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Canadian Pacific Railway Limited (NYSE:CP)

Q1 2014 Earnings Conference Call

April 22, 2014 11:00 am ET

Executives

E. Hunter Harrison – Chief Executive Officer

Keith Creel – President & Chief Operating Officer

Jane O’Hagan – Executive Vice President & Chief Marketing Officer

Bart Demosky – Executive Vice President & Chief Financial Officer

Nadeem Velani – Assistant Vice President, Investor Relations

Analysts

Brandon Oglenski – Barclays Capital

Steve Hansen – Raymond James

Scott Group – Wolfe Research

Bill Greene – Morgan Stanley

Turan Quettawala – Scotiabank

Chris Wetherbee – Citi

Ken Hoexter – Bank of America Merrill Lynch

Allison Landry – Credit Suisse

Thomas Kim – Goldman Sachs

Jeff Kauffman – Buckingham Research

Benoit Poirier – Desjardins Securities

Walter Spracklin – RBC Capital Markets

Jason Seidl – Cowen and Company

Keith Schoonmaker – Morningstar

Cherilyn Radbourne – PD Securities

David Newman – Cormark Securities

John Larkin – Stifel Nicolaus

Operator

Good morning. My name is Mike and I will be your conference operator for today. At this time I would like to welcome everyone to Canadian Pacific’s Q1 2014 Conference Call. The slides accompanying today’s call are available at www.cpr.ca. (Operator instructions.) I would now like to turn the call over and introduce Nadeem Velani, AVP Investor Relations. Please go ahead.

Nadeem Velani

Thanks, Mike. Good morning and thanks for joining us today. I’m proud to have with me here Hunter Harrison, our CEO; Keith Creel, President and Chief Operating Officer; Jane O’Hagan, EVP and Chief Marketing Officer; and Bart Demosky, our EVP and Chief Financial Officer.

Before we begin I want to remind you 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 2 in the press release and in the MD&A filed with Canadian and US regulators. This presentation also contains non-GAAP measures outlined on Slide 3.

The formal remarks will be followed by Q&A. We would appreciate it if you limited your questions to strategic items, and if you have any modeling questions please follow up with myself or Megan in Investor Relations after the call.

It is now my pleasure to introduce our CEO, Mr. Hunter Harrison.

E. Hunter Harrison

Thanks, Nadeem, and thanks for joining us this morning. I trust that you’ve seen the press release and I guess my comments are I’m glad it’s over. I’ve been in this business a long time as most of you know and this is probably the worst operating conditions that I have ever been through in that period of time. But despite that this group of railroaders came through with some outstanding performance, certainly in my view given the environment and the circumstances they were dealing with.

So we’ve got a lot of ground we’ve got to cover today, so I’m going to confine my remarks and turn it over to Keith and Bart and Jane. And then I’m sure we’ll have plenty of questions this morning, so Keith, over to you.

Keith Creel

Okay, thanks. Let me start by sort of echoing your comments. One of the most challenging operating conditions I’ve ever experienced in over two decades of railroading, but I’d be remiss not to say I’m extremely proud of the CP team who worked tirelessly. And I’m talking all departments, from headquarters, operations, finance, running trades employees, chemical employees, engineering employees, craft and officers alike – 24/7 just to survive this winter and to serve our customers.

We realize effectively our work’s not done. I’m not going to be satisfied myself until all of our customer service needs have been met and we’re doing it in the positive way we were doing before what I’ll call the winter for the record books. On a positive note we are making progress operationally. Rest assured we’re seized with doing what we’ve got to do to restore normal service levels and fluidity across the network.

I think it’s appropriate, let me provide a little bit of color to the challenges winter represented. To the naysayers or perhaps those who don’t understand the gravity of this challenge this winter represented, let me start by saying yes, winter does happen every year. I’ll provide a little color to how challenging this winter was.

We prepare extensively for it but absolutely one of the worst, not normal, not even close to a normal winter. To put it in more perspective in Canada according to the Environment Canada it’s the coldest December and January since 1950 – that’s seven decades. In the US, specific to Chicago which is critical to our network between the months of December and February according to those that keep the records in the States, 67.4” of snow were recorded in Chicago, making it the third snowiest winter on record matched by the third coldest winter on record – which is a very compelling point when it comes to operating railways.

From December through February if we go up to North Dakota, the 25th coldest on record; in Minnesota, the 6th coldest on record. So overall from December through February especially all modes of transportation, not just railroads – if you were flying in planes, if you were driving on the highways or trying to operate any kind of business with a mode of transportation you were severely impacted by this extraordinary severe and cold winter.

So again, I’d stress exceptional, I’d stress key words like “abnormal,” creating operational headwinds that were, to say a “headwind” is probably an understatement. I can tell you now running a railway, snow in large volumes and short timeframes can be challenging but you dig out of it; but sustained frigid temperatures like we experienced is crippling to an operation.

Train link productions of 50%, it’s not uncommon to be able to run the railway safely, and the key there is when you get to temperatures for a sustained period – in Canada if we want to talk Celsius, negative 250 C or lower, in the States that’s 16 below zero for those of you who don’t know how to do the conversion, that’s rough numbers of where it’s at – it’s cold. You get to a point where you can’t maintain your train brakes, you can’t maintain air thorough the train’s system and the brakes set up, or you can’t operate the train safely.

The only way to mitigate it is to run shorter trains which means you consume crew assets, you consume locomotive assets. You put additional train starts out on the railway and it consumes capacity, and essentially everything slows down. So all of your cycles on your locomotives as well as your car turns are prolonged and exaggerated which saps capacity out of the network.

Let’s talk a little bit about Chicago. I put a map in here to provide a little bit of perspective because I know I’ve heard a lot of people who are probably asking or thinking “How does Chicago impact CP as much as it has impacted CP?” Well effectively the way our franchise works, some of the challenges we deal with, CP’s Bensenville Yard is on an island to a point. When I say an island on the mainline with Metro, you’re talking about Metro that runs a tremendous amount of trains in Chicago. Between Metro and Amtrak they operate over 1300 trains a day.

We’re on a key corridor going into the city. Effectively we’ve got four-hour windows in the morning, four-hour windows in the afternoon and then every hour they run a pair of faster trains that we have to operate our freight in and around and through. The preponderance of our business that’s coming into Chicago, and you see our two lines, is coming in from Milwaukee or coming from the Kansas City area west of Chicago, goes to the belt.

The belt is a bridge carrier. It’s a switching carrier that all the railroads that operate in and around Chicago own a part of but effectively rent it to the benefit of all the railways. So they do command and represent a tremendous amount of workload. If the belt gets backed up; if the belt gets to the point where they’re not able to process their traffic efficiently then it’s going to back up on the other roads, and that’s what happened with CP in spades during the winter – has recently even to the point that winter is over as far as the weather but the challenges associated with it are not.

Two weeks ago it was not uncommon to come into this railway on a daily basis and be holding about twelve trains, which represents twelve trainloads of cars and twelve trainloads of locomotives in queue in line to get into the belt. And I’m not being critical of the belt; that’s just the operational challenges that we were facing. We’ve done some pretty extraordinary things with some of our partner roads to clear that backlog up and I’m happy to say that it is eased.

We’ve got a lot of the traffic that we had backed up all the way into Canada cleared out which is a positive sign, but again, on the car cycle standpoint, on the locomotive standpoint, until we regain fluidity – and I think we’re probably still about four weeks away – you won’t see normal cycle turns or normal velocity, normal capacity restored in the US network until that time. So it remains a challenge for us as we go forward.

Now you’re going to ask the next question: “A challenge, is it a challenge long-term or is it an opportunity?” I view it as an opportunity. If we continue to do the same thing we’ve always done, and if you have another winter like we’ve had this past year then you can expect similar results. We’re taking this as momentum, as an opportunity to create a desire in working with our other roads to try to get traffic out of Chicago that does not need to be in Chicago.

There’s certain amounts of traffic, and this is 25% of the entire industry’s volume goes through this center. It is the largest interchange location in North America. Some of that business simply doesn’t need to be there, so it serves this industry’s interest, it serves CP’s interest, it serves all connecting carriers’ interests for us to work together to identify that traffic and route it to alternate gateways to create additional capacity within this Chicago/Greater Chicago terminal, so that when and if these winters occur we mitigate the impact and we don’t have a repeat performance from this past year.

Moving to a couple comments on legislative grain volumes. As Hunter will mention and discuss on this call and in questions, the proposed legislative changes in Canada that we’ve dealt with are disappointing to say the least. The reality is this current grain supply chain, of which rail is only one component, simply can’t meet these extraordinary volumes over a short period of time.

To put it in perspective, this crop on the Canadian side is the largest grain harvest in Canadian history. It’s 37% more than our five-year average. On an annual basis normal demand for the two railroads to move in Canada to export is about 34 million metric tons. This harvest represented about 20 million more, or 50% more than the average on a five-year basis. So the bottom line is, the supply chain from the fill elevators to the railway to the port terminals can’t handle this kind of volume again in a short period of time.

Even in spite of the winter, in spite of some of these operational challenges and supply chain challenges, we were moving record grain volumes last fall which got impacted by the temperatures that came in December and January. With the weather improving we’ve regained momentum. We did 15% more western grain in February even in some of the toughest winter challenges, and 20% more in March than in the previous year. We’re currently exceeding the minimum thresholds as well that are outlined in bill C-30 which the government has imposed upon us.

