different operating leverage because your merchandise train and intermodal trains have more capacity on them and just as Fred has spoken to our bulk trains, already very large trains. So when bulk comes in, back in as we leverage up, it creates more train starts than our merchandise or intermodal networks.

So yes, as we saw in the second quarter, a lot of our volume improvement was in the bulk side, so you are going to have less leverage on those because you already are running big trains. So just as we have spoken at Investor Day, where we have capacity is in our merchandise and intermodal network and as those cars come on, we won't have to be adding train starts. So it does vary depending on where the volumes are coming back.

Can you give a degree of magnitude sort of for merchandising trains' sort of contribution or operating leverage magnitude versus bulk at this point?

We are not going to give different margins on each amount of traffic, but just as I think Mike gave at Investor Day, we have, on an average, 20% or more capacity on our merchandise and intermodal trains. So that next car goes on that train at literally very little additional cost except for fuel. And so that is where the group looks consistently, even if we can put some bulk on those merchandise and intermodal trains and blocks or whatever.

So it will depend on the OD point pairs. It depends on where the traffic is, but mostly it's you just think about -- it is whenever you have -- if you have got 20% more capacity on those merchandise and intermodal trains, it is at very high margins because it's an additional car. It is a great thing. But when you have to start adding train starts, that is when your leverage changes.

Okay, that's helpful. Thank you.

Cherilyn Radbourne, TD Newcrest.

Thanks very much. Good morning. I wonder if you could remind us of what is going on in your intermodal business in the East. You did refer to some short-haul traffic that was down. Can you just remind us if that short-haul traffic that you had deliberately demarketed or if something else is going on in the East?

I would just remind you that, as we said, our Eastern volume is flat and the short-haul business, that is business that we let go.

Okay. And then I wonder if you could speak about the rollout of your Winnipeg Yard pilot project to Toronto and Montreal. As you look at those yards, is there any thought that you may need to add capital to any of those yards in order to achieve the productivity that you are targeting or are you generally happy with the physical state of those assets?

I think the assets are in wonderful shape. The capacity exists. It is really a matter of working with the client base to spread the flow over seven days a week instead of kind of the Monday to Friday nine to five that many have historically encouraged or insisted on or demanded. And as we have learned in Winnipeg with the more concentrated dialogue and communication, the shipper community has generally been quite accommodating and that has enabled us to literally reduce by half the dwell time of cars arriving before they are placed. And that is -- when you multiply that over all of the yards, that could be a pretty good opportunity to one of the earlier questions about how do you get car miles a day up.

And so have you had to, in Winnipeg, do anything from either an incentive or a penalty point of view to kind of encourage that seven day a week activity?

No, nothing at all. It is really a better level of communication, a more frequent level of communication, reopening channels that, over time, for whatever reason have not been as open as they should have been. So I would call it a huge win on hopefully on everybody's part -- shippers, ourselves, car utilization, yard fluidity. It is a win-win all around the waterfront.

Thank you. That is all for me.

Benoit Poirier, Desjardins Securities.

Thank you very much and good morning. My question is on the flood, the impact that we should expect in the third quarter. If I understand, about half of the revenue will be recorded in Q3, so half of CAD23 million. And you mentioned -- you talked about additional expenses of CAD9 million. Will it impact only in the third quarter? What should we expect on the bottom line and on the operating ratio? Thank you.

Kathryn is going to address the -- I will just frame it up though. I think the revenue assessment we think is right, but it is very hard, as we said earlier, to identify whether those revenues that we are seeing are in fact attributed to this deferred. We know, for instance in grain, that there is some deferred revenues. That is probably the only thing you can identify. You should assume that the intermodal business that was diverted to highway or to other railroads during those periods will not return. So it is really more a handful of merchandise and some of the bulk business that we have that you should see to come forward.

From an expense perspective, there is no reason that there should be any Q3 expense impacts. We tried to either incur or approve all of the anticipated expenses in Q2 as far as that is a concern. And of course, there is the capital spend that has occurred and incidental, but there probably will be a couple of million dollars next year just buried in our normal program to do a handful of bridgework and things that we have got temporarily repaired that need more work.

Okay, perfect. Thanks, it's clear. And on Canpotex, is it too early to talk about the upcoming renewal, Fred.

Yes, I think it is, Benoit, because the contract has still got two full years to run on it. So it is kind of like you can -- we can talk a lot about it, but I am not sure what it accomplishes. So my view is it is a great client, one that we've have had a long, long relationship with, one that we hope to have a longer relationship with over time. And when the time is right for that type of dialogue, we will have it and of course, we will communicate. But I anticipate it is pretty far into the future.