On the safety side a couple of encouraging trends that are developing. I say this not to brag on the performance because I think one injury or one derailment is too much, but more to specify and highlight the safety culture that we’re driving and that continues to evolve and improve. Train accident frequency improved in the toughest winter operational conditions this railroad has experienced over 50% versus last year, which is phenomenal. We recorded less than 1 train accident per million train miles, so that’s not only an industry best, it’s a CP record as far as Q1 and as far as any quarter in fact.

And on the same positive note on the injury side our ratios improved 14% year-over-year. Again, not to brag about this but to highlight that our focus on driving a culture of accountability leveraged with the investments in technology and the physical plant is the way that we’ll continuously drive improvement on the safety front – which is good for our business, it’s good for the environment, it’s a moral responsibility and something we take very seriously at CP.

So that said I’ll turn it over to Jane to comment more on the commercial implications of this quarter and what the opportunities are on a go-forward basis.

Jane O’Hagan

Okay, thanks Keith. In the face of extreme cold weather and tough operating conditions revenue increased by 1% in the quarter. The impact of weather cost us about $75 million in the quarter but we see upside in our growth initiatives and strong demand fundamentals across our portfolio. As network velocity continues to improve we expect to make up this shortfall through 2014.

I remain confident in our revenue guidance of 6% to 7%. Renewals pricing came in above our target range of 3% to 4%. Average revenue per RTM was up 6% with our focus firmly on increasing revenue quality.

So turning to the lines of business, I’ll report Q1 2014 revenue highlights on a currency adjusted basis, but I’m going to spend the majority of my time on providing insights on Q2 expectations.

So starting with grains, in Q1 we were down 1% in revenue. In Canada the record crops presented an unprecedented demand for grain movement to export terminals. Despite ongoing severe weather early in the quarter, strong export deliveries to Vancouver helped drive positive year-over-year Canadian grain volume and revenue.

Adverse weather hampered our US grain movement, particularly through our key outlets in Chicago, while more fluid corridors serving the Pacific Northwest market remained flat versus last year. Overall, [southbound] challenges in our US portfolio offset gains in Canada with volumes down single digits year-over-year.

The outlook for grain: looking ahead to Q2 we have record levels of sustained grain demand across Canada and we expect performance similar to the record levels set during the peak September to November period last year. Strong demand in the US coupled with improved Chicago operating conditions will provide opportunities for strong year-over-year volume growth in eastern US markets. So we expect high single digit growth over last year in Q2.

Turning to fertilizers and sulfur, in Q1 we were down 16% in revenue. The revenues in the quarter were impacted due to lower fertilizer shipments as a result of high inventory following a late harvest and a narrow application window, sulfur production impacts and challenging operating conditions that limited us from taking full advantage of volume following a recovery in the potash markets. This led to a Q1 RTM decline of 12%.

As we look to the outlook, the demand for domestic fertilizer application remains very strong on excellent crop fundamentals in North America. We’re optimistic we can take advantage of some of the upside through Q2 despite a compressed season. The fundamentals are expected to carry forward into the fall season with additional potential upside into the second half of 2014.

International potash prices that began to stabilize and increase during the quarter created certainty for buyers. Volumes are expected to rebound in Q2 with more favorable operating conditions but are not likely to reach the record export levels we saw in Q2 2013.

Now turning to coal, in Q1 revenue was down 2%. Our Canadian [met] coal volumes increased strongly in the second half of Q1 as we overcame supply chain-related challenges. [Tech] westbound volumes hit an all-time monthly record in March. Continued weakness in US originated domestic and export thermal coal demand combined with supply chain challenges due to harsh winter operating conditions led to a decline in US coal. As a result, RTMs were down 4% in Q1.

For the outlook in Q2, despite some prevailing softness in [feed-borne met markets] we expect to see strong demand from [tech] due to their diverse market base, their high-quality product and competitive cost position. US exports thermal volumes are expected to fall off mid-Q2 due to customer net backs no longer supporting those shipments. Domestic thermal volumes in the US are expected to return as supply chains get reset, but the market dynamics continue to be challenged. Q2 coal volume is expected to strengthen through the quarter due to easier year-over-year compare.

Now turning to intermodal Q1 results revenue was down 3% but intermodal performance in the quarter was a highlight as we continued to improve the quality of revenue and grew our domestic business despite the volume impact from a contract we chose not to renew in international, the significant weather challenges and the Vancouver truckers’ strike.

Domestic led the way with a 5% RTM increase in the quarter, reflecting our best-in-class transcontinental service and our expressway growth. Cents per RTM and average revenue per car increased 2%, demonstrating our plan to target the segments and customers that drive the most value is in fact working.

So for the outlook we expect continued traffic gains in our domestic business as we sell our superior service and market capacity in high-volume corridors. The product consistency and reliability of our intermodal service will continue to generate interest from customers and segments who are looking for competitive alternatives and value our premium product. We’ll continue to translate our service improvements to revenue growth, where we have competitive advantage we’ll do pricing for value, and improve the operating income of the business.

In industrial and consumer products in Q1 we were up 3% in revenue. Challenging winter conditions limited our crude volume growth in Q1 with carloads slightly lower than Q4 2013. The ramp-up in [proxan] delivered double-digit volume growth in the quarter. Average revenue per car and cents per RTM were driven by FX and changes in mix from increases in [higher-R] sand and crude.

In terms of our outlook the new [Hardasee] facility will start up in mid-June and will ramp up through 2014. This is new capacity in the heavy crude market which will bring better balance to our franchise, given it’s less sensitive to crude spreads. The crude by rail model continues to be valued by our customers and capacity build-outs are on track. We expect double-digit sand growth in Q2 as the sand facilities on our network in Wisconsin continue to ramp up from 33,000 carloads in 2013. Our industrial products group will trend with GDP.

In automotive in Q1 our revenues were down 13% as adverse weather impacted automotive production and the supply chain. Chicago is a key hub for empties and connections to other carriers where congestion had a significant impact on shipments from southern Ontario plants. In terms of the outlook, as service improves in and around Chicago we expect to take advantage of improving velocity and car supply to handle backlog shipments. Our focus is on using our network and service to drive sustainable growth. We are aligned with strong automotive companies who are very competitive in their markets.

So in conclusion, like Hunter I’m glad to see the winter months behind us. Demand is strong across all of our lines of business. We’re delivering on our initiatives and we are working at improving revenue quality. We have a sales organization that’s highly motivated by a new incentive compensation program that rewards profitable growth. It’s early stages and we should see solid results as the year rolls on.

And on that note I’d like to turn it over to Bart.

Bart Demosky

Okay, thank you Jane and good morning, everyone. Suffice it to say that in spite of the significant challenges you’ve heard described by Keith and Jane already this was a record Q1 for CP, and I believe that does bode very well going forward.

Operating income and net income were both up 17%, resulting in earnings per share of $1.44 that was up 16%, and ROR of 72% was an improvement of 380 basis points year-over-year – which I see as a testament to the efficiencies and strong cost control the team continues to demonstrate.

I didn’t want to cover much in the way of the numbers but there are a couple of items from an operating expense standpoint that I thought would be worth noting. In particular we saw strong, continued improvement in the comp and benefits area this quarter. Efficiencies generated from both headcount reduction and lower pension expense more than offset the higher crew costs and overtime wages that we had to incur as a result of the harsh winter operating conditions.

Purchased services also saw some dramatic improvement in the quarter and in spite of headwinds that we saw due to higher land sales and a favorable $9 million legal settlement last year in the same quarter we were able to reduce this line by about 9% on an FX-adjusted basis. The improvement was largely driven by insourcing initiatives which have allowed us to reduce IT and third-party maintenance costs, so that strategy is working very well.

We did see an uptick in materials expense this quarter. We received a few calls on this this morning. It was really primarily due to higher winter-related freight car repairs, but keep in mind that those costs are mostly recovered through higher [AAR car billings] for those repairs so we will see a better run rate going forward.

Let me just touch on one other thing, and that’s enhancing shareholder value. As you may recall I mentioned on our last call, my first call, that I don’t believe in sitting on excess, idle cash. I view it as something that could be a drag on shareholder returns if we could be deploying that cash effectively to drive higher shareholder returns overall.

So consistent with that thinking in March we initiated a share buyback program which I believe reflects our confidence in the long-term prospects of the company and our fundamental belief that this is a value-enhancing proposition for shareholders. In other words, even with the share price where it is today we see ourselves as undervalued.

In conjunction with that program we have also put in place an automatic share repurchase plan which allows us to buy shares throughout our blackout periods. So over the last few weeks while we’ve been in blackout we’ve continued to purchase shares. We also announced as part of the program our intent to repurchase about 1.3 million shares thorough private agreements, and simply those enable us to purchase shares at a discount to prevailing market prices. For those of you who are familiar with those types of programs you’ll know that the counterparties tend to be Canadian financial institutions rather than institutional shareholders.

Lastly I’m also very pleased to highlight the ratings upgrade CP received from Standard & Poor’s last week. They bumped us up from BBB- to BBB and we were also able to retain a positive outlook from Standard & Poor’s. And my outlook on it is this upgrade is really a reflection of our strong operating performance, the improved balance sheet that comes along with that and a commitment from the company to financial discipline.

So to that end at the bottom of Slide 12 you’ll see it there. I have highlighted a couple of financial metrics that we are focused on. You’ll see there in the continuous improvement mode, it’s obviously not a complete list – there are other metrics that we’re steward to, but the intent is simply to show that we are committed to maximizing shareholder value while maintaining a strong financial discipline. And the company is certainly delivering on both those fronts.

So with that I’ll conclude my remarks and I’ll hand it back over to Hunter. Thank you.

E. Hunter Harrison

Thank you, Bart. Let me see if I can attempt to address some of the other issues that we were dealing with in Q1 that have got certainly potentially implications going forward, and that’s more some of the regulatory reactions that we’ve gotten from both Ottawa and Washington.

First let me talk a little bit about reaction in Canada. Taking it all in, I’m proud to report right now that in spite of the fact of all the winter conditions and environment and unprecedented operating conditions that we’re carrying 12% more grain than we were last year and that was at record paces. So you know, it’s hard to prepare for a winter like this but in spite of that I think I can best describe it as we probably had a very knee-jerk reaction from Ottawa with due respect to the regulators.

Once again with due respect, I’m not sure they understand really what they’re dealing with. If you think about the inter switching, you put in inter switching, you set it to 160 km and you take it north but not south so US carriers can come into Canada but a Canadian carrier cannot go into the US. And it only covers three provinces, it makes very little sense to me. It has political syrup all over it and I’m not sure what impact it’s going to have.

Number one, if you look at those three provinces the only road or other carrier that gets to come into our territory would be Burlington Northern, and I’ve talked to them several times and they’ve got their hands full trying to handle US grain. It’ll be a long time before they reach into our territories.

If you look at inter switching and the history of it, and see how much inter switching is used I think you’d be amazed that the numbers are very, very small. Will it be less efficient? Yes. Did the regulators understand that? No. But once again we had very little if any dialog or feedback or interplay as far as suggestions of if anything should have been done to fine tune the system.

Now, am I an opponent of inter switching? No. If you want to have inter switching, that’s fine. If you think inter switching encourages competition, maybe so – that’s fine. But I can tell you this, that in those kind of conditions is when the strong really stand out. And so I’m not concerned. The main issue I have with inter switching is the rates. You know, if it’s a regulated rate and it’s a fair assessment of the costs to provide that switching then I have no trouble with the background of inter switching.

But just think about what’s going to happen. I mean here we have a situation where it’s set up for a US carrier to come into Canada, not for a Canadian carrier to go into the US. They’re going to come up and take Canadian grain and take it south to the US, put it on a US road – non-regulated by the way; take it to western markets, take Canadian grain to US ports, take Canadian jobs away. I just in the long run don’t think it’s going to fly. So I think those things concern me. Well, I have a little concern. Do I lay awake at night about it? Absolutely not. You’re going to see us perform in spite of what reaction the regulators have taken.

And the same situation exists to a degree in Washington. There were some issues raised about service issues in Chicago. I think Keith has covered that very well, that look, when you’ve come to the end of the line that’s as far as you can go. If people won’t take the traffic further there’s not a lot we can do about it, and with due respect the regulator’s reaction is to hold [above the carrot] and people get up, and really there’s not any positive feedback.

But I will tell you this – some of you are aware and remember that before I retired the first time I promoted a type of commercial arrangement with other roads that was called routing protocol, that was to route cars in the most efficient route. I’m oversimplifying it but the most efficient route which would provide the best service for the customer and the lowest cost for the railroads, and our challenge would be able to split the pie up that would be created.

So with some of these conditions that have existed in Chicago we have had, I think it’s fair to say some encouraging dialog with some of the other carriers. I have said to you many, many times – in fact it wasn’t seven months ago or eight on one of these calls – that I told you that I was concerned about Chicago, that Chicago was fragile at best. Is this the last time that Chicago is going to get into this situation? No, probably not.

And in fact we felt so strong about it at my former employer that we tried to buy the Chicago belt railway; they wouldn’t sell it. We tried to buy the Indiana Harbor belt, they wouldn’t sell it. We tried to encourage a merger of the two in Chicago, they wouldn’t buy it. And so as a result at that point in time we bought a railroad that went around Chicago, which I think has probably put our competitor in the east in better conditions operating through Chicago as a result of recognizing those issues.

But all in, the ship is righted. It’s sun shining in Calgary, and in spite of this little rugged start here I’m very comfortable going forward with the guidance that we have provided to you. And I don’t see any need to change that; in fact I’m more encouraged all the time. So with that little political byplay I’ll turn it over to Mike to see if there’s questions from the group, which I’m sure there might be.

Question-and-Answer Session

Operator

(Operator instructions.) Your first question comes from Brandon Oglenski with Barclays. Please go ahead.

Brandon Oglenski – Barclays Capital

Good morning, everyone, and congratulations on what was a pretty difficult period. Hunter or Keith, I want to come back to the idea that there’s some concern from investors that maybe the cost reductions have been too fast, too quick. Has that in any way impacted the recoverability of the network or are you reducing volatility for CP looking forward?

E. Hunter Harrison

Well, let me comment and then Keith can kick in. You know, this has in no way created any more volatility. The cost reductions that we have made have been made in a very appropriate manner. There’s been no slash and burn, no obsession with headcount. It’s been done through the basic models that we have – provide service and control the cost, and asset utilization. And we’ve followed the same model now.

Those that are trying to find a crack in the mortar here are absolutely wrong, and I think what it really does is it says even more that here’s an organization that has maybe been accused of going a little too far to be able to produce the kind of results that this team produced in Q1 in spite of what we’ve been through. So no, I think that just bodes more strongly for the model than ever before.

Keith Creel

The only thing I’d add to that is I’d add emphasis to it actually has shortened the impact or minimized the impact of what this winter would have done to this railway. If you go back a year ago or two years ago when we had 30,000 more cars out [online in-road], we had more locomotives [online in-road], we had the kind of conditions we had – we wouldn’t have been adversely impacted, we would have been crippled. We would have been paralyzed.

So I would suggest this isn’t about cost reductions. It’s about asset turns; it’s about right-sizing the level of assets you have against the business demands and it has allowed us to maintain fluidity in those corridors where in the past we wouldn’t have been. And it’s mitigated even in those that we’ve been adversely impacted by. So it’s accelerating the recovery; it’s not impeding the recovery.

Brandon Oglenski – Barclays Capital

I’m sure a lot of folks will remember a pretty nasty winter a couple of years ago this company faced. Speaking to Chicago though what can proactively be done here to clear some of this interchange traffic issues that seem to come up every year?

Keith Creel

Well proactively, to Hunter’s point, routing protocol. We just don’t need to have as an industry cars in Chicago that don’t belong in Chicago. I’ll give you a case in point. We got engaged pretty heavily and early with our customers warning them what was going to happen in Chicago. Some listened, and I’m not being critical – for whatever reason some listened, some didn’t. I can give you two energy customers, and I talked about this at the STB last week – two different results.

One worked with us and we routed around Chicago to their end destination; one didn’t. The one that did, even in the face of this winter across this network moved comparable year-over-year volumes. The one that didn’t are dealing with potential plant shutdowns and having to curtail their end production. I’d make a case that one made the right decision, one didn’t make the right decision. So cases like that, when you multiply them you get an opportunity to do something different that’ll give you a different outcome.

So again, we’re seized with looking at all of our traffic, car by car, lane by lane. We’ve challenged the marketing team: I’m not interested in the long haul if it’s going to take me into Chicago and adversely impact the operations. So if we’ve done that selfishly shame on us but shame on our competitors as well. We need to work with them and figure out how to create synergies for the customers for car cycles, for locomotive cycles. We have the low cost operation, both us and our competing and partner carriers, and we figure out commercially how to split the revenue.

There’s cost savings to be split up, to be realized; there’s revenue implications that we all should be mature about and realize. And the end result is the customer is more satisfied, they get to move more freight, and you don’t have the impact of winter the way it has impacted us this past year. So it’s something we’ll continue to work on going forward. There’s no silver bullet, to Hunter’s point. This is about singles and doubles to keep winning the game and that’s exactly what we’re going to do.

Brandon Oglenski – Barclays Capital

Thanks, Keith, at least we’re thawing out here.

Operator

Your next question comes from Steve Hansen with Raymond James. Please go ahead.

Steve Hansen – Raymond James

Good morning. Just hoping you can provide some added color on this domestic intermodal franchise that you’re now growing some new service offerings in place. And I guess specifically how long do you think it’ll take to backfill some of the international businesses that you’ve strategically seeded?

Keith Creel

At the run rate now, the way it looks, Steve, we’re talking the revenues on domestic will lap what we’ve lost in international by the end of 2015 if not exceed. And then the quality of the book, because the contribution and the quality of the revenue is so much more positive in domestic versus international, it’s going to be a much greater success story bottom line for the company.