Okay, thank you very much. Thanks for the time.

Jeff Kauffman, Sterne Agee.

Thank you very much. Congratulations on a very solid quarter with the challenges. Most of my questions have been asked, so I will just do two quick ones. First on the grain rate adjustment, if indeed your grain haulage is below expectations as a result of the Canadian crop, is there the possibility of a further upward adjustment in the rate or no?

The way that the process works is it is set for one crop year. So in fact, the 7% that I spoke about as an adjustment, that will be effective for the 2010, 2011 year.

Okay. So if there -- so this just takes us back to where we were before last year's 7% reduction, but nothing else beyond that?

That's right.

Okay. Second question, Fred, if I interpret your comments correct on the run rate on the export potash being a little bit below what it has been, export potash was still a bad market in the second half last year, so that is not to say that you still don't have better year-on-year comps in the second half even with a slightly lower run rate. Am I thinking about that right?

I would clarify it two ways, Jeff. One is your summary is absolutely correct. I do believe that you're going to see a strong second-half relative to things that we experienced in '09. But I really am going back to what the potash shippers underlying Canpotex are telling us as recently as weeks ago. They have identified a set number. They believe the markets are there.

Obviously, just like some of the other bulk commodities, when people have gone from year-long or multiyear pricing agreements back to 30 and 90 days, they can't give us the visibility of exactly what sale will occur to what country at what point. They have to basically work the marketplace, gain the sale and we become aware of it. So that is back to nimbleness and agility.

But all in, these underlying potash companies are basically making statements publicly that they believe they will move X amount of tons over a period of time and that is the communication we have and we are preparing ourselves to move it. Albeit not perfectly smooth everyday of the week or every week of the month or every month of the quarter. It is going to be a little choppy. So what. We will figure out how to work it and we have shown our ability to do that.

Okay, great. Again, congratulations and thank you.

Jason Seidl, Dahlman Rose.

Thank you. Hello, everyone. Two quick questions. You talked about targeting 3% to 4% gains on pricing. Is that excluding the 7% adjustment to grain or including it?

No, that would be excluding it. So we would be targeting 3% to 4%. And as I indicated, our price went positive this quarter and we expect positive price for the remainder of 2010 and the 7% price will help us to deliver that as well.

Okay, fantastic. Thanks for the clarification. Also, if I could circle back to the short-haul intermodal business that you guys walked away from. Can you clarify why the business was walked away from?

Jason, that was a piece of business that was very short haul and very much out of balance between the US ports and Canada. So the consequence was it became quite inefficient for us to participate in because you ended up hauling either huge numbers of import containers from a port in the US Northeast into Canada and then weeks later, you might get a huge movement the other way, but it was a lot of inefficient movement. So we elevated the expectations between ourselves and the client with regard to a balanced movement, which is good for railways. And we were unable to find terms that were acceptable to both parties and they found other ways to move it.

Perfect. That's fantastic color. That is all I have and I appreciate the time as always, guys.

David Tyerman, Canaccord Genuity.

Yes, good morning. Your employment productivity gains are pretty impressive in terms of GTM per expense employee. I am assuming a lot of this is related to the rebound. I am wondering if you can help me understand how I should think about the kind of gains that would be sustainable at more normal volume growth rates.

David, it's a complex question because of the mix of activities. Depending on the type of business that comes back and how fast it comes back, we are going to find -- 18% -- I agree with your assessment -- it was very good; we are delighted with it. But you are not going to see that kind of incremental bump because you are starting to kind of hit the point last year where the recovery was beginning.

All that said and done, you know that we are going to continue to look for longer trains, look for heavier trains. Depending on the amount of bulk that comes back, you could well see continued improvement -- you will see continued improvement in productivity, but I don't think anybody could expect that level of increase quarter over quarter for the balance of the year.

Right. Should we be thinking in kind of a long-term sense of more like, I don't know, mid single digits or even low singles? Is that more of a reasonable kind of thing in the longer-term context?

Well, I don't think we have quantified it, so I would hesitate to kind of use this call to make those kinds of predictions. I think directionally, if it is helpful at all, David, I would say that directionally productivity per GTM is an underlying aspiration in everything that we are doing in product designing, everything we are doing in the adoption of new technologies, everything we are doing in our labor negotiations. So I wouldn't want to qualify it without a little more thought, but directionally you are on the money as far as what we would aspire to deliver.

Okay, great. Thank you very much.

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

Well, very good. Thank you all for spending time with us and we look forward to talking with you next quarter. Bye now.

This concludes today's conference call. You may now disconnect.