Steve Hansen – Raymond James

Okay great, that’s helpful. And then just turning to crude by rail quickly if I may, Hunter, I think in the past you’ve mentioned that the economics associated with some of the early stage contracts in crude by rail were not maybe as favorable as you would have liked, but presumably there’s been a learning curve. You’ve got a new large-scale unit train facility coming on in short order here. Can you give us a sense of how the economics might have changed for the business or if they have changed, or how that learning curve has evolved?

E. Hunter Harrison

Well, things have changed in those two ways. We continue to have growth with crude, and look – people may have misunderstood me to some degree. Look, I’d love to haul crude just like anything else. It’s just a fact that if you looked at the margins they didn’t qualify in my book of being the right quality. Now, Jane and team have worked very hard and going forward I think you’ll see the quality of revenue improve there. And once again, if “the regulators” stay out of it and let us that know how to railroad railroad then those issues will be behind us.

Steve Hansen – Raymond James

Okay, very good, thank you.

Operator

Your next question comes from Scott Group with Wolfe Research. Please go ahead.

Scott Group – Wolfe Research

Hey, thanks, good morning guys. So first, I just wanted to ask a couple follow-ups on the guidance for the year. Jane, the 6% to 7% revenue growth, what’s the FX rate you’re assuming and just maybe the implications of the rate being at 1.10 right now? And then Hunter, last quarter you suggested that maybe it could be as good as a 63 OR. I’m guessing that’s tougher now after Q1 but maybe just your latest thoughts on how good it could be this year.

Jane O’Hagan

I think I can answer your question on the FX pretty quickly. We’re assuming an FX of 1.05, and as we move forward and look at the book we’re hoping that the Canadian dollar stabilizes. Our export-oriented traffic and we’ll assume that we’ll see some additional traffic that’ll move in the merchandise sector to various points around North America. So Hunter, I’ll turn it back over to you then.

E. Hunter Harrison

Look, I hesitate to even put out numbers any more. The staff beats me up as soon as I walk out the room about being optimistic. [laughter] And you can color my questions with optimism. Look, there’s a lot of positive things going on here. Did we have a little setback with winter, but did we learn? Absolutely we learned. So you know, somebody asked the other day “Is the potential there,” quote potential, “for a 63?” Yeah, there’s potential. You don’t always fulfill your potential.

But yes the potential is there, yes, it’s a matter of timing. Yes there’s a lot of moving parts but yeah, so far so good. I’ve been doing this a long time and I haven’t missed too many numbers so I know I’ve got a short track going here but I don’t plan on missing any more.

Scott Group – Wolfe Research

Okay. That’s helpful. And then maybe just strategically just on the Chicago issue, so obviously the CJ&E has been bumped by CN but Hunter, you talked about some other acquisitions you tried to do in the past. Do you think those could open up again? And I know you’ve been one of the few proponents about more major consolidation in the industry. Does this issue in Chicago in your mind make that more likely or are you more interested in kind of bigger transactions?

E. Hunter Harrison

I think it does make it more likely, and this is not something that I’m some Johnny-come-lately here. I’ve been saying this for the last ten or fifteen years. Someday the whole industry is going to wake up about Chicago. You know, if you go back in time before previous mergers by the way, Chicago was not a big interchange locale. It was far behind St. Louis and Kansas City.

So what created all the business in Chicago? Well, it’s just a shift of the business away from Kansas City and St. Louis and other points on the Mississippi, and created a lot of business in Chicago because of the mergers. Railroads still have this, what I call “long haul mentality.” And we saw as we were getting into the commercial side of the business, we saw a lot of business being routed through Chicago that should have never gone through Chicago – that it’s out of route, that it’s more cost, that it’s worse service, that it’s less asset turns.

But the people that grew up in this industry who have this long haul division mentality are one day going to learn. As you get growth, further growth in Chicago, as the economy further picks up, Chicago does not have the infrastructure to handle the business going forward – particularly if you start talking about regulatory issues as far as hazardous commodities and those types of things. There’s got to be another place on the Mississippi to interchange traffic east/west.

Now, if you look at the amount of traffic that’s interchanged east/west and you look at the various gateways up and down the Mississippi, I mean I haven’t seen recent numbers but Chicago is probably 10:1 over any other gateway on the Mississippi and is more than all the rest of them put together of St. Louis and Memphis and New Orleans and those things.

So yes, do I think there’s going to be a point where people are going to need, have to look at other issues which might be a merger? Absolutely, because thorough a merger you can still maintain competition and have a much better flow of traffic, and if everybody wasn’t worried about the long haul they wouldn’t have it all routed through Chicago. So yeah, Chicago’s going to get fixed, it’s just a matter of time. For some reason we’ve got to get battered and bruised in this industry before we wake up.

Scott Group – Wolfe Research

Alright, thanks for the color, Hunter. I appreciate it, guys.

Operator

Your next question comes from Bill Greene with Morgan Stanley. Please go ahead.

Bill Greene – Morgan Stanley

Hi, good morning, thanks for taking the question. Can I ask you to talk a little bit about how we should think about base-lining traffic? We know that you lost some business by design here but how should we think about the recovery? What freight didn’t move in Q1 that we can expect to move in Q2 and maybe Q3? And also how much of the business is left that you may want to reset if you will? So I think, Hunter, in the past you’ve talked about 20 contracts or so that you didn’t like the margins on. Maybe having a sense for what that means on a net growth basis, whether you want to talk RTMs or traffic, would be helpful.

E. Hunter Harrison

Bill, let me make these comments and then Jane or Keith may want to get in. You know, if you look, clearly it’s going to be a strong grain year throughout the rest of the year. And there’s a huge amount of carryover so there’s going to be pickup there. Most of our other bulk commodities look positive, not with a big carryover like grain, but when you look at autos, forest products, particularly lumber, most of that softness is a result of car turns. Cars got stuck in other carriers, and where they were making 15- and 20-day turns we say 40- and 50-day turns with the assets.

So I think pretty well if you looked across the book intermodal is not affected as much, and typically what we think of is the intermodal business you’ve lost, you’ve lost. You don’t carry it. But I think the product that Keith and Jane have put together, the domestic intermodal, is very encouraging. Their staff just got back from Asia and Jane I think was with t hem, and there’s some very encouraging signs there related around something that’s unique in this industry called service. And I think some people that had left said “Have you got room for me to come back?”

So I think we’ll see some resetting, this is my view, of some intermodal business. So if you look throughout the year, and one of the reasons that I’m as bullish as I am on the guidance is that I think there’s going to be plenty of revenue out there if we continue to execute the way we’ve been executing.

Jane O’Hagan

Yeah, the only part I would add is you know, over the last year or so Hunter has really had us focused on ripping apart the book of business and really looking at ways to improve the revenue quality – attacking the profitability by customer, profitability by lane. And as Keith indicated part of our work will be to continue to look at that, to optimize how we can move more moving along the most efficient corridors.

But the one thing I will say is that to your question around contracts and those that Hunter has indicated that they’re not quite the way that we would like them to look, we’ve included them in our guidance – that’s included in that overall view.

Bill Greene – Morgan Stanley

Okay, that’s helpful, thanks. Bart, maybe I can just follow-up with you on one question: when we look at the target leverage ratio you sort of talk about, it kind of suggests some very large opportunity to increase the buyback significantly, particularly when you consider some of the things Hunter’s mentioned on asset sale potential. So can you just talk a little bit about how you would envision the scope or the capacity? Is it measured in the multiple billions here? Is that how we should think about the opportunity? Maybe some color there would be helpful, thank you.

Bart Demosky

Bill, it sounds like you’re pretty excited about the buybacks in the future. I think we are, too, and the way I’d maybe characterize it is I looked at given the way the business and the operations side of CP has continued to improve and will continue to improve going forward, we’ve started to not only repair the balance sheet but get it to a place where ultimately maybe adding some leverage down the road makes sense. But we’re talking about using truly free cash and excess cash to repurchase shares.

Now, I think what that does tell us is that going beyond the current $1 billion program, once we’ve fully executed that – and my view is we will of course fully execute it – we’ll be in a position to have lots of opportunity to continue to repurchase shares going forward beyond that program. And it comes with being able to put leverage on the balance sheet but it comes more from the great operating performance of the company and the cash that that produces.

So I can’t give you any specifics today. This is a journey. We just got to this point but it looks very, very promising from here.

E. Hunter Harrison

Bill, one thing I’ll add is this is kind of a matter of an issue that we’ve dealt with called confidence. So we’ve developed some confidence with the rating agencies, we developed some confidence with the Board. We’ve developed some confidence with people internally that thought this was unachievable and I told them it was going to have to be a leap of faith. So to Bart’s point, if we continue to have the operating performance that we had been having I think you’ll certainly see in the future steps two and three to a buyback program.

Keith Creel

Bill, let me add one comment of color, something just looking at the way the business is going right now as well. Grain, grain, and more grain is the story on the Canadian side, it’s the story on the US side. From an RTM standpoint though even though winter has ended and we are making progress it’s sort of a tale of two stories – you’re getting a lot of fluidity, you’re getting train speed back, you’re getting cycle turns back on the Canadian side, but we still have a drag with the impact of Chicago and sort of the ripple effect.

What goes in has got to come back out, so we’ve got the backlog cleared up but it’s not normal stakes yet. Train speed in the States at the worst of things was off about 35% to 40% compared to last year; now we’re down to about 25%. So it’s getting better, day by day getting better but we still have to mitigate our expectations. So I would expect over the next month probably flattish type RTM growth. You’ll start to see towards the end of Q2 an increased RTM growth year-over-year and then a strong Q3 and Q4 based on the base demand across all those business groups that Hunter spoke to.

So it’s solid demand across all business groups and that’s what gives me confidence. That’s what’s given us confidence to maintain our year-end earnings guidance in spite of this adverse Q1 that we’ve had.

Bill Greene – Morgan Stanley

Excellent, very helpful. Thank you.

Operator

Your next question comes from Turan Quettawala of Scotiabank. Please go ahead.

Turan Quettawala – Scotiabank

Yes, good morning. My question is back on the regulation side I guess. Hunter, you talked quite a bit about the regulators here. Are you concerned that maybe there’ll be some other customers who will start to knock on the regulators’ doors considering that the grain lobby I guess has met with some success here? And also is the government becoming a little more conversational now or is it still much more of a one-sided approach?

E. Hunter Harrison

Well, I don’t think there’s a lot of customers that are going to be knocking on regulators’ doors depending on what you’re talking about. Some of us who lived through regulation know that’s not the answer to this. I hope the customers know and understand and to some degree it’s been an educational issue with customers. We’ve seen cars riding out of Wyoming going out to Toronto for an example that go into Chicago that go to another carrier, and that just doesn’t make sense.

I think this was what you might describe as a perfect storm as some of this came together, and there was a lot of pressure from customers and reactions from the regulators. But I think that particularly in Canada all this has to go through a CTA review once this legislation is passed where you have some people that with due respect understand the business a little better. And then we’ll go through this five-year process of review that the transportation system goes through, and I think we have a lot of case to be made that look, don’t overreact. Don’t have some [emotional] or knee-jerk reaction. Think about what you’re doing.

This doesn’t make a lot of sense. Why do it in three provinces but not the others? Why is it just three provinces? Why is it they can come in, the US can come into Canada but we can’t go? It makes no sense. If you sat somebody down and said “Here’s what they’ve done,” they’d say “Why?” And then you ask them why and they don’t have real good answers. So I think a lot of the rhetoric is going to calm down. I think we’ve talked all morning about the weather being behind us and the operating performance getting better, and this too shall pass.

Keith Creel

Let me add a little color to that as well. I think there have been some customers knocking on the regulators’ doors specifically in Canada expressing concern about some of the legislation and about some of the things that have been done because of the unintended consequences that could transpire. If you’re a potash shipper, if you’re a coal shipper and you’re a world supplier you want to make sure that what’s happening in Canada is not in your worst interest. You want it to be in your best interest, and sometimes these things happen.

From a capacity standpoint, I’m not concerned about the commercial implications of inter switching; I’m concerned about the capacity implications. And if your objective is to increase capacity to move grain, which is what the rallying cry was for this legislation, then do you really need to do things that could impeded your ability and sap capacity? If you start trying to put 100-car unit trains through 20- or 30-car interchange tracks at designated interchange locations specific to CN and CP in this country you’re going to have an adverse impact not only on grain movements but also on the existing business that moves through the existing inter switch interchanges.

So to me you’ve got to think about unintended consequences. I don’t think there was enough consultation; I don’t think there’s enough understanding. And as I have in the past I’ll continue to express concerns to the regulators that make these decisions – they need to vet them and they need to think deep and hard before they do something that creates overall an adverse impact to the Canadian marketplace.

Turan Quettawala – Scotiabank

Thank you, that’s very helpful. And if I may ask one quick one, Keith, you talked about the second half being obviously a lot stronger here. Is there any sort of specific risk that comes to mind off the top as to what might change that in any way?

Keith Creel

I think the only thing that would change it is world economic meltdown. I just don’t think it’s in the cards, and even with that we’ve got a lot of grain to move, a tremendous amount of grain. If we were to move all the pent up demand that’s out there and really hit it on all cylinders, and dot all our I’s and cross all our T’s that’s a compelling opportunity for this company.

Jane O’Hagan

And there will be significant carryover of the crop this year as well to the tune of over 20 million metric tons, so when you factor that in we’ll be moving grain for some period.

Turan Quettawala – Scotiabank

Great. Thank you very much.

Operator

Your next question comes from Chris Wetherbee of Citi. Please go ahead.

Chris Wetherbee – Citi

Thanks, good morning. Keith, maybe just talking a little bit on the cost side, so when you think about the $0.30 or $0.35 impact that weather had in Q1, maybe it’s about half of that coming from the expense side? If you look to get the service ramped up over the course of the next four weeks or so, should we think of that sort of anything meaningful from a cost perspective being added into Q2? I guess I’m just roughly trying to get a sense of the cadence of costs ticking up to those more long-term 2014 targets.

Keith Creel

No, I would say there’s no homeruns there. I think it’s the railroad, and as we’ve experienced train links are going up, train loads are going up, train speeds are going up, cycle turns are growing, costs are coming down and overtime’s coming down, terminal dwell’s coming down. As those things happen they’ll reverse and account for some of the downfall that we had in Q1 especially considering if you remember year-over-year, we did our whiteboard sessions midyear last year.

So the first half, the comparables, if it had been a normal winter would be compelling. So we’ll realize those synergies in Q2, I’ve already seen the numbers, and we’ll regain the expense that we’ve chewed into or overshot I guess in Q1.

Chris Wetherbee – Citi

Okay, that’s helpful.

Bart Demosky

Sorry, Chris, maybe if I can just add a couple of words. The insurance expense in the quarter related to the weather was about $25 million so that’s a number that you can use to come out on a run rate going forward.

Chris Wetherbee – Citi

$25 million of expense, that’s helpful. And then Keith, when you think about resources – forgetting about headcount for the time being but may be thinking about capital resources, locomotives, etc. or actual sort of hard infrastructure assets, when you think about what this winter has taught us is there anything that you feel like you need to go to Bart to ask for when you look forward to the rest of the year as far as capital is concerned? Or do you guys feel relatively good about sort of the plans you talked about in the past?

Keith Creel

I would say if I went back and I had a crystal ball I wouldn’t add any more resources when it comes to locomotives, crews and people. I mean effectively we maintained a fluid railroad overall in Canada. The place that really hurt us was Chicago, and like I said if you’ve got 12 trains daily waiting to get into Chicago am I really doing anybody any good having 15, 16, 17 in line to get into Chicago? That’s just more additional locomotives, more people, more assets, more costs that once things normalize that’s a going out of business sale as far as I’m concerned.

So the short answer is no. We’ve got a very robust capital plan this year. We’ve got some strategic investments we’re making to increase capacity over the long run that will allow us to drive train velocity, take out additional train starts, train links and absorb incremental business at lower incremental costs. I think we’re right-sized and I think we’re right on target, and I wouldn’t suggest that we need to change anything.

Chris Wetherbee – Citi

Okay, thanks for your time. I appreciate it.

Operator

Your next question comes from Ken Hoexte with Bank of America Merrill Lynch. Please go ahead.

Ken Hoexter – Bank of America Merrill Lynch

Great, good morning. Hunter, you had mentioned in your previous position that it wasn’t about the operating ratio and at some point you want to start growing revenues. But now that you’ve been here for a little while and have seen the landscape change on the cost side you mentioned getting to sub 60. Is there a kind of, I know you didn’t want to set a hard number before of a target but do you still see that on the path given all the bulk traffic on this network compared to what you moved before? And then do you still see the outlook of at some point switching over to a stronger revenue growth and a less focus on the ramp up on the cost side?

E. Hunter Harrison

You’re going to get me abused by the staff here. Let me say this: I think that you’re exactly right about what I’ve said previously. I still believe that; I haven’t changed it. And I think we’re probably seeing the light at the end of the tunnel with that strategy and a shift and I would suggest to you that we’re going to talk about that a great deal at the Analyst Days in New York in October I think.

So I think we are approaching and to some degree the industry is approaching a point where I think that you’re going to see growth kick in as the economy stays stable. And I think you’re going to see some growth further for a lot of reasons, reasons that are I’ve talked about before. So yeah, I think we’re maybe a year or two away from that shift where there will be a point that it’s probably not in our interest to go necessarily lower. Now that’ll be a low point. It won’t be 63; it’ll break through that barrier.

But yeah, I think that we’re looking to the point where the real opportunity particularly for a business that’s as capital intensive and high fixed costs as this one is, there’s a point where growth can really kick in and give us a real boost to the next stratosphere.

Ken Hoexter – Bank of America Merrill Lynch

When you said “break through the barrier” do you mean 60 or do you mean the 63 that you had mentioned?

E. Hunter Harrison

63, let’s start with that, okay, and if we get through that… You know, look, you can say 59 is just one point less than 60, or four points less than 63 but it’s some kind of mental issue with certain people. So look, we have been involved, I’ve been involved with carriers before that have had operating ratios that start with 5’s that are clean quarters and weren’t some aberration. So could I see a day in the future if we were going to talk about more when we would get to some of these artificial barriers? Absolutely.

And when we wring all the costs out of this operation and get operating as efficiently and as effectively as this team would like to have, I think there’s going to be opportunity, a lot of opportunity for growth on the upside which will maybe be the next wave of the future for us.

Ken Hoexter – Bank of America Merrill Lynch

I appreciate that. And then just you had mentioned before you wanted to talk about Ottawa and Washington, and I know you talked about Ottawa for a while. I’m not sure if you ever kind of moved it over to Washington and your thoughts on maybe the switching proposal or the returns proposal that have now come before the STB? Can you kind of switch over to that side a little bit and maybe throw out your thoughts there?

E. Hunter Harrison

Yeah, I think if you look back, first of all the STB went for a good period where they only had two sitting on the Board; now they’ve got a third party. But I think that if you look back at history, if you look back at the numbers that they’re pretty compelling. If you look back since [Staggers] in the 1980s to today, and you look at railroads’ financial performance, service performance or whatever the case might be, and you say we’re going to go back to the old days and mess with that model, you need to be very, very careful.

We talked about inter switching in Canada; I remember the old days of reciprocal switching. Was it good for service? No. Was it good for costs? No. What was it good for? I couldn’t figure it out. So I think that once again like a lot of things it got headlines for a couple days, service has fallen back in shape. And I think I don’t have, and maybe I’m reading this wrong – I don’t have concerns that Washington is going to do something that’s not smart or appropriate for the railroads. And if they do, if they think about it or approach it I think there’ll be a lot more dialog and input from people who know a little something about the industry rather than once again snapping off and putting some legislation in that makes not very much sense.

Ken Hoexter – Bank of America Merrill Lynch

Wonderful, I appreciate the insight. Thank you.

Operator

Your next question comes from Allison Landry with Credit Suisse. Please go ahead.

Allison Landry – Credit Suisse

Thanks for taking my question. Hunter, referring back to your comments on there still being the potential to achieve a 63 OR this year, could you talk about some of the key levers that you could pull to make up for some of the setbacks in Q1? I know you mentioned a little while ago that there’s plenty of revenue out there so do you think that the top line have more of an impact than you initially expected or will it be more of a combination of that along with continued execution on the cost improvements that were already in place?

E. Hunter Harrison

Well I think that it’s going to be more of the same. We’ve got a little setback here with the snow drifts that were higher than locomotives. But all the initiatives that Keith has put in place, some that are just getting kicked in are going to get kicked in fully the rest of the year. Jane, forget new revenue for a minute – we’ve got old revenue out there that we can bring back.

I don’t think there’s a magic wand or a secret. Are there some other things going well? Yeah. I mean there’s some very encouraging dialog, for an example in the US on labor agreements, very encouraging. Now I don’t know where it’s going to end but I think we’ll be better off that way. I think there’s some dialog going on in Canada.

So I think it’s more of, if you look at our metrics and see the trends that had been created I think you’ll see more of that. So I think you’ll see some similar combinations to the setback in Q1 and going positive in the next three quarters. I think once we get car cycles back in some type of rhythm or temp if you will that we’ll see some pickup in the merchandise side, the auto side. And at the same time we’ll get back to the trends that were tracking as far as the operating initiatives that Keith and his team have put in.

And so I think it’ll be a combination but this is not a model that reacts just to the market and changes every quarter. Look, we’ve got a model; we’ve got what we think are the values that make this thing tick and they’ve worked pretty well over the test of time, and we get a level playing field here and a little snow melt and we’ll get back on the same trends and track you saw for some period of time until the point – to Ken’s earlier question – to the point where I think we’ll be talking about it at the meeting in Q4, about what is the shift that we see out in the future in the next three-, four-, five-year plan if you will.

Allison Landry – Credit Suisse

Okay, thank you for that comprehensive answer. And I have a follow-up question for Jane: just given the news this weekend regarding the Obama administration pushing back the Keystone decision again has your outlook changed at all on your crude by rail growth trajectory particularly as we look out to 2015? Could there be some additional room or upside to your 2x to 3x growth target?

Jane O’Hagan

I’d say, Allison, that we’ve always built into our crude target, our guidance, around 140,000 to 210,000 carloads that we believed was aggressive. But as I’ve said many times you know, our forecast is not dependent on pipelines not going ahead or in terms of pipelines moving forward. We believe we have a unique proposition that provides optionality, provides a clear alternative to get oil to markets where customers want to move it. So I think we feel very, we feel our guidance is on track to that number.

As I said before our capacity build outs are moving as planned. We continue to make headway, but again, we believe the pipelines are complementary to what we want to do as well. So we’re focused on our unique space, creating value, and as Hunter said really focusing on getting the right combination of facilities and movements into our [book of business] and identifying where we can grow profitably.

Allison Landry – Credit Suisse

Okay, thank you so much.

Operator

Your next question comes from Thomas Kim with Goldman Sachs. Please go ahead.

Thomas Kim – Goldman Sachs

Thanks. I wanted to ask a couple questions, the first one on the pricing side: to what extent were the pricing gains in grain, industrial and forestry during the quarter from core versus mix? And then to what extent did FX impact the average RPUs?

Jane O’Hagan

Well I would say that each of the groups are different, but I would say when you look at our grain pricing clearly when you look at the corridors that we move grain pricing was very strong. We took advantage of our opportunities, went to where grain wanted to flow; and as I indicated last quarter we expected that our yields in grain would be strong.

Certainly as I indicated before on the crude side there was some impact from FX but largely a good degree of this book now originates from the [Baccan] which is in US denominated currencies. When we look overall at what we’re doing in terms of the pricing side, I’ve been very clear that pricing is a journey for us and it’s a combination of two things. Number one it’s achieving our renewal targets of 3% to 4% which we’ve delivered on in the quarter, above that range; and it’s also really on taking a look and developing what is the right book of business for this network.

And as Keith indicated certainly our work is not finished in this area. We continue to work on core pricing, improving that opportunity. But again, a lot of what we’re going to be doing in the future is not only assessing just that profitability but also working on the roading options that’ll create the best efficiency that we can to continue to grow the business.

Thomas Kim – Goldman Sachs

Okay. And just in terms of setting our expectations for Q2, the momentum of pricing growth that we saw last quarter, is that you think sustainable for Q2 and should we anticipate that sort of decelerating a little bit off of a higher base into the second half of the year?

Jane O’Hagan

Well I think that certainly on the grain side, we use seasonal pricing so we might see a little movement on grain pricing as we move forward in our regulated corridors. But I think overall we’re very pleased with the momentum we’ve had on the pricing side. You know, I’d reiterate our guidance for 3% to 4% on our renewals, and as I said, the work that we’ve been doing on the book of business to get that right combination of yield and movement, I think that you know, I would suggest that that would be in line.

Thomas Kim – Goldman Sachs

Okay, thanks Jane. Bart, can I squeeze in one question just with regards to equipment rents? I think that was one area that you may not have detailed. If I missed it I apologize but I think you provided pretty good color with regard to purchase, rents, and materials, and I was just wondering if you could just highlight or detail what helped contribute to the lower equipment rents in Q1?

Bart Demosky

Yeah, it’s mostly lower leased cars is the primary item along with some locomotive rental costs, and those are the two factors. We were favorable about 16%.

Thomas Kim – Goldman Sachs

Okay, these are not rental rates but the number of cars leased – is that right?

Bart Demosky

That’s right.

Thomas Kim – Goldman Sachs

Okay, alright. Thank you.

Operator

Your next question comes from Jeff Kauffman of Buckingham Research. Please go ahead.

Jeff Kauffman – Buckingham Research

Thank you very much and congratulations, everyone. One question for Keith, one question for Jane. Keith, in previous years when we’ve had a lot of snow in Canada, we’re thinking about getting past the snow but we tend to have flooding in places like Saskatchewan as that snow starts to melt in the spring. Can you talk about some of your contingency plans if that is to present itself this year and what you’re seeing right now?

Keith Creel

I’ll talk about what we’re seeing, and what we’re seeing is a slow melt and favorable conditions. So we do not anticipate short of some global warming that hasn’t obviously happened as of late any overwhelming of the waterways on our network that would have an adverse impact when it comes to flooding. Now the Mississippi’s always a wildcard but we don’t see anything again right now, on a positive standpoint, that leads us to believe that we’re going to have anything like we’ve had in the past.

Jeff Kauffman – Buckingham Research

Okay, thank you. And Jane, you talked a little bit about some of the stabilization in fertilizer pricing but can you talk a little bit about how some of the currency swings, not just the Canadian currency but in some of your key export markets are impacting competitiveness?

Jane O’Hagan

Well what we’re hearing from customers is that we have not had any signals that this is having an impact on their ability to market their products in those markets. A lot of the customers that we talk about or who are part of our book are customers who lead in those segments. I think that what we’re seeing specifically on the product side is that the demand fundamentals are such that the prices are where the buyers are wanting to get into the market basically because they’ve been out of the market.

As you’ll recall last year we had periods where we weren’t moving much product, but again, the real focus has been on that they’re basically high-quality, low-cost providers that do well in their segments. So I haven’t heard anything that would be an indication of foreign exchange being cited as a reason for any change in volume.

Jeff Kauffman – Buckingham Research

Okay, thank you and again, congratulations.

Operator

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

Benoit Poirier – Desjardins Securities

Yes, thanks for taking my question. My first one, I was wondering whether you could provide more detail about the opportunity to monetize real estate? I understand that the $2 billion amount is more a 2015, 2016 story but I was wondering about the potential for a portion of D&H and whether it should be realized this year?

E. Hunter Harrison

I think you’re right – I think that most of this book of opportunity with real estate will be in the out years, ’15, ’16. We’re working hard, the staff is, on the right model to best optimize these assets. I think we anticipate a closing on the DM&E this summer, probably late May, early June; and then there’s still some activity that we talked about originally strategically on the D&H but certainly you won’t see anything this year that impacts that. But I think in the out years when you’re talking ’15, really ’16 and ’17 you’ll see this really kick in and start to pop.

Benoit Poirier – Desjardins Securities

Okay. Thank you very much. And just related to free cash flow am I right to say that it was $70 million before dividend? And is the $1.0 billion to $1.1 billion target still achievable this year?

Bart Demosky

I think you’re right on the pre-dividend free cash flow for the quarter. And we don’t provide guidance on cash but you know, the general consensus in the market is about $1.0 billion to $1.1 billion of free cash before dividends and we certainly wouldn’t disagree with that.

Benoit Poirier – Desjardins Securities

Thank you very much, that’s it.

Operator

Your next question comes from Walter Spracklin with RBC. Please go ahead.

Walter Spracklin – RBC Capital Markets

Thanks very much, good morning, good afternoon everyone. I want to swing back to regulatory for a second but in a little bit of a different vein. Hunter, I know as you’ll have seen and as you’re well aware, bill C-30 has a sunset clause attached to it and so it goes away soon. What really is in my view the more concerning or potentially concerning aspect of this, call it a more hostile regulatory environment, is the review of the CTA.

I think you’re right. I mean I completely agree with you that a lot of the stuff that came in bill C-30 was very surprising, didn’t make much sense to me either, but I’m wondering if the politicians who have been listening to that as well believe that they could make different changes that reflects in the law by the grain customers. I guess my question is what could that be? Have you had your ear to the ground in terms of what new aspects they might be looking at if inter switching is not the solution? Is there other solutions they might come up with that we’re not looking at right now that might down the road impact either your efficiency drive or the overall ability to deliver solid service to customer?

E. Hunter Harrison

Well Walter, that’s a good question, it’s a difficult question to answer. I would say this: first of all, I think you should split the grain customers out in two sections. You’ve got one that’s the large grain companies and you’ve got another that’s the farmer, and in my view with my ear to the ground and talking to a lot of people that’s potentially a lot of the friction.

Look, for this industry – and I’m saying “industry,” this is not an announcement for CP but for the industry to deliver grain in record levels in these kinds of conditions bodes well for the future. Now, you know, the market tends to say “Well, we don’t want to hold grain, store grain, carry grain over,” well sometimes you get these adverse effects. I think that every, staying with politicians for a moment, I think that every editorial, op-ed, whatever that I’ve read commenting on their actions to date have been wrote critical. I haven’t seen a lot of people endorsing this, that this is the way to go.

I think that for an example there’s issues with revenue cap. Does the revenue cap make sense to me? Absolutely not. Who’s going to buy equipment in the future? You know, the grain fleet’s getting old in this country and the ownership is very diverse, and you don’t build railcars overnight. But how could a company go to its board of directors and say “I’d like to buy a lot of train cars but I can’t tell you anything about what the returns are going to be. I don’t know what the cap’s going to be; I don’t know what the IRR’s going to be. I know nothing about it.” They’re not going to be very successful.

So I think that there’s some shakeout going on as we speak. There’s people that are learning more about the system that have not paid attention to it. And have I been pleased with all the reactions? Absolutely not. Have I been pleased with the dialog I’ve had with some of the participants? No. In the final analysis I think that the right things will be done. I mean I have not been able to get audiences with some of the people that are key players for whatever reason, but they don’t want to talk. If you don’t want to talk it’s hard to have a dialog and decide what the right model is if people don’t want to talk.

But I think this too shall pass and that we’ll come back to our senses and get to moving grain and product for Canada like we should and let this political wave go away.

Walter Spracklin – RBC Capital Markets

Do you think there’s any compromise solution where they relax a little bit on the revenue cap and it allows you to invest a little bit more in grain capacity or something along that line at all? Can the revenue cap go or is that just something that’s off the table?

E. Hunter Harrison

Look, I’ve heard feedback from some key people in the government, both provincial and federal, that are not all that pleased with the revenue cap. If you look at the revenue cap and you really peel it back which I have recently, it makes very little sense. So is there some compromise out there? Yes. Are there some considerations probably given to the elections coming up? Yes. I think once some of the political rhetoric dies down, and I think all of us have gotten smarter through this exercise, that yeah, I think there’s probably some positive compromise.

And I think that people are going to say “What is this inter switching at 160 km?” or “What does that do for us in Canada?” All it does from an efficiency standpoint, the carrier that’s going to [line] all the business has to purchase the equipment. And as I told you, I don’t think my friends at Burlington Northern are going to be a participant for a while – they’ve got their hands full in the US. But in this system they would have to give us cars at the border for us to take someplace, wherever, to unload to then take back to them and create other interchanges and exchanges and it just doesn’t make any sense.

But you know, once again it’s sometimes people making decisions who don’t really understand the issues and problems. So I think it’ll all shake out – and my optimism is bubbling through here – in the long run.

Walter Spracklin – RBC Capital Markets

Okay, perfect. Switching gears over to Keith, first I want to say that the FRA accident statistics, boy, those were pretty impressive. I thought it was a typo the first time I looked at them so great job given the conditions. But related to that on the volume side we did notice a significant revision so to say to what we were looking for, what [potentials] we were looking for on the volume side after the winter impact occurred; and you provided some really good insights into Chicago and let’s call it some of the structural challenges that you have with regards to the Chicago area.

My question is as you get lower and lower in your operating ratio do you start to hit up against…. You move away from operating efficiencies and you start to hit up against some structural impediments that make it a little more difficult to address the operating ratio? And does that mean we might have to see some more capital invested not in locomotives but more in addressing some of the structural constraints that might be in CP’s network be it in Chicago or perhaps in the west, or anywhere on the network?

Keith Creel

I would say the most eminent, the only structural constraint that we have in the network given the level of business we face today is Chicago, and I don’t know what the answer is to Chicago. If we could buy the Harbor if it were up for sale, if we could buy the belt if it were up for sale then I would make a compelling case that we could create some capacity for ourselves and for others. But outside of that our capital spend I think is right-sized. I would expect it to be the same. We’ve got to be careful what we spend to optimize the network because I don’t want to ramp up on employees and ramp up on those type assets just to lay them off when we get done.

So we’ve got a very robust and thorough five-, six-year plan that we’ve put together since I’ve arrived here that I feel very comfortable addresses our ability to bring on incremental, sustainable, profitable growth and at the same time maintain the leverage we need to maintain to control costs and produce a positive operating ratio.

Walter Spracklin – RBC Capital Markets

I guess my question though is does structural cost become an impediment down the road as you get lower and lower?

Keith Creel

No. I mean I’m only going to spend money in the lanes that I’ve strategically got growth, and it’s going to be profitable growth to provide a return to maintain that operating ratio. So short of that I’d say the answer’s no.

Walter Spracklin – RBC Capital Markets

Okay, perfect. Thank you very much.

Operator

Your next question comes from Jason Seidl with Cowen and Company. Please go ahead.

Jason Seidl – Cowen and Company

Yes, asked and answered, thank you.

Operator

Your next question comes from Keith Schoonmaker with Morningstar. Please go ahead.

Keith Schoonmaker – Morningstar

Thank you. I’d like to turn to what seem to be a couple of positive metrics, namely average train weight increased 6% and weight has also improved. I guess at face value this seems a little surprising in light of the extreme cold Keith mentioned. Was this just a function of mix of commodities that move in longer trains or could you add a little color please?

Keith Creel

It’s a function of train miles that we’ve taken out, train consolidation, using BP power; leveraging and optimizing BP where we could to maintain train lengths versus last year. And listen, that was definitely, definitely diluted with the weather. We’ve already seen incremental train length improvements that are quite healthy just in the month of April; train link improvements that are quite healthy in the month of April and we’re maintaining a train mile reduction. So it’s a combination of all three. It’s really not a mix issue at all; it’s just our operating model taking hold and providing the leverage that it provides and the strength that it provides to do this business at lower incremental costs.

Keith Schoonmaker – Morningstar

Great, thanks. And a quick quantitative question: how many locomotives and cars were online at the end of the quarter, please?

Keith Creel

We’ll have to get back with you on that exact number. Nadeem will get back to you.

Keith Schoonmaker – Morningstar

Very well, thank you.

Operator

Your next question comes from Cherilyn Radbourne of PD Securities. Please go ahead.

Cherilyn Radbourne – PD Securities

Thanks very much, good afternoon. I wanted to ask a broader question because it seems to me that the rail industry as a whole has lost some broader goodwill and I think that’s with the general public, with customers, with regulators. And I think that’s due to [Lake McGintak] and also capacity issues in Q1 as a result of winter. So I just wonder if you think the industry is doing enough as a whole to reassure those stakeholders that A.), there isn’t an underlying capacity issue and B.) that it’s a safe industry.

E. Hunter Harrison

Let me make an attempt at that. Number one I think that one of the problems that we’ve talked about as an industry, this industry is made up of seven Class I’s. Some of them are doing some things strategically; others are doing other things. And I don’t think that the industry deserves to get painted with a broad brush – a railroad is not a railroad is not a railroad. You know, that’s one of the reasons that we have not necessarily participated in some of the industry initiatives.

You know, I think we’d like to think that we’re trying to do everything we can to have enough positive influence on the industry and customers and the public as far as understanding some of our issues. But they’re difficult to deal with. Now let’s take what we have going on in Canada as we speak. We’ve got a lot of pressure on one side to catch up and deliver grain. On the other side we’ve got the regulators talking about [life of a get] tax for example, and talking about and they’ve just lowered the speed of trains. That’s inconsistent.

That’s going to slow the network down and we have not had, and I’m being very cautious when I say this, we’ve not had any derailment related to speed. We’ve had no derailment with crude related to speed. [Lake McGintak] had no issue with speed. Speed was not an issue. So I think maybe that some of us individually should do a better job of educating the public and the politicians and the regulators on the true bottom line issues, the way to approach them, the way to deal with them rather than once again, to borrow your comment about a knee-jerk reaction.

Yeah, I think that to some degree are we getting a little bit of a black eye if you will? Yeah. Am I concerned about that? Yeah, we should do a better job of talking to people about what we’re providing and what we’re doing. It really kind of concerns me at times when people are talking about the grain delivery in Canada. Guess what? You go to Vancouver on the weekends there’s not one grain company out there that’s working through the weekend. Our employees are working 365, 24 hours a day, seven days a week and if we stop to take holidays off or the weekends, you would see major shutdowns, major gridlocks.

So we just haven’t done a very good job in that respect and we hope to address that better individually as a company in the future.

Cherilyn Radbourne – PD Securities

And then just very quickly could we get the EPS impact of the weaker Canadian dollar on the quarter?

Bart Demosky

On average it’s about $0.05 per $0.01 change, so annualized we get about $0.70 this quarter.

Cherilyn Radbourne – PD Securities

Okay thank you, that’s all from me.

Operator

Your next question comes from David Newman with Cormark Securities. Please go ahead.

David Newman – Cormark Securities

Just a couple quick ones, guys. Just in terms of the headcount reductions you’ve had that you’ve been trucking towards, has there been any change at all because of the weather? In other words are you going to keep some bodies on a little longer just to kind of get through the Chicago congestion? And then I think you had a big nut for the IT side that you were going to reduce at the end of the year. Where do you stand on the headcount reductions? What’s kind of the waterfall chart from here?

E. Hunter Harrison

Well this is kind of a work in progress and there’s plusses and minuses. The headcount right now is about 4980 plus as we stand. You’re right – we had planned this bubble with IT. I’m not sure if it’s going to be as big a bubble as we initially thought but we’re right on schedule in that regard. I mean clearly this organization had too many people. I mean think about, and let’s turn the page back – and if you go back to 2011 the instructions here were to hire enough people to handle business plus 25%.

Now that, I don’t understand that rationale. But we’re working our way through that and there’ll be some, you know, we’ve got some attrition taking place in certain places, and we’ve had some people who don’t like to work in snow and cold and windy conditions unless it’s outdoor sports. If they don’t want to do that then now’s the time to find out. So I think overall we’re in pretty good shape there along the plan.

David Newman – Cormark Securities

And the IT, Hunter, is that sort of late this year? Was that the plan?

E. Hunter Harrison

Yeah, the plan was, I think that there was a bubble of about 300 people year-end and that, as I’ve said there’s a lot of moving parts. We’ve had a little bit of some challenges with our SAP cutovers and so I’m not sure that bubble is going to be as big as we had initially planned. But if you’re looking from a headcount standpoint there’s other opportunities that we didn’t see when we publicized those numbers. So I think overall the guidance that we provided in that regard I feel very comfortable with.

David Newman – Cormark Securities

Okay, very good. And the last one from me, I know your network’s not naturally aligned to it but obviously a big opportunity in BC and Alberta in the LNG side in terms of moving construction materials, pipe, frack sand, things like that. Are you seeing any early business on that or what sort of potential opportunity could LNG be for CP Rail?

Jane O’Hagan

Well clearly one of the things that we’d like to do as the model evolves, and as you say as the facilities get identified, is syndicate the crude by rail model that we have to LNG. And those discussions are in very, very early stages. But with respect to construction materials, I have a part of my organization, Canadian Pacific Logistics, and basically what we do is we go out and look to work with companies to basically handle those construction modules.

The discussions are early but again, this is an area that given the fact that we’ve had experience in moving wind energy, turbines, blades, etc., we move a lot of dimensional materials today and it’d be an area of growth for us as well.

David Newman – Cormark Securities

Very good. Impressive results in a very tough quarter.

E. Hunter Harrison

Thank you.

Operator

Your next question comes from John Larkin with Stifel. Please go ahead.

John Larkin – Stifel Nicolaus

I had a question as to whether or not any portion of the $0.30 to $0.35 of weather-related impact in Q1 could be tied to costs or foregone revenue associated with being compliant with the regulators’ requirement to haul 500,000 tons of grain per week?

E. Hunter Harrison

No. John, as I said to the regulators, look, our interest is to haul as much grain as we can selfishly. That goes to the bottom line. It starts at the top and goes to the bottom, so I want to haul all the grain we can possibly haul. So effectively you know, there’s very little if anything that has been done by the “regulators” that has impacted our operating strategy.

Now I’ll give you one exception for an example, some of the challenges that we face. Thunder Bay has had problems with ice and getting ships in and so forth. So when you can’t get through Thunder Bay the alternative is to go to eastern Canada, to effectively for us the Montreal and Quebec City markets. So we had customers literally begging to go to the long east. Well, that was going to start to jeopardize because they’re only counting units; they don’t look at the length of haul.

And so we said to the regulators “We’ve got this quandary. The customers want to go long east but that will impact your model about the number of cars,” and the response was “The law is the law is the law,” which is a wonderful response. But we took a chance and we hauled stuff to satisfy the customers to the east and have tried to serve those eastern markets with Thunder Bay having its problems, but that’s some of what you get into.

You’ve got the customer begging for one thing, the regulator asking for you to do something else. But with that exception it’s been kind of a nonevent.

John Larkin – Stifel Nicolaus

Thanks for that, and maybe just one more question on the whole issue of Chicago. There’s this project underway, it’s been underway for a number of years involving all the different parties that have a foothold in Chicago called CREATE. And in listening to Keith earlier it sounds as if you may be believe that CREATE isn’t having as much positive impact and that what would really work to solve the problem would be to route traffic completely around Chicago – that traffic that doesn’t need to go into Chicago. Is that a fair assessment?

E. Hunter Harrison

Yeah, I think CREATE was broke when it started and it’s been broke ever since, and it’s created zero value in my view. You know, it’s hard enough to get two railroads to agree on something much less seven or eight, and it’s a bureaucratic machine that adds additional layers that provides nothing in return. So the issue with Chicago, when you really peel it back is to take traffic out of Chicago that shouldn’t be going there. We’re hauling stuff out of Western Canada that is a perfect fit to go down the east coast of the US but people want to drive it to Chicago.

And so I’ve talked… This is not some recent phenomenon with me. I’ve talked about Chicago, I’ve talked about it for years. It’s not going to get better. And CREATE, which I’m not proud to say we’re a member and tried to participate in, but with due respect to those 12 or 14 people in there in that room that are getting instructions from three or four different places, CREATE just creates more mud in my view. Keith might want to comment further.

Keith Creel

Hunter is talking specifically to the way we coordinate through Chicago, trying to get all the railroads to agree. In the best of times it’s a challenge, in the worst of times which we’ve just experienced it’s almost like pulling your hair out. So I would echo Hunter’s comments about the value add of that central coordination office. Now there have been some CREATE projects from a capacity standpoint that increase capacity, increase velocity on some of these belt railways, on flyovers.

Some of those things that have transpired mitigated some of the impact this winter, but in spite of that investment it’s a compelling case that the only long-term solution to help mitigate the impact of this kind of weather in Chicago is to get as much traffic out of Chicago as we possibly can. There’s only so much infrastructure you can add. People don’t want you developing their backyards, you’re landlocked in many locations.

So I wouldn’t say it’s run its course but it’s pretty close to fruition from a capacity addition standpoint from a CREATE standpoint. And I’ll echo Hunter’s comments on the coordination and control in that central planning office. It’s challenged at best.

John Larkin – Stifel Nicolaus

If 25% of the traffic hubs over Chicago, what percentage of that do you think is divertible to another routing?

Keith Creel

You know, I’m not qualified to answer that. I can tell you that there’s a percentage of the business… 40% of our traffic either originates, terminates or passes through Chicago. If I could get 10% of that out it’d make a compelling case but it’s a little bit premature for me to say yet. I haven’t been here long enough to completely understand our flows, but rest assured my objective is to get 100% of it out that I can.

John Larkin – Stifel Nicolaus

Thank you.

Operator

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

E. Hunter Harrison

Thanks, Mike. Thanks for joining us and we appreciate the support you’ve shown, and we’ll talk to you in July and make your plans for Analysts Day in Q4.

Operator

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

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